16 Mai 2013

The Crown’s Allegation that CIBC’s Conduct in the Enron Scandal was “Egregious and Repulsive” is Struck Out by the Federal Court of Appeal

Par Sarah D. Pinsonnault
Revenu Québec

The question that is raised before the Federal Court of Appeal in Canadian Imperial Bank of Commerce v. Canada (2013 FCA 122) is whether or not a business’ moral conduct is relevant when determining its profit for income tax purposes.

As a general overview, CIBC found itself party to a lawsuit in which it was alleged to have aided Enron in its famous accounting fraud scheme. For those of you who are unfamiliar with the “Enron Scandal”, it was revealed that Enron wilfully created misleading financial reports that inflated and/or recorded fraudulent and nonexistent profits, as well as understated and/or eliminated some of the company’s debts from its books. 

CIBC ultimately agreed to pay close to $3 billion to settle this particular Enron lawsuit and the claims against it were then dropped.

When calculating its income for income tax purposes, CIBC deducted this $3 billion settlement payment from its income, deeming it as an expense “made or incurred […] for the purpose of gaining or producing income from the business”, pursuant to paragraph 18(1)(a) of the Income Tax Act (“ITA”).  

The Minister of National Review reassessed CIBC and refused this deduction. Following an unsuccessful objection to this reassessment, CIBC appealed before the Tax Court of Canada.

In the Crown’s over 83-page reply, CIBC had several issues with portions of the Crown’s pleading, notably the following, which led to its motion to strike:

“134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.”

The Tax Court judge dismissed CIBC’s motion to strike on this issue. Consequently, CIBC brought this decision before the Federal Court of Appeal; claiming that the judge erred in law when he concluded that said paragraph 134 provided a reasonable basis for the Crown in defending its reassessments.

The Federal Court of Appeal had to thus determine whether the Crown’s characterization of CIBC’s conduct as “egregious and repulsive” was relevant to the correct interpretation and application of paragraph 18(1)(a) ITA.

In its reply, the Crown relied on an obiter dictum delivered by Justice Iacobucci in the Supreme Court of Canada decision 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804 (a.k.a. the “Egg Case” given the taxpayer was an egg producer). This decision settled a longstanding debate over the application of the statutory income earning purpose test with regards to fines and penalties.

In a nutshell, the majority of the Supreme Court of Canada ruled in the Egg Case that it was Parliament’s duty, and not that of the Courts, to determine whether the deduction of a fine or penalty as a business expense should be denied, pursuant to paragraph 18(1)(a) ITA, because it would in theory undermine the actual public policy objective of imposing the fine or penalty in the first place.

Parliament took note of this decision and consequently amended the Income Tax Act to prohibit, under what is now section 67.6 ITA, the deduction of fines and penalties when computing one’s income.

However, in this case, it was not a fine or penalty that was called into play but rather an alleged unlawful or morally questionable conduct of the taxpayer.

Following a lengthy analysis of relevant jurisprudence, the Federal Court of Appeal found that the Crown misconstrued Justice Iacobucci’s reasoning in his obiter dictum:

“[65] The Crown submits that the emphasized obiter dictum affords a basis for its argument that the deduction of an expense incurred because of conduct that is “egregious or repulsive” may be prohibited by paragraph 18(1)(a). In my view, the Crown’s submission is based on a misinterpretation of the obiter dictum, and the judge erred in law when he accepted it. I do not accept that Justice Iacobucci, having rejected the notion that the Courts may superimpose on paragraph 18(1)(a) a non-legislated public policy test, would accept in the very same case the proposition that the Courts nevertheless may superimpose on paragraph 18(1)(a) a non-legislated requirement that the taxpayer’s conduct not be “egregious or repulsive”.

[66] As I understand Justice Iacobucci’s obiter dictum, he was making a point about determining the deductibility of a particular expense incurred as a consequence of the taxpayer’s conduct, where it is necessary to consider whether and how the conduct is connected to a business or a business activity of the taxpayer. Essentially, he was recognizing that certain conduct may, because of its egregious or repulsive nature, be so disconnected factually from the taxpayer’s actual business (or from any business) that an expense the taxpayer incurs because of that conduct cannot meet the income earning purpose test. He was not saying or suggesting that conduct in fact undertaken by a taxpayer for the purpose of earning income from a business can be disconnected from that business for income tax purposes solely because the conduct is egregious or repulsive. Nor was he saying or suggesting that the egregiousness or repulsiveness of particular conduct, in and by itself, changes the question to be asked in determining whether paragraph 18(1)(a) prohibits the deduction of an expense incurred as a result of that conduct.


[76] I conclude, following the statement of Justice Iacobucci in the last sentence of paragraph 39 of the Egg Case (quoted above), that the only question to be asked in determining whether paragraph 18(1)(a) prohibits a particular deduction is this: Did the taxpayer incur the expense for the purpose of earning income? Since that is the only relevant question, it follows that even if CIBC conducted itself as alleged by the claimants in the Newby Litigation and the MegaClaim Litigation, and even if that conduct was egregious or repulsive, that characterization of the morality of CIBC’s conduct is not legally relevant to the application of paragraph 18(1)(a). Therefore, I agree with CIBC that paragraph 134 of the reply should be struck. The same is true of factual assumptions or allegations elsewhere in the reply that assert a moral evaluation of the conduct of CIBC.” (emphasis added)

In closing, the Federal Court of Appeal did raise the point that a factual connection between the expense incurred by the business and the nature of its affairs must be present when calculating its income for income tax purposes (i.e. did CIBC’s settlement payment fall within the scope of its banking practices?). However, the Federal Court of Appeal noted that the Crown failed to detail this element in its reply.

Nevertheless, in terms of the moral conduct of the business, the Federal Court of Appeal concluded that it holds no place when determining the business’ profits:

“[77] […] I have been able to find no case that says or suggests that an evaluation of the morality of a taxpayer’s conduct is necessary before determining whether its business profit has been correctly determined for the purposes of subsection 9(1). Nor is the Crown’s argument consistent with the well established proposition that the principles to be applied in determining the profit of a business do not vary depending upon the legality of the business (see, for example, Smith and Eldridge, cited above, as well as the Egg Case).”

To read this decision in its entirety, click here.


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