George Weston Limited v. The Queen

George Weston Limited v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2015-02-19
Neutral citation
2015 TCC 42
File numbers
2011-3489(IT)G
Judges and Taxing Officers
Lucie Lamarre
Subjects
Income Tax Act
Decision Content
Docket: 2011-3489(IT)G
BETWEEN:
George Weston Limited,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on August 18, 19, 20 and 21, 2014, at Toronto, Ontario.
Before: The Honourable Justice Lucie Lamarre
Appearances:
Counsel for the Appellant:
Salvatore Mirandola
Patrick Lindsay
Counsel for the Respondent:
Elizabeth Chasson
Alexandra Humphrey
JUDGMENT
The appeal from the reassessment made by the Minister of National Revenue (Minister) against the appellant for its 2003 taxation year under the Income Tax Act (ITA) is allowed and the reassessment is referred back to the Minister for reassessment on the basis that the proceeds received by the appellant in that year in respect of the termination of cross-currency basis swap contracts totaling CAD$316,932,896 are a capital gain, half of which (CAD$158,466,448) is a taxable capital gain pursuant to section 38 of the ITA. The appellant is awarded its costs.
Signed at Ottawa, Canada, this 19th day of February 2015.
“Lucie Lamarre”
Lamarre A.C.J.
Citation: 2015 TCC 42
Date: 20150219
Docket: 2011-3489(IT)G
BETWEEN:
George Weston Limited,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Lamarre A.C.J.
Introduction
[1] During its taxation year ended December 31, 2003, the appellant, George Weston Limited (GWL), received in respect of the termination of cross‑currency basis swap contracts (swaps) proceeds totalling CAD$316,932,896. In its income tax return for its 2003 taxation year, GWL treated that amount as being on account of capital and reported a taxable capital gain of CAD$158,466,448. The Minister of National Revenue (Minister) reassessed GWL on the basis that the CAD$316,932,896 was on income account and added to GWL’s income the full amount, hence the present appeal.
[2] GWL is a Canadian publicly traded corporation and the parent holding company of subsidiary corporations inside and outside Canada. A significant portion of the assets owned and businesses operated by the GWL corporate group is in the United States.
[3] In its Notice of Appeal, GWL stated that it had entered into the swaps in order to preserve its consolidated balance sheet equity and protect against Canadian dollar and United States dollar (USD) foreign exchange fluctuations that would create volatility in GWL’s consolidated balance sheet equity. In its submissions to the Court, GWL offered some specifics. GWL indicated that it carried on various existing and newly acquired bakery-related businesses in the United States, using US currency, through indirectly held subsidiaries (referred to as self-sustaining foreign operations or USD Operations) and that this was the reason GWL was affected by the Canadian dollar and USD exchange rate fluctuations. Those fluctuations affected GWL’s consolidated equity, which in turn affected the debt to equity ratio. Hence, they had an impact on the value of GWL’s direct capital investments in other corporations in the GWL corporate group, and on GWL’s very capital structure.
[4] In the end, GWL took the position that, because the Canadian dollar had appreciated relative to the USD between 2001 and 2003, the proceeds it received in 2003 upon terminating the swaps it entered into in 2001 were a capital gain.
[5] The respondent is of the view that the receipts from the closing out of a derivative such as the swaps will be treated as being on capital account for income tax purposes only if it can be shown that the derivative is linked to an underlying transaction that is the purchase or sale of a capital asset, the repayment of a debt denominated in a foreign currency or the investment of idle capital funds, in accordance with what is referred to in the case law as the “linkage principle”. In the Crown’s view, if the derivative is not linked to such a transaction, the profit or loss on the closing out of the derivative is considered either as resulting from speculation or, by default, as being part of the ordinary business of the taxpayer, and is therefore considered to have been received on income account. In the present case, the respondent submits that, as the swaps were not linked to any transaction or debt obligation of the appellant denominated in a foreign currency that it entered into on its own account, the amount received by the appellant when it closed out the swaps is considered to be part of the business of the appellant and therefore a profit from its business that is taxable as income.
Facts
[6] The parties have agreed on many of the relevant facts in a Partial Statement of Agreed Facts (Exhibit A-7), which is attached at the end of my reasons for judgment.
Appellant’s interpretation of the facts
[7] The appellant gave its own assessment of the key facts in its opening statement and in its written submissions. I will summarize them below.
[8] GWL is a large publicly traded Canadian holding company that, at all relevant times, held direct and indirect subsidiaries that carried on food processing or food distribution businesses in Canada and in the United States.
[9] Prior to 2001, GWL carried on a bakery business in the United States through a company called Weston Foods Inc. (WFI US) and its subsidiaries. WFI US was an indirect subsidiary of the Canadian company Weston Foods Inc. (WFI Can), which was in turn a direct subsidiary of GWL.
[10] In 2001, the GWL corporate group acquired another mainly United States‑based bakery business called Bestfoods Baking (Bestfoods) and its subsidiaries and related trademarks. This acquisition drastically increased the GWL corporate group’s net investments in USD Operations from approximately US$800 million to well in excess of US$2 billion.
[11] The Bestfoods acquisition was financed entirely by debt, through loans from Canadian banks to GWL (CAD$2.1 billion and US$400 million). As a result, in 2001, GWL’s debt to equity ratio rose well beyond its internal corporate policy of 1:1 or lower. GWL invested the borrowed funds in its subsidiaries, which then acquired Bestfoods for US$1.765 billion, as detailed in the Partial Agreed Statement of Facts.
[12] As a Canadian publicly traded company, GWL prepared consolidated financial statements in Canadian dollars, in accordance with generally accepted accounting principles (GAAP). In those statements, it combined the assets and liabilities of its controlled subsidiaries, including the USD Operations. When the value of its net investments in the USD Operations was translated into Canadian dollars, the fluctuations in the exchange rate affected the equity section of GWL’s consolidated balance sheet (generally reflected in the “cumulative foreign currency translation adjustment” account — hereinafter “currency translation account” or “CTA”) in the sense that when the Canadian dollar appreciated relative to the USD, GWL’s consolidated equity decreased, and when the Canadian dollar depreciated, GWL’s consolidated equity increased.
[13] Because the Canadian dollar was at historical lows in 2001, GWL was concerned that it would appreciate substantially relative to the USD, with the effect of eroding its consolidated equity and worsening its debt to equity ratio, which in turn could affect its credit rating and cost of capital.
[14] After the acquisition of Bestfoods in 2001, the investment in USD Operations exposed to currency risk increased from US$666 million (US$816 million investment in WFI as at December 31, 2000, less US$150 million in swaps entered into in 2000) to approximately US$2 billion.
[15] To circumvent that risk, GWL decided to hedge its increased USD currency risk. Following the closing of the Bestfoods transaction, GWL entered into a number of swaps with various financial institutions (the “counterparties”) for terms of mostly 10 to 15 years to hedge, or protect against, currency fluctuations affecting the reported value of the old and the newly acquired USD Operations (Exhibit A-7, par. 27, and Transcript, vol. 1, page 211).
[16] The USD notional value of the swaps closely approximated the total net investments in the USD Operations that were exposed to currency risk. According to Ms. Lisa Swartzman, who held the positions of assistant treasurer, treasurer and vice president-treasurer of GWL at various times during the years at issue, the swaps were entered into by GWL, as opposed to subsidiaries, because the counterparties wanted to deal with the parent corporation, and GWL had a higher credit rating than the subsidiaries, which reduced the cost of swaps (Transcript, vol. 1, page 216).
[17] The appellant submitted that the swaps were entered into solely as a hedge. They mitigated GWL’s exposure to exchange rate fluctuations because changes in the value of the swaps due to those fluctuations varied inversely with, and therefore offset, changes in the Canadian dollar translated value of the net investments in USD Operations due to the same exchange rate fluctuations. Indeed, once the swaps were in place, if the Canadian dollar appreciated, the increase in the value of the swaps would offset the decrease in the Canadian dollar translated value of GWL’s net USD investments in USD Operations on GWL’s consolidated balance sheet; conversely, if the Canadian dollar depreciated, the decrease in the value of the swaps would offset the increase in the Canadian dollar translated value of GWL’s net USD investments in USD Operations on GWL’s consolidated balance sheet.
[18] The appellant stated that GWL’s balance sheet equity was protected and, because GWL was the ultimate parent company of the USD Operations, the swaps protected the value of GWL’s investments in its own subsidiaries.
[19] In the consolidated financial statements, the “swaps [were] identified as a hedge against foreign currency exchange rate fluctuations on [GWL]’s [US] dollar denominated net investment in self-sustaining foreign operations with realized and unrealized foreign currency exchange rate adjustments on . . . swaps recorded in the cumulative foreign currency translation adjustment.” (Notes to the 2002 consolidated financial statements, Exhibit A-1, Tab 2, page 125). This was in conformity with an internal memorandum issued on April 10, 2001, in which GWL recognized that the Bestfoods purchase would directly expose GWL to increased risk, and in which GWL designated the swaps as a hedge, indicating that if sufficient swaps were entered into, the debt to equity ratio would be protected from exchange rate fluctuations (Exhibit A-9, Tab 1).
[20] As a matter of fact, GWL’s risk exposure was commented on by credit agencies. On February 20, 2001, Standard & Poor’s Global Credit Portal issued a report titled “[GWL] ‘A’ Ratings Placed on Credit Watch Negative; Re: Purchase of Unilever Asset”, indicating that the Bestfoods acquisition would be bank‑financed and that “[t]he net effect . . . [would] be detrimental to Weston’s capital structure in light of . . . much higher overall leverage” (Exhibit A-8).
[21] Under GWL’s internal guidelines, the debt to equity ratio was to be no worse than 1:1 (Transcript, vol. 1, page 80 and GWL Quarterly Reports, Exhibit A-3, Tab 12, page 1021, and Tab 14, page 1050). After the Bestfoods transaction, the ratio worsened to well beyond that desired ratio. This was a particular concern because any devaluation in the USD would cause further deterioration in the ratio, which could negatively affect the capital structure if the credit rating were to drop. This was so because when the USD depreciated, GWL’s indirect investment in USD Operations, expressed in Canadian dollars, decreased in value, and consequently GWL’s direct investment in subsidiaries, expressed in Canadian dollars, similarly decreased in value, with a loss in balance sheet equity for GWL (Transcript, vol. 1, pages 167-168).
[22] In 2002, certain of GWL’s indirect US subsidiaries sold some of the assets of the USD Operations for proceeds that were US$200 million higher than had been anticipated. As a result, GWL terminated approximately US$200 million of the swaps so that the total USD notional value of the swaps would not exceed what was needed to ensure that the USD Operations were fully hedged. Retaining swaps that exceeded what was needed to hedge the investment in USD Operations was contrary to GWL’s credit facilities and corporate policy (testimony of Lisa Swartzman, Transcript, vol. 1, pages 221-222).
[23] By 2003, the Canadian dollar had appreciated to what GWL thought was a multi-year high against the USD, and GWL determined that its currency risk was waning. GWL had refinanced or repaid its initial Bestfoods acquisition financing and this, along with other measures, was expected to cause its debt to equity ratio to fall. GWL needed funds to, among other things, repurchase certain of its shares from its majority shareholder (Transcript, vol. 1, pages 228-232 and 237‑238). Accordingly, GWL and its counterparties agreed to terminate the swaps. Because the Canadian dollar had appreciated between 2001 and 2003, the counterparties had to make net principal repayments to GWL, and these make up the amount at issue in this appeal.
Facts added by the respondent
[24] The respondent added the fact that, prior to closing the Bestfoods transaction and entering into additional swaps in 2001, the appellant held approximately US$150 million in swaps to offset part of the net assets of GWL’s bakery business having a value of approximately US$816 million.
[25] The respondent recognized that the appellant entered into swaps after the acquisition of Bestfoods to offset fluctuations in the currency translation account (CTA) in its consolidated balance sheet. She also acknowledged that a negative adjustment to the account would result in an increase in the debt to equity ratio and that a decrease in shareholders’ equity would negatively influence that ratio and put the appellant outside of its 1:1 guideline (Respondent’s Argument, par. 7).
[26] The respondent pointed, however, to measures taken by the appellant in 2002 and 2003 to decrease its liabilities through refinancing its short‑term debt, increasing retained earnings through profits of the operating subsidiaries, selling assets to pay down debts and raising capital on the public markets through preference share issuance. These activities positively affected the debt to equity ratio and resulted in the appellant achieving its guideline figure in that regard (Respondent’s Argument, par. 8).
[27] The respondent added that, commencing in the first quarter of 2003, the Canadian dollar appreciated against the USD and the rate of exchange was significantly higher in 2003 than it had been in October 2001 when the swaps were entered into by the appellant (Respondent’s Argument, par. 9).
[28] According to the respondent, in 2003, the appellant made a business decision to terminate the swaps and realized a profit of close to CAD$317 million, being the amount at issue in this appeal. The Bestfoods assets that were exposed to fluctuations in the CTA were not sold in 2003. It was only in January 2009 that GWL’s indirect subsidiary Dunedin Holdings S.a.r.l, a Luxembourg company, sold some of the Bestfoods assets (Transcript, vol. 1, page 152, and Exhibit A-3, Tab 9, page 959).
[29] The respondent pointed out that the variation in the CTA is a notional amount which is not included in the income statement of the parent company. Relying on her accounting expert, Professor Chlala, she stated that foreign exchange translation risk exists because of the requirement under GAAP to translate the value of the net assets of subsidiaries into Canadian dollars for consolidated reporting purposes. According to the respondent, foreign exchange “translation” risk has no impact on the cash flow or earnings of a company. It is not reflected in the legal entity financial statements, that is, the unconsolidated financial statements, of GWL. In contrast, foreign exchange “transaction” risk arises from a legal obligation denominated in a foreign currency and does have an impact on the cash flow or earnings of a company. That risk is reflected in both the unconsolidated and the consolidated financial statements (Professor Chlala’s expert report, Exhibit R-1, pages 21-24 and 30).
[30] Thus, the unconsolidated financial statements filed for Canadian income tax purposes reflect only the income earned and the assets and liabilities held directly by the appellant. Thus, the appellant’s list of investments in the unconsolidated financial statements does not include shares in the capital of Bestfoods, as the appellant did not acquire the shares of that company. The shares of Bestfoods were acquired by Weston Acquisition Inc (WAI). Only the investment in a direct subsidiary is reflected, at historic cost (a figure that is therefore not subject to any fluctuation) in Canadian dollars, in the legal entity financial statements.
Issues
[31] The appellant raised three questions to be addressed in order to determine whether the proceeds received from unwinding the swaps are to be characterized as capital or as business income.
- Were the swaps entered into as a hedge?
- If so, what was the character of the item that prompted the hedge and was that item capital in nature so that the proceeds derived from the swaps are to be treated as being on capital account?
- Regardless of whether the swaps constituted a hedge, did the swaps relate to GWL’s capital structure such that the proceeds are on capital account or, instead, were the swaps part of GWL’s income earning process such that the proceeds are on income account?
[32] The respondent advanced three arguments in support of the determination that the profit received in the amount of CAD$316,932,869 is on income account:
- The swaps were not linked to an underlying capital transaction denominated in a foreign currency or a debt obligation denominated in a foreign currency that exposed the appellant to foreign currency risk. Accordingly, the profit received on the termination of the swaps is considered to be part of the business income of the appellant;
- In deciding to close out the swaps when they were “in the money” in the hands of the appellant (meaning that the Canadian dollar had strengthened at the time of termination of the swaps and the appellant received money from the counterparties), the appellant was speculating in currency or meeting a business need for cash. Thus, the profit received is income from an adventure in the nature of trade; and
- Swaps are not capital property and the payment received by the appellant on their termination is not proceeds of disposition of a capital property.
Appellant’s arguments
i) The swaps were entered into as a hedge
[33] The appellant stated that there is no reasonable basis for the respondent to deny that the swaps constituted a hedge. To so conclude, it referred to the following points from the evidence:
- The respondent agreed in her examination for discovery that GWL did not enter into the swaps for speculative purposes (Exhibit A-13, Tab 1, Undertaking Response 13).
- GWL had a formal derivative policy and GWL’s credit facilities prohibited it from speculating in derivatives (Transcript, vol. 1, pages 51-54, and Credit Agreement with various lenders, Exhibit A‑4, Tab 22, page 1230, article 6.6 Hedging Agreements).
- GWL’s contemporaneous annual reports publicly confirmed that GWL used swaps as a hedge and not for speculative purposes (Exhibit A-1, Tab 1, page 51, Tab 2, page 125 and Tab 3, pages 223-4).
- The relevant corporate records clearly and consistently indicated that GWL intended to and did enter into the swaps to hedge the risk associated with the investment in USD Operations, which risk was reflected in the CTA (Exhibit A-9, Tabs 1-8).
- The decision to enter into the swaps was made in a careful and systematic manner, having regard to the anticipated volatility in, and erosion of, the CTA as a result of the currency risk associated with the investment in USD Operations and the effect of this currency risk on GWL’s debt to equity ratio (Exhibit A-9, Tabs 3 and 6 and testimony of Richard Mavrinac, Senior Vice-president, Finance of GWL in 2001, and CFO of GWL in 2002-2003, and of Lisa Swartzman, Transcript, vol. 1, pages 59-61 and 167-179).
- Ms. Joyce Frost, who provided expert evidence on the commercial meaning of a hedge, explained that the swaps were inappropriate for use as a speculative trading instrument (Exhibit A-11, Riverside Report, page 24, par. 73 d.).
- Ms. Frost opined that, from a commercial perspective, the swaps “were hedges that mitigated the foreign exchange risk imbedded in GWL’s USD sensitive net assets” (Exhibit A-11, Riverside Report, page 9, par. 31).
- The respondent has agreed that GWL was not in the business of entering into and terminating swaps (Exhibit A-13, Tab 1, Undertaking Response 3).
- The notional amount of the swaps was determined on the basis of the amount needed to correspond with the total value of the investment in USD Operations that was subject to currency risk. GWL took steps to ensure that it would not own swaps in excess of what was needed to hedge that value (Partial Statement of Agreed Facts, par. 20-21 and 33, and testimony of Ms. Swartzman, Transcript, vol. 1, pages 221-222).
- The reason the swaps were terminated was the conclusion that the currency risk associated with the investment in USD Operations was waning and that GWL’s debt to equity ratio would return to desired levels independently of the swaps (testimony of Mr. Mavrinac and Ms. Swartzman, Transcript, vol. 1, pages 80-81 and 228-232).
- From an accounting perspective, the swaps were treated and properly recorded as a hedge in GWL’s consolidated financial statements in accordance with GAAP (Expert Accounting Report prepared by Professor Daniel B. Thornton, Exhibit A-12, page 7, par. 14).
[34] The appellant then argued that it entered into the swaps to hedge the foreign exchange risk with respect to its net investment in foreign operations, which risk is primarily borne by it, the parent company. It did so because volatility in equity due to changes in foreign exchange rates is not favourably regarded by equity investors or credit-rating agencies. In addition, declines in equity caused by foreign exchange losses could result in a violation of a loan covenant or encourage investors to sell the stock (testimony of Ms. Frost and Exhibit A-11, Riverside Report, pages 10 and 13, par. 34, 35 and 40).
[35] The appellant added that, had GWL not entered into the swaps to hedge the increased risk, a devaluation of the USD would have lowered the equity figure on its consolidated balance sheet. The attendant results would have been an erosion of GWL’s debt to equity ratio, a reduction in its credit rating, a deterioration of its capital structure and a negative impact on GWL’s share price. The experts called by the appellant concluded that the underlying USD net investments were highly and directly sensitive to GWL’s currency risk (Riverside Report (Ms. Frost), Exhibit A‑11, pages 10, 13, 17-18, par. 34, 53 and 54, and Thornton Report, Exhibit A-12, par. 73-75).
[36] Absent a definition of a hedge in the Income Tax Act (ITA) (except in section 20.3 in the context of weak currency loans), the appellant analyzed the meaning of hedge in its commercial and accounting sense as well as the meaning it has been given in the case law that I will review in my analysis. It concluded that GWL genuinely had investments exposed to currency risk and that it hedged that risk by entering into the swaps and explicitly designating those swaps, in its consolidated financial statements, as hedges of GWL’s investment in self‑sustaining foreign operations.
ii) The item that prompted the hedge was capital in nature and therefore the proceeds from unwinding the hedge were to be treated as being on capital account
[37] The appellant, unlike the respondent, is of the view that the underlying item to which the derivative (the swaps) relates does not necessarily need to be a separate transaction when it is the derivative itself, as is the case here, that directly gives rise to the gain or loss. In this case, the appellant argued that the evidence shows a strong link between the swaps and the investment in the USD Operations. This is confirmed by the GWL 2001 and 2003 presentation materials (Exhibit A-9, Tabs 3 and 6), which show no intention to relate the swaps to the business operations or to make a profit in the financial markets.
[38] Further, the swaps were entered into contemporaneously with the period in which the Bestfoods purchase occurred, which purchase greatly increased the investment in USD Operations and, accordingly, GWL’s currency risk. Most of the swaps were part of GWL’s planning for the Bestfoods acquisition and were implemented in connection with, and as a result of, that important acquisition. The amount of the swaps entered into correlated directly with the investment in USD Operations through the matching, as closely as possible, of the notional amount of the swaps with the amount of GWL’s net investment in self-sustaining US operations (Thornton Report, Exhibit A-12, par. 19). There was a sufficient correlation between the swaps and the investment that was subject to currency risk. Further, the fact that the swaps were terminated in 2003 does not retroactively change GWL’s intention when entering into the swaps in 2001. Indeed, GWL only intended to hedge the USD Operations while the associated currency risk exceeded acceptable levels.
[39] Finally, the appellant stated that the investment in USD Operations, the item that prompted the hedge, was capital in nature and, accordingly, the proceeds from unwinding the swaps are to be treated as being on capital account. According to the appellant, this is true whether one takes the approach that it is a direct investment for GWL or whether one views it as an indirect investment.
[40] On the one hand, one may consider the value of GWL’s direct investment in companies in the GWL corporate group (that directly or indirectly own the USD Operations), which necessarily fluctuates according to the value of the investment in USD Operations. From this perspective, it is the value of those USD Operations that is used to determine the amount of the hedge required to protect the value of GWL’s direct capital investment.
[41] On the other hand, there is the approach under which the USD Operations constitute a capital investment made by indirect GWL subsidiaries, all of which in the end are wholly owned by GWL at the top of the corporate chain. Changes in the Canadian dollar value of those indirect subsidiaries have a direct impact on GWL’s capital structure (debt to equity ratio). From this perspective, GWL is hedging an indirect capital investment that has a direct impact on GWL’s capital structure.
[42] The appellant submitted that, whatever approach is taken, GWL, as a holding company, held subsidiaries as a capital investment. Mr. Mavrinac testified that GWL acquired Bestfoods with the intention of holding it long-term (with the exception of one component of the business that was intended to be sold), which was in line with GWL’s corporate history of holding Loblaws and its US baking assets for the long term (Transcript, vol. 1, page 61). GWL financed its subsidiaries through loans or equity investments which were in turn used to acquire control of the USD Operations. Those outlays are of a capital nature (Neonex International Ltd. v. The Queen, [1978] C.T.C. 485; 78 DTC 6339; Stewart & Morrison Ltd. v. M.N.R., [1974] S.C.R. 477). GWL did not speculate and it was not in the business of acquiring and terminating swaps.
[43] The appellant also questioned the Canada Revenue Agency (CRA) approach according to which the linkage test demands the existence of a sale or proposed sale of an underlying item owned directly by the taxpayer. This restrictive view precludes the possibility of hedging an investment that is either (i) not intended to be sold or (ii) owned indirectly through subsidiaries.
[44] The appellant submitted that this restrictive view has no legal basis and makes no commercial sense. Among the case law relied upon by the respondent, the appellant referred to Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622. In the appellant’s view, the Supreme Court of Canada (SCC) made therein no statement consistent with the CRA’s position. On the contrary, that case, according to the appellant, stands for the proposition that hedge proceeds will be on capital account if the item being hedged (whether it is an asset, a liability or a transaction) is a capital item. Further, in Neonex, supra, the Federal Court of Appeal attributed the capital character of the subsidiary’s capital asset to the parent company’s investment in its subsidiary. In that case, it was held that a loan made solely for the purpose of replenishing the working capital of a subsidiary which had acquired control of another company was a capital transaction.
iii) Whether or not the swaps constitute a hedge, the proceeds from their termination were part of GWL’s capital structure and are on capital account
[45] The appellant examined the factors considered in the case law when the courts are seeking to characterize an “unusual” amount either as being part of the capital structure or as being part of the income-earning process. It concluded that the proceeds from the swaps were received as part of GWL’s capital structure and therefore were on capital account.
[46] The appellant submitted that the swap proceeds were analogous to awards of damages and to contract termination payments. It argued that such proceeds are on capital account where the underlying item is more closely connected to the capital structure than to the income-earning process (Tsiaprailis v. Canada, 2005 SCC 8, [2005] 1 S.C.R. 113 at par. 7 and 15 and Imperial Tobacco Canada Ltd. v. The Queen, 2011 FCA 308, 2012 DTC 5003 at par. 29).
[47] More generally, the appellant outlined the capital gain versus income test outside of the derivative context. The Supreme Court of Canada has framed the test as follows: “were [the] sums expended on the structure within which the profits were to be earned or were they part of the money-earning process?” (Johns-Manville Canada v. The Queen, [1985] 2 S.C.R. 46 at 57 (Lexum at par. 14), quoting from the Privy Council decision in B.P. Australia Ltd v. Comr. of Taxation of the Commonwealth of Australia, [1966] A.C. 224). Additionally, the SCC in Ikea Ltd. v. Canada, [1998] 1 S.C.R. 196, provided further guidance on the distinction between income and capital gains, in the context of a tenant inducement payment. The Court found that the payment was “clearly received as part of ordinary business operations and was, in fact, inextricably linked to such operations” (par. 24, 25, 30 and 33).
[48] The appellant stated that the courts often consider the following factors to distinguish income from capital: (1) intention, (2) benefit, (3) duration, (4) recurrence, and (5) financial reporting (Vern Krishna, The Fundamentals of Canadian Income Tax (Taxnet Pro, 2014), ch. 7.I.D, and see Interpretation Bulletin IT-479R, “Transactions in Securities” (February 1984)). A review of the case law under each heading was presented, which I will not summarize here.
[49] The appellant submitted that the common law often looks to an underlying item when seeking to characterize a receipt as income or capital for tax purposes. Under this test, the appellant argued, the same conclusion as above is reached; the swap proceeds were received in connection with GWL’s capital structure and were therefore on capital account.
The respondent’s arguments
[50] The respondent submitted that the character of hedging gains or losses is determined by reference to the underlying transaction to which the hedge relates. If the hedge cannot be linked to an underlying transaction that is on capital account, it must be considered as being on income account.
[51] The respondent acknowledged that as a result of the requirement to prepare consolidated financial statements, the translation of the financial statements of GWL’s subsidiaries from their domestic currency into Canadian dollars created a translation risk that was recorded in the CTA, which had a direct impact on the consolidated shareholders’ equity. However, she is of the view that the decision to enter into the swaps was a management decision flowing from concerns that a negative fluctuation in the CTA could have a material impact on the debt to equity ratio that could not be absorbed by the balance sheet alone. As a consequence of the designation of the swaps as hedges under GAAP hedge accounting rules, the impact that foreign exchange fluctuations had on the swaps was the opposite of the impact foreign exchange fluctuations had on the translation of the net assets. The swaps thus stabilized the CTA balance while GWL went about implementing other methods to bring its debt to equity ratio back to its 1:1 internal guideline. During that transition period, they ensured creditworthiness, which had an impact on the cost of borrowing, and all of these decisions were part of the ordinary business of managing a public company.
[52] In the respondent’s view, the fact that the appellant used swaps to hedge the translation account and applied hedge accounting in its consolidated financial statements does not assist in the determination of whether the swaps were a hedge for tax purposes. Hedge accounting is a choice that taxpayers make in their financial statements. For tax purposes, she submitted, whether the swaps were a hedge or not depends on whether there is interconnection or linkage with an underlying transaction undertaken by the appellant on its own account.
[53] In this case, while the appellant funded the acquisition with a borrowing on its own account, the swaps were not linked to this borrowing and the borrowing did not give rise to any foreign exchange exposure. The appellant made a series of loans and equity investments denominated in Canadian dollars to four of its subsidiaries.
[54] For income tax purposes, submitted the respondent, it is not sufficient to hedge the net investment in foreign subsidiaries through a hedge of the CTA without there being an intention to sell that investment, as there is no offsetting position against which any of the gains or losses arising from the contract could be matched. The respondent added that the appellant cannot, for tax purposes, link its derivative to the risk of another taxpayer. She concluded that here there is no hedge for income tax purposes.
[55] Further, she argued that the swaps were not linked to the acquisition of Bestfoods. The value of the swaps exceeded the value of the Bestfoods transaction but matched the combined value of the Bestfoods transaction and the pre-existing US bakery business. Hence, the appellant could not, for tax purposes, link the swaps with any foreign currency transaction or a debt obligation in a foreign currency.
[56] The respondent, referring to Salada Foods Ltd. v. The Queen, 74 DTC 6171 (FCTD) and Saskferco Products ULC. v. The Queen, 2008 FCA 297, 386 N.R. 276, stated that the courts have rejected the appellant’s argument. The hedging of net investments from an accounting perspective, that is, the hedging of translation exposure, is simply not sufficiently linked to the shares or the assets of a subsidiary for it to be possible to obtain capital account treatment. Such translation hedging is geared toward the net investment of the parent in a subsidiary on a book basis (including undistributed earnings) and not toward transaction exposure (Shawn D. Porter and Kenneth J.A. Vallillee, “Tax and Accounting Aspects of Treasury Operations”, Report of Proceedings of the Fifty‑Second Tax Conference, 2000 Conference Report (Toronto: Canadian Tax Foundation, 2001), 20:1-51 at 20:26).
[57] The respondent’s position is that, while it is possible for a taxpayer to establish a linkage between a currency-hedging contract and the net investment in a foreign subsidiary, a linkage for tax purposes would only be made out if the taxpayer had intended to sell the subsidiary, the subsidiary was directly held and it was likely that the sale would occur. Here, the swaps were not linked to any underlying capital transaction that exposed the appellant to foreign exchange risk.
[58] Further, the appellant did not have a foreign exchange risk from any of its own debt obligations as the CAD$2.1 billion loan was denominated and repayable in Canadian dollars.
[59] The swaps were never intended to be in place for a long time, but were only temporary in that the appellant took other measures to bring its debt to equity ratio back to 1:1. Thus, the swaps did not provide long-term benefits.
[60] Moreover, according to the respondent, once the board of directors decided to terminate the swaps and use the cash for another purpose, there was a change of intention from hedging the CTA to speculation. Having predicted that the Canadian dollar would not strengthen and that the balance sheet could absorb any fluctuation in the CTA, the appellant determined that it was an opportune time to crystallize its position and it closed out the swaps at a time when there was a business need for cash. Accordingly, the profit received was income from an adventure in the nature of trade.
Analysis
Preliminary issue
Admissibility of the appellant’s expert evidence, presented by Ms. Joyce Frost, on the use of derivatives to hedge commercial and financial risk
[61] The respondent objected to Ms. Frost’s testimony on the basis that it was highly prejudicial (in that her opinion was based on her anecdotal experience from working in risk management for 25 years), was not relevant to the issue to be decided, was not necessary to assist the trier of fact in analyzing evidence that is technical in nature and was subject to exclusionary rules (R. v. Mohan, [1994] 2 S.C.R. 9 at page 20; R. v. Sekhon, [2014] 1 S.C.R. 272).
[62] I overruled that objection. I did not agree that Ms. Frost’s opinion was anecdotal. Her opinion based on 25 years’ work experience in risk management cannot be compared to a police officer testifying as to the mens rea of a particular defendant in a criminal matter as was the case in Sekhon, referred to by the respondent. With respect to relevance and necessity, this is a case in which I find it particularly useful to have the insight of an expert in the risk management field as it is directly linked to one of the issues between the parties: i.e., whether or not the swaps qualify as a hedge. Hedge is not defined in the ITA in the context of a situation such as that existing in this particular case; it is therefore appropriate to consider, among other things, the commercial context of hedging, keeping in mind that well-accepted principles of commercial trading are acceptable as guidance in this regard (Symes v. Canada, [1993] 4 S.C.R. 695, par. 42-43). I also note that expert testimony on industry practice and on accounting principles related thereto was accepted as being relevant in Echo Bay Mines Ltd. v. Canada, 1992 CarswellNat 323, at par. 15-17, [1992] 3 F.C. 707 at pages 713-14, where the court had to decide, among others things, whether forward sales contracts for silver were a hedge designed to reduce the risk of wide price fluctuations.
[63] Further, I do not find that Ms. Frost’s testimony sought to usurp my role as a trier of fact as I will rely on her expertise only to better understand the hedge financing world, which in itself is not necessarily an area of common knowledge. Finally, I do not find that Ms. Fro