T-210-75; T-339-76
Alberta and Southern Gas Co. Ltd. (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Cattanach J. Calgary, June 7 and
8 and August 19 and 20, 1976; Ottawa, September
10, 1976.
Income tax—Construction of exempting provisions
Whether plaintiff acquired "Canadian resource property"
within meaning of s. 65 of Income Tax Act—Whether transac
tion between plaintiff and third party mere sham or subter-
fuge—Motivation of taxpayer irrelevant if agreements create
legal rights and obligations—Whether plaintiff within excep
tions defined in s. 66—Onus on taxpayer to prove his is
exceptional situation under Act—Whether interest on bor
rowed money deductible under s. 20(1)(c) Whether plaintiff
"operator" and had "interest" within meaning of Regulation
1202 for depletion allowances—Income Tax Act, S.C. 1970-
71-72, c. 63, ss. 20, 65, 66, 245—Income Tax Regulations
1201 and 1202.
Defendant disallowed plaintiffs claim for deduction of
Canadian exploration and development expenses in 1972 and
1973 and, consequently, its claims for depletion allowances and
deductions of interest on money borrowed for the purpose of
earning income from property during those two years. Plain
tiffs raison d'être—to supply parent company in U.S.A. with
natural gas—was limited by government requirement that
needs of domestic consumers must be satisfied before the
granting of an export licence. Plaintiff must maintain adequate
supplies and constantly seek new resources to provide for
replacement of gas used and increased demand. Thus, accord
ing to the plaintiff, prepayments for existing gas are, in effect,
loans for the development of future resources and risk explora
tion and therefore are legitimate objectives incidental to the
buying and selling of gas. Funds for these purposes were to be
derived from .03¢ added by agreement to the price of the gas
sold to the parent of company. The funds so required in 1972
and 1973 were not in fact used in this way and would therefore
normally constitute income. However, the plaintiff agreed in
each of those years with a gas-producing company ("Amoco")
to advance it $4 million in consideration for which Amoco
would give the plaintiff a percentage of its working interest,
defined as a right, to produce and dispose of petroleum prod
ucts in specified lands which were in fact lands from which the
plaintiff was receiving gas under gas purchase contracts. These
rights were inalienable until the plaintiff received either $4
million or petroleum substances worth $4 million. In fact the
money was repaid each year in cash; the plaintiff owned, under
the agreement, the petroleum substances, but allowed Amoco
to extract and dispose of them at its own expense and to pay the
plaintiff its share of the working interest in cash. The lands
specified were owned mainly but not solely by Amoco and the
other interested parties concurred informally in the plaintiff's
succession to the interest assigned to it by Amoco.
Held, the appeals are allowed. The plaintiff proved that it
acquired Canadian resource property in 1972 and 1973 as
defined by section 66(15)(c)(i) and (vi) of the Act and the cost
of so doing was deductible as being a Canadian exploration and
development expense as defined by section 66(15)(b)(iii) paid
by a "principal business corporation" as defined by section
66(15)(h) by virtue of section 66(1)(a). Plaintiff further proved
that its business was "marketing" as defined by section
66(15)(h)(i) and that it was not merely an agent for its parent
company since it had a separate corporate existence. The
agreements between the plaintiff and Amoco were intended to
and did create legal rights and obligations; they were therefore
not a sham. Finally, the plaintiff had borrowed money to pay
Amoco and the interest payable thereon was interest on a loan
used for the purpose of earning income from property. Deple
tion allowances are allowed under Regulation 1202(1) since the
plaintiff is not an "operator" as defined by Regulation
1202(1)(a).
Harris v. M.N.R. [1965] 2 Ex.C.R. 653, referred to.
Snook v. London & West Riding Investments, Ltd. [1967]
1 All E.R. 518 and The Commissioners of Inland Revenue
v. His Grace The Duke of Westminster [1936] A.C. 1,
agreed with.
INCOME tax appeal.
COUNSEL:
M. A. Putnam and F. R. Matthews for
plaintiff.
J. A. Scollin, Q.C., and N. W. Nichols for
defendant.
SOLICITORS:
MacKimmie, Matthews, Calgary, for plain
tiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
CATTANACH J.: These are appeals by the plain
tiff from assessments to income tax by the Minis
ter of National Revenue for the plaintiff's 1972
and 1973 taxation years whereby the Minister
disallowed the plaintiff's claim for a deduction of
Canadian exploration and development expenses in
the amount of $4,000,000 in each year and, conse
quent upon which disallowance, the Minister also
disallowed the plaintiff's claim for a depletion
allowance under regulations passed pursuant to the
Income Tax Act, as well as a claim for interest on
borrowed money in the plaintiff's 1972 taxation
year but not for a like claim by the plaintiff in its
1973 taxation year.
Counsel for the Minister indicated that the fail
ure to disallow the plaintiff's similar claim for
interest in its 1973 taxation year was an oversight
by the Minister. However, assuming that I should
conclude that the plaintiff's claim for interest in
that year was improperly made and should have
been disallowed by the Minister, which issue is
before me with respect to the 1972 taxation year,
this particular matter is not in issue with respect to
the plaintiff's 1973 taxation year.
In Harris v. M.N.R. 1 my brother Thurlow held
that on a taxpayer's appeal it is the Minister's
assessment that is under appeal. There is no appeal
given to the Minister from the assessment and
accordingly to allow the Minister to disallow the
plaintiff's claim for the deduction of interest for
the 1973 taxation year and so increase the plain
tiff's assessment is tantamount to an appeal by the
Minister from his own assessment. This I have no
authority to entertain. Counsel for the Minister,
when the point arose, quite properly neither sug
gested nor requested anything to the contrary.
The amounts involved are not in dispute be
tween the parties nor are the basic facts in dispute.
What is in dispute between the parties are the
proper inferences to be drawn from the undisputed
facts.
The plaintiff was incorporated as a joint stock
company pursuant to the laws of the Province of
Alberta on March 25, 1957. The plaintiff is the
wholly-owned subsidiary of Pacific Gas and Elec
tric Co., no doubt incorporated under the laws of
one of the States of the United States of America,
and that company is a major distributor of natural
gas and electricity in northern and central
California.
1 [1965] 2 Ex.C.R. 653.
Prior to the incorporation of the plaintiff it is
my recollection of the evidence that Pacific Gas
and Electric Co. purchased natural gas in Alberta
to supply its customers in California, but for
sundry varied reasons it found it expedient to
incorporate the plaintiff for this purpose.
Pacific Gas and Electric Co. was also instru
mental in securing the incorporation of Pacific Gas
Transmission or acquired the majority interest in
the shares of that company. Therefore Pacific Gas
Transmission is also a subsidiary of Pacific Gas
and Electric Co.
Pacific Gas Transmission operates a pipeline
from Kingsgate on the United States and British
Columbia border to the Oregon and California
border. Alberta Natural Gas Co., in which Pacific
Gas Transmission owns 45% of the shares, oper
ates a pipeline from a point in southwestern Alber-
ta to connect with the pipeline of Pacific Gas
Transmission at the United States and British
Columbia border. The plaintiff contracts with
Alberta Gas Trunk Lines to carry the natural gas
which the plaintiff purchases from producers in
the field to the point in southwestern Alberta as
well as to intermediate customers along the route
and the plaintiff contracts with Alberta Natural
Gas Co. to transport the gas purchased by it and
remaining from the point in southwestern Alberta
to connect with the pipeline operated by Pacific
Gas Transmission through which the gas is trans
ported to California to the ultimate consumers in
that State.
The raison d'être for the plaintiff is to buy
natural gas from producers in Alberta to satisfy
the requirements of its parent company for a
constant supply of natural gas to meet the needs of
its parent's customers in California. The plaintiff
does not sell that gas directly to its parent but
rather it sells the gas purchased by it in Alberta to
its sister company, Pacific Gas Transmission.
To that end the plaintiff has entered into some
300 to 350 gas purchase contracts with some 83 to
100 gas producers. These numbers are approxi
mate and vary from time to time dependent upon
the vagaries of available gas and obviously, from
the numbers, the plaintiff enters into more than
one gas purchase contract with the same gas
producer.
The plaintiff's two major purchasers of its gas
for foreign export are Pacific Gas Transmission
and Canadian Montana Pipeline Company. The
plaintiff also sells the natural gas it purchases in
Alberta to Columbia Natural Gas Limited for
distribution in British Columbia. Because of the
policy of the appropriate governments, export
licences are not forthcoming unless the needs of
domestic consumers are first satisfied. Accordingly
the plaintiff sells gas to two major distributors in
Alberta, Northwestern Utilities Limited and
Canadian Western Natural Gas Limited, and to
other domestic customers along the transporting
gas pipelines such as towns, gas co-operatives and
farmers. The plaintiff also sells gas to an extract
ing plant in Alberta. However, Pacific Gas Trans
mission is by far the major purchaser of the gas
purchased in Alberta by the plaintiff and is des
tined for ultimate consumption by customers of
the plaintiff's parent, Pacific Gas and Electric Co.
in California.
In 1972 approximately 86% of the plaintiffs
total gas sales was to Pacific Gas Transmission
Company. In 1973 the plaintiff's sales to Pacific
Gas Transmission represented 83% of the plain
tiffs total gas sales. In the same period approxi
mately 6.27% of the plaintiffs total gas sales was
to Canadian Montana Pipeline Company, its other
major purchaser. The balance of the plaintiffs
sales, which would range between 8% and 11%,
were to domestic consumers as mentioned above.
It is patently obvious that the plaintiff's obliga
tion is to maintain a constant source of supply of
natural gas, ultimately destined for its parent com
pany, and to maintain that supply it must also
satisfy the needs of domestic consumers, which by
reason of government policy, constitutes a first
charge on the plaintiff's supply. In all likelihood
the demands of the domestic market will increase
and even if the demand of the plaintiffs parent
merely remained constant, it follows that the
plaintiff must exercise vigilance to ensure that it is
in a position to meet both of these mandatory
demands. Accordingly that means that the plain
tiff must make certain that the current gas pur
chase contracts are adequate and to be on the
constant alert for additional sources when the
current sources become inadequate, depleted or
exhausted.
To do this the plaintiff makes risk exploration
advances to producers in the hope of the discovery
of further gas and participates as a working inter
est partner. Expenditures of this type made by the
plaintiff have been allowed by the Minister as a
deduction. To encourage exploration by producers
the plaintiff thus made prepayments for gas there
by making funds available to the producers for
exploration and to acquire the goodwill of those
producers in order to remain competitive as a
purchaser of gas.
The plaintiff has also made loans to producers
on the understanding that the loan would be repaid
by the dedication of gas which might be discovered
to the plaintiff.
These are the three normal methods adopted by
the plaintiff in furthering exploration for gas: (1)
prepayments for known gas in the ground, (2)
loans to producers to assist in the development of
future resources to be dedicated to the plaintiff
and (3) risk exploration activities. Thus this is a
legitimate objective of the plaintiff incidental to its
principal purpose of buying and selling gas.
The funds for these purposes are generated by
the inclusion of three cents in the price of the gas
sold by the plaintiff to its parent company through
the intermediary, Pacific Gas Transmission. The
price to the parent was .310 per thousand cubic
feet for specification gas or the cost of service
whichever was the higher. Arrangements were
made with Canadian Montana Pipeline Company
to provide the plaintiff with a fund to be used in
exploring for and developing gas resources in
Canada. However it was the .03¢ margin built into
the plaintiff's sale price to its parent that was the
greatest source of funds available to the plaintiff
for exploration and development expenses. That
was specifically agreed in arranging the sale price
of the gas and it was also agreed that the funds so
derived would be dedicated exclusively to that end.
The funds that the plaintiff derived from its sale
of gas to its parent company or, more correctly
put, to its sister subsidiary in the plaintiff's 1972
and 1973 taxation years was $4,000,000 in each
year. In neither year did the plaintiff expend those
amounts for exploration and development by any
one of the three normal methods the plaintiff had
adopted and as are described above. Accordingly
these two amounts, if not disbursed as exploration
and development expenses before the end of the
respective taxation years, would be clearly income
in each year and taxable as such. The officers of
the plaintiff are well aware of this fact. The plain
tiff sought the means, in each year, to circumvent
this inexorable result.
The device adopted, as was aptly put by the
witnesses, to "remove these amounts from the
grasping reach of the tax collector and so preserve
the funds for the purpose to which they were
dedicated" (that is exploration and development
expenses), was to enter into "carve-out" agree
ments with Amoco Petroleum Company Ltd.
(hereinafter for convenience referred to as "Amo-
co"), a gas producing company with which the
plaintiff had also entered into gas purchase agree
ments. This fact apparently had no material influ
ence on Amoco's willingness to enter these agree
ments with the plaintiff. These "carve-out"
agreements were well known to the oil industry
and Amoco had entered into several such agree
ments with parties other than the plaintiff.
The first such agreement between the plaintiff
and Amoco was entered into on December 27,
1972, and was introduced in evidence as Exhibit
7-2, applicable to the plaintiff's 1972 taxation
year, and the second such agreement was entered
into on December 27, 1973, applicable to the
plaintiff's 1973 taxation year, and was introduced
in evidence as Exhibit 12. Subject to minor varia
tions the two agreements are otherwise identical in
substance.
Basically what the agreements provide is that in
consideration of the payment by the plaintiff to
Amoco of $4,000,000 Amoco "grants, sells, con
veys, transfers and sets over unto" the plaintiff a
percentage (in 1972 the percentage was 59% and
in 1973 the percentage was 43.6%) of Amoco's
"working interest" which is defined in the agree-
ments as the "right, licence or privilege" of Amoco
to "produce, take and dispose of petroleum sub
stances" from the lands set forth in a schedule to
each agreement. Those lands were in fact the lands
from which the plaintiff received the specification
gas which it purchased from Amoco under existing
gas purchase contracts between them and accord
ingly the plaintiff was familiar with those
resources and exercised care and influence in the
lands selected to be included in the schedules.
By virtue of the agreements the plaintiff is
entitled to have and hold those assigned rights
forever but subject to the provision that the right
to Amoco's share shall end when the plaintiff shall
have received petroleum substances to the value of
$4,000,000 or the amount of $4,000,000, both with
interest at 3% per annum. In fact in each year the
amount of $4,000,000 was repaid in cash and not
in kind within the year following the execution of
each agreement. Again by virtue of the agree
ments, the plaintiff was given ownership of the
petroleum substances and given the right to take
those substances at no cost to it and to dispose of
those substances. The plaintiff did not elect to do
this but, as contemplated in the agreements, per
mitted Amoco to continue to extract the petroleum
substances from the lands, refine those substances
and dispose of the resultant products and conse
quent upon payment in monies the plaintiff
received payment of the full amount for the
petroleum substances which it was entitled to
receive. That being done the share that Amoco
conveyed to the plaintiff revested in Amoco.
The agreements specifically provide that all
costs and expenses of the production of petroleum
substances shall be borne by Amoco and not by the
plaintiff.
In the event that Amoco should default in its
obligations to extract the petroleum substances
and apply the proceeds of the disposition thereof to
the discharge of its indebtedness to the plaintiff,
then by virtue of the agreements the plaintiff has
the right to enter upon the lands, take over Amo-
co's rights to operate the extraction process, and so
operate the fields, dispose of the petroleum prod
ucts and apply the proceeds thereof first to the
costs incurred by it in taking such production and
then to discharge the amounts payable by Amoco
to the plaintiff under the agreements.
In the lands set forth in the schedules to the
agreements Amoco did not hold 100% of the work
ing interest therein. The lands were subject to
unitization agreements which is simply that a
number of leaseholders pool their leases and one of
the leaseholders becomes the operator and all
leaseholders who enter the pooling arrangement
share in the proceeds in proportion to their respec
tive contributions.
A review of the lands included in the schedules
indicates that in almost all instances Amoco was
the largest contributor to the pool and that Amoco
was the "operator" of the fields under operation
agreements entered into by the contributors.
Accordingly when Amoco assigned a percentage of
its working interest in these lands to the plaintiff it
succeeded to the partial interest assigned to it by
Amoco and became party to the appropriate uniti-
zation agreements with the concurrence of the
other parties thereto. This concurrence was
obtained in a most informal way usually by tele
phone conversations. Mr. Goudie, a vice-president
of the plaintiff, so testified.
Against the background of these facts the plain
tiff in preparing its income tax returns for its 1972
and 1973 income tax years claimed as a deduction
in each year the respective amounts of $4,000,000
as being laid out by it for the acquisition of a
"Canadian resource property" as defined by sec
tion 66(15)(c)(i) and (vi) of the Income Tax Act,
that by virtue of section 66(15)(b)(iii) the cost of
the acquisition of any Canadian resource property
is a Canadian exploration and development
expense and as such, by virtue of section 66(1)(a),
is deductible by a "principal-business corporation"
in computing its income for a taxation year. In
order to so qualify the plaintiff must first fall
within the definition of a "principal-business cor
poration" as outlined in section 66(15)(h).
At this point it is expedient to reproduce the
sections of the Income Tax Act mentioned
immediately above. Section 66(1)(a) reads:
66. (1) A principal-business corporation may deduct, in
computing its income for a taxation year, the lesser of
(a) the aggregate of such of its Canadian exploration and
development expenses as were incurred by it before the end
of the taxation year, to the extent that they were not
deductible in computing income for a previous taxation year,
and
Section 66(15)(b)(iii) reads:
(b) "Canadian exploration and development expenses"
incurred by a taxpayer means
(iii) the cost to him of any Canadian resource property
acquired by him,
Section 66(15)(c)(î) and (vi) read:
(c) "Canadian resource property" of a taxpayer means any
property acquired by him after 1971 that is,
(i) any right, licence or privilege to explore for, drill for,
or take petroleum, natural gas or other related hydrocar
bons in Canada,
(vi) any right to or interest in any property described in
any of subparagraphs (i) to (v).
Section 66(15)(h)(i) reads:
(h) "principal-business corporation" means a corporation
whose principal business is,
(i) production, refining or marketing of petroleum,
petroleum products or natural gas, or exploring or drilling
for petroleum or natural gas,
The general intention of the Income Tax Act is
to the effect that in computing income no deduc
tion shall be made in respect of a payment on
account of capital. Under normal circumstances
the payment made by the plaintiff herein to
acquire an interest in a gas-producing or potential
gas-producing property is an outlay for the acqui
sition of a capital asset and hence a capital outlay
not subject to deduction. The sections of the
Income Tax Act reproduced express a particular
intention incompatible with the general intention
and as such must be considered in the nature of an
exception.
In order to qualify for an exception a taxpayer
must fall precisely within the words of the exempt
ing provisions.
In Her statement of defence, Her Majesty
expressly first denies an allegation in the plaintiff's
statement of claim that the plaintiff was duly
qualified as a "principal-business corporation" as
those words are defined in the statute. Secondly,
the defendant also specifically denies in its state
ment of defence that the plaintiff acquired under
its agreements with Amoco a "Canadian resource
property".
The onus is on the plaintiff to establish both
such conditions precedent in order to succeed in
claiming the deductions it seeks for the cost
expended by it for the rights it acquired from
Amoco and the other consequential deductions
claimed by it but disallowed as has been men
tioned at the outset. If the plaintiff fails, that is the
end of the matter and both appeals must be dis
missed in their entirety.
Accordingly consideration must first be given to
whether the plaintiff falls within the definition of a
"principal-business corporation" as set forth in
section 66(15)(h)(i) as quoted above.
Mr. Goudie has described the business of the
plaintiff as the buying and selling of natural gas.
The question then arises whether that activity
constitutes "marketing" as that word is used in
section 66(15)(h)(i). The word "marketing" as
used in section 66(15)(h)(i) does not relate nor
does it profess to relate to the subject of a particu
lar art or science. In my view the word is not used
in a technical sense and has no technical meaning.
Therefore the word used in the Act must be under
stood as it is understood in the common language.
I am quite aware that dictionaries are not to be
taken as authoritative exponents of the meaning of
words used in statutes but it is a well-known rule
of courts of law that when a word is used in its
ordinary sense, as I have concluded that the word
"marketing" is so used, then I am sent and may
resort to dictionaries for instruction.
The word "market" is defined in the Shorter
Oxford English Dictionary, 3rd ed., as "The
action or business of buying and selling" and
"marketing", which is the verbal substantive of the
verb "market", is defined therein as "The action of
market".
Mr. Goudie described the business of the plain
tiff as buying and selling of natural gas and he also
described how these activities were conducted. The
plaintiff had to buy natural gas in sufficient quan
tity to meet the demands of its customers. Current
in each financial year there were some 350 gas
purchase contracts entered into by the plaintiff
with some 100 producers of natural gas. That, to
my mind, represents substantial buying. The plain
tiff sells the gas it purchases to a major purchaser,
its parent company. The parent company buys
about 83% of the gas that the plaintiff buys.
Another major purchaser buys some 6%, leaving
about 11%, which is sold to a variety of purchas
ers. There is no doubt that the number of purchas
ers is large and the parent company is not the
plaintiff's exclusive purchaser. It cannot be
because of the governmental policy that the
requirements of domestic consumers must be met
before an export licence is granted to the plaintiff.
Therefore, the plaintiff must buy sufficient gas to
meet the needs of its parent company but it must
first buy sufficient gas to meet the domestic
market which it must serve.
Counsel for the defendant contends that the
plaintiff has failed to discharge the onus of estab
lishing that its activities constitute "marketing"
because it did not conduct an active campaign to
search out purchasers. The plaintiff did not have
to do so. It had three major purchasers paramount
among which was its parent company which pur
chased the greatest volume of the plaintiff's pur
chases. It was obliged to purchase the gas to meet
the needs of its parent and those other customers it
was obliged to serve either by contract or to
become eligible for an export licence. Certainly the
plaintiff's parent was its dominant purchaser but
there were others, some of whom were imposed on
the plaintiff but whom the plaintiff must supply.
Therefore the plaintiff bought gas from numerous
purchasers and sold it to numerous consumers,
even though it sold the bulk of its purchases to one
customer. That is buying and selling and that, in
my view, constitutes "marketing".
It was also contended by counsel for the defend
ant that the plaintiff was merely the purchasing
agent for its parent company. The fallacies in that
contention are that it overlooks the doctrine of
separate corporate existence and the fact that the
parent company was not plaintiff's sole purchaser.
While a company may conduct the business of a
purchasing agent for more than one principal, the
plaintiff is not the purchasing agent of its other
customers (assuming that it is the purchasing
agent of its parent which assumption I do not
accept because of the separate entity concept), and
accordingly its business is not that of a purchasing
agent but that of purchasing and selling natural
gas and in my view for the reasons previously
expressed that still constitutes "marketing".
I therefore conclude that the plaintiff has dis
charged the onus cast upon it in this respect.
It was also contended that what the plaintiff
acquired under its agreements with Amoco was
not a "Canadian resource property" in that the
plaintiff under those agreements did not acquire
"any right, licence or privilege to ... take
petroleum, natural gas or other ... hydrocarbons",
but what the plaintiff did acquire under the agree
ments was ownership of Amoco's share in the
petroleum substances under the lands specified in
the schedules to the agreements and because what
the transactions really embodied in the plaintiff's
agreements with Amoco were temporary loans
with provision for the security thereof.
In my view the transactions are not temporary
loans by the plaintiff to Amoco for the reason that
an essential element of a loan is lacking. The
essence of a loan is that the advance shall be
repaid. The agreements provide that nothing there
shall be construed as creating a personal liability
on Amoco to repay the principal sum advanced
and interest thereon but that the plaintiff for its
reimbursement shall look exclusively to the
petroleum substances to the extent of Amoco's
share therein which was assigned to the plaintiff.
In the event that the petroleum substances should
become exhausted, or otherwise unavailable, which
is a distinct possibility which remains even though
the plaintiff exercised extreme care in selecting
fields for inclusion in the schedules to the agree
ments in which it was aware of the potential and
estimated deposits underground, then in that event
the plaintiff has no recourse against Amoco. I have
not overlooked a provision that Amoco shall be
liable for damages for breach of covenant but in
view of the provision to the contrary that provision
cannot include a covenant to repay.
It is for these reasons that I am of the opinion
that the transactions cannot be construed as being
a loan in substance.
The consideration which the plaintiff received
under the agreements for its payments of the two
amounts of $4,000,000 each was the conveyance
from Amoco of its percentage of its interest in
what is clearly a Canadian resource property in
the hands of Amoco, the cost of which to the
plaintiff is a Canadian exploration and develop
ment expense.
Clearly Amoco had the right to take its propor
tionate share of the petroleum, natural gas and
other related hydrocarbons and what the plaintiff
acquires was a percentage of Amoco's right or
interest in a Canadian resource property. The
plaintiff acquired that property and was entitled to
retain it until it was repaid by Amoco from the
production of petroleum substances at which time
the interest reverted to Amoco.
Amoco transferred to the plaintiff a share of its
ownership of petroleum substances and it also
conferred upon the plaintiff the right to take those
petroleum substances in kind.
A paramount right to "take" is predicated upon
ownership. While the plaintiff did not exercise its
right to take the petroleum by entering upon the
lands and itself extracting these substances it
.elected instead to permit Amoco to continue its
extracting of petroleum substances from the
ground which Amoco had been doing as operator
under a unitization agreement among the owners
of pooled resources as was the plaintiff's right
under the agreement with Amoco.
In my view the plaintiff in so doing has con
stituted Amoco its agent to take the petroleum
substances on its behalf. On the ordinary principle
of agency what one does by an agent one does for
oneself. That being so, in addition to having the
right to take petroleum substances, the plaintiff in
fact took petroleum substances which it also per
mitted Amoco to retain and dispose of the plain
tiff's share on its behalf, the proceeds of which
were applied in discharge of Amoco's obligation to
the plaintiff. To me there is no inconsistency in
transferring ownership in the petroleum substances
simultaneously with the transfer of a right to take
these petroleum substances. It seems to me that
ownership is a condition precedent to the right to
take.
I therefore conclude that the plaintiff acquired
from Amoco a Canadian resource property within
the meaning of those words as defined in section
65(15)(c) and not merely ownership of the
petroleum substances as contended on behalf of
the defendant.
The conclusions I have reached to this point do
not resolve the matter. In addition to contending
that the plaintiff was not a principal business
corporation and that the plaintiff did not acquire a
Canadian resources property counsel for the Min
ister contended that in substance the agreements
between the plaintiff and Amoco (which are col
loquially and aptly called "carve-out" agreements)
were a sham and subterfuge and that no matter
what gloss is put upon the language the true
purpose, which was to avoid tax, shines through
that artificial covering and further that the agree
ments were entered into by the plaintiff for no
business purpose but rather for the purpose of
claiming a deduction for Canadian exploration and
development expenses and depreciation allowance,
thereby unduly or artificially reducing the plain
tiff's income which is prohibited by section 245 (1)
of the Income Tax Act as amended by S.C. 1970-
71-72, c. 63, formerly section 137(1) of the Income
Tax Act, R.S.C. 1952, c. 148.
Section 245(1) of the Income Tax Act reads:
245. (1) In computing income for the purposes of this Act,
no deduction may be made in respect of a disbursement or
expense made or incurred in respect of a transaction or opera
tion that, if allowed, would unduly or artificially reduce the
income.
From the nature of these contentions there is
considerable overlapping of the argument in sup
port of each which cannot be segregated.
Both Mr. Goudie and Mr. Clark, who are offi
cers of the plaintiff, were called as witnesses and
candidly admitted that the motive of the plaintiff
for entering into these "carve-out" agreements
with Amoco was to remove the two amounts of
$4,000,000 which would have been taxable as
income in the 1972 and 1973 taxation years from
the grasp of the tax collector to preserve these
amounts which were dedicated for exploration and
development expenses and to use these monies at
some future time in a much more direct, active
and realistic way for that purpose than by resort to
carve-out agreements.
It appears to me, in the circumstances of these
particular appeals, so long as the transactions were
not shams, that if the plaintiff by resort to express
provisions in the Income Tax Act has succeeded in
bringing itself precisely within the terms of those
provisions regardless of the motivation which ins
pired the taxpayer to resort thereto, that motive
admittedly being the reduction of tax, and in these
appeals the reduction was to nil, or complete
avoidance, that that concludes the matter and the
motivation is irrelevant.
The classical exposition as to what constitutes a
sham was given by Diplock L.J. (as he then was)
when he said in Snook v. London & West Riding
Investments, Ltd. 2 at page 528:
As regards the contention of the plaintiff that the transac
tions 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 pejora
tive 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.
The agreements between the plaintiff and
Amoco created between the parties the exact legal
rights consequent thereon that the parties intended
to create and which both parties complied with in
2 [1967] 1 All E.R. 518.
accordance with the terms of the agreements be
tween them. That being so the parties had no
intention whatsoever that the agreements did not
create the legal rights and obligations other than
those which the agreements did in fact create.
Amoco got $4,000,000 in the years 1972 and 1973
which it could use as working capital at a rate of
interest one-half the current bank rate. That is
what Amoco wanted and was of benefit to it. At
the same time the plaintiff got from Amoco the
right to a share of Amoco's share in petroleum
substances.
The plaintiff had gas purchase contracts with
Amoco during the currency of the "carve-out"
agreements. While it is true that the gas purchase
contracts were for specification gas derived from
identical fields from which the plaintiff also
derived petroleum substances under the carve-out
agreements, nevertheless those derivatives are dif
ferent. It may be that while the bulk of the
petroleum substances that came from the under
ground deposit became specification gas, there
remained petroleum products other than specifica
tion gas which had value and that is what the
plaintiff received. It received the specification gas
under the gas purchase agreements and it received
the residue under the carve-out agreements, or the
proceeds of the disposition thereof, assuming that
the residue of the petroleum substances was sold to
purchasers other than the plaintiff, which my
recollection of the evidence indicates to have been
the case.
In my opinion the "carve-out" agreements were
not intended to give to strangers thereto, including
the Minister of National Revenue, the appearance
of creating rights and obligations other than those
created by the agreements as were intended by the
parties. To do otherwise would defeat the very
motive which influenced the plaintiff to seek out
these agreements. There was no dissemblance. Put
another way and in more succinct and colloquial
language if the parties to a contract do precisely
what they contract to do there is no sham.
As a corollary of that if the parties do as they
contract to do then that is the substance of the
contract. The agreements were realities and not
fictitious and they were within the competence of
the plaintiff as incidental to its business of market
ing natural gas.
Lord Tomlin in The Commissioners of Inland
Revenue v. His Grace The Duke of Westminster 3
said at page 20:
This so-called doctrine of "the substance" seems to me to be
nothing more than an attempt to make a man pay notwith
standing that he has so ordered his affairs that the amount of
tax sought from him is not legally claimable.
For these reasons I conclude that the arrange
ments between the plaintiff and Amoco were not
shams or subterfuges.
With respect to the applicability of section 245
to the results of these agreements between the
plaintiff and Amoco I do not think that section
245 is properly applicable in the circumstances of
these appeals.
As I have previously stated, it has been laid
down as a rule for the construction of statutes that
where there is a special section and a general
section in the statute a case falling within the
special section must be governed thereby and not
by the general section.
Section 66 and the sections immediately follow
ing dealing with exploration and development
expenses of principal business corporations quoted
above are special sections and clearly express a
particular intention of Parliament. On the other
hand, section 245 is a general section and
expresses a general intention.
In the present appeals the plaintiff has brought
itself precisely within the particular legislative
intent expressed in the particular section 66. The
general intention expressed in section 245 is
incompatible with the particular intention
expressed in section 66 from which it follows that
section 66 must govern and not section 245.
The Minister also disallowed the plaintiff's
claim for the deduction of interest paid on bor
rowed money.
Section 20(1)(c) reads:
20. (1) Notwithstanding paragraphs 18(1)(a),(6) 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:
3 [1936] A.C. 1.
(c) an amount paid in the year or payable in respect of the
year (depending upon the method regularly followed by the
taxpayer in computing his income), pursuant to a legal
obligation to pay interest on
(i) borrowed money used for the purpose of earning
income from a business or property (other than borrowed
money used to acquire property the income from which
would be exempt or to acquire a life insurance policy),
While the plaintiff had liabilities payable to it in
its 1972 taxation year in the amount of some
$4,000,000 from Pacific Gas Transmission, those
monies were not in the plaintiff's hands and there
fore it borrowed funds from its banker to pay the
$4,000,000 consideration to Amoco under its 1972
agreement.
The plaintiff did receive income from the trans
actions and accordingly the interest was paid on
borrowed money used for the purpose of earning
income from property. Income arose from the 3%
interest rate negotiated by the plaintiff and Amoco
on the consideration paid by the plaintiff to
Amoco. It is true that the interest rate on the
money borrowed from its bank by the plaintiff
exceeded the rate that the plaintiff received from
Amoco but that does not detract from the fact that
the interest the plaintiff received from Amoco was
income. As I recall the bank loan was paid by the
plaintiff with expedition and the indebtedness of
Amoco ran for a year which may have resulted in
a profit to the plaintiff. Profit is different from
income. Profit is the income less the cost laid out
to earn the income. Therefore the interest paid to
the plaintiff remains income even if no profit
resulted.
In the plaintiff's 1972 income tax return there
was disclosed royalty income received from Amoco
in the amount of $12,842.43 and in the 1973
return royalty income from Amoco in the amount
of $4,074,050.93 on which respective amounts and
in the respective years depletion allowances were
claimed in the respective amounts of $3,210.61
and $1,018,512.73, being 25% of the royalty
income in accordance with Regulation 1202(1). As
previously stated there is no dispute as to the
accuracy of these figures. It follows that the inter-
est so claimed by the plaintiff in its 1972 taxation
year is a proper deduction..
The plaintiff, as indicated, also claimed deple
tion allowances as a deduction in its 1972 and
1973 taxation years in the respective amounts of
$3,210.61 in 1972 and $1,018,512.73 in 1973,
being 25% of royalty income pursuant to Regula
tion 1202(1), both of which claims for deductions
were disallowed by the Minister. The amounts are
not in dispute only the deductibility thereof. The
depletion allowances claimed by the plaintiff in its
1972 and 1973 taxation years in respect of produc
tion income from a Canadian resource property
are predicated upon Income Tax Regulation
1202(1) which reads:
1202. (1) Where a person, other than an operator,
(a) has an interest in a resource and in the proceeds from the
sale of products therefrom, or
(b) receives a rental or royalty computed by reference to the
amount or value of production from a resource,
the deduction allowed is 25% of the amount included in com
puting his income for the year in respect of the interest in the
proceeds or in respect of the rental or royalty, as the case may
be.
In my opinion the plaintiff is not an operator
and falls under Regulation 1202 rather than an
operator to which Regulation 1201 would apply
and different methods of computing the deduction
and percentage rate thereon apply under each of
the two regulations mentioned. Under Regulation
1201 a person who operates a resource is defined
as a person who has an interest in the proceeds of a
resource "under an agreement providing that he
shall share in the profits remaining after deducting
the costs of operating the resource". Under the
plaintiff's agreements with Amoco it is specifically
provided that all costs relating to the operation of
the resource shall be borne by Amoco. It is for this
reason that I have concluded that the plaintiff is
not an operator and accordingly falls under Regu
lation 1202 which is applicable to persons other
than an operator.
I have also concluded for the reasons expressed
above that the plaintiff "has an interest in a
resource and in the proceeds from the sale of
products therefrom" and is therefore entitled to
claim the deduction to the extent provided in
Regulation 1202(1).
I mention the submission by counsel for the
Minister that the plaintiff did not record the
results of these transactions in clear and unequivo
cal terms in its financial statements as giving
credence to his submission that the agreements
between the plaintiff and Amoco do not mean
what they say only to indicate that I have not
overlooked that contention. An explanation was
proferred and a note to the balance sheet was
made to the effect that the exploration expenses
were written off even where creating an asset. The
financial statements are designed by the plaintiff's
auditors to reflect for the benefit of the sharehold
er the financial position of the plaintiff at its
financial year end. I do not think that I am obliged
to delve further into the vagaries or the intricacies
of accounting practices because I do not think that
such entries, though not specific, or the lack of
specific entries, can be accepted as contradictory
to the provisions of a written agreement and the
acts taken to implement those agreements when
there is adequate other evidence of that
implementation.
During the course of his submission, counsel for
the Minister characterized these transactions into
which the plaintiff had entered as a "gimmick"
with the avowed object of avoiding tax. That
description is both apt and accurate. These "carve-
out" agreements are an importation and are well
known in the industry. While they may well serve
as the means for persons with funds anxious to
participate in the production of petroleum and
natural gas with a producer in a potential or
proven field who has the right to exploit that field
and is willing to sell a share of that right, the
planning and execution of these transactions were
designed by the plaintiff as a tax avoidance device.
With funds available which, if not expended for
exploration and development, would be taxable as
income, with a willing vendor of a percentage of its
shares in a Canadian resource property and with a
detailed knowledge and familiarity of section 66 of
the Income Tax Act particularly and Regulations
1201 and 1202, it required no great ingenuity on
the part of the plaintiff to envision this scheme and
its possible results. In exculpation of the plaintiff it
can be said that the funds it possessed were gener
ated by an addition to the price it sold natural gas
to its parent company and were to be devoted to
exploration and development. The funds were not
so expended by the plaintiff by the means it nor
mally employed and accordingly the plaintiff was
anxious to keep those funds from the tax collector
and use them directly for the purpose for which
they were dedicated at a future time.
It is not my function to make any moral judg
ment. My function is limited to determining if the
plaintiff by those transactions has brought itself
within the four corners of section 66. For the
reasons given I think that the plaintiff has been
successful in doing so.
In my view the three decisions of the House of
Lords, Griffiths (Inspector of Taxes) v. J. P. Har-
rison (Watford) Ltd.', Finsbury Securities Ltd. v.
Bishop (Inspector of Taxes) 5 and FA & AB Ltd. v.
Lupton (Inspector of Taxes) 6 , are not helpful in
resolving the problem before me. Each of these
cases involved dividend stripping through the
device of the purchasé and sale of shares. In each
instance the question was whether the purchase
and sale of shares was trading in shares or not. In
the first case it was held to be and in the other two
cases it was held when the transactions were
viewed in their totality that the purchase of shares
was outside the scope of trading in shares but was
in fact planned and carried out for the purpose of
establishing a claim on the Treasury.
In my appreciation, the question before me is
not to determine if a transaction is one thing or
another but to determine if the plaintiff has
brought itself within the express provisions of sec
tion 66 and I have concluded that it has and I have
also concluded that since the plaintiff has so
brought itself within an express and specific provi
sion of the Income Tax Act which permits of the
plaintiff claiming deductions as it did, then section
245 is not applicable to the transactions.
[1962] 1 All E.R. 909.
5 [1965] 1 All E.R. 530.
6 [1971] 3 All E.R. 948.
Because of these conclusions which I have
reached for the reasons I have heretofore
expressed, it follows that the plaintiff's appeals
from its assessments for its 1972 and 1973 taxa
tion years must be allowed with costs.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.