Form versus substance

By Sandra Rosier
Illustrations : Mike Constable

At times it’s deemed that the legal form and, for tax purposes, the legal substance of leaseback transactions is a sale and a lease

The recent Tax Court of Canada decision in CCLI (1994) Inc. v. The Queen, 2006 TCC 240 highlights the difficulty of reconciling tax law to commercial practice where the legalform of a transaction does not necessarily reflect its economic substance.

At issue in this case was whether the economic substance of leaseback transactions as financing loans, rather than their legal form as capital acquisitions and leases, would dictate the tax treatment of CCLI’s foreign exchange gains and losses. Although Justice Campbell J. Miller accepted that CCLI was in the financing business, he concluded that the legal form and, for tax purposes, the legal substance of each transaction was a sale and a lease.

CCLI carried on a financial leasing business and borrowed funds in US dollars from its parent. It then entered into leaseback arrangements with its customers using the borrowed funds. In accordance with mandatory accounting guidelines, CCLI recorded its revenues and expenses from the leases in accordance with the accounting rules governing direct financing leases. For accounting purposes, therefore, the direct financing leases were treated by CCLI as interest bearing loans in the nature of financing. For tax purposes, CCLI reported the leases on a basis consistent with the accounting concept of operating leases. Specifically, CCLI included the payments from its customers as leasing revenue and deducted capital cost allowance on the leased assets. During the taxation years at issue, CCLI reported foreign exchange losses on the repayment of the borrowed funds on income account. The Minister of National Revenue took the position that CCLI’s foreign exchange gains and losses should be recognized on capital account and therefore should be included in the computation of CCLI’s income on a realized basis. According to the minister, CCLI did not lend money but borrowed money to acquire capital assets and enter into lease arrangements.

CCLI argued that the legal substance of the transaction was a loan. It claimed that it was in the financing business such that borrowing money was tantamount to acquiring inventory. CCLI relied on Justice John C. Major’s analysis in Gifford v. The Queen, 2004 DTC 6120 (SCC). At issue in that case was whether a payment made by the appellant, a financial adviser, to a fellow employee for the lat-ter’s client list was a capital expenditure ordeductible in computing employment income. Also at issue was the deductibility of interest paid on the amount the appellant borrowed to make the payment. Justice Major set out the following test for the determination of whether a payment is on account of capital or a capital expenditure: “Under our current act, it is not necessary to determine whether the payment is a capital expenditure but to determine whether the payment is being made ‘on account of capital.’ This distinction in terms is particularly important in relation to interest payments, because loan proceeds are seldom retained in the form they are re-ceived, unlike other capital assets. This distinction means that under our Act it is only necessary to consider what the proceeds of the loan are to the borrower when they are received, and does not require an examination of what those loan proceeds are spent on. If the money adds to the financial capital then the payment of interest on that loan will be considered to be a payment ‘on account of capital.’ If the loan proceeds constitute the inventory of the borrower, as is the case with moneylenders, then the payment of interest would be deductible.”

The Crown argued that CCLI had arranged its affairs in the legal form of a purchase and lease rather than a loan. The Crown also relied on the Gifford case but read in the light of Shell Canada Ltd. v. The Queen, 1999 4 CTC 313 (SCC). In Shell, the Supreme Court followed earlier jurisprudence to the effect that the characterization of a foreign exchange gain or loss generally follows the characterization of the underlying transaction. Thus, if the underlying transaction was entered into for the purpose of acquiring funds to be used for capital purposes, any foreign exchange gain or loss in respect of that transaction would also be on capital account.

The Crown took the position that the legalities of the arrangements were crystal clear and were not altered by accounting treatment. It asserted that ordinary commercial principles govern the computation of profit, not GAAP. It follows that monies borrowed by CCLI to implement the transactions were borrowed to acquire funds for capital purposes and, therefore, based on the Supreme Court of Canada’s approach in Shell, any foreign exchange gains or losses should likewise be on capital account. According to the Crown, the fact that CCLI, the borrowers and the accounting and banking industries believed that CCLI was in the financing business was not sufficient to conclude that, for tax purposes, CCLI was a moneylender and that money borrowed by it was inventory. The form of the transactions, the Crown argued, was a purchase of capital assets and a lease, and that is how CCLI reported for tax purposes. The Crown urged that CCLI should not be allowed to have it both ways.

At the outset, Judge Miller noted that certainty and legal form trump economic substance if legal form reflects legal substance. Miller queried whether a lease financing was in legal substance a loan arrangement. He concluded that both parties were correct: CCLI commercially was in the financing business and did not create the legal form of debtor/creditor. “It is one thing to pit legal form against economic substance,” he noted, “but what if the question is framed as legal form versus legal substance?” Miller grappled with the question of whether a company in the business of financial leases was, in legal substance, lending money. He observed that there were many examples where courts found that legal form mischaracterizes legal substance, citing the example of a contract between an employer and employee that stipulates that the contract is one of an independent contractor.

Judge Miller examined factors indicating the legal substance of each transaction was a capital acquisition and a lease. He also examined factors indicating that the economic substance of each transaction was a loan in order to consider whether these factors also reflected the legal substance as being a loan. The judge accepted that CCLI was in the financing business. However, he found that the relevant question, per Gifford, is not how the money was spent but what the loan proceeds to CCLI were when received. He considered whether the borrowed money was inventory and noted that no guidance was provided by the act on this point. Judge Miller observed that CCLI had borrowed specific sums for specific transactions and knew where the funds were going from the outset. He determined that the economic reality that CCLI was in the financing business was not sufficient to overcome the true legal substance of the transaction for tax purposes, that is, a sale and a lease. The judge held that this was both the legal form and, for tax purposes, the legal substance of the transaction and that accordingly, the foreign exchange gains and losses were on capital account and should have been reported by CCLI on a realized basis.

Miller observed that the act can sometimes be applied asymmetrically although it is seldom applied inconsistently. He derived some comfort from the fact that the act would be applied consistently since CCLI reported for tax purposes its revenue as though it was engaged in operating leases and claimed capital cost allowance on capital assets as though it was engaged in operating leases. Therefore, it stood to reason that CCLI’s foreign exchange gains and losses should be determined on capital account as though it was engaged in operating leases.

Ultimately, Judge Miller’s conclusions in CCLI are consistent with the approach adopted by the Supreme Court of Canada in Shell. Pursuant to this approach, courts must be sensitive to the economic realities of a particular transaction, subject to two requirements: first, that the taxpayer’s legal relationship 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. Second, a searching inquiry for either the economic realities of a particular transaction or the general object and spirit of the provision at issue can never supplant a court’s duty to apply an unambiguous provision of the act to a taxpayer’s transaction. Where the provision at issue is clear and unambiguous, its terms must simply be applied. In the CCLI case, the judge’s recharacterization of the foreign exchange gains and losses was based on the fact that the label attached to the leaseback transactions (financing loans) did not properly reflect their actual legal effect (sale and lease). In other words, the legal relationships created by CCLI were that of vendor/purchaser of capital assets and lessor/lessee of those same assets.

Sandra Rosier is an associate of Couzin Taylor LLP (allied with Ernst & Young) in Toronto
Technical editor: Trent Henry, partner, Ernst & Young LLP