Alamar Farms Ltd. v. The Queen, 93 DTC 121, [1993] 1 CTC 2682 (TCC)

Kempo, T.C.C.J.:—These appeals concern the appellant's 1987, 1988 and 1989 taxation years.

With respect to the 1987 taxation year the Minister of National Revenue (the "Minister") assessed federal tax as nil as a result of allowing an investment tax credit against tax otherwise payable. Appellant's counsel concedes there is no appeal from a nil assessment; R. v. Bowater Mersey Paper Co., [1987] 2 C.T.C. 159, 87 D.T.C. 5382 (F.C.A.). Therefore the 1987 appeal is dismissed.

Alamar Farms Ltd. is a Canadian controlled farming corporation. During the material times it received income from farming, from surface leases and from its mineral rights (the royalty”). All of the income arose from the appellant's farm land. In its financial statements the appellant reported all three sources as "active business income” and claimed entitlement to the small business deduction under subsection 125(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am.

S. C. 1970-71-72, c. 63) (the "Act"). The subject appeals are from the reassessments of the Minister wherein the royalty income was treated as derived from a "specified investment business” rendering it ineligible for the small business deduction.

Accordingly, the issue is whether the appellant's royalty income derived from the mineral rights included in its fee simple ownership of the farm land is from an "active business” within the meaning of paragraph 125(7)(c) of the Act as alleged by the appellant or is from a "specified investment business” within paragraph 125(7)(e) of the Act.

Facts

Evidence was given by the appellant's major shareholder and president, Mr. Allan Carr.

The farm land comprises of approximately 480 acres, legally described as the northwest quarter of section 6 and the south half of section 7 in township 7, range 4, W2nd meridian in the Province of Saskatchewan. The appellant's fee simple ownership includes mineral rights as to the south half of section 7. This land had been family owned and farmed for around 80 years. It was transferred to the appellant in 1977 on its incorporation for estate planning purposes. At that time there was one producing oil well which was set up in 1976. A second one was drilled in 1977 and the third and last one was drilled in 1985.

The farming operation took up all of the land surface. There was no involvement whatever with the oil activity except to receive royalty cheques each month at 12 /2 per cent of the gross oil produced. While conceding that the royalty receipts and the farm receipts were conceptually separate, Mr. Carr nonetheless stressed that both arose essentially out of harvestation” from the same land. He testified that all of the royalty income went into financing the farm operations, including acquisition of farm machinery as well as the purchase and repair of farm buildings. Mr. Carr affirmed that the farming operation would have somehow been carried on and continued well into the future without the royalty which was described as a great bonus or lucky draw.

Extracts from the financial statements filed as Exhibits 2-4 inclusive reveal the following pertinent information (amounts are rounded):

Mr. Carr confirmed that the prices of both oil and grain had decreased between 1987 to 1989 inclusive and that the cash on hand had declined accordingly. He also confirmed that the appellant did not have more than five full- time employees.

The law

The relevant portions of the applicable provisions of the Act follow:

125(1) There may be deducted from the tax otherwise payable under this Part for a taxation year by a corporation that was, throughout a taxation year, a Canadian- controlled private corporation, an amount equal to 16 per cent of the least of

(a) the amount, if any, by which the aggregate of

(i) the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada. .. . .

125(7)(a) "active business carried on by a corporation" means any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade;

(c)" income of the corporation for the year from an active business” means the income of the corporation for the year from an active business carried on by it including any income for the year pertaining to or incident to that business, but does not include income for the year from a source in Canada that is a property (within the meaning assigned by subsection 129(4.1);

(e) “specified investment business” carried on by a corporation in a taxation year means a business. . .the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties). . .

129(4.1) . . ."income" or" loss" of a corporation for a year from a source in Canada that is a property includes the income or loss from a specified investment business carried on by it in Canada. . .but does not include income or loss

(a) from any other business,

(b) from any property that is incident to or pertains to an active business carried on by it, or

(c) from any property used or held principally for the purpose of gaining or producing income from an active business carried on by it.

[Emphasis added.]

Positions of the parties

For the appellant

The thrust of the appellants position, as I understand it, was that the royalty derived by it from its mineral rights located within its farm property is to be treated as active business income, being income "pertaining to or incident to” the farm business within the general definition of income from an active business as set out in paragraph 125(7)(c).

Because the royalty was produced from the same property that produced the farm income, it is excluded from the definition of income from property by virtue of paragraph 129(4.1)(c). The terminology used in paragraph 125(7)(c) contemplates incidental income and thereby purposely includes income that is separable from active business income. The matter is likened to a taxpayer leasing out building space owned by it that was then surplus to its own business needs. If the leased space was proportionately excessive to the amount of space retained for the taxpayer's business then the rental income would not be from property held or used principally for the purpose of gaining and producing income from the active business within paragraph 129(4.1)(c). The converse situation of the leased to self-used space being proportionately low would then mean that it was. Here, the principal use of the appellant's land was farming, the royalties from the underlying mineral interests being merely incidently thereto. Farming is a renewable resource unlike oil which is not. The determination of principal activity should not be skewed by short term fluctuations in the relative price of oil to grain. When viewed over a period of time farming was Clearly the principal activity.

Alternatively, paragraph 129(4.1)(b) is applicable as the royalty was employed or risked in the farming business and that the risk was not remote. While the existing case law deals with interest income derived from cash investment certificates as opposed to royalty income derived from mineral interests, money cannot be equated with goods and services themselves and therefore it is logical that in order for interest to be considered active business income the underlying cash must be shown to have a close connection with the business. The test need not be so onerous where tangible property is involved and where the receipt of the royalty is incidental to ownership of the farm.

For the respondent

Surface rights and mineral rights are separate legal entities. Each are discrete types of property. Each of the farming income and the royalty income are based on different proprietary interests, and the fact of their common location makes no difference. The appellant was involved in at least two businesses. One was farming which produced active business income. The other was an oil royalty business which produced inactive ineligible business income and as such was income from a “specified investment business" within paragraph 125(7)(e).

As to paragraph 129(4.1)(c): The appellant's farming business was unrelated in character to its royalty business. Two separate businesses were being carried on, farming and royalty, the latter not attracting this inclusion.

As to paragraph 129(4.1)(b): It is not applicable because the underlying asset, the mineral rights, was not generated by the active business of farming itself. Alternatively, the royalty income was not incident to or pertaining to the farming business in that it was not employed or risked therein because the evidence was that farming would, some way or another, have continued into the indefinite future without those funds.

Analysis

As I appreciate the legislative provisions applicable to the facts of this appeal, prima facie the royalty was income derived from property which falls within the definition of income from a "specified investment business” pursuant to paragraph 125(7)(e) and which, similarly, is excluded from active business under paragraph 125(7)(c). The two activities were based on different proprietary interests notwithstanding their common location. The proprietary interests being exploited were separable. The fundamental issue is whether the royalty falls within either of the paragraph 129(4.1)(b) or (c) exclusions such that it may be treated as income from an active business under paragraph 125(7)(c).

Having regard to the totality of the facts, it is my opinion that either of these exclusions is applicable.

With respect to paragraph 129(4.1)(c) which excludes from the definition of property-sourced income the income from property used or held principally for the purpose of gaining or producing income from an active business, the royalty income was incidental to the principal activity of farming and was used or held principally for that purpose. This case is indeed analogous to the rental situation put forth by appellant's counsel. Counsel's point is well taken that there would be no purpose to the reference to “incidental income" in paragraph 125(7)(c) if its interpretation was to be confined to mean only income that was inseparably linked with the active business.

Further, grain harvestation is renewable and ongoing while oil extraction, by its very nature, is not. Price fluctuations influencing proportionate comparisons of royalty to farm income underscore the danger of using such comparisons as a guide in the determination of principal and incidental sources. Here, the royalty income was used for the farming business in that it had been employed and risked therein within the meaning attributable to those terms in the cases of The Queen v. Ensite Ltd., [1986] 2 S.C.R. 509, [1986] 2 C.T.C. 459, 86 D.T.C. 6521 and McCutcheon Farms Ltd. v. M.N.R., [1991] 1 C.T.C. 50, 91 D.T.C. 5047 (F.C.T.D.).

In Ensite Ltd. at pages 520-21 S.C.R. (C.T.C. 465, D.T.C. 6525-26) it was said:

The test is not whether the taxpayer was forced to use a particular property to do business; the test is whether the property was used to fulfil a requirement which had to be met in order to do business. Such property is then truly employed and risked in the business. Here the property was used to fulfil a mandatory condition precedent to trade; it is not collateral, but is employed and risked in the business of the taxpayer in the most intimate way. It is property used or held in the business.

If I am wrong with respect to the applicability of paragraph 129(4.1)(c) then and in any event the paragraph 129(4.1)(b) exclusion would apply in that the royalty was income from property that was incident to or pertained to the farming.

In McCutcheon Farms at page 52 (D.T.C. 5047-48) Strayer, J. stated:

Paragraphs 129(4.1)(b) and (c) thus describe certain exceptions to the general principle that income from property is investment income. Thus if one can bring the income in question here within the general definition of income from an active business in paragraph 125(6)(e) [now 125(7)(c)] including any income pertaining to or incident to that business. . ." and within either of paragraphs 129(4.1)(b) or (c) then such income will be treated as income from an active business and not "Canadian investment income”.

Counsel acting for the respondent pointed out that interest earned from cash deposits which arose out of active business operations was the subject matter in both Ensite Ltd. and McCutcheon Farms and that these authorities are therefore distinguishable. While that may be the case, I nonetheless find their analysis as persuasive to the facts and issues at bar and I see no reason why they should not be adopted here. As appellants counsel observed, the very essence or nature of money, being a simple medium of exchange, mandates an identifiable connection with active business income. Here the situs of the mineral rights being within the farm property and the receipt of the royalty income therefrom being incidental to the appellants ownership of that farm both form the appropriate linkage to the farming activity also being actively pursued thereon.

An overall appreciation of the facts supports the conclusion that the royalty income was employed or risked in the farming business, that it was necessary to its operations or working capital, that its withdrawal would have had a decidedly destabilizing effect, and that it had been actually used to fulfil a requirement which had to be met in order to do business; viz Ensite Ltd., McCutcheon Farms and more recently Irving Garber Sales Canada Ltd. v. M.N.R., [1992] 2 C.T.C. 260, 92 D.T.C. 6498 (F.C.T.D.), at pages 268-71 (D.T.C. 6504-08).

Counsel for the respondent urged that without the royalty income’ the evidence was that farm operations would have been altered to ensure its continuance and family holding. In my view future opportunities gained through altered business plans are irrelevant. The focus is and remains on the actual employment or use of the funds within the active income stream on an annual basis and not on whether the appellant is compelled to use a particular property to do or to remain in business in the future.

The appeals for the 1988 and 1989 taxation years are allowed, with costs, and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant's royalty income from its mineral rights located within its farm land was income from its active business within paragraph 125(7)(c) which is eligible for the deduction claimed pursuant to subsection 125(1) of the Income Tax Act.

Appeal allowed.