RECONSIDERING THE INCOME TAX TREATMENT OF INVESTIGATION FEES.

• Date: 22 March 2021
• Author: Hildebrandt, Paul

I INTRODUCTION 208 II AN OVERVIEW OF THE CURRENT VS CAPITAL ISSUE 209 III THE RIO TINTO CASE 212 A. The Facts 212 B. The Issue 212 C. The Conclusions of the Tax Court and the 213 Federal Court of Appeal IV THE SHORTCOMINGS OF THE OVERSIGHT EXPENSE APPROACH 213 A. Issue 1: "fees for services..." 214 B. Issue 2: "fees.that assist the board..." 214 C. Issue 3: "fees.that assist.in the decision-making 216 process..." D. Conclusion on the Shortcomings of the Oversight 218 Expense Approach V THE INVESTIGATION FEES APPROACH 218 A. The Core Current vs Capital Jurisprudence 219 B. The Costs Rules 235 VI THE INVESTIGATION FEES JURISPRUDENCE 239 A. Siscoe Gold Mines Ltd v MNR 239 B. Bowater Power Co v MNR 241 C. Neonex International Ltd v R 242 D. Firestone v R 243 E. Wacky Wheatley's TV & Stereo Ltd v MNR 247 F. Rona Inc v R 251 G. Pantorama Industries Inc v Canada 252 H. The Current State of the Law 253 VII CONCLUSION 254 I INTRODUCTION

In the opening line of his decision in Rio Tinto Alcan Inc v R, (1) Justice Pelletier stated "[t]his appeal raises, once again, the tax treatment of expenses incurred by a taxpayer in the course of investigating if and how it should proceed with a capital transaction." (2) In this paper, I aim to provide a definitive approach to determining whether investigation fees are current or capital expenditures for purposes of the Income Tax Act. (3) As one of the most recent cases to discuss the issue, I use Rio Tinto to illustrate why the existing jurisprudence should be reconsidered.

In Rio Tinto, the Tax Court of Canada ("the Tax Court") classified the investigation fees at issue as "Oversight Expenses" because they were incurred to help the taxpayer's Board of Directors make decisions and fulfil its oversight function. (4) The Tax Court established the novel principle that Oversight Expenses are current expenditures. (5) On appeal, the Federal Court of Appeal affirmed the Tax Court's decision. (6) The Supreme Court of Canada denied leave to appeal. (7)

In my view, while the Tax Court and the Federal Court of Appeal correctly concluded that the expenditures at issue in Rio Tinto were deductible on current account, the Oversight Expense approach should not have been used. The principle I advocate for is that all expenditures incurred for the purpose of determining the feasibility or merits of a business opportunity, including a capital transaction ("Investigation Fees"), are fully-deductible on current account unless they directly provide the taxpayer an enduring benefit. I argue that, to the extent it is contrary to the approach I advocate for, the existing jurisprudence should not be followed. (8)

In Part II, I provide a brief overview of what the current vs capital analysis seeks to achieve and why the classification of an expenditure as current or capital is an important tax attribute. Part III provides an overview of Rio Tinto. Part IV discusses why Rio Tinto's Oversight Expense approach should not be used to determine deductibility. In Part V, I reason from the core principles underlying the current vs capital jurisprudence to explain why Investigation Fees are current expenditures. Finally, Part VI addresses the case law that has considered Investigation Fees to be capital expenditures and discusses why the reasoning in those cases should not be followed.

II AN OVERVIEW OF THE CURRENT VS CAPITAL ISSUE

Whether a transaction is current or capital in nature is arguably one of the most difficult and frequently litigated issues in income tax law. The Income Tax Act does not define what constitutes a capital expenditure and, as such, resolving the current vs capital issue is a highly fact-dependent exercise. (9) The current vs capital analysis seeks to determine "what is acquired," (10) "what the expenditure is calculated to effect from a practical and business point of view," (11) or the "nature of the expenditure." (12) Typically, an expenditure will be capital in nature when it provides benefits in more than one tax year. (13) Conversely, an expenditure will tend to be current in nature where its benefits are entirely consumed during the year.

Consider an example where Taxpayer A spends $10,000.00 on a party for its employees. Once the party is over, the $10,000.00 is gone and Taxpayer A is left with nothing but fond memories. As a result, the party expenditure is current in nature. In contrast, Taxpayer B spends $10,000.00 on equipment for its business. After the purchase, while Taxpayer B no longer has $10,000.00 cash, it is left with equipment worth $10,000.00 which can be used to earn income for multiple years. As a result, Taxpayer B's expenditure is capital in nature.

The proper classification of an expenditure as current or capital is central to the accurate measurement of a taxpayer's income which is central to an accurate determination of tax-owing. (14) From a normative perspective, the reason accurately measuring income matters is because income tax law is generally premised on the notion that:

A taxpayer who receives greater income has a greater ability to pay [tax] than a taxpayer with lesser income, and therefore the income tax system ought to require the higher-income taxpayer to pay more tax. (15) If a taxpayer's income is inaccurately measured, the taxpayer will pay more or less tax than they are financially capable of paying which will thwart the policy goal of levying tax based on the ability to pay. Consider the example of Taxpayer A and Taxpayer B above. Holding all else equal, while both taxpayers spent $10,000.00, both taxpayers are not in the same financial position. Taxpayer A has nothing left to show for its $10,000.00 whereas Taxpayer B still has the equipment. Thus, to accurately measure the taxpayers' incomes, we must recognize that Taxpayer A's $10,000.00 is gone and reduce their income accordingly. In contrast, Taxpayer B's $10,000.00 is not "gone," nor has it been "consumed." Rather, Taxpayer B's $10,000.00 has, in essence, been "converted" into equipment. As a result, Taxpayer B's income should not be affected by the spending because the spending did not change Taxpayer B's financial position. (16) While admittedly a simplification, the result above is what the current vs capital jurisprudence seeks to achieve: classifying expenditures in accordance with "what is acquired," (17) "what the expenditure is calculated to effect from a practical and business point of view," (18) or the expenditure's "nature." (19)

The reason an expenditure's classification as current or capital matters to taxpayers is because it affects their taxable income. In general, when taxpayers incur an expense, they would rather it be classified as a current expenditure than as a capital expenditure because current expenditures generally are deductible from taxable income and a lower taxable income means less tax is payable. (20) In contrast, taxpayers generally cannot deduct capital expenditures from their taxable income. (21) The Income Tax Act generally only allows the deduction of capital expenditures if the underlying asset has been sold, (22) or if the capital cost allowance system permits the cost to be amortized (or "written off") over time. (23) As a result, taxpayers will usually wish to classify their expenditures as current in nature (to receive a deduction) whereas the Minister of National Revenue ("the Minister") would rather classify expenditures as capital in nature (to deny a deduction and thereby collect more tax). Such a situation arose in Rio Tinto.

III THE RIO TINTO CASE

1. THE FACTS

   The taxpayer in Rio Tinto was Rio Tinto Alcan Inc. ("Alcan"): the publicly traded parent company of a group of subsidiaries operating in the aluminum industry ("the Alcan Group"). (24) Alcan regularly sought new business opportunities for the Alcan Group to pursue, including new companies it could acquire. (25) In 2003, Alcan was considering the possibility of acquiring Pechiney SA ("Pechiney"), a French aluminum company. (26) To determine whether to acquire Pechiney, Alcan engaged investment bankers to advise its Board of Directors ("the Board") as to "the merits and feasibility of a potential transaction with Pechiney." (27) After considering the investment bankers' advice, the Board submitted a takeover bid for Pechiney and eventually acquired 100% of its shares. Alcan considered its payments to the investment bankers ("the Pechiney Investment Banker Fees") to be current expenditures and deducted them from its taxable income. (28)

   After acquiring Pechiney, competition regulators required Alcan to dispose of its shares in Arcustarget Inc. ("Archer"), a company that owned two rolling mills. (29) Two alternatives were proposed for disposing of the Archer shares: selling the shares to investors or spinning-off the shares to Alcan's shareholders. Alcan hired investment bankers to advise its Board as to which of the two options was best. (30) After considering the bankers' advice, the Board decided to implement the spin-off. Alcan considered its payments to the investment bankers (the "Spin-off Investment Banker Fees," referred to collectively with the Pechiney Investment Banker Fees as the "Investment Banker Fees") to be current expenditures and deducted them from its taxable income.

2. THE ISSUE

   The relevant issue was whether the Investment Banker Fees were current expenditures fully deductible from Alcan's income or non-deductible capital expenditures. The Minister argued the Investment Banker Fees were capital expenditures because they were part of a capital transaction: the purchase and disposal of the Pechiney and Archer shares, respectively. Alcan argued the Investment Banker Fees were deductible current expenditures because they were part of its ongoing management of the Alcan Group.

3. THE CONCLUSIONS OF THE TAX COURT AND THE FEDERAL COURT OF APPEAL

   At the Tax Court, Justice Hogan devised a novel approach to resolving the issues by considering the Investment Banker...