Asamera Oil (Indonesia) Ltd. v. The Queen, 73 DTC 5274, [1973] CTC 305 (FCTD)

Heald, J:—This is an appeal by the plaintiff from income tax assessments for the taxation years 1963 to 1971 inclusive. The aggregate amount so assessed was $6,177,968.

The plaintiff is a company duly incorporated on May 19, 1962 under the laws of Bermuda by virtue of the Asamera Oil (Indonesia) Company Act 1962 enacted by the Governor, Legislative Council and Assembly of the Bermudas or Somers Islands and pursuant thereto, by virtue of the filing on June 1, 1962 of a memorandum of association with the Registrar General of Bermuda and the holding thereafter of its incorporation meetings.

The plaintiff has never filed income tax returns with the Minister of National Revenue taking the position that it is not and never has been a resident of Canada and has never been subject to the Income Tax Act. The question of residence thus forms one of the two basic issues in this appeal. The other basic issue is the propriety of the disallowance by the income tax Department of expenses incurred by the plaintiff in its oil operations in Indonesia. The Minister has disallowed expenses incurred by the plaintiff in a sum in excess of $13,900,000 on the basis that they are capital expenses and has taxed the plaintiff on its gross receipts which total some $12,200,000.

It is common ground that if the expenses are properly chargeable against revenue and are not of a capital nature, then the plaintiff had no taxable revenue in any of the years under review. If there were any of said years in which revenues exceeded expenditures, in the first instance, paragraph 27(1) (e) of the Income Tax Act has the effect of allowing the prior years’ losses to reduce the taxable income to nil.

Accordingly, I propose to deal with the deductibility of said expenses first because if the plaintiff had no taxable income during the period under review, the question of residence becomes academic so far as this appeal is concerned.

The impugned expenses, in the documents filed, were broken down into the following categories:

(a) geological and geophysical costs;

(b) intangible drilling costs;

(c) production and operating costs;

(d) general and administrative expenses;

(e) equipment; and

(f) expendable supplies and parts.

The parties agree that said expenses were all of the same nature. The defendant does not contend that some are of a capital nature and some of a revenue nature. The defendant’s position is that all of said expenditures are capital expenditures.

The plaintiff corporation is a wholly owned subsidiary of Asamera Oil Corporation, Ltd, a Dominion corporation with head office at Calgary, Alberta (hereafter referred to as the parent company). Mr Thomas L Brook of Calgary has been the president and chief executive officer of the parent company at all relevant times. He was also the president of the plaintiff corporation until 1969. The parent company is a fairly large public Canadian oil company and is listed on the New York Stock Exchange.

In the late 1950’s, Mr Brook, through associates and acquaintances in the oil business became interested in the potential for oil exploration on the Island of Sumatra, Indonesia. As a result of many discussions with various people, Mr Brook went to Indonesia in 1960 to continue his negotiations. He described the political situation in Indonesia at that time as rather unstable and turbulent: Indonesia had been a Dutch Colony (the Dutch East Indies). Mr Brook said that from 1945 on the country had received what he described as a sort of “staggered independence” or independence by stages. When he arrived in 1960, he said that there was prevalent in the country an intense anti-colonial feeling, a spirit of nationalism, a strong belief that foreign ownership of the country’s natural resources should no longer be permitted. This seeming consensus of opinion in the country was reflected in legislation passed by the Government of Indonesia in 1960 which provided that a state-owned corporation (originally Per- mina, after 1969 Pertomina) was to do all of the exploration and development of the oil resources of the country. In recognition of the fact that the Indonesians themselves did not have the technical knowledge and experience necessary to explore for and develop said resources, the legislation permitted Permina to hire foreign contractors to assist them. As a result of all of his discussions and negotiations, Mr Brook was able, on behalf of the parent company, to have executed an agreement in writing dated September 1, 1961 between Permina and the parent company.

Mr Brook, in his oral evidence at the trial and in correspondence, has said that, in his view, the parent company was, under said agreement, merely a contractor for Permina. In a letter which he wrote in October of 1962 (Exhibit P-5) he said:

I wish to make it quite clear that Asamera actually owns nothing nor has it title to anything in the Republic of Indonesia but is merely a contractor or a “hired hand” for Permina.

Turning now to the agreement itself, the pertinent portions thereof are as follows:

WHEREAS Permina is an Indonesian Corporation, duly authorized by the Republic of Indonesia to explore for, exploit, develop, produce, transport and refine crude oil, natural gas and other hydrocarbons which might be found in certain areas in Sumatra which areas are more particularly described in Exhibit A attached hereto; and

WHEREAS Permina is desirous of expending its activities for exploration of these areas in order to increase as rapidly as possible the production ■of crude petroleum and other hydrocarbons; and

WHEREAS Asamera desires to join with and assist Permina in the further expansion and acceleration of the exploration and development of potential petroleum resources of Permina; and

WHEREAS Asamera has the requisite experience and is otherwise qualified to contribute the finances, as well as the recommended programmes, for exploration and development of these areas;

NOW; THEREFORE, Permina and Asamera mutually agree as follows:—

Article 1

(a) The area within which Permina will operate with the co-operation, aid, and assistance of Asamera subject to the terms of this Agreement, shall be the areas as designated in Exhibit A attached hereto.

Article 2

Obligations of Asamera

(a) Asamera will supply all financial requirements of exploration and development programmes recommended by Asamera in the areas subject to this Agreement.

(b) Asamera will purchase and supply all equipment required to carry out the work contemplated in Article 2(a) above.

(c) Asamera will supply all technical personnel reasonably required to help Permina carry out the recommended programmes.

(d) Within three months of the date of signing of this Agreement Asamera will submit to Permina a recommended programme for exploration of at least one geological prospect in the area subject to this Agreement. Asamera further agrees to submit to Permina a recommended programme for the drilling of an exploratory well not later than 12 months from the date this Agreement is signed.

(e) Asamera will assist Permina in the marketing of any crude oil produced from operations in the areas subject to this Agreement.

(f) After the start of commercial production, Asamera will submit to Permina an estimate of the oil to be produced in the ensuing 12 months and a budget of costs for the recommended programmes.

Article 3

Obligation of Permina

(a) Permina agrees to carry out the recommended programmes presented by Asamera with all diligence and in accordance with good oilfield practice.

(b) Permina agrees to supply all personnel (except as set out in Article 2(c) above) required to carry out the recommended programmes.

(c) Permina agrees to obtain whatever other approvals and documents which may be required to give this Agreement the full force and effect of law.

(d) Permina shall provide facilities owned by Permina which would reasonably be required to facilitate operations under this contract, including transportation and housing and Permina shall further provide facilities for all foreign personnel and supply all Indonesian personnel necessary for the orderly performance of this contract in accordance with good oilfield practices.

Article 4

(a) Oil produced under any development programme shall be sold and the Sales proceeds shall be divided as follows: Permina 60% and Asamera 40%. Sales proceeds shall, however, to the extent of the initial 40% thereof, be paid to Asamera for materials, services, equipment and other costs incurred or supplied and invoiced to Permina by Asamera. The balance of such sales proceeds shall thereupon be divided as first set forth above.

(b) All Indonesian taxes and charges assessed against either Permina or Asamera will be paid by Permina out of its 60% of net profits, and Asa- mera’s 40% share of net profits shall not be subject to any Indonesian taxes or charges.

(c) All permits, licenses and authorizations which may be required by governmental agencies or authorities in connection with the operations hereunder will be obtained and provided by Permina.

Article 5

(a) The exploration term of this Agreement shall be for a period of six (6) years. It is further agreed that two extensions of two years each will be granted if conditions and circumstances justify such a renewal.

(b) In the event that commercial production is found during the exploration period, then this Agreement shall remain in full force and effect for a term of twenty (20) years commencing from the end of the exploration period.

Article 6

Associates of Asamera

(a) Asamera has the right to associate with it under this Agreement Plymouth Oil Company of Pittsburgh, Pennsylvania and/or Benedum-Trees Oil Company and/or Hiawatha Oil & Gas Company and/or any subsidiary (or successor of said companies acceptable to Asamera).

()b Asamera shall have the right to associate any other parties under this Agreement only with the express approval of Permina.

(c) Notwithstanding any such association of other parties under this article, Asamera shall remain solely responsible to Permina for all of Asamera’s obligations under this Agreement.

In my view, the agreement reinforces Mr Brook’s opinion that the parent company’s function was that of a contractor. It owned no interest in any resources or assets and acquired none. The parent company was obliged to pay for the cost of performing the services, including the cost of all necessary equipment but the parent company was to own none of the equipment—it was all to be owned by Permina. The parent company was to provide all technical personnel. I think it is clear from the agreement that the parent company was essentially providing services and the necessary technical expertise to Permina. Those services were to be paid for only out of oil produced from the exploration area. I agree with plaintiff’s counsel when he says that the venture was, therefore, of a highly risky nature.

Article 4(a) provides the basis upon which the revenue from any oil recovered was to be divided. Under that Article, until the parent company’s expenses were recovered, it received 64 cents out of every dollar of oil proceeds. When the parent company’s costs were recovered, its remuneration became 40% of the proceeds of oil produced. Thus, in effect, the parent company’s remuneration was totally dependent on the sale of oil and was proportionately increased in the early stages of oil production to enable it to recover the expenses incurred by it in the performance of its obligations as contractor.

On July 9, 1962 the parent company assigned all its right title and interest in and to the said Permina agreement to the plaintiff, its wholly owned subsidiary. Thereafter, the plaintiff assumed all the obligations under said agreement and carried on the business of performing services as a contractor for Permina under the agreement.

Other participants were brought into the venture both before and after the assignment by the parent company to the plaintiff. On the date of the original agreement, September 1, 1961, the parent company owned a 45% interest; on July 9, 1962, the date of assignment to the plaintiff, the interest assigned was also 45%. Over the years from 1962 to 1967 plaintiff’s interest fluctuated from a low of 40% to a high of 80% and has not changed since November 30, 1967 when plaintiff’s interest became a 60% interest. During the early stages of the Indonesian operation, plaintiff’s staff was quite small. Mr Brook was in Indonesia a good deal of the time, a geologist had been hired, along with three or four other staff members. Because of subsequent successes in finding oil, plaintiff now has about 1,100 employees working in the oil fields of Indonesia, about 800 of these are local Indonesians, some 65 or 70 are North Americans. They are the specialists, the drillers, the mechanics, the geologists and the warehousemen.

In the spring of 1965 plaintiff’s extensive exploration activity in Indonesia was rewarded with an oil discovery. The discovery well produced 2,800 barrels a day of 54 gravity crude oil. By 1969 their continuing drilling activity had resulted in ten producing oil wells in the Guedondong field producing 3,000 barrels per day and six additional wells in another field capable of producing 6,000 barrels per day. Subsequent drilling has been successful and at the present time it is fair to say that plaintiff’s 60% interest in the Permina agreement has become very valuable indeed. However, while plaintiff’s potential for future profit looks favourable, the position at the end of the period under review was that while it had expended some $13,900,000 to find oil in Indonesia, it had received up to that time only some $5,600,000 in revenues from oil production.

A perusal of a breakdown of the impugned expenses satisfies me that said expenses were incurred year after year by the plaintiff in fulfilling its obligations under the Permina agreement, and were directly and immediately necessary to earn the income which the Minister has taxed, expenses which one would normally expect and find in the Operation of a large-scale oil field exploration and drilling venture— cost of renting or purchasing drilling rigs, trucks, caterpillars (perhaps peculiar to Indonesia because of the difficult tropical terrain); drilling mud and chemicals; bits; fuel; cement; employees’ wages; geological and geophysical costs, etc.

I said earlier that the Minister is taxing the plaintiff on some $12,200,000 of income in the period under review. This consists of 5.6 million dollars in revenues from oil production; some 4.6 million dollars from the sale of a part of its interests in the Permina agreement to other oil companies* [1] and the balance being interest and other charges. And yet, to earn a total of $12,200,000 in income in the period under review, the Minister only allows total expenses of approximately one million dollars, disallowing all the other expenses. Looking at the figures for some of the years individually we see that in 1969, for example, plaintiff's revenue from oil production was 1.1 million, yet the Minister allowed slightly less than $100,000 in expenses. Plaintiff’s total income in 1967 for example was 1.2 million. The total expenses allowed by the Minister were $68,000. This pattern repeats itself in each of the years under review. One does not really have to go much further than a perfunctory look at these total figures to conclude that the Minister’s position is patently untenable.

However, the defendant’s position is that although that position may produce an offensive or unreasonable result, because of the nature of the agreement of September 1, 1961, all the revenue derived thereunder by the plaintiff is income but that most of its expenditures thereunder are not deductible within the provisions of the Income Tax Act because they were of a capital nature, they were expended to acquire for the plaintiff a capital asset, the capital asset being the right to receive income under said agreement.

The Minister does not dispute that said expenses were necessary to earn the plaintiff’s income or that they were intended for business purposes but says that they brought into being a capital asset (the right to receive income) and were thus a capital outlay or payment on account of capital within the meaning of paragraph 12(1) (b) of the Income Tax Act and are therefore not deductible from income.

Dealing with the Minister’s submission that the “right to receive income” is a capital asset, the case of Gladys Evans v MNR, [1960] CTC 69 at 76; 60 DTC 1047 at 1050, is relevant. Mr Justice Cartwright (as he then was) in delivering the majority judgment of the Supreme Court said:

. . . I cannot agree that the fact that a bare right to be paid income can be sold or valued on an actuarial basis at a lump sum requires or permits that right, while retained by the appellant, to be regarded as a capital asset. I do not think that in ordinary language a right to receive income such as that enjoyed by the appellant would be described as a capital asset. . . .

This is not the case of an oil company owning mineral rights or mineral permits to explore which are exploited and developed by said company. The plaintiff owned nothing in Indonesia; it had no rights in the minerals; it had no property rights in the wells or the equipment; it had been hired to perform services and even its right to receive payment therefor was dependent on the oil production on the subject lands.

I cannot agree that, in these circumstances, the right to receive income can be regarded as a capital asset. I suppose it can be said that every business expense is laid out to acquire a right to income. Any time one person performs a service for another and incurs expense in so doing, there arises a right to income when the service is performed. If such expenses are not deductible from income, it is hard to think of a case where the expense would be deductible.

A situation in some respect similar to the case at bar prevailed in Denison Mines Ltd v MNR, [1972] CTC 521; 72 DTC 6444, where the appellant owned a producing uranium mine. In extracting the uranium ore from the mine, the appellant removed only part of the ore from the areas encountered as the miners moved out from the mine shaft so that the ore that was left would be support for the “ceiling” of rock above the ore body. The part of the ore body that was so left was in the form of walls or pillars arranged so as to leave throughways through which the ore could be transported back to the shaft. During the years 1958 to 1960 appellant spent some $21,000,000 in constructing said throughways within the orebody itself but the revenue from the ore contained in the passageways exceeded that amount. The said revenue was treated as income and this was not in issue in the action. What was in issue was the appellant’s claim for capital cost allowance based on its claim that, as a result of the way in which the ore was extracted during the first stage of operations, these throughways or passageways had been created for a use during subsequent operations that was intended to continue long into the future, thus creating a capital asset. Accordingly, the appellant contended further that the expense of removing the ore from the space where the passageways are, was the “capital cost” of such assets. In discussing this position of the appellant, Chief Justice Jackett makes the following comments at page 524 [6446]:

In our view, the correctness of the appellant’s position must be determined by sound business or commercial principles and not by what would be of greatest advantage to the taxpayer having regard to the idiosyncrasies of the Income Tax Act.

In considering the question, it must be emphasized that, as far as appears from the pleadings or the evidence, no more money was spent on extracting the ore the extraction of which resulted in the haulageways than would have been spent if no long term continuing use had been planned for them.

One business or commercial principle that has been established for so long that it is almost a rule of law is that “The profits . . . of any transaction in the nature of a sale, must, in the ordinary sense, consist of the excess of the price which the vendor obtains on sale over what it cost him to procure and sell, or produce and sell, the article vended’’ (see The Scottish North American Trust Ltd v Farmer (1910), 5 T.C. 693 per Lord Atkinson at 705).

In the case at bar, likewise, no long-term continuing asset was acquired by the impugned expenses nor was there any evidence of any extra or additional money being spent to acquire a long term or continuing asset. The impugned expenses were all expended to live up to the plaintiff’s covenants and obligations in the Permina agreement. They were day by day, month by month expenditures necessary for the exploration and development of an oil field. They were current expenses necessary to earn current income and, as such, are surely deductible.

President Jackett (as he then was) expressed a similar view in the case of Algoma Central Railway v MNR, [1967] CTC 130; 67 DTC 5091. In that case, the appellant operated a railway and steamship company in the unpopulated area of Northern Ontario. In 1960 the appellant commenced a five year mining and geological survey of the area to assess mineral possibilities at an average cost of $100,000 per year. Appellant’s objective was to make the resultant information obtained from the surveys available to interested members of the public in the hope and expectation that it would lead to development of the area that would produce traffic for the company’s transportation system. The learned President allowed the appellant to deduct said geological and survey costs as current expenses. At page 136 [5095] he said:

. . . once it is accepted that the expenditures in dispute were made for the purpose of gaining income, on the view, as I understand it, that they were part of a programme for increasing the number of persons who would offer traffic to the appellant’s transportation systems, I have great difficulty in distinguishing them in principle from expenditures, made by a businessman whose business is lagging, on a mammoth advertising campaign designed to attract substantial amounts of new custom by some spectacular appeal to the public. Such an advertising campaign is designed to create a dramatic increase in the volume of business. In a very real sense, it is designed to benefit the business in an enduring way. According to my understanding of commercial principles, however, advertising expenses paid out while a business is operating, and directed to attract customers to a business, are current expenses. . . .

The learned President expressed similar views in the case of Canada Starch Ltd v MNR, [1968] CTC 466; 68 DTC 5320, where he allowed as a business expense, a lump sum payment of $15,000 which the appellant had paid to another company to drop its opposition to the use of the appellant’s proposed trade name. Associate Chief Justice Noël also expressed similar views in the case of Bowater Power Company Limited v MNR, [1971] CTC 818; 71 DTC 5469.

The latest expression of opinion on this question is the decision of the Federal Court of Appeal in the case of Elias Rogers Co Ltd v MNR, [1972] CTC 601 ; 73 DTC 5030.

in that case, the appellant was in the business of selling fuel oil, in the course of which it acquired and leased water heaters to fuel oil customers, mainly for the purpose of increasing its sale of fuel oil. The leases contained a clause by which the customer agreed to buy fuel oil exclusively from the appellant. The question at issue was whether the cost of installing the heaters in the customers’ premises was a deductible expense. The Minister contended that said expense was capital in nature. The Federal Court of Appeal ruled in favour of the appellant taxpayer, holding that said expense was deductible from current income.

At page 605 [5032] Chief Justice Jackett said:

The significant prohibition in paragraph 12(1)(b) is the prohibition of the deduction, in computing income, of a “payment on account of capital”. These words clearly apply, in the ordinary case, to the cost of installing heavy plant and equipment acquired and installed by a business man in his factory or other work place so as to become a part of the realty. In such a case the cost of the plant and the cost of installation is a part of the cost of the factory or other work place as improved by the plant or equipment. Clearly this is cost of creation of the plant to be used for the earning of profit and not an expenditure in the process of operating the profit-making structure. Such an expenditure is a classic example of a payment on account of capital.

What we are faced with here is, however, quite different. The appellant has not used the water heaters to improve or create a profit-making structure. Quite the contrary, the appellant has parted with possession of the heaters in consideration of a monthly rental and it has no capital asset that has been improved or created by the expenditure of the installation costs. I think it must be kept clearly in mind that, while the installation costs are exactly the same as a business man would have incurred if he had bought a water heater and installed it in his own factory, from the point of view of the question as to whether there is a payment on account of capital, there is no similarity between such an expenditure and an expenditure made by a lessor of a water heater to carry out an obligation that he has undertaken as part of the consideration for the rent that he charges, for the lease of the water heater.

With great respect to the learned trial judge, as it seems to me, once the matter is regarded as an expenditure by a renter of equipment to carry Out one of the covenants in his leasing arrangement, it becomes quite clear that it is not an expenditure to bring into existence a capital asset for the enduring benefit of the appellant’s business. It does not bring into existence any asset belonging to the appellant. On the contrary, as I view it, there is no difference between the installation costs and any other expenditure, such as those for repairs or removal of the heaters, that the appellant has to make in the course of its rental business.

I should have thought that, in any equipment rental business, while the cost of the equipment and money spent to improve the equipment is payment on account of capital, because the thing rented is the capital asset of such a business, money spent in order to carry out the lessor’s obligations under the rental agreements is cost of earning the income just as rents received under such agreements is the revenue of such a business.

In the instant case, as in the Elias Rogers case (supra), no portion of the impugned expenses resulted in the acquisition of any capital assets for the plaintiff. Capital assets were acquired certainly with

some of the money: trucks, drilling rigs, permanent oil wells, etc, but they all became the property of Permina, many of said assets becoming permanently affixed to realty owned by Permina. As in the Elias Rogers case (supra), the expenditures here made by the plaintiff were made to carry out obligations undertaken by it as the consideration for the income which it would receive from oil production on Permina’s oil properties. These expenditures are expenditures by a provider oi services to carry out the covenants in his contract for services and do not bring into existence any asset belonging to the plaintiff. The defendant also took the position that the impugned expenditures were not really the plaintiff’s expenditures because under the 1961 agreement, the plaintiff was entitled to recoup most of the impugned expenditures from Permina. It is true that the plaintiff is entitled to recoup most of the impugned expenditures from the proceeds of oil production under the provisions of Article 4(a) of the 1961 agreement referred to supra by virtue of the provision that the first 40% of production revenue be earmarked for reimbursement of plaintiff's expense. However, in computing plaintiff’s revenue for the period under review, the defendant has taken the total amount received by the plaintiff from oil revenues including the 40% received by it for reimbursement of expenses. That is to say, the defendant, in its assessment of the plaintiff, wants it “both ways”.

In computing income, the defendant treats the “expense reimbursement” as income while at the same time refusing to allow those same expenses as a deduction from income. The plaintiff accepts the defendant’s decision to include in income the “expense reimbursement” portion of the total oil production revenue received thus far but, quite rightly in my view, seeks to deduct those expenses from total revenue received.

I have accordingly concluded that the said disallowed expenses in the sum of $13,901,224 are properly chargeable against revenue.

I said earlier that in computing plaintiff's total income at some $12,200,000 for the period under review, the Minister included as income some 4.6 million dollars profit made by the plaintiff on the resale of a portion of its interest in the Permina agreement to other oil companies. Specifically, the defendant sought to include in income, the plaintiff’s profit on a sale of a portion of its interest to The Union Texas Oil Co and on the sale of a further portion to the Mobil Oil Co. The plaintiff challenged this position. Plaintiff submitted that the defendant could not, on the one hand, say that nearly all of its expenses were expenses incurred in the acquisition of a capital asset and then contend, on the other hand, that when that asset or a portion of it was sold, the proceeds therefrom were not a return of capital but rather income.

Even if the said profits on resale are taken into income, the plaintiff is not taxable in any of the years under review when it is allowed to deduct the disallowed expenses (total income of $12,200,000 (approximately) against total expenses of $13,900,000 (approximately)). Therefore, it is not necessary for the purposes of this appeal to decide the question as to whether the said resale profits were properly taken into income.

Since I have decided in favour of the deductibility of the impugned expenses, it also becomes unnecessary to decide the question of residence.

The appeal is allowed with costs. Plaintiff’s assessments for the taxation years 1963-1971 inclusive are referred back to the Minister for reassessment not inconsistent with these reasons.