Annual Examinations, 2014-2015 Page 1 of 6

Canadian Income Tax Law, Professor Alarie

UNIVERSITY OF TORONTO
FACULTY OF LAW

DATE: Thursday, April 9, 2015

TIME: 9:30 a.m.—12:30 p.m.

CANADIAN INCOME TAX LAW

Examiner: Professor Alarie

NOTE: 1. You may use any kind of hard-copy material you wish during the examination, except
for books owned by the library. You may not use any electronic reference
materials. Calculators are permitted.

2. The exam has two “perspective” questions of equal value (worth 10%) and 16
“scenario” questions of equal value (worth 5% each). The two “perspective” questions
have a word limit of 150 words each. The other questions have no word limit.

3. Cell phones, pagers and other communication devices are prohibited in exams. Cell
phones are not permitted as a time keeping device and should not be visible on the desk
during an examination. Communication devices left on the desk during an exam may be
removed by the invigilator.

4. If you are handwriting, ensure that you have written your pseudoname, course name,
and the number of the booklet on each examination booklet and the name of the instructor
on the first booklet. If you request an additional booklet(s) during the examination, write
the required information on the booklet at the time you receive it. No time will be permitted
for this at the end of the examination.

5. During the examination, only one student at a time is permitted to leave the examination
room. No student may leave within fifteen minutes of the conclusion of the examination.

6. At the end of this examination, the invigilator will ask you to stop writing, count the total
number of booklets used, record this on the front of the first booklet, and insert all booklets
into the first booklet. For students who are typing their examination, the invigilator will ask
you to stop typing and exit Examsoft. You will then remain seated and quiet until all
the examination papers/envelopes are collected. The invigilator(s) will let you know
when you can leave the examination room.

7. Time limits will be strictly enforced. Students who continue to write or type after the
examination has ended will have their answer booklets/examination envelope collected
separately and may be subject to a penalty.
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Canadian Income Tax Law, Professor Alarie

Perspective Questions (limit your responses to 150 words each)

1. For what reasons might a reasonable person disagree with the following statement drawn from
the speech of Lord Tomlin in the Duke of Westminster decision (HL, 1936)? In your response,
please refer to at least one other case that we analyzed this year to support your reasoning.

Every man [sic.] is entitled if he can to order his affairs so that the tax
attaching under the appropriate Acts is less than it otherwise would be. If he
succeeds in ordering them so as to secure this result, then, however
unappreciative the Commissioners of Inland Revenue or his fellow tax-
payers may be of his ingenuity, he cannot be compelled to pay an increased
tax.

2. For what reasons might a reasonable person agree with the following statement drawn from the
headnote of Will-Kare Paving & Contracting Ltd. (SCC, 2000)? In your response, please refer to
at least one other case that we analyzed this year to support your reasoning.

Since the word “sale” has an established meaning, the technical nature of
the Income Tax Act does not lend itself to broadening the principle of plain
meaning to embrace popular meaning, although it would be open to
Parliament to provide for a broadened definition of sale for the purpose of
applying the incentives with clear language to that effect.

Scenario One (questions 3 to 6)

Static Inc., (“Static”) is an Ontario brewing corporation. Ms. Susan Smith and her spouse, Mr. Patrick
Jones, have always owned all of the shares of Static. Smith and Jones are full-time employees of
Static. Smith is the brewmaster. Jones provides administrative services to Static.

Smith and Jones always intended Static to be exclusively a family-owned craft brewery. Due to
Smith’s prowess, however, Static’s craft brewery soon acquired a sizable reputation for producing
tasty beer and the number of full-time employees grew to 12 at the peak. In early 2008, BrewCo, a
major publicly traded brewing company, negotiated with Static to purchase an irrevocable perpetual
exclusive license from the company to takeover all of Static’s brews for $2 million. In a separate
agreement signed in conjunction with this license, Static agreed that for the next three years that it
would provide non-exclusive consulting services to BrewCo as needed on the production of the
brews to ensure continuity of taste at a rate of $450 per hour. Finally, Static entered into a “non-
competition” agreement with BrewCo under which Static, and Smith and Jones personally, agreed
not to directly or indirectly produce any competing beers for the next 10 years in exchange for a one-
time lump sum payment of $1 each. As a consequence of these agreements, Static was no longer
involved in producing any beer at all, and instead became involved in consulting other brewers. This
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Canadian Income Tax Law, Professor Alarie

meant that all but Smith and Jones were no longer employed by Static. Smith and Jones were able
to convince BrewCo to hire all 10 of the Static employees displaced by the deal.

In 2008, Smith and the 10 former employees hired by BrewCo were directly involved in getting the
production of the lines of beer to scale to the volumes desired by BrewCo. By 2009, BrewCo had
developed quite a lot of experience in producing the Static beers and so needed only 200 hours of
Smith’s time. By 2010, BrewCo did not ask for any more of Smith’s time. This was just as well, since
Smith found herself increasingly in demand elsewhere in Ontario and Quebec to consult on how to
produce market-ready beers. In 2008, Static (through Smith) advised three breweries other than
BrewCo; in 2009 and 2010, that number increased to six to and ten, respectively.

In late 2010, a mid-sized brewer (MidCo) approached Smith and Static offering to hire Static to
provide Smith’s consulting services on a five-year full-time exclusive contract (from 2011-2015,
inclusive). After some back and forth on terms, Static (and Smith and Jones) agreed. Pursuant to
this agreement, Smith reported five days a week, 9-5, to the offices of MidCo; was provided with her
own desk, computer, access key card, etc.; and worked with MidCo’s senior brewmaster. The main
role of Jones was to help Static to invoice MidCo monthly for Smith’s time and perform all the other
sundry tasks associated with the administration operation of Static. In early 2015, MidCo expressed
an interest in renewing this arrangement with Static for another five years.

Questions re: Scenario One (no word limit)

3. Would you characterize the $2 million payment by BrewCo to Static as capital or as income?
What are the strongest arguments for each characterization?
4. Is Smith an employee of MidCo from 2011 to 2015? Why or why not?
5. How likely is it that Static would be operating a “personal services business” if it were to agree
to renew and extend the arrangement with MidCo until 2020?
6. If Jones and Smith each draw a salary from Static equal to ½ of the revenues that Static receives
from MidCo in 2016 to 2020, what unattractive tax consequences are there if Static is considered
to be carrying on a “personal services business”?

Scenario Two (questions 7 to 10)

Lucy, a daring University of Toronto law student, is going to produce an action movie. She has set
aside $30,000 of her own funds to help finance the production and has access to much more from
a crowd-funding site that will provide additional absolutely no-strings attached money for the film: a
single anonymous donor contributed the entire target amount of $250,000 (rumours suggest that it
may have been Hal Jackman). The plot of the planned film calls for a gigantic mechanical monster,
Lawzilla, to be constructed by the Dean of a rival Ontario law school. According to the storyline, after
its creation in January 2016 Lawzilla proceeds to downtown Toronto in its attempt to interfere with
the completion of the new law building of the University of Toronto. In the course of its rampage,
Lawzilla feeds on parked cars, spectacularly recharges itself by diverting electricity from overhead
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Canadian Income Tax Law, Professor Alarie

electricity lines, and is in the end decapitated by a group of ultimate Frisbee law students in
Philosopher’s Walk on its approach to the nearly completed Jackman Law Building. The script calls
for the monster’s last words to be, “My Dean, my Dean, why have you forsaken me?” Although Lucy
is content to achieve some of the desired special effects through clever computer animation, the
credibility of the special effects depends on the actual depiction of the destruction of vehicles. Lucy
has budgeted a total of $45,000 on vehicles (acquired for $45,000 in December 2014, expected to
be held for all of 2015, and expected to be destroyed during production in January 2016), $80,000
on salary and wages for the actors and film crew, $55,000 for the creation of special effects (including
Lawzilla), $75,000 on post-production, and $25,000 for miscellaneous other expenses. Lucy expects
the royalties to be enough to help her cover her tuition for third year, her living expenses for several
years, and to leave her enough remaining to help finance future film projects. The total production
cost will be $280,000 and Lucy alone will hold the rights to the film.

Questions re: Scenario Two (no word limit)

7. If the film flops and generate only $5,000 in revenues for Lucy, what is the most tax aggressive
and yet plausible position that she can adopt to soften the blow for tax purposes?
Correspondingly, what is the most aggressive and plausible position that the CRA might make
against Lucy? In your view, what is the most likely outcome that a court would reach if confronted
with this situation?
8. Can Lucy claim CCA in 2014 and 2015 on the vehicles that were acquired in 2014 and are going
to be destroyed during production in 2016? Why or why not? If so, how much?
9. If Lucy is offered $500,000 for the film on its completion and she accepts the offer, what is the
amount of the resulting gain? How will it be characterized? Does your answer to this question
depend on your answer to question 8 in any way?
10. In your view, what is the appropriate treatment of the amount contributed by the anonymous
donor and received from the crowd-funding website? How important is it to your answer that Lucy
has no way of knowing who the donor was?

Scenario Three (questions 11 to 14)

Blue Inc. (“Blue”) is an Ontario-based gas BBQ manufacturer. Although profitable, its market share
is starting to decline as consumers turn to increasingly higher quality and less expensive import
BBQs from China. To stem this development, from mid-2011 to early-2013, engineers and
technicians worked on the design of a new high-end BBQ called “the Hoover.” The Hoover went into
production at Blue’s plant outside Toronto in April 2013 with a planned launch for June 2013. At the
same time, Blue staff developed a new marketing strategy.

To help launch the Hoover, Blue purchased a luxurious 10,000 square foot cottage on a pristine lake
two hours north of Toronto to which it invited key retailers and purchasing agents for a splashy launch
of the Hoover BBQ in the summer of 2013. Since then, the cottage has been used on a regular basis
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Canadian Income Tax Law, Professor Alarie

to demonstrate Blue products. The total cost of the cottage was $2.7 million: the building was $1.5
million, the cost of the land was $1 million, and the cost to furnish the cottage was $200,000. In
computing its income for its 2013 taxation year, Blue added the capital cost of the cottage building
and furnishings to the undepreciated capital cost (UCC) of the relevant classes of depreciable
property and deducted the maximum permissible capital cost allowance for each of these classes
(adhering to the half-year rule in subsection 1100(2) of the regulations). In computing its income for
its 2014 taxation year, Blue plans to continue to deduct the maximum permissible capital cost
allowance for each of these classes (assume CCA rate of 10%). Blue also plans to deduct half the
cost of all food and beverages (total cost = $9,500, so ½ of the cost = $4,750) consumed by those
who have visited the cottage to test out the Hoover BBQ (adhering to section 67.1 of the Income Tax
Act). The cottage has other annual expenses of about $100,000.

Although the launch of the Hoover in June 2013 was a great financial and operating success, the
company suffered two significant setbacks in 2014. The first of these, in early December, was a
protest that caused all of the roads around Blue’s plant to be barricaded and they became
impassable. As a result, the Blue plant was involuntarily shut down for 10 business days. During this
period the company continued to incur the costs associated with its operations. Although the
company’s insurance policy did not cover this kind of protest-related disruption, it received
compensation of $150,000 from the provincial government under an emergency relief program
pursuant to which individuals and businesses were entitled to payments in proportion to the losses
their businesses incurred (Blue’s actual losses were around $300,000). The company does not plan
to include the compensation in computing its income for its 2014 taxation year.

The second setback involved a discovery of a defect that could, rarely cause the frame of the Hoover
to crack and break apart when grilling at high temperatures for three or more hours. Although senior
management was alerted to this defect in February 2014, the CEO decided not to recall the Hoover
on the grounds that it would be more economical to upgrade the company’s liability insurance to
include a specially negotiated rider to include coverage for liability for the defect in the Hoover, at a
cost of $400,000 per year. Fortunately for all involved, the improbable did not occur. No customers
have reported injuries. In computing its income for its 2014 taxation year, Blue plans to deduct the
$400,000 payment for additional insurance coverage.

Questions re: Scenario Three (no word limit)

11. How much, if any, of the operating costs and the costs related to meals and beverages consumed
at the cottage can Blue deduct? Why?
12. How much, if any, of the $400,000 additional insurance payment should Blue be permitted to
deduct? Why?
13. Does Blue have to include in its income any, or all, of the compensation that it received for losses
incurred from the closure of the highway? Why?
14. If the applicable CCA rate is 10%, how much can Blue deduct in respect of capital cost
allowances for the cost of the cottage and its furnishings?
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Canadian Income Tax Law, Professor Alarie

Scenario Four (questions 15 to 18)

In April 2015, David Goldfinger came to believe that the Bank of Canada was printing money at a
near-hyperinflationary rate in order to try to fend off the consequences of the drop in prices of oil and
gas for Alberta’s economy. Based on his undergraduate studies in economics, he believed that the
inevitable result was for a stark appreciation of other currencies against the Canadian dollar. In order
to benefit from this, David decided to borrow as much as possibly could in Canadian dollars in order
to “get out” of the soon-to-soften Canadian currency and to buy the strongest possible alternative
currency (in David’s mind, US dollars). Due to his fervent belief in the sure-fire nature of the
profitability of this move, David convinced his parents to co-sign a five-year loan, with their home as
security, for $500,000 Canadian. With these funds, David immediately opened up a US dollar
account at the same bank and deposited the $500,000 CDN, which was converted by the bank to
$400,000 US (with the exchange rate at $0.80US = $1 CDN). The US dollar account has fees of $10
US per month, and pays no interest. David’s Canadian dollar loan carries an interest rate of 4% per
year. Thus, in 2015, David expects to pay $20,000 CDN in interest. He has no intention of repaying
any of the principal until maturity of the loan in 60 months’ time. Although he is not certain about how
long it will take the market to catch up with his astute observations regarding the recklessly
accommodative monetary policy of the Bank of Canada, David is prepared to wait out the collapse
of the Canadian dollar vis-à-vis the US dollar.

Questions re: Scenario Four (no word limit)

15. Suppose that the Canadian dollar does not weaken further in the coming years and David must
repay the loan at the end of five years with the exchange rates unchanged, having paid $100,000
CDN in interest in the interim and $600 US in account fees. What argument would you expect
him to make about the tax treatment of his transactions? Why?
16. Suppose that the Canadian dollar in fact strengthens in the coming years and David must repay
the loan at the end of five years with the exchange rates of $1 US = $1 CDN (thereby losing
$100,000 CDN from the exchange rate fluctuation), having paid $100,000 CDN in interest in the
interim and $600 US in account fees. What argument would you expect him to make about the
tax treatment of his transactions? Why?
17. Suppose that the Canadian dollar does weaken in the coming years and David must repay the
loan at the end of five years with the exchange rates of $0.20 US = $1 CDN (thereby gaining
$1,500,000 CDN from the exchange rate fluctuation), having paid $100,000 CDN in interest in
the interim and $600 US in account fees. What argument would you expect him to make about
the tax treatment of his transactions? Why?
18. Knowing that the changes ahead for the Canada – US exchange rate are completely
unpredictable, what is the proper tax treatment of David’s interest expenses, US account fees,
and the ultimate gain or loss on this foreign exchange transaction? Why?

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