On May 22, 2008, the Supreme Court of Canada released its decision in the McLarty matter. The issue before the Court was whether Mr. McLarty’s liability under a promissory note that was owing by him upon the acquisition of a certain oil and gas property was an absolute as opposed to a contingent liability. To the extent that the promissory note was a contingent liability, no deduction would be allowed by Mr. McLarty for such portion of the otherwise oil and gas expense deduction. The other matter before the Court was whether or not McLarty was dealing at arm’s length with the vendor when he acquired the property. To the extent that he was not dealing in an arm’s length fashion with the vendor then the acquisition of such property would be required to be made at fair market value which the CRA had argued was much less than its original acquisition price.
On December 31, 1992, Allan McLarty purchased from Compton Resource Corporation (“CRC”) an interest in proprietary seismic data as a participant in an oil and gas joint venture. McLarty acquired a 1.5% interest in the data for the price of $100K satisfied by cash of $15K and a promissory note of $85K payable with interest to CRC on December 31, 1999. When Mr. McLarty filed his personal income tax return for 1992, he treated his purchase of the seismic data as a Canadian exploration expense and added $100K to his cumulative Canadian exploration expense pool. In calculating his income, he deducted $81,655 as CEE in 1992 and an additional $14,854 in 1994 reducing his pool accordingly. The Minister of National Revenue reassessed McLarty to allow a deduction of $32,182 and not $100K. The Tax Court of Canada analyzed the issue of whether McLarty’s liability under the promissory note was absolute or contingent and whether or not McLarty was dealing with CRC at arm’s length. The trial judge found in favour of McLarty on all issues, entitling him to a deduction of $100K. The Crown appealed to the Federal Court of Appeal and, again, the Federal Court of Appeal found that the promissory note was not a contingent liability but found that McLarty was not dealing with CRC at arm’s length and therefore it allowed the appeal and remitted the matter back to the Tax Court for a determination of whether the fair market value of the seismic data exceeded $32,182. Accordingly, the issue before the Supreme Court of Canada was whether or not McLarty’s liability under the promissory note was absolute or contingent and whether CRC was dealing with McLarty at arm’s length.
In a lengthy analysis, the Supreme Court found (with seven members of the Court agreeing with the decision on this point and two dissenting) that the promissory note was not a contingent liability. The Crown seemed to be bothered by the fact that the promissory note had limited recourse terms. For example, certain of the repayment terms of the note were tied to future cash flow to be received by the seismic data or by a certain percentage of the realized cash proceeds on a future sale of the proprietary rights to the data. Although CRC had recourse to the underlying asset (i.e. the proprietary rights to the data), to the extent that the cash flow and future cash received on a sale was not sufficient to repay the principal amount of the promissory note, CRC had no recourse to McLarty and any remaining amount would be forgiven. The Crown therefore argued that since the promissory note had limited recourse terms and the extent of such recourse was uncertain, the liability was therefore contingent. However, the Court disagreed and, in a very forceful decision, reviewed the prior legal tests of contingent liability and stated that the extent of recourse (i.e. the amount eventually paid) does not determine whether a liability is absolute or contingent and therefore did not agree with the Crown’s argument that the note was a contingent liability. Instead, the Court found that the issue must be determined by reference to the terms of the note and found that the promissory note in question was an absolute liability and therefore Mr. McLarty was entitled to a full expense deduction. The Court clearly stated that uncertainty as to the quantum, timing or risk of non-payment does not make a liability contingent.
The Court also reviewed whether or not McLarty was dealing at arm’s length with CRC and, again, in a very forceful decision, decided that the relationship to be reviewed is as between the taxpayer and the vendor and all of the circumstances leading up to the acquisition must be reviewed in making this determination. The Court further found that there was no basis to disturb the trial court’s factual finding that Mr. McLarty and CRC were in fact dealing at arm’s length.
This decision is a very interesting read and will have major implications into the future when dealing with the issue of whether or not certain indebtedness/expenses are contingent liabilities. There is no doubt that tax practitioners will continue to look to this decision for many years into the future given its succinctness.
On a side note, I need to congratulate my good friend, Jehad Haymour, who was part of the legal team at Fraser Milner Casgrain that argued this case in front of the Supreme Court of Canada. Well done Jehad!