Industries Perron Inc. v. R. – FCA: Posting of Security for Softwood Lumber Duties is Not a Deductible Expense

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Industries Perron Inc. v. The Queen[1] (July 5, 2013) is a decision of the Federal Court of Appeal that dealt with the tax consequences of aspects of the Canada-US Softwood Lumber controvery:[2]

[2]               Perron is a softwood lumber producer who exports softwood lumber to the United States.

[3]               In March 2001, the Canada-U.S. Softwood Lumber Agreement expired. Days later, the American softwood lumber industry filed a petition with the U.S. Department of Commerce (DOC) seeking the imposition of countervailing and anti-dumping duties. In the United States, the responsibility for assessing allegations of unfair subsidies and dumping is divided between the DOC and the International Trade Commission (the ITC).

 [5]               On November 6, 2001, the DOC made a preliminary determination that there were reasonable grounds to believe that certain softwood lumber products were being dumped into the U.S. market. The DOC determined that the “estimated weighted average dumping margin” was 12.58%. As a result, the U.S. authorities ordered “[t]he posting of a cash deposit, bond, or other security, as the administering authority deems appropriate, for each entry of the subject merchandise…”: United States Code, Title 19, article 1673b(d)(1)(B).

 [7]               Perron chose to post security but, rather than simply paying a bonding company a fee for a bond or guarantee in the appropriate amount, it entered into a more complicated arrangement. The Insurance Company agreed to guarantee a Perron’s potential liability to a maximum of US $1,530,000 (CAN $2,371,500) to allow it (Perron) to continue to do business in the United States. In these reasons, I will use the words “bond” and “guarantee” interchangeably to refer to the obligation undertaken by the Insurance Company on behalf of Perron.

[8]               One of the conditions of the bond was that the full amount of the bond be secured by irrevocable letters of credit in favour of the Insurance Company. The Royal Bank issued the letters of credit but it, in turn, required Perron to purchase term deposits for the full amount of the letters of credit and to hypothecate them to the Bank as security for the letters of credit. Pursuant to these arrangements, Perron deposited $2,371,500, in term deposits with the Royal Bank and hypothecated the term deposits in favour of the Bank. The result was that the amount of $2,371,500 stood to Perron’s credit on the Royal Bank’s books but Perron was unable to access those funds in any way so long as the Bank remained liable to pay on the irrevocable letters of credit.

 The U.S. Government confirmed the preliminary determinations by orders dated April 2, and May 22, 2002. However, it also decided that no countervailing duties or anti-dumping duties were payable for entries prior to May 22, 2002 and ordered the release of cash deposits or bonds guaranteeing the payment of duties for entries prior to that date. As a result, the Insurance Company was released from any further obligation, the letters of credit were allowed to expire and the hypothecation of the term deposits was discharged.

[10]           In filing its income tax return for its fiscal year ending December 31, 2001, Perron deducted from its income the sum of $3,576,088. In its income tax return for the 2002 taxation year, Perron recognized as income the same $3,576,088 which it had deducted in the previous year, given that the hypothecation agreement with respect to its terms deposits was discharged.

[11]           The amount which Perron deducted from its income for the 2001 taxation year, and included in its income in the subsequent year, includes the $2,371,500 invested in term deposits hypothecated to the Royal Bank as well as a further $1,204,588 which, according to the Perron’s Memorandum of Fact and Law represents the amount of security which would have been required on Perron’s exports to the United States from May 2001 to August 2001, had such security been required. No security was required with respect to that period and no amounts were paid by Perron with respect to that period, though it may have been restricted in its ability to dispose of goods which entered the U.S. during that period: see Appellant’s Memorandum of Fact and Law, paragraph 3 (note 1) and paragraph 17. Perron made no argument with respect to this amount and so, while it may not have abandoned the argument, it did not pursue it. As a result, I am of the view that the only amount in issue in this appeal is the amount of the term deposits hypothecated to the Royal Bank.

[12]           On February 3, 2005, the Canada Revenue Agency disallowed the deduction of $3,576,088 from Perron’s income for the 2001 taxation year. Perron filed a notice of objection to the reassessment. When the reassessment was confirmed, Perron launched this appeal.

 The court agreed that Perron could not continue to carry on business with the United States without the posting of a cash deposit, bond or other security.  At the same time it agreed with the Crown that no duties were in fact payable in 2001:[3]

[23]           I agree with Perron that it had a present obligation with respect to each shipment of softwood lumber it exported to the United States after the effective date of the preliminary determinations by the DOC and the ITC. If Perron was to continue to export softwood lumber to the United States, it could only do so by satisfying the obligation imposed on it by articles 1671b(d)(1)(B) and 1673b(d)(1)(B) of Title 19 of the United States Code, specifically by either making a cash deposit or by arranging for a bond or other security. To that extent, the obligation to provide a cash deposit or security was a present obligation, but this fact is not determinative of the deductibility of the amounts used to satisfy that obligation. I agree with the respondent that Perron did not have an obligation to pay countervailing or anti-dumping duties in 2001.

Since Perron retained property in the funds deposited as security for the letter of credit, the court concluded that the payment was not deductible:[4]

[29]           In this case, it is clear that the amounts deposited in term deposits with the Royal Bank remained to Perron’s credit. Perron’s financial statements showed them as an asset, though subject to a contingent liability: see Appeal Book, pages 70 and 74. Perron was a creditor of the Bank to the extent of the principal amount of the term deposit together with any accrued interest. As a result, these amounts were not deductible pursuant to paragraph 18(1)(a) since they were not made “once and for all, without recourse”, as Perron retained an interest in the funds.

Perron’s secondary argument was that, as a matter of economic substance, the situation was the same as if Perron had deposited the amounts with the US government.  The court rejected this argument as well:[5]

[31]           Perron’s second argument seeks to avoid the issue of whether the deposit of funds with the Royal Bank was “an expense or an outlay” by focusing on the words “an amount paid” and “as or on account of countervailing or anti-dumping duties” as provided in paragraph 20(1)(vv) of the Act. Perron’s argument is one of economic substance. It says that it is in exactly the same position financially as a result of acquiring the term deposits as it would have been had it satisfied its obligations to the U.S. authorities by making a cash deposit.

[32]           Perron says that if it had deposited the same funds with the U.S. Government, as it was entitled to do, paragraph 20(1)(vv) would have allowed it to deduct the amount paid from its income in the year of payment. Paragraph 12(1)(z.6) would have required it to include in income any amounts returned to it by the U.S. Government as a result of the ruling that no countervailing or anti-dumping duties were payable prior to May 22, 2002.

[36]           In tax law, form matters. In Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, [1999] S.C.J. No. 30 (Shell), the Supreme Court of Canada held that the courts are not to re-characterize a taxpayer’s transaction unless the label attached by the taxpayer to the transaction does not properly reflect its actual legal effect:

To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer’s legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect: Continental Bank Leasing Corp. v. Canada, [1998] 2 S.C.R. 298, at para. 21, per Bastarache J.

Shell, cited above, at paragraph 39

[37]           The corollary of this proposition is that the taxpayer will be held to the form of transaction which it has chosen so long as that form is consistent with the actual legal effect of the transaction.

This decision does not present any particularly novel points.  It does however confirm the “sauce for the goose, sauce for the gander” nature of the economic substance concept.  While it is normally the Crown which is unsuccessful in making economic substance arguments, the taxpayer will normally also fail in advancing such arguments.

[1] 2013 FCA 176.

[2] Id, per Pelletier JA.

[3] Id.

[4] Id.

[5] Id.