Terroco Industries Ltd. v. MNR, 93 DTC 1, [1993] 1 CTC 2614 (TCC)

Mogan, T.C.C.J.:—The principal business of the appellant is to provide a hot oil service for producing wells of major oil companies. The service is provided by transporting a hot oil unit to a particular well; operating the unit at the well for a number of hours; and then moving on to another well.The hot oil unit is mounted on the back of a substantial ten-wheel truck. For the purpose of deducting an investment tax credit for 1984 and 1985 under subsec- tion 127(5) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), the appellant classified the hot oil unit and the truck as "gas or oil well equipment" within the meaning of paragraph (j) of class 10 of Schedule II to the Income Tax Regulations. The respondent accepted that classification for the hot oil unit alone but rejected that classification for the truck on which the unit was mounted. The issues in this appeal are whether the truck (cab and chassis) should be regarded as"gas or oil well equipment" within the meaning of paragraph (j) of class 10; whether the truck was "designed for use on highways or streets” within the meaning of paragraph 4600(2)(e) of the Income Tax Regulations; and whether the truck was equipment used primarily "for the purpose of operating an oil or gas well” within the meaning of subparagraph 127(10)(c)(ii) of the Act.

Evidence concerning the appellants oilfield services was given by Terrence O'Connor, the shareholder and general manager of the appellant. The hot oil unit is used primarily to enhance the recovery of oil from existing wells (approximately 85 per cent of its working time). Although the appellant's work involves both oil and gas wells, Mr. O'Connor described the operation only at oil wells.

The bottom-hole temperature of an oil well when first drilled is very high (perhaps 400° F.) but, as the well gets older, the well bore cools and any paraffin wax in the oil will start to build up in the tubing and cause a restricted flow. Hot oil can reheat the well bore and production tubing and thereby melt the paraffin wax causing an enhanced recovery of oil from the older well. The appellant's function is to get the hot oil down to the bottom of the well where it can melt the wax. The production tubing which brings the oil from the bottom of the well to the surface is a pipe running up the centre of the outside casing of the well bore. The space between the production tubing and the outside casing is called the annulus. The appellant forces hot oil, under great pressure, down the annulus to the perforations in the casing at the base of the well and then circulates it back up the production tubing to the surface. By applying this hot oil treatment over a number of hours, the well bore and production tubing are reheated; the accumulated paraffin wax is melted and brought to the surface with the hot oil; and the production from the well is enhanced. An existing oil well in production would not have any equipment capable of heating oil or forcing it under pressure to the base of the well. Therefore, when paraffin wax begins to accumulate at the base of the well over a period of time, the well would need the hot oil services of some person like the appellant.

The hot oil unit comprises five basic components: a storage tank, a feed pump, a burner, a pressure pump and some pipe lengths. The first four components are mounted on the back of the truck and the pipe lengths (the fifth component) are stored and carried along the side of the chassis. The storage tank has two compartments: one stores the fuel oil to fire the burner and the second stores approximately 50 barrels of crude oil to be heated and pumped down the well. The feed pump moves the crude oil from the storage tank to the burner (where it is heated to a temperature of 250°F to 300°F) and then to the high pressure pump. This pump receives the hot oil and subjects it to pressures ranging from 3,000 pounds per square inch to 5,000 pounds per square inch. It takes that much pressure to circulate the hot oil down the annulus and up the production tube. The pipe lengths are used to transport the hot oil from the pressure pump to the well head where it is forced under pressure down the annulus. There are, of course, many gauges, valves, gears, levers, etc. connected with the five basic components and used in the operation of the hot oil unit.

The hot oil unit is accompanied by a tanker truck to provide the oil which will be heated before being pumped down the well of the appellant's eus- tomer. For an existing well, that oil is usually obtained from the" battery” which is a storage site within a few miles of the well where the customer collects all of the oil produced by its wells in that particular field. The battery has a separator and treater to separate gases and water from the oil as it arrives from the various wells. For the completion of a new well not yet in production, the oil in the tanker truck probably will have been purchasea I from some third party and will have been treated to remove some or all of the wax and other impurities. The oil brought to the well head in the appellant's tanker truck cannot be recovered by the appellant after being pumped under pressure down the well. If the appellant has been required to purchase that oil from a third party, the customer will be charged for the oil contributed by the appellant to the customer's well. The 50 barrels of crude oil in the storage tank (the first component of the hot oil unit) would not be sufficient for a complete hot oil treatment but they are adequate to put the hot oil unit in operation while the tanker truck goes to the battery or to some third party to obtain more oil.

In the years under appeal, the appellant purchased trucks from Kenworth Canada manufactured to the appellant's specifications. The appellant would inform Kenworth of the weight to be hauled and the power required for the equipment comprising the hot oil unit. When the truck is driven to a well, the power from its engine is going to the rear wheels. But when the truck is stopped and the hot oil unit is operating, the pumps in the unit are powered by the truck engine. The appellant orders a particular transmission on which two power take-offs can be mounted. Different belts from the power take-offs operate the feed pump and the pressure pump. The pressure pump alone will use 300 to 500 horsepower depending upon the pressure and volume of hot oil needed. The drive shaft to the rear axles has a split box so that power can be diverted up to the pressure pump. The truck engine is used only 10 per cent of its operating time to move the unit from well to well; the remaining 90 per cent of its operating time occurs when the truck is stationary and the hot oil unit is working. Mr. O'Connor emphasized this point by stating that over a ten-year period the truck engine may have only 50,000 miles of travel from place to place but 1,000,000 miles of operating the hot oil unit while stationary. The extraordinary uses for the truck engine to operate the hot oil unit were part of the appellant's specifications when it ordered a new truck.

Each truck required heavier springs for its use off highways and roads. This kind of truck could be built heavier Because it did not nave to transport cargo like a common carrier. Upon delivery, the appellant received only the cab and chassis. The appellant has its own shop in which the hot oil components were assembled and then mounted on the chassis. The cost of the cab and chassis alone was $85,000; the cost of the hot oil components was approximately $140,000; the cost of labour to mount the hot oil components and integrate them with the truck was approximately $40,000. Therefore, the appellant incurred a total cost of about $265,000 to put a hot oil unit out in the field ready to operate.

Having regard to the operation of a hot oil unit as described above, I turn to the labyrinth of statutory provisions in the Income Tax Act and Regulations upon which this appeal will be decided. Subsection 127(5) permits the deduction of an investment tax credit from the tax otherwise payable. [1] Subsection 127(9) defines investment tax credit in relation to” qualified property". Subsection 127(10) contains a long definition of qualified property from which I will extract only the relevant parts:

127(10) For the purposes of subsection (9), a "qualified property" of a taxpayer means a property (other than a certified property) that is

(b) prescribed machinery and equipment acquired by the taxpayer after June 23,1975,

that has not been used, or acquired for use or lease, for any purpose whatever before it was acquired by the taxpayer and that is

(c) to be used by him in Canada primarily for the purpose of

(ii) operating an oil or gas well or processing heavy crude oil recovered from a natural reservoir in Canada to a stage that is not beyond the crude oil stage or its equivalent. . . .

The prescribed machinery and equipment referred to in paragraph 127(10)(b) is defined in section 4600 of the Income Tax Regulations:

4600(2) Property is prescribed machinery and equipment for the purposes of paragraph 127(10)(b) of the Act if it is depreciable property of the taxpayer (other than property referred to in subsection (1)) that is

(e) a property included in paragraph (a) of Class 10, or Class 22, in Schedule II

(other than a car or truck designed for use on highways or streets);

(g) a property included in any of paragraphs (b) to (f), (h), (j), (k), (o), (r), (t), or (u) of Class 10 in Schedule II;

The relevant portions of Class 10 (30 per cent) in Schedule II are:

Property not included in any other class that is

(a) automotive equipment, including a trolley bus, but not including

(i) an automotive railway car acquired after May 25, 1976,

(ii) a railway locomotive, or

(iii) a tramcar,

and property that would otherwise be included in another class in this Schedule that is

(j) gas or oil well equipment;

The appellant and respondent use the statutory provisions set out above to support their respective arguments. The appellant argues that the truck and chassis and the hot oil unit are an integrated parcel of machinery and equipment which is "gas or oil well equipment" within the meaning of paragraph (j) of Class 10 in Schedule II; that such equipment is prescribed machinery and equipment within Regulation 4600(2)(g); that such equipment is used in Canada primarily for the purpose of operating an oil or gas well within the meaning of subparagraph 127(10)(c)(ii); and that such equipment is therefore "qualified property". The respondent has two principal arguments. First, he argues that the truck should be regarded as separate and apart from the hot oil unit; that the truck is automotive equipment within the meaning of paragraph

(a) of Class 10 in Schedule II; that the truck is designed for use on highways or streets within Regulation 4600(2)(e); and, therefore, the truck falls outside the definition of prescribed machinery and equipment. And secondly, the respondent argues that the truck is not used in Canada primarily for the purpose of operating an oil or gas well within the meaning of subparagraph 127(10)(c)(ii); and, therefore, the truck is not “ qualified property”.

I propose to consider first whether the truck (cab and chassis) should be regarded as separate and apart from the hot oil unit. There are a number of recent decisions in the Federal Court of Appeal which are helpful on this question. In The Queen v. Nowsco Well Service Ltd., [1990] 1 C.T.C. 416, 90 D.T.C. 6312, the taxpayer corporation provided services to those who operated oil and gas wells. Nowsco deducted an investment tax credit on machinery and equipment which it claimed was prescribed and used for the purpose of manufacturing or processing goods for sale or lease within subparagraph 127(10)(c)(i). The Minister of National Revenue argued that Nowsco's equipment was "designed for use on highways or streets" within the meaning of Regulation 4600(2)(e). Urie, J.A. delivered the unanimous judgment of the Court and stated, at page 426 (D.T.C. 6319):

While perhaps initially the vehicles used by the respondent were “ designed for use on highways or streets" their design was so modified for purposes of their utilization, that the limited design purpose was of minimal importance. Their primary purpose was to become parts of an integrated process for the cementing and/or stimulation of oil or gas wells.

In The Queen v. Halliburton Services Ltd., [1990] 1 C.T.C. 427, 90 D.T.C. 6320, Halliburton carried on the same kind of business as Nowsco; and the Federal Court of Appeal held in favour of Halliburton for the same reasons as were given in Nowsco. The decisions in Nowsco and Halliburton were delivered on the same day. The trial judge in the Halliburton case had held that the cab and chassis should be separated from the equipment mounted thereon ([1985] 2 C.T.C. 52, 85 D.T.C. 5336 at page 59 (D.T.C. 5341)) but that part of her judgment was not appealed. Referring to the statement of Urie, J.A. quoted above, the Federal Court of Appeal was prepared to set aside the original design of the vehicles in Nowsco because that design was so modified for purposes of the commercial use of the vehicles.

Counsel for the respondent argued that the Federal Court of Appeal was able to set aside the original design of the trucks in Nowsco because the trial judge in that case had found as a fact that Nowsco operated a mobile factory [see [1988] 2 C.T.C. 24, 88 D.T.C. 6300]. Cullen, J. stated at page 39 (D.T.C. 6311);

To me, the activities at the well head are conducted by a "mobile factory”, and this mobility should not disentitle the plaintiff to the tax benefits enjoyed by a processing plant which is always situated at one location.

This was also the position adopted by Bonner, J. of this Court in Laidlaw Waste Systems Ltd. v. M.N.R., [1989] 1 C.T.C. 2375, 89 D.T.C. 259 at page 2381 (D.T.C. 263). What are the consequences of the trial judge's finding that Nowsco was operating a“ "mobile factory"? I infer that the vehicles in Nowsco, after modification, were not used to transport different loads of cargo from place to place. Any heavy equipment (e.g., a hot oil unit) can be made mobile by mounting it on wheels. If it is towed around on a trailer, there is no risk that it will be mistaken for a truck. But if, for efficiency, safety and convenience, it is mounted on the chassis of a truck and the truck's engine is used to power it, is the resulting equipment primarily a truck used to transport only a hot oil unit or is it primarily a self-propelled hot oil unit which has assimilated what was Originally designed as a truck? If the hot oil unit and the truck are brought together for the sole purpose of making the unit mobile, it does not seem reasonable to regard the truck component of the resulting equipment as if its chassis and engine had not been absorbed into the overall system of the hot oil unit to provide it with power and a platform. To me, the resulting equipment has become more of a hot oil unit and less of a truck because the truck component, in its basic concept, was designed to transport different cargo from place to place. It is the specifications imposed by the appellant which change the basic concept of the truck into a power plant which can operate equipment at a fixed location and then move it to another location.

The average citizen does not see a hot oil unit because it operates only in oil or gas fields but the average citizen is familiar with other mobile equipment like a concrete mixer which can be seen on many urban streets. The rotating hopper can mix a large quantity of concrete while stationary or moving along a street or highway, and it can discharge small manageable batches while at a construction site. If the rotating hopper is powered by the truck engine, is the mobile unit primarily a concrete plant or primarily a truck? Similarly, a mobile crane has the capacity to raise, shift and lower heavy weights at different locations. If the lifting device is powered by the truck engine, is the mobile unit primarily a hoist or primarily a truck?

In this case, the appellant's hot oil equipment needed low end gears and the truck's speed even on a good highway was therefore limited to 55 m.p.h. Mr. O'Connor stated that if the hot oil unit were mounted on a skid or platform (e.g., as in the far north) it would still need an engine, transmission and main drive like that provided by the truck engine on any one of the appellant's mobile units. The unit is necessarily mobile because its services at any particular well are required for only a few hours or a couple of days; and it must be able to move from well to well either along highways and roads or across open country. On this question of whether the truck (cab and chassis) should be integrated with the hot oil unit, the most persuasive evidence is the fact that about 90 per cent of the truck engine's operating time is in a stationary position providing power for the hot oil unit, and about 10 per cent of its operating time is spent moving from well to well or from the appellant's service depot to a well.

I cannot dissociate the operation of the hot oil unit from the operation of the truck engine on which the unit is totally dependent. In my opinion, the truck must be regarded as an integral part of the hot oil unit. There is no doubt that when the truck is manufactured by Kenworth and delivered to the appellant, it is "designed for use on highways or streets" within the meaning of Regulation 4600(2)(e). But as a consequence of the specifications issued by the appellant to Kenworth, it is also designed for three other purposes of equal importance: (i) to carry the weight of and to provide a permanent base for a hot oil unit; (ii) to provide power for the pumps and other components of the hot oil unit; and (iii) to transport the hot oil unit by highway, road or across open ungraded country. When the appellant has taken delivery of the truck (only the cab and chassis) from Kenworth and has completed the installation of the hot oil unit using the power take-offs from the transmission and the split box, it is no longer reasonable to regard the truck as simply designed for use on highways or streets because it now has the capacity to store and power the hot oil unit and move that unit from well to well across open ungraded country. The fact that the low end gears required by the hot oil unit reduce the maximum highway speed of the truck to 55 m.p.h. is a good indication that its primary design was not for use on highways or streets.

Having found that the truck is an integral part of the hot oil unit, I cannot reasonably characterize it as a "truck designed for use on highways or streets". Therefore, the truck is not excluded from the definition of“ prescribed machinery and equipment" by reason of Regulation 4600(2)(e). This disposes of the respondent's first argument. I will now consider the respondent's second argument that the truck is not used in Canada primarily for the purpose of operating an oil or gas well.

A fundamental question in the respondent's second argument is whether the truck together with the hot oil unit mounted thereon is “gas or oil well equipment” within the meaning of paragraph (j) of Class 10 in Schedule II. Those words are defined in subsection 1104(2) of the Regulations:

1104(2) In this Part and in Schedule II,

"gas or oil well equipment" includes

(a) equipment, structures and pipelines, other than a well casing, acquired to be used in a gas or oil field in the production therefrom of natural gas or crude oil, and

(b) a pipeline acquired to be used solely for transmitting gas to a natural gas processing plant,

but does not include

(c) equipment or structures acquired for the refining of oil or the processing of natural gas including the separation therefrom of liquid hydrocarbons, sulphur or other joint products or by-products, or

(d) a pipeline for removal or for collection for immediate removal or natural gas or crude oil from a gas or oil field except a pipeline referred to in paragraph (b):

The relevant words in paragraph (a) are“ equipment. . . acquired to be used in a gas or oil field in the production therefrom of natural gas or crude oil”. Mr. O'Connor's unchallenged evidence is that the hot oil unit is used 85 per cent of its working time to enhance or stimulate the recovery of oil from producing wells and 15 per cent of its working time to assist in the completion of a new well. Each producing well needs the service of a hot oil unit on a periodic basis but not frequently enough to justify the purchase and maintenance of the required equipment. The appellant therefore provides a necessary service which enhances the production of oil from many wells and permits the completion of new wells. It could be concluded, on the plain meaning of the above words in subsection 1104(2), that the appellant's equipment (truck plus hot oil unit) is used in a gas or oil field in the production of natural gas or crude oil. I am inclined to reach that conclusion.

In Bunge of Canada Ltd. v. The Queen, [1984] C.T.C. 284, 84 D.T.C. 6276, Bunge owned and operated grain elevators about 200 feet from the wharf at Bassin Louise, in the Port of Quebec. Bunge purchased new equipment to increase its efficiency in discharging grain from its elevators into large oceangoing vessels; and it claimed an investment tax credit under subparagraph 127(10)(c)(ix) on the basis that the new equipment was to be used primarily for the purpose of "the storage of grain". Bunge’s appeal was allowed and Pratte, J.A. delivering judgment for the Court stated at page 285 (D.T.C. 6277):

The only question on this appeal, therefore, is whether those new discharging facilities were used by the appellant“ primarily for the purpose of . . . the storing of grain”. That question must, in my view, be answered in the affirmative. The storage of grain requires not only that there be silos where the grain can be stored but also that the silos be provided with the equipment necessary to receive the grain for storage and deliver it to its owner after it has been stored. In my opinion, the equipment required to discharge grain from the appellant's silos was equipment used for "the storing of grain” because the discharge of grain from a silo appears to me to be a necessary and integral part of the storing of the grain.

In Lor-Wes Contracting Ltd. v. The Queen, [1985] 2 C.T.C. 79, 85 D.T.C. 5310, Lor-Wes did not own any timber limits or cutting rights but constructed logging roads and performed site services for persons who owned timber limits or cutting rights. Lor-Wes deducted an investment tax credit on the basis that its equipment was used for the purpose of "logging" within the meaning of subparagraph 127(10)(c)(vii). The Federal Court of Appeal recognized that the investment tax credit in subsection 127(10) was “incentive” legislation and allowed the Lor-Wes appeal. MacGuigan, J.A. delivering judgment for the Court affirmed the earlier decision in Bunge and stated at pages 83-84 (D.T.C. 5313):

Taking a broader look at the provision, we have what appears from the text to be an inducement to taxpayers to undertake or augment specific activities, viz., those listed in paragraph (c). From that point of view, it would be a matter of indifference whether the increased activity was that of a logging company itself or of a subcontractor: in both cases the increase in investment and economic activity would be the same.

Here, the words "primarily for the purpose of logging” are not followed by the words "by him” or otherwise qualified so as to limit the benefit of the section to cases wherein the corporation taxpayer itself has the timber or cutting rights. Not only was the appellant's equipment used to carry out an integral part of logging, but owners of such rights are required by law in British Columbia to obtain approval from the Forest Service of a five-year development plan and a two-year logging plan, including in both cases proposed road designs. Moreover, since road building is one of the most expensive parts of the total logging operation, owners subcontract to road building companies for the sake of their own cost efficiency. It is impossible to regard the work of such road builders, whose total operation is dedicated to building roads for logging, as isolated from the totality of the logging industry. Their work is dedicated, and their equipment is used by them, primarily for the purpose of logging.

Adopting the comment by Macguigan, J.A., the words “primarily for the purpose of operating an oil or gas well” subparagraph 127(10)(c)(ii) are not followed by the words "by him".

In the Bunge case, the Court held that the new equipment to discharge grain was used primarily “for the purpose of the storage of grain” within subparagraph 127(10)(c)(ix) because discharging grain from the elevator was an integral part of storing grain in the elevator. In the Lor-Wes case, the Court held that equipment used by one person to build logging roads for another person who owned the timber limit or cutting rights was used primarily "for the purpose of logging” within subparagraph 127(10)(c)(vii) because the construction of logging roads was an integral part of logging. Following these two cases, I conclude that equipment to provide a hot oil service is used primarily “for the purpose of operating an oil or gas well” within subparagraph 127(10)(c)(ii) because enhancing the recovery of oil from a producing well is an integral part of operating the well. Accordingly, the hot oil unit is “ qualified property" within subsection 127(10). This disposes of the respondent's second argument.

Counsel for the respondent cited the decision of the Federal Court-Trial Division in Texaco Exploration Co. v. The Queen, [1975] C.T.C. 404, 75 D.T.C. 5288 in which Collier, J. construed the words" production of oil or gas" (at page 5293). In my view, that case can be distinguished. Subparagraph 127(10)(c)(ii) uses the words "operating an oil or gas well” and not "production". As was pointed out in Lor-Wes above, the "logging" need not be performed by the subcontractor claiming the tax credit who built the roads for the logging companies. Although the word "production" appears in paragraph 1104(2)(a), the use of the appellant's equipment to enhance the recovery of oil from a producing well is the use of equipment for the production of oil or gas.

As stated at the beginning of these reasons for judgment, the respondent has acknowledged that the equipment comprising the hot oil unit (apart from the cab and chassis of the truck) is "qualified property” within subsection 127(9). Having regard to the evidence and, in particular, the degree to which the truck's engine, the transmission and the drive shaft are integrated with the equipment comprising the hot oil unit, I can only conclude that the cab and chassis of the truck are also "qualified property" within subsection 127(10). I may not have reached this conclusion if the truck's engine had not powered the hot oil unit.

The appeals are allowed and the assessments for 1984 and 1985 are referred back to the respondent for reconsideration and reassessment on the basis that a truck which transports and powers a hot oil unit is equipment used primarily for the purpose of operating an oil or gas well within the meaning of subparagraph 127(10)(e)(ii) of the Income Tax Act.

Appeals allowed.