Summary Report 67

VOLUME II,

REPORT No.₆₇2008

The commentary revisions this month include changes to the chapters on Transfer of Property to a Corporation, Capital Transactions and Winding-Up reflecting recent jurisprudence and developments in administrative policies. For its part, the Summary Report reviews the recent decision of the Federal Court of Appeal (“FCA”) in Dow Chemical rendered on July 4, 2008 wherein the FCA was called upon to review the application of subsection 78(1) of the Income Tax Act (the “Act”) in the context of an amalgamation of the debtor corporation following an acquisition of control.

n The contextual and purposive interpretation made by the Court of paragraph 87(7) in order to reach its conclusion that subsection 78(1) applied.

n The FCA concluded that the purpose of subsection 87(7) is to put the new corporation resulting from the amalgamation in the shoes of the predecessor corporations.

The FCA recently interpreted the application of subsection 78(1) in conjunction with the application of subsection 87(7). Of interest in this particular case is the fact that the FCA adopted a contextual and purposive approach in order to support its conclusion.

• Dow Chemical Canada (“Dow Canada”), a Canadian corporation, was a controlled subsidiary (direct or indirect) of Dow Chemical (“Dow”), a U.S. corporation.

• Union Carbide Corporation (“UCC”), a U.S. corporation, held directly or indirectly, all of the shares of Union Carbide Canada Inc. (“UCCI”) and Union Carbide Canada Finance Inc. (“UCCFI”), both Canadian corporations.

• Dow and UCC were dealing at arm’s length at all relevant time before the relevant transactions described below.

• For the fiscal year ending as of December 31, 2000, UCCI was indebted to UCCFI under a loan agreement. As both UCCI and UCCFI were controlled by UCC, UCCI and UCCFI were related at the time the loan agreement was entered into.

• For the fiscal year ended December 31, 2000, approximately $30 million of interest expenses under the loan agreement were claimed by UCCI. It is acknowledged that the interest remained unpaid at all material times. By virtue of subparagraph 251(2)(c)(i), is acknowledged that UCCI and UCCFI were not dealing at arm’s length at the time the interest expenses were incurred.

• On February 6, 2001, Dow acquired control of UCC, thereby triggering a fiscal year-end for UCCI pursuant to subsection 249(4).

• On October 1, 2001, Dow Canada and UCCI amalgamated to form Amalco (being the respondent in this particular instance). A fiscal year end for UCCI pursuant to paragraph 87(2)(a) was as a result triggered.

• As a result of the acquisition of control and of the amalgamation, UCCI had three taxation year ends within the interval of nine months (upon the normal December 31 year end, the acquisition of control and the amalgamation).

Interestingly, it is not mentioned whether UCCFI had included the unpaid interests in calculating its income but it is reasonable to conclude that it followed the accrual method and thus included the unpaid interests in its taxable income.

The issue to be determined by the Tax Court of Canada and subsequently by the FCA was whether the unpaid interest for which a deduction was claimed by UCCI in its fiscal year ending on December 31, 2000, had to be included in the first taxation year of Amalco pursuant to subsection 78(1). The first taxation year of Amalco being, if Amalco and UCCI were the same person, the third taxation year of UCCI.

The relevant parts of the statutory provisions on which the taxpayer and the Crown argued are set out below.

Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer to a person with whom the taxpayer was not dealing at arm’s length at the time the outlay or expense was incurred and at the end of the second taxation year following the taxation year in which the outlay or expense was incurred, is unpaid at the end of that second taxation year, either

(a) the amount so unpaid shall be included in computing the taxpayer’s income for the third taxation year following the taxation year in which the outlay or expense was incurred, or […]

Where there has been an amalgamation of two or more corporations after May 6, 1974 […]

(d) shall apply as if the new corporation had incurred or issued the debt or other obligation at the time it was incurred or issued by the predecessor corporation under the agreement made on the day of which the predecessor corporation made an agreement under which the debt or other obligation was issued […]

More particularly, in order for paragraph 78(1)(a) to apply, the courts had to determine whether Amalco and UCCFI were related at the time the expense was incurred, namely during the taxation year ending on December 31, 2000.

As more extensively summarized in Report No. 59 (2007), the Tax Court found that subsection 78(1) did not apply to Amalco on the basis that Amalco and UCCFI were not related in the taxation year ending on December 31, 2000. Indeed, although the Tax Court recognized that UCCFI and Amalco were related immediately before the amalgamation by reason of subsections 251(3) and (3.1), there was no provision which extended such conclusion to the taxation year of UCCI ending on December 31, 2000. In that respect, the Tax Court Judge stated that subsection 87(7), which essentially provides that a debt of a new corporation resulting from an amalgamation is deemed to have been incurred by the new corporation at the time and in the same manner as it was incurred by the predecessor corporation, was not sufficient to deem Amalco and UCCFI to be related at the time the debt was incurred.

Finally, the Tax Court concluded that subsection 87(7) was not drafted with section 78 in mind as it addresses a different purpose and does not contain language that would indicate that it should apply to section 78. In support of its conclusion, the Tax Court put forward three grounds. First, subsection 78(1) anticipated two periods of 12 months (i.e., two taxation years) before requiring that an unpaid amount be included in the taxable income of a taxpayer. Therefore, the inclusion in the taxable income of Amalco after only nine months by reason of the acquisition of control and amalgamation contravened the intent of subsection 78(1). Second, based on The Queen v. Pan Ocean Oil Ltd.,^[1] Amalco and UCCI are distinct corporations and thus the first taxation year of Amalco cannot be considered to be the third taxation year of UCCI. Third, subsection 78(2) deals specifically with the application of subsection 78(1) in the case of a wind-up and, therefore, since there is no equivalent provision for an amalgamation, it is to be concluded a contrario that subsection 78(1) should not apply in the present instance. On the latter point, the Court concluded that the absence of a specific provision for the application of subsection 78(1) in the case of an amalgamation was indicative of a legislative gap and that it was not the role of the Court to fill this gap.

Justice Noël for the FCA reversed the conclusions of the Tax Court primarily on the basis that the object and purpose of subsection 87(7) is to provide, in the case of an amalgamation, for the continuation of the rights and obligations of the predecessor corporations in the new corporation. More particularly, paragraph 87(7)(d), dealing with the debt incurred by the predecessor corporations, is to be applied “as if” the obligation had been incurred by the “new corporation” at the time it was incurred or issued by the predecessor corporation under the same terms and conditions. In the present situation, the purpose of 87(7) was thus essentially to place Amalco in the shoes of UCCI with respect to the debt incurred by UCCI.

Based on the foregoing, the FCA concluded that it would be incongruous to come to the conclusion that subsection 87(7) was to be applied without regard to the arm’s length relationship that existed at the time the interest became payable. In the words of Justice Noël:

In order to give effect to paragraph 87(7)(d) and place the respondent in the shoes of UCCI at that time, one must conclude that Amalco was not dealing at arm’s length with UCCFI when the obligation to pay the interest was incurred.^[2]

The FCA went on to respond to the other conclusions reached by the Tax Court. In that respect, the FCA rejected the conclusion that the application of subsection 78(1) requires two periods of 12 months and concluded that when the Act refers to taxation years, it must be applied regardless of their duration.

The FCA also found no merit in the argument that the third taxation year of UCCI could not be the first taxation year of Amalco on the basis that UCCI and Amalco were not the same taxpayer. The FCA found that by virtue of paragraph 87(7)(d), which places Amalco in the shoes of UCCI, UCCI’s previous taxation years were to be viewed “as if” there were Amalco’s.

Finally, the FCA also rejected the Tax Court’s analogy to subsection 78(2). In the FCA’s view, the existence of subsection 78(2) was specifically required since on a wind-up, a corporation ceases to exist and thus it is impossible for the corporation to have a third taxation year. On the other hand, in the case of an amalgamation, there is a continuity of the various tax attributes of the predecessor corporations by virtue of subsection 87(7) and thus no provision similar to subsection 78(2) had to be provided in order for subsection 78(1) to apply.

It remains to be seen if an appeal to the Supreme Court if Canada will be made. As the decision of the FCA in Dow Chemical was released on July 4, 2008, the taxpayer has until early October 2008 to appeal the decision to the Supreme Court.

The FCA adopted a more contextual and purposive approach in its interpretation of subsections 78(1) and 87(7) than the Tax Court. This also contrasts with the recent decision in Cascades^[3] in which the Tax Court adopted a more textual interpretive approach. Although this approach was vetoed by the Supreme Court of Canada in Canada Trustco and Kaulius, this may lead to some uncertainty in the interpretation of the Act. In this regard, the taxpayer might have considered putting greater emphasis on the fact that the wording of paragraph 87(7)(d) does not specifically provide that “the new corporation shall be deemed to be the same as, and a continuation of, each predecessor corporation,” as is the case for many provisions of subsection 87(2). For instance, with respect to the application of the debt forgiveness rules, paragraphs 87(2)(h.1) and (l.21) specifically provide that the new corporation shall be deemed to be the same corporation as, and a continuation of, each predecessor corporation. However, it is noteworthy to point out that there is no equivalent rule for the application of subsection 78(1). With the interpretation of the FCA given to paragraph 87(7), paragraphs 87(2)(h.1) and (l.21) would appear to be redundant.

It is also interesting to note that the CRA’s administrative position to not apply subsection 78(1) where the debtor and the creditor are on an accrual basis was not discussed nor was it raised by the taxpayer. Indeed, presumably UCCFI was reporting on an accrual basis and included the interest in its taxable income on such basis. It may have been that UCCFI had claimed a deduction. Otherwise, the application of the decision may result in double taxation.

^[1] 94 DTC 6412.

^[2] Paragraph 32 of the Dow Chemical decision (FCA).

^[3]Cascades Inc. v. R., 2008 DTC 2387 (TCC).