Judgments

[2002] 3 F.C. 170

A-701-00

2001 FCA 398

Her Majesty the Queen (Appellant)

v.

Canadian Pacific Limited (Respondent)

Indexed as: Canada v. Canadian Pacific Ltd. (C.A.)

Court of Appeal, Strayer, Sexton and Evans JJ.A.— Toronto, November 7; Ottawa, December 21, 2001.

Income Tax — Income Calculation — Deductions — Appeal from T.C.C. decision borrowing of Australian dollars arranged primarily for bona fide business purposes other than to obtain tax benefit — Income Tax Act, s. 245(2) providing where transaction avoidance transaction, tax consequences shall be determined in order to deny tax benefit that, but for s. 245, would result from transaction, series of transactions — S. 245(3) defining “avoidance transaction” as any transaction, part of series of transactions, that, but for this section, would result directly or indirectly in tax benefit, unless transaction reasonably considered to have been undertaken or arranged primarily for bona fide purpose other than to obtain tax benefit — Taxpayer issuing debentures in Australian dollars, immediately converting proceeds into Canadian dollars, contracting with financial institutions to secure future delivery of foreign exchange necessary to make interest payments under terms of debentures, retire principal — Cost in Canadian dollars to repay principal locked in, less than amount received in exchange for Australian dollars even though Australian interest rates higher because Australian inflation rates higher when debentures issued, value of Australian dollar declining in relation to Canadian dollar — Taxpayer deducted cost in Canadian dollars of interest required to be paid under debentures — Minister disallowing part of deduction as payment on account of principal — Assuming deduction of disallowed interest artificially reducing taxpayer’s income, invoking s. 245 — Application of OSFC Holdings Ltd. v. Canada to determine whether s. 245 applied — Taxpayer reaped two tax benefits: (1) interest expenses deducted earlier than offsetting capital gains included in income; (2) because capital gains taxed at lower rate than interest expenses, taxpayer able to reduce taxable income, reduce tax liability — Next step to determine primary purpose to ascertain whether avoidance transaction — “Primary purpose” implying possibly more than one purpose; necessary to consider transaction as whole — Could not separate currency of borrowed funds, borrowing into two transactions — Not argued T.C.C. applied wrong test in determining Australian dollar borrowing for business purposes, nor made palpable, overriding error in finding primary purpose other than tax benefit — Minister’s argument abuse of Act as whole failed as depended upon recharacterizing interest payments as capital, but s. 245 permitting such recharacterization only after avoidance transaction established, and that otherwise misuse, abuse.

This was an appeal from the Tax Court’s decision that the borrowing of Australian dollars had been arranged primarily for bona fide purposes other than to obtain a tax benefit. CP had issued debentures in Australian dollars. It converted the proceeds of the debenture issue into Canadian dollars as soon as it received the borrowed funds. At the same time, it entered into contracts with various financial institutions to secure the future delivery of the foreign exchange necessary to make the periodic payments of interest called for by the debentures and to retire the principal on maturity. The cost to CP in Canadian dollars of the foreign exchange required to repay the principal amount of the loans was thus locked in at the very outset and was less than the Canadian dollar proceeds received in exchange for the foreign money which CP had borrowed. Inflation rates were higher in Australia than in Canada when the debentures were issued and the value of the Australian dollar was declining in relation to the Canadian dollar. The stated foreign interest rates denominated in foreign currency exceeded Canadian rates on comparable debentures. However, at the time the loans were negotiated CP could expect to be compensated for the difference because the company would pay future interest and principal amounts in devalued New Zealand and Australian dollars. CP locked in this off-setting compensation by taking long positions in forward currency contracts in which the forward exchange rates were lower than the spot exchange rates that existed when CP issued the debentures. CP deducted as interest for its 1990 taxation year under Income Tax Act, paragraph 20(1)(c) the cost in Canadian dollars of the interest required to be paid under the debentures. The Minister of National Revenue disallowed part of the deduction. Tax was assessed on the basis that the disallowed interest reflected payments on account of principal and could not be regarded as a reasonable amount in respect of CP’s obligation to pay interest on the money under the debentures. The Minister also assumed that the deduction of the disallowed interest would unduly or artificially reduce CP’s income and invoked subsection 245 of the Act, the GAAR. Subsection 245(2) provides that where a transaction is an avoidance transaction, the tax consequences shall be determined as is reasonable in order to deny a tax benefit that, but for this section, would result from that transaction or from a series of transactions that includes that transaction. Subsection 245(3) defines an avoidance transaction as any transaction or part of a series of transactions that, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit. The Tax Court found that, although there was a tax benefit, this was not the primary purpose of the borrowing, which was, in fact, to generate capital required in CP’s business.

The issues were: (1) whether the primary purpose for arranging to issue the debentures in Australian currency was other than to obtain a tax benefit; and (2) whether deducting the excess interest did not result directly or indirectly in an abuse having regard to the provisions of the Act as a whole.

Held, the appeal should be dismissed.

(1) This Court, in its recent decision in OSFC Holdings Ltd. v. Canada, outlined the steps in an analysis of whether section 245 applies. The first step was to determine whether the taxpayer had received a tax benefit as a result of the transaction or series of transactions. CP reaped two tax benefits from these transactions: (1) the interest expenses were deducted from income in earlier tax periods than were the offsetting capital gains included in income, thereby deferring taxable income and tax liability; and (2) because capital gains are taxed at a lower rate than interest expenses are deductible, CP was able to reduce its taxable income and thereby reduce its tax liability.

The next step was to determine whether there had been an avoidance transaction. If the primary purpose of a transaction or of any transactions in a series is to obtain the tax benefit, then it is an avoidance transaction. The appellant argued that the only purpose of the more costly Australian borrowing was to obtain a tax benefit, and that if any one transaction in a series was not carried out primarily for bona fide non-tax purposes, that transaction will be an avoidance transaction. It is not possible to separate the currency of the borrowed funds from the borrowing itself so as to make the denomination of the borrowing a discrete transaction. The borrowing was the transaction, not the denomination of the currency. The foreign currency was the very thing that CP borrowed under the debentures and without those Australian dollars the lenders could not have provided CP with the money that was the subject-matter of the contract. By the definition in subsection 245(2), a transaction includes an arrangement or event. Thus the definition of transaction is extended to include circumstances that would not strictly be considered to be a transaction within the normal meaning of that term. However, that extended definition cannot be interpreted to justify taking apart a transaction in order to isolate its business and tax purposes. The necessity to determine primary purpose implies that there is more than one purpose and that the transaction is to be considered as a whole. The Crown could not artificially split off various aspects of it in order to create an avoidance transaction. The Australian dollar borrowing was one complete transaction, and could not be separated into two transactions by labelling the designation in Australian dollars as a separate transaction.

The Tax Court found, as a matter of fact, that the primary purpose of this Australian dollar borrowing transaction was for business purposes. Since it was not argued that the Tax Court had applied the wrong legal test to determine CP’s primary purpose, and it was not established that the Tax Court made a palpable or overriding error that affected its assessment of evidence such that the finding of fact was clearly wrong, the finding that CP’s primary purpose was not to minimize tax could not be reversed.

(2) The above finding was sufficient to dispose of the appeal, but the issue of whether the borrowing was an abuse of the Act as a whole was dealt with as it had been fully argued by counsel. The appellant argued that there was an abuse of the Act as a whole because the payments which were labelled interest under the debentures were actually made up of partial payments of principal plus interest, resulting in deduction of principal, contrary to the policy of the Act. The debenture document labelled payments thereunder as interest and absolutely prohibited pre-payment of principal. The Court could not ignore the arm’s-length relationship between CP and the lender and, in effect, rewrite the terms of their agreement. A recharacterization of a transaction is expressly permitted under section 245, but only after it has been established that there has been an avoidance transaction and that there would otherwise be a misuse or abuse. A transaction can neither be portrayed as something which it is not, nor can it be recharacterized in order to make it an avoidance transaction. The Minister’s argument as to abuse of the Act as a whole failed because it depended upon recharacterizing the interest payments as capital payments.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, ss. 20(1) (c), 67, 245.

CASES JUDICIALLY CONSIDERED

APPLIED:

OSFC Holdings Ltd. v. Canada, [2002] 2 F.C. 288 (2001), 2001 DTC 5471; 275 N.R. 238 (C.A.).

CONSIDERED:

Canadian Pacific Ltd. v. Canada (1998), 98 DTC 2021 (T.C.C.); Canada v. Shell Canada Ltd., [1998] 3 F.C. 64 (1998), 157 D.L.R. (4th) 655; [1998] 2 C.T.C. 207; 98 DTC 6177; 223 N.R. 122 (C.A.); leave to appeal to S.C.C. granted [1998] S.C.C.A. 179 (QL); Canadian Pacific Ltd. v. Canada (1999), 99 DTC 5132 (F.C.A.); Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; (1999), 178 D.L.R. (4th) 26; 99 DTC 5669; 247 N.R. 19; Canadian Pacific Ltd. v. Canada, [1999] S.C.C.A. No. 97 (QL); Canadian Pacific Ltd. v. Canada (2000), 2000 DTC 6174 (F.C.A.).

APPEAL from Tax Court decision (Canadian Pacific Ltd. v. Canada (2000), 2000 DTC 2428 (T.C.C.)) that the primary purpose for arranging to issue debentures in Australian currency was other than to obtain a tax benefit and that deducting the excess interest did not result directly or indirectly in an abuse having regard to the provisions of the Income Tax Act as a whole. Appeal dismissed.

APPEARANCES:

Harry Erlichman and Jenna L. Clark for appellant.

Michael E. Barrack for respondent.

SOLICITORS OF RECORD:

Deputy Attorney General of Canada for appellant.

McCarthy Tétrault, Toronto, for respondent.

The following are the reasons for judgment rendered in English by

Sexton J.A.:

INTRODUCTION

[1]        The issue in this case is whether a company which requires capital for use in its business is caught by the general anti-avoidance rule (GAAR) of the Income Tax Act [R.S.C., 1985 (5th Supp.), c. 1] when it borrows the required money in foreign currency because it will obtain greater tax benefits than it would if it had borrowed the money in Canada.

HISTORY OF THESE PROCEEDINGS

[2]        At the relevant time the respondent (CP) carried on transportation and various other businesses directly and through its subsidiary corporations. In assessing CP for the 1990 taxation year, the Minister of National Revenue disallowed part of a deduction claimed by CP under paragraph 20(1)(c) of the Income Tax Act (Act) as an interest expense. CP had claimed an interest deduction for amounts required to be paid under certain debentures denominated in foreign currency. The Minister claimed that the deduction should be reduced by gains from dealings in foreign exchange which were closely linked to the foreign currency borrowings.

[3]        The disallowed interest was payable under two separate issues of debentures, one denominated in New Zealand dollars and the other in Australian dollars. Because CP did not require capital in the form of either New Zealand dollars or Australian dollars, it converted the proceeds of the debenture issues into Canadian dollars as soon as it received the borrowed funds. At the same time, it entered into contracts with various financial institutions unrelated to the purchasers of the debentures to secure the future delivery of the foreign exchange necessary to make the periodic payments of interest called for by the debentures and to retire the principal on maturity. The cost to CP in Canadian dollars of the foreign exchange required to repay the principal amount of the loans was thus fixed or locked in at the very outset and was in each case considerably less than the Canadian dollar proceeds received by CP in exchange for the foreign money which it had borrowed. The interest which CP sought to deduct in computing its income was the cost to it in Canadian dollars of the interest which it was legally obliged to pay and did in fact pay under the terms of the debentures.

[4]        The transactions were feasible because inflation rates were higher in New Zealand and Australia than in Canada at the time when the debentures were issued and the value of the New Zealand and Australian dollars was declining in relation to the Canadian dollar. The stated foreign interest rates denominated in foreign currency exceeded Canadian rates on comparable debentures. However, at the time the loans were negotiated CP could expect to be compensated for the differential because the company would pay future interest and principal amounts in devalued New Zealand and Australian dollars. CP locked in this off-setting compensation by taking long positions in forward currency contracts in which the forward exchange rates were lower than the spot exchange rates that existed when CP issued the debentures.

[5]        The Minister of National Revenue assessed tax on the basis that the disallowed interest reflected payments on account of principal and could not be regarded as a reasonable amount in respect of CP’s obligation to pay interest on the money under the debentures. The Minister also assumed that the deduction of the disallowed interest would unduly or artificially reduce CP’s income and invoked subsection 245 of the Act, the GAAR.

[6]        The history of the litigation arising from CP’s borrowing is linked with that involving Shell Canada Limited, which had entered into similar transactions. Thus, on July 3, 1998, the Tax Court of Canada, (1998), 98 DTC 2021 (T.C.C.), upheld the Minister’s reassessment indicating that it was bound by the decision of the Federal Court of Appeal in Canada v. Shell Canada Ltd., [1998] 3 F.C. 64 (C.A.). On February 9, 1999, this Court (Canadian Pacific Ltd. v. Canada (1999), 99 DTC 5132 (F.C.A.)), followed its own decision in Shell, supra, and dismissed CP’s appeal of the July 3, 1998 judgment of the Tax Court.

[7]        Shell, supra, contained virtually identical facts to those before the Court in the case at bar, in that Shell Canada Limited (Shell) had issued debentures in New Zealand dollars, had converted the proceeds into Canadian dollars, and had entered into forward exchange contracts for the repurchase of New Zealand dollars for the repayment of the debentures. In Shell, supra, the Minister only permitted the company to deduct interest at the rate it would have paid had it borrowed US dollars, namely 9.1 per cent instead of the 15.4 per cent interest rate that Shell in fact paid on the New Zealand debentures. The Federal Court of Appeal upheld the Minister of Revenue’s reassessment.

[8]        On October 8, 1998, Shell was granted leave to appeal to the Supreme Court of Canada [[1998] S.C.C.A. 179 (QL)] from this decision, and CP was granted intervener status in Shell’s appeal.

[9]        The Supreme Court of Canada allowed the appeal of Shell on the issue of interest deductibility and dismissed the cross-appeal of Her Majesty the Queen on the issue of income versus capital characterization of foreign exchange gains arising in connection with the transactions: [1999] 3 S.C.R. 622.

[10]      On November 10, 1999, the Supreme Court of Canada ([1999] S.C.C.A. No. 97) ordered that CP’s case be remanded to the Federal Court of Appeal to be dealt with in accordance with the decision of the Supreme Court of Canada in Shell, supra.

[11]      On February 17, 2000, this Court ((2000), 2000 DTC 6174 (F.C.A.)) allowed CP’s appeal from the July 3, 1998 judgment of the Tax Court of Canada that had upheld the Minister’s reassessment with respect to the New Zealand borrowing and held that CP would also succeed in its appeal with respect to the Australian dollar borrowing unless the GAAR as amended applied to it. The Court therefore remitted the matter of the Australian borrowing to Judge Bonner of the Tax Court to make such factual and legal determinations as he considered necessary solely with respect to GAAR. In the July 3, 1998 decision, Judge Bonner had made no finding as to whether the borrowing undertaken by CP of Australian dollars had been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit because he regarded himself as bound by the decision of this Court in Shell, supra. However, following the Supreme Court of Canada’s decision, a finding on this issue was required.

[12]      None of the previous judgments by the Tax Court, the Federal Court of Appeal or the Supreme Court of Canada had dealt with the issue of GAAR as it applied to CP’s borrowing of Australian dollars. The Supreme Court decision in Shell, supra, dealt only with the unamended version of GAAR which was applicable to the New Zealand borrowing. CP’s New Zealand dollar borrowing was similarly governed by the amended GAAR provision.

REMAINING ISSUE — GAAR

[13]      The only transaction in issue now with respect to the GAAR provision is CP’s borrowing of Australian dollars. Details of that series of transactions were set out in an agreed statement of facts and are as follows:

(i) The Appellant issued by private placements to a number of different banks and financial institutions, A$ 260,000,000 aggregate principal amount debentures due on April 21, 1994 with interest payable semi-annually at a rate of 16.125% per annum. The debentures were issued at a 2% premium or A$ 5,200,000.

(ii) The Appellant entered into a Master Swap Agreement with Morgan Guaranty Trust Company of New York (“Morgan”) wherein:

A. The Appellant exchanged the Australian dollar principal amount for Japanese yen at the spot rate of exchange.

B. The Appellant entered into a series of forward contracts to purchase Australian dollars using Japanese yen on the interest payment dates and the principal maturity date under the Australian debentures.

C. The Appellant agreed to swap the Japanese yen proceeds for Canadian dollars at the spot rate on the date of issue and to exchange Canadian dollar payments for Japanese yen for its obligations under the Japanese yen/Australian dollar forward contracts, and

D. The Appellant entered into an interest rate swap arrangement with Morgan.

[14]      The Tax Court Judge found in favour of CP in his reasons dated October 13, 2000 on the ground that, although there was a tax benefit, this was not the primary purpose of the borrowing: (2000), 2000 DTC 2428 (T.C.C.). The borrowing was for capital required in CP’s business. The Tax Court Judge also declined to find that there was any abuse of the Act as a whole under subsection 245(4) of the Act.

Issues

[15]      Two issues are raised by the appellant in this appeal:

1. Did the Tax Court Judge err in law by holding that the primary purpose for arranging to issue the debentures in Australian currency was other than to obtain a tax benefit?

2. Did the Tax Court Judge err in law by holding that deducting the excess interest did not result directly or indirectly in an abuse having regard to the provisions of the Act as a whole?

Legislation

Income Tax Act (the Act)

20. (1) … in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

…

(c) an amount paid in the year or payable in respect of the year … pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy).

…

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

…

245. (1) In this section,

“tax benefit” means a reduction, avoidance or deferral of tax or other amount payable under this Act or an increase in a refund of tax or other amount under this Act;

“tax consequences” to a person means the amount of income, taxable income, or taxable income earned in Canada of, tax or other amount payable by or refundable to the person under this Act, or any other amount that is relevant for the purposes of computing that amount;

“transaction” includes an arrangement or event.

(2) Where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that, but for this section, would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction.

(3) An avoidance transaction means any transaction

(a) that, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit; or

(b) that is part of a series of transactions, which series, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.

(4) For greater certainty, subsection (2) does not apply to a transaction where it may reasonably be considered that the transaction would not result directly or indirectly in a misuse of the provisions of this Act or an abuse having regard to the provisions of this Act, other than this section, read as a whole.

(5) Without restricting the generality of subsection (2),

(a) any deduction in computing income, taxable income, taxable income earned in Canada or tax payable or any part thereof may be allowed or disallowed in whole or in part,

(b) any such deduction, any income, loss or other amount or part thereof may be allocated to any person,

(c) the nature of any payment or other amount may be recharacterized, and

c) la nature d’un paiement ou d’un autre montant peut être qualifiée autrement;

(d) the tax effects that would otherwise result from the application of other provisions of this Act may be ignored,

in determining the tax consequences to a person as is reasonable in the circumstances in order to deny a tax benefit that would, but for this section, result, directly or indirectly, from an avoidance transaction.

Analysis

[16]      In a recent decision of this Court, Justice Rothstein, for the majority in OSFC Holdings Ltd. v. Canada, [2002] 2 F.C. 288 (C.A.), outlined in a useful way the steps to be taken in analysing whether or not section 245 applies to a given set of facts. The first step is to determine whether or not the taxpayer has received a tax benefit as a result of the transaction or series of transactions. If a tax benefit has been received, it is next necessary to consider whether there has been an avoidance transaction within the meaning of subsection 245(3). Once it is determined that there is such a tax benefit, any transaction that is part of the series may be found to be an avoidance transaction. If the primary purpose of the transaction or of any transactions in a series is to obtain the tax benefit, then it is an avoidance transaction. This test is an objective one and therefore the focus must be on the relevant facts and circumstances and not on statements as to the intention by the taxpayer. The primary purpose is a question of fact and is to be determined at the time the transaction in question was undertaken. It is not a hindsight assessment to be made on the basis of facts and circumstances that occurred after the transactions were undertaken. Justice Rothstein said at paragraph 58:

As a final observation, I would stress that the primary purpose of a transaction will be determined on the facts of each case. In particular, a comparison of the amount of the estimated tax benefit to the estimated business earnings may not be determinative, especially where the estimates of each are close. Further, the nature of the business aspect of the transaction must be carefully considered. The business purpose being primary cannot be ruled out simply because the tax benefit is significant.

[17]      If a transaction or series of transactions creates a tax benefit and the primary purpose of any one of those transactions is to obtain a tax benefit, then there is an avoidance transaction. Once it has been established that an avoidance transaction occurred, subsection 245(4) must be considered. This involves determining whether it may reasonably be considered that any of the avoidance transactions or the series of transactions would result in a misuse of a specific provision or provisions of the Act. If so, the tax benefit resulting from the series will be denied. If there is no misuse, then it is still necessary to determine whether it may reasonably be considered that any of the avoidance transactions or the series of transactions would result in an abuse, having regard to the provisions of the Act other than section 245, read as a whole. If such an abuse is found, the tax benefit resulting from the series will be denied.

[18]      In OSFC, supra, Justice Rothstein cautioned that, notwithstanding his finding in that case that the avoidance transactions had resulted in an abuse of the provisions of the Act other than GAAR read as a whole (at paragraph 117):

… It is important to note that there is no general rule against structuring transactions in a tax effective manner or a requirement that transaction be structured in a manner that maximizes tax.

Justice Rothstein further held that, where there has been strict compliance with the Act, a tax benefit can only be denied, because the avoidance transaction constitutes a misuse or abuse, if the relevant policy contained in the Act is clear and unambiguous.

Tax Benefit

[19]      The Tax Court Judge found that there was a tax benefit and CP does not argue against this finding on this appeal. It is clear to me that there was a tax benefit. CP arranged the series of transactions such that increased interest expenses were offset by capital gains. CP reaped two tax benefits by entering into these transactions. First, the interest expenses were deducted from income in earlier tax periods than were the offsetting capital gains included in income, thereby deferring taxable income and hence tax liability. Second, because capital gains are taxed at a lower rate than interest expenses are deductible, CP was able to reduce its taxable income and thereby reduce its tax liability.[1]

Primary purpose

[20]      Section 245 excludes from the definition of avoidance transactions those transactions which “may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit”. It was the appellant’s argument on this appeal that the Court must pay particular attention to the manner in which CP arranged its borrowing. Specifically, the Court must have regard to the fact the only purpose for the more costly Australian borrowing was to obtain a tax benefit. The appellant then argued that subsection 245(3) states that, if any one transaction or event taken in a series of transactions was not carried out primarily for bona fide non-tax purposes, that transaction or event in itself will constitute an avoidance transaction.

[21]      The appellant argued that CP’s act of denominating the debentures in Australian dollars was in and of itself a transaction. The appellant relied on the definition of “transaction” in subsection 245(1) as including “an arrangement or event”, to argue that the designation of Australian dollars in the debenture amounted to an arrangement.

[22]      The appellant then argued that the “separate transaction”, namely the designation of borrowing in Australian dollars, was entered into solely for tax purposes. The appellant relies for this upon the statement of the Tax Court Judge as follows in paragraph 12 of his reasons:

… a direct borrowing of [Canadian dollars] is what the Appellant could have done and, in my opinion, would, but for tax reasons, have done.

The appellant therefore says that since this “separate transaction” was undertaken solely for tax reasons, it is therefore an avoidance transaction, and, subject to further analysis under subsection 245(4), falls within section 245.

[23]      In my opinion, this approach is flawed. I do not believe that it is possible to separate the currency of the borrowed funds from the borrowing itself so as to make the denomination of the borrowing a discrete transaction in and of itself. It is the borrowing which is the transaction, not the denomination of the currency. The foreign currency is the very thing that CP borrowed under the debentures and without those Australian dollars the lenders could not have provided CP with the money that is the subject-matter of the contract.

[24]      By the definition in subsection 245(2) a transaction includes an arrangement or event. Thus the definition of transaction is extended to include circumstances that would not strictly be considered to be a transaction within the normal meaning of that term. However, that extended definition cannot be interpreted to justify taking apart a transaction in order to isolate its business and tax purposes. The necessity to determine primary purpose implies that there is more than one purpose and that the transaction is to be considered as a whole.

[25]      The implication of the Crown’s argument, if accepted, would have consequences which Parliament did not intend. If this argument was correct, the Crown could allege that the tax planning component of any transaction amounted to an event or arrangement constituting a “separate transaction”. Because it was undertaken for purely tax purposes, the “separate transaction” would be an avoidance transaction. In other words, any action taken to obtain a tax benefit would be an avoidance transaction and there would never be an occasion to determine the primary purpose of a transaction. The Crown’s argument would make the use of the word “primarily” in subsection 245(3) redundant.

[26]      The words of the Act require consideration of a transaction in its entirety and it is not open to the Crown artificially to split off various aspects of it in order to create an avoidance transaction. In the present case, the Australian dollar borrowing was one complete transaction and cannot be separated into two transactions by labelling the designation in Australian dollars as a separate transaction.

[27]      The Tax Court Judge found as a matter of fact that the primary purpose of this Australian dollar borrowing transaction was for business purposes. He said at paragraph 8:

In my view the Appellant must succeed because the A$ borrowing and the series of transactions of which it formed a part may reasonably be considered to have been arranged primarily to raise capital and that was, within the meaning of s. 245(3), a bona fide (business) purpose which was not tax driven.

He said further at paragraph 15:

The transactions which the Respondent says constitute the series were, when viewed objectively, inextricably linked as elements of a process primarily intended to produce the borrowed capital which the Appellant required for business purposes. The capital was produced and it was so used. No transaction forming part of the series can be viewed as having been arranged for a purpose which differs from the overall purpose of the series. The evidence simply does not support the Respondent’s position. Accordingly none of the transactions on which the Respondent relies was an avoidance transaction within the meaning of s. 245(3). [Emphasis added.]

[28]      Since it is not alleged that the Tax Court Judge applied the wrong legal test to determine CP’s primary purpose, his finding that CP’s primary purpose was not to minimize tax cannot be reversed by this Court unless the appellant can establish that the Tax Court Judge made a palpable or overriding error that affected his assessment of evidence such that his finding of fact was clearly wrong. I am unable to conclude that there was any such palpable or overriding error.

Misuse or abuse—subsection 245(4)

[29]      The above conclusion is sufficient to dispose of this appeal. However, since the issue was argued fully by counsel, I shall consider whether the borrowing was an abuse of the Act as a whole. The thrust of the appellant’s argument is that there was an abuse of the provisions of the Act read as a whole because the borrowing was structured so as to result in the deduction of Canadian dollar principal payments, which is contrary to the policy in the Act prohibiting the deduction of principal in the form of interest.

[30]      The appellant takes the position that the payments which were labelled interest under the debenture were in actuality made up of partial payments of principal plus interest. This involves taking the capital gain which occurred at the end of the five-year period under the debenture and applying it to the periodic interest payments so that there was in effect a deduction from each interest payment representing part of the amount of a capital gain which was in fact only obtained at the end of a five-year period. The premise of the appellant is that the payments made under the debenture were in reality payments in part of principal. However, the premise is wrong. The debenture agreement labels them as payments of interest. Clause 3.01 of the debenture provides that interest will be payable semi-annually in Australian dollars based on the face of the amount of the debenture. The principal amount of the debenture is to be paid five years from the date of the debenture and clause 7.01 of the document provides “this debenture is not subject to pre-payment or redemption in whole or in part prior to the stated maturity date”. Thus on its face, the document absolutely prohibits pre-payment of principal. There is no evidence that the parties, who were at arm’s length, considered that the payments which were labelled as being interest were in fact principal, as this would fly in the face of the specific terms of the document itself. There is no authority which permits the Court to ignore the nature of the relationship between CP and the lender and, in effect, to rewrite the terms of their agreement.

[31]      The Tax Court Judge found that there was no abuse of the Act as a whole. He said at paragraph 16:

In my view the Minister put the cart before the horse when, as already explained, he attempted to recharacterize events by asserting that issuing the debt in A$ was an abuse of the Act as a whole because it converted non-deductible Canadian principal repayments to a deductible expense. That, I repeat, is not what happened. The Appellant seeks to deduct the interest expense payable pursuant to the A$ debentures. In respect of the virtually identical transaction considered in Shell (supra) McLachlin J. (as she then was) stated at page 649:

Allowing Shell to deduct its interest payments at the actual rate that was paid to the foreign lenders in exchange for the NZ$150 million that was then used for the purpose of producing income is not contrary to the object and spirit of s. 20(1)(c)(i). To the contrary, it fulfills its purpose.

[32]      In Shell, supra, the Supreme Court considered a similar transaction and rejected a similar argument made on the part of the Minister. Justice McLachlin (as she then was) wrote at paragraph 30:

Shell had a legal obligation to make the semi-annual payments to the foreign lenders under the Debenture Agreements. Those semi-annual payments constituted “interest”…. As between Shell and the foreign lenders, there is no indication that the semi-annual payments were anything but consideration for the use, for five years, of the NZ$ 150 million that Shell borrowed. It was not a synthesized US$ loan from the foreign lenders to Shell: Shell actually received the NZ$ 150 million from the foreign lenders under the Debenture Agreements and paid real interest in consideration for its use.

And later wrote at paragraph 39:

… this Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer’s bona fide legal relationships. To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer’s legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect.

And later, wrote at paragraph 41:

It is my respectful view that by paying insufficient attention to these very important principles, the Minister and the Federal Court of Appeal fell into error. First, the Federal Court of Appeal effectively recharacterized for tax purposes Shell’s legal relationship with the foreign lenders. Indeed, Linden J.A. held that, when the Forward Exchange Contract between Shell and Sumitomo was considered alongside the Debenture Agreements between Shell and the foreign lenders, “[t]he higher interest rate coupled with the discounted forward rate created a blended payment of interest and principal” (para. 58). With respect, this ignores the actual relationship between Shell and the foreign lenders, a relationship to which Sumitomo was not a party. As between Shell and the foreign lenders, the semi-annual payments were entirely “interest”, paid in consideration for the loan of NZ$ 150 million. That characterization cannot be changed by whatever other legal relationship Shell may have concluded with third parties, or indeed by anything that Shell did with the borrowed funds after receiving them from foreign lenders. [Emphasis added.]

[33]      This does not mean a recharacterization cannot occur. A recharacterization of a transaction is expressly permitted under section 245, but only after it has been established that there has been an avoidance transaction and that there would otherwise be a misuse or abuse. A transaction cannot be portrayed as something which it is not, nor can it be recharacterized in order to make it an avoidance transaction.

[34]      The Minister’s argument as to the abuse of the Act as a whole must fail because it depends upon recharacterizing the interest payments as capital payments. It is therefore unnecessary to comment on his argument as to the policy of the Act.

CONCLUSION

[35]      For the above reasons, I would dismiss this appeal with costs.

Strayer J.A.: I agree.

Evans J.A.: I agree.