Praxair Canada Inc. v. The Queen, 93 DTC 5100, [1993] 1 CTC 130 (FCTD)

Walsh, J.:—This action involves an appeal from a decision of the Tax Court of Canada dated April 4, 1989 dismissing plaintiff's appeal from an assessment of taxes for its 1978 taxation year ending December 31, 1978.

The issue involves the valuation to be given to Class C shares of Petrosar Ltd. held by plaintiff Union Carbide Canada Ltd. at the time of their issue in 1978 in consideration of the surrender of subordinated debentures and interest thereon of an equivalent face value. Plaintiff contends that the debentures, and hence the Class C shares received in exchange were worthless at the time, and that the word amount” in paragraph 12(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act") is the value in terms of money of the right or thing, namely the C shares which is the actual intrinsic realizable value and not the legal or notional par value thereof. It is contended therefore that no portion of the $3,090,900 was received by plaintiff in its 1978 taxation year, as, on account of or in lieu of payment of, or satisfaction of interest on the Petrosar subordinated debentures so the said amount should be excluded from plaintiff's income. Defendant, Deputy Attorney-General of Canada on behalf of Her Majesty the Queen states that the debentures were surrendered according to a Petrosar Directors' resolution dated January 31, 1978 for"the fair equivalent of a consideration payable in cash" and plaintiff received Class C preference shares of Petrosar in the amount of $28,213,500 of which amount $3,090,900 was received as on account of, in lieu of payment of, or in satisfaction of, the accrued interest on the surrendered debentures.

This is the wording of paragraph 12(1)(c) of the Income Tax Act in effect in 1978 which required the inclusion of:

(c) any amount received by the taxpayer in the year or receivable by him in the year (depending upon the method regularly followed by the taxpayer in computing his profit) as, on account of or in lieu of payment of, or in satisfaction of interest.

It is necessary to go into the background of a series of complex financing and refinancing agreements between Petrosar, various banks, plaintiff and other interested corporations to understand the situation in 1978 when plaintiff acquired the said shares. This is well set out in the statement of claim which reads as follows:

1. The plaintiff is a public corporation incorporated under the laws of Canada. At the relevant time it carried on a variety of businesses, including the production of plastics, chemicals, gases and metals.

2. In 1974, in order to ensure an adequate supply of ethylene for use in its polyethylene manufacturing operations, the plaintiff and two unrelated Canadian corporations (Dupont of Canada Ltd., "DuPont", and Polysar Ltd., a subsidiary of Canada Development Corporation, Polysar") with similar requirements entered upon a joint venture and caused a company, Petrosar Ltd. ("Petrosar"), to be incorporated pursuant to the laws of Ontario to construct, own and operate a petrochemical manufacturing facility in Sarnia, Ontario.

3. Throughout the relevant period, the plaintiff held 20 per cent of the issued common shares of Petrosar. Dupont and Polysar held 20 per cent and 60 per cent, respectively, of the issued common shares of Petrosar. The common shares were issued for an aggregate consideration of $50,000,000.

4. The plaintiff, Dupont and Polysar (collectively referred to as the “ shareholder corporations") entered into "take or pay" contracts with Petrosar which obligated them to purchase production from the Petrosar plant. In particular, the plaintiff was required by such an agreement, (ethylene sales agreement, dated April 4, 1974), to purchase specified quantities of ethylene.

5. The construction and start-up costs estimate for the Petrosar facility in September, 1974 was $371,000,000. To finance this cost Petrosar used $50,000,000 of common share equity, $300,000,000 of loans from financial institutions (the"banks") comprised of a term loan of $265,000,000 and an operating loan up to a maximum of $35,000,000, $2,000,000 of contributed surplus from a prior participant in the joint venture who had withdrawn and $19,000,000 principal amount of Petrosar subordinated debentures issued to the shareholder corporations.

6. By the terms of a shareholders' agreement dated July 10, 1974 and Loan Agreement dated September 20, 1974 which provided for the loans referred to in paragraph 5, the shareholder corporations agreed to fund interest and mandatory principal repayments to the banks, if necessary, until Petrosar met certain financial ratios. The mechanism by which this was to be accomplished was by the acquisition of Petrosar subordinated debentures by the shareholder corporations.

7. The Petrosar subordinated debentures were unsecured obligations of Petrosar subordinated to the bank loans. Although the subordinated debentures bore interest at two per cent over prime, it was agreed by the banks, Petrosar and the shareholder corporations that no such interest would be paid unless Petrosar maintained certain financial ratios. The shareholder corporations were obliged to acquire such subordinated debentures in the same proportion as the amount of production required to be taken by them under the” take or pay" contracts.

8. Over the period from 1974 to late 1977, the costs of construction and start-up of the facility had escalated to $700,000,000. The banks increased their loan commitment to Petrosar to $470,000,000 comprised of a term loan of $370,000,000 and an operating loan of a maximum of $100,000,000. The financial ratios prescribed in the loan agreement and referred to in paragraph 6 above were not met.

9. As a result, by the end of 1977 pursuant to the aforementioned financial arrangements, Petrosar had issued subordinated debentures to the shareholder corporations in an aggregate principal amount of $124,000,000. The plaintiff held Petrosar subordinated debentures representing approximately 20 per cent of all such debentures issued by Petrosar, the total principal outstanding on which was $25,122,600, and in respect of which no interest had been paid.

10. By 1978, Petrosar was in financial difficulty. A refinancing proposal which altered the capital structure of Petrosar was demanded by the banks as a condition to their continued financial support. In the absence of such refinancing, the shareholder corporations would have been obliged to purchase additional Petrosar subordinated debentures, in the amount of approximately $120,000,000, in the period from 1978 to 1983, in order to finance the continued operations of Petrosar.

11. The refinancing, implemented in January of 1978, entailed the following steps. Three classes of non-voting preferred shares were created. The bank indebtedness totalling $420,000,000 was replaced and $25,000,000 of additional working capital was provided by an issue to the banks of $445,000,000 of Class A preference shares of Petrosar (the "A shares"). The subordinated debentures of Petrosar in the aggregate principal amount of $124,000,000 held by the shareholder corporations, and interest aggregating $15,271,000 thereon, were surrendered and cancelled in consideration for the issuance of 1,392,717 Class C preference shares of Petrosar (the"C shares”). In particular, 399,182 C shares were issued to the plaintiff, 282,135 of which were subscribed for on its own behalf and 117,047 on behalf of Union Carbide Corporation, the plaintiff's United States parent corporation, in consideration for the surrender and cancellation of Petrosar subordinated debentures in the aggregate principal amount of $35,720,000, $25,122,600 of which relates to subordinated debentures held by the plaintiff, and interest accrued thereon aggregating $4,198,200, $3,090,900 of which relates to subordinated debentures held by the plaintiff. In addition, 2 million Class B preference shares (the"B shares") were issued for $100 per share, of which $99 was contributed surplus, by Petrosar to the shareholder corporations, 20 per cent to the plaintiff, for cash, as a means of generating a surplus with which to service dividends required to be paid on the A shares in the event that the retained earnings of Petrosar were not sufficient to enable it to pay dividends or redeem the A shares when required.

12. The terms and conditions of the A shares provided that they should rank first with respect to dividends payable quarterly at an annual rate of 52 per cent of prime plus 1.21 per cent. A portion of the A shares were redeemable from 1979 to 1987, at which point all of the 4.45 million A shares issued for a par value of $100 each were to be redeemed. The holders of A shares had a right to “put” the A shares to the shareholder corporations if Petrosar failed to meet the redemption obligations on the A shares.

13. The terms and conditions of the B shares provided that they should rank second, after the A shares, with respect to aggregate dividends of $100 per share, in priority to C shares and common shares. The B shares were to be issued with a par value of $1 and $99 of contributed surplus. After payment of dividends totalling $100 in respect of each B Share, they were redeemable for $1 per share. No such redemption was to occur unless all accrued dividends on the A shares had been paid in full, all redemption obligations on the A shares had been met, and after redemption of the B shares, there was sufficient working capital of at least $10,000,000 plus an amount equal to the mandatory redemptions of A shares required during the next 12 months.

14. The terms and conditions of the C shares provided that they should rank third, in priority as to dividends only to the common shares, at a fixed cumulative dividend rate of 6.75 per cent. No such dividends were payable unless dividends had been paid on the A and B shares, and only if working capital remaining after payment of all dividends exceeded $10,000,000. The C shares were to be issued with a par value of $100 each. The C shares were redeemable in 1990, but could not be redeemed unless, (i) the outstanding B shares had been redeemed, (ii) working capital was maintained equal to $10,000,000 plus an amount equal to the mandatory redemptions of A shares in the next 12 months and (iii) certain financial ratios were met. The C shares were not to be transferred, sold, assigned or otherwise disposed of without the consent of the holders of A shares.

15. In computing its income for the 1978 taxation year, the plaintiff did not include any amount as, on account or in lieu of payment of, or in satisfaction of, interest on the Petrosar subordinated debentures on the basis that no such amount was received or receivable.

16. At the time of the refinancing of Petrosar in 1978, both the subordinated debentures of Petrosar held by the plaintiff and the C shares received by the plaintiff had no value.

17. The defendant issued a notice of reassessment in respect of the plaintiff's 1978 taxation year dated June 22, 1983 to which the plaintiff duly objected by notice of objection dated on or about September 19, 1983.

18. The defendant reviewed the said notice of objection and confirmed the notice of reassessment by notice of confirmation dated April 28, 1987.

19. In the said notices of reassessment and confirmation referred to in paragraphs 17 and 18 above, the defendant determined that in computing the plaintiff's income for the 1978 taxation year the amount of $3,090,900 should be included as an amount received by it in that year from Petrosar as, on account or in lieu of payment of, or in satisfaction of, interest on the Petrosar subordinated debentures under the provisions of paragraph 12(1)(c) of the Income Tax Act (the "Act").

20. The plaintiff appealed by notice of appeal filed in the Tax Court of Canada on July 28, 1987. Such appeal was heard on January 11, 1989, at the city of Toronto by His Honour Teskey, J. who dismissed the plaintiff's appeal by a Judgment dated April 4, 1989.

There is no dispute as to the facts — it is the interpretation of them with respect to whether the right to receive interest on the said Class C shares had any value at all in 1978 which is in dispute.

As might be expected, defendant does not admit paragraphs 8 and 10 of the statement of claim requiring proof thereof, only admits the portion of paragraph 15 to the effect that plaintiff did not include the amount in question as income in its 1978 income tax return, but denies the statement therein that it was not included because no such amount was received or receivable, and denies paragraph 16. Otherwise, all the facts are admitted.

Since the institution of proceedings, Union Carbide Canada Ltd. has changed its name to Praxair Canada Inc. Nothing turns on this and an oral motion to amend the name was accordingly granted. It will be convenient however to refer to plaintiff in these reasons as Union Carbide since all the documents use the former name.

Only two witnesses were called. Douglas Coate now employed by Union Carbide Chemicals and Plastics Inc. of which he has been general secretary and counsel since January 1992 and before held what he described as essen- tially the same position with Union Carbide Canada for some 25 years, including the period in question, testified at length, producing the various documents exhibited and explaining them. He explained that it was at the start of 1992 that Union Carbide Canada Ltd. was split up; the gas division becoming Praxair and the other business going to the new company with which he is now associated. There are now four divisions — Chemicals and Plastics, Industrial Gas, Consumers Products, and Metals and Carbon. While the reorganization was therefore more than a mere change of name, the parties appeared satisfied that any judgment rendered in the present proceedings be in the name of Praxair which now has the interest formerly in the name of Union Carbide Canada Ltd. He was cross-examined at length with respect to the various documents and especially Minutes of Meetings and intra-company memos produced as exhibits.

The only other witness called by plaintiff was James Doak an expert in the evaluation of shares, specifically of oil and gas companies.

Defendant called no witnesses.

Facts

Plaintiff, a large producer of plastics and other products, manufactures large quantities of polyethylene for which a steady supply of ethylene was required. In 1974 a joint venture was established to construct and own a petrochemical manufacturing facility at Sarnia, producing inter alia ethylene. The company was named Petrosar Ltd. Polysar Ltd., a subsidiary of Canada Development Corporation, was the principal shareholder with 60 per cent of the shares, with plaintiff holding 20 per cent of the common shares and Dupont of Canada Ltd. another 20 per cent. The aggregate consideration paid for all the common shares was $50,000,000. They all entered into “take or pay" agreements with Petrosar to purchase its products and plaintiff agreed to purchase specified quantities of ethylene.

It was estimated that the facility would cost $371,000,000 of which the banks would provide $300,000,000 by way of a term loan of $265,000,000 and operating loan of up to $35,000,000.

Under the shareholders' agreement and loan agreement the shareholders guaranteed the bank financing, agreed to fund interest and mandatory principal repayments if necessary until Petrosar met certain financial ratios. (In the event these were never met.) If further funds were required the shareholders agreed to furnish them by subscribing to subordinated debentures of Petrosar. An amount of $19,000,000 was so subscribed and $2,000,000 of contributed surplus from a prior participant who had withdrawn, made up with the above- mentioned amounts the estimated total requirement of $371,000,000.

The subordinated debentures were subordinated to the bank loans and provided for interest at two per cent over prime but it was agreed that no such interest would be paid until the specified financial ratios were met, and they never were.

Unfortunately, there was a very substantial cost overrun from the initial estimates, final financial requirements about doubling to $700,000,000. Also world oil prices had risen precipitously and Petrosar's production costs were high compared to U.S. competitors, so profit margins on sales of ethylene suffered. Additional financing was required from the banks whose loans by the end of 1977 had increased to $470,000,000 (term loan of $370,000,000 and operating loan commitment of $100,000,000). Furthermore, the subordinated debentures held by the shareholders had now increased to $124,000,000 of which plaintiff Union Carbide held $25,122,600. Interest had accrued but of course had not been paid since financial ratios permitting this had not been met.

Accordingly, the banks demanded refinancing which took place in 1978. The capital structure of Petrosar was substantially changed. Three classes of non-voting preferred shares were created. The bank loans were exchanged for Class A preference shares and the subordinated debentures and interest due on them were exchanged for Class C shares. The banks increased their financial support, but in order to ensure payment of dividends, a somewhat ingenious device was created requiring the shareholders (i.e., Union Carbide, Polysar and Dupont) to subscribe to sufficient Class B shares to fund all dividends required to be paid to the banks on their Class A shares. These Class B shares, issued at a premium over par, were eventually issued to a total of about $20,000,000.

Class A shares ranking first had a dividend equal to 52 per cent of bank prime plus 1.21 per cent and were subject to mandatory redemption from 1979 to 1987. Moreover, in any one year the Shareholder corporations could be required to purchase some of the said Class A shares from the banks at par. The banks bought $445,000,000 of them, replacing the then current bank term debt of $370,000,000, the funding of customer prepayments of $50,000,000 and $25,000,000 additional working capital.

Class C shares of a par value of $100 each ranked after Class A and Class B shares and would only receive dividends if Petrosar was current with respect to Class A dividends and specified working capital requirements were met. They could only be redeemed if Petrosar was current in its redemption obligations with respect to Class A shares, their par value was more than half that of Class A shares and working capital conditions had been met. Class C shares issued for the surrender and cancellation of Petrosar Subordinated Debentures totalled 1,392,717 for an aggregate principal amount of $124,000,000 with contingent accrued interest of $15,271,700. Plaintiff Union Carbide received 282,135 of them for the amounts already stated of $25,122,600 as capital plus $3,090,900 contingent accrued interest.

The banks also provided operating loans of up to $100,000,000.

As can be seen, the shareholders remained obligated to the banks not only as initially for repayment of principal and interest, but now also to fund dividend and redemption requirements by virtue of the Class B shares, and to purchase from the banks any Class A shares not redeemed when required. However, the rate of dividends on the Class A shares was substantially lower than the interest rate payable on prior bank loans, thereby increasing Petrosar's cash flow. Payments received by the banks by way of dividends instead of interest would not be taxable in the bank's hands. On the other hand, Petrosar could not deduct any such dividends paid by it as an expense item as it could interest on loans, in its tax returns. The resulting commercial advantages for the parties is not a matter for the Court to consider in these proceedings.

With respect to the Class C shares no cash or property was paid to or received by Petrosar for their issue, and conversely the Shareholder corporations received no cash for the surrender of their subordinated debentures for cancellation. This cancellation was the consideration received by Petrosar for the issue of its Class C shares and again conversely the consideration the Shareholder corporations received for surrendering their debentures and accrued interest therein was the Class C shares received.

It may be helpful at this stage to introduce a table which counsel prepared showing the situation as it changed from the initial investments to 1978 after the refinancing, to which I have added some explanatory notes.

*The $50,000,000 shown in 1978 was said to be a prepayment made by Ontario Hydro.

** Original participant which had withdrawn.

James Doak, a chartered financial analyst, testified for plaintiff as an expert witness. From 1979-83 he was a research analyst with McLeod, Young, Weir, responsible for energy and chemical securities, and now does the same work for Marathon Securities Inc. Since 1980 he has analyzed the equity of various Canadian chemical companies, including Canada Development/Polysar and visited Sarnia three times to meet Polysar managers to discuss the operation of its ethylene cracker and butyl roller operation.

For his report he relies on “fair market value" predicating an open and unrestricted market between informed and prudent parties, neither being under any compulsion to contract. By contrast" value to owner” is a subjective value expressing the adverse values of the loss direct and indirect that the owner might suffer if deprived of the property. In performing his valuation he examined the relevant financial statements of Union Carbide, Petrosar and Polysar for the 1977-87 fiscal years and the various Agreements, internal memos of Union Carbide and resolutions and minutes of meetings of directors of Petrosar and Union Carbide, as well as various industry and government studies.

Using various valuation techniques, he concluded that the Class C preference shares had no fair market value either on a going concern or liquidation and replacement value basis but only a “hypothetical option value” which would have had to be based on Petrosar returning to sustained profitability necessary to repay all prior dividend obligations, maintain working capital of $10,000,000 and generate a “going concern” value for the Class C shares — which hypothetical option value was in his opinion worthless to a knowledgeable purchaser.

He also concludes that the said shares had no value to the owner as Union Carbide was not in a special position to create value by virtue of having control of Petrosar or an agreement to sell the shares to a third party.

In reaching his conclusion, he considered the financial position of Petrosar and other parties including:

(a) the capital cost per annual pound capacity of Petrosar as compared to U.S. Gulf Coast producers;

(b) the configuration of the Petrosar plant, especially its lack of feedstock flexibility and production of residual fuel oil;

(c) the disadvantageous oil feedstock pricing, due to discriminatory Province of Alberta treatment and transport costs, and the escalation of world oil prices during the period under discussion;

(d) the non-optimal capacity utilization due to soft product markets for ethylene derivatives and rising hydrocarbon prices;

(e) the position of Class C preference shares in the capital structure of Petrosar, including their ranking in liquidation, dividend characteristics and the cash flow coverage of Petrosar's fixed charges;

(f) the deteriorating economic outlook for Petrosar Ltd. at the time of the issuance of the Class C preference shares;

(g) the inability of Petrosar Ltd. to meet the working capital levels specified in the bank loan agreement at the time of the issuance of the Class C preference shares;

(h) the restrictions in the sponsors' purchase agreement on the transfer of the Class C preference shares and the absence of any public market for the shares;

(i) U.C.C.L.'s minority equity interest in Petrosar Ltd.;

(j) U.C.C.L.'s right to nominate only one of the six members of the board of directors of Petrosar Ltd.;

(k) the market prices of crude oil, ethylene and high density polyethylene and, therefore, the hypothetical margin on Union Carbide's associated production of polyethylene at its Moore Plant, using ethylene from Petrosar's Corunna Plant; and

(l) the lack of any credit rating on the preferred shares and debenture.

In his oral evidence, he stated that value to owner is not something taken into consideration in the securities market which merely looks at the value which the public will put on the security — the market value.

He pointed out that plants to produce ethylene can be constructed in the Gulf Coast of the United States for less than similar plants in Canada — the difference being in the nature of 30 per cent, and with respect to the subject plant the cost was double. The market value of the plant in 1978 would in his opinion only be about $200,000,000 to $250,000,000 — less than the bank liability. It was not flexible as to the feed stocks it could use, and moreover, between 1980 and 1986, one-third of United States polyethylene plants were shut down. He suggested that plaintiff was eventually aware that the subject plant was not practical, for its principal, Nova, actually built an ethylene plant in Alberta using gas as feed stock.

Argument

Subsection 248(1) of the Income Tax Act defines the word "amount" (as used in paragraph 12(1)(c), supra) as "money, rights or things expressed in terms of the amount of money or the value in terms of money of the right or thing”.

Petrosar received for the Class C shares issued no money, but the cancellation of the subordinated debentures and accrued interest at face value. It was argued that a right or thing cannot be expressed in terms of an “amount of money" but only in terms of its value in money. It is therefore the value in terms of money of the right or thing which must be included for tax purposes under 12(1)(c). Reference was made to the Interpretation Bulletin IT-396 “Interest income" (October 17, 1977 paragraph 2) which states:

Interest is received at the time payment of the interest debt is obtained in cash or its equivalent by the taxpayer — For example, a taxpayer is considered to receive payment when the value of a commodity is accepted in lieu of cash.

It was therefore argued that since the shares issued in payment of interest were valueless, the interest cannot be considered as having been paid.

This is so, but only if the said shares were in fact valueless which is the issue to be decided.

It was also argued that the par value need not and often does not reflect the actual value of shares. Par value is merely a means to fix a minimum subscription price for the original issue of shares. If such shares are received in payment of an obligation to pay interest, the amount received is the value in terms of money of the said shares, so it is the real value rather than the par value which must be determined.

Section 44 of the Ontario Business Corporations Act, R.S.O. 1970 c. 53 in 1978 read in part as follows:

(2) Shares with par value shall not be allotted or issued except for a consideration at least equal to the product of the number of shares allotted or issued multiplied by the par value thereof.

(4) No share shall be issued until it is fully paid and a share is not fully paid until all the consideration therefor in cash, property or services, as determined under this section, has been received by the corporation.

(5) For the purposes of subsection (4) . . . the value of property or services shall be the value the directors determine by express resolution to be in all the circumstances of the transaction the fair equivalent of the cash value.

Thus, if a corporation (in this case Petrosar) owes $100 and the creditor (Union Carbide) agrees to accept shares with a par value of $100 in cancellation of its claim, the share issue is valid. The value of the share to the holder may, having regard to interest rate fluctuations, the credit rating of the debtor corporation and other factors, be less than $100. From the issuer's point of view the release of indebtedness as a result of the share issue was worth $100 but this is regardless of the value of the claim to the creditor.

The Petrosar directors in accepting the subscription by plaintiff for a specified number of Class C shares allotted them "at the par value thereof" as they had to by virtue of the Ontario statute. The directors’ minutes read:

The company having agreed that the aggregate subscription price of $139,271,700 for the 1,392,717 Class C preference shares series one so subscribed for shall be satisfied by the surrender thereof to the company on the closing date, for cancellation of $124,000,000 principal amount of subordinated debentures upon which unpaid interest of $15,271,700 will have accrued to and including January 31, 1978, which aggregate principal amount and interest is owed by the company to the said subscribers, the company shall on the closing date apply the said sum of $139,271,700 in full payment of the said subscription price for the said 1,392,717 Class C preference shares series one subscribed for as aforesaid.

That the consideration for the allotment and issue of the said Class C preference shares series one as aforesaid, namely the payment of the aggregate sum of $139,271,700 by such application of the aggregate principal amount of and interest accrued on the said subordinated debentures is in all the circumstances of the transaction the fair equivalent of a consideration payable in cash on such date of $139,271,700 . . . .

This is legal and proper for Petrosar but does not determine the tax position of plaintiff with which this case is concerned. Plaintiff reiterates its argument that it is the real value and not the par value of the Class C shares that fixes" the amount” received by plaintiff for surrendering its contingent right to accrued interest on the subordinated debentures.

Although it is difficult to find jurisprudence directly in part plaintiff referred to a U.S. case somewhat analogous in nature, that of C./.R. v. Capento Securities Corporation et al. (1944), 140 F. 2d 382 in the Court of Appeals, First Circuit. The facts and finding were as follows:

In 1929 a corporation, R, issued bonds of $500,000 face value, presumably for cash at par. In 1983, a related corporation, C, purchased the bonds for $15,160 in order to provide subordination in favour of R's bank. In 1935, the bank requested that the bonds be converted to equity. The bonds were transferred by C to R solely in exchange for a new issue of 5,000 preferred shares of R with a par value of $100 each. As a matter of fact, the preferred shares were worth $50,000 upon their acquisition by C. In these circumstances the Court found:

(a) Since C had acquired the bonds for $15,160, it made a gain of $34,840. However, under specific U.S. legislation, that gain was not recognized as constituting a tax-free recapitalization.

(b) R realized no gain on the transaction.

This case is authority for the proposition that a taxpayer receiving payment of a debt by issuance of par value shares calculates income based on the real value of the shares.

As far as Petrosar is concerned, as in the Capento case it simply substituted a preferred stock claim for a debt claim.

It is true as defendant alleges that the officers and directors of Petrosar from time to time expressed opinions indicating some optimism with respect to the company's business, and hence the value of the subordinated debentures or Class C shares. On November 1, 1976, an internal memorandum states "Our net income outlook is very poor — a disastrous loss of almost $40 million in 1978 and a slow recovery to a profit level of only $12 million in 1982.” It recommends arranging with shareholders to convert their subordinated debentures to preferred shares and arranging with the banks for additional financing and for deferring start of repayments for 36 months after start-up instead of 15 months as agreed.

A status report of January 24, 1977 states that it will be 1983 before the working capital requirements of the bank loan agreements can be met.

An internal memo of Union Carbide dated January 24, 1978 indicates that under the refinancing proposal dividends will be in arrears on the Class C shares commencing in 1981 after a three-year dividend holiday and will increase to $31 million in 1988. It refers to redemption of Class C shares now being delayed two more years until 1990.

It would appear that in 1978 Union Carbide had not given up all hope of ever getting anything back for its investment in Class C shares. With respect to Petrosar's memos and directors’ resolutions, it is certainly not unusual for officers and directors of a corporation to adopt an optimistic viewpoint even when it is evident that the business of the corporation is in deep trouble. Moreover the fact that the shares had to be issued at par value, for a consideration of cancellation of subordinated debentures of equivalent value does nothing to establish the actual value of the shares.

It was argued by defendant that the shares had a value to the owners even if they had no market value for third party purchasers. Union Carbide in particular required the ethylene which the Petrosar plant would produce, for its polyethylene plastic plant it was building nearby. The fact that the market price for ethylene is set by United States prices usually established by Gulf Coast plants and some 30 per cent lower than cost of production in Canada was of no help to Union Carbide as the supply had to be available nearby. It therefore wished the plant to be completed and when functional to produce ethylene and not be converted to the production of heating oil for example, in winter when there was a good market for same. However, Union Carbide only had a 20 per cent interest originally and one out of six representation on the board of directors, whereas Polysar had 60 per cent, and was interested in some of the other products of the plant as well as ethylene.

From the subjective point of view therefore it is understandable that Union Carbide continued to hope that the completion and operation of the plant would eventually be successful, in which event the Class C shares might have some value. Vague and speculative projections of a possibility that the shares might have some value in the future, however, does not give them a definite value in 1978, the year with which that action is concerned. The expert witness Doak, as previously stated, considered in his valuation report this hypothetical option value” and attributed no value to it. While, in concluding that the said shares had no fair market value he does not reject the possibility of their having a value to the owner, he states however, that this would only be so if Union Carbide had been in a special position to create value which it was not, and that it would have suffered no direct or indirect loss if it had been deprived of the shares. (Save of course for the loss of funds already invested in the subordinated debentures for which they were exchanged.)

No other evidence was submitted by either party to attempt to establish that the shares had some nominal value to Union Carbide. Both parties take a categoric position — Union Carbide that they were worthless in 1978 (or more specifically those issued for accumulated dividends with which this assessment is assessed), and defendant that they were worth their par value at which they were issued. It is unnecessary therefore to look into issues of burden of proof which were argued by Union Carbide in its alternative argument.

While plaintiff argues that defendant failed in its assessment to make an assumption that the said shares were worth their par value and that there is no onus on a taxpayer to disprove assumptions which were not made, it is clear that defendant made such an assumption at least by implication when in its defence it states the Class C shares were “valued” at $28,213,500 and that plaintiff received Class C shares "in the amount of" $28,213,500. This sustains the assumption made by defendant as to the value of the shares.

The Court is not concerned in the present case with how Petrosar treated the said Class C shares or the portion of them representing accumulated unpaid dividends on the subordinated debentures in its 1978 tax return, which was not before the Court, nor with how Dupont and Polysar, the other holders of said shares, dealt with the matter in their 1978 returns, nor with how any of these corporations were assessed by defendant in the 1978 year. Neither is the Court concerned in this case with what became of the said shares in future years or whether Union Carbide eventually received anything from disposal of said shares and the tax treatment thereof. While such disposal for cash or considerations equivalent to cash might indicate that the said shares did have some value for their owners in 1978, it is not future value, at best highly speculative, with which we are concerned but the value in 1978 when they were issued. Forecasts by officers or directors whether of Polysar or Union Carbide do not establish the value of such shares at the time of issue.

The expert witness Doak looked into some developments in the industry after 1978 and even the financial statements of the corporations, from 1977 to 1987, in concluding that the said shares had no value to the owners at the time of their issue and no fair market value. During his testimony he stated very categorically that the value of the plant when completed was worth considéra- bly less than the liability to the banks. From any realistic point of view therefore the said shares were worthless at the time of issue.

Moreover, in order to succeed in its action plaintiff does not have to prove that the shares were valueless, but merely that they were not worth their par value, which is the assumption on which the assessment was made. This proof has been amply made and therefore plaintiff's action must succeed.

Aside from the American case of Capento Securities Corp. which has been discussed, supra, some Canadian, British and Australian jurisprudence was also referred to, none directly in point, but giving some indication as to how actual or real value as distinct from par value should be dealt with from a taxation point of view. Moreover, most of these cases dealt with how the issuing corporation (in this case Polysar) must deal with them, whereas we are only concerned with the holders (Union Carbide).

In the case of Piercy v. M.N.R. (1956), 15 Tax A.B.C. 217, Fordham reviewed the jurisprudence at some length. In that case, shares had been allotted at an inflated value in payment for an hotel. It was held that the shares were given an artificial value so the shareholders received no gain on the issue of them, as the Minister had contended. At page 221, the decision states" in assessing the appellant in respect of this matter, the respondent has fallen into the not uncommon error of assuming that the shares allotted to the appellant had an actual value of $100 per share in his possession.”

Reference was made to the British case of Humphrey v. Gold Coast Selection Trust Ltd. (1948), 30 T.C. 209 in which Viscount Simon said at page 240:

If the asset takes the form of fully paid shares, the valuation will take into account . . . a number of . . . factors, such as prospective yield, marketability, the general outlook for the type of business of the company which has allotted the shares, the result of a contemporary prospectus offering similar shares for subscription, the capital position of the company, and so forth. There may also be an element of value in the fact that the holding of the shares gives control of the company. If the asset is difficult to value, but is none the less of a money value, the best valuation possible must be made. Valuation is an art, not an exact science. Mathematical certainty is not demanded, nor indeed is it possible.

In the case of Australian Machinery & Investment Co. Ltd. v. D.F.C. of T. (1948), 30 T.C. 244, Atkinson, J. in commenting on the case of Craddock v. Zevo Finance Co. (1946), 27 T.C. 267 stated at page 254:

The Zevo case merely laid down this proposition, that an investment company which has bought investments for fully paid shares by transactions which were not illusory is entitled to treat the par value of the shares as the cost to the company of the investments purchased by the company for fully paid shares. The case concerned only a company purchasing by the issue of fully paid shares. Quite apart from the fact that the transactions here were obviously illusory as a test of value, the Zevo case did not touch the question of the value of the shares in the hands of the person to whom they were issued. That value, as the Gold Coast case shows, was the fair intrinsic value or market value of the shares. Still less did it touch the question of the cost of the shares to the person to whom they were issued. In this case that cost was the value of what the company paid for them.

He goes on to state at page 255:

There is no "lawyers' mystery", to quote Sir Cyril Radcliffe (page 223), which bound or entitled the Commissioners to say that the cost of these shares must be deemed to be their par value. The cost was a matter of evidence. The cost was the value of the mines. As I have said, the commissioners did not find what the real cost of the shares was. The case must go back to them to find as a fact what was the cost of the shares to the company. That cost is to be measured by the true value of the mines at the time of their sales.

Much of the jurisprudence referred to by both parties dealt with situations where shares were issued for property and whether at an inflated value or not, which is not the case here where the subordinated debentures had an identical cash value to that of the shares issued at par, so equivalence of value is not an issue.

If this jurisprudence, and that referred to above, has any value at all in this case, it suggests that it is the real or actual value of the shares which must be considered rather than the par value even if the issuing corporation has agreed to issue them at their par value as fully paid.

Also not directly pertinent are certain Interpretation Bulletins dealing with other sections of the Income Tax Act which were referred to as indicating that it is real values which must be looked at even if the documents may indicate otherwise. For example, Interpretation Bulletin 422 dealing with bad debts states in paragraph 14: “A taxpayer may accept property, for example, securities, or real estate in full settlement of a trade debt or of a loan made in the ordinary course of the business. Where such a debt is of a kind that would qualify for consideration as a bad debt, and the fair market value of the property received by the taxpayer at the date of the acquisition is less than the amount owing to him, the difference is deductible as a bad debt” (emphasis mine).

In conclusion, the jurisprudence reinforces rather than changes the conclusion already reached on the facts.

Plaintiff's action is allowed and the notice of reassessment in respect of plaintiff's 1978 taxation year dated June 22, 1983 and confirmed April 28, 1987 is vacated and referred back to the Minister of National Revenue for reassessment on the basis that no portion of the amount of $3,090,900 was received by the plaintiff in its 1978 taxation year as, or in account of, or in lieu of payment of, or satisfaction of interest on the Petrosar subordinated debentures and the said amount should therefore be excluded from the plaintiff's income. With costs.

Appeal allowed.