Judgments

Decision Information

Decision Content

T-647-74
Sigma Explorations Ltd. (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Collier J.—Calgary, January 20; Ottawa, April 3, 1975.
Income Tax—Deductions—Plaintiff claiming outlays for purchase of data—Whether sham—Whether capital outlay not for purpose of gaining or producing income—Income Tax Act, R.S.C. 1952, c. 148, s. 137(1).
Plaintiff, a subsidiary of G.T.S., an American corporation which had developed a system of digitizing well log informa tion, paid $60,000 for seismic data. Far less was realized from the sale of this data than plaintiff had forecast, in fact, only $33,565. The second outlay by plaintiff concerned well log information developed by G.T.S. It was thought that plaintiff, as a well-known Canadian firm, could maximize profits by marketing this information as principal, rather than agent of G.T.S. Plaintiff purchased 5,000 such logs by agreement with its parent for $214,000. Which 5,000 logs plaintiff would select would depend on demands of potential customers. Hopes of profit were over-optimistic. Three years later, plaintiff can celled the agreement, and wrote off the cost of the logs, which had been treated as deferred cost in 1970 and 1971, as a business loss. The Minister re-assessed plaintiff's 1969 income, disallowing the deduction of $60,000 as a capital outlay exclud ed under section 12(1)(b) of the Income Tax Act, but permit ting capital cost allowance. He further disallowed the deduction in respect of the logs, claiming it was (1) a sham, or, (2) not deductible because it would unduly or artificially reduce income (section 137(1)), or (3) a capital outlay, and not for the purpose of gaining or producing income. Plaintiff appealed.
Held, allowing the appeal, both amounts are proper deduc tions. (1) To constitute sham, parties must intend not to create rights and obligations which they appear to be creating; here, there was no dissembling, masquerading or lack of bona fide intention. (2) Under section 137(1), the test is objective, while the evidence is often subjective. While an expenditure may reduce income, if reasonable, for legitimate business purposes and not primarily intended to minimize tax, then no matter how drastic the reduction of income, it cannot be said to be unreal. The expenditure for the rights to the logs did not have an undue or artificial effect on plaintiff's 1969 income. (3) The practical and commercial aspects of the transaction must be considered; simply because both outlays turned out to be unremunerative does not prevent their deduction if they were laid out to gain or produce income. The expenditures were not made to create an advantage for plaintiff's enduring benefit,
but to bring into inventory information which plaintiff reason ably expected to market quickly and profitably.
Snook v. London and West Riding Investments, Limited [1967] 1 All E.R. 518, agreed with. M.N.R. v. Cameron [1972] C.T.C. 380; Shulman v. M.N.R. [1961] Ex.C.R. 401; Algoma Railway v. M.N.R. [1968] S.C.R. 447; Brit- ish Columbia Electric Railway Company Limited v. M.N.R. [1958] S.C.R. 133 and The Queen v. Jones Tobacco Sales Co. Ltd. [1973] F.C. 825, followed. Algoma Railway v. M.N.R. [1967] Ex. C.R. 88 and British Insulated Cables, Limited v. Atherton [1926] A.C. 205, applied.
INCOME tax appeal.
COUNSEL:
J. G. McDonald, Q.C., for plaintiff.
F. J. Dubrule, Q.C., and B. J. Wallace for
defendant.
SOLICITORS:
McDonald & Hayden, Toronto, for plaintiff.
Deputy Attorney General of Canada for defendant.
The following are the reasons for judgment rendered in English by
COLLIER J.: The plaintiff ("Sigma") appeals a re-assessment by the Minister of National Reve nue of income tax for its 1969 taxation year. In its return, the plaintiff sought to deduct, from taxable income, two outlays. One was for an amount of $60,000 paid on the purchase of certain seismic data from a bankrupt company hereafter called "Angus". The second was for an amount of $214,- 000 paid by the plaintiff to its parent company, G.T.S. Corporation, pursuant to an agreement concerning 5000 digitized Canadian well logs.
In respect of the outlay for the Angus data, the Minister disallowed the claimed deduction on the basis it was an outlay of capital and therefore excluded by paragraph 12(1)(b) of the Income
Tax Act'. The Minister did, however, in his re assessment, permit a capital cost allowance for this purchase. In respect of the outlay made pursuant to the agreement concerning digitized well logs, the Minister disallowed the claimed deduction on three grounds:
(a) The alleged outlay was a sham.
(b) If not a sham, it was not deductible because it would unduly or artificially reduce the plain tiff's income (subsection 137(1)).
(c) Alternatively, it was a capital outlay and not one made for the purpose of gaining or producing income.
The plaintiff was incorporated under Alberta law on November 2, 1966. It is essentially a geophysical corporation. The major portion of its revenue (at the relevant times here) is generated from seismic surveys carried out on its own account in Alberta and other places in Canada. It sells the information so obtained to other compa nies. Additionally, the plaintiff carries out seismic surveys for individual customers. As well, the com pany obtains revenue as a broker by purchasing seismic information and selling it to companies or persons interested in that information.
The plaintiff itself has never owned gas or oil leases or developed on its own account gas or oil properties. The primary reason for not venturing into those activities is because it is considered unethical for a geophysicist, or in this case a geophysical company, to launch into the actual oil and gas business in competition with its customers. The seismic or geophysical data acquired by the plaintiff (other than on a custom basis for an individual customer) is stockpiled by it for possible sale to others.
The financial statements for the year ending November 30, 1968 (Exhibit 5) and the thirteen- month period ending December 31, 1969 (Exhibit 6) illustrate the operations of the plaintiff com pany. In 1968 it recorded a net revenue of approxi mately $46,000 from commissions on the sale of
R.S.C. 1952 c. 148 and amendments.
seismic data. The revenue from data sales derived from seismic surveys carried out by the plaintiff on its own account was approximately $410,000. The cost of the surveys was approximately $303,000. In 1969 the gross revenue from sales of data was approximately $632,000. The cost of the data was approximately $545,000. The revenue arising from data sales as a result of seismic surveys shot by the company was approximately $664,000. The cost, including amortization expense, was approximate ly $282,000.
Mr. Rabey, the president of the plaintiff com pany, said all this seismic data has, after a short period of time, little value. He estimated that five years after gestation, the probabilities are it would have no value. Nevertheless, the company does not destroy or discard any data it has in its stockpile even though it may be, from day to day, relatively valueless. There is always the chance the informa tion may have to be upgraded in some way. It may, at any time, be called for by some future customer. It was his view that seismic data only acquires value when someone wants to buy that particular information. I accept all this evidence.
The defendant has categorized, and argued that the $214,000 outlay was a "sham". I therefore think it desirable, at this stage, to comment on credibility. In my estimation, Mr. Rabey was a trustworthy and honest witness. The same remarks apply to Mr. Walsh. Their testimony on material facts was, I find, acceptable, and consistent with all reasonable inferences and probabilities to be drawn from the other evidence.
I resume my narrative. In January or February of 1969, G.T.S. Corporation, an American com pany, also in the seismic data-marketing business, was considering the expansion of its business activities to Canada. It had developed a system of digitizing well log information. The well log data was put on a digital magnetic tape. The tapes were to be used with computers. Exhibit 17 accurately describes its activities:
GTS Corporation is primarily engaged in the translation of older seismic data and well logs into a digital format that is
compatible with present-day computer equipment and techniques.
The plaintiff was interested in the digitized well log system as an exploration tool. It had merger discussions with G.T.S., as well as with another company in a similar business. Ultimately, an agreement was made to merge with G.T.S. The formal agreement, Exhibit 38, was entered into on August 6, 1969. G.T.S. purchased the issued and outstanding shares of the plaintiff company from their owners, Mr. Rabey and Mr. James Fowlie. The practical result of this transaction was that the plaintiff became a subsidiary of G.T.S.
In October of 1969 the plaintiff purchased the Angus data. Angus had spent approximately $3,000,000 to assemble, over a period of time, the information. Angus went into bankruptcy. The plaintiff estimated it might realize potential reve nue of $100,000 from the sale of the Angus infor mation to customers. It purchased the data for $60,000. Looking at this transaction from a practi cal business point of view, the plaintiff, to my mind, brought this data into its inventory. From that same point of view, however, its forecasts of potential sales proved wrong. It, in reality, realized only $33,565 in gross revenue up to and including 1973.
I turn now to the transaction between G.T.S. and the plaintiff. G.T.S. had developed a digitized well log library including 20,350 digitized Canadi- an well logs. These wells were located in Alberta, British Columbia, and the Northwest Territories. G.T.S. and its subsidiary had come to the conclu sion, based on a market survey and its own investi gations, that a profitable volume (12 million dol lars) of sales of digitized well log information could be made to Canadian companies. It was decided the venture should be handled by the plaintiff on its own account rather than as an agent. The thinking was that Sigma had become well known from its Alberta base, to the major Canadian oil and gas companies, and that more profit could be realized by its active participation, as principal rather than agent, in the marketing of the digitized well log data. An agreement, dated November 13, 1969, was signed. It was changed and superseded. The first agreement for some reason remained in corporate files. I find nothing unusual in that fact. It is not uncommon in the business, world that superseded documents are
retained, either deliberately or by accident. The effective agreement is dated November 24, 1969 (Exhibit 13). I set it out:
GTS CORPORATION (herein "GTS") hereby sells to SIGMA EXPLORATIONS LTD. (herein "Sigma") and Sigma hereby pur chases copies of 5,000 digitized Canadian well logs owned by GTS, in accordance with the following stipulations:
1. Sigma shall have the right to select the 5,000 well logs from the library of digitized Canadian well logs owned by GTS.
2. GTS will reproduce the logs selected, in tape form (tape to tape), and ship same to Sigma in Calgary, Alberta, Canada, at the expense of GTS, all insurance to be paid by Sigma.
3. Sigma will pay GTS the sum of $214,000 (base price) for said copies, payable as follows:
a. $107,000 upon the execution of this agreement.
b. $107,000 after June 30, -1970, at the option of Sigma, but in no event later than December 31, 1970.
c. A royalty of 23 per cent of the gross sale price from sales of reproductions made by Sigma of such logs. Royal ty payments shall be due on the 15th day of every fourth month following the execution of this agreement and cov ering sales made by Sigma during each successive three- month period hereafter.
THUS DONE AND SIGNED THIS Twenty-Fourth (24th) day of November, 1969.
The purchase figure of $214,000 was based on a cost of approximately $40 per log of taping the information. What was being sold was, from a realistic business viewpoint, not the physôÿal tapes, but the right to reproduce and market the com mercially valuable information on them.
The plaintiff did not have in mind, before it entered into the agreement, any particular 5000 logs. Nor, immediately following the signing of the agreement, did it select any particular 5000 logs. That selection, naturally, would depend on the demands of its customers and the particular infor mation those potential customers might be inter ested in.
Unfortunately the high hopes of substantial profit return to the plaintiff flowing from the operation of Exhibit 13 were never realized. Mr. Rabey said, and his evidence was uncontradicted, there was a down-turn in the industry. Oil and gas companies were, to some extent, cutting back.
More important, perhaps, many companies did not have computer facilities required to extract the necessary information from the log tapes. Even though the earlier market survey had indicated there was a lucrative potential market, cold reality proved there was no market.
Whether, in respect of both the Angus and the digitized well log transactions, there was bad busi ness judgment or unrealistic projections, is, to my mind, not particularly determinative. I am satis fied on the evidence of Mr. Rabey and Mr. Walsh when viewed with and tested against the other objective evidence (mostly documentary) that the intentions of the plaintiff and G.T.S. were real and bona fide. Those plans were simply to earn income from the sale of information contained in the Angus data and the Canadian well log library. In the latter situation, if the market had been there, the plaintiff had the right to bring, from time to time, particular information into its inventory.
I shall complete the history of the outlay of the $214,000. The only request for digitized data came in 1970 from Chevron for three logs. The auditors in 1972 advised the plaintiff to cancel the agree ment of November 24, 1969, and to write off the cost of the well logs. This was done partly because of the position taken by the defendant but substan tially, I find, on sound accounting and commercial principles. The $214,000 had been treated as a deferred cost in 1970 and 1971. The digitization system was a new field with unknown risks. Even tually in the third year, after no profit, proper accounting procedure demanded that the fact of a business loss be recognized.
It is convenient to deal firstly with the defend ant's two submissions directed particularly to the $214,000 outlay.
It is said the transaction was a sham; the plain tiff received nothing of value; the parent and sub sidiary were not at arm's length; the whole trans action was merely a method of siphoning profits to
the parent company. I do not accept this conten tion. It is contrary to the evidence of Mr. Rabey and Mr. Walsh (and I have accepted their testimo ny), and in my view no reasonable inference of sham can be drawn from the other objective facts. I accept the plaintiff's contention that there were sufficient restrictive conditions in the merger agreement (Exhibit 38) preserving the indepen dence of Sigma in respect of the making of expen ditures, including of course the expenditure impugned here. I refer particularly to clauses 9 and 15.
Financial sham has been described by Diplock L.J. in Snook v. London and West Riding Invest ments, Limited':
As regards the contention of the plaintiff that the transactions between himself, Auto-Finance, Ltd. and the defendants were a "sham", it is, I think, necessary to consider what, if any, legal concept is involved in the use of this popular and pejorative word. I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create. One thing I think, however, is clear in legal principle, morality and the authorities (see Yorkshire Railway Wagon Co. v. Maclure (1882) 21 Ch. D. 309; Stoneleigh Finance, Ltd. v. Phillips [1965] 1 All E.R. 513; [1965] 2 Q.B. 537, that for acts or documents to be a "sham", with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating.
That passage has been cited with apparent approval by the Supreme Court of Canada in M.N.R. v. Cameron 3 .
The transaction between the plaintiff and its parent company, including the documents, were not intended, in my opinion, to give to anyone the appearance of creating rights and obligations dif ferent from those the parties intended. There was in this case no dissembling, masquerading, or lack of bona fide intention.
z [1967] 1 All E.R. 518 at page 528.
3 [1972] C.T.C. 380. Other decisions where sham has been considered are: Susan Hosiery Ltd. v. M.N.R. [1969] 2 Ex.C.R. 408; Concorde Automobile Ltée v. M.N.R. [1971] C.T.C. 246 and Simard-Beaudry Inc. v. M.N.R. [1974] 2 F.C. 131.
The defendant relies also on subsection 137(1) of the Income Tax Act. I conclude the prohibition there is directed not only at sham transactions but at something less, where the outlay, although real and apparently bona fide, would unduly or artifi cially reduce a taxpayer's income. I conclude fur ther that the subsection is aimed at prohibiting deductions in respect of transactions more tainted than those resulting in unreasonable outlays other wise deductible (subsection 12(2)), or in respect of purchases not carried out at arm's length (subsec- tion 17(1)).
Parliament has not defined the meaning of the phrase "unduly or artificially reduce the income". The taxpayer, in the carrying on of his business affairs, is left to speculate on the arcane intention of the legislators, and the perhaps unpredictable attitude or opinion of the Minister in each individual case. As I understand the process, ini tially the Minister 4 reviews the evidence available to him, and then by assessment or re-assessment indicates his opinion that the particular disburse ment would, if allowed, unduly or artificially reduce income. If that legally undebated opinion were conclusive or overriding, the Revenue Department could indirectly control the nature, purpose and amounts of a vast number of commer cial expenditures. The test in deciding whether a deduction is prohibited by subsection 137(1) must, as I see it, be an objective one. The main source of the evidence relating to it is commonly the taxpay er. The evidence is therefore often subjective in nature. An assessment of its weight and reliability is of necessity required, but in the final analysis the overall finding of undueness or artificiality (or not) is a value judgment based 'on all the facts and factors. Undoubtedly, many expenditures arith metically reduce a taxpayer's income. The $214,- 000 outlay here certainly does that. If, however, the expenditure is a reasonable one for legitimate income-earning and business purposes, and not in its true light a vehicle primarily to minimize tax, then no matter how drastically income may be diminished, I do not think the transaction can, or ought to be, at the same time characterized as an
4i use "the Minister" in the technical and legislative, and not in the practical, sense.
unreasonable reduction of income, or an unreal or unnatural reduction 5 . In this case, it is my opinion that when all the facts in the record (and the reasonably probable inferences to be drawn from them) are viewed realistically and objectively, and the evidence of the plaintiff's two chief witnesses assessed and accepted as trustworthy and cogent (as I have), then the expenditure for the rights to some of the well log digitized data cannot be described as having an undue or artificial effect on the plaintiff's income for 1969.
The remaining issue (applicable to both outlays) is whether, to use the words of Jackett C.J.
Is such an expenditure in substance "a revenue or a capital expenditure"? 6
The well-known statement as to what is a capi tal outlay is that of Viscount Cave L.C., in British Insulated and Helsby Cables, Limited v.
5 The latter words are borrowed from the reasons for judg ment of Ritchie D.J. in Shulman v. M.N.R. [1961] Ex.C.R. 410 at pages 424-425:
While the language of section 137(1) is not as clear and explicit as, on first examination, it appears to be, I do not regard any of it as surplus.
In my opinion the word "that" relates to "deduction". I interpret "unduly" as relating to quantum and meaning "excessively" or "unreasonably". In the context found here, "artificially" means "unnatural",—"opposed to natural" or "not in accordance with normality".
I construe subsection (1) as though it read:
In computing income for the purpose of this Act no deduction that if allowed would unduly or artificially reduce the income may be made in respect of a disburse ment or expense made or incurred in respect of a transac tion or operation.
In considering the application of section 137(1) to any deduction from income, however, regard must be had to the nature of the transaction in respect of which the deduction has been made. Any artificiality arising in the course of a transaction may taint an expenditure relating to it and preclude the expenditure from being deductible in computing taxable income.
6 Algoma Central Railway v. M.N.R. [1967] 2 Ex.C.R. 88 at page 91.
Atherton':
But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.
The Supreme Court of Canada approved that passage in British Columbia Electric Railway Company Limited v. M.N.R. 8 . Abbott J. made this comment:
Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made "for the purpose of gaining or producing income" comes within the terms of s. 12(1)a) whether it be classified as an income expense or as a capital outlay.
On the appeal to the Supreme Court of Canada in the Algoma case 9 the Court said this:
Parliament did not define the expressions "outlay ... of capital" or "payment on account of capital". There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B.P. Australia Ltd. v. Commissioner of Taxation of the Common- weath of Australia, [1966] A.C. 224; [1965] 3 All E.R. 209, by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said, at p. 264:
The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indica tions in the contrary direction. It is a commonsense apprecia tion of all the guiding features which must provide the ultimate answer.
As was said by Noël A.C.J. in The Queen v. F. H. Tones Tobacco Sales Co. Ltd. 10 one must consider the practical and commercial aspects of the trans action in question, and not merely the legal aspects.
Here, the circumstances that both outlays in question turned out to be economically unsound does not prevent their deduction if they were in fact and law laid out for the purpose of gaining or producing income. In my opinion the sums expend
7 [1926] A.C. 205 at pages 213-214. s [1958] S.C.R. 133 at page 137.
9 [1968] S.C.R. 447 at pages 449-450.
10 [1973] F.C. 825 at page 834.
ed were not made with a view of bringing into existence an advantage for the enduring benefit of the plaintiff's business. From a practical and com mercial point of view, the plaintiff's intention or "view" was to bring into inventory information which it reasonably expected to market quickly and produce revenue or income.
Both amounts should therefore have been per mitted as proper deductions in computing the plaintiff's income. The appeal is allowed. The re assessment of the plaintiff's tax for the years in question is referred back to the Minister with the direction that the plaintiff is entitled to deduct the two amounts accordingly. The plaintiff is entitled to its costs.
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