Canada: Plains Midstream: Looking For Tax Symmetry In All the Wrong Places?

The recent Tax Court of Canada decision in Plains Midstream Canada ULC v. The Queen, 2017 TCC 207¹ is a good example of how the tax analysis of a relatively simple fact situation can become quite complex.

Facts

The loan

In 1981, two Canadian corporations, Dome Petroleum Limited and Encor Energy Corporation, borrowed $400 million from the Arctic Petroleum Corporation of Japan (APCJ).

The loan was interest-free and repayable in 2030. While both corporations were jointly liable for the full principal amount, they agreed between themselves that Dome Petroleum would be responsible for $175 million of the loan and Encor would be responsible for the other $225 million.

By 1987, Dome Petroleum was in financial difficulty and Amoco Canada Petroleum Company Ltd., the predecessor to the Appellant, decided to acquire it. To eliminate one of the obstacles to the acquisition, the Appellant accepted a payment of $17.5 million from Encor in return for which it assumed the latter's liability to APCJ. The tax consequences of this transaction – specifically, the permissibility of a deduction for interest that the Appellant claimed – were at issue in the appeal.

The deduction

In computing its income for its 1995 and 1996 taxation years, the Appellant claimed a deduction for interest in respect of the obligation to pay APCJ $225 million that had been assumed from Encor. Initially, it calculated the deduction by taking the difference between the amount received from Encor and the amount payable to APCJ ($207.5 million) and apportioning it on a straight-line basis over the remaining life of the loan from APCJ. Shortly before trial, however, the Appellant amended its position to claim a deduction on the basis of applying simple interest of approximately 6 per cent to the $17.5 million it received from Encor. The basis for the interest deduction was the combined application of subsection 16(1) and paragraph 20(1)(c) of the Income Tax Act (Canada).²

Issue

The key issue was whether subsection 16(1) applied to the Appellant's obligation to pay APCJ to deem a portion of the payment to be interest.

At the relevant time, subsection 16(1) provided as follows:

16 (1) Where, under a contract or other arrangement, an amount can reasonably be regarded as being in part interest or other amount of an income nature and in part an amount of a capital nature, the following rules apply:

(a) the part of the amount that can reasonably be regarded as interest shall, irrespective of when the contract or arrangement was made or the form or legal effect thereof, be deemed to be interest on a debt obligation held by the person to whom the amount is paid or payable.

The Appellant argued that subsection 16(1) allowed the transaction to be recast for tax purposes with respect to its "economic substance", by reference solely to the Appellant's own perspective, without regard to how the transaction appeared

Decision: Subsection 16(1) applies symmetrically

The Tax Court of Canada judge conducted a thorough analysis of the history, purpose and amendments to subsection 16(1) and ultimately accepted the Crown's argument that subsection 16(1) required symmetry in its application. If it deemed an amount to be interest to the payer it must also be interest to the recipient. Since the $225 million payment to be received by APCJ was clearly principal and not interest, subsection 16(1) could not apply to deem any portion of this payment to be interest payable by the Appellant.

Analysis: Symmetry, yes ... but in which transaction?

That subsection 16(1) dictates symmetry seems incontrovertible. The question that the decision raises is in what transaction is the symmetry required.

As we have noted, the case involved two transactions. The first was a $225 million loan from APCJ to Encor that was to be repaid, on an interest-free basis, after 49 years. In the second transaction, Encor paid the Appellant $17.5 million, in exchange for which the Appellant agreed to assume the repayment obligation with respect to the $225 million owed by Encor to APCJ. The Court noted that the amounts received by APCJ were clearly principal, from which it followed that no portion of the amount paid by the Appellant could be considered interest to allow for the application of subsection 16(1). However, of the two transactions noted above, the Appellant was a party only to the second. It is true that it agreed to pay the $225 million that Encor owed to APCJ, but it did not thereby become a party to the transaction that had created that obligation. Should the symmetry not be tested, therefore, with respect to the second transaction rather than the first? If so, can it then be said that Encor is to receive an amount, part of which may be regarded as interest?

Symmetry in the second transaction

Encor had an obligation to pay APCJ $225 million in the year 2030. As an alternative to paying the Appellant $17.5 million to have the Appellant satisfy its obligation, it could have invested the $17.5 million in interest-bearing securities that would have produced enough income to leave Encor with $225 million in 2030. Had it done so it would have taxable income equal to such amount. Does the transaction Encor entered into with the Appellant allow it to avoid this income inclusion? If not, there would be symmetry in the transaction between the Appellant and Encor if the Appellant was able to deduct the same difference. Intuitively this seems to be the correct result.³

The Court addresses the transaction between the Appellant and Encor but seems to conclude that it did not involve a payment from the Appellant to Encor that could invoke the application of subsection 16(1). At paragraph 60 of the decision the Court notes that:

[60] A textual interpretation of subsection 16(1) of the ITA, which provides for symmetrical treatment, does not favour the Appellant's position, as no part of the amount that is due by the Appellant can reasonably be regarded as interest that is payable to APCJ under the terms and conditions of the exploration loan. Nor, for that matter, was the Appellant required to make blended payments to Encor under the Settlement Agreement or the Encor Indemnity and Subrogation Agreement.

And then again at paragraph 103:

[103] The Settlement Agreement does not create obligations on the Appellant to make payments to Encor. There are no blended payments to be considered under that agreement. The Appellant simply commits to performing Encor's obligations under the Formal Contract and to indemnifying and holding Encor harmless as regards any damage that it suffers from the Appellant's failure to do so.

Is the performance of another person's obligation under a contract not equivalent to a payment to that person? If an employer commits to pay an employee's mortgage payments is that not the equivalent of a payment of salary to the employee?

Conclusion

Apologies for the "Blowin' in the Wind" stream of questions, but the result in the case raises many issues. The transaction between the Appellant and Encor economically resembles a loan but neither the lender nor the borrower incurred the tax consequences of a traditional loan.

Footnotes

1 This decision has been appealed to the Federal Court of Appeal.

2 All statutory references are to the Income Tax Act (Canada).

3 In fact, once Encor was released from its obligation to pay APCJ, it arguably would have debt forgiveness consequences. Would this be enough to create the symmetry the Court required?

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