Astral Energy Ltd. v. MNR, 90 DTC 1844, [1990] 2 CTC 2422 (TCC)

Bonner, T.C.J.:—The appellant appeals from assessments of income tax for its taxation years ending on April 30, 1984, 1985 and 1986. At issue is the amount of the resource allowance which, by virtue of paragraph 20(1)(v.1) of the Income Tax Act (“Act’’), the appellant may deduct in computing its income. What is in dispute is the extent to which the appellant is obliged to deduct what are said to be its general and administrative expenses in the computation of "resource profits" under section 1204 of the Income Tax Regulations.

Paragraph 20(1)(v.1) in the form applicable to the appellant's 1985 and 1986 taxation years read:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(v.1) such amount as is allowed to the taxpayer for the year by regulation in respect of [natural accumulations of petroleum or natural gas in Canada], oil or gas wells in Canada or mineral resources in Canada.

In the form applicable to the appellant's 1984 taxation year the words in brackets were not present.

Section 1210 of the Regulations permits, for purposes of paragraph 20(1)(v.1) of the Act, the deduction in the computation of income of an amount calculated by reference to the taxpayer's "resource profits” for the year. The term "resource profits" is defined by section 1204 of the Regulations. The section 1204 calculation must, however, be modified as laid down in section 1210 when "resource profits" are being computed for purposes of paragraph 20(1)(v.1) of the Act. Section 1204 to the extent now relevant reads:

1204. (1) For the purposes of this Part, "resource profits” of a taxpayer for a taxation year means the amount, if any, by which the aggregate of

(b) the amount, if any, of the aggregate of his incomes for the year from

(i) the production of petroleum, natural gas or related hydrocarbons from oil or gas wells in Canada operated by him,

(ii) . . .

exceeds the aggregate of

(c) the aggregate of his losses for the year from the sources described in paragraph (b), and

computed in accordance with the Act, on the assumption that he had during the year no incomes or losses except from those sources and was allowed no deductions in computing his income for the year other than

(f) such other deductions for the year as may reasonably be regarded as applicable to the sources of income described in paragraph (b) or (b.i), other than a deduction under section 1201 or subsection 1202(2) or (3), 1203(1), 1207(1) or 1212(1 )J [1]

It was the position of the appellant that in computing "resource profits” a substantial part of its general and administrative expenses did not form part of

. . . such other deductions for the year as may reasonably be regarded as applicable to the sources of income described in paragraph (b) . . . within the meaning of paragraph 1204(1)(f).

The appellant is owned by a holding company which in turn is owned by Gerhard Kasdorf and members of his family. During the years in question the appellant derived income from the production of oil and gas from wells in Canada. The income came from "working interests" in the wells. The appellant acquired those interests as an investor. It did not operate the wells. [2] The appellant's activities in relation to the wells which generated the revenues which it received during 1984, 1985 and 1986 appear to have consisted of little more than receiving cheques from the operators of the wells and recording such receipts. This work was performed by a person who served both as Mr. Kasdorf's secretary and as bookkeeper. The appellant rented a small office which was occupied in part by the secretary and in part by Mr. Kasdorf. Mr. Kasdorf did not find it necessary to devote any significant amount of time to matters pertaining to producing wells already in the appellant's portfolio. In his testimony Mr. Kasdorf repeatedly stated that his work pertained to finding new ventures. It is evident that during the taxation years under review the appellant's activities connected with the receipt of revenues from working interests which had previously been acquired by it were neither extensive nor costly.

The appellant's income for the 1986 taxation year was reported under three headings as follows:

a) Rental income:

c) Income (loss) from investments

On the statement of income for 1986 expenses were claimed as follows:

While, obviously, the results for 1984 and 1985 are different the differences are not material for present purposes.

Exhibit A-10, reproduced below, is a calculation prepared by Frederic Charles Allen, a chartered accountant who served for the appellant both during the years in question and at the time of the hearing. The appellant contended that only the amounts listed under the heading 'Allocated To Oil & Gas Production” were required by paragraph 1204(1)(f) of the Regulations to be deducted in computing resource profits.

Astral Energy Ltd.

Allocation of General and Administrative Expenses

		1986
	Expenses Allocated Unallocated Not deductible
	Per Financial To Oil & Gas G&A			from Resource
Statements		Production	Expenses	Profits
Accounting and legal	$ 38,414	$ -	$15,867	$22,547™
Advertising
and promotion	22,329	—	18,701	3,628™
Automotive	4,276	—	4,276	—
Bank charges
and interest	778	—	—	778
Depreciation	4,134	—	—	4,134
Donations	2,000	—	—	2,000
Dues and
subscriptions	1,517	—	1,517	—
Insurance	2,500	—	2,500	—
Management fees	15,000	—	15,000	—
Miscellaneous	9,680	—	9,680	—
Office, postage
and stationery	8,413	6,310	2,103	—
Rent	11,576	5,788	5,788	—
Salaries and benefits	27,795	20,846	6,949	—
Telephone	4,838	—	4,838	—
Travel	9,672	—	6,656	3,016
	$162,922	$ 32,944	$ 93,875	$ 36,103
Disallowed expenses

Note: The total of allocated and unallocated expenses equals the general and

administrative expenses calculated by the Department and deducted from Resource Profits, namely $126,819.

Based on the net book value of the underlying assets the unallocated expenses would be allocated as follows:

Oil and gas production (76.1%)	$71,439
Other (23.9%)	22,436
	$93,875
Similar allocations were produced for 1984 and 1985.

Two matters should be noted at this point. Firstly the allocations were produced by the appellant for the first time at the hearing of the appeals. No claim to so allocate was made in the returns of income. The details of the claim have not, therefore, been subjected to the audit process. Secondly, the reference in Exhibit A-10 to allocation on a net book value basis was introduced as the foundation for an alternative claim. The suggestion that an allocation might properly be made proportionately to the net book value of the assets producing the income was not vigorously pressed. Mr. Allen admitted that the income generated by an asset is unrelated to its net book value. It is obvious that allocation on a net book value basis is logically untenable and not contemplated by the language of paragraph 1204(1)(f) of the Regulations.

Counsel for the appellant based his main argument on the premise that the "sources of income” referred to in paragraph 1204(1 )(f) are the “oil or gas wells in Canada operated by . . .” the taxpayer to whom reference is made in paragraph 1204(1 )(b) of the Regulations. He argued that:

. . . What I'm saying with these G and A expenses is, those expenses didn't affect the amount produced from the oil and gas wells, they had no bearing on it. The wells just kept producing and the cheques kept coming in. . . had the regulation been drafted differently, it would very definitely require these types of costs to go to those revenues. If it had said, aggregate of your incomes from the year from all resource businesses carried on by you, then I would think we wouldn't have much of a case at all, because these management fees, administration costs were part of the resource business, I grant that, I don't deny that. But they haven't used the business source of income. If you look in Section 4 of the Act, you calculate your income from the source, which is employment, business or property, and you would look to the business. But here we go to a sub-source, we go to a very narrow source, which is production from the well.

The argument of counsel for the respondent was much less consistent with the language of section 1204 of the Regulations. He submitted that the paragraph 1204(1)(f) words “. . . the sources of income described in paragraph (b) . . ." refer in this case to ”. . . the oil and gas business, the production of it . . .". In support of this rather surprising argument he relied on Moldowan v. The Queen, [1978] S.C.R. 480; [1977] C.T.C. 310; 77 D.T.C. 5213 as authority for the proposition that "source of income is an equivalent term to business”. The argument proceeded:

. . . this company is in the business of producing oil from oil wells. [. . .] Its exploration and development is geared to production, to obtaining producing wells. [. . .] The source of income is the whole oil and gas operation. [. . .] A source is a very broad concept that exists within the Act and I think it’s only reasonable to say that general and administrative expenses are reasonably applicable to the production of oil and gas income. [. . .] What the Minister says is you have to source the general and administrative expenses. And if they're not applicable to the production, what do they relate to?

In my view, this argument is ill-founded. In Moldowan, Dickson, J. was dealing with the words "source of income" as used in section 13 of the former Act (now section 31). The statutory context in which the term "source of income" was there used was entirely different from that now being considered. The language of section 1204 of the Regulations contemplates the existence of taxpayers who derive revenues from several wells which are spoken of as sources of income. Nowhere in paragraph 1204(1 )(b) is reference made to the business of producing hydrocarbons from wells.

Counsel for the respondent may be correct in a broad or general sense when he suggests, that the general and administrative expenses of the appellant are reasonably applicable to the production of oil and gas income. Mr. Kas- dorf's efforts may be expected to result in the acquisition of other sources of such income. It is not at all clear, however, that such expenses are, as required by section 1204 of the Regulations, applicable to the sources of income described in paragraph (b) thereof, viz., the oil or gas wells in Canada which generated the incomes for each of the years in respect of which the general and administrative expenses were claimed. The evidence of Mr. Kasdorf, which was uncontradicted, established that at least a substantial part of the costs described as general and administrative expenses related not to the wells which generated the appellant's revenues for the years in question but rather to activities intended to result in the acquisition by the appellant of new wells or at least different wells. I have therefore concluded that the assessment proceeded on an erroneous basis.

The evidence does not support any defensible conclusion as to the exact extent to which the amounts described as general and administrative expenses are properly attributable to the wells operated by the appellant during the taxation years under appeal. Mr. Allen's allocations rested on factual premises as to which he had no personal knowledge. Mr. Kasdorf, the only other witness, was unable to explain some of the allocations. For example, he could not say why approximately 75 per cent of the secretary-bookkeeper's salary was allocated to production but none of the expense of her telephone was so allocated. As well, he could not explain why advertising and promotion expenses of the appellant's United States subsidiary entered into the calculation of the appellant's overhead at all. Finally, Mr. Kasdorf's oft-repeated generalization that virtually all of his activities related to the acquisition of new investments seems improbable. If it were literally true then it is difficult to imagine why the costs of his activities were not capitalized but rather were entered on a list of current general and administrative expenses. (See D. Morgan Firestone v. The Queen, [1987] 2 C.T.C. 1; 87 D.T.C. 5237.) I can only conclude that the evidence regarding the nature of the costs was incomplete. For the foregoing reasons the appeals will be allowed with costs and the assessments will be referred back to the respondent for reconsideration and reassessment on the basis that the deductions contemplated by paragraph 1204(1 )(f) of the Regulations are only those which may reasonably be regarded as applicable to the oil and gas wells in Canada operated by the appellant during the years in question and do not include the capital costs of acquisition of new sources of income.

Appeals allowed.