[1] This appeal concerns the fair market value of certain software acquired by Commcorp Financial Services Inc. ("Commcorp"), the predecessor to the appellant, in a sale-leaseback arrangement. Through a series of transactions involving intermediary corporations, the software was acquired from and ultimately leased back to its original owner BHP New Zealand Steel Ltd. ("BHP"). The fair market value of the software is necessary for the purposes of determining the capital cost of the software and thus Commcorp's entitlement to deduct capital cost allowance ("CCA"). The Tax Court Judge determined that the fair market value of the software was approximately $20 million lower than the amount claimed by the appellant. The appellant appeals this determination.

[2] In the Tax Court, the respondent argued that the general anti-avoidance rule ("GAAR") contained in section 245 of the Income Tax Act, R.S.C. 1985 (5^th Supp.), c. 1 (the "ITA") applied so as to deny entirely the deduction of the CCA claimed by the appellant. The Tax Court Judge held that GAAR did not apply so as to deny the entire CCA claim. The respondent launched a cross-appeal of this decision but abandoned it just prior to the hearing of the appeal.

[3] For a full recitation of the facts in this case, the decision of the Tax Court Judge is reported at, 2003 D.T.C. 1138.

II. Background

[4] Normally, for the purposes of determining CCA, the "cost" of property is simply the amount of money that the taxpayer paid to acquire it - in this case, $33,091,255. Paragraph 20(1)(a) is the basic provision of the ITA which entitles taxpayers to deduct capital cost in accordance with the regulations when computing their income from a business or property:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by the regulation;

20. (1) Malgré les alinéas 18(1)a), b) et h), sont déductibles dans le calcul du revenu tiré par un contribuable d'une entreprise ou d'un bien pour une année d'imposition celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qu'il est raisonnable de considérer comme s'y rapportant:

a) la partie du coût en capital des biens supporté par le contribuable ou le montant au titre de ce coût ainsi supporté que le règlement autorise;

[5] However, because the appellant conceded that Commcorp acquired the software in a non-arms-length transaction, a specific anti-avoidance provision applies to limit the capital cost of the software to its fair market value. Paragraph 69(1)(a) of the ITA provides:

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

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

69. (1) Sauf disposition contraire expresse de la présente loi:

a) le contribuable qui a acquis un bien auprès d'une personne avec laquelle il avait un lien de dépendance pour une somme supérieure à la juste valeur marchande de ce bien au moment de son acquisition est réputé l'avoir acquis pour une somme égale à cette juste valeur marchande;

As a result of paragraph 69(1)(a), it is necessary to look beyond what the formal legal agreements indicate Commcorp paid for the software, and instead determine the cost based on its fair market value.

[6] The appellant claims that the fair market value of the software at the time Commcorp acquired it was approximately $33 million. In order to support this claim, the appellant put forward two expert reports regarding fair market value at the trial. The first report, which I will refer to as the MACC report, was completed before any of the transactions at issue took place. Its purpose was to determine the price at which the software would be purchased and ultimately leased back in the sale-leaseback arrangement. The MACC report determined the fair market value of the software using the replacement cost method.

[7] The second expert report, which I will refer to as the KPMG report, was completed after the purchase and lease transactions were completed and for the purposes of the trial. The KPMG report determined the fair market value of the software based on the present value of the lease payments Commcorp was entitled to under the terms of the lease. Using this cash flow method, the value of the software was estimated at approximately $33 million.

[8] The Tax Court Judge rejected both expert reports regarding the fair market value of the software. First, with respect to the MACC report, while the Tax Court Judge agreed that the replacement cost method was the appropriate method to use to value the software, he disagreed with the report's conclusions as to value and found that there were many errors in the report. The Tax Court Judge found that the replacement cost method was the best way to value the software in this case because the software was specifically designed to run a particular steel mill, and would not likely have much value to any other steel company or be bought and sold on the open market. He stated at para. 36:

... however valuable it may be to BHP in running its business it could not be readily adapted to anyone else's business.... Put differently, any company that wanted to install a computer system to run its steel mill would find it easier and cheaper to develop its own system than to pay $33,000,000 or any other amount for BHP's system and then try to adapt it.

In finding that the $33 million replacement cost in the MACC report was too high, the Tax Court Judge noted, inter alia, that BHP had reported to the Inland Revenue of New Zealand that the cost to develop the software was $7,405,823. Using the replacement cost method and relying in part on the Crown's expert, the Tax Court Judge determined that the fair market value of the software was $13,100,000.

[9] The Tax Court Judge also rejected the fair market value as expressed in the KPMG report on the basis that this report inappropriately valued the lease payments instead of valuing the software itself. He found that, in the circumstances of this case, the value of the lease payments did not reflect the fair market value of the software because the lease payments were part of a circular series of transactions, the value of which was originally based on the severely inflated value provided in the MACC report.

[10] The appellant does not challenge the Tax Court Judge's factual determination of the replacement cost of the software; however, it challenges the fact that he used the replacement cost method to value the software instead of the cash or earnings method, upon which the KPMG report was based. In particular, the appellant argues that the value of the software is equal to the present value of the income generated by the lease, which is approximately $33 million. The appellant also argued that the Tax Court Judge erred in law by introducing the factor of artificiality when applying paragraph 69(1)(a) of the ITA. According to the appellant, absent a sham, the legal effects of a transaction must be respected; under the transactions at issue, the software was subject to a lease, which entitled Commcorp to receive lease income, the present value of which was approximately $33 million.

III. Analysis

[11] The appellant argued that when determining the fair market value of the software, the Tax Court Judge was required to consider the fact that it was subject to the lease and that for the purposes of determining fair market value, the lease and the software could not be separated. However, in my opinion, this argument is fundamentally flawed, and the Tax Court Judge did not err when he determined that the present value of the income generated by the lease did not reflect the fair market value of the software in the circumstances of this case.

[12] First, the Tax Court Judge was clearly aware of the fact that the software was subject to the lease at the time that Commcorp acquired it, and that the lease was a legally effective transaction and not a sham. Nevertheless, the Tax Court Judge correctly determined that the ITA required him to determine the fair market value of the software and not the lease. While in some circumstances lease income may be a useful proxy for determining the value of the underlying asset which is subject to the lease, in the circumstances of this case, the Tax Court Judge concluded that it was not. The Tax Court Judge was entitled to reach this conclusion.

[13] The jurisprudence is clear that the determination of fair market value is a question of fact rather than a question of law. See for example Gold Court Selection Trust Limited v. Humphrey (Inspector of Taxes), [1948] A.C. 459 at 473. As a result, according to Housen v. Nikolaisen, [2002] 2 S.C.R. 235, the standard of review with respect to findings of fact is palpable or overriding error. There is ample authority for the proposition that a trial judge is entitled to arrive at his own opinion as to value. Connor v. The Queen, 79 DTC 5256 (FCA), R. v. Whent, 2000 DTC 6001 (FCA). In my opinion, the Tax Court Judge has not committed a palpable or overriding error in this case. To the contrary, I agree that, in the circumstances of this case, the lease income did not reflect the fair market value of the software. This was because the parties had predetermined the amount of the lease payments based on the MACC report's determination of fair market value, which the Tax Court Judge found was approximately $20 million too high. Indeed, at the trial, counsel for the appellant expressly acknowledged the fact that the parties determined the amount of the lease payments based on the MACC report:

When the lease was entered into between 583 and Eagle, they knew that the software had a value of $33 million [based on the MACC report]. They assumed the software had a value of $33 million. One assumes when they put the lease together, they said what will give a commercial return on $33 million. And so the lease was probably drafted to give a commercial return on $33 million.

Since the value of the lease was completely dependent upon the flawed value in the MACC report, to the extent that the MACC report over-valued the software, the value of the lease income also does not provide an accurate picture of the software's value. Accordingly, the Tax Court Judge appropriately rejected the cash flow method used in the KPMG report.

[14] I do not think that the Tax Court Judge erred in arriving at the fair market value of the software. He considered the reports of the experts, accepting parts of their evidence and rejecting others, as he was entitled to do. His reasoning in arriving at fair market value based on the replacement cost method is sound.

[15] The appeal should therefore be dismissed with costs.

"J. Edgar Sexton"

J.A.

"I agree

Robert Décary"

"I agree

B. Malone"

FEDERAL COURT OF APPEAL

NAMES OF COUNSEL AND SOLICITORS OF RECORD

DOCKET: A-455-03

STYLE OF CAUSE: CIT FINANCIAL LTD.

Appellant

and

HER MAJESTY THE QUEEN

Respondent

PLACE OF HEARING: TORONTO, ONTARIO

DATE OF HEARING: MAY 18, 2004

REASONS FOR JUDGMENT: SEXTON J.A.

CONCURRED IN BY: DÉCARY J.A.

MALONE J.A.

DATED: MAY 20, 2004

APPEARANCES:

Mr. Warren J. A. Mitchell

Mr. Paul Tamaki

Mr. David Davies

FOR THE APPELLANT

Ms. Alexandra Brown

FOR THE RESPONDENT

SOLICITORS OF RECORD:

Thorsteinssons

Barristers & Solicitors

Toronto, Ontario

FOR THE APPELLANT

Morris Rosenberg

Deputy Attorney General of Canada

FOR THE RESPONDENT

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