George Weston Limited v. The Queen
(February 19, 2015 – 2015 TCC 42, Lamarre ACJ).
Précis: During its 2003 taxation year George Weston Limited closed swap contracts and realized a profit of $316,932,896. It reported a taxable capital gain of half that amount. CRA took the position that the profit was business income and assessed accordingly. The Court found that “the swaps were entered into as a hedge in order to protect a capital investment and that therefore the gain derived from terminating the swaps was on capital account.” They were terminated early for sound business reasons. The resulting profit was neither business income nor income from an adventure in the nature of trade.
Decision: The underlying facts of this case were not complex:
 During its taxation year ended December 31, 2003, the appellant, George Weston Limited (GWL), received in respect of the termination of cross‑currency basis swap contracts (swaps) proceeds totalling CAD$316,932,896. In its income tax return for its 2003 taxation year, GWL treated that amount as being on account of capital and reported a taxable capital gain of CAD$158,466,448. The Minister of National Revenue (Minister) reassessed GWL on the basis that the CAD$316,932,896 was on income account and added to GWL’s income the full amount, hence the present appeal.
 GWL is a Canadian publicly traded corporation and the parent holding company of subsidiary corporations inside and outside Canada. A significant portion of the assets owned and businesses operated by the GWL corporate group is in the United States.
 In its Notice of Appeal, GWL stated that it had entered into the swaps in order to preserve its consolidated balance sheet equity and protect against Canadian dollar and United States dollar (USD) foreign exchange fluctuations that would create volatility in GWL’s consolidated balance sheet equity. In its submissions to the Court, GWL offered some specifics. GWL indicated that it carried on various existing and newly acquired bakery-related businesses in the United States, using US currency, through indirectly held subsidiaries (referred to as self-sustaining foreign operations or USD Operations) and that this was the reason GWL was affected by the Canadian dollar and USD exchange rate fluctuations. Those fluctuations affected GWL’s consolidated equity, which in turn affected the debt to equity ratio. Hence, they had an impact on the value of GWL’s direct capital investments in other corporations in the GWL corporate group, and on GWL’s very capital structure.
 In the end, GWL took the position that, because the Canadian dollar had appreciated relative to the USD between 2001 and 2003, the proceeds it received in 2003 upon terminating the swaps it entered into in 2001 were a capital gain.
The Crown’s primary position was that there could be no capital gain since there was no underlying purchase or sale of a capital asset:
 The respondent is of the view that the receipts from the closing out of a derivative such as the swaps will be treated as being on capital account for income tax purposes only if it can be shown that the derivative is linked to an underlying transaction that is the purchase or sale of a capital asset, the repayment of a debt denominated in a foreign currency or the investment of idle capital funds, in accordance with what is referred to in the case law as the “linkage principle”. In the Crown’s view, if the derivative is not linked to such a transaction, the profit or loss on the closing out of the derivative is considered either as resulting from speculation or, by default, as being part of the ordinary business of the taxpayer, and is therefore considered to have been received on income account. In the present case, the respondent submits that, as the swaps were not linked to any transaction or debt obligation of the appellant denominated in a foreign currency that it entered into on its own account, the amount received by the appellant when it closed out the swaps is considered to be part of the business of the appellant and therefore a profit from its business that is taxable as income.
The swap transactions were as a result of the acquisition in 2001 of Bestfood Bakery and the resulting increased US$ debt exposure of the taxpayer:
 In 2001, the GWL corporate group acquired another mainly United States‑based bakery business called Bestfoods Baking (Bestfoods) and its subsidiaries and related trademarks. This acquisition drastically increased the GWL corporate group’s net investments in USD Operations from approximately US$800 million to well in excess of US$2 billion.
 The Bestfoods acquisition was financed entirely by debt, through loans from Canadian banks to GWL (CAD$2.1 billion and US$400 million). As a result, in 2001, GWL’s debt to equity ratio rose well beyond its internal corporate policy of 1:1 or lower. GWL invested the borrowed funds in its subsidiaries, which then acquired Bestfoods for US$1.765 billion, as detailed in the Partial Agreed Statement of Facts.
 After the acquisition of Bestfoods in 2001, the investment in USD Operations exposed to currency risk increased from US$666 million (US$816 million investment in WFI as at December 31, 2000, less US$150 million in swaps entered into in 2000) to approximately US$2 billion.
 To circumvent that risk, GWL decided to hedge its increased USD currency risk. Following the closing of the Bestfoods transaction, GWL entered into a number of swaps with various financial institutions (the “counterparties”) for terms of mostly 10 to 15 years to hedge, or protect against, currency fluctuations affecting the reported value of the old and the newly acquired USD Operations (Exhibit A-7, par. 27, and Transcript, vol. 1, page 211).
In the taxpayer’s consolidated financial statements the transactions were described as a currency hedge:
 In the consolidated financial statements, the “swaps [were] identified as a hedge against foreign currency exchange rate fluctuations on [GWL]’s [US] dollar denominated net investment in self-sustaining foreign operations with realized and unrealized foreign currency exchange rate adjustments on . . . swaps recorded in the cumulative foreign currency translation adjustment.” (Notes to the 2002 consolidated financial statements, Exhibit A-1, Tab 2, page 125). This was in conformity with an internal memorandum issued on April 10, 2001, in which GWL recognized that the Bestfoods purchase would directly expose GWL to increased risk, and in which GWL designated the swaps as a hedge, indicating that if sufficient swaps were entered into, the debt to equity ratio would be protected from exchange rate fluctuations (Exhibit A-9, Tab 1).
As a preliminary matter the Court allowed the taxpayer to introduce the evidence of Ms. Joyce Frost, an expert in hedge financing:
 The respondent objected to Ms. Frost’s testimony on the basis that it was highly prejudicial (in that her opinion was based on her anecdotal experience from working in risk management for 25 years), was not relevant to the issue to be decided, was not necessary to assist the trier of fact in analyzing evidence that is technical in nature and was subject to exclusionary rules (R. v. Mohan
,  2 S.C.R. 9 at page 20; R. v. Sekhon
,  1 S.C.R. 272).
 I overruled that objection. I did not agree that Ms. Frost’s opinion was anecdotal. Her opinion based on 25 years’ work experience in risk management cannot be compared to a police officer testifying as to the mens rea
of a particular defendant in a criminal matter as was the case in Sekhon
, referred to by the respondent. With respect to relevance and necessity, this is a case in which I find it particularly useful to have the insight of an expert in the risk management field as it is directly linked to one of the issues between the parties: i.e., whether or not the swaps qualify as a hedge
The Court accepted the taxpayer’s evidence that the transactions were a hedge and not speculative currency transactions:
 Here, I find that the evidence establishes that the appellant, in entering into the swaps, was acting in close consultation with and on behalf of its subsidiaries in order to protect the equity of the whole Weston group, as disclosed in the consolidated financial statements. As stated by Ms. Frost and Mr. Thornton, the underlying USD net investments were in a direct way highly sensitive to GWL’s currency risk. Indeed, I agree with the appellant that the fluctuations in the USD investments affected GWL’s own capital structure and had an impact on the value of GWL’s direct investments in its subsidiaries.
 The respondent submitted that the foreign exchange translation risk existed only because of the GAAP requirements that the value of the net assets of the subsidiaries be translated into Canadian dollars for consolidated reporting purposes. In her view, that translation risk had no impact on the cash flow or earnings of the appellant. This view does not seem to be shared by Ms. Frost, whose opinion was that, although there was no periodic cash effect, GWL still faced the risk that changes in foreign exchange rates could have a negative impact on the book value of its equity, and this risk could be particularly harmful to GWL’s stakeholders. In her opinion, volatility in equity due to changes in foreign exchange rates is not favourably regarded by equity investors or credit‑rating agencies (par. 34 of her report, Exhibit A-11). I infer from this that the translation risk referred to by the respondent did have an impact on the cash flow earnings of the appellant, which might have lost its borrowing capacity had it not put in place a hedge to mitigate that risk. As a matter of fact, Standard and Poor’s raised a red flag with regard to GWL’s credit rating after GWL’s decision to use bank financing for the acquisition of Bestfoods.
 Further, the respondent’s argument fails to recognize that a real risk existed in GWL’s business after the Bestfoods acquisition, regardless of any GAAP requirements or “notional” reporting prior to the termination of the swaps. That risk was reflected in the CTA, in accordance with GAAP, but that does not change the fact that GWL was exposed to currency risk associated with an increasing debt to equity ratio as a result of its expanded indirect holdings in US assets. That risk led to tangible consequences as detailed by Ms. Frost and as evidenced by Standard & Poor’s credit watch discussed above. This caused management to hedge the risk using swaps which were directly tied to the value of GWL’s US assets.
The Court concluded that the gains were on capital account and, in so finding, rejected that Crown’s argument that there must be a purchase and sale of the underlying capital asset being hedged:
 I come to the conclusion that the appellant entered into the swaps and rightly reported them as a hedge in its consolidated financial statements for accounting and tax purposes. As noted by Professor Thornton in his report, the consolidated financial statements are GWL’s financial statements (Exhibit A-12, par. 49 and footnote 15). I am satisfied that the appellant was not speculating, and that it was not its policy to speculate through derivative instruments. It has been demonstrated that the amount of the swaps matched as closely as possible the amount of the net investment in self-sustaining US operations (Thornton Report, Exhibit A-12, par. 19).
 I also do not accept the respondent’s approach which denies capital treatment to proceeds earned from a hedging contract if there is no sale or proposed sale of the underlying item being hedged (see the CRA’s published view on the matter reproduced in par. 110 of the appellant’s submissions). I agree with the appellant that this view has no legal basis and is a wrong interpretation of the case law. In Salada Foods
, there was no evidence linking the proceeds from the derivative to the capital investment in the subsidiaries, and the derivative was clearly speculative. In Shell
, it was determined that hedge proceeds will be on capital account if the item being hedged is a capital item. The Court did not lay down a rule that would support the respondent’s restrictive approach. In Atlantic Suga
r and Tip Top Tailors
, the derivatives were used to hedge what were clearly income transactions. With regard to Placer Dome
and Echo Bay
, neither of these cases involved a capital versus income characterization. In Ethicon
, a secondary intention was established and a portion of the funds was clearly used for income transactions.
 In sum, the present case involves a situation that has not previously been brought before the courts, at least that I am aware of. The appellant made a commercial and business decision, after careful consideration, to enter into the swaps in order to protect its consolidated group equity. It knew better than anyone else the consequences of having its net investment assets exposed to the risk of currency fluctuations. The swaps are commercial derivatives designed expressly to circumvent that kind of risk. As stated by Ms. Frost, the swaps were not speculative transactions. They were designed for hedging in the financial market. Now when the risk vanished, there was no need to keep the swaps. Here, GWL was satisfied that the swaps were no longer necessary when the risk exposure of the net investment assets was reduced significantly. They therefore decided to unwind the swaps. I have concluded that the swaps were entered into to protect a capital investment, and therefore they were linked to a capital asset. Absent unacceptable risk with regard to those capital assets, the swaps had to be terminated since the reason for their existence no longer applied, and the gain or loss from unwinding the swaps should, in my view, be treated as being on capital account. The swaps were not linked in any manner to any business income per se.
Finally the Court rejected the argument that the taxpayer somehow turned into a speculator when it closed the swaps in 2003 at a profit:
 As described earlier in these reasons, GWL’s intention at the time of entering into the swaps was to hedge the currency risk associated with an increasing debt to equity ratio as a result of translating its US assets. Once the debt to equity ratio returned to acceptable levels, management determined that the swaps were no longer necessary. Although there was a need for cash in the business at the time the swaps were closed out, the evidence demonstrates that the unhedged currency risk was acceptable to management given the improved debt to equity ratio in 2003. In other words, in 2003 management felt that volatility in an unhedged CTA would not put GWL offside of its internal debt to equity guideline. GWL did not transform into a speculator in the derivatives market, thereby violating its internal policies and credit agreements, simply because the swaps were “in the money” when terminated.
As a result the appeal was allowed with costs.
Comment: This decision of Associate Chief Justice Lamarre combines a detailed examination of the underlying facts as well as a scholarly examination of the law as it relates to hedging transactions, capital gains and adventures in the nature of trade. The Crown’s position that a capital gain can only arise on a hedging transaction if there is a sale or a proposed sale of the item being hedged seems to have been somewhat of a Hail Mary pass. As the Court succinctly points out “this view has no legal basis and is a wrong interpretation of the case law”. It is unusual for a court to deal with an argument quite this bluntly but in my view the Court was absolutely right to do so here.