McKeown J.:—The plaintiff, Gulf Canada Resources Ltd. (Gulf), appeals two notices of reassessment for the 1978 taxation year. In computing the plaintiff’s resource profits under section 1204 of the Income Tax Regulations, P.C. 1976-559, SOR/76-188, the Minister deducted capital cost allowance in the amount of $45,656,563 claimed by Gulf with respect to assets at the Syncrude project and interest expense in the amount of $9,504,816 incurred by the plaintiff in the 1978 taxation year on loans or indebtedness in respect of financing for the Syncrude project. In computing the plaintiff’s capital cost of properties described in class 29, Schedule II of the Regulations, for the purpose of determining the plaintiff’s capital cost allowance pursuant to paragraph 21(a) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1 (the "Act”) and for the purpose of determining the plaintiff’s investment tax credit under subsection 27(9) of the Act, the Minister deducted the amount of $1,088,967. The plaintiff takes issue with these deductions.
The first two deductions relate to the "Syncrude issue”. The question to be determined is whether there was any source of income in 1978 for purposes of paragraph 1204( 1 )(b) of the Regulations. If I disagree with the assertion that there was no source of income throughout the period in 1978, it is the position of the plaintiff that there was no source of income for part of 1978 and the amount should therefore be prorated.
The second issue in this case is whether the expenditures incurred by the plaintiff at its Clarkson Refinery in extending the water intake further into Lake Ontario was an expenditure in respect of a pipeline, as asserted by the Minister in reclassifying such expenditure from class 29 to class 2.
The plaintiff is an integrated oil company which had as its principal activities during the 1978 taxation year the production, refining and marketing of petroleum and petroleum products. These activities took place at different locations and in different capacities. It is in respect of two completely different activities and locations that the issues arise before me, and I propose to deal with the facts and law related to each under separate headings.
Issue I-Syncrude project
The first question relates to whether Syncrude was a source of income in 1978 for purposes of paragraph 1204(1)(b) of the Regulations. If I disagree with the submission that there was no source of income throughout the period of 1978, it is the position of the plaintiff that there was no source of income for part of 1978 and that the amount should be prorated.
The Syncrude project (Syncrude) involves the production of synthetic crude oil from bituminous sands mined from a bituminous sands deposit.
Facts
A. History
The history of Syncrude goes back to the discovery of the oil sands in 1778. In 1920, methods were identified for separating bitumen from the oil sands. In 1955, Royalite Oil, a predecessor of the plaintiff, acquired the Crown lease to what is the site of today’s Syncrude plant. In 1958, Royalite brought other participants into Syncrude. Royalite and British American Oil amalgamated and were continued under the name Gulf Oil Canada Ltd. In 1964, Syncrude Canada Ltd. (also referred to as "Syncrude") became the agent of the participants. Up until December 1974, the participants in Syncrude were Atlantic Richfield Ltd. (30 per cent), Canada Cities Service Ltd. (30 per cent), Gulf Oil Canada Ltd. (10 per cent), and Imperial Oil Ltd. (30 per cent).
In 1966, a trial mine employing earth scrapers was developed on the Syncrude site. In September 1969, the Alberta Energy Conservation Board granted approval for Syncrude to proceed with a plant to produce 80,000 barrels of crude oil per calendar day, provided commercial production did not commence prior to 1976. In 1971 and 1972, this approval was increased to 129,400 barrels per calendar day.
In 1972, a trial mine using draglines was initiated to appraise the feasibility of mining with draglines at Syncrude. In December 1973, initial agreement was reached with Alberta regarding royalty provisions and other major terms, and the four participants agreed to proceed with Syncrude. Agreement was also reached with the federal Government that the synthetic crude oil produced at Syncrude would receive world price and that royalty payments to the province of Alberta would be deductible for tax purposes. It was further agreed that there would be no restriction on the quantity of oil produced. Site clearing started in the same month and, in 1974, the foundations were started for the separation and upgrading plants. The plant foundations were not without risk because there was no precedent for founding major structures on oil sands. In addition, some permafrost was discovered in the plant area.
While there was always concern about the viability of Syncrude throughout its history, in 1974 two events occurred that put Syncrude in jeopardy. The first event was the Budget of the federal Government of May 6, 1974, whereby royalties paid to Alberta would no longer be deductible from income under the Act. The second event occurred in December 1974, when the major contractor, Canadian Bechtel Ltd., presented a revised estimate of the costs of Syncrude, under which the estimated cost was increased to in excess of $2 billion. This was in the order of four times the original cost estimate (about $600 million) and twice the more recent cost estimates (about $1 billion). As a result of these two events, Atlantic Richfield Ltd. withdrew from Syncrude.
In an effort to save Syncrude, the remaining participants, Canada Cities Service Ltd., Imperial Oil Ltd. and the plaintiff, met in Winnipeg with the federal, Alberta and Ontario governments. As a result, an agreement, called the Winnipeg Agreement, dated February 12, 1975, was reached wherein the participants and their interests were represented as follows:
Federal Government: 15%
Alberta Government: 10% Ontario Government: 5% Cities Services: 22%
Gulf: 16.75%
Imperial: 31.25%
As part of this agreement, the Alberta Crown Agreement and the Alberta Energy Option Agreement, both dated February 4, 1975, were entered into. The Alberta Crown Agreement provided for the payment of royalties by the participants in Syncrude to the province of Alberta. These royalties were to commence after the ’’date of start of production”. By agreement, "production" did not commence until the output of the five millionth barrel of synthetic crude oil at Syncrude. Under the Alberta Energy Option Agreement, the participants in Syncrude granted Alberta Energy Corporation (AEC) an irrevocable option to acquire a participating interest in Syncrude.
The plaintiff and the province of Alberta also entered into a loan agree- ment dated April 30, 1976, under which Alberta provided a $100 million loan to the plaintiff and the plaintiff issued a convertible debenture to Alberta. The proceeds of the loan were to be used by the plaintiff towards the costs of Syncrude. Alberta was given the right to convert the whole or any part of the principal amount of the debenture into a percentage equity interest in Syncrude. This equity interest was determined by reference to the costs incurred at Syncrude prior to the "date of start of production". Again, by agreement, "production" did not commence until the output of the five millionth barrel of synthetic crude oil at Syncrude.
The output of the five millionth barrel of synthetic crude oil at Syncrude (which was the starting date of production for purposes of the Alberta Crown Agreement and the loan agreement) occurred in March 1979. By agreement between Revenue Canada and the participants, commercial production at Syncrude commenced on April 1, 1980. The plant had by then begun three months of sustained production at rates above 60 per cent of design production rate which Dr. Devenny, the plaintiff’s expert, and one of the few experts on mega projects, agreed was one of the tests that could determine the start of commercial production. He had some concerns about this test, however, since in his opinion, the plant was not commercially viable at 60 per cent of design production.
In June 1977, the mining component commenced when an opening cut was made in the mine. In March 1978, the extraction plant started to process feed from the mine. In July 1978, the first coker began to process the bitumen and on July 30, 1978, the first barrel of synthetic oil was produced. This latter event was the start of the upgrading component.
B. Description of the project
Syncrude was designed to produce synthetic crude oil from the oil sand. The object was to sell the synthetic crude oil to conventional refineries. The plant involves three major components:
I. mining, which lifts the bituminous sands from the bituminous sands deposit and transports those sands from the mine via conveyor belts to the extraction plant;
IT. extraction (i.e., separation), which separates the bitumen from the sands; and
III. upgrading, which processes the bitumen into light synthetic crude oil so that it can then be pipelined to market (the light synthetic crude oil enters the Alberta Oil Sands Pipeline and is transported to Edmonton to be further refined).
Bituminous sands deposits are either "shallow deposits" or "deep deposits". A "shallow deposit" is covered by a thin overburden and is exploited by surface mining methods. This involves the mining of the bituminous sands from the bituminous sands deposit and the subsequent extraction (1.e., separation) of the bitumen from the sands. The bituminous sand is what is mined from the deposit. It is only after such mining that the bitumen is extracted from the sand. The bituminous sands deposit at Syncrude is an example of a "shallow deposit" where surface mining methods are employed. In contrast, a "deep deposit" is exploited using in situ extraction methods. This involves the drilling of wells into the deposit and the injection of steam to heat the deposit. The bitumen itself is what comes forth from the deposit. This bitumen is similar to the bitumen which is obtained, after mining, in the extraction process in a "shallow deposit". The bituminous sands deposit at Cold Lake is an example of a "deep deposit" where in situ extraction methods are employed.
In the extraction plant, the ore 1s separated into its sand (the "solid") and hydrocomponents (bitumen). The bitumen then becomes feed for upgrading. Primary and secondary upgrading is necessary to convert the heavy, sour bitumen to light, sweet crude that can be pipelined to distant refineries.
Dr. Devenny testified that:
This is a rather unique way of making crude oil. Having to mine it, transport it, heat it up to extract bitumen, then clean that bitumen and send it through an upgrader is an awful lot of work compared to what they do in Saudi Arabia, or in easier oil fields of the world is drill a well and put appropriate screens on but pump the oil directly out of the ground, and it’s a competitive world, so that production from this plant has to compete with that oil from other parts of the world, or conventional oil, and the only way it was visualized that that would happen is this project had to be huge to achieve economy of scale in everything that it did so that it would get the operating cost down quite low.
That philosophy led to the use of very large components and duplicate trains or quadruplicate trains, so there would be efficiency in maintenance and in the mining component. These are biggest units or amongst the biggest units available. They would-and there’s four-four of them were provided to achieve the production rates needed.
In upgrading, the two cokers are the largest in the world. They provided two of them. That way when one coker is down for its annual turnaround, the other one keeps going, and so there’s production continuing on in a part of the plant, so that’s the design philosophy.
The other part of the design philosophy was in order to achieve the high volume throughput planned, all the pieces in this plant had to work to their peak capacity or at their design rate of capacity, and they not only had to work individually, they had to work together without a lot of interference between the different units, and they had to do that for sustained periods of time.
Extensive support facilities maintain the main production components. The main auxiliary facility is the utilities plant. It provides water, steam, electricity and compressed air to the main components. As an indication of its size, the power produced by the utilities plant is sufficient to support a city of 250,000 people. The other main auxiliary facility is the waste area containing the tailings pond.
In addition, to support the upgrading process, the following peripheral
plants are required:
I. hydrogen plant (to produce hydrogen for the hydrotreaters);
IT. sulphur plant (to receive the hydrogen sulphide that comes off the hydrotreaters);
III. sour water processing unit (to treat waste water);
IV. flare system (to handle combustible waste gas);
V. heat exchangers (to recover excess heat which can then be recycled);
VI. boilers (to provide heat needed by the processors);
VII. storage tanks (to store the bitumen and its by-products between the process units);
VIII. pipeline (to transport the synthetic crude oil to market);
IX. control centre (to act as the control centre for upgrading);
X. sewage system (to handle the fluid produced in the plant area); and
XI. maintenance facilities (to maintain the units).
C. Design philosophy
There was a two-part design philosophy at Syncrude. The first part was to achieve a low per unit cost through economies of scale. This resulted in a mega project that uses very large production units. Although the production of a barrel of synthetic crude oil at Syncrude involves mining, extraction and upgrading, a more difficult process than that required in conventional sources, the synthetic crude oil produced at Syncrude has to compete with oil from such sources. This led to the use of very large equipment (the equipment at Syncrude had never previously existed on as large a scale anywhere in the world) and duplicate (in upgrading) and quadruplicate (in mining and extraction) production trains.
The second part was design rates of production which required that all production units work without interruption at capacity for extended periods of time. Each part in the operation had to be working, and all parts had to work together. Syncrude is a highly complex integrated facility. Each part of the operations at Syncrude had to work at high throughput rates. This had to occur for sustained periods without interruption. Plant shutdown periods (for plant maintenance) were short, in order to maximize production time.
The three main components of the plant are de-linked to a limited extent to allow for small, temporary deficiencies in a particular component. Mining and extraction are de-linked by the dump pocket, extraction and upgrading by bitumen tankage, and upgrading and the pipeline by product tankage. There is also some de-linking of the various equipment within a particular component.
All three production components of the plant were needed to make a product that could be transported (pipelined) to market (distant refineries). Mined ore itself had no value because there was no market for it. Similarly, bitumen had no value because there was no way of moving it from the Syncrude site to market. Upgrading was needed to convert the bitumen to a pipelineable product. Development plans recognized the need for all components to work together before there can be a marketable product.
D. Syncrude as a mega project
Syncrude is a large complex plant. Some examples will illustrate the scale of its size. Lease 17 (one of the two leases occupied by Syncrude) has an area of about 200 square km. It took 650,000 person years to build the plant. The plant contains 248,000 cubic metres of concrete, 853 km of piping in the plant, 2,920 km of wire and cable. The power plant is large enough to serve a city of 250,000. The mine 1s one of the biggest open pit mines in the world. The drag lines are as tall as a 25-storey building. Their booms are as long as a Canadian football field. There are over 50 km of conveyor belts in the mine. The cokers are the largest in the world. The enormity of this project gives some idea of the difficulties one has in attempting to relate Syncrude to other businesses.
Dr. Devenny testified that the phases through which a typical mega project progresses are the "construction phase", the "debugging phase" and "mature operations". There is no precise date which divides these phases and, furthermore, there is overlap between them. A number of things were occurring simultaneously at Syncrude in attempting to bring it "on stream". The various parts of the operations at Syncrude were turned over from construction at different times. While some parts of the operations were turned over from construction earlier than others, construction of the remaining parts continued. When Dr. Devenny testified that the construction phase ended in July 1978, he was referring to only one component of the operations at Syncrude, namely mining which was completed when all the draglines used in mining had been turned over from construction. At that point, construction still continued in extraction and upgrading. For example, only one train in upgrading had been turned over from construction in July, the second train did not get turned over until later in 1978. As stated above, for the plant to have commercial output, each part of the operations has to be up and running. In addition, in December 1978, $100 million was budgeted for remaining construction and fix-up at Syncrude. While $100 million is an enormous amount of money, it is less than five per cent of the total cost of the project.
According to Dr. Devenny, it is only after the "debugging period" that Syncrude was complete and ready for commercial use. Dr. Devenny described the point at which the "construction period" ended for a particular part of the operations as the point at which that part was "turned over" from construction. In this description, he was referring to the turning over of that part of the plant from the construction contractor to the Syncrude staff. At that point, the equipment had to be tested to see if it would work and the staff had to be trained at how to work and maintain it.
Dr. Devenny described this period of testing and training as a "debugging period". It is only after the "debugging period" that Syncrude was complete and ready for commercial use. Given the complexity and scale of the plant at Syncrude, it was a long and arduous process to get through this period. The plant at Syncrude was not complete at the end of what Dr. Devenny called the "construction period". Syncrude was not a "turnkey" operation. Equipment was not "constructed" in one day and in operation the next.
The only way to get through the "debugging period" was by actual experience and practice on a trial and error basis. The only way to determine the problems that will be encountered in running a plant is to try to make it work. Similarly, the only way to come up with solutions to such problems and discover whether such solutions are viable, is to try such solutions in practice. The problems that will be encountered in the "debugging period" or how long this period might last cannot be determined in advance. These problems defy the predictions of the designers and the plans for a project. At Syncrude, the designers knew there would be some "debugging", but could state neither how extensive it might be nor how long it would take.
A "debugging period" is typical in any large project. Further, the length of this period and the problems encountered during it are magnified when dealing with mega projects. Dr. Devenny’s opinion on this is supported by the findings of the Rand Corporation. The experience with Syncrude bears this out.
With mega projects, there are always problems to be solved and learning to be done before the project is complete. What differentiates the "debugging" period from "mature operations" is the frequency with which those problems occur and the impact those problems have on the operation.
E. Problems encountered in 1978 and subsequent years
In 1978, Syncrude could not be operated in a commercial manner as there were a number of problems which not only prevented it from moving into commercial production, but which Gulf considered threatened the existence of Syncrude.
In the winter of 1978-79, the mine fell far short of its assignment to provide feed to the extraction system. The feed became saturated and froze and there was difficulty in providing feed at the planned rate. It was very important for the plant that the mine produce feed on a reliable, sustained basis, which was not achieved until after the winter of 1979. Examples of the problems encountered in mining included:
1. Each drag line had to be taken off and replaced. While the one drag line was being replaced, the other three were operating. The replacement of the drag lines was not completed until late 1979 or early 1980.
2. A buried stream valley was encountered in the centre of the mine. This valley had soft clay in it and could not support major equipment such as the draglines. An area of the mine called a "pillar" had to be abandoned. Mining in the quadrant where the valley was found "leapfrogged" over the valley and a second cut was made in the mine where mining in that quadrant later continued.
3. Problems were caused by the stockpiling of the bituminous sands in the windrows. Through the summer of 1978, the bituminous sands stayed in the windrows, was rained on and oxidized, causing problems and interruptions when extraction began to process the sands. In addition, during the winter of 1978-79, these wet, water- soaked windrows froze making handling by the bucketwheels very difficult.
4. There were several defects in the bucketwheels. First, the shaft of the bucketwheel could not handle the tremendous torque that drives the wheel and it wore out. Secondly, the buckets on the wheel originally picked up large rocks (which would slice the conveyor belts), requiring the installation of false bottoms on each bucket (to restrict the entrance to the bucket). Lastly, the ballbearing ring in the base unit that supports the revolving bucketwheel had to be replaced by a stronger system, requiring the bucketwheel to be taken apart and causing it to be out of commission for a month or two.
By the end of 1977, there were four million tons of feed stockpiled, which is not a large amount by Syncrude standards since there was usually much more. However, the problem was that the bucketwheels were not in place at the end of 1977. Therefore, the feed could not be transferred to the extraction plant. There was sufficient feed available to start only one train.
Examples of the problems encountered in extraction were as follows:
1. Early on, there was extensive down time with the centrifuges. The water nozzles in the centrifuges very frequently wore out, requiring a centrifuge to be taken off line, torn down and the nozzles repaired. The balls in the centrifuges (which came from Sweden) were also wearing out with the result that, at any one time, a third of Syncrude’s stock of centrifuges was in transit to or from Sweden, and a third was under repair in Sweden, leaving only the remaining third working. Further, muskeg fibres got into the very fine openings in the centrifuges through which water and clay were intended to pass, requiring frequent shutdown to clean these out. This was all occurring during 1978. These problems were subsequently resolved and today the centrifuges run for long periods of time without interruption.
2. There were problems with the screen system requiring large amounts of time to maintain.
3. There was a lack of instrumentation to control the process in the primary separation vessel.
4. The rake that "stirred" the sands in the primary separation vessel would frequently burn out.
Examples of the problems encountered in upgrading are as follows:
1. The cokers at Syncrude are the largest in the world and problems were encountered in getting them to run. It was necessary to learn how to achieve proper operating conditions, such as temperature, feed rates, the rate the coke is moved around inside the coker, and the size of the coke particles themselves. It was also necessary to learn how to achieve design (or near design) throughput rates. Initially, coker throughput was well below design rates, due in part to problems with the coker (also due to limitations in feed rates to the coker, caused by problems in mining and extraction). Further, changes were required in the coker internals and to operating procedures to resolve problems with the coke removal system and to fix damage caused by sudden fluctuations in operating conditions.
2. The cokers are the core of upgrading and any disruption to coker operation forces a shutdown of the plant. In addition, the turnaround time is much longer for an unplanned as opposed to a planned shutdown. In a planned shutdown, the feed rate to the coker can be adjusted and the coker can be shut down empty, in which case, it may take only a day or two to weather the shutdown and get it running again. In an unplanned shutdown, the coker suddenly shuts down full of bitumen and coke, which hardens, thereby making it very difficult and time consuming to clean the coker out. The turnaround caused by an unplanned shutdown is even longer in the winter months. In the early years, including 1978, there were many unplanned shutdowns of the cokers. In addition to problems with the cokers themselves, these were caused by problems with the services that support the cokers. For example, any interruption in power supply to a coker, however brief, would cause an unplanned shutdown. Coker 8-1, also referred to as coker No. 1, went down in September 1978 for 91 days. There appears to be two reasons why it was down for so long. Firstly, it took a long time cleaning it out, and making repairs was very time consuming. Secondly, an employee of Gulf indicated that there may not have been enough feed to supply two cokers. Coker 8-1 was down for an additional 193 days in 1979 which again may have been because of a lack of feed.
3. There are a few thousand miles of piping which sit outside in the wintertime and problems were encountered in the systems which prevent this piping from freezing. In the winter of 1978-79, the electrical heat tracing (which was the technique originally used) failed in numerous locations throughout the plant, resulting in frozen lines and many interruptions. The steam based system (which replaced the heat tracing) was itself a problem, as the plant was short of steam.
Problems during the "debugging period" also affected the auxiliary plants. Examples of these are as follows:
1. The standard to which the utilities plant was designed was found to be inadequate for purposes of supporting upgrading. Any interruption in the power supply to a coker would cause an unplanned coker shutdown. In addition, in the early years, the many safety checks in utilities would detect problems in operating conditions and shut down the plant, again causing an unplanned coker shutdown. These sudden shutdowns were made more frequent by faulty instrumentation in the utilities plant. Further, the cogeneration unit, which was supposed to supply steam to the utilities plant, collapsed and never worked, causing a shortage in the power supply. These problems continued throughout
1978.
2. Some time in 1979, one of the main compressor units in the hydrogen plant exploded, resulting in the loss of half of the hydrogen plant.
In addition, there were general problems that affected each part of the operations during the "debugging period". Examples of these are as follows:
1. As stated above, Syncrude is a highly complex integrated facility. Thus, problems encountered in one part of the operations affect the whole operation. It took some time for the various parts to work together efficiently.
2. The technology used at Syncrude was "new technology" as defined in various studies done by the Rand Corporation. To provide some examples some of the technology was wholly new, there were new configurations of existing technology, much of the technology had never previously existed on as large a scale, and all of the technology was new to the staff who were going to run Syncrude: "the staff that were going to operate [the technology] were all green". It was therefore necessary for the staff to learn how to run the various complex machinery and procedures had to be developed for the maintenance of this machinery with a minimum of interference with operations.
3. There was a totally new organization brought in to run Syncrude. There was a fresh staff of 3,500 employees and approximately 2,000 contract personnel. It took some time for them to work together as an organization.
Dr. Devenny testified that Syncrude would not have been viable and would have been terminated if the problems experienced in 1978 persisted and it was expected that they were not repairable. The output would have been too low, since cokers 8-1 and 8-2 were both operational at the same time for only six days during 1978. Dr. Devenny testified that the debugging period for Syncrude was from July 1978 to April 1980.
F. Accounting
The plaintiff accounted for its interest in Syncrude in 1978 on a capital basis. It capitalized (1.e., included in its share of the costs of the Syncrude plant and equipment) its share of the costs incurred at Syncrude in 1978 (all costs, not merely those on tangible capital), after netting (deducting) the "incidental revenue" or "early flow of revenue" received from the sale of its share of the output of synthetic crude oil at Syncrude in 1978 ($7 million).
The plaintiff continued to capitalize all of its costs and net revenues to the balance sheet up to March 1979, when it commenced to amortize its costs on the income statement. According to Mr. Quinn, the plaintiffs manager of taxation, the plaintiff started accounting for the Syncrude revenues on a profitable basis in March 1979 because of a significant event which occurred at that time. He described the significant event as the production of the five millionth barrel of oil which triggered the account for the Alberta royalty calculations and it also triggered the account for the Alberta loan conversion. However, Mr. Quinn admitted that this was not a normal measure of commercial production. I agree with Mr. Quinn, but this does not mean that management was wrong in concluding there was no commercial production in 1978. It is of no assistance to me that Imperial Oil chose to commence amortizing the costs when it had production of 30,000 barrels for 30 consecutive days. I was not provided with any rationale for this policy and, accordingly, I do not find it to be relevant to the matter before me.
This accounting policy derived from the following decisions of management:
I. Syncrude was not yet substantially complete and capable of reasonable commercial output in 1978; and
II. given the status of Syncrude in 1978, accounting on a capital basis was the proper accounting policy.
I am satisfied that Syncrude was not capable of reasonable commercial output in 1978. The plaintiffs accounting policy was in accordance with generally accepted accounting principles (GAAP). The alternative accounting method was for the plaintiff to account for its interest in Syncrude in 1978 on a profit and loss basis. Given management’s decision regarding the status of Syncrude in 1978, the plaintiff’s accounting policy (i.e., capitalization) gave a truer picture of its financial position with respect to Syncrude than this alternative.
Following from its accounting policy, no amount with respect to Syncrude was shown in any profit and loss statement of the plaintiff in 1978. From a financial accounting perspective, the plaintiff had no ’’income” or "loss” from Syncrude in 1978. While "income" equals "revenue" minus "expenses", the "revenue" and "expenses" must be related to profitmaking activities for there to be "income".
G. Processing
Tar sand (bituminous sand) is petroleum. Bitumen is petroleum. The froth (dirty bitumen) that comes off the top of the primary separation vessel in the extraction plant is petroleum. A diluted crude product is achieved in the extraction plant some place between the froth stage and where the diluent (naphtha) is added to go through the centrifuges. The material handled throughout extraction and upgrading is petroleum and such material becomes a lighter, more concentrated and purer form of petroleum as it progresses through these components. Diluted crude, similar to that which is the output of the extraction plant, is received by refineries. The activities that take place in upgrading at Syncrude are very similar to the activities that take place in a typical refinery, and the equipment used in upgrading is similar. The upgrading at Syncrude and a typical refinery both have fractionation, gas oil and naphtha hydrotreating, hydrogen generation, the blending of treated products to make a saleable product, cokers, a very large utilities plant supplying steam, air and power, sulphur plants, etc.
Income tax legislation
In order to review the Syncrude issue, it is necessary to review section 1204 of the Income Tax Regulations. The relevant parts of subsection 1204(1) are as follows:
1204(1) For the purposes of this Part, "resource profits" of a taxpayer for a taxation year means the amount, if any, by which the aggregate of
(b) the amount, if any, of the aggregate of his incomes for the year from
(i) the production of petroleum, natural gas or related hydrocarbons from oil or gas wells in Canada operated by him,
(ii) the production in Canada of
(A) petroleum, natural gas or related hydrocarbons, or
(B) metals or minerals to any stage that is not beyond the prime metal stage or its equivalent,
from mineral resources in Canada operated by him,
exceeds
(c) the aggregate of his losses for the year from the sources described in paragraph (b),
computed in accordance with the Act, on the assumption that he had during the year no incomes or losses except from those sources and was allowed no deductions in computing his income for the year other than
(f) such other deductions for the year as may reasonably be regarded as applicable to the sources of income described in paragraph (b)....
The words "mineral resource" and "minerals" are defined in section 248 of the Act as follows:
"Mineral resource".-"mineral resource" means
(a) a base or precious metal deposit,
(b) a coal deposit,
(c) a bituminous sands deposit, oil sands deposit or oil shale deposit, or....
"Minerals".—"minerals" do not include petroleum, natural gas or related hydrocarbons (except coal, bituminous sands, oil sands or oil shale);
Evidence ruling
During the course of the trial I was asked to make a ruling with respect to proposed evidence to be given by Robert Clark, Director of Tax Legislation Interpretation with Natural Resources Canada, since the summer of 1991. He was going to provide evidence with respect to the ad- ministrative policy on the prime metal stage, which is relevant under Regulation 1204(1). This subsection provides that resource profits means the amount, if any, of the taxpayer’s incomes for the year from "(B) metals or minerals to any stage but not beyond the prime metal stage or its equivalent, from mineral resources in Canada operated by him". Gulf took objection to this evidence on four grounds:
1. Mr. Clark was testifying on a matter of law;
2. he was asked for an opinion and is not qualified as an expert;
3. the evidence is irrelevant in any event; and
4. the evidence is hearsay.
The Crown submitted that the evidence was admissible pursuant to the judgment of Mahoney J.A. in Canadian National Railway Co. and Canadian Pacific Ltd. v. Canada (1994), 171 N.R. 64 (F.C.A.). In that case the appellant, The Queen, argued that the conclusion that the "prime metal stage" is reached at the point where a metal is refined to the point of purity is nourished by a departmental excise tax ruling dated March 25, 1985. The Court of Appeal was dealing with a published ruling. Mahoney J.A. stated at page 74:
Departmental rulings are not definitive but, I accept, departmental policy and practice is not irrelevant. I do not think, however, that the appellants can draw comfort from the ruling recited above....
The Crown took the position that it was not relevant to the decision that the departmental ruling was published.
However, in my view there is a distinction between administrative policy or rulings which are published and those which are unpublished. I am in agreement with the reasoning of Muldoon J. in Fibreco Pulp Inc.. v. Canada, [1994] 2 C.T.C. 114, 94 D.T.C. 6325, where he stated at page 123 (D.T.C. 6330):
The subjects of the admissibility of the defendant’s administrative practice in regard to the legislation in question, and of the use of Hansard, both as aids to the interpretation of that selfsame legislation, were debated by the parties’ respective counsel at great length. The defendant’s counsel sought strenuously to introduce both categories of evidence and the plaintiffs’ counsel objected adamantly.
There is one factor common to both subjects which militates against the admission of the evidence, and that is the rule of law. It will be discussed further on in these reasons.
Muldoon J. continued at pages 128-29 (D.T.C. 6334):
The defendant sought to introduce the government’s administrative practice in dealing with first grantees and later taxpayers in order to bolster its case against the present plaintiffs. Included would be policy formulations and memoranda between government offices. This is rather like communications between one synapse of the government’s "brain", and another synapse-it is all within the government’s "mind". It is utterly disregarded by this Court on that very basis. To do what the defendant wants to do here is to breach the rule of law, whose principles inform and motivate the Constitution of Canada.
Given that in this tax case, as in all others where the government is the adversary with all the weight of the eternal intimidating State, the previous unadjudicated practices of the government’s servants unfairly bear on the taxpayers. To assert that government’s view of the law can be proved and enforced because its view is supported by how the government has previously always dealt with taxpayers is to assert autocracy. Fair enough if the government puts its view of the law before the Court in intellectual competition with the plaintiffs’ view, but when the government seeks to adduce evidence of its own previous practices to support the alleged correctness of its own interpretation of the law, the government seeks to breach the rule of law.
It would be condoning special pleading to permit the proof of public servants’ own agreed internal interpretations of the law to be offered to the Court in support of the government’s contentions....
He went on to find that if the government believes that the advice was so good in interpreting statutory provisions at page 129 (D.T.C. 6335):
...the Crown may submit the same advice in the form of legal argument to the Court. If the Crown adopts that advice as argument, it will be before the Court, without its being considered to be evidence....
The case of Fibreco Pulp Inc., supra, is under appeal but until such time as the result may be changed, I agree with the reasoning contained therein. I do agree with the Crown that where the Government’s policy 1s set out in published rulings or interpretation bulletins, such as are published by Revenue Canada, that this part of administrative policy can be admitted. I, therefore, rule that if Mr. Clark had any published administrative policy to present to the Court, that he could be questioned on this, but I will not permit the introduction into evidence of unpublished administrative policy. The Crown should not be able to elevate a good argument on the interpretation of Regulation 1204 into evidence.
I do not agree with the plaintiff that the evidence of Mr. Clark was expert opinion. The Crown specifically stated that it did not intend to ask Mr. Clark his opinion of any of the policy, but rather solely on what was the policy with respect to the prime metal stage.
In my view the Crown is not assisted by Hard v. D.M.R. (Quebec), [1978] 1 S.C.R. 851, [1977] C.T.C. 441, 77 D.T.C. 5438, at page 859 (C.T.C. 448, D.T.C. 5442), where de Grandpré J. states:
Once again, I am not saying that the administrative interpretation could contradict a clear legislative text, but in a situation such as I have just outlined, this interpretation has real weight and, in case of doubt about the meaning of the legislation, becomes an important factor.
Following my ruling the Crown elected not to ask any further questions
of Mr. Clark and he was not cross-examined by counsel for Gulf.
Analysis
The parties agree with respect to the following two matters. Firstly, there is a bituminous sand deposit at Syncrude, and secondly, if Syncrude was being operated in 1978 it was operated by Gulf as a participant in the Syncrude project.
In 1978, the plaintiff, in calculating its general or worldwide income, deducted capital cost allowance (CCA) with respect to the assets at Syncrude. It also deducted the interest paid to the Alberta government with respect to a loan incurred to purchase its interest in Syncrude. Under the Income Tax Act calculation of resource profits is a separate code and distinguished from the calculation of income under Part I. When one looks at paragraph 1204(1)(f), the effect of it is that if Syncrude is not the source of income under paragraph 1204(l)(b) the CCA deduction and the interest deduction cannot reduce income, because it cannot be reasonably regarded as applicable to the source of income described in paragraph (b). Accordingly, the key issue is whether Syncrude is a source of income under paragraph 1204(l)(b).
The plaintiff Gulf submits that whatever production means under Regulation 1204(1)(b) it cannot include processing petroleum, natural gas or related hydrocarbons. Gulf relies on Regulation 1204(3) which reads as follows:
1204(3) Income or loss from a source described in paragraph (l)(b) does not include income or loss derived from transporting, transmitting or processing petroleum, natural gas or related hydrocarbons.
Subsection 1204(1) of the Regulations requires a taxpayer to compute its "resource profits" by determining the amount by which the aggregate of the taxpayer’s incomes for the year from the various "sources" described in paragraph (b) exceeds the aggregate of the taxpayer’s losses for the year from those "sources". "Resource profits" is a "source-by-source" computation. It includes each of the types of "sources" of income described in paragraph 1204(1)(b), from (i) through (v), and any number of "sources" within each type.
For the purposes of the "resource profits" computation, incomes and losses from the "sources" described in paragraph 1204(1)(b) are to be determined in accordance with the provisions of the Act, on the assumptions that the taxpayer had no incomes or losses except from those "sources" and was allowed no deductions in computing such incomes and losses other than those specifically enumerated in paragraphs (d) through (f).
This is not the first case between the parties dealing with Syncrude and whether it is a "source" of income. Gulf Canada Ltd. v. The Queen, [1991] 1 C.T.C. 99, 90 D.T.C. 6622 (F.C.T.D.); aff’d [1992] '1 C.T.C. 183, 92 D.T.C. 6123 (F.C.A.), leave to appeal to the Supreme Court of Canada refused in [1992] 2 S.C.R. ix, dealt with the plaintiff’s 1974 and 1975 taxation years and the predecessor provisions to subsection 1204(1) of the Regulations. It was determined in that case that Syncrude was not a "source” of income under those provisions in those years. The case was heard by McNair J., in the Trial Division, and his judgment was upheld on appeal in a unanimous decision of the Court of Appeal delivered by Hugessen J.A. Leave to appeal to the Supreme Court of Canada was refused.
The parties have consented to judgment for the 1976 and 1977 taxation years on the basis that Syncrude was not a "source” of income in those years. The legislation at issue in those years was the same as the legislation before this Court.
Subsection 1204(1) of the Regulations sets up a separate and complete code for the determination of a taxpayer’s "resource profits”. See McNair J. in Gulf, supra, at page 112 (D.T.C. 6632):
In my opinion, sections 124.1 and 124.2 [the predecessor provisions to subsection 1204(1)] set up their own separate scheme of inclusions and exclusions from income for purposes of the special incentive programs.
It is apparent that the concept of a separate code extends to both income inclusions and deductions. A "source" of income is relevant in the computation of "resource profits”, and an income or loss computation is to be made in respect of such "source”, only if it is found to be one of the enumerated "sources" of income in paragraph 1204(1)(b). Similarly, a deduction is to be taken in the computation of incomes and losses from the enumerated "sources" only if the deduction is described in one of paragraphs 1204(1)(d) through (f). In the case at bar only paragraph 1204(1)(f) is relevant.
The "sources" of income described in paragraph 1204(I)(b) of the Regulations are much more specific and, thus, narrower in scope than the "sources" of income which are relevant in computing a taxpayer’s income under Part I of the Act (which calculates income from all "sources"). The primary "sources" of income under Part I are business, property and employment, whereas paragraph 1204(1 )(b) of the Regulations describes a limited number of narrow and specific "sources".
Hugessen J.A., for the Court of Appeal in Gulf, supra, recognized this, at page 186 (D.T.C. 6126):
The structure of the two sections [the predecessor provisions to subsection 1204(1) of the Regulations] is clearly such as to identify and isolate income from certain specific and described "sources" of income and then to subtract, therefore (sic), the aggregate of the losses from those same sources together with five specific and described categories of "deductions"....
Hugessen J.A. restates this principle later in his judgment. Having recognized that "source" of income means "business", he states in the passage set out below that it does not follow that the "sources" of income described in paragraph 1204( 1 )(b) refer to Gulf’s "upstream business" or its overall "business", at page 187 (D.T.C. 6127):
That does not, however, assist us in determining what is meant by "production" or what is included in the business; it certainly does not support the Crown’s argument that "production" comprises the whole of the "upstream" end of the taxpayer’s business, including exploration and development and whether or not there is any actual production, a contention for which there is no warrant whatsoever in the sections. The taxpayer, as an integrated oil company, also has refining, distribution and marketing as parts of its whole business, but it could not be seriously suggested that they, too, should be included in the concept of production as a source of income....
The "source" of income at issue in this action 1s described in subparagraph 1204(1 )(b)(ii) of the Regulations. That subparagraph refers to:
incomes...from...the production in Canada of...petroleum, natural gas or related hydrocarbons, or...metals or minerals to any stage that is not beyond the prime metal stage or its equivalent, from mineral resources in Canada operated by him.
Subparagraph 1204(l)(b)(ii) contains two clauses, clause (A), which refers to "petroleum, natural gas or related hydrocarbons", and clause (B), which refers to "metals or minerals to any stage that is not beyond the prime metal stage or its equivalent". These clauses merely describe the subject matter of the "production".
Hugessen J.A. dealt with the question as to whether clause (A) was the relevant clause for determining the existence of a source of income in Gulf, supra, when he stated at page 186 (D.T.C. 6126):
Again, for present purposes, the "source" of income described in paragraph (l)(b) of both sections which is of concern to us is the "production" of "petroleum, natural gas or related hydrocarbons" from mineral resources or oil or gas wells in Canada "operated by" the taxpayer.
In that case however, Hugessen J.A. did not address the question of clause (B). As a result, the question as to whether (A) or (B) was the proper clause was not argued; both parties proceeded on the assumption that Syncrude fell under (A). Hugessen J.A. established the applicability of clause (A) in his decision. I have discussed clause (A), and its relevance to the present case, below. The parties were not in agreement however, on the applicability of clause (B). Gulf has argued that clause (B) has been precluded from this matter as a result of Justice Hugessen’s decision. The Crown did not accept this argument and I agree the question is not res judicata since the question was not argued. As a result, I find it necessary to briefly examine clause (B) in conjunction with the facts of this case.
In this instance, the Crown submitted that Syncrude met the following tests. There must be production in Canada of minerals to any stage, not beyond the prime metal stage or its equivalent, from a mineral resource in Canada operated by the taxpayer. Thus, Syncrude: constituted a source within the meaning of clause 1204(l)(b)(ii)(B) in 1978. I cannot agree with the Crown that the Syncrude project is a mine from which a mineral-oil sands-is produced to the synthetic crude oil stage. The definition of "minerals" in subsection 248(1) of the Act states:
"Minerals".-"minerals" do not include petroleum... (except...bituminous
sands...)
Parliament has clearly stated that bituminous sand is petroleum.
The Crown contends that minerals are not petroleum, however, the definition of "minerals" excludes only certain forms of petroleum. In particular, bituminous sands are excluded from the types of petroleum which are deemed not to be "minerals". Accordingly, bituminous sand is both a mineral and petroleum.
Clause (B) covers the activities done to get materials to the equivalent of the prime metal stage, that is, in the case of Syncrude, to the prime mineral stage. By definition under the Act, the mineral is the bituminous sands. Therefore, Syncrude has already achieved the prime mineral stage with mining. That is, the material entering the extraction plant, bituminous sands, is already to the prime mineral stage. Consequently, Syncrude is not processing to the prime mineral stage, because the material had already arrived at that stage at the start of the processing. None of the processing which occurs at Syncrude makes the material a "purer" form of bituminous sands.
Any processing which occurs at Syncrude is processing of material after the prime mineral stage has been reached. I reach this conclusion by applying the definition of "mineral" to the facts at Syncrude. The evidence of the witnesses was that petroleum is a broad concept encompassing a range of material, including the bituminous sands, the bitumen removed therefrom, diluted bitumen, naphtha, heavy gas oil, light gas oil and synthetic crude oil. By definition none of these forms of petroleum, except the bituminous sands, are a "mineral". Therefore, processing of the nonmineral petroleum substances cannot be regarded as processing to the prime mineral stage but rather in the case of Syncrude it is processing at or beyond that stage.
Further, the subsequent amendment of subparagraph 1204(l)(b)(ii) 1s clearly founded upon the premise that activities carried on at tar sand locations subsequent to the lifting of the bituminous sands are the "processing" of such sands. Effective for taxation years commencing after November 12, 1981, subparagraph 1204(l)(b)(ii), as it applies to a bituminous sands deposit, reads as follows:
(ii) the production and processing in Canada of
(C) tar sands ore [defined to include ore extracted from a mineral resource that is a deposit of bituminous sand] from mineral resources in Canada operated by him to any stage that is not beyond the crude oil stage or its
equivalent
It is apparent from this amended language that the activities being carried on in extraction and upgrading now constitute "processing" for purposes of section 1204, including subsection 1204(3) of the Regulations.
This conclusion is confirmed by reference to the contemporaneous amendment to subsection 1204(3) of the Regulations. As amended, that subsection provides:
1204(3) Income or loss from a source described in paragraph (1)(b) does not include income or loss derived from transporting, transmitting or processing (other than processing described in clause (1 )(b)(ii)(C), (iii)(C) or (iv)(C) or subparagraph (l)(b)(v)) petroleum, natural gas or related hydrocarbons.
If "processing" the bituminous sands, such as which occurs in extraction and upgrading at Syncrude, was not "processing...petroleum" as that phrase appears in the subsection, it would be unnecessary to specifically exclude it therefrom. I agree with the plaintiff’s submission that these amendments are so fundamental that it cannot be held to be declaratory. Accordingly, subsection 45(2) of the Interpretation Act is not applicable as suggested by the Crown.
Accordingly, such activities as extraction and upgrading cannot fall within clause (B). I cannot agree with the defendant that an interpretation of production that would exclude processing would also result in anomalies in the scheme of the Act. For example, as subparagraph 1204(l)(b)(iii) applies only to "processing...to any stage that is not beyond the prime [mineral] stage...", processing of bituminous sands from a mineral resource not operated by the operator of the plant would not fall within this subparagraph for the same reasons that such processing at Syncrude does not fall within clause (B) of subparagraph 1204(l)(b)(ii) of the Regulations. Therefore, the disharmony which the defendant alleges does not occur. As stated earlier, the deduction in paragraph 1204(l)(f) may be taken in the computation of income and losses from the enumerated sources. Under that paragraph, a deduction is to be taken in the computation of "resource profits" only if, or to the extent that, the deduction "may reasonably be regarded as applicable to" the "source" of income described in paragraph 1204(1)(b). The phrase "may reasonably be regarded as applicable to" was interpreted by Rand J. in Home Oil Co. v. M.N.R., [1955] S.C.R. 733, [1955] C.T.C. 192, 55 D.T.C. 1149, as meaning "specifically or directly related to" (at page 736 (C.T.C. 196, D.T.C. 1150)).
Accordingly, for the purposes of this action, the plaintiff’s capital cost allowance claim and interest expense are deductible in the computation of its "resource profits" only if or to the extent they are:
...specifically or directly related to incomes...from...the production in Canada of...petroleum, natural gas or related hydrocarbons...from mineral resources in Canada operated by him.
The amount arrived at as the plaintiff’s "resource profits" 1s used for the
purpose of determining the following:
I. the plaintiff’s "depletion deduction" authorized by section 65 of the Act and section 1200 of the Regulations, and
II. the plaintiffs "resource allowance" authorized by paragraph 20(l)(v.l) of the Act and section 1210 of the Regulations.
These are referred to as the "special incentive programs" mentioned by McNair J. in Gulf, supra.
I will now review why, in my view, there was no source of income in 1978 from Syncrude or any part thereof.
1. The requirement for a "business"
Production is not a source of income in and of itself. For there to be a source of income described in subparagraph 1204(l)(b)(ii) of the Regulations, there must be the "business" of "production". It follows from the requirement for a "business" that "production" in the context of the computation of "resource profits" requires more than the mere extraction of material from the ground since it cannot in itself generate income. A "business" is a profit-making activity and, accordingly, "production" as a "business" must include the disposition of the material by sale or otherwise.
In Gulf, supra, the Crown advanced the argument that "production" in the computation of "resource profits" means the "business" of "production". Hugessen J.A., at page 187 (D.T.C. 6127), stated:
Finally, we would simply mention the Crown’s argument to the effect that "production" simpliciter cannot be a "source" of income and that it is rather the "business" of production which is in fact the source. To the extent that the argument is one of semantics, it is meritorious but sterile. It is true that the mere physical act of taking minerals or oil or gas from the ground does not and cannot produce income; when Parliament has described “production” as being a "source", as it clearly has in sections 124.1 and 124.2, [the predecessor provisions to subsection 1204(1)] it must be understood as the business of production....
Judson J. in Imperial Oil Ltd. v. M.N.R., [1960] S.C.R. 735, [1960] C.T.C. 275, 60 D.T.C. 1219, at page 749 (C.T.C. 288 (D.T.C. 1224), took the same view of the requirement for a business when he stated.
No company makes an actual profit merely by producing oil. There is no profit until the oil is sold....
The same principles have been applied in the context of the phrase "income derived from the operation of a mine". That phrase appeared in a three-year exemption from tax granted to "new mines" which was found in various sections of the Act and the Income Tax Application Rules. Mahoney J.A., in We star Mining Ltd. v. Canada, [1992] 2 C.T.C. 11, 92 D.T.C. 6358 (F.C.A.), summarized the principles as enunciated in similar cases. After reviewing M.N.R. v. Bethlehem Copper Corporation Ltd., [1973] C.T.C. 345, 73 D.T.C. 5281 (F.C.A.); aff’d [1975] 2 S.C.R. 790, [1974] C.T.C. 707, 74 D.T.C. 6520; Falconbridge Nickel Mines Ltd. v. M.N.R., [1972] C.T.C. 374, 72 D.T.C. 6337 (F.C.A.), and Gunnar Mining Ltd. v. M.N.R., [1968] S.C.R. 226, [1968] C.T.C. 22, 68 D.T.C. 5035, Mahoney J.A. stated at page 17 (D.T.C. 6363), of Westar, supra:
It is the operation of a mine as an economic activity, not the physical acts involved in extracting and processing, that generates income.
2. When a "business" comes into existence
There are two conditions to the existence of a "source" of income. The first is a reasonable expectation of profit. This question has generally been examined in the context of cases in which losses have been claimed in respect of farming businesses. Dickson J. in Mo I do wan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, at page 485 (C.T.C. 313, D.T.C. 5215) stated:
Although originally disputed, it is now accepted that in order to have a "source of income" the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term to business: Dorfman v. M.N.R., [1972] C.T.C. 151,72 D.T.C. 6131....
The question then becomes what is the threshold for a reasonable expectation of profit. I point out that the difference between the case at bar and most of the previous cases is that in the previous cases the taxpayer wants the date of commencement of existence of the business to be as early as possible and the Minister has been opposed. In this case, due to the unusual nature of resource profits, the parties are on the opposite sides as the taxpayer is seeking to put off the commencement date for the existence of the business. Taylor J.T.C.C. in McClure v. M.N.R., [1988] 2 C.T.C. 2140, 88 D.T.C. 1504, at pages 2154-55 (D.T.C. 1514), stated:
I am not impressed with the view that "a source of income", means merely that revenue can or will be generated. The operation should have the potential, not only of producing revenue, but the prospect-even the fairly immediate prospect in most cases-of showing an excess of revenue over expenditures. The word "income", even in the phrase "source of income", as I understand it, has a much closer affinity to "profit", than merely to "revenue" (see section 9 of the Act). The term "start-up costs" in my view, does not represent all outlays and expenses incurred to start a business, it does signify the accumulation of such outlays and expenses from the start of the business up to the point of profit. A "business", is an economically viable operation from which it can be determined at that point in time that there is a "reasonable expectation of profit”. "Reasonable" is a term encompassing both objective and subjective considerations; "expectation", means something more than mere "hope"-perhaps it is closer to "anticipation"; and "profit", is a calculation taking into account the Act and GAAP, with little need for subjectivity in my view....
This demonstrates that "start-up" refers to the period from the commencement of a "business" to the date when the "business" realizes a profit.
Start-up costs depend on the facts in each case. See Cullen J. in Timpson v. The Queen, [1987] 1 C.T.C. 389, 87 D.T.C. 5266 (F.C.T.D.), at page 394 (D.T.C. 5270); (reversed on other grounds, [1993] 2 C.T.C. 55, 93 D.T.C. 5281 (F.C.A.)). Start-up costs must be distinguished from costs which are properly characterized as being anterior to the commencement of the business, as in the case of Merchant v. The Queen, [1984] C.T.C. 253, 84 D.T.C. 6215 at page 259 (D.T.C. 6220) (F.C.T.D.).
The plaintiff submits that before a business can be considered to exist, in addition to a reasonable expectation of profits, there must be a capital and asset base which is sufficiently constructed, improved and established so as to be structurally capable of supporting the operations which are expected to be profitable. The case law is not clear in this respect. In the farming cases, the taxpayers were working "to get the property to a condition which would support what they wanted to do with it". See Rip, J.T.C.C. in Craddock et al. v. M.N.R., [1986] 1 C.T.C. 2006, 86 D.T.C. 1014 (T.C.C.), at page 2009 (D.T.C. 1016).
In the case at bar, over 90 per cent of the capital expenditures had been completed, although $100 million remained to be spent. In my view, the more important feature is that the cokers were not fully operational, as evidenced by the fact that cokers 8-1 and 8-2 operated concurrently for only six days during 1978. Without both cokers operational, it is difficult to find that the operations were expected to be profitable. This same problem does not arise in the farming cases. In my view, a "source" of income comes into existence only when all the activities making up the "source" are being carried on. It is not sufficient that there is an expectation that the remainder of the activities that are not being carried on will follow shortly. See Sweet D.J. in Falconbridge Nickel Mines Ltd., supra, at page 378 (D.T.C. 6341), where he stated:
I am of the opinion that the relief which is granted by the quoted legislative provision is confined to the 36 months’ period during which that enterprise, in its entirety, and which has for its purpose the operation of the mine, is being conducted.
I agree with the Crown that there is a rebuttable presumption that income from an activity which was included in the constituting documents of a corporation was income from that business. However, as Taylor J.T.C.C. stated in McClure, supra, it is necessary to distinguish between determining that revenue can or will be generated and determining that profits can be expected. The test should be that the operation must have the potential not only of producing revenue, but also the prospect of showing an excess of revenue over expenditures in the fairly near future. Syncrude did generate $7 million of income in 1978, but it cannot be forgotten that this is a mega project and that $7 million revenue must be looked at in light of the $2,400,000,000 investment in the project. The facts in any tax case involving a mega project must be looked at very closely so that abstract numbers are not given undue influence.
3. No "business" at Syncrude in 1978
In my view there was no source of income described in subparagraph 1204(1 )(b)(ii) of the Regulations at Syncrude in 1978. As stated earlier, in assessing whether a "source" of income existed at Syncrude in 1978, I must look at the overall operations and not into any particular part of those operations. The only "source" of income which can be found to exist at Syncrude is the "production" of synthetic crude oil. I found that: (1) Syncrude was designed to produce synthetic crude oil from bituminous sands mined from a bituminous sands deposit; and (2) there was no marketable product at Syncrude other than synthetic crude oil, as neither the bituminous sand (the output from mining) nor the bitumen (the output from extraction) was marketable.
In addition, in assessing whether a "source" of income existed at Syncrude in 1978, when I look at all the parts of the operations, including all the equipment that makes up the various trains, the duplicate production trains that make up the various components, and the three main and additional auxiliary components that make up these operations, I do not find that they were working together at the design rates of production for sustained periods without interruption during 1978. I find that in 1978 Syncrude was not capable of being operated on a scale which could be expected to be profitable in 1978 or the near future. The plant could not attain output of crude oil in quantities that could give rise to profits. At no time in 1978 was the plant capable of being profitable.
I accept the evidence of Dr. Devenny. Dr. Devenny is one of the few experts in the world on mega projects. I realize that he was employed by the plaintiff in the past and continues to represent the plaintiff in the Syncrude project, but his evidence was candid, forthright and very credible. I do not accept the position of the defendant that his evidence was not supported by academic writings. Since mega projects are so rare in the world today, one would hardly expect there to be a vast amount of literature on the subject. In any event, there was no literature produced that contradicted the testimony of Dr. Devenny. I have earlier reviewed much of Dr. Devenny’s testimony and do not intend to review it in detail again at this time. Dr. Devenny testified that Syncrude would not have been viable and would have been terminated if the problems experienced in 1978 persisted and it was determined that they were not repairable. This evidence is important to the issue of Syncrude’s viability as a business. Dr. Devenny’s evidence with respect to whether there was a source of income in 1978 was supported by the plaintiff’s expert in accounting. While the defendant’s accounting expert’s evidence was very helpful on whether GAAP mandated a particular accounting treatment, she expressed no opinion as to when a source of income came into existence at Syncrude. I find that the necessary economic elements were not in place and therefore determine that there was not a business at Syncrude in 1978.
Dr. Devenny testified that in mega oil sands projects such as these there must be an intermediate phase between the time you finish construction and the time you start commercial production. In his opinion, in 1978 Syncrude was in this intermediate period which he called the start-up mode. He agreed with counsel for the Minister that a coker was working and barrels of oil were coming out. The significance of this was Syncrude had a product that could be marketed. He said, however, that there is no market for bitumen until there 1s a commencement of the upgrading process. He therefore selected April 1980 as the date production started. He selected that date because it met the accounting definition of production and it is significant also that the plant had produced five million barrels of oil. Furthermore, the designer was off the hook after the plant was running for 12 months, which by this time it had. Despite this, Dr. Devenny did not think that 60 per cent of design rate was a good guideline, since the plant was not economic at that rate. He testified that he wanted to delay production commencement until there was a positive rate of return.
I am satisfied that the plaintiff has met the onus of showing that the two deductions relating to the Syncrude issue should not have been deducted and the plaintiff is entitled to judgment accordingly.
In light of my finding that there was no source of income as described in paragraph 1204(l)(b) of the Regulations at Syncrude in 1978, I do not have to deal with the alternative arguments relating to attribution and prorationing of income.
Issue Il-water intake line
In computing the plaintiffs capital costs of properties described in class 29, Schedule II of the Regulations, for the purpose of determining the plaintiffs capital cost allowance pursuant to paragraph 21(a) of the Act, and for the purpose of determining the plaintiffs investment tax credit under subsection 27(9) of the Act, the Minister deducted the amount of $1,088,967.
Evidence
There was a statement of agreed facts with respect to the Clarkson Refinery water intake, the relevant parts of which I shall set out:
The parties agree to the following facts being true but reserve the right to introduce further evidence at trial and to make submissions as to the relevance of any of the agreed facts:
1. During the 1978 taxation year, the plaintiff owned the Clarkson Refinery ("the refinery") located on Lake Ontario west of Toronto.
2. The refinery processed crude oil into consumer products, including gasoline. This crude oil was delivered to the refinery through the interprovincial pipeline from western Canada.
3. The refinery could not operate without water and, in particular, required water for four purposes:
— as a coolant in the heat exchangers
— as make-up water to the lube area cooling system — to produce steam in the utility plant
— to fight fires
4. Approximately 80 per cent of the water used in the refinery was used as a coolant in the heat exchangers. These were pipes which ran in close proximity to the processing units in order to draw off the heat. The water circulated through these pipes on a once through basis.
5. The remaining 20 per cent of the water was used in other areas of the refinery. Approximately ten per cent was used in the area where lubricating oils were made. It acted as a coolant, but unlike the water circulating through the heat exchangers, this water was used to top up a closed system and was recirculated. The other ten per cent was used to feed the boilers in the utility plant which furnished steam for the processing unit.
6. The water used as a coolant in the heat exchangers was untreated other than being chlorinated which was done in the pumphouses. The water used in the lube area and the utility plant required additional chemical treatment to adjust the PH level and the mineral content.
7. The facilities which supplied water to the refinery served three functions:
(A.) to bring water into the refinery; (B.) to store the water; and (C.) to distribute the water throughout the refinery
A. The Water Intake
8. Water was supplied to the refinery via two concrete water intake lines (lines "A" and "B") which extended into Lake Ontario and were buried approximately three feet below the lake bed.
9. The water intake lines commenced inside the refinery and extended into Lake Ontario. Most of the length of the line was outside the refinery.
10. The main water intake was line B, built in two stages. The first stage was built in 1954. It was six feet in diameter and extended into the lake approximately 900 feet to a depth of approximately 14 feet.
11. Algae build-up and ice restricted the flow of water and ultimately led to processing interruptions. To remedy this, a 2200- foot extension was added to line B in 1978 so that the intake extended approximately 3100 feet to a depth of 36 feet. This extension was seven feet in diameter.
12. At issue in this appeal is the extension made to line B in 1978.
13. Water flowed through the lines by means of gravity and without any power from pumps or other machinery and without requiring day to day operation.
14. The water flowed into the wells and rose to the level of the lake.
15. A screen covered the well intake to prevent any debris from reaching the wells.
16. The only routine maintenance of the lines and wells was an annual visual inspection.
17. The water intake lines were not built to specifications applicable to
pressurized lines.
B. Storage
18. The water from lines A and B was received in two wells (wells "A" and "B") located within the refinery boundaries approximately 15 feet from the shoreline of the lake.
19. These wells were rectangular concrete cisterns located side by side and joined together by a 3 foot x 6.8 foot concrete channel. They were built below ground and were approximately the following dimensions:
well A: 62 ft. long x 24.5 ft. wide x 25 ft. deep
well B: 29.6 ft. long x 28.3 ft. wide x 28 ft. deep
C. Distribution
20. Situated on top of the wells were pumphouses which housed pumps and other machinery necessary to chlorinate and pump the water from the wells.
21. There were 11 pumps located in these pumphouses which pumped the water to two main "header" pipes.
22. The water was distributed throughout the refinery by means of various pipes which branched off from these headers.
Three experts testified on the meaning of a pipeline. The plaintiff’s expert, Mr. Moffatt, concluded that the extension to intake line B was not a pipeline within the ordinary or technical engineering meaning of the term. I find that he did not substantiate this opinion from an engineering point of view. His opinion relied heavily on dictionary meanings of the term and he was not an expert on dictionaries. In his report, he set out the features of a prototypical pipeline as follows:
The pipeline would use steel pipes as a primary component, but would also include fittings, valves, pumps, control systems, communication systems, and other components. It would extend over a considerable distance (perhaps hundreds of miles), and would operate at elevated pressure. It would have been designed in accordance with specialized and specific pipeline engineering standards, and would be operated (typically by a distinct pipeline company) using specialized operators.
However, in cross-examination he admitted that there was little, and in many instances, no authority in his field requiring the presence of those features he believed were important for something to be a pipeline. In other instances, he himself admitted that these features were not necessary. He also admitted that the fundamental prototypical pipeline upon which he based his opinion was not adequately descriptive of many types of pipelines, only that he selected a type typical in the oil and gas industry.
I preferred the evidence of Professors Chakma and Nandakumar as being more representative of the view in the engineering field. However, I found their evidence was not definitive on the issue as to whether the Clarkson intake line is a pipeline. The word "pipeline" means different things to different people and much depends upon the purpose for which people wish to define it. In particular, Professor Nandakumar very candidly admitted on cross- examination that the word "pipeline" is used in different contexts depending upon who you are speaking with. Professor Nandakumar referred to certain engineering treatises and found that:
In all these sources, the term pipeline is used and understood to broadly mean a connected sequence of pipes used in the transportation of fluids from one location to another.
Both professors for the defence admitted, notwithstanding their definitions, a water intake line could be described simply as that and not a pipeline.
Legislation
With respect to the issue of whether the Clarkson Refinery water intake is a pipeline, the statutory framework is found in section 1100 of the Regulations where it sets out:
1100(1) For the purposes of paragraph 20(1 )(a) of the Act, there is hereby allowed to a taxpayer, in computing his income from a business or property, as the case may be, deductions for each taxation year equal to
Rates
(a) such amounts as he may claim in respect of property of each of the following classes in Schedule II not exceeding in respect of property
(1) of class 1, 4 per cent, (ii) of class 2, 6 per cent, (iii) of class 3, 5 per cent, (iv) of class 4, 6 per cent, (v) of Class 5, 10 per cent, (vi) of Class 6, 10 per cent, (vii) of class 7, 15 per cent, (viii) of Class 8, 20 per cent, (ix) of class 9, 25 per cent,
(x) of Class 10, 30 per cent, (xi) of Class 11, 35 per cent, (xii) of Class 12, 100 per cent, (xiii) of Class 16, 40 per cent, (xiv) of Class 17, 8 per cent, (xv) of Class 18, 60 per cent, (xvi) of Class 22, 50 per cent, (xvii) of Class 23, 100 per cent, (xviii) of Class 25, 100 per cent, (xix) of Class 26, 5 per cent,
(xx) of Class 28, 30 per cent, (xxi) of Class 30, 40 per cent, (xxii) of Class 31, 1 per cent,
(xxiii) of Class32, 10 per cent,
(xxiv) of Class 33, 15 per cent, and (xxv) of Class 35, 7 per cent,
of the undepreciated capital cost to him as of the end of the taxation year (before making any deduction under this subsection for the taxation year) of property of the class;
As well, class 2 and class 29 properties are described as follows:
Class 2 (6 per cent)
Property that is
(b) a pipeline, other than gas or oil well equipment, unless, in the case of a pipeline for oil or natural gas, the Minister in consultation with the Minister of Energy, Mines and Resources, is or has been satisfied that the main source of supply for the pipeline is or was likely to be exhausted within 15 years from the date on which operation of the pipeline commenced,
Class 29
Property, that would otherwise be included in another class,
(a) that is property manufactured by the taxpayer, the manufacture of which was completed by him after May 8, 1972, or other property acquired by the taxpayer after May 8, 1972,
(i) to be used directly or indirectly by him in Canada primarily in the manufacturing or processing of goods for sale or lease, or
(ii) to be leased, in the ordinary course of carrying on a business in Canada of the taxpayer, to a lessee who can be reasonably expected to use, directly or indirectly, the property in Canada primarily in the manufacturing or processing by him of goods for sale or lease, if the taxpayer is a corporation whose principal business is
(A) leasing property,
(B) manufacturing property that it sells or leases,
(C) the lending of money,
(D) the purchasing of conditional sales contracts, accounts receivable, bills of sale, chattel mortgages, bills of exchange or other obligations representing part or all of the sale price of merchandise or services, or
(E) selling or servicing a type of property that it also leases, or any combination thereof, unless use of the property by the lessee commenced before May 9, 1972, and
(b) that is
(i) property that, but for this class, would be included in class 8, but not including railway rolling stock or a property described in paragraph (e) of class 8,
(ii) an oil or water storage tank,
(iii) a powered industrial lift truck,
(iv) electrical generating equipment described in class 9, or
(v) property described in paragraph (b) or (fa) of class 10.
Analysis
The Clarkson Refinery issue is an example of a case in which the onus is very important. The law is clear that the onus is on the plaintiff to rebut the Minister’s assessment, as per Pollock v. Canada, [1994] 1 C.T.C. 3, 94 D.T.C. 6050 (F.C.A.). In my view, the plaintiff has not met this onus. As I stated earlier, Mr. Moffatt did not rely on his engineering expertise, but rather common dictionary meanings to establish that the water intake line was not a pipeline. Thus, although a water intake line is not always considered to be a pipeline, the evidence did not show on a balance of probabilities that the water intake line in question was not a pipeline.
The test that should be applied to pipelines was set out by the Federal Court of Appeal in Nova, an Alberta Corp. v. The Queen, [1988] 2 C.T.C. 167, 88 D.T.C. 6386, at page 174 (D.T.C. 6390), where Urie J.A. (MacGuigan J.A. concurring) stated:
The Income Tax Act itself applies to all taxpayers earning taxable income. Class 2 in Schedule B certainly does not relate solely to the natural gas industry.... Clause (b) relates to pipelines without reference to what is transmitted through them be it gas, oil, water, steam or solids. I would have thought that in construing it in its "popular sense" would mean that sense "which people conversant with the subject matter with which the statute is dealing [in this case those utilizing the service of the pipeline for the transmission of gas, oil, water, steam or solids] would attribute to it" not the popular sense derived from the perception of the man in the street not conversant with either the user industries or pipelines....
Accordingly, it is not the view of the person in the oil and gas industry but rather the view of people "conversant with the subject matter with which the statute is dealing" that is relevant. In my view, the evidence of Professors Chakma and Nandakumar more appropriately meets the test enunciated by the Federal Court of Appeal in Nova, supra, because (1) their opinions are based upon scientific literature within the areas of their engineering expertise, and their opinions are referenced to and supported by this literature; and (2) their opinions canvassed the literature in order to ascertain the accepted understanding among engineers as to the meaning of the word "pipeline". While the definition of "pipeline" is not as wide as Professors Chakma and Nandakumar would have it, in my view the plaintiff has not met the onus of showing that the water intake line is not a pipeline. The definition of a pipeline is not as narrow as Mr. Moffatt
attempted to make it.
Therefore, on this second issue of the Clarkson Refinery, the Minister’s assessment stands and the plaintiff’s appeal is dismissed.
Conclusion
Judgment will go allowing the plaintiff’s appeal on the Syncrude issue and the matter is referred back to the Minister in accordance with these reasons. On the second issue of the Clarkson Refinery the plaintiff’s appeal is dismissed.
On consent judgment will also go as follows:
The matter be referred back to the Minister for reconsideration and reassessment on the basis that:
1. The expenditures in the amount of $1,182,298 described by the plaintiff as frontier development expenditures will be classified as pre-production operating expenses;
2. Gulf’s eligible capital expenditures under paragraph 14(5)(b) of the Income Tax Act for its 1978 taxation year will be reduced by the amount of $43,300. This will result in a reduction to the cumulative eligible capital amount and a reversal of the deduction of $2,165 allowed by the Minister as an eligible capital amount under paragraph 20(1 )(b) of the Act;
3. Gulf will be allowed a deduction as an operating expense in respect of the $43,300 reclassified by the Minister as an eligible capital expenditure;
4. The amount of $716,805 claimed by Gulf as a scientific research expenditure will be reclassified as an operating expense. The amount of $35,840 allowed as an investment tax credit in respect thereof will be disallowed; and
5. Gulf’s resource profits under section 1204 of the Regulations for purposes of computing its depletion deduction under section 65 of the Act and section 1200 of the Regulations and its resource allowance under paragraph 20(l)(v.l) of the Act and section 1210 of the Regulations for its 1978 taxation year as calculated under the further notice of reassessment mailed April 27, 1993 will be increased by the amount of $1,105,322.
6. Gulf’s resource profits under section 1204 of the Regulations for purposes of computing its depletion deduction under section 65 of the Act and section 1200 of the Regulations and its resource allowance under paragraph 20(l)(v.l) of the Act and section 1210 of the Regulations for its 1978 taxation year as calculated under the further notice of reassessment mailed April 27, 1993 will be increased by the amount of $724,840 in respect of Syncrude scientific research expenditure.
The parties shall bear their own costs with respect to the settled issues.
The parties may speak to me about costs with respect to the disputed issues, if they cannot agree.
Appeal allowed in part.