Indalex Ltd. v. The Queen, [1988] 1 CTC 60, 88 DTC 6053 (FCA)

Mahoney, J.:—This is an appeal and cross appeal from a decision of the Trial Division dealing with the appellant's income tax assessments for its taxation years 1971 to 1974 inclusive. [1] Put briefly, the appellant, an extruder of aluminum, purchased its requirements of aluminum billet from an associated Bermuda corporation. It paid that corporation the price that had been paid the primary supplier, Alcan. The Bermuda corporation immediately received from Alcan a percentage discount which it did not entirely pass on to the appellant. In addition, the Bermuda corporation was paid by Alcan in each of the years in issue a “special credit" of $100,000 (U.S.) which was not subject of the assessments in issue.

In a reported judgment, [1986] 1 C.T.C. 219; 86 D.T.C. 6039, the learned trial judge held that the appellant’s taxable income had been artificially reduced to the extent of 80 per cent of the discount retained in Bermuda and, to that extent, sustained the corporation income tax assessments in issue. She also held that non-resident tax was exigible in respect of the benefit conferred on the Bermuda affiliate and, to that extent, sustained the withholding tax assessments in issue. Further, she deprived the respondent of costs because "[t]he defendant's handling of its case at trial was confused and disorganized".

The gist of the appeal is that the learned trial judge made such numerous egregious errors in her findings of fact as to be tantamount to error in law, that this Court ought to conclude that the evidence admits only of the conclusion that the price paid the Bermuda affiliate was the price that would have been established at arm's length and that, therefore, the assessments ought entirely to be set aside. In addition to attacking the refusal of costs, the cross appeal asserts error of law in the determination of what a reasonable arm's length price would have been and in the failure to take the annual special credit into account.

The learned trial judge determined that the arrangements in issue were not a sham and that subsection 56(2) of the Income Tax Act, subsection 16(1) as the Act stood in 1971, was not applicable in the circumstances.

56(2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him.

Neither determination was questioned in this proceeding but I should not wish silence to be taken as necessarily acquiescence in the latter.

The Undisputed Facts

Numerous corporate entities, ownership and name changes and reorganizations over time, described by the learned trial judge, make for a complicated story and, in my view, are entirely irrelevant to the issues here. I shall, therefore, simply refer to the United Kingdom parent of both the appellant and the Bermuda corporation as “Pillar”, the Bermuda company being “Pillar International”. Likewise, I shall refer to various members of the Alcan Aluminium Limited family of companies by the generic term “Alcan”.

At all material times, the appellant was a wholly owned subsidiary of Indal Limited, a company whose shares were publicly traded on Canadian stock exchanges. Fifty-eight per cent of the shares of Indal Limited were owned by successive holding companies themselves wholly owned by Pillar. [2] Pillar also had interests in aluminum extruding companies in other countries, notably the United Kingdom and the Federal Republic of Germany. In 1965, Pillar and Alcan entered into a contract, Ex. P-1(114), whereby Pillar agreed that its subsidiaries throughout the world would buy not less than 50 per cent of their aluminum billet requirements from Alcan if there was "a native manufacturer" in the country. A native manufacturer was defined as one not controlled by non-residents of the country. For Canada, the United Kingdom and countries without a native manufacturer, the commitment was at least 80 per cent. In fact, the appellant in Canada invariably bought its entire requirement from Alcan. Actual purchase prices were subject of periodic negotiation. A so-called "competition clause" gave Pillar the right to buy elsewhere if, all else being equal, a price 2 per cent lower than that offered by Alcan was available and if Alcan refused to meet that lower price. The agreement also provided that Alcan would annually pay Pillar, in sterling in London, an amount equal to 1 /2 per cent of the value of purchases from Alcan by all its subsidiaries during the previous year.

By letter agreement dated July 24, 1967, Ex. P-1 (115), the minimum commitments of Pillar’s Canadian, United Kingdom and German subsidiaries was increased to 100 per cent. The letter confirmed in vague, but evidently satisfactory, terms Pillar’s entitlement to additional discounts of 3 /2 per cent in respect of the purchases by those subsidiaries. After July 1967, Pillar was entitled to receive from Alcan, in London in sterling, 5 per cent of the value of the appellant's purchases of aluminum billet.

In mid-1969, Pillar acquired a dormant Bermuda corporation, changed its name to Pillar International Services Limited, and activated it. As of January 1, 1970, the 1965 agreement as amended was replaced by an agreement between Alcan and Pillar International, Ex. P-1 (117). It bound Alcan to sell to Pillar International stipulated maximum quantities and Pillar International to buy from Alcan stipulated minimum quantities of aluminum billet for each of Canada, the United Kingdom and Germany. The competition clause factor was reduced to 1 per cent. The prices were to be "Alcan's published list prices effectively being charged to all other customers for such material in each of the three respective countries". It provided for Alcan to repurchase scrap on what the learned trial judge termed "a no profit no loss basis” and also

With respect to the purchase of billet under these new arrangements Alcan will pay to Pillar International a minimum discount on the "gross" value of such purchases of:

Canada	10%
U.K.	9%
Germany	8%

This minimum discount will be paid to Pillar International monthly contemporaneously with payment for the metal in respect of which the discount payment is due, and will be paid to Pillar International in Bermuda partly in Canadian dollars, sterling and Deutsche marks as Pillar International may direct with reasonable notice from time to time.

The minimum discount for Canada was renegotiated from time to time. During the years in issue, it ranged between 3 per cent and 17.3 per cent, whereof Pillar International retained between 2.48 per cent and 5.34 per cent, Ex. P-1 (109). Between 40 per cent and 50 per cent of the billet purchased by Pillar International was resold to the appellant.

Pillar International received discounts aggregating $6,258,313 in respect of billet sales to the appellant in the latter’s taxation years 1971 to 1974 inclusive.

It remitted a total of $3,614,004 to the appellant and retained $2,644,309: $653,370, $599,763, $452,187 and $938,989 respectively in those years. The corporation tax assessments in issue reflect those amounts as do the withholding tax assessments at an agreed rate of 10 per cent without penalty or interest.

During 1970, Pillar International was administered by the Bermuda office of an international firm of chartered accountants. In January 1971, it hired its first full-time employee as managing director. He rented 1500 square feet of office space and engaged a secretary. The manner in which the arrangement worked, in so far as the appellant was concerned, was described as follows by the learned trial judge, C.T.C. 221; D.T.C. 6040;

When ordering billet, which occurred on a weekly basis, the plaintiff sent a purchase order to Pillar International in Bermuda, sending a copy at the same time to Alcan Ingot. On receipt of the purchase order, Pillar International masked out the plaintiff's letterhead, replacing it with its own (keeping the original invoice number), and forwarded that order to Alcan Ingot. Alcan Ingot acted on receipt of the copy which had been received from the plaintiff but the official order was the one received from Pillar International. Once the billet had been delivered by Alcan Ingot to the plaintiff, Alcan Ingot invoiced Pillar International at the Alcan list price and Pillar International invoiced the plaintiff at the same price.

When payment was subsequently made, on what was called settlement day, the plaintiff credited Pillar International’s Bermuda bank with the invoiced price, Pillar International credited Alcan Ingot's Montreal bank with the identical sum and Alcan Aluminum Limited of Canada paid to Pillar Internationales Bermuda bank (Butterfield) which had an account in a Canadian bank in Montreal, a discount attributable to the purchase price. This discount was paid partly in U.S. dollars and partly in Canadian dollars. The U.S. dollars were forwarded to Bermuda to the credit of Pillar International’s bank account there; the Canadian dollars were forwarded to the credit of the plaintiff's Canadian bank in Toronto. The payment by the plaintiff to Pillar International, by Pillar International to Alcan, and the payment of the related discounts all took place simultaneously on the same day, through electronic banking facilities, in accordance with standing instructions filed with the respective banks.

A similar arrangement (in reverse) prevailed with respect to scrap returns.

The learned trial judge found, C.T.C. 223; D.T.C. 6042, and the appellant was frank in admitting that

The evidence is clear that one motivation, at least, for the establishment of the Bermuda company was to allow Pillar Holdings (RTZ-Pillar) to establish a pool of capital offshore free from United Kingdom income tax and exchange controls.

The agreement between Alcan and Pillar International, Ex. P-1(117), was originally expressed to run to the end of 1972. By a further letter agreement, dated August 10, 1970, Ex. P-1(118), in consideration of its extension to December 31, 1974, and of increased purchase commitments, Alcan agreed, inter alia, that

Pillar International will receive from Alcan Aluminum a special credit of U.S. $120,000 in 1970. Special credit of U.S. $190,000 in each of the four years 1971/74. The payment should, in each case, be made on the last day of the calendar year to which the particular credit relates.

It is the $100,000 (U.S.) paid in each of the taxation years in issue, no part of which was included in the reassessments, that is germane to the cross appeal.

Alcan had acquired a 20 per cent interest in the appellant in 1962. Pillar acquired an 80 per cent interest in 1964 and bought out Alcan in March 1968. That said, there is no dispute that Alcan, at all material times, dealt at arm's length with the Pillar group.

De Facto Arm's Length Transactions

The appellant's principal position was that the price paid to Pillar International for billet was, in fact, the price that would have been paid had they dealt at arm's length. The learned trial judge concluded otherwise. She defined the approach, C.T.C. 226; D.T.C. 6043 ff., as follows:

Considerable evidence was led to try and establish that despite Pillar Holdings’ (RTZ-Pillar’s) control of both Indalex and Pillar International, the prices paid by Indalex to Pillar for aluminum billet were really the result of arm's length type negotiations.

Appellant's counsel acknowledged that that was, indeed, its thesis. The learned trial judge concluded, in the course of her review of the evidence,

While I accept all these statements as true, they must be put in context. In context it is simply not credible to conclude that anyone other than RTZ-Pillar (in the persons of Messrs. Fredjohn (later Greenwood) and Paterson) determined the price to be paid by Indalex to Pillar International.

That conclusion was characterized as a major error since, it was said, all of the evidence demonstrated hard bargaining including the uncontradicted, unimpugned testimony of three witnesses who had, at the time of the trial, severed all connections with the Pillar group.

Counsel's indignation that the word of these witnesses was not accepted at face value seemed to me not entirely unrelated to the indignation that impelled him to make so much of the outside directors of the appellant's immediate parent. It is, therefore, perhaps necessary to point out that a trial judge does not err in viewing the uncontradicted evidence of respectable participants in a non-arm's length arrangement having income tax consequences with some scepticism. In the usual absence of direct contradictory evidence, it is entirely proper to measure the outcome of a non-arm's length transaction against evidence, expert or otherwise, as to the value, in the market place, of that outcome.

There was certainly evidence that, on occasion, the appellant did question the price Pillar International had agreed to pay Alcan, both in terms of whether the list price had, in fact, been increased and of the gross discount allowed by Alcan, e.g. Ex. P-1(39); (53) and (61); Transcript, Vol. 2, s. 366; Vol.

3. p. 501; Vol. 4, p. 572; Vol. 5, p. 783 ff. The only evidence to which we were directed that suggests that Pillar International's discount retention was subject of hard bargaining was that of W.E. Stracey, who had not severed his connection with the group, who said, for example, at Transcript, Vol. 2. p. 269, lines 27 to 30, under cross-examination,

Whether you use the words bargain, talk or negotiate I am telling you under oath that I did my very best at all times to get the best possible price I could from Pillar International.

The learned trial judge's doubts as to Stracey's credibility, C.T.C. 226; D.T.C. 6044; were peculiarly within her competence to entertain. She said, inter alia,

Mr. Stracey's evidence was often very evasive. On more than one occasion he refused to answer simple questions to which he would obviously know the answer.

In my opinion, the learned trial judge did not err in rejecting the appellant's contention that the price paid for aluminum billet by the appellant to Pillar International was the price that would have been established by arm's length negotiations. Neither did she err in her conclusion, C.T.C. 230; D.T.C. 6046; that

. . . it is clear that the arrangements existing in the present case had a great deal of artificiality about them and I would hold that the purchasing by Indalex from Pillar International and by Pillar International from Alcan Ingot were artificial transactions.

Subsection 137(1) of the Income Tax Act, as it applied to the 1971 taxation year, and subsection 245(1), as the Act applied to the subsequent years, were identical.

In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

The learned trial judge, correctly, held that provision to apply and that the remaining issue was whether the artificial transactions had unduly reduced the appellant's income. At this point, the issue on the appeal and the principal issue on the cross appeal merge.

Undue Reduction of Income

In considering whether the arrangement had unduly reduced the appellant's income, the learned trial judge considered that section 67, paragraph 69(1)(a) and subsection 69(2) of the Act, as they stood in 1972 through 1974, applied. These had their counterparts in subsections 12(2), 17(1) and 17(3) of the earlier legislation. There are minor differences. Nothing turns on them. There is no reason to recite both.

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

69(1) Except as expressly otherwise provided in this Act,

(a) where a taxpayer has acquired anything from a person with whom he was not dealing at arm's length at an amount in excess of the fair market value thereof at the time he so acquired it, he shall be deemed to have acquired it at that fair market value;

(2) Where a taxpayer carrying on business in Canada has paid or agreed to pay, to a non-resident person with whom he was not dealing at arm's length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as "the reasonable amount") that would have been reasonable in the circumstances if the nonresident person and the taxpayer had been dealing at arm's length, the reasonable amount shall, for the purpose of computing the taxpayer's income from the business, be deemed to have been the amount that was paid or is payable therefor.

The learned trial judge correctly determined that the issues whether, and, if so, to what extent the appellant's income had been unduly reduced turned on the reasonableness of the price the appellant paid Pillar International for billet. She also, correctly on the evidence, C.T.C. 230 ff.; D.T.C. 6047, found that the market price of billet in North America depended on North American conditions and, C.T.C. 232; D.T.C. p. 6048, that the best arm's length comparable prices were those established from time to time between Alcan and Pillar International for billet delivered to the appellant.

The leaned trial judge then considered the adjustments that ought to be made to that price as a result of the intervention of Pillar International. She rejected the argument that the discount retention was somehow legitimized and validated because it was a mere continuation of the pre-1970 arrangement. She also refused to find that any part of the retention had been established to be a fair return on capital employed by Pillar International in benefitting the appellant. I certainly cannot disagree with those conclusions. The legitimacy of the pre-1970 arrangement from the point of view of Canadian income tax law had not, on this record, been established. The manner in which payments were in fact handled required the commitment of little, if any, capital by Pillar International for the appellant's account.

The argument accepted, upon which the learned trial judge concluded that a one per cent differential was justified, was based on the conclusion that Pillar International's global purchasing power permitted it to obtain from Alcan a price that much better than the appellant could have obtained in direct negotiation with Alcan. The appellant had argued that there were several ways in which the appellant derived economic benefit from its arrangement with Pillar International, which she described, at C.T.C. 235 ff.; D.T.C. 6050:

. . . These were enumerated as the possibility of metal switches with other members of the Pillar extruder group (if Indalex should under-estimate or over-estimate its billet requirements); the extension of the billet purchase contracts by Alcan in December 4, 1973 in tight market conditions; refusal in 1974 to allow Alcan to call force majeure because of a strike at Arvida, Quebec on the ground that the contract for billet was with Alcan Aluminum Ltd. and not with Alcan Aluminum of Canada Ltd; discount payments on billet upcharges as well as on the base metal price; 90 days credit terms, instead of the 30 days prevailing in the North American market; excellent scrap return terms; simultaneous settlement of invoice payments and discounts; regular efforts by Pillar to prevent or defer price increases or increases in scrap tolling charge or reduction in the credit terms (see P-1-105).

The learned trial judge rejected the notion that the appellant derived any significant value from "the first three alleged benefits" (metal switches; continuation of supply and no force majeure). As to the others she went on :

What then of the remaining advantages (discount terms; credit terms; scrap return terms; times of payment). In my view in order to conclude as counsel suggests, I have to find: (1) that these advantages or ones of an economic equivalent nature are ones which Indalex could not have obtained for itself without the interposition of Pillar International (RTZ-Pillar); and (2) that as a matter of quantum they are worth the additional amount paid by Indalex to Pillar International over what Pillar International paid Alcan. That is, the question becomes whether the plaintiff negotiating on his own could have obtained [from Alcan] the price in the same range as that which Alcan charged Pillar International or whether the plaintiff could only have obtained [from Alcan] the price similar to that which it paid Pillar International.

I have added [from Alcan] as I think it clear that is what the learned trial judge had in mind since she was considering what, if any, adjustment ought to be made to the best comparable arm's length price: that charged Pillar International by Alcan. The omission of those words was the basis for some spurious argument before us, the appellant insisting that she should have stated the issue in terms of “from Pillar International" rather than "from Alcan". Such a statement of the question would only make sense if the learned trial judge had not already rejected the appellant's argument that the price paid Pillar International was that which would have been reached if negotiated at arm's length.

It is that statement of the issue which the respondent challenges in the cross appeal. After considering the evidence, C.T.C. 237; D.T.C. 6051, the learned trial judge found

. . . that a 1% or less differential was the additional discount obtained by Pillar International over what the plaintiff could have negotiated on its own [from Alcan]. The plaintiff has not proven that the amounts it paid for billet was a reasonable price in the circumstances [to Pillar International].

I have again, perhaps pedantically but because of quibbling argument, identified the undoubted entities to whom express reference was omitted.

In my opinion, the learned trial judge erred in law in resolving the issue on the apparent assumption that Pillar International was entitled to the benefit of the better price obtained from Alcan because of greater bargaining power. That greater bargaining power was exclusively due to the pooling of the purchasing power of a number of members of the Pillar group to which the appellant was an important contributor. There was no evidence whatsoever that Pillar International itself contributed an iota of that pooled purchasing power. On the contrary, it bought no billet for its own account. Where non-arm's length parties combine to obtain an advantage from an outsider not available to them individually, any allocation of the advantage among them except on a pro rata basis has to be justified. Nothing in the evidence or in the findings of fact by the learned trial judge support the allocation of any part of that advantage to Pillar International. The question was not whether the appellant could itself have negotiated as good a price directly with Alcan but whether or not the withholding of any part of the benefit of the entire discount allowed in respect of sales to it unduly reduced its income.

Conclusion

The appellant had the burden of proof. It did not claim any part of the discount retention as reimbursement to Pillar International of a share of the actual cost of administering the arrangement.

The learned trial judge was right in rejecting its principal argument that the price paid Pillar International by the appellant was the price that would have been paid if it had been established at arm's length. She was also right in rejecting the propositions that the discount retention was in any way justified by either the pre-1970 arrangements or by the capital employed by Pillar International. Had she asked herself the right question, she would also have rejected the proposition that any part of it could be sustained by Pillar International's global purchasing power.

In the result the appeal should be dismissed with costs and the cross appeal as to the reassessments allowed with costs. That being the result, it is unnecessary to deal with the issue of the “special credit". We did not hear argument from the appellant on the cross appeal as to costs being of the view that no error in principle in the exercise of her discretion on the part of the trial judge had been demonstrated. I would dismiss it without costs. The judgment of the Trial Division should be set aside and the reassessments in issue restored.

Appeal dismissed.

Cross appeal allowed in part.