Citation: 2014 TCC 30
Date: 20140618
Docket: 98-1659(IT)G
BETWEEN:
ALLAN McLARTY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Favreau J.
I. Introduction
[1]
The appellant appealed
from two sets of reassessments made by the Minister of National Revenue (the
“Minister”) under the Income Tax Act, R.S.C. 1985, c. 1 (5th
Supp.), as amended, (the "Act") for the 1993, 1994, 1995, 1998
and 1999 taxation years. One set of notices of reassessment is dated May 1,
1997 and concerns the 1993, 1994 and 1995 taxation years while the other set of
notices of reassessment is dated October 29, 2001 and concerns the 1998 and
1999 taxation years.
[2]
The appellant, together
with other individuals, entered into a joint venture agreement on December 31,
1993 (the “Joint Venture Agreement”) with 507326 Alberta Ltd. (“507326”), the
joint venture operator, pursuant to which he purported to carry on the business
of petroleum and natural gas exploration, development and production as a
member of the 507326 Alberta Ltd. 1993/1994 Oil and Gas Joint Venture (the
“Joint Venture”).
[3]
On December 31, 1993,
507326 acquired from Carlyle Management (1993) Inc. (“Carlyle”), on behalf of
the Joint Venture, a 100% interest in a large body of seismic data relating to
the province of Manitoba (the “Technical Data” or the "Seismic Data")
for a consideration totalling $6,500,000 made up of cash in the amount of
$975,000 and promissory notes in favour of Carlyle in the aggregate principal amount
of $5,525,000.
[4]
The total consideration
paid by the individual joint venturers for the Technical Data was $6,500,000:
$975,000 in cash and $5,525,000 by way of promissory notes in favour of Carlyle
(the “Promissory Notes”).
[5]
The appellant acquired
his undivided interest in the Technical Data for a consideration of $110,000 composed
of cash in the amount of $20,000, a promissory note in the amount of $85,000 in
favour of Carlyle (the “appellant’s Promissory Note”) and an additional debt of
$5,000 to be utilized by the Joint Venture to acquire petroleum and natural gas
properties in Manitoba.
[6]
The appellant filed his
1993 return of income, claiming an addition of $110,000 to his cumulative
Canadian exploration expense as defined in subsection 66.1(6) and
paragraph 66(12.1)(a) of the Act (the “CCEE”), and he
deducted certain amounts from his CCEE account to the extent that these amounts
had become receivable by him as a result of sales of licensed copies of the Technical
Data.
[7]
The appellant elected to
capitalize the interest expenses associated with the purchase of his undivided
interest in the Technical Data such that the interest paid on the appellant’s
Promissory Note, in the amounts of $4,250 and $4,093.08 for the 1994 and 1995
taxation years respectively, constituted Canadian exploration expenses as
defined in subsection 66.1(6) of the Act (the “CEE”) rather than interest
expense deductions that can be claimed under paragraph 20(1)(c).
[8]
The interest of $4,092 paid
or payable on the appellant’s Promissory Note was also deducted by the
appellant in computing his income from the Joint Venture for each of the 1998
and 1999 taxation years.
[9]
As a result of netting the
additions to the CCEE and the deductions therefrom to take into account the
proceeds from the sales of licensed copies of the Technical Data, the appellant
filed his returns of income claiming deductions of $89,797 and $6,056 from his CCEE
account for the 1993 and 1994 taxation years respectively.
[10]
By way of the reassessments
dated May 1, 1997, the Minister (1) disallowed the amounts of the deductions
claimed by the appellant from his CCEE account for the 1993 and 1994 taxation
years, (2) included in the appellant’s income for the 1994 and 1995 taxation
years the amounts of $8,720 and $8,126 respectively as “licensing revenue to be
included in income", and (3) treated the appellant’s cash portion of his
investment in the Technical Data ($20,000) as being an eligible capital
expenditure, as defined in subsection 14(5) of the Act (the “ECE”)
and added 75% of the cash portion of the appellant’s investment in the Joint
Venture to the appellant’s “cumulative eligible capital account” (the “CEC
Account”).
[11]
By way of the reassessments
dated October 29, 2001, the Minister disallowed the interest amounts of $4,092
claimed in respect of the appellant’s Promissory Note for each of the 1998 and
1999 taxation years.
II. The Issues
[12]
The issues to be
decided in these appeals are:
(a) What expense did the
appellant incur in respect of the purchase of the Seismic Data?
(b) Does the expense, or
any part of it, incurred by the appellant qualify as a CEE?
(c) If the expense does
not qualify as a CEE, is it deductible pursuant to paragraph 20(1)(b)
of the Act as a cumulative eligible capital amount?
(d) If the expense does
not qualify as a CEE, is it deductible pursuant to paragraph 20(1)(c)
of the Act as interest?
(e) In the alternative, should
the appeal be dismissed in any event as the deductions claimed by the appellant
were part of a structure designed to implement shams with a view to deceiving
the Minister?
[13]
The following issues
are not before the Court:
(a) whether the appellant
acquired proprietary rights with respect to his undivided interest in the Seismic
Data;
(b) whether the
expenditure incurred by the appellant to purchase his undivided interest in the
Seismic Data qualifies as a CEE by virtue of its having been made for the
purpose of determining the existence, location, extent or quality of an
accumulation of petroleum or natural gas in Canada;
(c) whether the
appellant's Promissory Note constitutes a contingent liability;
(d) whether the appellant
was dealing at arm's length with Carlyle, the vendor of the Seismic Data; and
(e) whether the price
paid by the appellant for the Seismic Data was reasonable in the circumstances.
III. The Minister’s Assumptions of Fact
[14]
In reassessing the
appellant’s 1993, 1994 and 1995 taxation years, the Minister assumed the
following facts, as set out in paragraph 10 of the Further Amended Reply
to Second Amended Notice of Appeal:
(a) On 20 April 1993, Probe Exploration Inc. (“Probe”)
entered into negotiations with Chevron Canada Resources (“Chevron”) to acquire
a proprietary interest in seismic data sets (“seismic”) consisting of a minimum
of 1,000 kilometers.
(b) Probe proposed to have some of Chevron’s seismic
appraised (taking into account such factors as replacement cost, quality,
technical parameters and area activity), and pay Chevron a cash consideration
of 8% of the appraised value plus 50% of revenue earned from future sales of
copies of the seismic.
(c) In previous transactions of this nature, Probe had used
Citadel (sic) Engineering, Curtz (sic) Consulting (Brian Curtz), and Jaskella
Resources Consulting to appraise the seismic.
(d) While Chevron was receptive to a straight cash sale of
some of its seismic, it advised Probe on 31 May 1993 that it would not agree to
Probe’s proposal.
(e) On 21 December 1993, Carlyle Management (1993) Inc.
(“Carlyle”) made an offer to Chevron that Carlyle or its nominee would purchase
Chevron’s entire interest in the proprietary rights to approximately 5,905
kilometers of seismic (the “Manitoba Seismic”, also the “Technical Data Base”
and the “Venture Data” in the Notice of Appeal) for $805,000 cash.
(f) Chevron
accepted Carlyle’s offer on 23 December 1993.
(g) Carlyle
and Chevron dealt with each other at arm’s length.
(h) The
following events occurred on 31 December 1993:
•
Chevron purportedly sold the Manitoba Seismic to
Seitel, Inc. (“Seitel”), a non-resident corporation and Carlyle’s nominee, for
$805,000 cash;
•
Seitel purportedly sold the Manitoba Seismic to
Carlyle for $6.5 million, composed of $805,000 in cash and a limited
recourse debenture for $5,695,000;
•
Carlyle purportedly sold the Manitoba Seismic to
507326 Alberta Ltd. (“507326”) as agent on behalf of the 507326 Alberta Ltd.
1993/1994 Oil and Gas Joint Venture (the “Joint Venture”) for $6.5 million,
composed of $975,000 in cash and a limited recourse promissory note for
$5,525,000;
•
507326, Carlyle and Seitel entered into a Data
Management and Sales Agreement whereby Seitel was authorized as worldwide agent
to license copies of the Manitoba Seismic to third parties; and
•
507326 entered into a Joint Venture Agreement
with the Appellant, 30 other individuals and one corporation (the “Individual
Joint Venturers”) involving the purported acquisition, exploration, development
and production of petroleum and natural gas.
(i) The Appellant purportedly purchased an interest in the
Joint Venture for $110,000, composed of $20,000 in cash, a limited recourse
promissory note to Carlyle for $85,000 (the “Promissory Note”), and an
additional debt of $5,000.
(j) Repayment of the Promissory Note was by assignment of
50% of net licensing revenues due to the Appellant from future sales of
licensed copies of the seismic, and 20% of the production cash flow generated
from the Appellant’s interest in petroleum rights acquired by the Joint
Venture, first to interest and then to principal.
(k) In the event that the Promissory Note was not paid at
maturity, Carlyle had the right to force the sale of the investor’s undivided
interest in the seismic and 20% of other joint venture interests by a trustee
for cash only, with 50% of the proceeds going to Carlyle, the remaining 50% to
the Appellant, with any shortfall being forgiven.
(l) The division of forced sale proceeds described in the
previous paragraph is not in accordance with normal lending practice.
(m) The price paid by Carlyle to Seitel for the Manitoba Seismic
was inflated by the use of limited recourse financing, and the true
consideration was $805,000 plus 50% of net licensing revenues for nine years.
(n) The price paid by 507326 to Carlyle for the Manitoba
Seismic was inflated by the use of limited recourse financing, and the true
consideration was $975,000 plus 50% of net licensing revenues for nine years.
(o) The price paid by the Appellant for his interest in the
Joint Venture was inflated by the use of limited recourse financing, and the
true consideration was $20,000 plus 50% of net licensing revenues for nine
years.
(p) There was never any intention between the parties that
the holders of the limited recourse financing would receive payment of the
principal sum of the debenture and the promissory notes.
(q) The purpose of the limited recourse financing was to
ensure that the holders receive a revenue stream from future sales of copies of
the seismic, and to provide an inflated income tax deduction.
(r) It is not necessary to acquire proprietary rights to
seismic to use it for exploration purposes, a licensed copy is sufficient.
(s) Any expenses incurred by 507326 were incurred for the
purpose of providing income tax deductions for the Individual Joint Venturers,
and not for any of the purposes referred to in s. 66.1(6)(a)(i) of the Income
Tax Act (the “Act”).
(t) Expenses in the amounts of approximately $123,725,
$124,625 and $54,000 (most of which were management fees based on sales of
copies of the seismic) were incurred by 507326 in 1994, 1995 and 1996
respectively for the purpose of giving the impression that the Manitoba Seismic
had been acquired for the purposes referred to in s. 66.1(6)(a)(i) of the Act.
(u) Any expenses incurred by the Appellant in connection with
his participation in the Joint Venture were incurred for the purpose of
obtaining an income tax deduction, and not for any of the purposes referred to
in s. 66.1(6)(a)(i) of the Act.
(v) The expense incurred by the Appellant in connection with
his participation in the Joint Venture did not exceed $20,000.
(w) Any expense incurred by the Appellant in excess of $20,000
in connection with his participation in the Joint Venture was unreasonable in
the circumstances.
(x) Any expense incurred by the Appellant in excess of $20,000
in connection with his participating in the Joint Venture was a contingent
liability.
(y) The Appellant had previously invested in other seismic in
order to obtain income tax deductions.
(z) The three appraisals of the Manitoba Seismic
obtained by 507326:
•
were not independent expert valuations;
•
were based on discounted replacement costs of
re-shooting the seismic;
and
•
used erroneous methodology that produced
inaccurate and overstated
opinions
of value
(aa) The value of the Manitoba Seismic on 31 December 1993 did
not exceed $975,000.
(bb) In determining the sale price of seismic, it is industry
practice to apply volume discounts on the sale of blocks in excess of 1,000
kilometers.
(cc) These volume discounts vary with the size of the block and
the relative negotiating strength of buyer and seller.
(dd) An 80% volume discount on the Manitoba Seismic purchased by
507326 would have been in accordance with industry practice and reasonable in
the circumstances.
[15]
In reassessing the appellant’s
1998 and 1999 taxation years, the Minister assumed the following facts, as set
out in paragraph 10.1 of the Further Amended Reply to Second Amended
Notice of Appeal:
(a) The
facts as described in paragraph 10 above.
(b) In claiming interest expenses in the amount of $4,092 in
each of his 1998 and 1999 taxation years, the Appellant advanced the position
that the said expenses were deductible on the basis that these deductions were
wholly applicable to their alleged oil and gas exploration business.
(c) The Joint Venture and as such the Appellant did not carry
out an oil and gas exploration business and therefore there is no source of
income against which the interest deduction may apply.
(d) The series of transactions further described in paragraph 14
below which were undertaken for the purpose of attempting to show that the
Appellant and others were carrying [out] oil and gas exploration constitutes
steps in shams.
(e) In the alternative, if any interest expenses is [sic]
deductible, the interest expenses claimed by the Appellant, were not reasonable
and should be reduced.
[16]
The series of
transactions to which subparagraph 10.1(d) of the Further Amended Reply to
Second Amended Notice of Appeal refers is the following:
14.
The incorporation of 507326, the agreement between Chevron and Carlyle for the
purchase of the Manitoba seismic data for an amount of $805,000 on December 21,
1993, the purchase of the data from Chevron by Seitel in lieu and in place or
as agent of Carlyle for the amount of $805,000 on December 31, 1993, the
purchase by Carlyle of the same data and on the same day from Seitel at the
inflated price of $6.5 million, the sale by Carlyle of the same data to 507326
on the same day for the amount of $6.5 million, the Data Management and Sales
Agreement which provides that Seitel will act as the agent of 507326 to manage
and licensed copies [sic] of the data for a commission fee of 10%, the
Joint Venture agreement between 507326 and 30 other individuals and one
corporation and the alleged acquisition by the appellant of an interest in the
Joint Venture, were steps in shams that were arranged in attempts to deceive
the Minister into believing that the expenses in issue were incurred for the
purpose of exploration, rather than for the purchase of income tax deductions.
IV.
Summary of
the Testimony
Mr. Allan McLarty
[17]
The appellant is an
energy regulatory lawyer practising with Fraser Milner LLP, who made various
investments in the oil and gas exploration industry before becoming a member of
the Joint Venture. He was an investor in the Petroleum Capital 1987 Partnership,
which purchased 13,795 kilometres of proprietary seismic data. The appellant
claimed CEE in excess of the cash he had invested in the Petroleum Capital 1987
Partnership (paragraphs 34 and 35 of a document referred to as "Facts
Admitted" filed at the hearing of the appeals of the appellant in the Tax
Court of Canada, 2005 TCC 55, and reproduced by Justice Little in his reasons
for judgment in those appeals). On December 31, 1992, the appellant entered
into a subscription agreement with Compton Resource Corporation pursuant to
which he acquired an undivided interest in the Compton Resource Corporation
1992/1993 Oil and Gas Investment Fund (paragraph 12 of the “Facts Admitted” document
referred to above).
[18]
The appellant's
investment in the Joint Venture on December 31, 1993 was made despite the fact
that no offering memorandum was prepared and no cost estimates for the exploration
program were provided to the investors.
[19]
The appellant was not
involved in the management of 507326 or in any of the transactions executed by
the Joint Venture. The appellant was a "passive" member of the Joint
Venture. He had no personal knowledge of the exploration program or of the
exploration expenses to be incurred by the Joint Venture. He did not know who Seitel
and Carlyle were or who controlled them. He did not know if the Technical Data were
insured or in any way protected. He had not seen any information concerning the
well that was drilled. The appellant's sources of information concerning the
operations of the Joint Venture were the updates from the Joint Venture, the
financial statements of the Joint Venture, the tax information slips, and the
Annual Reports of Compton Petroleum Corporation.
[20]
The appellant confirmed
that paragraphs 14 and 17 of the Second Amended Notice of Appeal were not
correct in that the $5,000 amount was not advanced by the appellant to the
Joint Venture to be used by the Joint Venture to acquire petroleum and natural
gas properties or to finance the exploration and development activities of the
Joint Venture. The $5,000 amount in question was instead a cash call by the
Joint Venture for the purpose of mounting a defence against the CRA's
reassessments and proceeding with appeals in this Court.
[21]
The appellant stated
that he received from the Joint Venture licensing revenues in the amount of
$5,000 in 1994 and in the amount of $2,500 in 1995.
The total licensing revenues generated by
the Technical Data were $650,000 in 1994 and $325,000 in 1995, and those
revenues were used as follows:
|
|
1994
|
1995
|
|
Distribution to the Individual Joint Venturers
Payment under the Promissory Notes due to Carlyle
|
$ 325,000
$ 325,000
|
$162,500
$162,500
|
[22]
The appellant
acknowledged that the Technical Data were sold in 2006 at a price of $560,000
and that, as a result of that transaction, an amount of $7,080,471 of debt was forgiven
on the Promissory Notes. The appellant did not include his share of the forgiven
debt in his initial tax return for the 2006 taxation year but he did include it
when he filed an amended tax return for that year.
Mr. Ernie Sapieha
[23]
Mr. Sapieha was the
promoter of the Joint Venture. He was the president and the only director of
507326. He was also a participant in the Joint Venture. The Joint Venture and
the Compton Resource Corporation 1992/1993 Oil and Gas Investment Fund were
vehicles set up to raise money from a limited number of investors to finance
the acquisition of seismic data to be used for oil and gas exploration
activities to be conducted jointly with Compton Resource Corporation and
Compton Petroleum Corporation. Compton Petroleum Corporation was created in
1994 and became public in 1996 when its shares were listed on the Toronto Stock
Exchange and the New York Stock Exchange.
[24]
Mr. Sapieha pointed out
that by signing the subscription agreements the investors acquired an undivided
interest in the assets of the Joint Venture and an equivalent percentage of
shares of 507326.
[25]
Mr. Sapieha stated that
Mr. James P. Morin of Carlyle is the person who informed him that the Technical
Data were on the market. He testified that he had first asked for an internal
valuation of the Technical Data and that he had thereafter sought three
appraisals from independent firms. 507326 did indeed receive three appraisals
of the Technical Data, which purported to estimate the fair market value thereof
as follows:
Curts Seismic Consultants Ltd. $
8,718,546
Solid State Geophysical Inc. $ 10,343,048
Citidal Engineering Ltd. $ 10,318,000
[26]
Only the Joint Venture
paid the cost of the three appraisals despite the fact that Seitel, Carlyle and
Compton Resource Corporation also benefited from the said appraisals. Mr.
Sapieha could not explain how the value of $6.5 million for the Seismic Data
was arrived at, nor did he remember who made that determination. Apparently
there was nothing regarding this matter in the files.
[27]
Mr. Sapieha pointed out
that only four months after the purchase of the Technical Data a licensing
agreement for the use thereof was signed with Trinity Energy Ltd. for $875,000
and that many other licensing agreements were entered into between 1993 and
2006. The total revenues generated by the licensing of the Technical Data amounted
to $2.8 million from 1994 to 2006.
[28]
Mr. Sapieha explained
that, because the revenues generated from the licensing activities were
substantial, the Joint Venture had to change its accounting presentation for
the 1996 fiscal year. Since 1993, the Joint Venture has used the "full
cost method" of reporting, which means that all costs have been
capitalized by property or pool of properties. This method was common in the
oil and gas industry prior to 2011 for entities that were in a pre-production
stage. For the 1996 fiscal year and the following years, the Joint Venture
presented a statement of operations, which is the equivalent of a statement of
earnings (profit and loss).
[29]
Mr. Sapieha further
stated that a total of 84 mineral leases on the territory covered by the Technical
Data were acquired by Compton Petroleum Corporation on its own behalf and on
behalf of the Joint Venture on a fifty-fifty basis. Mr. Sapieha confirmed
that there was no formal joint venture agreement between Compton Resource
Corporation or Compton Petroleum Corporation and the Joint Venture for the use
of the Seismic Data, for the acquisition of the mineral leases or for the
drilling of wells. On well licence No. 4577, only the name of Compton Petroleum
Corporation, as the operator, appeared. One unsuccessful well was drilled in
1996 and abandoned on August 23, 2004. Mr. Sapieha asserted that three other
wells were drilled by Compton Petroleum Corporation in 2001, 2003 and 2004 and
that none of them were located on the territory covered by the Technical Data. Those
wells were drilled after the Joint Venture had disposed of all of its assets
other than the Technical Data to Compton Petroleum Corporation in 2000. None of
the wells reached the commercial production stage.
Mr. Michael Erskine Heier
[30]
Mr. Heier was the
president of Trinity Energy Ltd., a private corporation providing basic
services to oil and gas corporations. On March 1, 1994, Trinity Energy Ltd.
entered into an exclusive 14-month licensing agreement with Seitel for the use
of the Technical Data. Trinity Energy Ltd. ultimately paid the full amount of
$875,000 for the licence. Trinity Energy Ltd. used the Seismic Data and drilled
in 2001, 2003 and 2004 with Compton Petroleum Corporation, as a partner and
operator, three wells not located on the territory covered by the Seismic Data.
The cost of the wells was between $200,000 and $250,000 each and Mr. Heier
considered the wells as being technical successes despite the fact that there was
no commercial production of oil and gas. Mr. Heier did not know Mr. Sapieha
personally, but he knew that Compton Petroleum Corporation was using the
Seismic Data.
Mr. Carl Ringdahl
[31]
Mr. Ringdahl, a
geophysicist, worked for Compton Resource Corporation as a consultant. He
charged $200 per day of work and spent half of his time working for the Joint
Venture and the other half working for the Compton Resource Corporation 1992/1993
Oil and Gas Investment Fund. He did not keep daily records of his time worked for
each. Half of his fees came from the Joint Venture, in which he was an
investor.
[32]
Mr. Ringdahl explained
that the copy of the Technical Data received from Chevron in January 1994
consisted of 200 to 300 lines and 500 boxes of field tapes. The data had to be
reprocessed and the content of the tapes had to be transferred to new tapes for
more efficient storage and location of the available information. His work
consisted in reprocessing the data, mapping the lines with geologists and
updating them with information coming from any other sources, evaluating land
sales by the Manitoba government and preparing bids, and considering
opportunities and offers for "farm-in" agreements with third parties.
[33]
Mr. Ringdahl was
working closely with Mr. Sapieha, with whom he had meetings every day, and with
Mr. Denike, a geologist hired by him in the fall of 1994. Mr. Ringdahl
confirmed that the Daly Well drilled in 1996 by Compton Petroleum Corporation
was located on the territory covered by the Technical Data, on seismic line
5-22-10-28 WW1.
[34]
Mr. Ringdahl explained
that the Daly Well was drilled under the name of Compton Petroleum Corporation,
without any reference to the Joint Venture, in order to facilitate the obtaining
of the drilling licence from the Manitoba government. For that purpose, Compton
Petroleum Corporation secured the services of Scott Land & Lease Ltd. for
the acquisition of the land leases, entered into a standard daywork contract,
filed an application for a well-drilling licence, and subsequently retained a
consulting engineer for the well site and took out a liability insurance
policy.
[35]
Mr. Ringdahl also
confirmed that in October 1994 Seitel and Compton Petroleum Corporation agreed
to reprocess 15 lines of seismic data and to share the cost on a fifty-fifty
basis. Three lines were indeed reprocessed by Veritas in 1994. According to the
witness, Veritas did not know that the Joint Venture held an interest in the
Seismic Data.
[36]
Mr. Ringdahl considered
that his work of looking at and interpreting seismic data constituted
exploration work. As an investor in the Joint Venture, he was aware of the tax
deductions that were available and knew that the risk associated with his
investment was precisely with regard to the availability of the tax deductions.
He did recognize that the Joint Venture had no budget for exploration and that
the licensing revenues from the Seismic Data were supposed to generate enough
money to pay the exploration expenses. He assumed that he would never have to
make the payments under the promissory note that he had signed when he became a
participant in the Joint Venture.
[37]
Mr. Ringdahl ceased
working for Compton Petroleum Corporation in December 1996 and Mr. Sapieha
hired Ms. Kim Davies, a geophysicist, to replace him.
Mr. Kelvin Denike
[38]
The services of Mr. Denike,
a geologist, were secured by Mr. Ringdahl in the fall of 1994 to work two weeks
per month on the mapping of the Joint Venture’s Technical Data in order to
identify where to drill wells. He invoiced Compton Development Corporation for
his services but he was paid by the Joint Venture. He worked for the Joint
Venture until 1998 and then joined Compton Petroleum Corporation.
[39]
He was not an investor
in the Joint Venture, but he invested in the Compton Resource Corporation
1992/1993 Oil and Gas Investment Fund. According to him, the services that he
rendered were part of normal exploration activities and he confirmed that the drilling
of the Daly Well in February 1996 was based on the Seismic Data on which he had
worked.
[40]
Mr. Denike also
confirmed that Mr. Ringdahl or Ms. Keitha Dobson, the controller and chief
financial officer of Compton Petroleum Corporation, has asked him to correct
all his invoices from October 1994 to April 11, 1997 and to resubmit them under
the name of 507326.
Ms. Keitha Dobson
[41]
Ms. Dobson was the
chief financial officer and controller of Compton Petroleum Corporation when
she left that company in 1998. She was responsible for keeping the books and records
of the Joint Venture, recording revenues, making the bank deposits and paying
invoices. She had no authority to sign cheques on behalf of any entity. The
payment of all invoices by 507326 had to be approved by Mr. Ringdahl or Mr. Sapieha.
She was also responsible for the preparation of the annual tax information
slips for the investors in the Joint Venture after the review by Mr. Sapieha
and the external auditors. She had the list of the participants in the Joint
Venture. She knew that some of the participants were behind the original
subscribers despite the fact that no nominees were allowed under the terms and
conditions of the subscription agreements. She was instructed by Mr. Sapieha to
accept the sharing of the units and of the benefits from the unitholders’
investments in the Joint Venture.
[42]
She was informed by Mr.
Sapieha that Compton Petroleum Corporation and the Joint Venture were carrying
on joint exploration operations.
[43]
She did not remember
having asked Mr. Denike to redo his invoices and resubmit them to 507326. She
stated that 507326 had a goods and services tax number and claimed input tax
credits.
Mr. Norman Glen Knecht
[44]
Before joining Compton
Petroleum Corporation in 1997 as chief financial officer, Mr. Knecht was an
audit partner with Doane Raymond (which later became Grant Thornton) in charge
of the audit of the Joint Venture, Compton Resource Corporation and Compton
Petroleum Corporation. As such, he signed the financial statements of the Joint
Venture for 1993 to 1996.
[45]
Mr. Knecht knew about
the existence of a joint venture between Compton Petroleum Corporation and
507326 acting on behalf of the Joint Venture, but he never saw any agreement relating
thereto.
[46]
Mr. Knecht explained
that the Data Management and Sale Agreement entered into on December 31, 1993 between
Carlyle and Seitel referred to a list of principals who had a royalty-free
right to use the Seismic Data. The list of principals was compared with the
list of investors in the Joint Venture. The conclusion was that the list of
principals matched the list of investors, except for Carlyle, which was specifically
named in the Data Management and Sale Agreement, and Compton Petroleum
Corporation, which obtained the consent of the investors in the Joint Venture
to use the data.
Mr. Daniel Blyth Thornton, PhD, FCA
[47]
Mr. Thornton testified
on behalf of the Crown as an expert accounting witness. His expertise in oil
and gas accounting was contested by the appellant's lawyers, but after
reviewing his qualifications, the Court came to the conclusion that the witness
was qualified for the purpose of this case.
[48]
Mr. Thornton's expert
accounting witness report was filed in Court as Exhibit R-31 and the
conclusions of the report are as follows:
61. The
purpose of financial statements is to convey reliable information to users of
the statements by accounting for transactions and events in a manner that
conveys their substance rather than necessarily their legal form.
62. Under
full cost accounting, an oil and gas enterprise records all exploration and
development costs incurred in a country, including the costs of drilling dry
holes, as assets that will be depleted when production begins.
63. Oil
and gas companies are in the preproduction stage while initially exploring for
oil and gas. During this stage, they capitalize all costs, including the costs
of drilling dry holes. Any incidental revenues earned during this stage are
subtracted from the costs capitalized on the balance sheet rather than shown as
revenues on an income statement, the rationale being that such revenues reduce
the costs of exploration. The net capitalized costs are assessed each time
financial statements are issued, to see if it is likely that such net costs may
be recovered in the future; if not, they are written off.
64. Financial
statements of prior periods are adjusted only for a change in an accounting
policy or for a correction of an error in prior period financial statements.
The Joint Venture's cessation of preproduction accounting and retroactive
restatement of prior years' financial statements in 1996 suggests that it was
never in a preproduction stage.
65. The
reliability of the financial statements is called into question for the
following reasons. If the Joint Venture had really been an oil and gas
exploration enterprise without any production, it would have continued to use
preproduction accounting. If it had been producing anything, it would have
recorded depletion expenses but it did not do so. When it wrote off its
property interests in 2005, it would have called the cumulative result
"accumulated depletion" but instead called it "accumulated
depreciation." For accounting purposes, therefore, the Joint Venture never
qualified as an oil and gas exploration enterprise or an oil and gas producer.
Rather, according to the financial statements, the Joint Venture was an
extremely unprofitable enterprise that earned revenues from selling the rights
to use its Seismic Data—revenues that were vastly outweighed by depreciation
and interest expenses—so that by 2005 the Joint Venturers' Deficiency (the
cumulative net losses experienced since inception) totaled approximately
$7.3 million.
66. The
enterprise's apparent lack of profitability stemmed largely from its inability
to generate sufficient profits to meet an obligation—the Promissory Notes—that
was carried on the financial statements at an amount that was unlikely to be
paid. It is questionable whether the Notes satisfied the definition of a
liability for accounting purposes and, if they did, whether they satisfied an
accounting criterion for recognition in the financial statements at the full
amount of principal and accrued interest. Therefore, the unprofitable operations
of the enterprise were not reliably portrayed for accounting purposes.
Mr. Ward G. Zimmer, CA
[49]
Mr. Zimmer testified as
an expert rebuttal witness. His expert accounting witness rebuttal report was
filed in court as Exhibit A-15 and the conclusions of the report are as
follows:
26. The
Report does not dispute the existence and valuation of the asset acquired, the
technical data base. In order to recognize the asset, the Joint Venture must
recognize the instrument issued in exchange for the asset. The Report has used
hindsight to conclude that the promissory note is not a liability because the
Joint Venture failed to fully repay it. However, the Report has failed to
establish what the promissory note is if it is not a liability. The promissory
note does not meet the definition of an equity instrument as it is not an
interest in the net assets of the Joint Venture. Therefore, it must be a
liability and the use of hindsight to conclude otherwise is not appropriate.
27. The
Report does not consider the activities of the Joint Venture in assessing
whether it is an oil and gas entity. Instead, the Report makes inferences and
assumptions based on the results of those activities and the accounting
thereof. An entity is not an oil and gas entity based on its accounting, it is
an oil and gas entity based on its activities. The Joint Venture engaged in oil
and gas exploration activities such as acquiring seismic data, using the data
to identify prospective areas for drilling, acquiring an interest in oil and gas
leases and drilling an exploratory well. Based on these activities, the Joint
Venture was an oil and gas exploration entity.
V. Statutory Provisions
[50]
The parties relied, inter
alia, on the following provisions of the Act, as amended for the
1993 to 1995 taxation years and for the 1998 and 1999 taxation years: subsection
14(5) for the definition of "eligible capital expenditure",
paragraphs 18(1)(a), 20(1)(b) and 20(1)(c), section 21,
paragraph 66(12.1)(a), subsection 66.1(6) for the definition of
"Canadian exploration expense" and section 67:
14(5) "eligible
capital expenditure" — "eligible capital expenditure" of a taxpayer in respect of a business
means the portion of any outlay or expense made or incurred by the taxpayer,
as a result of a transaction occurring after 1971, on account of capital for
the purpose of gaining or producing income from the business,
other than any such outlay or expense
(a) in respect of which any amount is or would be,
but for any provision of this Act limiting the quantum of any deduction,
deductible (otherwise than under paragraph 20(1)(b)) in
computing the taxpayer's income from the business,
or in respect of which any amount is, by virtue
of any provision of this Act other than paragraph 18(1)(b), not
deductible in computing that income,
(b) made or incurred for the purpose of gaining or
producing income that is exempt income, or
(c) that
is the cost of, or any part of the cost of,
(i) tangible
property of the taxpayer,
(ii) intangible
property that is depreciable property of the taxpayer,
(iii) property in respect of which any deduction
(otherwise than under paragraph 20(1)(b)) is
permitted in computing the taxpayer's income from
the business or would be so permitted if the taxpayer's
income from the business were sufficient for the purpose, or
(iv) an interest in, or right to acquire, any property
described in any of subparagraphs (i) to (iii)
but,
for greater certainty and without restricting the generality of the foregoing,
does not include any portion of
(d) any amount paid or payable to any creditor of the taxpayer
as, on account or in lieu of payment of any debt or as or on account of the
redemption, cancellation or purchase of any bond or debenture,
(e) where the taxpayer is a corporation, any amount
paid or payable to a person as a shareholder of the
corporation, or
(f) any amount that is the
cost of, or any part of the cost of,
(i) an interest in a trust,
(ii) an interest in a partnership,
(iii) a share, bond, debenture, mortgage, note, bill or
other similar property, or
(iv) an interest in, or right to acquire, any property
described in any of subparagraphs (i) to (iii).
18(1) General
limitations — In computing the income of a taxpayer
from a business or property no deduction
shall be made in respect of
(a) General limitation — an outlay or expense except to the extent that it was made or incurred
by the taxpayer for the purpose of gaining or producing income from
the business or property;
20(1)(b) Cumulative eligible capital amount — such amount as the taxpayer
may claim in respect of a business, not exceeding 7% of the taxpayer's
cumulative eligible capital in respect of the business at the end of
the year;
20(1)(c) Interest — an amount paid in the year or payable in respect of the year
(depending on the method regularly followed by the taxpayer in computing
the taxpayer's income), pursuant to a legal obligation to pay
interest on
(i) borrowed money used for the purpose of earning income from
a business or property (other than borrowed money used to acquire property the
income from which would be exempt or to acquire a life insurance policy),
(ii) an amount payable for property acquired for the purpose of
gaining or producing income from the property or for the purpose of gaining or
producing income from a business (other than property the income from which
would be exempt or property that is an interest in a life insurance policy),
. . .
or a reasonable amount in respect thereof, whichever is the lesser;
21(1) Cost of borrowed money — Where in a taxation year a taxpayer
has acquired depreciable property, if the taxpayer elects under this subsection
in the taxpayer's return of income under this Part for the year,
(a) in computing the taxpayer's income for the
year and for such of the 3 immediately preceding taxation years as the taxpayer
had, paragraphs 20(1)(c), (d), (e) and (e.1)
do not apply to the amount or to the part of the amount specified in the
taxpayer's election that, but for an election under this subsection in respect
thereof, would be deductible in computing the taxpayer's income (other than
exempt income) for any such year in respect of borrowed money used to acquire
the depreciable property or the amount payable for the depreciable property;
and
(b) the amount or the part of the amount, as the
case may be, described in paragraph (a) shall be added to the capital
cost to the taxpayer of the depreciable property so acquired by the taxpayer.
21(2) Borrowed money used for exploration or development — Where in
a taxation year a taxpayer has used borrowed money for the purpose of
exploration, development or the acquisition of property and the expenses
incurred by the taxpayer in respect thereof are Canadian exploration and
development expenses, foreign exploration and development expenses, Canadian
exploration expenses, Canadian development expenses or Canadian oil and gas
property expenses, as the case may be, if the taxpayer elects under this
subsection in the taxpayer's return of income under this Part for the year,
(a) in computing the taxpayer's income for the year and
for such of the 3 immediately preceding taxation years as the taxpayer
had, paragraphs 20(1)(c), (d), (e) and (e.1)
do not apply to the amount or to the part of the amount specified in the
taxpayer's election that, but for an election under this subsection in respect
thereof, would be deductible in computing the taxpayer's income (other than
exempt income) for any such year in respect of the borrowed money used for the
exploration, development or acquisition of property, as the case may be; and
(b) the amount or the part of the amount, as the case may
be, described in paragraph (a) shall be deemed to be Canadian exploration
and development expenses, foreign exploration and development expenses, Canadian
exploration expenses, Canadian development expenses, or Canadian oil and gas
property expenses, as the case may be, incurred by the taxpayer in the year.
. .
.
21(4) Borrowing for
exploration, etc. — In computing the income of a taxpayer for a particular
taxation year, where the taxpayer
(a) in any preceding
taxation year made an election under subsection (2) in respect of borrowed
money used for the purpose of exploration, development or acquisition of
property,
(b) in each taxation year, if any, after that preceding
taxation year and before the particular year, made an election under this
subsection covering the total amount that, but for an election under this
subsection in respect thereof, would have been deductible in computing the
taxpayer's income (other than exempt income) for each such year in respect of
the borrowed money used for the exploration, development or acquisition of
property, as the case may be,
if an election under this subsection is made in the
taxpayer's return of income
under this Part for the particular year, paragraphs 20(1)(c),
(d), (e) and (e.1) do
not apply to the amount or to the part of the amount
specified in the election that,
but for an election under this subsection in respect
thereof, would be deductible in
computing the taxpayer's income (other than exempt income)
for the particular
year in respect of the borrowed money used for the
exploration, development or
acquisition of property, and the amount or part of the
amount, as the case may be,
shall be deemed to be Canadian exploration and development
expenses, foreign
exploration and development expenses, Canadian exploration
expenses, Canadian
development expenses or Canadian oil and gas property
expenses, as the case may
be, incurred by the taxpayer in the particular year.
21(5)
Reassessments — Notwithstanding any other
provision of this Act, where a taxpayer has made an election in accordance with
the provisions of subsection (1) or (2), such reassessments of tax, interest or
penalties shall be made as are necessary to give effect thereto.
66(12.1) Limitations of Canadian exploration and development expenses —
Except as expressly otherwise provided in this Act,
(a) if as a result of a transaction occurring after May
6, 1974 an amount has become receivable by a taxpayer at a particular time in a
taxation year and the consideration given by the taxpayer therefor was property
(other than a share or a Canadian resource property, or an interest therein or
a right thereto or services, the original cost of which to the taxpayer may
reasonably be regarded as having been primarily Canadian exploration and
development expenses of the taxpayer (or would have been so regarded if they
had been incurred by the taxpayer after 1971 and before May 7, 1974) or a
Canadian exploration expense, there shall at that time be included in the
amount determined for G in the definition “cumulative Canadian exploration
expense” in subsection 66.1(6) in respect of the taxpayer the amount that
became receivable by the taxpayer at that time; and
. .
.
66.1(6) "Canadian exploration expense" — "Canadian
exploration expense" of a taxpayer means any expense incurred after May 6,
1974 that is
(a) any expense including a geological, geophysical or
geochemical expense incurred by the taxpayer (other than an expense incurred in
drilling or completing an oil or gas well or in building a temporary access
road to, or preparing a site in respect of, any such well) for the purpose of
determining the existence, location, extent or quality of an accumulation of
petroleum or natural gas (other than a mineral resource) in Canada,
. .
.
67. General
limitation re expenses
In
computing income, no deduction shall be made in respect of an outlay or expense
in respect of which any amount is otherwise deductible under this Act, except
to the extent that the outlay or expense was reasonable in the circumstances.
VI. Analysis
A. Statutory Purpose Test
[51]
The first question to
determine is whether the appellant purchased an undivided interest in the Technical
Data for the purpose of exploration, as required by paragraph (a) of the
definition of “Canadian exploration expense” in subsection 66.1(6) of the Act.
[52]
At the opening of the
hearing, the respondent conceded that the expense incurred by the appellant to
purchase his share of the Technical Data qualifies as a CEE, as defined in subsection
66.1(6) of the Act (paragraph (a) of the definition), by virtue
of being for the purpose of determining the existence, location, extent or
quality of an accumulation of petroleum or natural gas in Canada. Despite that
concession, it appears to me that it would be worthwhile to make the following
comments.
[53]
In Global
Communications Ltd. v. R., 1999 CarswellNat 1027, 99 DTC 5377, and in Petro-Canada
v. The Queen., 2004 FCA 158, 2004 DTC 6329, the Federal Court of Appeal looked
at what was actually done on the ground or with the seismic data in order to
make the determination. At paragraph 35 of the Petro‑Canada
decision, the Court made the following comment concerning the application of
the purpose test:
. .
. As I read those cases, the purpose test in the definition of
"Canadian exploration expense" requires at least some connection
between the purchased seismic data and actual exploration work. Evidence of the
actual use of the seismic data for exploration could provide that connection.
However, in the absence of such evidence, there must be at least a credible
plan for the use of the seismic data in an exploration program within a
reasonable time after its acquisition. A hypothetical connection to exploration
work that might be done in the future cannot suffice.
[54]
In this case, the evidence
clearly shows that the Seismic Data were actually used for exploration. The
drilling of one well , in 1996, was based on the Seismic Data. Mr. Ringdahl
reprocessed 4 or 5 lines of the Seismic Data and worked with Mr. Denike in
mapping the lines and updating them with information from various sources. The
Technical Data were used in evaluating land sales by the Manitoba government
and preparing bids, and in considering opportunities and offers for
"farm-in" agreements with third parties.
[55]
In 1994, additional
reprocessing work was performed by Veritas for Compton Petroleum Corporation on
three lines of the Seismic Data, and in his testimony Mr. Ringdahl referred to
the fact that, in October 1994, Seitel and Compton Petroleum Corporation had agreed
to reprocess 15 lines of data and to share the cost of that exercise on a fifty-fifty
basis.
[56]
Furthermore, the CRA,
by reassessing the appellant and allowing him the CEE deduction up to the amount
that he had invested in cash recognized that the Seismic Data were acquired for
and used in, exploration activities.
B. The "Cost
Amount" of the Technical Data Purchased by the Appellant That Constitutes
"Canadian Exploration Expenses"
[57]
At the opening of the
hearing, the respondent conceded that the appellant's promissory note was not a
contingent liability.
[58]
In light of that
concession, the only conclusion that can be drawn is that the amount of the
promissory note must be equated with an incurred expense.
[59]
The respondent's
position is that the price paid by the appellant for his interest in the Joint Venture
was inflated by the use of limited resource financing and that the true
consideration was $20,000 plus 50% of the net licensing revenues for nine
years. Any expense incurred by the appellant in excess of $20,000 in connection
with his participation in the Joint Venture was unreasonable in the
circumstances.
[60]
The Minister reassessed
the appellant by applying section 67 of the Act to deny the deduction of
the expenses incurred by the appellant in excess of $20,000. The reassessment
was not based on section 69 of the Act as the Minister assumed that the
appellant was dealing at arm's length with the vendor of the Seismic Data.
Consequently, the fair market value of the Seismic Data is not an issue here.
[61]
In Petro-Canada,
supra, Sharlow J.A. referred to the test developed by Cattanach J. in Gabco
for determining whether an expense is reasonable:
62 The leading case on the statutory predecessor to
section 67 is Gabco Limited v. Minister of National Revenue, [1968] 2
Ex.C.R. 511, [1968] C.T.C. 313, 68 D.T.C. 5210 (Ex. Ct.). In that case,
Cattanach J. stated the following test for the application of this provision:
It is not a question of the Minister or this Court
substituting its judgment for what is a reasonable amount to pay, but rather a
case of the Minister or the Court coming to the conclusion that no reasonable
business man would have contracted to pay such an amount having only the
business consideration of the appellant in mind.
[62]
In the Petro-Canada decision,
madam Justice Sharlow's conclusion concerning the application of section 67 was
as follows:
64 Reasonableness, like value, is a question of fact. In this case, it is a fact upon which
the Judge made no finding. While it may be true, as suggested in Mohammad,
that paying fair market value for something is prima facie reasonable, I
am unable to agree with the Crown that it necessarily follows that paying more
than fair market value is unreasonable. There may be circumstances in which a
decision to pay more than fair market value for something is a reasonable
decision. Considering the test stated in Gabco, I am not persuaded that
this is an appropriate case for the application of section 67.
[63]
In McLarty v. The
Queen, 2005 TCC 55, 2005 DTC 217, this Court found that the appellant's
payment of $100,000 for his interest in the Seismic Data was reasonable within
the meaning of section 67 of the Act:
73
Given the highly speculative nature of the oil and gas exploration industry,
the fact that seismic data is very difficult to value as well as the experience
of Mr. Sapieha in the oil and gas exploration industry, this is not an
appropriate case to question the participants' business judgment. This is not a
situation where paying more than the fair market value would be unreasonable.
However, I find that a reasonable businessman in the Appellant's position would
have paid at least $100,000.00 in return for the undivided interest in the
Venture Data and the unlimited access that the Appellant obtained.
74
Since this was an arm's length transaction, and the expense was reasonable this
is not an issue of fair market value. . . .
[64]
Considering the
respondent's admission that the transaction whereby the appellant acquired an
undivided interest in the Technical Data was an arm's length transaction, the
onus is on the respondent to establish that the fair market value of the Technical
Data was not higher than that assumed by the Minister. This demonstration has
not been made by the respondent. Mr. Morin, the owner of Carlyle, was
subpoenaed but not called as a witness by the respondent. Consequently, there
is no evidence before this Court which explains why there was an increase in
the value of the Technical Data after their acquisition from Chevron and why
Carlyle appointed Seitel as its nominee for the purpose of completing that
transaction.
[65]
The fact that the
revenues from the licensing of the Seismic Data amounted to $1.8 million over a
three-year period supports a value for the Technical Data at the time of their
acquisition by the Joint Venture in excess of $975,000. Trinity paid $875,000
for only a copy of the Technical Data and 14 month’s exclusivity.
C. The Deductibility of Interest
[66]
The interest paid or
payable on the Promissory Notes was a real obligation of the joint venturers.
The Promissory Notes were recognized in the financial statements of the Joint
Venture as a liability at the full amount of principal and accrued interest.
The Crown admitted that the Promissory Notes were not a contingent liability.
[67]
Mr. Thornton, the
Crown’s expert, questioned the accounting treatment of the Promissory Notes and
was of the opinion that they were carried on the financial statements at an
amount that was unlikely to be paid on account of the lack of profitability of
the enterprise of the Joint Venture during the period from 1993 to 2006. Mr.
Zimmer, the appellant’s expert rebuttal witness, disagreed with Mr. Thornton’s
opinion and concluded that the Promissory Notes were a liability for accounting
purposes and that the use of hindsight was not appropriate in the
circumstances. I am in agreement with Mr. Zimmer’s opinion on this point.
[68]
Given the fact that
interest was paid on the Promissory Notes by the joint venturers in each of the
1994 and 1995 taxation years, that approximately $104,000 was repaid on the
principal amount of the Promissory Notes during those years and that the
statutory purpose test of paragraph (a) of the definition of “Canadian
exploration expense” in subsection 66.1(6) of the Act was met, the
appellant was entitled to capitalize the interest expenses associated with the
purchase of his undivided interest in the Technical Data for the 1994 and 1995
taxation years such that the interest he paid constituted CEE.
[69]
The appellant was also
entitled to deduct in computing his income from the Joint Venture for the 1998
and 1999 taxation years the amount of interest payable on the appellant’s
Promissory Note because that interest expense was incurred pursuant to a legal
obligation to pay interest on an amount payable for property, the Technical
Data, acquired for the purpose of gaining or producing income from that
property or for the purpose of gaining or producing income from a business.
[70]
In 1998, an amount of $242,600
was added to the principal amount of the Promissory Notes and, in 1999, an
amount of $262,500 was added to the principal amount of the Promissory Notes.
During those two years, the Seismic Data generated revenues of only $53,800,
but the total revenues generated by the Seismic Data in the years 1997 to 2006
were close to $1,000,000.
[71]
This shows that the
Joint Venture, despite the fact that it had ceased its exploration activities
in 1996, continued to earn licensing revenues from the Seismic Data until 2006.
This justifies the deduction of the interest payable on the appellant’s
Promissory Note in the 1998 and 1999 taxation years.
D. The Sham Argument
[72]
In Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, the Supreme Court of
Canada made the following comment concerning what constitutes a “sham
transaction” (at pages 545 and 546):
. . . A sham transaction: This expression comes to us
from decisions in the United Kingdom, and it has been generally taken to mean
(but not without ambiguity) a transaction conducted with an element of deceit
so as to create an illusion calculated to lead the tax collector away from the
taxpayer or the true nature of the transaction; or, simple deception whereby
the taxpayer creates a facade of reality quite different from the disguised
reality. . . .
[73]
The classic definition
of “sham” in Snook v. London and West Riding Investments, Ltd., [1967]
1 All ER 518, has been repeatedly endorsed by Canadian courts. The required
elements for a sham are (1) an intention of the parties to the transactions (2)
to give a false appearance (3) that legal rights and obligations have been
created that are different from the actual legal rights and obligations of the
parties.
[74]
Contrarily to the
Crown, I do not see the existence of the required elements for a sham in the
transactions carried on by the appellant or by the Joint Venture.
[75]
The appellant was not a
party to a great number of specific transactions alleged to be steps in a sham
and entered into by parties dealing with each other at arm’s length. In the
series of transactions described in paragraph 16 above, the appellant was
involved in only the Joint Venture agreement between 507326 and the joint venturers
and in the acquisition of an interest in the Joint Venture.
[76]
There is no evidence in
the record showing that the appellant and the parties to the series of
transactions had the intention of giving a false appearance to the
transactions. The legal rights and obligations that were created were not
different from the actual legal rights and obligations of the parties to the
transactions.
[77]
The Minister assessed
the appellant on the basis that the appellant did in fact acquire an undivided
interest in the Seismic Data. The revenues derived from the licensing of the
Seismic Data ($2,800,000 in total from 1994 to 2006) were included in the
income of the joint venturers. Interest was paid on the Promissory Notes in the
1994 and 1995 taxation years, and approximately $104,000 was repaid on the
principal amount of the Promissory Notes during those same years. The
Promissory Notes were real legal obligations and not a contingent liability, as
admitted by the Crown. The debt forgiveness rules were applied by the Minister
in respect of the $7,080,471 of debt that was forgiven with respect to the
Promissory Notes in the 2006 taxation year.
[78]
In my opinion, the
Crown cannot apply the doctrine of sham to only a part of a particular
transaction while considering another part of the same transaction as being
legally valid and effective. For example, I have difficulty with the Crown being
permitted to apply the doctrine of sham to only that part of the acquisition by
the appellant of an undivided interest in the Seismic Data that was paid for by
the appellant’s Promissory Note.
[79]
The statutory purpose
test of paragraph (a) of the definition of “Canadian exploration
expense” in subsection 66.1(6) of the Act was met in this instance,
which means that the expenses in issue were incurred for the purpose of
exploration. The acquisition of the Seismic Data, the work performed by Mr.
Ringdahl in reprocessing the data, in mapping the lines with geologists and in
updating them with available information, in evaluating land sales by the
Manitoba government and in preparing bids for the purpose of such sales, and the
drilling of the Daly Well were all standard exploration activities conducted on
behalf of the Joint Venture.
[80]
The fact that while there
were 22 signatories to the Joint Venture Agreement, 30 persons claimed tax
deductions because there were other individuals behind the original investors,
despite the fact that no nominees were allowed, is not an indication of a sham.
It is rather an indication that some persons were not legally members of the
Joint Venture and were not entitled to the deductions. The Minister should have
simply denied those persons the tax deductions after making sure that the offering
of participations in the Joint Venture was made in accordance with Alberta securities legislation.
[81]
The Crown alleged that
the valuations obtained by Mr. Sapieha were not true valuations because they
were prepared after the acquisition of the Seismic Data. The determination of
the fair market value of the Seismic Data is a matter of expertise and the
evidence is that Mr. Sapieha received oral valuations on December 31, 1993 and
that these were confirmed in January 1994 when he received the formal
valuations.
[82]
The Crown alleged that
Mr. Ringdahl, as an investor in the Joint Venture, assumed that the only risk
inherent in his investment was the loss of his tax deductions. He never
expected to have to repay the principal of his promissory note or to pay the
interest thereon. I do not consider that as being an element of a sham
considering the fact that the Promissory Notes were structured as non-recourse
financing.
[83]
The role played by
Compton Petroleum Corporation was considered by the Crown to be an element of a
sham because Compton Petroleum Corporation had royalty-free access to the
Seismic Data and carried on exploration activities without disclosing the 50%
interest of the Joint Venture in those activities.
[84]
The evidence revealed
that Mr. Sapieha was the directing mind of all the Compton entities, including
Compton Resource Corporation, Compton Petroleum Corporation, 507326 and the
Joint Venture. All these entities operated out of the same offices. The
evidence also revealed that there was no written agreement between Compton
Petroleum Corporation and 507326 acting on behalf of the Joint Venture
entitling Compton Petroleum Corporation to carry on exploration activities on
behalf of the Joint Venture. The financial terms of the arrangement were not
known except for the sharing of the exploration expenses on a fifty-fifty
basis.
[85]
Concerning access to
the Seismic Data, the evidence revealed that Compton Petroleum Corporation was
added to the list of principals referred to in the Data Management and Sale
Agreement entered into between Carlyle and Seitel so as to allow Compton
Petroleum Corporation to use the Seismic Data in conjunction with the Joint
Venture. The evidence is that Compton Petroleum Corporation benefited from a
royalty-free right to use the Seismic Data.
[86]
All exploration
activities of the Joint Venture were carried on by Compton Petroleum
Corporation on its behalf despite the absence of any written agreement defining
the terms and conditions of the arrangement. The costs of all such exploration
activities were shared on a fifty-fifty basis, except for the cost of
acquisition of the Seismic Data and the consulting fees of Mr. Ringdahl and Mr.
Denike, which were all assumed by the Joint Venture alone. According to the
testimony of Mr. Sapieha and Mr. Ringdahl, it is standard practice in the
industry to use only the name of the operator on a well licence and on the land
leases for exploration.
[87]
The evidence revealed
that no exploration budget was submitted to the participants in the Joint
Venture. It must be recognized that it would have been difficult or impossible
to prepare an exploration budget before the Joint Venture had had the
opportunity to look at the Seismic Data and to evaluate the potential for
exploration. The intent was to use the revenues from the licensing of the
Seismic Data to fund the exploration activities of the Joint Venture. The funds
available for exploration for the 1994, 1995 and 1996 taxation years were
$394,000, $390,000 and $210,000 respectively. An authorization for expenditures
in the amount of $154,150 was signed by Compton Petroleum Corporation on
February 15, 1996 for the drilling of the Daly Well (Exhibit R-6). The
participants in this exploration program were Compton Petroleum Corporation and
507326, each holding a 50% working interest. It may be worthwhile mentioning
here that the Joint Venture also had a 50% interest in approximately 80 mineral
leases acquired during the period from 1994 to 2000 and that those mineral
leases were transferred to Compton Petroleum Corporation in 2001 to reimburse
Compton Petroleum Corporation for $324,000 in expenses incurred by it for the
benefit of the Joint Venture.
[88]
Considering the
evidence before me, I cannot accept the Crown’s position that the creation of
the Joint Venture and the transactions carried on by it and by Compton
Petroleum Corporation on its behalf were mere window dressing intended to
deceive the Minister. The legal rights and obligations created by the said
transactions were not different from the actual legal rights and obligations of
the parties. The way in which the financial statements of the Joint Venture
were presented is not relevant in the circumstances because the issue does not involve
determining whether or not the Joint Venture was an oil and gas entity for
accounting purposes or whether or not the licensing revenues derived from the
Seismic Data were incidental to the exploration activities of the Joint Venture
or were related to a separate business. The financial statements of the Joint
Venture were audited financial statements with no qualified opinion. As such,
they were accurate and reliable.
[89]
For the foregoing
reasons, the appeals concerning the appellant’s 1993, 1994, 1995, 1998 and 1999
taxation years are allowed with costs and the reassessments dated May 1, 1997
and October 29, 2001 are vacated.
Signed at Ottawa, Canada, this 18th day of June 2014.
"Réal Favreau"
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