In Canada v Rio Tinto Alcan, the Federal Court of Appeal (“FCA”) upheld the Tax Court of Canada (“TCC”) decision confirming, inter alia, the deductibility of certain takeover expenses incurred by Rio Tinto Alcan Inc. (“Alcan”) in its takeover of Pechiney S.A. (“Pechiney”).
The Appeal dealt with two transactions: 1) the acquisition of shares of Pechiney S.A. (the “Pechiney Transaction”); and 2) the spin-off of some of Alcan’s businesses through the disposition of shares of Arcustarget Inc. (“Archer”) to Novelis Inc. (“Novelis”) (the “Novelis Transaction”) to comply with regulatory requirements to carry out the Pechiney Transaction.
The issue was whether Alcan was entitled to claim expenses paid to various services providers involved in the Pechiney Transaction and the Novelis Transaction, including fees paid to two investment banking firms that were tasked with analyzing the business and financial conditions of Alcan and Pechiney and preparing financial models for both the Pechiney Transaction and Novelis Transaction (the “Investment Banking Expenses”).
In addition to the Investment Banking Expenses, at issue in the appeal was the deductibility of legal and other expenses incurred in the Pechiney Transaction and Novelis Transaction. In this article, however, we will focus on the TCC and FCA reasons for allowing the current deduction of the Investment Banking Expenses.
Alcan argued that the Investment Banking Expenses were currently deductible pursuant to subsection 9(1) of the Income Tax Act (the “ITA”). In other words, Alcan defended its entitlement to the current deduction of the Investment Banking Expenses on the basis that such expenses were incurred within the realm of Alcan’s income earning process. Alternatively, Alcan argued they were deductible pursuant to paragraph 20(1)(bb) of the ITA.
The Crown’s position was that the Investment Banking Expenses were in the nature of capital expenditures which, pursuant to paragraph 40(1)(a) of the ITA, should have been added to the adjusted cost base of the Pechiney shares (in the case of the Pechiney Transaction) or deducted from the proceeds of disposition of the Archer shares (in the case of the Novelis Transaction).
After referring to subsection 9(1) and paragraphs 18(1)(a) and (b) of the ITA, Hogan TCJ summarized his demarcation line between currently deductible takeover expenses and ones incurred on capital account:
I designate fees for services that assist the board in the decision-making process and in the fulfilment of its oversight function as “Oversight Expenses”. I designate fees for services that facilitate the execution of a capital transaction as “Execution Costs”.
Hogan TCJ referred to the extensive jurisprudence and summarized the three main tests that have been developed by the Courts for distinguishing capital expenditures from current expenditures.
The first test was considered in British Insulated and Helsby Cables v. Atherton and takes into account the recurring or single outlay characteristic of the expense. Recurring expenses are considered to be current expenditures; conversely, single outlay expenses, or expenses incurred “once and for all” will likely be considered capital expenditures.
The second test, also considered in British Insulated, takes into account whether the expenditure is made with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, in which case the expenditure will be on account of capital, unless there are special circumstances leading to an opposite conclusion.
The final test, set-forth in Ikea Ltd. v. Canada, considers whether the expense that is incurred is related to the income earning process, in which case it would be a current expenditure, or whether the expense is incurred for the implementation of a transaction that results in the acquisition of a capital asset or the creation, enhancement, or expansion of a taxpayer’s business, in which case it would be a capital expenditure. Based on Ikea, the underlying purpose of an expenditure is to be considered within the context of the taxpayer’s business.
After applying these three tests to the case at bar, Hogan TCJ found that the Investment Banking Expenses characterized as oversight expenses were current expenses, deductible under subsection 9(1) of the ITA. Hogan TCJ emphasized that in the modern corporate world, shareholders of corporations expect that directors will review material transactions with the same level of scrutiny as that undertaken by well-advised investors. Hogan TCJ noted that oversight expenses per se do not create enduring benefits for taxpayers; rather, it is the actual implementation of an approved capital transaction that creates the enduring benefit.
In support of his proposition that not all expenditures made to bring a capital asset into existence are capital in nature, Hogan TCJ cited the decision in Bowater Power Co. Ltd. v. M.N.R , in which the Federal Court ruled that the costs of engineering studies to determine the feasibility of power development sites were current expenses. Hogan TCJ also relied on an earlier TCC judgment in Wacky Wheatley’s TV & Stereo Ltd. v. M.N.R, in which travel costs to explore the feasibility of a plan to expand the taxpayer’s audio business into Australia were also held to be current expenses.
Hogan TCJ also pointed out that if Alcan had hired employees to perform the services provided by the investment bankers, the Minister of National Revenue would likely have allowed the claim for salary expenses for those employees. The fact that Alcan decided to outsource one aspect of its business was found to have no bearing on the tax treatment of the expenditure, following the Court’s ruling on Pantorama Industries Inc. v. Canada.
Alternatively, Hogan TCJ found that the Investment Banking Expenses were deductible under paragraph 20(1)(bb) of the ITA, which specifically provides for the deductibility of expenses paid for advice “as to the advisability of purchasing or selling of specific shares”, except where the payment is in the nature of a commission.
Hogan TCJ performed the requisite textual, contextual and purposive analysis and considered the decisions in ITA Travel Agency Ltd. and Consolboard Inc. v. MacMillan Bloedel and found that the term “commission” signified payments determined by reference to a percentage on sales or volume. As the amounts to be paid to the investment bankers in this case were fixed fees, they did not come within the meaning of “commission”.
The Crown argued that paragraph 20(1)(bb) was not applicable in the situation of the purchase of all of the shares of a target corporation, given the reference to “specific share” in the English version of the provision and the use of the phrase “certaines actions” (“certain shares”) in the French version.
Hogan TCJ concluded that the use of the terms “specific shares” and “certaines actions” were not meant to distinguish between the purchase or sale of all, versus only some, of the shares of a corporation. Rather, they merely reflected Parliament’s intention to exclude generic investment advice, such as a recommendation that 10% of an investor’s savings be invested in preferred shares. Hogan TCJ found that the wording and context of paragraph 20(1)(bb) suggested that Parliament intended that a deduction would be available where the investment advice was clear and concerned shares of a particular issuer. In the present case, as the Investment Banking Expenses pertained to particular shares of Pechiney and of the Appellant, they were deductible under 20(1)(bb).
The FCA dismissed the Crown’s appeal (and Alcan’s cross-appeal with respect to other issues), holding that Hogan TCJ did not err in finding that Alcan was entitled to claim the Investment Banking Expenses on a current basis, finding that Hogan TCJ’s “factual conclusions support the proposition that a core feature of Alcan’s business model included the acquisition of corporations for the purpose of generating revenue, increasing its income and adding to shareholder value”.
The FCA concurred with Hogan TCJ’s conclusion that the “oversight expenses” incurred by Alcan met the recurring expense test and were related to Alcan’s income earning process. The FCA also clarified that the normal management of a company’s business operations may include the evaluation of a future course of action which may or may not result in the construction or acquisition of a capital asset; the mere fact that an expenditure is incurred in the course of deciding whether or not to acquire a capital asset does not mean it is necessarily made on account of capital.
Among the reasons for allowing the deductibility of “oversight expenses” under subsection 9(1) of the ITA, the FCA emphasized that the context in which directors of publicly traded widely-held corporations operate is different from that of directors of closely held corporations, such that Hogan TCJ’s comments on the “standard of care” issue clearly contemplate the position of directors of widely held corporations.
The FCA also endorsed Hogan TCJ’s interpretation of paragraph 20(1)(bb) of the ITA, holding that the determination of investment bankers’ fees based on certain performance benchmarks did not bring those fees within the definition of a “commission” and pointing out that the Minister did not identify a statutory purpose which would justify a distinction between advice related to the purchase of some shares of an issuer as opposed to advice with respect to the purchase of all of the shares of that issuer.
The TCC and FCA judgments in Rio Tinto Alcan represent a marked departure from the long-standing CRA policy to automatically treat all of the expenses related to acquisition of a capital asset as a capital expenditure. The FCA reference to a more stringent “standard of care” attributable to directors of public corporations may, however, limit the holding in this case to mergers and acquisitions involving public corporations and not closely-held corporations (where paragraph 20(1)(bb) of the ITA is not otherwise applicable), contrary to the reasoning and apparent intent of Hogan TCJ.