Originally Published in International Tax Review - May 10, 2013.
In a ruling handed down May 6, 2013, the Federal Court of Appeal ordered that portions of a Crown pleading be struck out for suggesting that a deduction may be disallowed on the basis that the conduct of the taxpayer in incurring the expense was “egregious or repulsive”. Sharlow J. A. wrote the reasons in Canadian Imperial Bank of Commerce v. The Queen, 2013 FCA 122 in which Evans J.A. and Stratas J.A. concurred.
By way of background, the Canada Revenue Agency reassessed CIBC to disallow the deduction of some $3 billion of expenses incurred between 2002 and 2006. The expenses at issue were incurred to settle litigation in the United States arising from losses suffered due to the collapse of Enron Corporation. In the U.S. litigation, it was alleged that CIBC participated in the financing of Enron in a manner that made it liable to the complainants.
The Income Tax Act provides the formula for determining a taxpayer’s income for the year for income tax purposes. Under paragraph 3(a), one component of a taxpayer’s income is income from a business of the taxpayer. Under subsection 9(1), a taxpayer’s income for a year from a business is the taxpayer’s profit for the year from that business.
The most important limitation on the scope of subsection 9(1) is paragraph 18(1)(a) which provides:
18. (1) In computing the income of a taxpayer from a business […] no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business […];
In 65302 British Columbia Limited v. The Queen, a 1999 decision in which the deduction of a fine was allowed (later to be specifically disallowed by Parliament), Iacobucci J. of the Supreme Court of Canada made the following observation:
It is conceivable that a breach [of the law] could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income.
In the contentious part of its pleading, the Crown relied on that obiter statement and offered the following theory of non-deductibility of expenses:
134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.
The Crown’s contention, in a nutshell, was that an expense incurred due to conduct of the taxpayer that was “egregious or repulsive”, is precluded from deduction by paragraph 18(1)(a) of the Income Tax Act.
The CIBC asked the Tax Court of Canada to strike out that paragraph along with the other portions of the pleading reflecting the same theory. The Tax Court chose not to do so. The Federal Court of Appeal disagreed and struck out the contentious paragraph along with the related parts.
In dismissing the Crown’s argument, the Federal Court of Appeal emphasized that “the only question to be asked in determining whether paragraph 18(1)(a) prohibits a particular deduction is this: Did the taxpayer incur the expense for the purpose of earning income?” The Court concluded by stating that the characterization of the morality of a taxpayer’s conduct is not legally relevant to the application of paragraph 18(1)(a) of the Income Tax Act.
Parties are generally given the opportunity to make whatever arguments they consider necessary to their case with the ultimate determination being made by the trial judge who is in the best position to decide questions of relevance and weight in light of all the evidence. It is rather unusual for a legal theory, novel though it is, to be taken off the table at such an early stage. At the same time, courts are increasingly concerned about “proportionality” and are reluctant to allow scarce judicial resources to be spent on matters that are unlikely to have any effect on the outcome of the hearing. Whatever one’s view of the matter the Crown rarely seeks leave to appeal on procedural points, making it unlikely that this decision will be reviewed by the Supreme Court of Canada.
Notwithstanding the decision of the Federal Court of Appeal, the Crown will still be able to argue that the deductions taken by CIBC ought to be disallowed on a variety of other grounds including:
the deduction of the settlement payments does not accord with well accepted business principles;
the settlement payments were not made for the purpose of earning income from a business;
the settlement payments were outlays on account of capital;
the settlement payments were contingent liabilities when made; and
the amount of the settlement payments were not reasonable in the circumstances.
Although the taxpayer has prevailed in this battle, the war has just begun.