By Ken Snider
The decision in Wabush Iron Company Limited v. The Queen, 2009 DTC 1157 (Tax Court of Canada), which confirmed a substantial assessment by the Canada Revenue Agency (“CRA”), was based on an interpretation of a supply agreement. The Tax Court of Canada upheld the CRA’s interpretation, which increased taxable income of Wabush Iron Company Limited (“Wabush”) for the taxation years 1991 to 1994 by $28,075,164. The unfavourable tax consequences could have been avoided had the contract been drafted differently.
Wabush entered into a joint venture agreement with The Steel Company of Canada Ltd. and Dominion Foundries and Steel Ltd. to develop iron ore deposits. Each of the joint venturers was entitled to a proportionate share of the iron pellets produced by the operations of the joint venture. In order to finance its participation in the joint venture, Wabush issued bonds to institutional investors. Furthermore, to provide security to the bondholders, Wabush entered into a Pellet Sale Agreement (“Agreement”) with its shareholders. In accordance with the Agreement, the shareholders had an obligation to purchase Wabush’s share of iron pellets for the price which was the greater of (i) fair market value of the pellets and (ii) the pro rata costs incurred in relation to the joint venture operation, as defined in the Agreement (“Costs”). Notably, the shareholders were required to pay the consideration even if no pellets were produced in any given year.
For the relevant taxation years reassessed being 1991 to 1994, the Costs exceeded the fair market value of the pellets it sold to the shareholders. Consequently, pursuant to the Agreement, the shareholders paid their proportionate share of Costs to Wabush. Wabush’s financial statements recorded the amount received for the pellets as income. However, in computing its taxable income, Wabush included in its income only the fair market value of the pellets, which was less than the Costs contributed. Wabush treated the difference between the amount it actually received (i.e. Costs) in excess of the fair market value of the pellets as a non-taxable contribution of capital by the shareholders.
The Minister reassessed Wabush for the years from 1991 to 1994 on the basis that the full amount of the Costs constituted taxable income as the funds were purchase price paid by the shareholders for the pellets. As a result of the reassessment, taxable income of Wabush for the taxation years 1991 to 1994 increased by an aggregate of $28,075,164. Wabush appealed the assessment to the Tax Court of Canada.
Position of Wabush
Wabush argued, in summary, that although the Agreement labelled the amounts paid for the iron pellets as purchase price, it was incorrect in law and therefore not determinative of the nature of the payments. The parties’ true intentions were to treat the amounts in excess of fair market value of the pellets as capital contributions made in order to protect bondholders. The shareholders had to pay the Costs even if no pellets were produced. Therefore, the drafters could not have intended the payment provisions to simply set a purchase price. The intentions of the parties should determine the legal character of the payments.
Position of the Minister
The Minister argued that the Agreement was clear that all of the amounts paid by the shareholders were payments for the pellets. The amounts must have been a purchase price because the shareholders had no other obligation to make any payments to Wabush. Even Wabush’s financial statements recognized the payments as income. Wabush cannot ask the court to re-characterize the legal relationship created by the Agreement based on its economic substance.
The Tax Court upheld the Minister’s assessment. The court relied on the unambiguous language of the Agreement to say that the intention of the parties was to have a relationship as a vendor and a purchaser of the pellets at a specified purchase price. The parties in fact carried out this intention by transferring pellets in exchange for the specified payments. The court accepted the fact that the motivating factor behind entering into the Agreement was to provide adequate financing to the operations and to protect bondholders. However, the parties chose to achieve this purpose by securing a guaranteed purchase price for the pellets, not by contributing capital to Wabush. The court held that tax consequences should be determined by reference to the legal results, as opposed to the economic effects.
This case is a reminder of the need for very careful drafting of commercial agreements from a tax perspective. The issue in this case could seemingly have been avoided had the Agreement provided for a periodic obligations to issue shares to the shareholders to the extent the contributed Costs exceeded the fair market value of the pellets instead of treating these amounts as the sale price.
The issue arises whether there will also be “double taxation”. This will happen if, and to the extent that, the shareholders of Wabush adopted a tax cost in the pellets based on fair market value and not the amounts actually contributed. This issue was not before the Tax Court of Canada.
Wabush Iron decision is now under appeal in the Federal Court of Appeal.