FCA Provides New Test for Section 68 of the Income Tax Act

The Federal Court of Appeal unanimously allowed TransAlta's appeal of the Tax Court's judgment in TransAlta Corporation v. The Queen, 2010 TCC 375, with regard to s. 68 of the Income Tax Act (Canada) on January 20, 2012. That section permits the Crown to reallocate unreasonable proceeds of sale allocations for the purposes of income tax.

In this case, the Minister reassessed TransAlta under s. 68 to reallocate from goodwill to depreciable property, $190 million of the proceeds from the sale of a power transmission business. This reassessment resulted in a large amount of recaptured income and, accordingly, a significant increase in taxes payable.

TransAlta appealed to the Tax Court, which decided the case in TransAlta's favour on the basis that approximately $140 million of the $190 million was reasonably allocated to goodwill. As a result, $50 million was reallocated under s. 68 to depreciable property. The Tax Court reasoned that a century-old definition of goodwill formulated to determine whether goodwill existed, excluded certain aspects of the transmission business from goodwill. Then, on the basis of unstated valuation principles and no direct evidence as to how the purchaser valued these attributes, the Court valued them at $50 million and applied s. 68 to allocate that amount to depreciable property.

On appeal, the Federal Court of Appeal ruled in TransAlta's favour. The Court rejected the goodwill definition and valuation approach used earlier by the Tax Court, and articulated a new reasonableness test for s. 68. That is, s. 68 should not apply where “a reasonable person, with business considerations in mind, would have adopted the purchase price allocation in question.” The Court went on to note that s. 68 will accordingly not apply where the purchase price allocation is consistent with regulatory, industry, audit, and valuation practices. Other aspects of the judgement make it reasonable to conclude that to apply s. 68, the Crown must establish that no reasonable business person with business considerations in mind would have agreed to the allocation, or possibly that the allocation is clearly unreasonable.

The Federal Court of Appeal's decision in TransAlta provides a s. 68 test that is more certain and more difficult for the Crown to meet. This should reduce the volume of s. 68 assessments. Further, the Federal Court of Appeal's approach to reasonableness for purposes of s. 68 may apply to a variety of other sections of the Income Tax Act (Canada).

Robert McCue and Laurie Goldbach of Bennett Jones LLP were counsel to the appellant, TransAlta Corporation.

Chang Du of Department of Justice Canada, Tax Law Services was counsel to the respondent, Her Majesty the Queen.