A former land developer in Henco Industries Limited v. The Queen 32 successfully argued before the Tax Court that a $15.8 million payment from the Ontario government should be characterized as a non-taxable capital receipt and a separate payment of $650,000 from the Ontario government should be characterized as a non-taxable windfall. Although the decision is noteworthy for concluding that these payments are not taxable, the decision by Miller J should also interest members of the tax community because of its analysis of various other issues discussed in the final ruling, including the distinction between eligible capital amounts and non- taxable capital receipts, the scope of paragraph 12(1)(x), the nature of inventory in the context of section 23, and the applicability of the parol evidence rule in interpreting agreements before the Tax Court.
Although legislative amendments may in part limit the relevance of the Henco decision to future cases attempting to delineate the boundary between eligible capital amounts and non-taxable capital receipts, the case raises broader structural questions about the nature of Canadian taxation and the types of payments that are subject to taxation under the Act. As noted by Miller J in his decision on costs,
[f]inding a payment to be a non-taxable capital receipt is not something any Tax Court of Canada judge does lightly. It can have serious repercussions in our overall system of taxation as to what is a source of income that is subject to Government taxation. Circumstances are rare that a payment, perhaps shrouded in a commercial light, is non-taxable. But cases that peak under that shroud, and give both Government and taxpayers alike guidance as to what can and cannot be swept into the taxing regime, should be of keen interest.33
Henco was in the business of developing land in and around Caledonia in south- western Ontario. As of February 2006, Henco's landholdings included properties described in the decision as (1) the Douglas Creek Estates (DCE), (2) the Seneca property, and (3) the Morrison property.34
Beginning in February 2006, protests on or near the site of the DCE land by certain First Nation members and their supporters made development of the land impossible. The protesters were reported to dispute, among other things, whether the land had been properly surrendered by the First Nation during the 19th century. According to the agreed statement of facts, the protests were held "to try to stop, or at least disrupt, further development of the subdivision."35
Henco obtained certain injunctions from the Ontario Superior Court of Justice to clear the protesters from the DCE land. However, the Ontario Provincial Police declined to enforce the injunctions following a failed attempt to disperse the protest in April 2006.
After the police failed in their attempt to disperse the protest, the Ontario government offered Henco the $650,000 payment. The documentation accompanying the payment indicated that it was made "to mitigate the impact of continued occupation of DCE."36 The documentation also stated that the DCE "Funding Assistance is in respect of development, building and other related costs and expenses that have been incurred by Henco in connection with the [DCE land] because of the occupation."37 Henco's representatives indicated that the terms were not negotiated nor agreed to by Henco. Although Henco accepted payment on May 3, 2006, it signed nothing to confirm its acceptance of the offered terms and nothing to confirm that it was to do or refrain from doing anything as consideration for the payment.
In its T2 income tax return for the taxation year that ended on April 29, 2006, Henco wrote down the value of the land inventory in respect of the DCE to $7. The Canada Revenue Agency (CRA) and Henco each had valuation reports prepared that confirmed that the DCE property had only nominal fair market value on May 1, 2006.
Representatives of the protesters, the Ontario government, and the federal government entered into a three-party agreement on May 16, 2006, agreeing to halt any development on the DCE land for an indeterminate period of time. Provincial zoning regulations enacted on May 17, 2006 generally prohibited development of the DCE land.
Before February 2006, Henco estimated that it would earn profits of approximately $30 million in respect of the development of the DCE land on revenues of approximately $45 million.
An agreement was signed in June 2006 pursuant to which Henco sold the DCE land and certain related business assets to the government of Ontario in exchange for $15.8 million. Henco was also obliged under the terms of the agreement to stop developing the DCE land, take steps to have the injunction removed, and release Ontario from any and all claims in respect of the land. As part of the agreement, the government of Ontario agreed to reimburse Henco for reasonable costs relating to the retention of consultants, legal advisers, appraisers, experts, advisers, or other third parties, subject to a maximum amount of $300,000.
At the beginning of the trial, the Crown brought a motion seeking to exclude, among other things, extrinsic evidence that Henco might try to admit to interpret or contextualize the agreement. The Crown brought the motion on the basis that this evidence was not admissible pursuant to the parol evidence rule. Quoting Wad- dams, the Crown described the parol evidence rule as follows:
By the general rules of the common law, if there be a contract which has been reduced into writing, verbal evidence is not allowed to be given of what passed between the parties, either before the instrument was made, or during the time that it was in a state of preparation, so as to add to, or subtract from, or in any manner to vary or qualify the written contract.38
The Crown acknowledged that there are certain exceptions to the parol evidence rule that permit courts to review extrinsic evidence to interpret a contract. In argument, it suggested that these circumstances are limited to situations in which there is either a patent or a latent ambiguity in the contract. Accordingly, the Crown took the position that evidence concerning the circumstances at the time of contracting should be admitted only when the words of the contract, viewed objectively, bore two or more reasonable interpretations.
However, the Crown acknowledged that certain courts have accepted extrinsic evidence to establish the "factual matrix" or "surrounding circumstances" that led to the formation of an agreement to assist them in determining the parties' contractual intentions as they would be determined by a reasonable person.39 A factual matrix or the surrounding circumstances can help a court to understand what the parties meant by the words that they used in a contract. Henco went further, suggesting that such an analysis was necessary to the proper interpretation of a contract, citing River Hills Ranch Ltd. v. The Queen, in which it was found that "the objective contextual scene in which the written agreement was made is an integral part of the interpretive process and is not something that is resorted to only where the words viewed in isolation suggest some ambiguity."40
In considering the parties' positions, Miller J observed that "there is no discernible bright line establishing a factual matrix (clearly admissible) and evidence of subjective attention [sic] (perhaps inadmissible)."41
The court noted the difference between the task before the civil courts, where two parties to a contract may be disputing the presence or significance of unwritten contractual rights or obligations, and the task before the Tax Court, which must assess the correctness of the characterization of the nature of a payment by a third party, the government of Canada. In the latter case, the court noted that the factual matrix is essential in determining the true nature of the payment for the purposes of assessing tax.
The court expressed concern that a contract may be drafted without due consideration of its tax implications or, more significantly, may be misleadingly drafted to affect the character of the transaction for tax purposes. A broad interpretation of the parol evidence rule in these circumstances could produce inappropriate results that are inconsistent with the object and purpose of the Act. As an example, the court cited the line of jurisprudence distinguishing employment relationships from independent contractor relationships. In these circumstances, the courts are required to look beyond the text of the contracts to the actions of the parties. Similarly, section 68 requires the courts to look beyond the stated allocation of the parties to determine a reasonable allocation in the circumstances. Such an inquiry into reasonableness would almost certainly necessitate an examination of the surrounding circumstances.
Applying the above principles to the Henco decision, the court found that a review of the factual matrix or surrounding circumstances giving rise to the signing of the agreement was imperative in interpreting the nature of the payments made under the agreement. Rather than being an ordinary commercial arrangement that was committed to writing, the agreement was drafted in "exceptional circumstances" in which market forces did not play a material role.42
Moreover, the terms of the contract itself invited the use of extrinsic evidence: the preamble stated "[w]hereas based on circumstances relating to the use and development of the property."43 The court also found that the agreement was ambiguous because it failed to allocate the payment among the assets being sold. The parties' failure to make such an allocation made the examination of extrinsic facts necessary in order to allocate these amounts for tax purposes.44
Income or Windfall: The $ 650,000Payment
The Crown argued that the $650,000 payment fell within the scope of paragraph 12(1)(x). In general terms, paragraph 12(1)(x) deems certain amounts to be included in a taxpayer's income from a business or property, including certain amounts paid by a government that are received by a taxpayer in the course of earning income from a business or property, to the extent that the payment can reasonably be considered to have been received as assistance in respect of an outlay or expense.
The court summarized the four criteria that would have to be satisfied for the $650,000 payment to be included in Henco's income pursuant to paragraph 12(1)(x):
1) The $650,000 must have been received by Henco "in the course of earning in- come from a business or property";
2) The payment must have been from a government;
3) The payment can reasonably be considered to have been received as assistance in respect of an outlay or expense;
4) The payment was not for the acquisition of Henco's business or property.45
Henco's position before the court was that the $650,000 payment did not fall within the scope of paragraph 12(1)(x) because (1) the payment had not been received in the course of earning income from a business or property, and (2) the payment could not reasonably be considered to have been received as assistance in respect of an outlay or expense. In the alternative, Henco argued that the $650,000 had been received in respect of Henco's disposition of the DCE land.
In the Course of Earning Income from a Business or Property
Henco emphasized that the first requirement could be satisfied only if the $650,000 payment were received by Henco "in the course of earning income from a business or property." This wording contrasts with the wording in paragraph 12(1)(a), which merely requires a payment to have been received "in the course of a business." Commenting on this distinction, the court observed that it would be possible that a taxpayer could receive a payment while in business yet not in the course of earning income from a business.
Henco was clearly in business and receiving revenue in the course of earning in- come from a business in 2005 and the first part of 2006 (until the protests began in February 2006). However, the court observed that the $650,000 payment was not made in respect of this period. Rather, it was made in respect of the period beginning in late February 2006 and ending on May 3, 2006, when the payment was received. The court found that it was this latter period that must be examined to determine whether the payment was made in the course of earning income from a business or property.
The court concluded that Henco was not taking steps in the course of earning income from a business during the protests. Rather, it was attempting to preserve the business itself, with an expectation that the protests would eventually cease, thereby permitting it to resume earning income in the course of a business. An example of a step taken by Henco during the protests was the seeking of the injunctions before the Superior Court of Justice.
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32 2014 TCC 192.
33 2014 TCC 278, at paragraph 9.
34 The court also made rulings relating to (1) the fair market value of the Seneca and Morrison properties and (2) whether the Seneca property was held on income or capital account.
35 Supra note 32, at paragraph 9.
36 Ibid., at paragraph 29.
38 S.M. Waddams, The Law of Contracts, 6th ed. (Aurora, ON: Canada Law Book, 2010), at paragraph 320, note 10, quoted in Henco, supra note 32, at paragraph 82.
39 Supra note 32, at paragraph 84.
40 2013 TCC 248, at paragraph 42.
41 Supra note 33, at paragraph 88.
42 Ibid., at paragraph 92.
43 Ibid., at paragraph 95.
44 Ibid., at paragraph 98. Paragraphs 100-16 of the court's reasons considered which forms of extrinsic evidence would be admitted into evidence under one of the exceptions to the hearsay rule. The court found that certain government press releases were admissible into evidence, but it prohibited the admission of the affidavits of certain public officials. If counsel for Henco wished to have the evidence admitted, Henco would have to have called the public officials as witnesses.
45 Supra note 32, at paragraph 119.
First published by the Canadian Tax Foundation in the Current Cases feature (2015) 63:1 Canadian Tax Journal 227-39.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2015