Canada: Tax Court Of Canada Litigation Update "Henco Industries Limited v HMQ"

The recent Tax Court of Canada decision in Henco Industries Limited v. Her Majesty the Queen, provides litigation and tax practitioners with guidance on evidentiary and substantive tax issues.

BACKGROUND

Henco Industries Limited ("Henco") was the owner and developer of the Douglas Creek Estates in Caledonia, Ontario ("DCE Property"), which became the site of a volatile situation in 2006. Protesters from Six Nations occupied the property and erected barricades, halting all development efforts by Henco. Henco obtained court orders requiring the protestors to vacate the land, which the Ontario Provincial Police was unable to enforce. The Government of Ontario, after rezoning the land to preclude all development, paid $15.8 million to Henco under an agreement of purchase and sale to acquire the DCE Property, ensure the removal of the court orders, and secure a release from Henco, among other things (the "Agreement").

The primary issue at Tax Court was the proper tax treatment of the $15.8 million receipt. Following a seven day trial at the Tax Court of Canada, the Honourable Mr. Justice Campbell Miller ruled in favour of Henco, finding that the entire $15.8 million payment was a non-taxable capital receipt.

The decision contains a number of important evidentiary and substantive findings, which are summarized below.

ADMISSIBILITY OF FACTUAL MATRIX EVIDENCE IN TAX COURT

• Evidence of the "factual matrix" in which a contract is made between the taxpayer and a third party is "essential" to determine the correct characterization of a payment made under that contract.
• Regarding the parol evidence rule, the Court noted that there is "no discernable bright line" between evidence of the factual matrix, which is "clearly admissible," and evidence of the subjective intentions of the parties, which is "perhaps inadmissible." Further, the Court was "not convinced" that the existence of an ambiguity in a contract is necessary for extrinsic evidence to be admissible, although it is sufficient. Rather, in cases such as this, extrinsic evidence will be necessary to "achieve a correct, just result."
• As such, the Court expressed "some reservations about the universal application of the parol evidence rule" in the Tax Court. The Court noted that it is often required to look past the words of an agreement to its substance. For example, section 68 of the Income Tax Act empowers the Court to look beyond the parties' allocation of consideration in the sale of assets to determine what is reasonable, which the Court observed may not be possible "in a vacuum."

Based on these principles, Justice Campbell Miller dismissed a preliminary motion by the Respondent for an order excluding extrinsic evidence relating to the execution of the Agreement. His Honour ruled that "extrinsic evidence is not only admissible, it is critical to the proper characterization of the $15,800,000 payment. [...] To impose the parol evidence rule in these circumstances would thwart the goal of determining the correctness of that assessment."

PUBLIC DOCUMENTS EXCEPTION TO THE HEARSAY RULE

The decision provides guidance regarding the public documents exception and the principled approach to the hearsay rule. Based on these exceptions, Henco sought to introduce the following documents into evidence without calling their authors as witnesses: 

• Certain press releases issued by the Government of Ontario, among others, relevant to the issues in the Appeal, the authenticity of which were not in dispute; and
• Certain affidavits sworn by public officials. The affidavits had been filed with the Court of Appeal for Ontario in support of a motion to stay an order of the Superior Court of Justice, which refused to set aside the injunctions obtained by Henco after the execution of the Agreement.

The Court admitted the press releases into evidence on the basis that they are public in nature, permanent and accessible to the public. The Court agreed that, in such circumstances, it is unnecessary to call the authors as witnesses.

Conversely, the affidavits were not public documents. Although public officials swore the affidavits, they did so as witnesses of events and not as recorders of public records. The affidavits also did not satisfy the "necessity" requirement under the principled approach to the hearsay rule. As such, the Court stated that the best evidence from the affiants would be their oral testimony. Notably, Henco went on to call one of the affiants (the Assistant Deputy Minister for the Ontario Ministry of Aboriginal Affairs) as a witness, whose oral testimony was cited extensively in the reasons for judgment.

DESTRUCTION OF A BUSINESS CONCEPT IS ALIVE AND WELL

• On the income versus capital spectrum a payment for the destruction of a business is on capital account and not income account. This is the case even in circumstances where exactly which capital assets were sterilized is unclear.

The Tax Court's decision followed earlier jurisprudence dealing with the cancellation of contracts and the destruction of a distinct part of a business being regarded as a capital receipt rather than on ordinary income account.  Justice Campbell Miller found that Henco had its business destroyed by the occupation and related events. Therefore, the entire $15.8 million dollar payment to Henco was a non-taxable capital receipt.

INTERPRETATION OF SECTION 12(1)(x) AND 23(1)

Subparagraph 12(1)(x) of the Income Tax Act (Canada) (the "Act"), which is intended to catch payments that are considered to be government assistance among other things, requires that an amount is received "in the course of earning from a business or property." To be included in income, an amount must be received in the course of earning income from a business at the time the payment is received.

The volatile situation in Caledonia meant that while Henco was technically still in business, Henco was not earning income from a business at the time it received a $650,000 payment from the Government of Ontario in 2006. Henco was therefore not required to include the amount in income under subparagraph 12(1)(x) of the Act.

• Section 23(1) of the Act applies where there is a cessation of a business and inventory is sold to include such proceeds from the sale of inventory in income. It does not apply on the cessation of a business to include in income proceeds from the sale of inventory where such inventory has lost the nature and characteristics of inventory.

The Province of Ontario placed a moratorium on the DCE Property which rezoned the land and made it impossible to develop. This fundamentally changed the nature of Henco's inventory (e.g., the land it held for development). Justice Campbell Miller interpreted section 23 of the Act to not cover such a situation.

A copy of the full decision can be found here.

Cassels Brock & Blackwell LLP represented the appellant, Henco Industries Limited.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.