Test for reasonableness of interest amount is whether no business would have contracted to pay that amount:  Alberta Court of Queen’s Bench

This summer saw the first case in which a court articulated the test for determining whether an interest amount is reasonable for purposes of paragraph 20(1)(c) of the Income Tax Act (Canada) (“ITA”).  No other Canadian federal or provincial court has ruled on this question.

In ENMAX PSA Corp. v. Alberta (2016 ABQB 334), the two taxpayers were subsidiaries of ENMAX Corp., which was owned by the City of Calgary.  Government-owned businesses in Alberta are usually exempt from provincial and federal tax statutes, unlike privately-owned and publicly-traded corporations.  To even things out, government-owned businesses are required to make payments in lieu of tax (“PILOT”) to a “balancing pool”.  PILOT payments are calculated in accordance with tax statutes.  A taxpayer may deduct a “reasonable amount” of interest on borrowed money used for the purpose of earning income to the extent permitted under paragraph 20(1)(c).

The taxpayers in this case paid interest to ENMAX Corp. on funds borrowed from it and deducted the interest under paragraph 20(1)(c) in calculating their PILOT payments.  Alberta’s Minister of Finance took the position that the interest rates on the loans were unreasonable and only allowed deductions for amounts computed at about half of the actual interest rates.  The taxpayers appealed to the provincial court.

The issue before the Alberta Court of Queen’s Bench was whether interest paid by each taxpayer was reasonable pursuant to paragraph 20(1)(c).  The Court identified three broad considerations that govern the determination of what is reasonable:

1. Reasonableness must be measured with reference to the legal transaction to which the borrower was a party, not other contracts it might have made.
2. The interest that would have been paid in an arm’s length transaction may be a relevant factor, but it does not define what is reasonable.
3. The standard of reasonableness does not require that a taxpayer’s deduction be ascertainable as a precise, correct amount. Rather, it allows for a range of amounts to be considered reasonable.

Justice Poelman concluded that the question to ask when determining whether the interest deducted by a taxpayer is a reasonable amount is:  Whether no business would have contracted to pay that amount, having only its business considerations in mind and under the form of transaction pursuant to which the obligation was incurred?  Also noteworthy are his statements that the reasonableness standard in paragraph 20(1)(c) is not an arm’s length standard and that an interest rate higher than an arm’s length rate may be reasonable in the circumstances.

After extensively canvassing the evidence tendered by fact and expert witnesses, Justice Poelman found that the interest deducted by the taxpayers (and hence the interest rates) were reasonable.