Kaiser Petroleum Ltd. v. The Queen, 90 DTC 6034, [1990] 1 CTC 62 (FCTD), rev'd 90 DTC 6603 (FCA)

Joyal, J.:—The issue before this Court is to determine if a payment of $2,772,217 by the plaintiff in the taxation year 1978 is in the nature of a deductible expense or an outlay on account of capital pursuant to the provisions of the Income Tax Act.

Outline:

The payment in question has its roots in the terms of a preferred employees stock option plan (the "Plan") instituted by the plaintiff's predecessor company, Ashland Oil Canada Ltd. (Ashland Canada) on February 2, 1971.

Ashland Canada at that time was in the oil and gas business in Calgary. It was effectively controlled by Ashland Oil Inc. (Ashland U.S.), a corporation which held some 10,989,918 common shares in its subsidiary out of a total of some 13,000,000 shares outstanding. On July 11, 1978, Ashland U.S. entered into an agreement with a Canadian company called Kaiser Resources Ltd. of Vancouver for the sale of its shares in Ashland Canada. The agreed price was $33.50 per share.

At that time, Ashland Canada had in force its stock option plan and under this plan, qualified employees had optioned some 126,370 company shares exercisable over a period of time. The terms and conditions of the plan were standard but in essence it obliged Ashland Canada to deliver the optioned shares at the option price whenever the options should be exercised.

In the July 11, 1978 agreement between Ashland U.S. and Kaiser Resources Ltd., the seller gave an undertaking on behalf of Ashland Canada to attempt to eliminate any outstanding options held under Ashland Canada's plan by offering to make a cash payment to its option holders equivalent to $33.50 a share.

In its 1978 tax return, Ashland Canada included the sum of $2,772,317 as a current and deductible expense.

On April 18, 1973, Revenue Canada issued a notice of reassessment disallowing that sum as a deductible expense and claiming that it was an outlay or payment on account of capital within the meaning of paragraph 18(1)(b) of the Income Tax Act.

In the meantime, Ashland Canada had caused to have its corporate name changed to Kaiser Petroleum Ltd. and the tax records were amended accordingly. For all purposes of this action, therefore, Ashland Canada and Kaiser Petroleum Ltd. are synonymous.

The Facts:

The preferred employees stock option plan as disclosed in the evidence is one which comes within the terms of reference of section 7 of the Income Tax Act and, as a consequence, any benefit derived from it constitutes income in the hands of an employee-member of the plan.

It is stated in the plan that its purpose is to encourage common stock ownership by officers and other key employees of the company with resulting benefits to the company by way of additional incentive to assure superior performance, better recruitment of able people and greater attachment to their several appointments.

Some 300,000 common shares of the company were reserved at one time for purposes of the plan. The term of the option was five years, unexercisable during its first year but thereafter exercisable as to one half during the second year and as to one quarter during each of any subsequent year.

The plan was renewed in June of 1976, incorporated certain changes in the terms and conditions attached to it, none of which, however, are material to the issue before me.

In the takeover agreement of July 11, 1978, there is found the provisions relating to Ashland Canada's stock option plan.

It is Article 4.2 and it reads as follows:

4.2 Employee Stock Options. Prior to the Closing Date, AOCL shall (i) make an offer to each of its employees who holds an employee stock option of AOCL to obtain the cancellation of such option upon the payment by AOCL to such employee of an amount per share covered by such option equal to the difference between the exercise price per share under such option and Cdn. $33.50 per share and (ii) upon the request of any such employee, to the extent such employee's option may not be exercisable by its terms, amend such terms so that the option shall become immediately exercisable.

In compliance with this contractual undertaking, Ashland Canada duly adopted the required amendments at its board of directors’ meeting of August 8, 1978.

On September 20, 1978, the holders of stock options in Ashland Canada were informed of the purchase of its outstanding shares by Kaiser Resources Ltd., were told of the changes in the plan resulting from that purchase and were advised that, according to opinion of counsel, a receipt by any option holder of a cash settlement amount upon surrender of his option would constitute a benefit under paragraph 7(1)(b) of the Income Tax Act.

On September 26, 1978, the holders of stock options were further advised that as the cash settlement amount constituted a benefit pursuant to paragraph 7(1)(b) of the Act, it would be necessary for Ashland Canada to withhold tax thereon at the appropriate rate, unless of course any option holder wished to roll over the benefit into an income averaging annuity contract.

Another feature in the takeover agreement of July 11, 1978 between Kaiser Resources Ltd. and Ashland U.S. is reflected in subparagraph 4.1(ii) which obliges the seller "to diligently endeavour to keep available the present employees of Ashland Canada and to preserve relationships with all third parties having business dealings with Ashland Canada”.

As witness for the plaintiff, Mr. William John Whelan, Executive Vice- President of Ashland Canada at the time of the takeover, explained the situation. He stated that Kaiser Resources Ltd. wished to bring the plan to a term. The offer of a cash payment in lieu of the option rights granted under the plan appeared to be a reasonable solution. Ashland Canada felt it had an obligation to its employees under the plan and it wished to deal fairly with them. Ashland Canada had a continuing obligation to its employees as the company's operations were a going concern. It was not expected that the takeover by Kaiser Resources Ltd. would mean anything more than change of control. Furthermore, Ashland Canada, under the takeover agreement, had to assure a continuity of operations.

The other side of the transaction, according to Mr. Whelan, was that Kaiser Resources’ involvement in the oil and gas industry, prior to the takeover, was quite limited. Its experience was in the coal mining business. The lay-off of staff, especially of experienced staff, was not contemplated. Mr. Whelan, who subsequently became president of Oil & Gas, Kaiser Petroleum Ltd., could add that as the events unfolded, no material changeover in personnel took place.

Defendant's Position:

The position taken by Revenue Canada is a technical one. It proceeds on the basis that the expenditure of $2,772,317 incurred by Ashland Canada was not for the purposes of gaining or producing income in relation to its operations but resulted from its obligation to issue company stock. The payment was of a capital nature in order to obtain the cancellation of all outstanding options. Counsel for the defendant argues that the transaction falls within the terms of paragraph 18(1)(a) of the Act which disallows outlays or expenses for tax purposes except to the extent that they are made or incurred for the purpose of gaining or producing income from a business or property. Counsel also quotes paragraph 18(1)(b) which specifically disallows any outlay of capital except as expressly permitted in the Act.

Counsel for the defendant further argues that the issue is covered by subsection 7(3) of the Act which provides as follows:

7. (3) Where a corporation has agreed to sell or issue shares of the capital stock of the corporation or of a corporation with which it does not deal at arm's length to an employee of the corporation or of a corporation with which it does not deal at arm’s length

(a) no benefit shall be deemed to have been received or enjoyed by the employee under or by virtue of the agreement for the purpose of this Part except as provided by this section, and

(b) the income for a taxation year of the corporation or of a corporation with which it does not deal at arm's length shall be deemed to be not less than its income for the year would have been if a benefit had not been conferred on the employee by the sale or issue of the shares to him or to a person in whom his rights under the agreement have become vested.

Counsel urges the Court to consider specifically paragraph 7(3)(b) which prohibits, in somewhat arcane language, any deduction from income for such purposes.

Plaintiffs Position:

Counsel for the plaintiff suggests that the Court should adopt a more substantive view of the matter. The plaintiff had granted certain options and the terms and conditions thereof which subsequently involved an outlay or expense were for a business purpose. In essence, he says, payments made and benefits received in relation to those arguments represent deductible outlays to the payor and taxable benefits to the employees.

Counsel submits that the issue should be approached on the grounds that the plan was an integral part of the plaintiff's policy with respect to its key employees and in fact, the payout by the plaintiff was in furtherance of its contractual obligations to these employees. Anytime a company enters into such a plan it assumes obligations which might eventually cost it money. It views that obligation, however, as a cost of doing business and as a well- established and universally accepted method of rewarding and keeping good employees. When the deal with Kaiser Resources came through, the plaintiff's offer to terminate the rights and to accelerate the timely exercise of these rights was motivated by a desire to deal fairly with the employees and consonant with its obligations under subparagraph 4.1 (ii) of its takeover agreement "to diligently endeavour to keep available the present employees of Ashland Canada".

Counsel for the plaintiff submits that the intent of the Income Tax Act is to tax as income from employment benefits derived by employees in respect of stock option plans up to the point in time at which shares are actually acquired under an agreement such that the terms of the agreement have been performed in full. This principle is reflected in subsection 7(1) of the statute. It is therefore only at the time that shares are actually acquired by an employee pursuant to an option agreement that obligations thereunder have been discharged and that thereafter the relationship ceases to be one in respect of employment and becomes simply a matter between a shareholder and the company. If such a situation should become somewhat akin to that found in Reynolds et al. v. The Queen, [1975] C.T.C. 85; 75 D.T.C. 5042, it would then likely be in the nature of a capital transaction. But, says counsel, such is not the case before the Court.

Counsel also refers to the agreed statement of facts wherein both parties recognize that the amount of $2,772,317 was deductible by the plaintiff in accordance with generally accepted accounting principles. Any deviations from this principle, counsel suggests, require some specific statutory provision, otherwise these generally accepted principles should be respected.

Plaintiff's counsel makes another point. He dismisses out of hand the defendant's contention that subsection 7(3) of the statute applies. That provision, says counsel, has no application as no issue of shares took place.

Finally, counsel for the plaintiff underlines the fairly insignificant feature of the transaction in relation to the whole of the plaintiff's operations. The plan had its origins back in 1971. Its provisions reflected work and performance by the employees covered by it over many years. The exercisable rights were personal to the individual member, non-assignable and the whole deal was in fulfilment of the plan's avowed purpose. The amount of reserved shares was small as compared to the company’s total outstanding shares. The takeover by Kaiser Resources involved close to 11 million shares out of some 13 million shares outstanding. The transaction was in excess of $98,000,000. The option shares were 120,370 in number of which 108,620 were already exercisable and these shares obviously had no effect in the controlling block the purchaser wished to acquire. Counsel concluded that it was not an extraordinary item, in other words, no big deal.

Case Law:

On the issue of what constitutes a capital outlay or properly deductible expense, there are decided cases galore. The genesis of these cases may aptly be summarized in the dictum of Lord Pearce in, B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224; [1965] 3 All E.R. 209, found at page 264:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.

Fauteux, J. (as he then was) said substantially the same thing in M.N.R. v. Algoma Central Railway, [1968] S.C.R. 447; [1968] C.T.C. 161 at page 162:

Parliament did not define the expressions “outlay . . . of capital” or “payment on account of capital”. There being no statutory criterion, the application or nonapplication of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination . . .

Through the years, of course, courts have attempted to express certain principles which should be considered whenever the perennial question came up.

In Atherton v. British Insulated and Helsby Cables Ltd., [1926] A.C. 205; 10 T.C. 188, a once and for all payment £31,000 to form the nucleus of a company pension fund was held by the House of Lords to be a capital and non-deductible expense.

In the case of M.N.R. v. Canadian Glassine Co., [1976] C.T.C. 141; 76 D.T.C. 6083, the Federal Court of Appeal held that the expenditures incurred by the taxpayer to link its plant with another, although taking on the appearances of being expenditures to perform two supply contracts, was an outlay of capital.

In Canada Forgings Ltd. v. The Queen, [1983] C.T.C. 94; 83 D.T.C. 5110, the purchase of share options by the taxpayer in the hands of two shareholders was held by Grant, D.J. of the Federal Court to constitute a capital outlay. Of interest in that case, however, was that the controlling shareholder of the taxpayer company insisted on owning all the shares of the company and did not wish to have any minority group of shareholders.

In Eagle Motors Ltd. v. M.N.R., 37 Tax A.B.C. 118; [1964] D.T.C. 829, the Tax Appeal Board ruled that a $20,000 payment by the taxpayer to terminate a designated supplier obligation and which still had some four years to run was not an operating expense. It was a non-recurring one by the taxpayer in order to recover its freedom to trade with suppliers of its choice.

There is, of course, another line of cases.

In Canada Starch Co. v. M.N.R., [1968] C.T.C. 466, 68 D.T.C. 5320, President Jackett of the Exchequer Court ruled that a once and for all payment of $15,000 to have an opposition to the taxpayer's trade mark application withdrawn constituted a deductible expense. The President, in that case, attempted to classify the distinction between expenditures on revenue account and expenditures on capital account as follows at page 472 (D.T.C. 5323):

(a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition to such an entity, structure or organization, is an expenditure on account of capital,

and

(b) on the other hand, an expenditure in the process of operation of a profitmaking entity, structure or organization is an expenditure on revenue account.

Applying this test to the acquisition or creation of ordinary property constituting the business structure as originally created, or an addition thereto, there is no difficulty. Plant and machinery are capital assets and moneys paid for them are moneys paid on account of capital whether they are

(a) moneys paid in the course of putting together a new business structure,

(b) moneys paid for an addition to a business structure already in existence, or

(c) moneys paid to acquire an existing business structure.

His Lordship then went on to observe that in keeping faith with the foregoing distinctions, regard must be had to the business and commercial realities of the matter. He said at page 475 (D.T.C. 5325):

Mere registration is an empty right if it is not based on a trade mark that has business or commercial reality as an incidental consequence of the current operations of the business. In my view, therefore, the trade mark in question as an “advantage for the enduring benefit of the . . . business”, if it is such an advantage, was not acquired by the payment of $15,000.

His Lordship then went on to say:

. . . while a trade mark once it becomes a business or commercial reality is a capital asset of the business giving rise to it, just like goodwill, . . . a trade mark is not a capital asset that has been acquired by a payment made for its acquisition, but is a capital asset that arises out of, and can only arise out of, current operations of the business . . .

In M.N.R. v. Algoma Central Railway, supra, the Supreme Court of Canada confirmed an Exchequer Court decision holding that fees paid out by the taxpayer for a geological survey along its railway line in Northern Ontario, purportedly to increase development possibilities along the right-of-way were properly deductible as current expense.

In Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46; [1985] 2 C.T.C. 111; 85 D.T.C. 5373, the Supreme Court of Canada, reversing a Federal Court of Appeal decision, ruled that the purchase of lands adjoining the taxpayer's open-pit Operations represented, in the circumstances of the case, a cost in the nature of an expense.

After reviewing any number of precedents and after surveying both U.S. and Canadian authorities on the capital or current expense issue, the Court concluded, at page 122 (D.T.C. 5381):

After this review of the authorities, it can be seen that the principles enunciated by the courts and the elucidation on the application of those principles is of very little guidance when it becomes necessary, as it is here, to apply those principles to a precise set of somewhat unusual facts.

In B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, supra, the Privy Council decided that a lump sum payment made by the taxpayer to induce a service station operator to deal exclusively with it was an income expenditure. In effect, the expenditure was made in an attempt to sell more gasoline.

In Mitchell v. B.W. Noble Ltd., [1927] 1 K.B. 719; 11 T.C. 372, a case which involves employer-employee transactions, the Court of Appeal ruled that a lump sum payment to an employee in order to terminate an employment contract or rights on dismissal was in the nature of a charge against revenue rather than capital.

Finally, reference should be made to the case of The Queen v. Metropolitan Properties Co., [1985] 1 C.T.C. 169; 85 D.T.C. 5128 (F.C.T.D.), where Walsh, J. deals with the matter of generally accepted accounting principles. After an elaborate analysis of what he calls confusing jurisprudence on the point, his Lordship concludes, at page 180 (D.T.C. 5137) that:

1. General Accepted Accounting Principles (GAAP) should normally be applied for taxation purposes also, as representing a true picture of a corporation's profit or loss for a given year.

2. By exception they need not be applied for income tax purposes if there is some section or sections in the Income Tax Act which justify or require a departure from them or do not correspond with what are commonly accepted business and commercial practices.

Findings on the Evidence:

The foregoing case review makes it quite clear in my mind that I should eschew blind adherence to whatever might have been decided in specific cases. These cases cannot provide ready answers nor can they do more than indicate the general lines of questions which must be judicially put before a particular determination is made.

As a consequence, and quoting again from the B.P. Australia case, supra, what is the "common sense appreciations of all the guiding features . . . to provide the ultimate answer"?

My appreciation of these various features in the case at bar may be summarized as follows:

1. The establishment by the plaintiff of a preferred employee stock option plan was in furtherance of company policy to offer a form of reward to its employees. The plan had therefore the earmarks, in an orthodox and well- recognized form, of an equally recognized business purpose.

2. The plan enabled preferred employees to enter into binding option agreements with the plaintiff.

3. This resulted in an obligation on the plaintiff to deliver the shares whenever these employees exercised their options.

4. On the takeover, the plaintiff undertook to offer to pay these employees a sum in lieu of the outstanding stock options. This was an undertaking at the request of the Kaiser Resources which did not wish to leave any loose ends. It is a fact that subsequent to the takeover, Kaiser Resources made a follow-up offer for all the remaining outstanding shares in Ashland Canada.

5. The undertaking was essentially one which would satisfy the purchaser and at the same time reflect fully the plaintiff's obligation to its employees and its desire to deal with them fairly.

6. The plaintiff in fact respected that obligation and paid off its employees.

There is little doubt that without that undertaking, the plaintiff would not have incurred the expense. Upon the exercise of their several options, the employees would have been issued shares producing a benefit to the employees but at no cost to the plaintiff. What transpired, however, is that the plaintiff did bear a cost which, according to generally accepted accounting principles, was an expense properly charged against revenue.

The formula adopted was to pay on the basis of outstanding stock options. It was to pay for the cancellation of the rights exercisable under these options, As the defendant's counsel argues, the purchase and sale of these rights take on the character of a capital transaction. It is no longer a payout to employees to assure their better performance or their continued loyalty. It is a simple purchase of a capital asset on a once and for all basis and as such a non-deductible capital expense.

As I have mentioned earlier, such is the technical approach adopted by the defendant. In my respectful opinion, however, the issue cannot be simply resolved on technical grounds. It leaves too many questions begging: what capital asset was purchased? What could be its lasting value to the plaintiff? What was of enduring benefit to the trade? Would those shares, as issued, have effectively diluted share values? What would have been the tax treatment of the expense if the employees had simply torn up their option agreements and the plaintiff had paid them an equivalent bonus?

The same technical approach could equally, of course, be taken with respect to a lump sum payment in settlement of any purported right as in the case of Mitchell v. B.W. Noble Ltd., supra, but in that case the Court of Appeal in England ruled otherwise. Quoting the British Insulated and Helsby Cables Ltd. case, supra, at page 735, their Lordships agreed that "a sum of money expended, not of necessity and with a view to a direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency and in order indirectly to facilitate the carrying on of a business, may yet be expended wholly and exclusively for the purposes of a trade.

This kind of principle, in my respectful view, imposed a more objective as against a more technical view of what transpired in the case at bar. It requires that the pith and substance of the deal be explored.

Conclusion:

My first conclusion is that the issue before me is basically one of employer-employee relationships. It is my view that the preferred employees stock option plan, once established, created a term and condition of employment for those employees covered by the plan. It imposed on the plaintiff a contractual obligation to deliver shares, shares which of course would only be delivered when the shares' market price would result in a substantial benefit to the employees.

It may be presumed that the plaintiff's undertaking in 1979 to dispose of outstanding optioned shares was in fulfilment of a business purpose. It was as well a fulfilment of its obligation to the employees. The plaintiff assumed that in so doing it was conferring a benefit which, in accordance with section 7 of the Income Tax Act, constituted a taxable benefit. Within the terms of the various business considerations relevant at the time of the takeover agreement, that was a reasonable assumption to make and one to which the plaintiff formally subscribed.

Yet, as was said in Olsen v. The Queen, S.C.C. No. 20640, January 24, 1989, one must not permit "a triumph of form over substance". What we are facing here is essentially a payment by a plaintiff to its employees in fulfilment of a term and condition of employment. Common sense dictates that salaries, wages, bonuses and commissions paid to employees are proper charges against revenue. No evidence or argument was advanced that the payment was otherwise than a bona fide one. It was not tainted by any artificiality or by any discernable tax avoidance purpose. Therefore the employees' acceptance of a cash payment with the seeming novations of the original deal does not change its essential character.

If the payment was made under the guise of an option rights purchase, its true character was one of taxable compensation to employees in lieu of a taxable benefit which the employees would otherwise have enjoyed. In essence, the option rights formula at the equivalent takeover price of $33.50 was the formula which the plaintiff agreed to adopt, but it remains no less a form of compensation, the cost of which is a charge against revenue.

The plaintiff's action is therefore maintained with costs and the defendant's reassessment is vacated.

Appeal allowed.