Minister of National Revenue v. St. Catharines Flying Training School Ltd., 55 DTC 1145, [1955] CTC 185, [1955] S.C.R. 738

LOCKE, J.:—The respondent was incorporated as a private company under the provisions of the Dominion Companies Act by letters patent issued on September 12, 1940, the capital stock consisting of five thousand shares without nominal or par value. The declared purposes and objects as stated in the letters patent were :

“To establish, maintain, conduct and operate a school or schools for instruction and training in flying to be operated for the purposes of and in conjunction with the British Commonwealth Air Training Plan.’’

A clause in the letters patent which has been regarded as affecting the liability of the respondent reads:

‘ 1 And it is further ordained and declared that the company shall be prohibited from declaring dividends and shall also be further prohibited from distributing any profits during hostilities or during the period that the company is required to carry on elementary training under the British Commonwealth Air Training Plan.”

The persons at whose instance this company was incorporated were M. A. Seymour, Q.C., and two other members of a company incorporated in 1928 under the provisions of the Companies Act of Ontario named St. Catharines Flying Club, the principal purposes and objects of which were the promotion of flying and aviation in general and the teaching and training of persons in flying and aerial navigation. The letters patent of this last named company contained a provision that the company should be carried on without the purpose of gain for its members and that any profits or other accretions should be used in promoting its objects.

The Dominion Compames Act, 1934, contained in Part I the provisions under which commercial and other corporations organized for the purpose of carrying on business with a view to profit may be incorporated. Part II of this statute provided for the incorporation of companies without share capital for the purpose of carrying on, without pecuniary gain to its members, objects of a national, patriotic, religious, philanthropic, charitable, scientific, artistic, social, professional or sporting character, or the like.

Whatever is to be said as to the admissibility of the evidence, it was shown at the trial that Mr. Seymour, who was the vice- president of the St. Catharines Flying Club, and his associates, wished to incorporate the Dominion company under the provisions of Part II but, for reasons which are not explained and which cannot in any event affect the question to be determined, leave to do so was refused and, of necessity, the incorporation was carried out under the provisions of Part I.

On the same date as that of the grant of the letters patent, a contract was entered into by His Majesty, represented by the Minister of National Defence, and the respondent, for the establishment, equipment and carrying on of a flying school at St. Catharines, Ont. for the purpose of the instruction and training of members of the Royal Canadian Air Force. It is unnecessary to consider in any detail the terms of this arrangement other than to say that the services to be rendered by the respondent in the operation of the school were to be paid for on specified terms, and that the agreement was to continue until March 1, 1943, unless earlier terminated by the Crown, either by reason of the cessation of hostilities or for any other reason for which it should be considered that the school was unnecessary.

Following the incorporation of the respondent, common shares were issued to ten persons, in addition to the three applicants for incorporation. The Minister of National Defence, as a term of entering into the contract, had apparently stipulated that the company should have not less than $35,000 in cash, and $387,850 was donated by a number of corporations in St. Catharines and the vicinity. These monies were not paid as the purchase price of shares but were simply gifts for the purpose of assisting in the war effort.

Twelve of the thirteen shareholders became directors of the respondent, six of them being nominees of the St. Catharines Flying Club and the others representing the donor companies. It was the intention of the incorporators and their associates that any surplus that might result from the operations of the respondent company should enure to the benefit of the St. Catharines Flying Club and, in November of 1940, a declaration of trust was signed by the thirteen shareholders declaring that they held their shares in trust for that company and that, after completion of flying training under the contract with the Crown, or as might be required by the Crown, and upon the fulfilment of the objects for which the respondent was incorporated, they would vote to return the capital donated by the various companies without interest and would transfer the shares to the said cestui qui trust.

The declaration of trust contained, in addition, a recital that the life of the respondent company was by its letters patent “limited to duration of the war’’ but this was inaccurate: the letters patent contained no such limitation. It further declared that it was the intention of the Minister of National Defence for Air and the Minister of Transport that the St. Catharines Flying Club should benefit from any surplus earned by the respondent.

Mr. Seymour, who apparently had charge of the matter of incorporating the respondent and of negotiating the agreement with the Crown, said that, when permission to incorporate under Part II of The Companies Act was refused, he had asked that a complete prohibition of the declaration of dividends should be incorporated in the letters patent but this was refused, the prohibition being ‘‘restricted to the life of the contract’’.

The respondent operated the flying school under the terms of the agreement of September 12, 1940, as amended from time to time by agreement between the contracting parties, for the term agreed upon and the operations were continued thereafter under a new agreement dated March 23, 1943, between the respondent and His Majesty, represented by the Minister of National Defence for Air. The term of the new contract was until March 31, 1945, subject to earlier termination under its terms. The only term of the new arrangement which affects the matter to be decided was one which provided that the amount retained by the company “shall not be distributed and shall be held by the company in a reserve account until the termination of the contract and shall then be paid to a flying club approved by the Minister, failing which it shall revert to the Crown’’.

The result of the operations carried on by the respondent under the first agreement was that a substantial profit was realized. Whether the amounts received by the company surplus to the cost of operation under the second contract should be designated as income in view of the above quoted term of that contract, a sum of money remained in the respondent’s hands at its conclusion which, it is claimed by the appellant, was liable to taxation under the Income War Tax Act and the Excess Profits Tax Act, 1940.

There can be no doubt in the present matter that the public spirited persons who were responsible for the incorporation of the respondent company were actuated by a desire to be of some service to the State by assisting in the war effort and that it was their intention that if any profits resulted from its activities they should be paid to the St. Catharines Flying Club, to assist in carrying on its work. The question, however, is not what the promoters of the company intended to do with these monies but whether profit realized in the operation of the respondent company under the powers granted to it by its letters patent was income liable to taxation under the terms of these statutes.

Different considerations apply, in my opinion, to the profits realized from the operations under the first contract and any surplus resulting from the operations under the second contract. As to the latter, it appears to me undoubted that there was no income liable to taxation since the surplus resulting was held by the respondent upon terms that, unless the Minister should consent to its being paid over to a flying club, it was to be paid to the Crown. The status of such monies does not, therefore, differ from that which would have existed had the contracts simply declared, without more, that the respondent would hold any surplus in trust for the Crown. The respondent is, in my opinion, entitled to succeed upon this aspect of the matter, not on the footing that the exempting provisions relied upon affect the matter but on the ground that there was no income.

The situation is, I think, different in regard to the income realized from the operations under the first contract. The carrying on of such work was one of the declared objects of the company. That it was contemplated that, as in the case of other companies incorporated under Part I of The Compames Act, profits would be realized is made clear by the reference to dividends.

It is said in the reasons for judgment delivered in the Exchequer Court, in support of the finding that the respondent was organized and operated solely for non-profitable purposes, within the meaning of that expression in Section 4(h) of the Income War Tax Act, that ‘‘the appellant could never keep any of its profits or distribute them to its stockholders or members’’ but, with respect, this appears to overlook the fact that the profits made were the property of the company and there was nothing in the letters patent which prohibited it from retaining them and the prohibition against declaring dividends or distributing profits was restricted to the period of the duration of hostilities or the period during which the company was required to carry on elementary training under the British Commonwealth Air Training Plan. There was nothing which prohibited the declaration of dividends or the distribution of profits after that time.

The question of the liability of the respondent to taxation depends, not upon the intention of the promoters or the shareholders as to the disposition to be made of the profits but rather upon consideration of the terms of the letters patent, the nature of the business authorized to be carried on and of the business which was carried on which resulted in the earning of the income. As I have pointed out, the fact that the company was incorporated under Part I and the reference to dividends in the letters patent both indicate that it was contemplated that profits would be made, and there was no restriction of the right of the company to retain such profits which would enure to the benefit of the shareholders by increasing the value of their shares or to pay dividends, except to the extent above indicated. If the company had succeeded in obtaining letters patent which prohibited the pay- ment of dividends completely and, in addition, the retention of any earned income by the company, different considerations, which need not here be considered, would arise.

For these reasons, it is my opinion that the income resulting from the operations of this company under the first contract with the Crown is not exempt from taxation, either under the provisions of Section 4(h) or Section 4(e) of the Income War Tax Act. I think the liability to taxation of the income of this company resulting from those operations did not differ in any way from that of the income of any commercial company incorporated under Part I of The Companies Act.

Nothing said in the judgment of this Court in Sutton Lumber Company v. M.N.R., [1953] 2 S.C.R. 77; [1953] C.T.C. 237, or in the passage from the judgment of Sir Lyman Duff in Anderson Logging Company v. The King, [1925] S.C.R. 45; [1917-27] C.T.C. 198, there referred to, conflicts with the views above expressed.

I assume that all of the monies payable by the Crown under the first contract were received by the respondent before the end of its fiscal year in 1948. I would accordingly allow the appeal as to the assessments made for the years 1941, 1942 and 1943.

As success is divided, I think there should be no costs either of this appeal or of the proceedings in the Exchequer Court. HOME OIL COMPANY LIMITED, Appellant,

and

MINISTER OF NATIONAL REVENUE, Respondent.

Supreme Court of Canada (Rand, Kellock, Estey, Locke and Cartwright, JJ.), October 4, 1955, on appeal from judgment of Exchequer Court of Canada, reported in [1954] C.T.C. 301.

Income tax—Dominion—Income Tax Act, 1948, S.C. 1948, c. 52—Section ll(l)(b)—Income Tax Amendment Act, 1949, S.C. 1949 (2nd Sess.), c. 25—Section 53(1)—Allowances in respect of oil and gas wells—Whether such allowances are to be computed upon an individual well basis—Whether exploration and drilling costs are to be deducted on an individual well basis—Rules of construction of taxing statutes.

The appellant is a corporation in Alberta, engaged in exploring for and producing petroleum and natural gas. In computing its income for the taxation year 1949 it claimed as an allowance under Section 1201 of the Income Tax Regulations the sum of $796,023.22, being one-third of $2,388,069.65, which it considered as net profits for the year reasonably attributable to the production of oil and gas from the wells operated by it at a profit. In computing this profit the appellant did not reduce it by those exploration and development expenditures not related to the profit producing wells since it claimed that the depletion allowances permitted under the above-mentioned Regulations were to be computed on an individual well basis. The appellant computed its income for the 1950 taxation year in the same manner. The Minister, in assessing the appellant for the taxation years in question, permitted an allowance under the above-mentioned Regulations of only one-third (44) of the net profit in respect of all the wells operated by the company, including non-producing wells, after deducting all exploration, drilling and other special allowances under Section 53 of the Income Tax Amendment Act, 1949, Statutes of 1949 (2nd Sess.), c. 25. An appeal to the Income Tax Appeal Board was dismissed. On appeal to the Exchequer Court it was held:

(i) That the Exchequer Court is concerned only with the validity of the assessments and should deal with that question as if there had never been any proceedings before the Income Tax Appeal Board;

(ii) That the use of the word “well” in the singular in Section 1201 of the Income Tax Regulations does not settle the matter for Section 31 (j) of the Interpretation Act provides that unless the contrary intention appears, words in the singular include the plural;

(iii) That since Section 1201 of the Regulations confers a benefit upon the taxpayer it should be construed in the same way as an exempting provision of a taxing Act and the taxpayer must show that every constituent element necessary to the right of deduction is present in its case ;

(iv) That the word “well” in Section 11(1) (b) of the Act, Section 1201 of the Regulations and Section 53(1) of the Income Tax Amendment Act, 1949, should be read as including “wells” and there is no justification for assuming that it was applicable to wells operated only at a profit;

(v) That the appellant was not entitled to have the benefit of the deduction permitted by Section 53 of the 1949 Act and at the same time ignore the requirement of Section 1201(4) of the Regulations;

(vi) That the appeal must be dismissed with costs.

HELD (per curiam) :

(i) That the total allowance under Section 53 of the Income Tax Amendment Act, 1949, can be said to be made in respect of the profitable wells ;

(ii) That unless the items of expenditure under Section 53 are clearly related to a profitable producing well, they are not to be taken into account in determining the allowance under Regulations 1201 in respect of that well;

(iii) That drilling costs of wells operating at a loss cannot be related under Section 53 to the profitable wells and that no depletion can accrue in relation to them because they do not represent a productive value;

(iv) That the appeal be allowed with costs.

EDITORIAL NOTE: In this judgment of great importance to the oil industry, the Supreme Court by a unanimous decision, reversed the judgment of the Exchequer Court which upheld the view of the Income Tax Appeal Board.

The issue turns upon the deduction from the profits of oil companies of preproduction, exploration and development expenses and depletion. Under the Minister’s interpretation of the Regulations and law referred to herein, an oil company was required to determine the total net proceeds of production from its wells. It was then required to deduct therefrom the drilling and exploration costs of all its wells, including dry holes or wells operating at a loss. Only on the resultant figure of profit, if any, was the 3314% allowance for depletion permitted to be calculated and deducted.

The position of the oil industry as exemplified by the contentions of Home Oil Company, Limited, was that the expenses of producing wells should be deducted from each producing well. Only then could depletion be taken against the profits of each such well. It was contended further that only then also could the expenses of the dry holes or non-profitable wells be taken to reduce the resulting income of the company.

The two positions cannot be better stated than in the words of the Court as follows :

“Mr. Nolan’s contention is that the expression ‘profits of the well’ requires a separate ascertainment for each profitable well: that drilling which does not win oil does not produce a ‘well’; and that only operating expenses plus, by virtue of Section 53, exploration and development costs related directly to each producing well with their appropriate share of general administrative costs are to be deducted from the proceeds of that well to determine its profit as the datum for the purpose of the allowance. On the other hand, Mr. Riley’s position is that the word ‘well’, by force of the Interpretation Act, is to be taken as including ‘wells’ where more than one are operated, and that so taken, the profits from the wells, for the purposes of the allowance, and given the operation of Section 53 and subsection (4) of the regulation, are the total income less total outlays as mentioned.

The claim of the Crown reduces itself here to a deduction from total oil income of three items, (a) exploration and drilling expenditures other than those directly related to the company’s producing wells, (b) general and administrative expenses allocated to that exploration and development, and (c) operating deficits on individual wells. Both the Income Tax Appeal Board and the President of the Exchequer Court have upheld the Minister’s contention, and the question is whether they are right . . .

Unless, then, the items of expenditure under Section 53 are clearly related to a profitable producing well, they are not to be taken into account in determining the allowance under Regulation No. 1201 in respect of that well. The purpose of enacting Section 53 was to promote exploration and development on the widest scale throughout the country, but I cannot take it as intending an effect that might wipe out what otherwise would be allowed to third persons under Section 11(3). The same considerations apply to wells that are operating at a loss; they represent drilling costs under Section 53 that cannot fairly be said to be ‘in respect of’ profitable wells: no depletion can accrue in relation to them because they do not represent a productive value; but on the contention made, the total loss connected with them can be applied to deny depletion to profitable wells and to third persons interested in them.”

II. G. Nolan, Q.C., and J. Ross Tolmie, Q.C., for the Appellant.

H. W. Riley, Q.C., and J. D. C. Boland, for the Respondent.

RAND, J.:—This is an appeal by a company engaged in the production of natural oil and gas, and the question raised is whether the income in respect of which the allowance for depletion under Section 11(1) (b) of the Income Tax Act as defined by Regulation No. 1201(1) and (4) is calculated, is or is not to be reduced by the total allowance authorized by Section 53 of 13 Geo. VI, c. 25.

Section 11(1) (b) reads:

“(1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year

(b) such amount as an allowance in respect of an oil or gas well, mine or timber limit, if any, as is allowed to the taxpayer by regulation,’’

Subsections (1) and (4) of Regulation No. 1201 provide that:

“(1) Where the taxpayer operates an oil or gas well or where the taxpayer is a person described as the trustee in subsection (1) of section 73 of the Act, the deduction allowed for a taxation year is 3314 per cent of the profits of the taxpayer for the year reasonably attributable to the production of oil or gas from the well. ’ ’

‘ 1 (4) In computing the profits reasonably attributable to the production of oil or gas for the purpose of this section a deduction shall be made equal to the amounts, if any, deducted from income under the provisions of section 538 of chapter 25 of the Statutes of 1949, Second Session, in respect of the well.”

Section 53 is as follows :

“ (1) A corporation whose principal business is the production, refining or marketing of petroleum or petroleum products or the exploring and drilling for oil or natural gas, may deduct, in computing its income for the purposes of The Income Tax Act, the lesser of

(a) the aggregate of the drilling and exploration costs, including all general geological and geophysical expenses, incurred by it, directly or indirectly, on or in respect of exploring or drilling for oil and natural gas in Canada

(i) during the taxation year, and

(ii) during previous taxation years, to the extent that they were not deductible in computing income for a previous taxation year, or

(b) of that aggregate an amount equal to its income for the taxation year

(i) if no deduction were allowed under paragraph (b) of subsection one of section eleven of the said Act,

and

(ii) if no deduction were allowed under this subsection, minus the deduction allowed by section twenty-seven of the said Act.’’

The aggregate of outgoings under Section 53(a) was the amount deductible in this case; and in determining the allowance under Regulation No. 1201 the Minister held that from the total income of the company arising from the oil production that aggregate amount should first be deducted. In this view ‘‘profits . . . reasonably attributable to the production of oil or gas from the well' 1 means the total income from all the wells operated less the total aggregate outlay related to oil in addition to the purely operating costs. That aggregate here is made up of costs of exploration and drilling, and general administrative expenses referable to those two items.

Mr. Nolan’s contention is that the expression “profits of the well’’ requires a separate ascertainment for each profitable well: that drilling which does not win oil does not produce a “well”; and that only operating expenses plus, by virtue of Section 53, exploration and development costs related directly to each producing well with their appropriate share of general administrative costs are to be deducted from the proceeds of that well to determine its profit as the datum for the purpose of the allowance. On the other hand, Mr. Riley’s position is that the word “well”, by force of the Interpretation Act, is to be taken as including “wells” where more than one are operated, and that so taken, the profits from the wells, for the purposes of the allowance, and given the operation of Section 53 and subsection (4) of the regulation, are the total income less total outlays as mentioned.

The claim of the Crown reduces itself here to a deduction from total oil income of three items, (a) exploration and drilling expenditures other than those directly related to the company’s producing wells, (b) general and administrative expenses allocated to that exploration and development, and (c) operating deficits on individual wells. Both the Income Tax Appeal Board and the President of the Exchequer Court have upheld the Minister’s contention, and the question is whether they are right.

The immediate consideration is that of Regulation No. 1201(1). The use of the word “profits” and of the expression ‘‘from the well’’ is, in the general context of the Act, singular, and to me they bear a signification that differentiates them from both “income” and ‘‘wells’’ or ‘‘oil’’. A company may operate only one well or a single well may be the subject of a lease from a land owner and many leases from any number of land owners may be operated by one company. Certainly the partitioned allowances to the lessor and lessee under Section 11(3) must be related to the profits strictly of at least the wells of the lessor: otherwise a lessee by large scale exploration costs in Nova Scotia might wipe out the “profits” on which a substantial allowance would otherwise be made to a lessor in Alberta. I am not in doubt, therefore, that the ‘‘profits’’ of a “well” are not intended to be identical in the sense claimed with the income of a company from its total oil operations remaining after the deduction of the allowance under Section 53 of amounts expended for capital work carried on anywhere in Canada. It remains to be seen in what they differ.

Subsection (4) of the regulation speaks of a deduction equal to that made from income under Section 53 ‘‘in respect of the well” from the profits “reasonably attributable to the production of oil or gas for the purpose of this section (1201)’’. I take this to imply that the outlays charged against the income under Section 53 must be “reasonably attributable” to the wells that have produced the profit and that means especially or directly related to them. On the argument of the Crown every outlay of every nature and wherever made in Canada, other than direct operating costs, must be taken as contributing to the income from the wells operating at a profit which produce it, and, for the purposes of the regulation, as attributed to those wells and as having been, under Section 53, deducted ‘‘in respect of’’ them. The allowance under Section 53 is an overall allowance related to total income for a specific purpose; the ascertainment of profits for the purposes of Regulation No. 1201 is on the basis of reasonable relation to the source of income and for a different purpose; and I am unable to agree that the total allowance under Section 53 can be said to be made ‘‘in respect of’’ the profitable wells. It might be that a dry hole is so related to a producing well that its cost, in one sense wasted, could be said to be incurred ‘‘in respect of’’ a profitable second well; that would be a question to be determined on geological and mining engineering considerations. But the costs of a dry hole, say, in Township 2 in Alberta could not, in any fair sense of the words, be related to a producing well in Township 20, and much less to such a well in another province.

The difficulties in an attribution based on such matters are obvious. The anomalies in its application to lessors and lessees have been indicated : lessors would be deprived of their increment of wasting asset, though that asset produced the return that paid the general outlay, through means unrelated to their leases and over which they have no control. A dry hole on sec. 4 owned by A might be related geologically to a producing well on see. 5 owned by B and to make that deduction for the purposes of a depletion allowance to B might deny depletion to him, while another producing well in A’s land would be free of any such relation. That this allowance is made to offset the wasting capital resource is clear from the language of Section 12(b) which speaks of “depreciation, obsolescence or depletion’’, and if its purpose is not to be defeated, the producing wells must be dealt with individually.

Unless, then, the items of expenditure under Section 53 are clearly related to a profitable producing well, they are not to be taken into account in determining the allowance under Regulation No. 1201 in respect of that well. The purpose of enacting Section 53 was to promote exploration and development on the widest scale throughout the country, but I cannot take it is intending an effect that might wipe out what otherwise would be allowed to third persons under Section 11(3). The same considerations apply to wells that are operating at a loss; they represent drilling costs under Section 53 that cannot fairly be said to be ‘‘in respect of’’ profitable wells: no depletion can accrue in relation to them because they do not represent a productive value: but on the contention made, the total loss connected with them can be applied to deny depletion to profitable wells and to third persons interested in them.

I would, therefore, allow the appeal and remit the matter back to the Minister for a re-assessment of the taxes for the years 1949 and 1950 on the basis indicated. The appellant will have its costs in both courts.

Appeal allowed.