http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/146037/index.do
Rio Tinot Alcan Inc. v. The Queen (July 15, 2016 – 2016 TCC 172, Hogan J.).
Précis: At issue in this appeal were roughly $100 million in expense claims in two related transactions: one acquisition transaction in 2003 and one disposition in 2004. The claims involved many different types of expenses, but the bulk (roughly $50 million) represented fees paid to investment bankers. The Tax Court held that the fees paid prior to the transactions having been the subject of a commitment to proceed were deductible as “Oversight Expenses” since the taxpayer was aggressively involved in the pursuit of increased shareholder value on a continuous basis. Costs are under reserve pending submissions from the parties.
Decision: Rio Tinto Alcan Inc. v. Canada is a complex case by any standard. It involved roughly $100 million in disputed expense claims in two inter-related transactions. The first transaction in 2003 (Pechiney - in dispute $77,374,669) involved a corporate acquisition of the Pechiney shares while the second transaction in 2004 (Novelis – in dispute $19,759,339) involved a divestiture of assets necessitated by the Pechiney transaction. The disputed payments covered everything from legal advisors to printing costs but the largest amounts at issue were fees paid to investment bankers ($34.2 million in the Pechiney transaction and $16.3 in the Novelis transaction). The Court framed the issue largely on the basis of whether the disputed expenses were for Oversight or Execution:
[72] In contrast, the Appellant argues that the Disputed Expenses were incurred as part of its ordinary business operations and not on capital account. In particular, the Appellant contends that the investment banking fees that it seeks to deduct under subsection 9(1) of the Act are current expenses because they relate to costs for professional advice relied upon by the Appellant’s board of directors in deciding whether or not the Pechiney and Novelis transactions should be approved. For the purposes of my Reasons for Judgment, 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”.
In a nutshell the Court concluded that expenses incurred prior to formally entering into the two transactions were Oversight Expenses:
[88] Simply put, Oversight Expenses are current expenses because they relate to the management of a corporation’s income‑earning process. Proper management includes the judicious allocation or reallocation of capital for the purpose of maximizing the income earned by the corporation. Ineffective oversight over the capital allocation process is a formula for disaster that often leads to a decline in earnings and cash flow and, as a result, the destruction of shareholder value. In this context, Oversight Expenses serve an income‑earning purpose. 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 this context, the Court must carefully scrutinize the evidence, with proper regard to the applicable evidentiary burden, in order to ensure that the expenses that are treated by a taxpayer as current expenses actually pertain to advice given to the board of directors to assist it in the decision‑making process undertaken as part of the exercise of the board’s oversight function. This is to be contrasted with expenses incurred as part of the implementation of a transaction leading to the acquisition of capital property. In that context, the Court must look at the primary purpose of the work performed. Was the work commissioned primarily to assist in the oversight or management process, or was it primarily linked to the implementation of a transaction carried out on capital account?
…
[98] I conclude that Oversight Expenses are deductible by the Appellant. The evidence shows that Oversight Expenses are of a frequent and recurring nature for this taxpayer. More importantly, the Oversight Expenses are deductible because they were incurred to facilitate the board of directors’ oversight over the income‑earning process, which includes, as noted earlier, oversight over the allocation of capital. Ineffective oversight by directors has a destructive domino effect for a corporation; it is a pathway to poor decision‑making, which in turn leads to poor earnings, which then results in poor share price performance. In this regard, the Appellant’s Oversight Expenses form part of the Appellant’s annual costs of business.
In the end the Court allowed as current deductions 65% of the fees paid to Morgan Stanley on the Pechiney transaction as Oversight Expenses. However it only allowed 35% of the fees paid to Lazard Frères on that transaction as Oversight Expenses. This likely arose at least in part from the Court’s annoyance at the manner in which the evidence from Lazard Frères went in:
[62] I cannot say the same for Mr. Erik Maris, who worked on both transactions on behalf of Lazard Frères. On common agreement of the parties, he testified by video conference from Paris. While counsel for the Appellant read his questions from his written notes, I observed that Mr. Maris was typing on his smart phone, which was hidden from view under the table. He constantly glanced down at it. At times, he paced around the room. Unlike his counterpart from Morgan Stanley, his answers often struck me as rehearsed. As he was double‑tasking throughout his testimony, he appeared to have had little opportunity to carefully consider the questions posed to him and to elaborate on his answers. Tellingly, his answers to counsel’s questions were very short. For these reasons, I attach less weight to his testimony. This is not altogether fatal for the Appellant, as at times the documentary evidence is sufficient to establish a fact critical to the Appellant’s case.
On the Novelis transaction the Court allowed 88.69% of the fees paid to Lazard Frères as a current deduction for Oversight Expenses but disallowed a small amount (roughly $300,000) paid to Morgan Stanley because it was not satisfied with the evidence on this payment.
The treatment of expenses other than payments to investment bankers is a mixed bag and likely not of too much interest other than to specialist readers.
The big take away from this case is the distinction between Oversight Expenses and Execution Costs. In the first place the Court established a “bright line” date test for distinguishing between the two types of expenses. It endorsed a distinction which had been publicly adopted by CRA based on whether there was a binding commitment to proceed with the project in question:
[83] The Appellant also notes that the CRA has publicly endorsed the principles enunciated in Bowater and Wacky Wheatley’s in its interpretation bulletin IT‑475 “Expenditures on Research and for Business Expansion”, as follows:
3. A taxpayer may carry out a continuous research program the purpose of which is to ensure that the taxpayer's business maintains or improves its position in its industry. Expenses of such a research program are treated as current expenditures deductible from income in the years in which they are incurred, notwithstanding the fact that from time to time the acquisition of capital assets may be a result of the research program.
. . .
5. Expenditures made as part of a taxpayer's ordinary business operations in respect of research to determine whether a capital asset should be created or acquired, but which themselves are not directly linked to the creation or acquisition of a capital asset, are current operating expenses which are deductible in the year incurred. However, once the commitment is made to proceed with the particular project all expenditures which are directly linked to the creation or acquisition of a capital asset form part of the capital cost of that asset unless that asset is not, in fact, created or acquired. In this latter case, architectural, engineering and other expenses relating to the proposed creation or acquisition of a specific capital asset are eligible capital expenditures (as defined in paragraph 14(5)(b)) for which an allowance is permitted by virtue of paragraph 20(1)(b) of the Act, provided that the expenses are incurred in connection with a business carried on by the taxpayer. If there is no such business at the time the expenses were incurred, no deduction for the expenses may be made.
[Emphasis added.]
In the case of Pechiney that date was July 7, 2003, the date of a public offer by Rio Tinto Alcan Inc. to acquire the Pechiney shares; in the case of Novelis it was November 23, 2004, the date of approval of the spin off plan by the Rio Tinto Alcan Board.
[90] The Appellant seeks to deduct, under subsection 9(1) of the Act, $18,887,115 out of the total amount of $26,051,194 that it paid Morgan Stanley for services in connection with the Pechiney transaction. This works out to 72.5% of the total amount paid to Morgan Stanley. This percentage is based on the following breakdown of fees provided by Morgan Stanley in a letter dated June 18, 2004:
(a) 30% attributed to general advisory services prior to June 1, 2003;
(b) 25% attributed to investigative and due diligence efforts prior to July 7, 2003 (the date the offer was publicly announced). These activities included among other things, reviewing general financial information, market and industry analyses and capital structure analysis to evaluate the advisability of the transaction;
(c) 10% attributed to rendering prior to July 7, 2003 (the date the offer was publicly announced), a financial opinion to Alcan with respect to the fairness of the consideration; and
(d) 7.5% (or half of the total of 15%) attributed to the analysis related to the amended and revised offers.
[Note that the 65% figure arrived at by the Court excluded the 7.5% referred to in para. (d) above incurred after July 7, 2003, the date of the public offer - see para. 99 of the decision.]
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[106] The evidence shows that the financial advisory process for the Novelis transaction extended over a long period of time because of the complexities arising from the simultaneous investigation of both alternatives. For this reason, the fairness opinion was delivered to the board of directors on November 23, 2004. The Board of Directors formally approved the Spin‑off at this same meeting. The Spin‑off was finalized on January 6, 2005.
[107] I agree with the Appellant’s submission that the evidence demonstrates that substantially all of the work performed by Lazard Frères in connection with the Novelis transaction related to financial advice provided in the course of the oversight process. I observe that Lazard Frères spent approximately 345 days, out of a total of 389 days they spent on the Novelis transaction, working on that transaction prior to its final approval. This works out to 88.69% of the total number of days they spent providing advice in connection with the transaction. In the absence of contrary evidence, I conclude that 88.69% of the total amount of $16,031,657 claimed by the Appellant as a deduction for its 2005 taxation year is deductible on current account.
[Footnotes omitted; emphasis added]
If the case is appealed (which seems likely) the crucial question is whether the Federal Court of Appeal (or Supreme Court of Canada) will accept the Tax Court Judge’s determination of both:
a. the entitlement to deduct Oversight Expenses; and
b. the cut off date for such deductions.
In my view the decision is likely to survive scrutiny on appeal. In the first place that is because the Tax Court Judge based his conclusions on the “bright line” date, i.e, the commitment to proceed test, in large part on the public position of CRA in in its interpretation bulletin IT‑475 “Expenditures on Research and for Business Expansion”. I think it highly unlikely that an appellate court would deprive a taxpayer of the benefit of that interpretation. Secondly the deduction of Oversight Expenses was also closed tied by the Judge to the nature of the business of the taxpayer which, on the evidence, was constantly looking for methods of improving shareholder value:
[9] One of Alcan’s business priorities was the maximization of shareholder value, which it accomplished by seeking out additional opportunities for increased revenues, earnings and economic value. Alcan had a long history of major acquisitions and transactions it had entered into for this purpose. Alcan sold its products to its subsidiaries and also received management fees and dividends from its subsidiaries.
Findings of fact of this nature and many others found throughout the decision are notoriously difficult to upset on appeal and it seems quite unlikely that an appellate court would do so in this case. The Federal Court of Appeal might seek to moderate the Oversight/Execution test by limiting it to larger commercial enterprises monitoring investments on a continuous basis (and not, e.g., incorporated sole proprietors) but at the end of the day this decision is likely good news for public companies carrying on business in Canada.
Costs are under reserve pending submissions from the parties.