ONTARIO

SUPERIOR COURT OF JUSTICE

COURT FILE NO.: CV-10-398065

DATE: 20130626

BETWEEN:

Inter-Leasing, Inc.

Appellant

– and –

The Minister of Revenue

Respondent

Al Meghji, Caroline D’Elia, Adam Hirsh, Monica Biringer, for the Appellant

Anita C. Veiga, Jonathan Burshtein, Ryan Mak, for the Respondent

HEARD: May 6, 7, 8, 14 and 15, 2013

aston j.

Background

[1] Inter-Leasing appeals tax assessments of the Ontario Minister of Revenue (the “Minister”) dated March 17, 2008 for Inter-Leasing’s 2001-2004 taxation years. Under s. 85(1) of the Ontario Corporations Tax Act, R.S.O. 1990, c. C.40 (the “OCTA” or the “Act”) the appeal is heard as a trial de novo.

[2] The assessments relate to Inter-Leasing’s participation in refinancing transactions undertaken by certain related companies (the “Precision Group”), whose parent is Precision Drilling Corporation. As a result of a series of inter-corporate transactions Inter-Leasing received interest payments which are the focal point of the issue in this case.

[3] For the purposes of corporate income tax, the Minister included $271,756,874 in Inter-Leasing’s income for the taxation years. The Ontario tax thereon would exceed $36 million. Interest to the date of the assessments would add almost $19 million more to the amount the Minister claims is due. The exact amounts are not in dispute. Nor are the other material facts, except those to be drawn inferentially. The issue is whether the interest income is taxable by Ontario.

[4] Precision Drilling Corporation (“Precision”) is a large scale supplier to the oil and gas industry. During the relevant taxation years its shares were publicly traded on both the Toronto Stock Exchange and the New York Stock Exchange. It had a number of directly and indirectly owned subsidiaries. Two of those were Montero Oilfield Services Limited (“Montero”) and Computalog Ltd. (“Computalog”). Precision, Montero and Computalog were all resident in Canada for purposes of the federal Income Tax Act (the “ITA”) but none of them had a permanent establishment in Ontario for the purposes of either the OCTA or the ITA.

[5] Inter-Leasing had been incorporated under the International Business Companies Act of the British Virgin Islands in 1991. Immediately preceding the material times in this case it was indirectly a subsidiary of Computalog.

[6] In the spring of 2000, Deloitte and Touche presented a proposal to Precision for the restructuring of certain inter-corporate debts in a manner aimed at reducing the after-tax cost of capital. The actual refinancing transactions – the transactions at the heart of this case – took place on June 13th to 15th, 2000 and on April 1, 2001.

[7] The refinancing transactions began on June 13, 2000. Russell McKay, an Ontario resident and former partner at Deloitte and Touche, became the sole director of Inter-Leasing. A new company 31795 Yukon Inc. (“Yukon”) was incorporated on that date.

[8] As of June 14, 2000 the following non-interest bearing inter-company debts existed within the Precision Group:

(a) Precision owed Precision Drilling Limited Partnership (“PDLP”) an Alberta limited partnership, $372 million;

(b) Montero owed Precision $92 million;

(c) Computalog owed Precision $55 million.

[9] On that same date Inter-Leasing amended its Memorandum of Association to state:

the company is prohibited from carrying on business (except in the capacity as a limited partner) in Canada and its sole purpose will be to hold investments, including deposits, bonds, shares, and units in mutual funds, trusts and limited partnerships, and to earn income from property” (the “Amended Memorandum of Association”).

[10] On June 14, 2000 Precision acquired all the shares of Inter-Leasing for $1. It also purchased units in a limited partnership (“McMaster LP”) for $25,079 then contributed those units to Inter-Leasing for additional common shares of Inter-Leasing.

[11] The next day, June 15, the $372 million non interest bearing debt owing by Precision to PDLP, the $92 million non interest bearing debt of Montero to Precision and the $55 million non interest bearing debt of Computalog to Precision were all refinanced by (new) interest bearing promissory notes. In a series of related exchanges Precision, Montero and Computalog ended up owing those respective amounts to Yukon and Yukon became indebted to Inter-Leasing for the same sums, that debt in the form of three separate “deeds of specialty debt”.

[12] By April 1, 2001 Computalog had become indebted to Precision for an additional $135 million. This debt was refinanced in similar fashion – Computalog became indebted to Yukon and Yukon became indebted to Inter-Leasing for that $135 million, again in the form of a “deed of specialty debt”.

[13] The four deeds of specialty debt were physically transferred to the British Virgin Islands some months afterwards and then stored there continuously.

[14] Each of Precision, Montero and Computalog deducted interest payable on the refinanced debts in computing their federal and provincial income tax. Inter-Leasing included the corresponding interest it received as income for federal tax purposes but not for Ontario tax purposes. Inter-Leasing’s net after-tax income was then channeled back to Precision by a combination of tax-free inter-corporate dividends or as interest free loans.

[15] Inter-Leasing does not dispute that the Precision Group (of which it is a part) implemented these refinancing transactions motivated by tax savings – to lower the after tax cost of its capital. The very title of the Deloitte Touche proposal dated February 2, 2000 is “Provincial Tax Elimination Tax Plan Prepared for Precision Drilling Corporation”. The essence of Inter-Leasing’s position is that the Precision Group saved tax legitimately by taking advantage of Ontario’s deliberate choice in defining a corporate tax base different from the federal tax base and those of other provinces. The 2005 amendments to the OCTA eliminated that difference, so the issues in this case only rise for the taxation years 2001 – 2004.

[16] During those tax years other provinces had become “agreeing provinces” – having entered into agreements with the federal government for the collection of corporate taxes on the condition they use the same tax base as the federal government, by reference to the “residence” of the corporation. Ontario on the other hand defined its corporate tax base on the basis of a company’s place of incorporation.

[17] At the relevant time, subsection 2(2) OCTA read as follows:

Every corporation that is incorporated under the laws of a jurisdiction outside Canada, and that … had a permanent establishment in Ontario within the meaning of s. 4 … shall … pay to Her Majesty for the uses of Ontario the taxes imposed by this Act...”

[18] Inter-Leasing does not dispute that it is a “2(2) Corporation”. Other provisions of the Act determine what income of any corporation is subject to tax. Under s. 2(1) income tax is levied on all world-wide income for corporations incorporated in Canada. However, for a “2(2) Corporation” it is necessary to refer to sections 6(2), 8 and 37(1) of the OCTA and section 115 of the federal Income Tax Act to understand what income is taxable and what is not. Corporations incorporated outside Canada are subject to Ontario income tax only on specifically enumerated sources of income. In this case Inter-Leasing’s interest income is only taxable as income under the OCTA if it is “income from a business carried on in Canada”.

[19] The first issue to be decided on this appeal is whether the interest is income from a business carried on in Canada, or not. If, as Inter-Leasing contends, it is not “income from a business”, but only “income from property”, the next issue to address will be the Minister’s alternative position that the interest income is taxable by virtue of the General Anti Avoidance Rule (“GAAR”) provision in s. 5 of the OCTA. If it is not, the third issue to address will be whether the interest income is nevertheless subject to corporate minimum tax under the OCTA, either because it is income “from property situate in Canada” or because the application of the GAAR provision would treat it as if it were.

Is the Interest Income “income from a business carried on in Canada” within the meaning of s. 115 of the Income Tax Act?

(i) Positions of the Parties

[20] Inter-Leasing submits that a taxpayer who merely owns four debt instruments and passively earns interest income from those instruments is not carrying on a business in relation to that interest. The magnitude of the debts or interest earned is irrelevant. Extensive business-like intervention or activity is required to convert property income into business income. Inter-Leasing contends that the interest income it earned was quintessentially income from property.

[21] The Minister submits that to decide this question it is necessary to take a broader look at Inter-Leasing’s activities, and even its raison d’être, to ascertain:

(i) whether it carried on a business in Canada; and

(ii) if so, whether the interest income was an integral part of that business or not.

[22] I agree that this is the proper way to frame the issue.

[23] In 2005, Ontario amended the OCTA so that its corporate tax base became the corporation’s residence as opposed to its place of incorporation. Inter-Leasing submits that Ontario considered applying the amendment to s. 2(2) retroactively but made a policy decision not to do so. If it had made the 2005 amendment retroactive to 2001 the interest income at issue here would have been captured and subject to corporate income tax. Inter-Leasing submits that in this case, the Minister is seeking to achieve indirectly through the GAAR provision of the OCTA what it chose not to do directly, by making the 2005 amendment retroactive. I do not accept that submission. The evidence does not establish a “policy decision” but even if it did it would be irrelevant to the Court’s task of interpreting the pre-2005 legislation. This is a case of statutory interpretation in which the object is to determine the purpose and intent of the legislation, not the subsequent policy of the government of the day.

[24] However, I do agree with the submission of counsel for Inter-Leasing that any GAAR analysis can only be conducted after there has been a determination that the transactions at issue complied with the relevant statutory provisions. In the present context, the GAAR only becomes relevant if a determination is first made that the interest income is not income from a business carried on in Canada.

(ii) Analysis

[25] Returning to the facts, Inter-Leasing does not dispute that it is a resident of Canada for the purposes of the ITA and that it had a “permanent establishment” in Ontario. Russell McKay, an Ontario resident, was at all material times the sole director of Inter-Leasing. Inter-Leasing was, without a doubt, carrying on some business activity in Canada. The issue is whether the interest income is part of that business. Although it also invested in a limited partnership in Ontario, that was also a relatively passive investment.

[26] The distinction between income from a business and income from property is a fundamental income tax issue that has been the subject of many cases. The question cannot be narrowly framed as whether the interest income is “actively generated”. The question here is whether the interest income earned is an integral part of “a business carried on in Canada”. In the case of a corporate taxpayer, there is a rebuttable presumption that any income received from the pursuit of an object set out in the corporation’s constating documents is income from a business. Even “holding companies” can be said to carry on a business. Whether the income is “actively” or “passively” generated is a very important factor to consider but not always determinative of the answer to the question.

[27] In general, interest income that is received on investments is considered to constitute income from property rather than income from a business. See Langhammer v. The Queen [2000] T.C.J. No. 828 at para. 33. There are two exceptions to this general principle: (i) where investments constitute an integral part of the taxpayer’s business activities; or (ii) where the activities associated with the generation of interest income are in and of themselves a business.

[28] Investments have been held to constitute an integral part of a business if the investments are “employed and risked” in the business. See for example Ensite v. The Queen, 1986 41 (SCC), [1986] 2 S.C.R. 509, paras. 14 and 15. How, if at all, were the debt instruments “employed and risked” in whatever activity Inter-Leasing was engaged in? There was little or no risk, but “how the debts it held were employed” engages a broad analysis of what Inter-Leasing was doing. This overlaps with the second exception identified in Langhammer: whether the activities associated with the generation of the interest income are in and of themselves a business.

[29] Are the refinancing activities associated with the generation of the interest a business on their own? In my view the answer is inextricably connected to an understanding of Inter-Leasing’s core purpose, while remaining mindful that the transactions are legitimate on their face and must not be coloured by words like “artificial” that are only appropriate to a GAAR analysis.

[30] In Canadian Marconi Company v. The Queen, 1986 42 (SCC), 86 D.T.C. 6526 (S.C.C.) the court engaged in a consideration of when interest or investment income peripheral to the core business of the taxpayer was nevertheless income from a business. In that case, Canadian Marconi was required by government regulation to sell its broadcasting division. It received $18 million in cash from the sale which it invested in short term securities pending the purchase of a suitable replacement business. Canadian Marconi earned interest income from those securities. The court found that the taxpayer had become involved in an investment business as a result of the extensive amount of time and resources devoted to managing the investments. The Supreme Court of Canada offered the following guidance in a passage that has been widely recognized as establishing the “level of activity test”:

“The characterization of income as income from a business or income from property must be made from an examination of the tax payer’s whole course of conduct viewed in light of the surrounding circumstances … in following this method courts have examined the number of transactions, their volume, their frequency, the turnover of the investments and the nature of the investments themselves.”

[31] In this case, the facts which support the conclusion that the interest income is not business income from a business are these:

(a) Inter-Leasing’s Amended Memorandum of Association explicitly prohibited it from carrying on business in Canada, except in the capacity of a limited partner;

(b) Inter-Leasing did not have any employees;

(c) earning the interest income did not require Inter-Leasing to undertake any regular administrative activity or oversight;

(d) Inter-Leasing did not have to manage any risk or make decisions in that regard

(e) Inter-Leasing had a single director throughout the taxation years;

(f) Inter-Leasing earned the interest income from merely four debt instruments that were acquired and held throughout the taxation years with no turnover;

(g) once the debts had been put in place as a result of the refinancing transactions, Inter-Leasing received one payment per year for the interest on each of the debts and simply turned around and advanced those funds to its parent Precision in the form of annual non-taxable dividends and non-interest bearing loans; and

(h) the debts required no monitoring activity.

[32] In looking at the factors which support the conclusion that the interest income is income from a business, it is important to recognize that the transactions cannot be recharacterized or labeled as artificial. The GAAR provisions cannot be used to determine whether the interest income is income from a business. That said, it is nevertheless relevant to look at the activities of Inter-Leasing more broadly than simply looking at the passive nature of its operations. In particular, it is relevant to consider Inter-Leasing’s core function and purpose.

[33] The facts in support of a conclusion that the interest income was an integral part of a business being carried on in Canada are as follows:

(a) Inter-Leasing is a corporation, not an individual, presumptively carrying on a business in pursuit of its own stated objects;

(b) It had a “permanent establishment” in Ontario;

(c) its sole director was an Ontario resident and its central management and control was situated in Canada as evidenced by its own federal tax returns;

(d) it did not carry on any business activity outside of Canada;

(e) it did not maintain any bank account outside of Canada and none of the money paid to it as interest and passed on to its Canadian parent ever left Canada;

(f) it entered into contracts and other legal transactions only in Canada;

(g) its only administrative activities took place in Canada;

(h) its Memorandum of Association states that its “sole purpose” is to hold investments such as debts and to earn income from property such as interest;

(i) the passive nature of its activity is a factor to take into account but not determinative. (In this case, a high level of activity was not required because the business purposes of Inter-Leasing were all capable of being fulfilled as a passive but critically essential partner in a joint venture with other affiliated corporations.)

(j) the core activity of Inter-Leasing is an investment holding business. The interest income is obviously within its own corporate objects and there is no reason to say that this interest income is not part of its core business activity; in fact, the main part of its core activity.

(k) the Amended Memorandum of Association restricting it from carrying on any business in Canada (except investing in a limited partnership) is a voluntary, unenforceable and unenforced restriction. It is not necessary to characterize that document as a “sham”. It is only necessary to look at what Inter-Leasing actually did rather than placing any weight on what it said it would not do.

(l) Inter-Leasing represented itself to Ontario in its application for an extra-provincial licence and in its tax returns as an “investment holding company” and it also represented that its “major business activity” was “earning income from property” and “holding company”. It is clear from the evidence that the interest income of Inter-Leasing falls within that self-description.

(m) the Administrative Services Agreement with Precision and the other contracts and authorizations that Inter-Leasing executed are evidence of business activity in Ontario directly connected to the interest income in issue. It incurred expenses in running a business which included payment of annual fees to Precision, precisely to administer and account for the receipt and disbursement of the interest income in Canada.

[34] Inter-Leasing’s raison d’être and principle function and purpose was to assist the Precision Group in attempting to legitimately reduce the after-tax cost of capital for companies within the Precision Group. It had no other object or activity to speak of. Even its investment in McMaster LP was a part of that enterprise. Inter-Leasing’s role was fundamental and critical to the accomplishment of an ongoing joint venture with the other companies in the Precision Group. That being the true nature of Inter-Leasing’s business, the transactions that it entered into, coupled with the subsequent administration and routing of the interest income earned, are core activities and ought to be considered income from a business in Canada

(iii) Conclusion

[35] It would be possible to characterize the interest at issue in this case as “income from property”. However, in balancing the factors I have listed, in the specific context of Inter-Leasing’s commercial objective and the activities it engaged in to achieve that objective, I find that the interest is income from a business carried on in Canada within the meaning of s. 115 of the Income Tax Act. Accordingly, the Minister’s assessment of corporate income tax is correct.

GAAR Analysis

[36] It is unnecessary to conduct a GAAR analysis or to consider the further alternative of the applicability of corporate minimum tax. However, because so much of the trial focused on the GAAR provision in the OCTA, I will offer some brief comment. In doing so, I recognize that no deference needs to be afforded to these comments on any appeal.

[37] Any GAAR analysis starts with the recognition that arranging one’s affairs so as to attract the least amount of tax is a legitimate and accepted part of Canadian tax law. The GAAR is an extraordinary provision because it can be used to override the tax treatment specifically provided for in other provisions of the statute. It is a provision of last resort.

[38] The analytical framework for the application of the GAAR has been established by the Supreme Court of Canada. The three requirements which must be established to permit application of the GAAR are these (emphasis added):

(1) A tax benefit resulting from a transaction or series of transactions;

(2) That the transaction is an avoidance transaction in the sense that it cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and

(3) That there was abusive tax avoidance in the sense that it cannot be reasonably concluded that a tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the tax payer.

[39] Transactions cannot be re-characterized in order to determine whether the GAAR applies, or portrayed as something they are not.

[40] A “tax benefit” is defined in s. 5 of the OCTA to include a reduction or avoidance of tax “or other amount payable” by a corporation under either the OCTA or under the ITA. There is a federal tax rebate under s. 124 of the ITA to recognize that corporations pay provincial income tax. In this case, Inter-Leasing enjoyed the benefit of the federal rebate provision based upon the assumption that it was paying provincial income tax, when in fact it was not. If the transactions in this case had successfully resulted in Inter-Leasing owing no Ontario tax, then there would have been a “tax benefit” within the meaning of s. 5 of the OCTA. Furthermore, the transactions are quite obviously “avoidance transactions” within the meaning of s. 5(1) of the OCTA for the same reason. They were not reasonably undertaken for any purpose other than to obtain a tax benefit.

[41] The “misuse or abuse” step in the analysis historically begins by looking at the “object, spirit and purpose” of the tax provisions and then determining whether the transactions in issue frustrate that purpose. This case is distinguishable from prior precedents and may require a new approach. In my view, a charging provision in a tax statute is different from a provision creating a deduction or exemption when it comes to a GAAR analysis. The jurisprudence to date has only dealt with deductions and exemptions.

[42] Governments pass tax legislation allowing for deductions and exemptions to encourage or discourage certain decisions by taxpayers. The policy, objects and purposes of such provisions span a broad range - from encouraging individuals to invest in their own retirement through deductible contributions to registered savings plans to encouraging businesses to invest in capital and job creation through accelerated depreciation or other special allowances and tax credits. When examining a transaction through the lens of the GAAR, it has been held to be appropriate to consider the underlying policy, that is to say the goal of the legislator. However, a charging provision is not aimed at encouraging or discouraging certain taxpayer decisions or behaviour. The purpose, plain and simple, is to raise revenue. As a charging provision, the purpose of s. 2(2) of the OCTA (including the related sections which enumerate what sources of income are taxable) is to define the tax base as broadly as possible in order to generate tax revenue.

[43] As a consequence, it will be very difficult to find that any “tax benefit” resulting from an “avoidance transaction” is consistent with the “object, spirit or purpose” of this category of legislative provision. It seems unlikely there will be any underlying policy choice by the legislator that will afford refuge for the taxpayer under the third part of the analytical framework. Expressed another way, the Minister would likely have no difficulty meeting the onus of establishing that such tax avoidance is inconsistent with the object and purpose of the particular legislative provision in issue. When it comes to charging provisions the object and purpose is to raise revenue, rather than promoting certain taxpayer choices the government wants to encourage.

[44] Had it been necessary for me to address the GAAR issue there are two particular aspects of the transactions that I would single out: (1) the Amended Memorandum of Association by Inter-Leasing prohibiting it from carrying on business in Canada (except in the capacity of a limited partner) and (2) the creation of four deeds of specialty debt and the storage of those deeds in the British Virgin Islands.

[45] Neither transaction is in any way relevant to earning interest income. Those transactions do not change the legal relationship between Inter-Leasing as creditor and Yukon as debtor, nor do they have any bearing on the rate of interest, the potential risk, or the amount of the principal. However, the success of the tax avoidance scheme depends upon recognizing the validity of these unilateral, voluntary and unnecessary transactions.

[46] In the analysis of whether Inter-Leasing was carrying on a business in Canada, I accepted the Amended Memorandum of Association at face value but looked at what Inter-Leasing was actually doing and not just at what it said it would not do. A GAAR analysis might go further and find that amendment to be an artificial sham.

[47] The physical location of the deeds of specialty debt in the British Virgin Islands was assumed to have legal significance in this case. Had those instruments been located in Ontario, or elsewhere in Canada, it would have been clear that the interest was earned in Canada and subject to Ontario minimum tax. Inter-Leasing’s position is set out in its letter of March 11, 2005 to the Minister’s Field Auditor: “We understand that a specialty debt instrument has its legal situs in the jurisdiction where the instrument is physically located or maintained. In contrast, a standard debt instrument has its legal situs in the jurisdiction of the borrower.” The line of authority Inter-Leasing relies upon traces its roots to centuries old common law procedure wherein the deed itself was the foundation of any action for enforcement, rather than the covenant to pay. Is the “property” the debt or is it the piece of paper evidencing the debt? The principle that the physical location of the document has determinative legal significance may remain appropriate in the context of succession duty and the devolution of estates, but in the specific context of a tax avoidance scheme and a GAAR analysis, it may deserve re-examination.

Costs

[48] If counsel are unable to agree on costs, concise written submissions may be exchanged and submitted within the next 60 days.

Aston J.

Released: June 26, 2013

COURT FILE NO.: CV-10-398065

DATE: 20130626

ONTARIO

SUPERIOR COURT OF JUSTICE

BETWEEN:

Inter-Leasing, Inc.

Appellant

– and –

The Minister of Revenue

Respondent

REASONS FOR JUDGMENT

Aston J.

Released: June 26, 2013