Defining the Scope of Absolute Liability: A Lay Analysis of R v. McLarty

A little more then a week ago, the Supreme Court of Canada handed down R v. McLarty 2008 SCC 26, a decision which made its way to Canada’s top court via the Tax Court and subsequently the Federal Court of Appeal. McLarty provided the Supreme Court with the opportunity to define the parameters of two important concepts — absolute liability and ‘arm’s length’ transactions — as they relate to income tax deductions. In this post, I will consider the arguments made by the majority and dissent on the issue of absolute liability, (arguably the most contentious issue raised in the decision). Prior to proceeding however, a qualifying note: I am a neophyte in the area of tax law. On a rudimentary level, I understand that various levels of government occasionally extract capital from the general population and use it to fund, among other things, the activities of state (some of them nefarious). I am also cognizant of the fact that the particular form and volume of taxation that takes place can have broad ranging policy implications. Beyond that, however, my familiarity with tax law is rather limited.

Facts and Procedural History

McLarty stems from a business transaction in which Mr. McLarty acquired a 1.57% interest in proprietary seismic data (used to locate oil and gas reserves) for the price of $100,000. Mr. McLarty paid $15,000 up front and the remaining $85,000 by way of a limited recourse promissory note. The latter was to be paid for out of revenue from the business venture. In the event that the revenue therefrom was insufficient, the entitlement of the noteholders would decrease to a maximum of 60% of the value of the resale of the seismic data, as calculated at the time when the promissory note reached maturity. Put another way, whether or not Mr. McLarty paid the “full” ($85, 000) value of the promissory note was contingent on the profitability of the business venture.

On his income tax return, Mr. McLarty claimed “Canadian Exploration Expenses” (pursuant to s. 66.1(6) of the Income Tax Act R.S.C. 1985, c. 1 (5th Supp.)) of $81,655 for the year of 1992, and $14,854 for 1994. These claims were reassessed by the Minister of National Revenue, who found that the purchase price of the seismic data on which the claims were based was substantially in excess of fair market value. The Minister accordingly reduced the amount claimable by Mr. McLarty.

Taking issue with Minister’s assessment, Mr. McLarty appealed to the Tax Court, which allowed his appeal, reinstating the deductions as originally claimed. However, the Minister sought leave to appeal to the Federal Court of Appeal, which overturned the decision of the Tax Court. Mr. McLarty then sought leave to appeal to the Supreme Court.

The Supreme Court Weighs In

The issue on appeal before the Supreme Court was whether Mr. McLarty’s liability with respect to the promissory note he issued was absolute or contingent. The significance of this issue lies in the fact that s. 66.1(6) of the Income Tax Act dictates that deductions for Canadian exploration expenses are legitimate only when the taxpayer claiming the deduction is absolutely liable for the expenses claimed.

Also at issue by way of cross-appeal was whether or not the impugned transaction between Mr. McLarty and the vendor occurred at arm’s length. Acquisitions that do not occur at arm’s length are automatically deemed to have been made at fair market value.

Writing for the majority, Rothstein J. dismissed the appeal and allowed the cross appeal, finding that Mr. McLarty’s promissory notes disclosed absolute, not contingent liability, and that the transaction in question occurred at arm’s length. The majority accordingly found that the deductions made by Mr. McLarty were consistent with the requirements set out in 66.1(6) of the Income Tax Act In dissent, Abella and Bastarache JJ. agreed with the majority’s finding on the arm’s length issue, but found that Mr. McLarty’s promissory note was constitutive of contingent liability. As such, the dissenting opinion claimed that Mr. McLarty had not satisfied s. 66.1(6) of the Act.

Competing Accounts of Contingent Liability

Rothstein J., for the majority, began by considering whether Mr. McLarty’s promissory note constituted contingent liability. He defined a “contingency” as “an event which may or may not occur.” By extension, a contingent liability, Rothstein J. reasoned, is “a liability which depends for its existence upon an event which may or may not happen.”

Drawing on Winter v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), and Wawang Forest Products Ltd. v. The Queen 2001 DTC 5212, 2001 FCA 80, Rothstein J. articulated a three part test for contingent liability:

(a) Uncertainty as to whether the payment will be made. For example, a liability may be incurred when the taxpayer is in financial difficulty and there is a significant risk of non-payment. That does not mean the obligation was never incurred;

(b) Uncertainty as to the amount payable. There is always uncertainty as to the amount that may be payable. There is never certainty that the borrower will be able to pay the amount owing when the note comes due. That type of uncertainty does not make a liability contingent;

(c) Uncertainty as to the time by which payment shall be made. An obligation is not contingent because payment may be postponed if certain events occur.

Applying this test to McLarty, Rothstein J. undertook a detailed analysis of the impugned promissory note, ultimately concluding that while it disclosed uncertainty, such uncertainty was not based on whether or not a future event would occur. The uncertainty contained in the promissory note, Rothstein J. found, was not preclusive of absolute liability. “The extent of recourse [of a promissory noteholder]” Rothstein J. explained, “has no bearing on the question of whether a liability is absolute or contingent.” The Minister’s argument was premised on the impugned promissory note being non-recourse.

Put another way, Rothstein J. refused to countenance any arguments to the effect that “the quantum of repayment must be certain in order for a liability not to be contingent.” Such arguments he likened to “just another way of attacking non-recourse debt and looking at the value of security to test whether the liability was contingent or absolute.”

Rothstein J. also pointed to the ‘forgiveness clause’ in the promissory note — the provision that any balance owing after allocation of the profits of the sale of the security “will be forgiven by the Noteholder and the undersigned will have no further liability under this promissory note” — to substantiate his finding of absolute liability. “If the liability in this case was contingent upon the happening of a future event and the event did not occur,” he reasoned, “there would be no surviving liability and nothing to forgive.”

For these reasons, Rothstein J. concluded that the promissory note did not meet the test for contingent liability established in Winter and Wawang.

Bastarache and Abella JJ., in their dissenting opinion took a different view. Like Rothstein J., the dissenting opinion found the origins of the test for discerning contingent liability in Winter. Unlike the majority however, the dissent relied primarily on Mandel v. The Queen, [1980] 1 S.C.R. 318, aff’g [1979] 1 F.C. 560 (C.A.), aff’g [1977] 1 F.C. 673 (T.D.). In the dissent’s view, Mandel stands for the proposition that “where liabilities depend on whether a business venture generates revenues, they must be characterized, for tax purposes, as contingent.”

Bastarache and Abella JJ. accordingly focused on the fact that the full payment of the promissory note was contingent on the profitability of the seismic data:

Mr. McLarty’s liability depends on whether the business venture generates revenues. Mr. McLarty only needs to sell the seismic data if the venture has not generated sufficient revenues to cover the $85,000 face value of the promissory note. Whether it will do so is uncertain. This in turn makes the liabilities that depend on revenue generation uncertain and, accordingly, contingent. This means that Mr. McLarty’s obligation to resell the venture data is also contingent, because it too depends on whether sufficient revenues have been generated to cover the face value of the promissory note.

The dissent also refused to accept that the “default” provisions of the promissory note, (which dictated that in the event that there was no profit, the noteholder would receive payment of 60% of profits derived from the sale of the data and 20% of the drilling rights) negated a finding of contingent liability. Mr. McLarty likened this default provision to “debt foregiveness” (the implication of which is that, for tax purposes, it would have no impact on the Mr. McLarty’s liability). However, the dissent rejected this characterization, pointing to the fact that the alleged ‘debt forgivenss’ “was specified within the loan arrangement.”

Rothstein J. responded to the Bastarache and Abella JJ’s dissenting opinion in his reasons for the majority. He took issue with the their reliance on the impact of the profitability of the seismic data on the payment of the promissory note as grounds for a finding of contingent liability. “Whether liability under the note is to be satisfied from the generation of revenue or from the sale of the seismic data,” Rothstein J. explained, “when these events are viewed in the sequence they occur, it is clear the liability is to be repaid and thus its existence does not depend upon an event which may or may not happen.”

Moreover, Rothstein J. charged the dissent with “conflating the issue of whether the security is sufficient to repay the full value of the note and implicitly, that the seismic data was overvalued, with the issue of whether the liability is absolute or contingent.” “In an appropriate case,” he continued, “overvaluation to obtain a tax advantage may be attacked by the Minister on at least the basis that the valuation is unreasonable or that a note constitutes a sham or that the parties are not dealing at arm’s length.” However, McLarty did not pose any of these issues.

The Underlying Policy Question: How Should Absolute Liability be Defined for Income Tax Deduction Purposes

Two distinct accounts of absolute liability emerge from the majority and dissenting opinions in McLarty. Each arguably represents an attempt to strike a balance between two competing policy considerations: encouraging the development of Canadian resources on the one hand, and discouraging tax avoidance on the other. The broader account of absolute liability advanced by the majority arguably creates a greater incentive for the exploration and development of Canadian resources, making it far easier for taxpayers to claim deductions for Canadian Exploration Expenses under s. 66.1(6) of the Income Tax Act. However, by effectively loosening the requirements for claiming deductions under 66.1(6) of the Act the majority’s conception of absolute liability also makes it easier for taxpayers to engage in tax avoidance.

By contrast, the narrower conception of absolute liability proposed by the dissenting opinion makes tax avoidance more difficult, but arguably does not encourage the development of resources to the extent that the majority decision does.