This article was originally published in Blakes Bulletin on Cross-Border Taxation - May 2005
Article by David Spiro and Edward Rowe, ©2005, Blake, Cassels & Graydon LLP
In Transocean Offshore Limited v. The Queen, Canada’s Federal Court of Appeal has adopted a liberal and expansive approach to the meaning of the phrase "in lieu of" as it appears in the preamble to the withholding tax provisions of Part XIII of the Canadian Income Tax Act (the Act).
According to its March 21, 2005, decision, amounts not otherwise subject to Canadian withholding tax may be subject to that tax on the basis that they were paid "in lieu of" amounts (such as dividends, management fees, interest, rent, royalties, pension benefits, retiring allowances, and so on) that ordinarily are subject to withholding tax.
The question before the Court was whether damages for breach of a contract to rent an offshore drilling rig were paid "in lieu of" rent and were therefore subject to Canadian withholding tax under paragraph 212(1)(d) of the Act. Madam Justice Karen Sharlow, one of the leading tax experts on the Court, wrote the decision for a unanimous panel. The Court upheld the Crown’s position, which had also been successful at trial.
On May 15, 1997, Petro-Canada, on behalf of a group of co-venturers including itself, entered into an agreement (the Bareboat Charter) to rent an offshore drilling rig (the Explorer) from a non-resident, Transocean Offshore Limited, for exploratory drilling off Canada’s east coast. At that time, the Explorer was operating in the North Sea under another contract.
The Bareboat Charter provided that the daily rental rate for the Explorer would be US$60,000 for two years, after the Explorer was transported and modified for Canadian use at Petro-Canada’s expense. The anticipated rent over the two-year term was approximately US$43 million. Petro-Canada’s costs to modify and transport the rig were estimated at US$52 million and US$11 million, respectively.
The Bareboat Charter provided that the Explorer would be available for use after December 31, 1997. However, that date subsequently was extended by a year. Based on better opportunities available elsewhere, Petro-Canada notified Transocean of its intention not to take delivery of the Explorer in December 1998.
In consideration for its release from its obligations under the Bareboat Charter, Petro-Canada agreed to pay Transocean US$40 million in accordance with a deed of settlement. Petro-Canada withheld and remitted to the Canada Revenue Agency (the CRA) 25% of that amount (US$10 million) in accordance with Part XIII of the Act. Transocean applied to the CRA for a refund of that amount, but its request was denied. Transocean then appealed to the Tax Court of Canada.
Paragraph 212(1)(d) of the Act provides that: Every non-resident person shall pay an income tax of 25% on every amount that a person resident in Canada pays or credits, or is deemed by Part I to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of ... (d) rent, royalty or similar payment, including, but not so as to restrict the generality of the foregoing, any payment (i) for the use of or for the right to use in Canada any property ... but not including ... (ix) a rental payment for the use of or the right to use outside Canada any corporeal property.
It was agreed that Part XIII tax would have been payable on the daily rent under the Bareboat Charter had Petro-Canada actually commenced using the Explorer. It also was agreed that the US$40 million payment was not actually "rent." The only question was whether the US$40 million paid by Petro-Canada to be released from its obligations under the Bareboat Charter was an amount paid "in lieu of" rent within the meaning of the abovementioned provision.
The Pleadings in the Tax Court of Canada
As part of the balance of interests between taxpayers and the state in the self-assessment tax system in Canada, the taxpayer bears the onus of disproving, on a balance of probabilities, the assumptions made by the CRA in its review of the taxpayer’s position. In Transocean, the government of Canada pleaded that an assumption underlying the refusal of Transocean’s request for a refund of withholding tax was that: d) before starting to drill, Petro-Canada decided it did not want to rent the rig and agreed to pay the Appellant [US]$40 million instead of paying rent.
Transocean provided no evidence in the Tax Court to challenge the pleaded assumption, and its appeal was dismissed. Justice Lamarre Proulx of the Tax Court relied on the aforementioned critical assumption and applied it in the context of certain previous Canadian jurisprudence, to the effect that a settlement payment generally is accorded the same tax treatment as the payment for which it compensates (the "fill the hole" or surrogatum approach to the treatment of settlement payments). The essence of her reasoning is reflected in the following passage:
I find that the damages paid to the appellant were so paid to compensate for the rent that would have been paid under the Bareboat Charter if it had not been repudiated. In accordance with the caselaw on the taxation of amounts of damages received as compensation for breach of trade agreements, I therefore find that the compensatory monetary amount here in question was paid as, on account or in lieu of payment of, or in satisfaction of, rent or similar payment for the use of, or for the right to use in Canada, a property.
The Federal Court of Appeal
In the Federal Court of Appeal, Transocean argued that the case should not be decided on the basis of the Tax Court judge’s finding of fact. However, in the absence of any evidence on the record to contradict that assumption, the Court of Appeal rejected that argument, as follows:
In finding in favor of the Crown, the Court engaged in a three-step process. First, it recognized that "rent" means an amount paid as compensation for the use or occupation of property, or for the right to use or occupy property. Second, it found that the phrase "in lieu of" means "instead of" or "in place of". Third, it presumed that every word or phrase in the legislation must have some meaning. Accordingly, the Court found that:
Parliament, in using the words "in lieu of" in paragraph 212(1)(d), must have intended to expand the scope of paragraph 212(1)(d) to include payments other than payments that have the legal character of rent.
On the facts of the case, then, the Federal Court of Appeal concluded that the words of paragraph 212(1)(d) of the Act "include an amount paid as compensation for the anticipatory breach of a rental agreement".
Impact of the Decision
The case can be interpreted in a number of ways. It may be limited to its own factual and evidentiary peculiarities — a situation in which a clear assumption by the Crown, combined with an absence of evidence to the contrary, led to a strong finding of fact by the Tax Court judge. The judgment also may be seen as a cautionary tale — a case study of the perils of failing to seek tax advice when negotiating and structuring the payment of liquidated damages in a cross-border context. However, in the view of the authors, the impact of the judgment may very well extend beyond the perils of well-crafted Crown pleadings.
In particular, the Federal Court of Appeal has clearly endorsed a surrogatum-type approach to the treatment of liquidated damage payments in a cross-border context, even though that doctrine had not been uniformly adopted in Canada’s domestic tax treatment of damage payments on the recipient’s side. The other theory that could have been adopted would have held that the amount was paid as compensation for the termination of the contract itself (arguably a capital asset of Transocean in this case), and not as compensation for the payments under that contract.
In light of the Court’s broad interpretation of the preamble to the withholding tax provisions in the Act and its acceptance of what amounts to a surrogatum principle for the treatment of damage payments, the CRA now may be emboldened to challenge a wide range of payments to nonresidents as having been made "in place of" or "instead of" payments that otherwise would have been subject to withholding tax. In short, the possibility that the CRA will take full advantage of the Court’s liberal interpretation of the preamble to subsection 212(1) of the Act cannot lightly be dismissed.
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