Date: 19990618
CORAM: STRAYER J.A.
DÉCARY J.A.
ROBERTSON J.A.
A-426-97
BETWEEN:
GLOBAL COMMUNICATIONS LIMITED
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
------------------------------
A-427-97
AND BETWEEN:
GLOBAL COMMUNICATIONS LIMITED
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
Heard at Vancouver, British Columbia, on Tuesday, May 18, 1999.
JUDGMENT delivered at Ottawa, Ontario, on Friday, June 18, 1999.
REASONS FOR JUDGMENT BY: ROBERTSON J.A.
CONCURRED IN BY: STRAYER J.A.
DÉCARY J.A.
Date: 19990618
CORAM: STRAYER J.A.
A-426-97
BETWEEN:
GLOBAL COMMUNICATIONS LIMITED
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
-------------------------
A-427-97
AND BETWEEN:
GLOBAL COMMUNICATIONS LIMITED
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
ROBERTSON J.A.
INTRODUCTION
Section 66 of the Income Tax Act permits a taxpayer to deduct from income a "Canadian exploration expense", which is defined as an expense incurred for the purpose of determining the existence or location of oil and gas reserves in Canada. It confers a distinct tax advantage upon a taxpayer, since it permits the full deduction of an expense which would otherwise constitute a capital outlay.
The term "seismic data" is used to describe geophysical information obtained by installing sound recorders in the earth's surface and tracing the results of explosions ("shot seismic"). It also describes the physical media (tapes, film, computer data storage devices or paper printouts) on which the information is recorded. The primary use of seismic data is to facilitate the location of oil and gas reserves. Such data is regarded as a "standard research tool" because it is much less expensive than actual drilling. Seismic data can be sold outright or licensed for a fee.
The appellant taxpayer, Global Communications Limited, purchased seismic data for $15 million. Of that amount, $1.8 million was paid in cash. The balance of $13.2 million was secured by a limited recourse promissory note, that is to say, a note by which Global"s liability is limited to the proceeds of sale of the seismic data and any gas and oil assets owned at the time the note matures. Global proceeded to deduct the full purchase price from its income over its 1991 and 1992 taxation years on the basis that that amount qualified as a Canadian exploration expense within the meaning of paragraph 66.1(6)(a) of the Income Tax Act . On reassessment, the Minister of National Revenue disallowed the deduction in its entirety on the ground that the acquisition of data with a view to licensing does not come within the purpose test set out in that provision. In addition, the Minister maintained that Global had not used the seismic data in carrying out its own exploration. On appeal, the Tax Court Judge ruled that the purchase of seismic used for licensing purposes qualified as a Canadian exploration expense, but limited the deduction to the amount of the cash outlay. He did so, apparently, on the ground that the promissory note did not qualify as such under the Bills of Exchange Act. Global appeals to this Court on the basis that the entire purchase price is deductible. The Minister cross-appeals on the basis that his reassessments should be affirmed.
In the reasons that follow, I take the respectful position that the taxpayer is not entitled to a tax deduction, either in whole or in part. This case is one in which the tax strategy was as defective in its design as it was in its execution. Specifically, I find that seismic data purchased for the purpose of resale or licensing does not qualify as a Canadian exploration expense within the meaning of paragraph 66.1(6)(a) of the Income Tax Act. In addition, I am of the view that Global did not establish that oil and gas exploration was being carried out on its behalf with the aid of the seismic data which it had purchased. Alternatively, I find that if the activities of Global satisfy the purpose test set out in paragraph 66.1(6)(a), then Global is limited to a Canadian exploration expense deduction of $1.8 million. I reach this alternative conclusion for two reasons. First, Global failed to establish that the seismic data had a fair market value greater than the cash amount. Second, the balance of the purchase price secured by the promissory note represents a contingent liability and, for that reason, it is not deductible from income for the year in which the obligation arose.
FACTS AND DECISION BELOW1
Global is a well known Canadian broadcasting company. In 1984 and 1985, it participated in three limited partnerships involving the purchase of 20,000 kilometres of seismic data. All of the transactions were arranged by Leonard Shapiro of Calgary, who controls a number of related companies generally referred to as "Shapco". Shapco is in the business of petroleum exploration and production; it also manages a library of 200,000 kilometres of seismic data. In 1991, Global contemplated another seismic purchase which, according to the company's chairman, "could wipe out Global's entire tax position for the current year" and "could save us up to $9 million of tax". The events leading up to the purchases in question are as follows.
In the fall of 1989 or 1990, Mr. Shapiro became aware that Petroseis Energy Surveys Ltd. ("Petroseis"), a seismic data broker, was interested in selling 7,850 kilometres of seismic data. Mr. Shapiro approached Robert Kondrat, the owner of Karon Resources Ltd. ("Karon"), to acquire the Petroseis data for Shapco for approximately $2 to $2.5 million. Since Petroseis wanted $3 million for the data, no agreement was reached. In the spring of 1991, Mr. Shapiro again asked Mr. Kondrat to acquire the Petroseis data, offering between $2.15 and $2.25 million, provided the "appraised value" was between $18 and $20 million. Finally, in July of 1991, Petroseis agreed to sell the 7,850 kilometres of data to Karon for $2 million cash, subject to confirmation as to its appraised value, and 50% of the net licensing revenues derived by Karon over a three year period. The written agreement was not entered into until August 28, 1991, on which date the transaction was to close. However, the closing was contingent on certain conditions precedent that were not fully satisfied until October 2, 1991.
Karon split the 7,850 kilometres of seismic data into two blocks. One block, consisting of 6,400 kilometres of data, was sold to a company incorporated by Shapco for that sole purpose. That company was Technical Data Holdings Ltd. ("Technical"). The purchase price was $15 million, consisting of $1.8 million cash and $13.2 million secured by a limited recourse promissory note. In turn, pursuant to a written agreement dated August 29, 1991, this data was sold by Technical to Global for the same amount and on the same terms as the earlier contract. Before entering into the contract, Shapco obtained three "independent" appraisals as to the market value of the seismic data to be purchased. The appraisals ranged from $15 to $19 million.
With respect to the second block of seismic data, Karon sold the remaining 1,450 kilometres to Technical for $0.5 million cash and a limited recourse promissory note for $2.8 million. In turn, that data was sold by Technical to thirty-three individual investors.
In summary, for the 7,850 kilometres of seismic data which Petroseis owned, Karon paid $2 million cash and agreed to pay 50% of any licensing revenue received over the next three years. Karon then turned around and sold this data a day later to Technical for $18.3 million: $2.3 million in cash and $16 million secured by limited recourse promissory notes. Of the $2.3 million paid to Karon, Petroseis received $2 million while Mr. Kondrat earned $300,000 on behalf of his company, Karon.
Under the promissory note given by Global to Technical, interest accrued at the rate of 5% per annum and was not payable until the note matured on August 29, 1998 or the extension date, August 29, 2001. Recourse under the note was limited to that which could be realized on the sale of the Global data and any Canadian oil and gas leases that Global held at the time the note came due. In short, Global could not be sued for any deficiency under the note. Under the terms of the purchase agreement, Global was obligated to apply the following amounts against payment of the note, if and when received: (1) 50% of gross revenues derived from the sale or licensing of Global's data, minus brokerage and management fees; and (2) 50% of net oil and gas revenues. Provision was made for the assignment of licensing revenue to Technical from Global. In turn, Technical made an assignment of licensing revenues to Karon, who in turn made an assignment to Petroseis.
A contract for the management of the Global data was entered into with Four Star International Corporation ("Four Star"), another Shapco company. Under that agreement, Four Star was to receive a monthly fee of $6,250 for its management of the Global data. However, it had no employees and did "nothing"2. After paying over $400,000 in management fees to Four Star, Global unilaterally terminated the contract prior to the contract's expiration. At trial, Global adduced evidence to support its argument that Shapco performed the contractual obligations that had been originally undertaken by Four Star. As I understand the facts, Technical was responsible for the licensing of Global"s data, while Shapco supposedly looked after the exploration side of the business.
It is common ground that the Global data was a source of licensing revenue to Global. The parties, however, do not agree as to whether any gas or oil exploration was carried out with the aid of the Global data or whether any revenue was derived from such initiatives. It is also common ground that title to the Global data was not transferred to Global until October 2, 1991.
For its 1991 taxation year, Global claimed a Canadian exploration expense of $5.2 million. It claimed a $9.6 million expense for its 1992 taxation year. With respect to the 1991 taxation year, the Tax Court Judge held that no deduction could be claimed. He concluded: "[t]he Court finds that the Appellant did not pay for, acquire, own or possess the seismic data in its 1991 fiscal year. Its agreements with TDHL of August 29, 1991 were a nullity"3.
The dismissal of Global's appeal for the 1991 taxation was appealed to this Court (A-427-97). However, the parties now agree that that appeal should be dismissed without costs, since the transactions did not close by the end of Global's 1991 taxation year. They also agree that this fact did not render the contracts a nullity; rather, the law and the evidence demonstrate that the closing date under the respective contracts was extended until October 2, 1991. On that date, Petroseis transferred title to the seismic data directly to Global, and Global paid Technical $1.8 million in cash. Thus, it is now common ground that if Global is entitled to a deduction, it is for its 1992 taxation year.
The Tax Court Judge went on to consider whether Global was entitled to a Canadian exploration expense in the amount of $15 million for its 1992 taxation year. One of the principal findings of the Tax Court Judge was that the purchase of seismic data for licensing purposes qualifies as a Canadian exploration expense. In support thereof, the decision of the Alberta Court of Appeal in Fulcrum Resources Ltd. v. Alberta (Minister of Energy and Natural Resources)4 was applied. However, no express finding was made as to whether Global had used the data for exploration purposes. Nor was any finding made with respect to the reasonableness of the $15 million outlay. The Minister had taken the alternative position that if Global were entitled to a deduction, it was limited to the cash outlay of $1.8 million. According to the Minister's "assumptions", any deduction in excess of that amount was unreasonable in the circumstances. Although the Tax Court Judge limited the deduction to $1.8 million, he gave no formal reason for doing so. Earlier in his reasons, the Tax Court Judge noted that the promissory note did not qualify as such under the Bills of Exchange Act. In section 176 of that Act, a promissory note is defined as an "unconditional promise" to pay. The Tax Court Judge observed that since recovery under the promissory note was limited to the value of seismic data, and since no data had been transferred, the note had no value. He also observed that because the note in question was a limited recourse promissory note, its value was limited to the value of the seismic data at the date of recovery. He concluded by stating that the description of the note was a "misnomer". I assume that this is the reason underlying the Tax Court Judge's decision to limit the deduction of the Canadian exploration expense to the $1.8 million cash payment.
ISSUES
There are several issues to be decided by this Court. The first issue is whether Global's purchase of seismic data qualifies as a Canadian exploration expense within the meaning of paragraph 66.1(6)(a) of the Income Tax Act. Succinctly stated, does Global"s purchase of the data come within the purpose test set out in that provision; that is, is it an expense incurred for the purpose of identifying or locating oil and gas reserves in Canada? To answer that question, we must address two additional questions. First, does the purchase of shot seismic with a view to licensing (or resale) qualify as a Canadian exploration expense? If so, then the purpose test has been satisfied. If not, we must ask a second question, namely, whether Global was using the data for the purpose of oil and gas exploration. That question involves a finding of fact. If it is answered in the negative, then Global is not entitled to any deduction. Assuming, however, that Global satisfies the purpose test set out in paragraph 66.1(6)(a), it remains to be determined whether the deduction should be limited to the $1.8 million cash outlay, or whether it should reflect the stated purchase price of $15 million. The Minister argues that the proper amount is $1.8 million for two reasons. First, it is argued that the true value of the seismic data was no more than $2 million and, therefore, any amount in excess of that figure is unreasonable. Second, and alternatively, it is argued that the $13.2 million secured by the promissory note represents a contingent liability, which according to tax law, does not qualify as an expense. I shall deal with each of these arguments in turn. Before doing so, I must emphasize that two of the issues identified involve findings of fact not made by the Tax Court Judge. However, counsel for Global was insistent that this Court deal with all of the issues raised, instead of remitting them back to the Tax Court for further consideration.
ANALYSIS
The first issue involves a pure question of law: does the purchase of seismic data with a view to licensing or resale qualify as a Canadian exploration expense within the meaning of paragraph 66.1(6)(a) of the Income Tax Act? That provision reads as follows:
| 66.1(6) "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 him (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, |
|
66.1(6) < < frais d"exploration au Canada > > d"un contribuable s"entend des dépenses suivantes engagées après le 6 mai 1974:
| (a) une dépense, y compris une dépense à des fins géologiques, géophysiques ou géochimiques, engagée par le contribuable (à l"exception d"une dépense engagée pour le forage ou l"achèvement d"un puits de pétrole ou de gaz, la construction d"une route d"accès temporaire au puits ou la préparation d"un emplacement pour un tel puits) en vue de déterminer l"existence, la localisation, l"étendue ou la qualité d"un gisement de pétrole ou de gaz naturel (à l"exception d"une ressource minérale) au Canada, |
|
The essential terms of that provision are that any expense, including a geophysical expense, must have been incurred by the taxpayer for the purpose of determining the existence and location of oil and gas reserves in Canada. There are four groups of taxpayers who could conceivably claim a Canadian exploration expense. First, there are those who shoot their own seismic and then use the resulting data for their own exploration purposes. This group of taxpayers falls squarely within the purpose test set out in paragraph 66.1(6)(a). The second group consists of those who shoot seismic solely for the purpose of sale or licensing. This group of taxpayers is not involved in oil and gas exploration; however, on the authority of Fulcrum, this group is entitled to claim a Canadian exploration expense with respect to monies expended in generating seismic data. The third group of taxpayers consists of those who purchase or license seismic data from others, and then use it for their own exploration purposes. It is common ground that this group is entitled to claim a Canadian exploration expense with respect to the cost of acquiring seismic data. Global argues that it used the shot data which it had purchased for the purpose of conducting its own gas and oil exploration. The fourth group of taxpayers consists of those who purchase existing seismic data for the purpose of resale or licensing. They are not in the business of shooting seismic, nor are they in the business of oil and gas exploration. In short, they act strictly as brokers of seismic data. It is Global"s position that even if it did not carry out exploratory work with the data it purchased, it is entitled to claim a Canadian exploration expense because the purchase of shot seismic for the purpose of licensing or resale alone satisfies the purpose test set out in paragraph 66.1(6)(a) of the Income Tax Act . I shall deal with this issue first.
In my opinion, a careful reading of paragraph 66.1(6)(a) reveals that the type of expenses contemplated are those which the taxpayer carries out on the land itself. Under the Act, exploration expenses receive the most generous of tax treatment. The full amount is deductible. With respect to development expenses, the deduction is limited to 30% of expenses. The rate falls to 10% for oil and gas property expenses. The obvious purpose of the Canadian exploration expense is to encourage actual exploration in an industry exposed to large financial risks in the search for oil and gas reserves. In theory, but for the tax incentive, such exploration might not be undertaken. It is equally obvious, however, that the legislation's purpose is not to encourage the accumulation of huge inventories of seismic data which may or may not be of any value to those actually involved in oil and gas exploration. Seismic brokers are not exposed to the types of financial risks which confront those directly involved in oil and gas exploration. The only risk that these entrepreneurs must contend with is the risk that licensing or resale revenues might not cover the purchase costs. Even then, there can be no exposure to financial risk if the tax savings actually exceed the cash outlay required to purchase this type of data. By design, limited recourse promissory notes do not expose the purchaser to the risk of financial loss. They merely represent a convenient way of inflating the value and sale price of seismic data without exposing the buyer to personal liability for the amount secured by the note. I propose to say more on this matter below.
The idea that purchases of seismic data for the purpose of licensing or resale do not qualify as Canadian exploration expenses finds support in the decision of this Court in Gulf Canada Ltd. v. Canada5. That case involved a corporate taxpayer which sought to deduct rental payments made to provincial governments with respect to subsurface oil and gas rights. One of the issues raised was whether those payments qualified as a Canadian exploration expense under paragraph 66.1(6)(a). Writing for the Court, Hugessen J.A. stated at pages 6127 and 6128:
| |
[a]s a matter of law, to qualify as a Canadian exploration expense, the rental payments in question would have to meet the definition in subparagraph 66.1(6)(a)(i) as an "... expense ... incurred ... for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas." We agree with the view, apparently accepted by the trial judge, that payments made to maintain an acreage inventory upon which exploration, development and production may or may not take place at some undetermined time in the future are not within that definition . We also agree with the statement of Mahoney, J., as he then was, in New Continental Oil Co. v. The Queen, that there is a distinction between "payments for the right to drill and explore" and "expenses incurred in drilling or exploring". Furthermore, we would, as a general rule, expect that for any expense to be said to have been incurred for the purpose of determining the existence, etc., of petroleum or natural gas on a property, there would have to be at least some connection between that expense and work actually done on the ground . Accordingly, and while the rental payments made in respect of those parts of the acreage inventory upon which exploration activity actually took place in a taxation year might qualify as Canadian exploration expenses, we do not find it necessary to express an opinion on the point since no attempt was made by the taxpayer to quantify any such expenses, the amount of which would, in any event, be of minimal significance. We are quite satisfied that the purpose of the special treatment accorded by the legislation to exploration expenses was to encourage actual exploration and not to finance from public funds the accumulation of huge dormant inventories of subsurface rights. [emphasis added; footnotes omitted] |
|
Of particular relevance to this appeal is the finding that, "as a general rule", there would have to be some connection between that expense and work actually done on the ground for an expense to have been incurred for the purpose of determining, inter alia , the existence of oil or gas. The acknowledgement of possible exceptions to the rule is arguably a valid basis for distinguishing the Alberta Court of Appeal's decision in Fulcrum. That case involved provincial legislation, modelled on the Income Tax Act, which extended grants to those who incurred expenses which qualified as Canadian exploration expenses. The issue was whether monies expended for geophysical testing and the production of seismic data met the purpose test set out in what is the equivalent of paragraph 66.1(6)(a) of the Income Tax Act. The claimant had ordered the seismic work to be carried out by a third party, thinking that it would either sell the results or negotiate an interest in an oil or gas venture. Thus, the seismic data was acquired with the intention of resale only. The Alberta Court of Appeal upheld the claimant's right to a provincial grant with respect to the expenditure on the ground that it met the purpose test. At page 316 of its reasons, that court stated: "[t]he mere fact that the claimant might have sold the work to strangers does not disentitle it to the benefit [available under the provincial legislation]".
It seems to me that Fulcrum can be distinguished readily on the facts. We are not dealing with a case in which a taxpayer has expended monies to shoot seismic with a view to selling or licensing the data, as in Fulcrum. Moreover, assuming that Fulcrum is in conflict with this Court"s decision in Gulf , judicial comity dictates that we apply the latter decision. But there is another reason why Fulcrum should not be followed in this case. It stems from an analogy made by the Alberta Court of Appeal. In its reasons, that court stated that seismic data is no more than a "research tool" to be used in exploring for gas or oil reserves. If that is so, then neither the claimant in Fulcrum nor Global is in position to claim a Canadian exploration expense deduction.
Accepting that seismic data is no more than a research tool, it must be asked whether a retailer such as Global, or a manufacturer such as Fulcrum, can lay claim to a Canadian exploration expense. To me, the answer is obvious. Neither entity has incurred an expense for the purpose of determining the existence of oil and gas reserves. Rather, they have incurred an expense for the purpose of promoting their own financial interests by offering a product which enables others to engage in oil and gas exploration. In my view, a taxpayer who purchases seismic data with a view to licensing or resale is no more entitled to claim a Canadian exploration expense than a retailer or wholesaler of equipment designed to facilitate oil and gas exploration. It seems to me that the only way in which Fulcrum can be rationalized is through a purposive analysis of paragraph 66.1(6)(a) of the Income Tax Act. For example, it could be argued that those who actually shoot the seismic data provide an integral and indispensable service to those who undertake the actual exploration. I leave that issue for another day.
In summary, I am of the view that Global is not entitled to claim a deduction for a Canadian exploration expense in regard to shot seismic which it purchased and subsequently licensed. This leads to the question as to whether Global was carrying on an oil and gas exploration business. As noted earlier, the Tax Court Judge made no express finding of fact on this point. Of course, it was unnecessary to decide this point once he determined that the mere licensing of Global"s data satisfied the purpose test set out in paragraph 66.1(6)(a) of the Income Tax Act . The Tax Court Judge did, however, make a number of tangential findings which are relevant to this issue.
What is clear from the Tax Court Judge"s reasons and the evidence is that Four Star, the company formed for the purpose of managing Global's data, did nothing over a period of several years without any objection by Global, and yet Global paid hundreds of thousands of dollars in management fees before cancelling the contract. This is the point at which the execution of the tax stratagem begins to unravel.
The Tax Court Judge began by noting that over the ten year period during which Global participated in joint partnership ventures with Shapco, it had netted no profits, despite spending several millions of dollars. All that Global had to show for its ten year relationship with Shapco was "about two [oil] wells".6
As for the evidence that actual oil and gas exploration was carried out with the use of Global's data, the evidence is terminally weak. In 1994, three years after Global acquired the data, and after the Minister began to examine the transactions in question, Shapco requested that Ralph Landberg, a geophysicist, conduct a "quick recognizance" of the Global data. The Tax Court Judge had no difficulty in characterizing this self-serving evidence as intended to "impress the Court that [Global's data] was being used for exploration purposes"7.
Shapco's Vice-President, Mr. McMullen, testified that Shapco managed Global's seismic data for the purpose of exploration, just as it did for others whose data was kept in Shapco's library. The Tax Court Judge found that Shapco managed seismic data on behalf of its limited partners. Mr. McMullen testified that Shapco"s procedure in conducting exploratory work was to review seismic data and then select appropriate exploration sites. The decision as to where to drill and who was to receive what interest in a well was at the discretion of Mr. McMullen. The Tax Court Judge accepted the evidence that Mr. McMullen"s personal choices seemed to benefit Shapco, rather than the investors for whom Shapco supposedly acted as "trustee". The Tax Court Judge noted that the opportunities for abuse by Shapco were rampant in light of the absence of any written agreements by which investors such as Global could exercise control over Shapco.8 In addition, the Tax Court Judge noted that only one report was ever provided to Global respecting alleged exploration using the seismic data purchased by Global in 1992.
The Tax Court Judge concluded that, of the 6,400 kilometres of seismic data owned by Global, Mr. McMullen could only show that two sets of its data might have been used by Shapco in deciding whether to drill wells. (He also concluded that Mr. McMullen"s testimony as to the use of Global"s data in other drilling programs failed to fall within the time parameters in which Global owned the data.) One set of data, comprising 16 kilometres, constituted the first possible use of Global"s seismic data by Shapco for exploration purposes on behalf on Global.9 The method of choosing the well-site in question is described by those in the oil industry as "garbage picking", since drilling is undertaken at the limits of a recognized field or existing well. The Tax Court Judge seemed to accept this characterization.10 The second set of data, consisting of 120 kilometres was found by the Tax Court Judge to be "in the area of the two wells that Global has participated in drilling"11. It is not clear from his reasons whether those two wells were the product of Global"s earlier partnership arrangement with Shapco.
In my view, the findings of the Tax Court Judge and the evidence do not support the argument that Global was using its seismic data for exploration purposes. Another way of stating this conclusion is to hold that Global failed to establish that it was carrying on the business of oil and gas exploration. This is not to suggest that Global was required to undertake its own exploration. It would have been sufficient to establish that someone else was carrying on that business on its behalf, someone such as Four Star.
The definition of "business" set out in subsection 248(1) of the Income Tax Act is not helpful in identifying what constitutes a business. According to the jurisprudence, a business is best described as an organized activity carried on with a view to a reasonable expectation of profit. I shall deal with these criteria in reverse order.
During oral argument, counsel for the Minister focussed on the fact that the revenue generated from the licensing of Global"s data was not even sufficient to cover the 5% interest accruing on the $13.2 million secured by the limited recourse promissory note. The general thrust of their argument was that there could not have been any reasonable expectation of profit. It is understandable that Global would remain indifferent as to whether the licensing or exploration initiatives proved profitable. As long as the full purchase price of the seismic data qualified as a Canadian exploration expense, Global"s cash investment of $1.8 million was off-set by the anticipated $9 million in tax savings. Although I was impressed by counsel"s argument, I am not prepared to accept it, as there is still a question as to how much revenue was generated from the exploration undertaken on Global"s behalf. Given the complexity of the factual evidence underlying this issue, I decline the invitation to make a ruling. For this reason, I turn to whether the initiatives undertaken on behalf of Global may be characterized as a systematic effort to gain income. This is where Global"s tax strategy also fails.
In my view, the failure of Four Star to carry out exploration on Global"s behalf was fatal to Global"s tax strategy. That finding is not altered by the fact that Shapco expended efforts on Global"s behalf. The so-called informal arrangement which Global had with Shapco (Mr. McMullen) to use the Global"s data for exploration purposes does not demonstrate that a business was being carried on, that is to say, that its data was being used in an organized and systematic manner in the search for oil and gas reserves with a view to a reasonable expectation of profit. The suggestion that Shapco acted in the capacity of a "trustee" is contradicted by the Tax Court Judge"s finding that Shapco was more inclined to look after its own interests than the interests of those for whom it was supposedly acting. In conclusion, the informal arrangement between Shapco and Global is insufficient to establish that Global was involved in the business of exploring for oil and gas. Even if that informal arrangement were found to be acceptable, I am of the alternative view that the evidence clearly fails to establish that Shapco used Global"s data in a systematic or business-like manner. Only two small segments of Global"s data were actually used for exploration purposes. This is not sufficient to support the argument that Global was involved in oil and gas exploration.
In conclusion, I am of the view that Global"s purchase and licensing of seismic data does not satisfy the purpose test set out in paragraph 66.1(6)(a) of the Income Tax Act , nor does the evidence support the conclusion that Global was using its data in a systematic or business-like manner for the purpose of oil and gas exploration. Thus, Global is not entitled to deduct any amount of the purchase price of the data as a Canadian exploration expense for its 1992 taxation year. If, however, I am in error, and Global is entitled to a deduction, then it is necessary to decide whether the Tax Court Judge erred in limiting the deduction to the cash outlay of $1.8 million.
I agree with the Tax Court Judge"s finding that the limited recourse promissory note for $13.2 million does not constitute a note under the Bills of Exchange Act . However, my concurrence on that point does not detract from the fact that the note is valid as between the parties. The Bills of Exchange Act only comes into play when the instrument has been negotiated to a third party. Indeed, the rights of that third party as against the maker of the note depend on whether the note qualifies as such under that Act. However, that is an issue which does not arise in this case.
The Minister advances two principal arguments in support of its position that Global is limited to a deduction of $1.8 million. The first argument is that the true value of the seismic data does not exceed $2 million. In effect, the Minister is arguing that the $15 million expense is unreasonable within the meaning of section 67 of the Income Tax Act. The second argument is that the promissory note for $13.2 million constitutes a contingent liability and, therefore, does not qualify as an expense, let alone a Canadian exploration expense. I shall deal with the Minister"s arguments in that order.
One cannot help but question Global"s commercial acumen in agreeing to pay $15 million for 6,400 kilometres of seismic data when, on the day of the purchase, it knew that that data, together with an additional 1,450 kilometres, sold for $2 million, plus the right to 50% of all licensing revenue for the next three years. During oral argument it was conceded that the licensing revenue was not of critical significance, since no one was under any obligation to generate such revenue. It is significant, however, that the licensing revenue actually received by Global over a five year period was $2.7 million. Moreover, the sale from Petroseis to Karon must be deemed to be a sale at fair market value, since the parties were clearly at arm"s length. How, then, did the so-called experts arrive at a fair market value for the data of $15 to $19 million? Obviously, Global"s appraisers were not prepared to look at the price paid for seismic data on the open market. According to the Minister"s uncontradicted evidence, seismic data trades at about 10% of the value at which it is appraised.
In my opinion, appraisals which ignore cash transactions are simply self-serving opinions designed to inflate the value of seismic data and, therefore, must be rejected for tax purposes. Global"s tax strategy depended upon the appraised value greatly exceeding the actual cash outlay. Thus, taxpayers such as Global can remain indifferent as to whether oil and gas exploration is ever undertaken or the seismic data is licensed. This follows from the fact that a cash outlay of $1.8 million results in a $15 million deduction, resulting in a potential $9 million tax saving. In addition, Global can remain indifferent to the fact of its continuing liability for $13.2 million secured by the promissory note for two reasons. First, under the limited recourse note there is no potential for personal liability, as recovery under the note is limited to the liquidation of the seismic data and any oil and gas assets held on the date of realization. Since all that Global had to show for its ten year partnership with Shapco was an interest in two wells, the thought of losing those assets could not have been of much concern to Global. Second, and most conveniently, Global cannot be sued for any deficiency, nor is it obligated to make minimum payments on principal or interest under the note. Its only obligation is to pay a percentage of the licensing revenue, if and when received. Whether such revenue would be generated was a decision left to Technical, the vendor of the seismic data and a Shapco company. The reality is that Global could have given Technical a promissory note for $15 billion without blinking an eye, as long as it was cast in the form of a limited recourse note. Understandably, the Minister cannot help but blink, whether the purchase price is $15 million or $15 billion.
There is another fact which sheds light on the true value of the seismic data. Apparently, buying back limited recourse promissory notes for pennies on the dollar is standard industry practice. In the present case, another Shapco company bought the two notes that Technical had given to Karon in connection with the purchase of Petroseis"s seismic data. The face value of those notes totalled $15 million; however, the notes were purchased for $100,000. Another example involved Shapco purchasing seventeen promissory notes with a face value of $36 million for $600,000. This evidence supports the understanding that the true value of the notes bears no relationship to their stated amount and, therefore, to the price paid for the seismic data.
Global responds by asserting that only its four appraisers (three were retained prior to the purchase, another at trial) had practical valuation experience, and that the Minister"s expert witness lacked this practical perspective. In my opinion, the appraisal evidence submitted by Global is fatally flawed. The fact that Global"s appraisers adopted the view that the price at which Petroseis sold the data to Karon had no effect on the value which they placed on the data defies both commercial and common sense.
At the end of the day, it is understandable that the Minister would characterize the transactions in question as a "scam", as distinguished from a "sham". A sham involves deceit on the part of a taxpayer; that is, conduct intended to mislead the Minister as to the true state of affairs. In other words, the documents say one thing while the taxpayer does another. In the present case, the documentation does not seek to mislead the Minister, but only to tax his gullibility. It is one thing for taxpayers to arrange their affairs so as to move a tax loss from one related company to another, as in Stubart Investments Ltd. v. The Queen12. It is quite another to create a market place which would not exist but for inflated values attached to a commodity which is nothing more than a highly leveraged tax deduction.
In conclusion, I am of the view that Global has failed to establish that the seismic data which it purchased had a value greater than $1.8 million. If I am in error on this point, then my alternative conclusion is that the underlying debt represented by the promissory does not qualify as an expense, let alone a Canadian exploration expense, because it is a contingent liability. Hence, Global cannot claim a deduction for the amount of the purchase price represented by the promissory note.
I agree with the Minister that the $13.2 million note represents a contingent liability and, on the authority of Mandel v. The Queen13, no deduction may be claimed for Global"s 1992 taxation year. In Mandel , the taxpayers were claiming a capital cost allowance with respect to the acquisition of a movie for $577,000. However, the full purchase price had not been paid. The taxpayers made a down payment of $150,000 and agreed to pay the balance out of the profits to be generated once the movie was completed and distributed. The taxpayers assumed no liability for the balance of the purchase price in the event that the movie failed to generate sufficient profits. The Minister permitted a deduction, but only for the amount that was actually paid. The Tax Court Judge, the Court of Appeal and the Supreme Court agreed with that assessment. The taxpayers" liability to pay the balance of the purchase price was found to be a contingent liability, since they were liable only if an event occurred which was by no means certain, namely, that the movie would generate sufficient profits.
In the present case, the limited recourse promissory note represents a contingent liability, since it only arises to the extent that licensing revenue is generated which, by definition, is an uncertain event. There is no question that there is an underlying debt in respect to Global"s purchase of the seismic data. It is equally true that personal liability will attach to Global with respect to licensing revenues actually received. Until such revenues are received, however, Global"s liability to pay the proceeds and ultimately the balance of the purchase price is a contingent one. Understandably, tax law does not permit the deduction of an expense which may not have to be paid.
In my view, the facts in this case fall squarely within the parameters of the Mandel decision. Furthermore, it is evident that Global"s reliance on the Supreme Court"s decision in Holt v. Telford14 is misplaced. It would require another tome to outline the facts and issues in that case and, therefore, I shall confine my remarks to its essentials. In Telford, the Supreme Court was looking at section 41 of the Law of Property Act, R.S.A. 1980, c. L-8 which limits the rights of a mortgagee in cases of default by a non-corporate mortgagor. In such circumstances, the lender must look to the land and not the borrower to satisfy the underlying debt. If there is a deficiency upon liquidation (by foreclosure) of the land, the lender cannot proceed to sue the borrower personally, that is, on the covenant, because there is no personal liability on the part of the mortgagor under section 41. Thus, Telford only stands for the proposition that the relevant legislation could not extinguish the underlying debt. Telford does not alter my conclusion, which is that the debt evidenced by the $13.2 million promissory note represents a contingent liability.
DISPOSITION
I would dismiss the appeal in A-427-97 without costs, as agreed by the parties. I would also dismiss Global"s appeal in A-426-97, allow the Minister"s cross-appeal by setting aside the judgment of the Tax Court dated May 27, 1997, and remit the matter back to the Minister for reassessment on
the basis that Global is not entitled to a Canadian exploration expense deduction for the 1992 taxation year. The Minister is entitled to one set of costs here and in the Tax Court of Canada.
"J.T. Robertson"
J.A.
"I agree
B.L. Strayer J.A."
"I agree
Robert Décary J.A."
__________________
1 Now reported at [1997] 3 CTC 2499 (T.C.C.).
2 Ibid. at 2520.
3 Ibid. at 2518.
4 (1986), 45 Alta. L.R. (2d) 315 (C.A.).
5 92 DTC 6123 (F.C.A.); leave to appeal to the Supreme Court denied.
6 Global Communications Ltd. v. R., supra note 1 at 2520.
7 Ibid. at 2523.
8 Ibid. at 2522-23.
9 Ibid. at 2521.
10 Ibid. at 2524.
11 Ibid. at 2520.
12 [1984] 1 S.C.R. 536">[1984] 1 S.C.R. 536.
13 78 DTC 6518 (F.C.A.), aff"d 80 DTC 6148 (S.C.C.).
14 [1987] 2 S.C.R. 193.
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