FCA affirms the importance of GAAP in computing liability for LCT rejecting the Crown’s economic substance argument

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The Federal Court of Appeal has once again affirmed the importance of Generally Accepted Account Principles (GAAP) in computing liability for the large corporation tax (LCT) applicable prior to 2006 while rejecting the Crown’s economic substance argument: The Queen v. Bombardier Inc.

The case turned on how Bombardier accounted for advances received in connection with long-term construction contracts:

[9] It can be seen from this agreement that the respondent has two divisions: the Aerospace Division (aircraft sale contracts) and the Transportation Division (public transportation equipment) and aircraft parts and components. It can also be seen that, in the Aerospace Division, as shown at paragraph 6 of the agreement, “[t]he income from contracts for aircraft sales is recognized as work progresses, on the basis of the delivery date, whereas in the Transportation Division, as shown in paragraph 10, “[i]ncome from long‑term contracts is recognized as work progresses, on the basis of costs incurred”.

[10] In summary, in the Aerospace Division, financing for long‑term work is obtained through advances of funds paid on dates predetermined in the contract of sale. The amounts of these advances do not depend on the work in progress or the work completed. They correspond to a portion of the selling price.

[11] Conversely, in the Transport Division, financing for work of the same nature is acquired through payments in amounts determined by progressive billing proportionate to the work completed.

In the case of aircraft sale contracts Bombardier used the “percentage-of-completion” method. The Crown did not dispute that this method was authorized by GAAP:

[27] The fact that the respondent’s balance sheet was GAAP‑compliant in all respects is recognized and acknowledged by the appellant and its expert. Indeed, the appellant’s expert, Mr. Thornton, confirmed this on cross‑examination. He also admitted that the respondent had correctly exercised its judgment regarding the advances, seemed to have applied standard SOP 81‑1 and had used paragraph 6.19 as a basis for its judgment; and that standard SOP 81‑1 was an acceptable source: see Mr. Thornton’s cross‑examination, Appeal Book, Vol. 10, at pages 109 to 114. He also acknowledged that the advances had been allocated to the project for which they had been paid, not used to finance other projects: ibidem, at page 117.

The Crown’s position was that in this case GAAP did not reflect economic reality:

[32] The appellant’s position, with which the Court of Québec agreed [a decision which is currently being appealed to the Québec Court of Appeal], gives precedence to the legal reality over the commercial and accounting reality by not allowing the amount of the advances to be reduced by the cost of the work for the purposes of calculating the taxable capital under paragraph 181(3)(b). According to the respondent’s expert, by designating the full amount of the advances as liabilities, the appellant is refusing to recognize that, on a commercial and economic level, the respondent used its inventory to perform the contract and sold that inventory, although from a legal standpoint ownership had not yet been transferred: see Mr. Chlala’s cross‑examination, Appeal Book, Vol. 9, at pages 40 to 43. In other words, the appellant’s position does not reflect the [translation] “economics of the situation” prevailing between the parties, which [translation] “suggest that a continuous sale occurs as the work progresses, and revenue should be recognized accordingly”: see the excerpt from the work by Messrs. Chlala, Ménard et al., quoted above in connection with the percentage‑of‑completion method.

The Court of Appeal rejected the Crown’s argument citing its earlier decision in Attorney General of Canada v. Ford Credit Canada Ltd.

In that decision Ryer JA wrote:

[27] In my view, this decision is far from helpful to the Minister in this appeal. In essence, Rothstein J.A. determined that the balance sheet of the taxpayer must be accepted for LCT purposes if it was accepted by the Superintendent of Financial Institutions. In my view, the same logic should apply where the corporation in question is subject to subparagraph 181(3)(b)(i) rather than subparagraph 181(3)(b)(ii). On that basis, provided that the balance sheet in question has been prepared in accordance with GAAP and otherwise complies with the specific provisions of Part I.3, that balance sheet must be accepted for the purposes of the determination of the LCT liability of the corporation.

While LCT decisions are of limited application to most taxpayers, this decision and the Ford Credit Canada Ltd. decision (where David Spiro was the successful lead counsel) form a useful bulwark against attacks mounted by the CRA based on “economic substance”.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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