Bell J.T.C.C.:—The appeal of Central Supply Company (1972) Limited ("Central") is from a reassessment of its 1987 taxation year, ending on December 31, 1987, by virtue of which the Minister of National Revenue ("Minister") disallowed a deduction in the amount of $10,000,000 claimed by it as "cumulative Canadian exploration expense" pursuant to the provisions of subsection 66.1(3) and paragraph 66.1(6)(b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").
The appeal of Carousel Travel 1982 Inc. ("Carousel") is from a reassessment of its 1987 taxation year, ending on December 31, 1987, by virtue of which the Minister disallowed a deduction in the amount of $6,000,000 claimed by it as "cumulative Canadian exploration expense" under the same provisions of the Act for that taxation year.
The appeal of Central and the appeal of Carousel were heard together on common evidence. For ease of comprehension these reasons for judgment, with respect to both appellants, will set forth the facts and reasons relating to the two appeals.
Issue
The issue is whether four limited partnerships incurred "Canadian exploration expense" pursuant to the provisions of paragraph 66.1(6)(a) of the Act and, if so, whether the appellants became members of those partnerships on December 14, 1987, the last day of the fiscal period of each of those partnerships, with the result that the appellants would be entitled to the deductions claimed as aforesaid.
As explained below, oil and gas expenses incurred by a partnership are not claimed at the partnership level. Rather, for the purposes of deduction, they become the expenses of the taxpayers who are members of such partnership at the end of its fiscal period in which the expenses are incurred.
It appears from respondent’s counsel’s submissions that the reassessments were made because the appellants were partners for 24 hours only and that they had become partners of the partnerships on the last day of the fiscal period in which such partnerships incurred exploration expenses, the well having been proved unsuccessful two and one half months earlier.
Facts
The facts are complex and detailed as are the pleadings. The pleadings consist of an amended notice of appeal, reply, answer, appellant’s request to admit, respondent’s response to request to admit, respondent’s request to admit and amended reply. The Court was obliged to examine several documents and a lengthy transcript of the evidence herein with respect to most of the facts in order to set forth a cogent statement thereof. Where pleadings are numerous, lengthy and complex, a statement of agreed facts (not provided in this case) would be of immense assistance to the Court.
In order to aid comprehension of the facts, diagrams describing same and referenced herein are contained in the appendix hereto. Before setting forth a full statement of facts, a summary of the salient facts is presented in order to place the issue in focus.
Summary of facts
1. The four limited partnerships were formed, under the Partnership Act of Alberta on December 31, 1986.
2. A company, herein described as Northcor, entered into an agreement, effective that day, with each such partnership. Under that agreement Northcor became the agent of each partnership for the purpose of incurring Canadian exploration expense on behalf of such partnership at the partnership’s expense. As consideration therefor Northcor granted to each partnership rights to purchase its shares.
3. Each partnership assigned to Northcor all amounts it might receive by way of drilling assistance from the Government of Canada in respect of the Canadian exploration expense so incurred by it as payment for the portion of the drilling costs (80 per cent) not being provided directly by it and it appointed Northcor to make applications therefor on its behalf. Northcor commenced drilling operations in early June 1987 on a well off the east coast of Canada and spent a sum in excess of $27,500,000 thereon, approximately $17,500,000 of which was said to be expended on behalf of the four partnerships.
4. The drilling proved unsuccessful and the drilling rig was released and abandonment operations commenced on October 1, 1987, various winding-up activities being said to have been carried on for the rest of the partnerships’ 1987 fiscal periods.
5. A company described herein as Encee, which controlled Northcor, under documents dated December 10, 1987, subscribed for and paid a total of $3,500,000 for units in the four partnerships. Encee replaced the founding limited partner.
6. Encee, on December 14, 1987, sold its interests in the four partnerships to a company described herein as 747942 for the total sum of $1,855,414.
7. On that date, under agreements among Encee, a company herein described as NRI (controlled by Encee) and each of the four partnerships, NRI granted a "put" whereby it agreed to purchase the units of each partnership if so required by 747942 on or before December 15, 1988.
8. Also, on December 14, 1987, 747942 sold to Carousel, for $1,080,000, such number of units in the four partnerships that "Canadian exploration expense" in the amount of $6,000,000 would be allocated to it at the end of the 1987 fiscal period of those partnerships and 747942 sold to Central, for $1,800,000, such number of units in the four partnerships that "Canadian exploration expense" in the amount of $10,000,000 would be allocated to it at the end of the 1987 fiscal period of those partnerships. The rights of 747942 to require NRI to purchase partnership units under the "put" agreements were assigned by 747942 to Carousel and Central.
9. Each of the appellants dealt at arm’s length with Northcor and with 747942.
10. All documents respecting the partnerships and the registration thereof were fully executed and registered in accordance with the provisions of Alberta law.
11. No government assistance amounts, which would have had to be deducted from the appellants’ exploration expenses in the year in which they were received or became receivable, were so received or receivable by the appellants in their respective 1987 taxation year.
12. On December 15, 1987, Central, Carousel and 747942 exercised their rights to compel the purchase by NRI of the units of the partnerships owned by them with the result that Central and Carousel were members of the partnerships for approximately 24 hours only.
Full statement of facts
Encee Group Limited ("Encee”) owned 72 per cent of Northcor Resources Ltd. ("Resources”), 74 per cent of Northcor Energy Ltd. ("Northcor") and 100 per cent of 279397 Alberta Limited ("279397"). See Diagram 1.
Resources owned 19 per cent of Northcor and 100 per cent of NRI Holdings Ltd. ("NRI").
On December 31, 1986, 279397, as general partner, and one Jan M. Alston, as initial limited partner, entered into the following limited partnership agreements:
(a) Northcor Exploration Program 1987-82 (b) Northcor Exploration Program 1987-83 (c) Northcor Exploration Program 1987-84 (d) Northcor Exploration Program 1987-85 (e) Northcor Exploration Program 1987-86 (f) Northcor Exploration Program 1987-87
On that date a certificate of limited partnership was filed with respect to each of those limited partnerships in the central registry office of the Province of Alberta. The contribution of the initial limited partner was $100 in respect of each partnership.
Each limited partnership was described in the respective certificate of limited partnership as being formed for the following business purposes:
(a) To acquire, explore, develop, operate and sell oil, natural gas and other petroleum substances;
(b) To purchase or sell interests in oil, natural gas and other petroleum substances or rights in respect of any of the foregoing;
(c) To construct and operate facilities for the treatment, production, collection, storage, delivery and sale of oil, natural gas and other petroleum substances;
(d) To incur Canadian exploration expense solely as consideration for the issuance of shares of the capital stock of Northcor Energy Ltd.;
(e) To incur Canadian exploration expense solely as consideration for the right to purchase Class "A" common shares in the capital stock of Northcor Energy Ltd.; and
(f) To enter into a share subscription agreement.
It is the four latter partnerships (”1987-84”, "1987-85", ”1987-86” and "1987-87”) which are involved in these appeals. See Diagram 1. Each such partnership was expressed to continue until December 31, 1990 unless dissolved "only upon” the occurrence of certain events, each of which is normally included in a partnership agreement. Provision was made in the limited partnership agreements for the admission of additional limited partners.
The paragraph contained in each certificate of limited partnership entitled "participation in profits and losses", reads as follows:
The general partner shall determine and allocate the net income, net loss, taxable income and tax loss including Canadian exploration expense and petroleum incentive payments for any fiscal year as at the end of such fiscal year. If at any time during the fiscal year of the limited partnership, a limited partner shall assign or transfer his limited partnership interest(s) in the partner ship, no share of net income, net loss, taxable income, tax loss (including Canadian exploration expense and petroleum incentive payments) or other allocation of the partnership to the date of such transfer shall be allocated to such limited partner’s account as at the date of such sale or transfer. Any allocation or distribution to the partners as provided for in the limited partnership agreement shall be made among those limited partners who were shown on the register as limited partners at the end of the fiscal year for which such allocation or distribution is made. Any allocations to the partners as provided for in Article 8 of the limited partnership agreement shall be allocated among the partners’ accounts or distributed to the partners as follows:
(a) 0.01 per cent to the general partner; and
(b) 99.99 per cent to the limited partners pro rata to the number of limited partnership interests owned as at the end of the fiscal year for which such allocation is made.
Northcor entered into an identical share subscription agreement (’’agreement"), expressed to have effect on December 31, 1986, with each of the four limited partnerships, each partnership being described as "investor". Each agreement provided that Northcor had entered into a farm out agreement pursuant to which it would be expending funds in the drilling and testing of a well called the "Northcor et al Narwhal F-99 well" ("well") off the east coast of Canada. It also provided that the investor wished to incur, under the provisions of subparagraph 66.1(6)(a)(v) of the Income Tax Act, "Canadian exploration expense", described therein as "E expenditures". Each Investor appointed Northcor as its agent to incur E expenditures on its behalf in an amount not exceeding $5,000,000 in drilling and testing the well. The sole consideration for the investor so incurring E expenditures was the issuance by the company to the investor of rights to purchase Class "A" common voting shares ("rights"). The rights to be so issued thereunder would entitle the investor to purchase one Class "A" common voting share at a price of $20 per share for each $50 of E expenditures, such rights to be exercised on or before June 30, 1980. Paragraph 3(d) respecting income tax deductions read as follows:
The investor shall be entitled to all income tax deductions relating to the E expenditures incurred on the investor’s behalf by the company and the company hereby acknowledges that it has no right to any such E expenditures and will not claim the same when filing any of its income tax returns.
Another pertinent provision, paragraph 4(b) reads, in part, as follows:
the investor agrees to pay to the company by December 31, 1987 in connection with this agreement amounts equal to 20 per cent of the amount of E expenditures set out in clause 1 hereof. In addition, the investor hereby assigns to the company as further and final payment of its obligations hereunder, all of the investor’s right, title, estate and interest in and to any governmental grants Or assistance payments which may arise or be available to the investor pursuant to the E expenditures to be made hereunder, and shall execute an assignment in the form of Schedule "A" attached hereto.
The final relevant clause from that agreement, paragraph 6(b), reads as follows:
All federal grants and incentive payments earned as a result of any exploration associated with the farm out agreement and contemplated hereby will be earned solely for the account of the investor. The company hereby agrees to apply monthly for such grants and incentives on behalf of the investor and, subject to clause 4(b) hereof, to pay such sums to the investor promptly upon receipt thereof by the company. The company also agrees to send to the investor copies of such applications forthwith upon the making of same.
Each agreement has a two-page attachment entitled "This is Schedule "A" to that certain assignment of petroleum incentive payments and power of attorney". This description is strange because those two pages constitute the agreement whereby each of the four limited partnerships assigns to Northcor all and any petroleum incentive payments (PIPs) to which it is or may become entitled pursuant to the Petroleum Incentives Program Act ("PIP Act") respecting costs incurred or to be incurred by that partnership pursuant to the agreement. It also authorizes and instructs the administrators of the Petroleum Incentive Program ("program") to pay to Northcor all moneys to which it becomes entitled pursuant to the aAgreement. Finally, it appoints Northcor as the agent of the partnership for all matters in connection with any application for PIPs.
There follows a Subscription agreement and power of attorney in respect of each of the four partnerships. Encee subscribed for 10,000 limited partnership interests in each of 1987-84, 1987-85 and 1987-86 for the sum of $1,000,000 and 10,000 limited partnership interests in 1987-87 for the sum of $500,000, the total of such subscriptions being $3,500,000? In each case, Encee appointed 279397 its attorney and agent for the purposes of executing documents and performing acts necessary to conduct the business of the partnership and, in particular, to execute and file documents with any governmental agency and to execute and deliver to the Petroleum Monitoring Agency any and all applications, certificates and documents required in order to apply for and to receive on behalf of the partnership and\or the limited partners all payments to be made under the program. These documents were dated December 10, 1987.
Northcor then issued a certificate of rights to each of the four partnerships granting to 1987-4, 1987-5 and 1987-6 the right to acquire 100,000 Class "A" common voting shares of Northcor at a price of $20 per share and to 1987-7 the right to acquire 50,000 of such shares at the same price. These certificates, each dated December 11, 1987 provided that the rights could be exercised by 1987-4 on or before June 30, 1988, by 1987-5 on or before July 31, 1988, by 1987-6 on or before August 31, 1988 and by 1987-7 on or before September 30, 1988.
By documents described as "notice no. 1 to amend the certificate of limited partnership" of each of the four partnerships dated December 10, 1987 and bearing endorsement of registration in the Calgary Registration District, each certificate of limited partnership was amended to delete Jan M. Alston as initial limited partner and to add Encee as a limited partner with 10,000 limited partnership interests, the contribution totalling $3,500,000 above described. This sum was paid to the limited partnerships by Encee on December 11, 1987.
As at December 14, 1987 Northcor had incurred Canadian exploration expense ("E") in excess of $27.5 million in drilling and testing the well.
It is agreed that the first $10,000,000 of expenses giving rise to entitlement for PIPs under the PIP Act was allocable under the provisions of the Agreements to Northcor Exploration Program 1987-2 and Northcor Exploration Program 1987-3, the two limited partnerships in respect of which the appellants had no interest.
By document dated December 14, 1987, 279397, as general partner for the four partnerships, set the fiscal year end of each of same at 11:59 p.m. on December 14, 1987.
Jan M. Alston, the initial limited partner, gave evidence on behalf of the appellants. At the relevant times, he provided general, corporate and administrative legal services to the Northcor group of companies. He testified that he worked on a daily basis with management of Northcor. He was involved in setting up several limited partnerships and assisting in attempts to raise financing by way of seeking investors for the limited partnership units. He stated that "flow-through limited partnerships" were a common financing tool for junior exploration companies in the oil and gas business and that this was the financing method contemplated by Northcor. He made it clear that the sum of approximately $10,000,000 had been raised and expended in relation to investors other than the appellants and that a sum equal to the remaining exploration costs of approximately $17,500,000 related substantially to the appellants.
He described the relationship of Northcor with the Petroleum Incentives Administration ("PIA") as being very businesslike because the successful raising of funds depended upon its cooperation in structuring transactions where receipt of PIP’s would be as assured as possible. He explained that the Northcor Group had $1,375,000 available in cash and that it negotiated a loan with DCC Equities Limited of $3,275,000, the total of $5,000,000 being deposited with Chevron, the farmor of the resource property to be drilled. This "gave the Department comfort that we wouldn’t default on the non-PIP portion of the well".
He stated that drilling operations by Northcor commenced in early June 1987, that the well was spudded on July 14, 1987 and drilling operations were completed by October 1, 1987, the date on which it was known that the well had proven unsuccessful. He confirmed that a sum in excess of $27,500,000 had been expended in so drilling. He testified that the drilling rig was released on October 1, 1987, meaning that drilling operations and abandonment operations were completed and that the rig was no longer required on the well site. He said that there would, after that date, be a number of de- commissioning activities that would be associated with the well. He said that there was a lot of heavy equipment involved resulting in ongoing activities and expenses in winding up the operations. He stated that one of the specific pieces of equipment that had to be tailor-made for any particular well is the risers, being the tubing string down through which the drill pipe is extended through the water. That would have to be refurbished and put back into the same state that it was in when it was acquired for the well. He said there were a number of other things of that nature that remained to be done, such as returning unused casing equipment and casing pipe to shore and to suppliers.
He stated that the general partner monitored the expenses through the flow-through share agreements and did accounting and financial statements for the limited partnerships and that it was in continuing discussion with officials of the PIA. He said that Northcor incurred a sum in excess of $27.5 million of E in drilling and testing the well and that it was incurred as agent for the partnerships that had been established pursuant to the agreement. Mr. Alston confirmed receipt of a letter dated December 14, 1987 addressed to Northcor Energy Ltd. from the PIA division of Energy, Mines and Resources Canada, reading, in part,
no entitlement to Northcor Energy Ltd. for petroleum incentives for exploration costs incurred drilling the Narwhal F-99 well subsequent to December 31, 1986 and prior to December 15, 1987 in excess of $10,322,000 has arisen.
He said that Northcor wanted to be sure that the partnerships whose interests were being sold had not received any notices of entitlement with respect to E incurred by Northcor as agent on their behalf. There was considerable evidence by this witness respecting the $10,322,000 of E above referred to. It is clear that these were expenses incurred before the $17.5 million of E was incurred in respect of the four partnerships in which the appellants had interests.
Mr. Alston also explained that the normal mechanism in the industry for selling a partnership interest was that the PIP income would be received in the second year of the partnership so that the limited partners would then include it in their income, having deducted the E incurred by the partnership in its first fiscal year. He stated that it helped the sale of partnership interests and that the PIA, over the years, understood that fact.
He then referred to the sale and purchase agreement made December 14, 1987 between Encee Group Ltd. and 747942 Ontario Ltd. ("747942”) in which Encee sold to 747942 for the sum of $1,855,414 (receipts for the constituent figures of which were filed as exhibits) all of Encee’s interest in 1987-4, 1987-5 and 1987-6 and 8,500 of the 10,000 limited partnership interests in 1987-7. By virtue of a put agreement made December 14, 1987, NRI, 747942 and Encee entered into an agreement with each of the four partnerships whereby NRI granted a ’’put” in which it agreed to purchase the units of each partnership if so required on or before December 15, 1988. Under this agreement, Encee represented and warranted that NRI had sufficient tax deductions available
to shelter the allocation of petroleum incentive grants allocable to it, in respect of the units, after exercise of the put.
Mr. Alston stated that this agreement was intended to enable the partnership units to be sold to NRI and had no other purpose.
Mr. Alston was then referred to two exhibits, each being entitled assignment and novation agreement re: sale and purchase agreement, both stated to be made and effective as of December 14, 1987. By virtue of one of these agreements entered into by 747942, Carousel and Encee, 747942 assigned to Carousel such number of limited partnership units of the four partnerships that the total amount of E to be allocated to Carousel by them at the end of their 1987 fiscal year would be $6,000,000. The sale and purchase agreement expressed to be made December 14, 1987 between Encee and 747942 referred to above was attached as an exhibit. Carousel, under an assignment and novation agreement, accepted an assignment to it and agreed to be bound by the provisions of the aforesaid sale agreement. A similar agreement with respect to Central provided for the assignment by 747942 to it of such number of limited partnership units of the four partnerships that the total amount of E to be allocated to Central by them at the end of their 1987 fiscal year would be $10,000,000. Carousel paid $1,080,000 for its partnership units and Central paid $1,800,000. Mr. Alston stated that these documents were intended to provide for the conveyance of those interests and had no other purpose. Further, in each case there was an assignment and novation agreement re: put agreement expressed to be made and effective as of December 14, 1987 under which Carousel and Central respectively had the rights of 747942 under the aforesaid put agreements assigned to them and they accepted the assignment and agreed to be bound by and to perform under same. Mr. Alston said that they were intended to accomplish exactly that and had no other purpose.
The respondent admitted in pleadings that Encee, Carousel, Central and 747942 were not related corporations for the purposes of the Act but did not admit that they dealt with each other at arm’s length. Mr. Alston’s evidence was that Northcor had never done business with Carousel, Central or 747942 before these transactions. He also testified that the purchase price of $1,855,414 paid by 747942 to Encee was negotiated by a commission agent for the Northcor group and that such price was agreed on after ’’tough negotiations". He stated that Northcor had no participation with or dealings with Carousel or Central other than through the assignment and novation agreements. He testified further that Northcor had nothing to do with establishing the price at which the assignments from 747942 to Carousel and Central took place, stating that he had no direct knowledge of those transactions. His only function with respect thereto was to make appropriate filing of the notices of amendment in order to reflect the new partners. He was then referred to four exhibits, each of which was a photocopy of a notice to amend the certificate of limited partnership and each of which bore an endorsement of registration on December 14, 1987 in the Calgary registration district and identified them as the registrations filed by him. His evidence was also clear that NRI acquired its partnership interests pursuant to notices dated December 15, 1987 from each of Carousel and Central compelling NRI to purchase all the partnership units held by each of them, copy of which notices were introduced in evidence. He stated that he had no knowledge of what claims the appellants made in their respective income tax returns for the 1987 taxation year.
Finally, Mr. Alston testified that notices of entitlement from the PIA with respect to eligible expenditures totalling almost $17,500,000 and PIPs totalling almost $14,000,000 were all received after December 15, 1987.
On cross-examination, Mr. Alston stated that all of the PIPs were to end up with Chevron, the farmor, or with the drilling contractors. He also stated that a letter was sent from Northcor to the PIA dated October 15, 1987 asking it not to issue further PIP entitlements for the Narwhal F-99 well costs until notified in writing by Northcor. He said that the $3,500,000 received by the partnerships was paid on the following day to Northcor. He said that the registration of documents respecting the partnership was effected at the Central Registry pursuant to the Partnership Act of Alberta. In response to a question about the possibility of benefiting from the project having disappeared on October 1, 1987, he said he agreed with that proposition to a considerable extent but that there was a post-mortem on the well that would be carried out for several months and there was a slim possibility that something further might be done in the structure, even though that was not considered probable.
The second and last witness for the appellants was Bernard D. Katchen who was a shareholder, officer and director of 747942. He stated that his company was approached by an agent in the fall of 1987 with respect to finding investors for the partnerships. He said that the matter was researched from a tax view point and that he then pursued it. He stated that the purchase price of $1,855,414 was established through negotiations, 747942 having set out to buy the interest as cheaply as possible. He also stated that he had never dealt with Encee or Northcor or any of the Northcor companies before these transactions. He testified that the sale price of the partnership interests of $2,880,000 was negotiated as the best price possible. He testified that 747942 retained partnership interests entitled to $800,000 of E, that it deducted same in its income tax return and had not been reassessed with respect thereto.
On cross-examination, Mr. Katchen stated that there was a closing book for the transactions which took place on December 14, 1987 and that the closing was coordinated between the offices of lawyers in Calgary and in Toronto.
Appellants’ counsel then read into the record extracts from the examination for discovery of one Mr. Nowoselski, an auditor with the Department of National Revenue. On that examination for discovery, Mr. Nowoselski stated that he accepted certain paragraphs contained in a memorandum from the Department of National Revenue, Head Office, Rulings Directorate Resource Industries Section to Calgary District Office. He said he did not know what the general partner itself actually did and further, that although he did not verify same, he accepted paragraphs 6 and 7, these two paragraphs reading as follows:
6. Since the rig release date, the general partner has been actively engaged on behalf of all of the limited partnerships to locate and bring in additional limited partners to pay the indebtedness incurred. In addition, the limited partnerships were engaged in various wind-down activities, 1.e., (i) refurbishing risers (the tube that they drilled through); (ii) refurbishing other equipment etc. (this occurred basically from October 1, 1987 to mid-November 1987); (iii) disposing of leftover material and equipment and the same is still ongoing (see letter from Manadrill, dated November 9, 1987 attached hereto).
7. The general partner maintains an office at 10th Floor, 600- 6th Avenue S.W., Calgary, Alberta, and prior to the rig release date and subsequent to that date, has maintained a staff. The general partner has been and continues to perform various accounting functions. The general partner, through Dundee Capital Corporation (there is an agreement between the general partner and Dundee Capital Corporation) have been actively soliciting investors for each of the limited partnerships.
Then, with respect to a letter dated March 30, 1988 to Code Hunter, a Calgary law firm, from the Department of National Revenue, Head Office in Ottawa, Mr. Nowoselski stated that he accepted all of the facts in paragraph 1 through paragraph 18. Those paragraphs include two paragraphs identical to those referred to above. The remaining paragraphs set forth matters already outlined above as evidence.
Carousel deducted the sum of $6,000,000 in computing its income for its fiscal period ending December 31, 1987. It also reported a capital gain of $4,920,000 producing a taxable capital gain of $2,460,000 in respect of the disposition of limited partnership interests for deemed disposition proceeds of $6,000,000, such interests having an adjusted cost base of $1,080,000.
Central deducted the sum of $10,000,000 in computing its income for its fiscal period ending December 31, 1987. It also reported a capital gain of $8,200,000 producing a taxable capital gain of $4,100,000 in respect of the disposition of limited partnership interests for deemed disposition proceeds of $10,000,000, such interests having an adjusted cost base of $1,800,000.
Questions posed by the respondent
I shall set forth my distillation of the questions raised by the respondent in support of its position that the appellants should not succeed in their appeals. For convenience the pertinent portion of the statutory references contained in the statement of each such question will be set out in the discussion thereof.
1. Were the appellants members of the four partnerships in question?
2. If the appellants were members of the aforesaid partnerships were they entitled, subject to the determination of the issues below, to the deductions claimed as "cumulative Canadian exploration expense" by virtue of subsection 66.1(3) and subparagraph 66. l(6)(b) of the Income Tax Act?
3. Were the transactions or any of them a sham?
4. Did the deduction of $10,000,000 claimed by Central and the deduction of $6,000,000 claimed by Carousel unduly or artificially reduce the respective incomes of those appellants within the meaning of subsection 245(1) of the Act?
5. Were the transactions under which the appellants acquired and sold limited partnership interests in the partnerships within the object and spirit of section 66.1 of the Act?
6. Were the appellants, within the meaning of subparagraph 66.1(6)(b)(ix) entitled to receive, any "assistance" as defined in paragraph 66(15)(a. 1) in respect of any of the E in the 1987 taxation year of the partnerships thereby reducing the amount of the E pool that could be deducted?
7. Was the interest held by each appellant in each of the four partnerships an "exempt interest" within the meaning of subsection 96(2.5) with the result that by virtue of subsection 96(2.4) it would not be a "limited partner" as defined therein? If it were not a "limited partner", then by virtue of subsection 96(2.2) it would not have an "at-risk amount" with the result that no amount would, under subsections 66.8(1) and (3), reduce the appellants’ E for the purpose of subparagraph 66.1(6)(a)(iv).
General
I propose dealing with each question by stating the appellants’ position and the respondent’s position followed by my analysis and conclusion. This process should assist the comprehension of a parade of complicated facts that become mired in the complexity of knotty and gnarled legislation. Before so doing I will set forth my understanding of the relevant sections of the Act and of the PIP Act.
In the oil and gas context, a taxpayer, other than a corporation whose principal business is in the oil and gas area, may deduct in, computing income, an amount not exceeding his "cumulative Canadian exploration expense". This is a cumulative, continuing pool of expenses ("E pool") to which defined exploration expenses such as seismic and drilling costs are added and from which certain sums received or receivable are deducted. One of such amounts required to be deducted for the taxation period herein was any grant under the PIP Act. In short, a taxpayer would add all E to his E pool and deduct statutorily described amounts therefrom. If the E pool at any year end was a positive amount the taxpayer could deduct same. If the E pool was a negative amount the taxpayer was obliged to include same in income. Partnerships did not deduct E and they did not include in income any amounts received or receivable in respect thereof. These expenses were deemed to be the expenses of the partners in the appropriate amounts and were added to a partner’s E pool and that partner deducted same as above described. A partner could deduct his share of the E incurred by the partnership in a fiscal period if he was a member thereof at end thereof.
Section 66.8, combined with certain subsections of section 96 provided, in essence, that unless a partnership carried on an active business continuously throughout a defined period, a limited partner thereof would not have an ’’exempt interest” and would be limited to deducting an amount of his share of the partnership’s E equal to the amount for which he was "at risk".
Therefore, assuming,
A. that the appellants were members of the four partnerships on December 14, 1987,
B. that the appellants incurred E of $16,000,000 in respect of their partnership interests therein,
C. that none of those partnerships was entitled to any "assistance" (PIPs) in respect of the $16,000,000 of E in its 1987 taxation year,
D. that the partnership interest of each of the appellants was an "exempt interest", and
E. that the issues of undue and artificial reduction of income, sham, object and spirit, self-cancellation and other such arguments raised by the respondent did not exist,
the appellants would be entitled to succeed in their appeals with the result that Carousel could deduct $6,000,000 of its E pool and Central could deduct $10,000,000 of its E pool in its appropriate taxation year. This places the issues in focus.
First question
Were the appellants members of the four partnerships in question?
Appellant's position
Appellant’s counsel commenced his argument in respect of a number of issues with reference to Antosko. v. The Queen, [1994] 2 S.C.R. 312, [1994] 2 C.T.C. 25, D.T.C. 6314. He referred to Mr. Justice lacobucci’s quotation, at pages 326-28 (C.T.C. 31-2, 6319-20), of the words of Estey J. in Stubart Investments Ltd. v. The Queen, [1984] S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305, namely,
where the substance of the Act, when the clause in question is contextually construed, is clear and unambiguous and there is no prohibition in the Act which embraces the taxpayer, the taxpayer shall be free to avail himself of the beneficial provision in question.
lacobucci J. then said,
This principle is determinative of the present dispute. While it is true that the court must view discrete sections of the Income Tax Act in light of the other provisions of the Act and of the purpose of the legislation, and that they must analyze a given transaction in the context of economic and commercial reality, such techniques cannot alter the result where the words of the statute are clear and plain and where the legal and practical effect of the transaction is undisputed.
and
The motives of the parties, and the setting in which the transfer took place, are simply not determinative of the application of the subsection.
and
In this appeal, despite conceding that these factual elements are present, the respondent is asking the Court to examine and evaluate the transaction in and of itself, and to conclude that the transaction is somehow outside the scope of the section in issue. In the absence of evidence that the transaction was a sham or an abuse of the provisions of the Act, it is not the role of the court to determine whether the transaction in question is one which renders the taxpayer deserving of a deduction. If the terms of the section are met, the taxpayer may rely on it, and it is the option of Parliament specifically to preclude further reliance in such situations.
Counsel then stated that the partnerships in question were limited partnerships within the meaning of Part 2 of the Alberta Partnership Act, the law in respect of same being different from the law applicable to ordinary partnerships falling under Part 1 of that Act. He referred to the definition of partnership in section 1 of the Act (appearing before Part 1 and Part 2), reading as follows,
"partnership" means the relationship that subsists between persons carrying on a business in common with a view to profit.
and then referred to section 4 of Part 1 which sets forth certain criteria for determining whether or not a partnership exists. He pointed out, by way of contrast, that section 48, the first section under Part 2, reads,
This Act shall, in the case of limited partnerships, be read subject to this Part.
He submitted that whereas section 4 under Part 1 sets out certain criteria for determining whether a partnership exists, subsection 51(1) under Part 2 reads,
Subject to subsection (1.1), a limited partnership is formed when a certificate substantially complying with subsection (2) is filed with and recorded by the Registrar.
He submitted that no criteria are specified under this Part and that, therefore, the simple filing of a certificate was all that was required to form a limited partnership. Subsection 51(2) requires the certificate to be signed by all persons desiring to form a limited partnership and requires it to state the firm name, character of business, name and place of residence of each general partner and limited partner, the term of the partnership, the assets contributed, etc.
Counsel then referred to subsection 65(1) which provides that a limited partner’s interest is assignable, to subsection 65(2) which says that a substituted limited partner is a person admitted to all the rights of a limited partner who has died or has assigned his interest in the limited partnership and to subsection 65(5) which states that an assignee becomes a substituted limited partner when the certificate is appropriately amended in accordance with Part 2. He continued with reference to subsection 65(6) which provides that a substituted limited partner has all the rights and powers and is subject to all the restrictions and liabilities of his assignor except those liabilities of which he was ignorant at the time he became a limited partner and which could not be ascertained from the certificate. He submitted that
we don’t need to deal with whether or not there is a relationship that subsists between persons carrying on business in common with a view to profit. Once you comply with the requirements of the statute, you have a limited partnership and a substituted limited partner who complies with the requirements of the statute, is a member of the partnership.
Section 56 of the Partnership Act provides that subject to Part 2, a limited partner is not liable for the obligations of the limited partnership except in respect of the amount of property he contributes or agrees to contribute to the capital of the limited partnership. Counsel then stated, with obvious reference to section 63 of the Partnership Act, that where a limited partner participates in the business of the partnership he loses his limited liability. Section 63 of the Act reads,
A limited partner does not become liable as a general partner unless, in addition to exercising his rights and powers as a limited partner, he takes part in the control of the business.
He then asked how it could be said that a limited partner, in order to be considered a partner in the partnership, "must carry on business". He said that if he does so participate he loses his limited liability and that makes no
sense.”
sense.
Counsel then stated that he had found no authorities providing that a limited partner is required to carry on business in order to be considered a partner. He then referred to Robinson Trust et al. v. The Queen, [1993] 2 C.T.C. 2685, 93 D.T.C. 1179, in which Judge Beaubier of this Court found that not only was it not necessary for a limited partner to be carrying on business but the appellant there had taken no part in the management or business of the partnership and could not be considered to have carried on any "active business".
Respondent" s position
Respondent’s counsel argued that the appellants were not persons carrying on business in common with a view to profit. He said that the definition of "partnership" applied to both Part 1 and Part 2 of the Partnership Act of Alberta. He referred to section 50 of that Act which reads,
A limited partnership may, subject to this Part, be formed to carry on any business that a partnership without limited partners may carry on.
and argued that the definition of "partnership" applies respecting limited partnerships and that it requires a business to be carried on. He submitted that the appellants were not carrying on business in common with a view to profit on December 14 and 15, 1987 and that no business was being carried on by the Northcor partnership at that time. He said that the business that had been carried on was the partial financing of a drilling program in the summer of 1987. He said the view to profit that the partnerships had was the possibility of successful drilling increasing the value of the share options granted to them. He stated that the "clean-up activity" could not be regarded as an ongoing business activity and certainly not one with a view to profit. He stated that it was contemplated that the partnership units would be "put" by the appellants to NRI forthwith and there could subsequently be no view to profit. He then quoted Lindley on the Law of Partnership, 15th edition at page 12 which reads,
Where a partnership is formed with some predominant motive other than the acquisition of profits, e.g., tax avoidance, but there is also a real, albeit ancillary, profit element, then it may be permissible to infer that the business is being carried on "with a view of profit".... But it is apprehended that if any given "partner" entered the partnership solely with a view to being credited with a tax loss (or capital allowance), and it was contemplated from the outset that whilst he remained a partner, there would be no real profit (in the sense of
an income profit), then he would not be a partner properly so called.
He then stated that the partnerships were valid at the outset but that there was no possibility of profit when the appellants arrived on the scene.
Respondent’s counsel then referred to Van Halderen et al. v. The Queen, [1994] 1 C.T.C. 2187, 94 D.T.C. 1027, in which Judge Christie, holding that there was not a partnership said, at page 2201-2 (D.T.C. 1037):
When the certificate of limited partnership signed by the appellant on behalf of the general partner...was filed with the Registrar...there was, contrary to what is envisaged under paragraphs 5 l(2)(a) and (d) of the Partnership Act and what is said in paragraphs (b) and (d) of the certificate, no intention whatever on the part of anyone concerned with the partnership that it would carry on a mining business or a business of any kind. And no business was, in fact, ever carried on by it. The exclusive aim and purpose of the limited partnership was to create a capital gain with respect to the profit on the disposition of the coal licenses and the surface assets.
and
To my mind the limited partnership was intended to give the appearance of a legal entity having been created that had a bona fide intention of carrying on a business and, in particular, the business of owing and exploiting mineral resources in the province of British Columbia.
This was a case in which, essentially, assets were "rolled over" on a tax free basis to a limited partnership with the object of disposing of partnership interests thereby converting what would otherwise be an income gain to a capital gain. He stated that no ongoing profit was being generated and reiterated his submission that there was no purpose of carrying on business in common with a view to profit.
Discussion and conclusion
The evidence was clear that each partnership was formed on December 31, 1986 with the execution of a limited partnership agreement and the appropriate filing of a certificate of limited partnership. Each partnership had, inter alia, the express business purposes of exploring for and developing oil and natural gas, incurring Canadian exploration expense as consideration for the right to purchase shares of Northcor and to enter into a share subscription agreement. Northcor did enter into such an agreement with each of the four partnerships and each partnership, by virtue of same, appointed Northcor as its agent to incur exploration expenses on its behalf in drilling and testing the well. The consideration for each partnership so incurring expenses was the issue by Northcor of rights to purchase its shares. Northcor conducted the drilling operations as contracted for, monies were raised on behalf of the partnerships and paid to the partnerships and other activities were carried on. The four partnerships carried on business in quest for profit.
Respondent’s counsel submitted that the appellants did not carry on business in common with a view to profit. His reference to the Van Halderen, supra, case is not helpful to the respondent’s position because it was clear that no business was ever intended to be carried on. It is fact that Alston assigned his interests in validly formed partnerships to Encee, that Encee contributed $3,500,000 to such partnerships, that Encee sold its interests to 747942 and that 747942 sold its interests to the appellants, each of such conveyances being meticulously documented and appropriately registered. What else could have been done?
I am not persuaded that the definition of ’’partnership" in the Partnership Act of Alberta does not apply to limited partnerships formed thereunder. If it does not, the appellants’ argument in this regard succeeds. However, even if it does apply (and I lean to that view) such definition must be read in the context of and as modified by Part 2 of that Act. Section 48 states that the Act "shall, in the case of limited partnerships, be read subject to" that Part.
Part 2 acknowledges the concept of partnerships having partners whose liability is limited and it sets out provisions for their formation and for the assignment of interests therein. If the definition of "partnership" is not modified for the purposes of Part 2 the paradox of limited partners being obliged to be "carrying on business in common" while risking the loss of limited liability if taking "part in the control of the business" defeats the apparent reason for the existence of that Part. Because a limited partnership is a statutory creation having the feature of limited liability, section 48, supra, must, inter alia, have the effect of qualifying the definition of "partnership".
Counsel for the respondent admitted the validity of the partnerships at the outset. There is no pleading and he made no submission to the effect that they had ceased to exist yet he argued that the appellants could not become partners because there was no longer a possibility of profit when they arrived on the scene. The appellants did not form the partnerships. They complied with the statutory requirements to become members thereof at a later date. How can a person be said to be unable to become a member of an extant partnership when that person did everything required by the very legislation by virtue of which it was created, in order to become a member? With respect to the reference to Lindley, supra, it is my view that the words quoted must be read in the context of the limited partnership provisions in the Partnership Act of Alberta and in the context of the specific provision in the Act allocating deductible expenses to a taxpayer who is a member of a partnership at the end of its fiscal period and in the context of the use of such partnerships as funding vehicles created pursuant to government incentives in the oil and gas business.
Accordingly, I have concluded that the appellants were members of 1987-4, 1987-5, 1987-6 and 1987-7 on December 14, 1987.
Second question
If the appellants were members of the aforesaid partnerships were they entitled, subject to the determination of the questions below, to the deduc- tions claimed as "cumulative Canadian exploration expense" by virtue of subsection 66.1(3) and paragraph 66.1(6)(b) of the Act?
Appellant's position
The appellants’ position is simply stated. It is that in 1987, the four partnerships incurred $17,242,400 of E. It is assumed that although the share subscription agreement provides that Northcor was appointed agent of the partnerships to incur such expenses, the partnership incurred same under subparagraph 66.1(6)(a)(v). Not only did the share subscription agreement appoint Northcor as agent for the partnership but, in an obvious effort to qualify under the foregoing subparagraph, it provided that the sole consideration for the partnership incurring the expenses would be the issuance by the company to the partnerships of rights to purchase shares of the company.
In any event, the appellants’ position is that the partnerships, having incurred such expenses, the appellants were partners thereof on December 14, 1987, the end of the fiscal year of the partnerships and were, by virtue of subsection 66.1(3) entitled to deduct the cumulative Canadian exploration expense allocated to each of them, namely $6,000,000 in the case of Carousel and $10,000,000 in the case of Central.
Respondent's position
The respondent, as stated above, denies that the appellants were members of the partnerships and were, accordingly, not entitled to any deductions whatever. His alternative position was that if the appellants were entitled to deduct cumulative Canadian exploration expense, the total deduction should be $3,200,000 made up of $1,200,000 for Carousel and $2,000,000 for Central. Counsel arrived at such figures by saying that the total funding of the partnerships was the sum of $3,500,000, $3,200,000 of which related to the $16,000,000 allegedly allocable to the appellants, such 20 per cent figure being arrived at without taking into account the 80 per cent financing provided by the PIPs. He emphasized that Encee contributed $3,500,000 and the other $14,000,000 came from the government as PIPs.
Respondent’s counsel supported his submission for the deductibility of such reduced amounts in an amendment to the reply filed at the commencement of the hearing. By that amendment the respondent submitted that
the Petroleum Incentive Program grants were not expenses incurred by the partnerships within the meaning of paragraph 66.1(6)(a)(iv) of the Act.
He argued that the true legal effect of the agreements was that the partnerships were liable for and paid only 20 per cent of the E. He argued further that
In respect of the Petroleum Incentive Program payments that might be received, the said agreements were self-cancelling in that in the same agreement by which the partnerships purported to acquire from Northcor the right to receive the Petroleum Incentive Program grants, such rights were assigned back to Northcor.
He referred to clause 4(b) of the agreement and quoted the following portion, namely,
In addition, the investor hereby assigns to the company as further and final payment of its obligations hereunder, all of the investor’s right, title, estate and interest in and to any governmental grants or assistance payments which may arise or be available to the Investor pursuant to the E expenditures to be made hereunder....
and stated that there was no period of time whatever where the partnerships were entitled to those grants because paragraph 6(b) assigned them back to Northcor stating that,
that’s a nothing, that’s self-cancelling in law....
For ease of reference I shall restate the pertinent portions of paragraph 6(b) as follows,
All federal grants and incentive payments earned as a result of any exploration associated with the farm out agreement and contemplated hereby will be earned solely for the account of the investor. The company hereby agrees to apply monthly for such grants and incentives on behalf of the investor and, subject to clause 4(b) hereof, to pay such sums to the investor promptly upon receipt thereof by the company.
Counsel stated that the legal result is that the arrangement could not be considered a financing provided by the partnership because it was financing provided by the government out of payments that could only be earned by Northcor at the moment of the agreement and could only be received by Northcor after the agreement. He then stated that the PIP payment was not, in law, the partnership’s payment. The pith of his submission appears to be contained in his statement that,
The problem is they cannot properly be so considered in law because in order to be considered an expenditure incurred by the partnership, the partnership has to find the funding from somewhere else than the recipient of the funding, namely, Northcor.
He then referred to Ensign Tankers (Leasing) Ltd. v. Stokes (Inspector of Taxes), [1992] 2 ALL E.R. 275 (H.L.). In that case the appellant and four other companies entered into a limited partnership agreement with a subsidiary of a film company, LPI, which was to make a film on behalf of the partnership as agent thereof. Under a production services agreement, the partnership agreed to provide the financing of approximately $13,000,000. Specifically the partnership was to provide $3.25 million in cash and LPI was to lend $9.7 million on a non-recourse basis to the partnership. The partnership was to receive 25 per cent of the net receipts from exploitation of the film and LPI was to receive 75 per cent thereof. The appellant, as the major member of the partnership, took the position that the sum of $14,000,000 (there being an over- run of $1,000,000) was expended by the partnership and that this was the basis for capital allowance. The House of Lords decided that the monies paid by LPI were simply paid into a bank account opened in the partnership’s name to enable it to indulge in a tax avoidance scheme and for no other purpose.
Counsel referred to two other English cases describing them as similar but not adding anything to the analysis contained in Ensign, supra. He argued that the principle established therein should be applied to the present case with the result that, leaving out the amount of the PIPs, Carousel would be entitled, in this alternative argument, to a deduction of $1,200,000 and Central would be entitled to a deduction of $2,000,000.
Discussion and conclusion
I cannot accept the respondent’s submission with respect to the agreement being "self-cancelling”. He conveniently overlooks the fact that Northcor had, at no time, any right to receive PIPs. By virtue of the agreement it was the agent of the partnerships to incur E on their behalf. Further, paragraph 6(b) of the agreement states clearly that all federal grants and incentive payments earned as a result of any exploration would be earned solely for the partnerships’ account. In this situation, Northcor was, of itself, never entitled to receive any PIPs. It could only receive same as agent for the partnerships. Under paragraph 4(b), the partnerships assigned their right to PIPs to Northcor as payment, in addition its 20 per cent, of the amount of E expenditures.
The right to receive PIPs was created by the PIP Act. The PIPs were a percentage of eligible exploration expenses incurred. At the time the agreement was executed, no such eligible expenditures had been made and no one was entitled to PIPs. The right to apply for and receive PIPs could only have arisen upon the incurring of expenses as aforesaid. Accordingly, I do not accept the arguments advanced by respondent’s counsel. The case of Ensign, supra, dealt with a situation where moneys were advanced by a company to a partnership of which its subsidiary was the general partner in a partnership. That fact situation does not pertain here.
Subparagraph 66.1(6)(b)(iv) 1s clear. It provides that, subject to section 66.8, a taxpayer’s share of any Canadian exploration expense incurred by a partnership in a fiscal period is his share thereof if at the end of that period he was a member thereof [emphasis added].
I have found that each of the four partnerships existed throughout its 1987 fiscal period ending on December 14, 1987 and that the appellants were members thereof on that date. The obvious intent of the resource and partnership provisions was that, until the implementation of section 66.8, all E incurred by a partnership be deductible just as it was for any corporation or individual who incurred same. The method selected was simple. The expenses were allocated to taxpayers, as to their respective share, who were members of a partnership at the end of its fiscal period in which they were so incurred. I reiterate the words of Estey J., in Stubart Investments Ltd, supra, at page 580 (C.T.C. 317, D.T.C. 6324),
where the substance of the Act, when the clause in question is contextually construed, is clear and unambiguous and there is no prohibition in the Act which embraces the taxpayer, the taxpayer shall be free to avail himself of the beneficial provision in question.
and the words of lacobucci J. in Antosko et al., supra, in referring to same, at pages 326-28 (C.T.C. 31-32, D.T.C. 6320):
This principle is determinative of the present dispute. While it is true that the courts must view discrete sections of the Income Tax Act in light of the other provisions of the Act and of the purpose of the legislation, and that they must analyze a given transaction in the context of economic and commercial reality, such techniques cannot alter the result where the words of the statute are clear and plain and where the legal and practical effect of the transaction is undisputed.
and
In the absence of evidence that the transaction was a sham or an abuse of the provisions of the Act, it is not the role of the court to determine whether the transaction in question is one which renders the taxpayer deserving of a deduction. If the terms of the section are met, the taxpayer may rely on it, and it is the option of Parliament specifically to preclude further reliance on such situations.
Parliament has chosen the method for the allocation of certain resource expenses incurred by a partnership and for the deduction thereof by the partners. Both are clear. It has amended subparagraph 66.1(6)(a)(iv), the allocating provision, to make it subject to section 66.8 and has added complex companion provisions to prevent claims evidently offensive to its intended purpose and operation. Those amendments related to the amount to be deducted and not to allocation of E for the purpose of deduction.
Therefore, I find that the appellants were members of the aforesaid partnerships and were entitled, subject to the questions below, to the deductions claimed as "cumulative Canadian exploration expense".
Third question
Were the transactions or any of them a sham?
Appellant’s position
Appellants’ counsel referred to Snook v. London & W. Riding Invest. Ltd., [1967] 2 Q.B. 78, [1967] 1 All E.R. 518, at page 802 (D.T.C. 528), where Diplock L.J. said,
As regards the contention of the plaintiff that the transactions between himself, Auto-Finance Ltd. and the defendants were a "sham", it is, I think, necessary to consider what, if any, legal concept is involved in the use of this popular and pejorative word. I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the courts the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.
He also referred to Stubart Investments Ltd. v. The Queen, supra, and said,
Mr. Justice Estey, I believe, took it even a little bit farther. He said that a sham necessarily involved an element of deceit, creating or giving the appearance of creating legal rights and obligations with the intention of fooling someone, (i.e., the taxing authority that you intended to create those legal rights but never did).
Counsel then stated that the respondent had contended, not that the transactions as a whole were a sham but, that a very narrow part of the transactions, namely, the appellants’ membership in the partnerships, was a sham. He submitted that such argument was not open to the respondent, stating that either the whole transaction or series of transactions stands or falls. He said that one isolated element of same cannot be regarded as being a sham. He referred to Mark Resources Inc. v. The Queen, [1993] 2 C.T.C. 2259, 93 D.T.C. 1004, at page 2267 (D.T.C. 1010), where Judge Bowman of this Court said,
One final observation must be made. We have here a series of interrelated transactions. The Crown has challenged under subsection 245(1) only one aspect of the entire arrangement, the deduction of interest, on the basis that it results in an artificial or undue reduction of the appellant’s income. Yet it has chosen to leave intact the consequences of all but one of the component parts. Either the whole structure falls or it does not. It cannot be dismembered piecemeal. In any fiscally motivated scheme, if no sham is involved, there must necessarily be legally effective steps that have specific tax consequences. The tax results of each of those steps that forms an integral part of the entire scheme must be respected unless the Minister is prepared to say that the scheme as a whole fails.
Counsel then referred to Continental Bank of Canada et al. v. The Queen, [1995] 1 C.T.C. 2135, 94 D.T.C. 1858 (T.C.C.), and said,
The allegation of sham in Continental Bank...was very similar to the allegation in the present case. The allegation was not that the entire series failed, it was that the appellant’s membership in a partnership was a sham. And Judge Bowman said, essentially, you can’t do that, you can’t simply take one piece out of a larger transaction and call that piece a sham. Either the whole transaction is a sham or it’s not.
He then submitted that the evidence was clear that the parties intended to accomplish exactly what the documents purported to do. He stated that the appellants would not have intended anything different because their object was to bring themselves within the statute, that being the only manner of availing themselves of the deductions sought. He emphasized this point by saying that that was exactly what the documents were designed to do and that was exactly what the parties intended to do and that to intend something different would have been entirely self-defeating. He referred to Alberta and Southern Gas Co. v. The Queen, [1976] C.T.C. 639, 76 D.T.C. 6362, where Cattanach J., at page 650 (D.T.C. 6370) said,
The agreements between the plaintiff and Amoco created between the parties the exact legal rights consequent thereon that the parties intended to create and which both parties complied with in accordance with the terms of the agreements between them. That being so the parties had no intention whatsoever that the agreements did not create the legal rights and obligations other than those which the agreements did in fact create.
and
In my opinion the "carve-out" agreements were not intended to give to strangers thereto, including the Minister of National Revenue, the appearance of creating rights and obligations other than those created by the agreements as were intended by the parties. To do otherwise would defeat the very motive which influenced the plaintiff to seek out these agreements. There was no dissemblance. Put another way and in more succinct and colloquial language if the parties to a contract do precisely what they contract to do there is no sham.
Counsel then returned to the decision in Continental Bank Ltd., supra, quoting Bowman J. at page 2149 (D.T.C. 1868),
If the legal relationships are binding and are not a cloak to disguise another type of legal relationship they are not a sham, however much the tax result may offend the Minister or, for that matter, the court, and whatever may be the overall ulterior economic motive. When something is a sham the necessary corollary is that there is behind the legal facade a different real legal relationship. If the legal reality that underlies the ostensible legal relationship is the same as that which appears on the surface, there is no sham.
He stated that in that case the appellants were members of a partnership over a three day period, two of which days were holidays.
Respondent's position
Respondent’s counsel seems to have abandoned the sham argument. During his submission with respect to whether the appellants were members of the four partnerships he said,
the real issue is more confused by calling it sham than simply by addressing the real issue: Did these people become partners? We don’t have to accuse them of sham, we simply have to persuade your honour that they didn’t become partners because they couldn’t become partners in law.
Discussion and conclusion
I have no difficulty in concluding that the actions taken by the appellants were precisely those that were anticipated and that were reflected in the detailed documentation. The uncontroverted evidence made it clear that those documents created precisely the legal rights intended by the parties who executed same. Accordingly, no sham exists in the transactions entered into by the appellants.
Fourth question
Did the deduction of $10,000,000 claimed by Central and the deduction of $6,000,000 claimed by Carousel unduly or artificially reduce the respective incomes of those appellants within the meaning of subsection 245(1) of the Act?
Appellant's position
Appellant’s counsel referred to paragraph 12(a) of the respondent’s amended reply which said that one of the issues is
whether the $6,000,000 deduction claimed by the appellant was in respect of transactions or operations that, if allowed, would unduly or artificially reduce the income of the appellant within the meaning of subsection 245(1) of the
Income Tax Act....
He then referred to The Queen v. Irving Oil Ltd., [1991] 1 C.T.C. 350, 91 D.T.C. 5106. At page 360 (D.T.C. 5114) Mahoney J., dealing with this subject, said,
In order to come within the terms of subsection 245(1), a transaction or operation must have the effect of unduly or artificially reducing income; the artificiality of the transaction or operation itself does not determine the issue.
The learned justice then referred to Spur Oil Ltd. v. The Queen, [1981] C.T.C. 336, 81 D.T.C. 5168, where Heald J.A., speaking for the Court at pages 343 (D.T.C. 5173) said:
To be caught by that subsection, the expense or disbursement being impeached must result in an artificial or undue reduction of income. "Undue" when used in this context should be given its dictionary meaning of "excessive".
and
Turning now to "artificial", the dictionary meaning when used in this context is, in my view, "simulated" or "fictitious".
Counsel then submitted that over $27,500,000 of E was incurred in drilling and testing the Narwhal well and that this not being disputed by the respondent, there was nothing fictitious or simulated about those expenses. He said that the expenses had actually been incurred and that there was nothing undue or excessive about them, the amount having been certified on audit by the Government of Canada as expenses actually incurred, 80 per cent of same having been reimbursed by it. Counsel said,
How could it be said in this case that the expense would unduly or artificially reduce the income of the taxpayer when it is uncontested that these expenses, in these amounts, were in fact incurred?
With respect to the question of artificiality he referred to Alberta and Southern Gas, supra, in which the taxpayer had entered into a "carve-out" arrangement with Amoco. In short, the appellant, wanting to shelter $4,000,000 of income, purchased from Amoco a working interest in Amoco’s properties for $4,000,000 under which arrangement Alberta and Southern Gas was to receive certain petroleum and natural gas substances. The working interest was to terminate when Alberta and Southern Gas had received petroleum substances, the value of which totalled $4,000,000 plus an amount as an interest factor. The Minister of National Revenue, inter alia, advanced an argument of artificial reduction of income. On appeal ([1977] C.T.C. 388, 77 D.T.C. 5244 (F.C.A.) aff’d [1979] 1 S.C.R. 36, [1978] C.T.C. 780, 78 D.T.C. 6566 (S.C.C.)), the learned chief justice referred to amounts specifically deductible by statute, for example, at page 396 (D.T.C. 5248):
amounts that were not laid out for the earning of profit (either as current or capital expenditures) but the deduction of which is allowed by Parliament to achieve some end that Parliament wishes to encourage (incentive allowances).
With reference to the resource sections of the Act, the Court said, at page 397 (D.T.C. 5249),
These provisions for deduction and taxation of capital amounts seem to me to have the obvious purpose of encouraging taxpayers to put money into such resource properties and keep it there. That being what the provisions seem to have been intended to encourage, as it seems to me, a transaction that clearly falls within the object and spirit of section 66 cannot be said to unduly or artificially reduce income merely because the taxpayer was influenced in deciding to enter into it by tax considerations.
Counsel stated that this case was followed in Edmonton Liquid Gas Ltd. v. The Queen, [1984] C.T.C. 536, 84 D.T.C. 6526 (F.C.A.), in which MacGuigan J., at page 545 (D.T.C. 6533) said,
In The Queen v. Alberta Southern Gas Co. Ltd., [1977] C.T.C. 388, 77 D.T.C. 5244, aff’d by the Supreme Court of Canada, [1979] 1 S.C.R. 36, [1978] C.T.C. 780, 78 D.T.C. 6566, Jackett C.J., held for this Court that where provisions of the Income Tax Act have the obvious purpose of encouraging taxpayers to enter into an expenditure of a particular kind, a taxpayer who otherwise falls within the object and spirit of the relevant provisions cannot be said to unduly or artificially reduce income because he was influenced to enter into it by tax considerations.
At page 546 (D.T.C. 6534) the Court said,
Earlier the Government had made a positive decision to continue to encourage exploration through a 100 per cent write-off for Canadian exploration expenses.
and then cited the part of a budget speech made by the Minister of Finance in the House of Commons, noting that there had been quick response after that speech to the newly enunciated Government Economic Policy Objective. It concluded with this statement,
There was nothing contrived or artificial in this corporate initiative. It was a good-faith response to what was in effect a new, or at least an unexpectedly renewed government policy, and was fully in accord with the object and spirit of the allowance provision.
Respondent's position
Respondent’s counsel stated that the deductions claimed by the appellants would unduly or artificially reduce the incomes of the appellants and were, therefore, prohibited by subsection 245(1) of the Act. That subsection read as follows,
245(1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.
Counsel shaped his argument by saying,
I say that 245(1) applies because in structuring a complicated prearranged transaction involving these features that are very unusual, the taxpayer becoming a partner in a business that has already fully or substantially completed its activities for which it was formed, and in remaining a partner only 24 hours and in seeking to receive an allocation only of expenses incurred before the taxpayer joined the partnership and in seeking to deliberately avoid an allocation of receipts relating to those expenses, the appellants have engaged in a transaction that would unduly or artificially reduce their income.
The special arrangements made with Petroleum Incentives Administration to deliberately delay the issue of some of the notices of entitlement and payment of the PIP grants was also an artificial step, in my submission.
He stated that the appellants had blocked the receipt of an offsetting credit that should properly reduce the amount of the expense they had borne by virtue of their manipulation of the PIP grants. He submitted that a transaction becomes undue where one effectively departs from what, in every sense but a tax sense, would be the only advantageous way to proceed-namely to collect receipts as soon as possible. He stated,
When you don’t do that, you are conducting your business so as to unduly reduce your income.
He then referred to Don Fell Ltd. et al. v. The Queen, [1981] 1 C.T.C. 363, 81 D.T.C. 5282 (F.C.T.D.), where Cattanach J., said, at page 375 . (D.T.C. 5292):
The word "unduly" relates to quantum and means "excessively" or "unreasonably" and "artificially" means "not in accordance with normality”.
The learned justice stated that the complex procedure in that case was "not in accordance with normality" and so "artificial" within the adverb form of that word used in the subsections.
Counsel’s point was that it is abnormal for a business person to delay receipt of moneys until after a certain date. He stated that it is reasonable to arrange affairs in that order if one could obtain a tax advantage from so doing but that it is not reasonable to do so apart from the tax factor. He referred to one of Mr. Justice Estey’s interpretation guidelines in the Stubart, supra, case respecting section 245 when he said, on page 579 (C.T.C. 316, D.T.C. 6323), of his decision,
Where the facts reveal no bona fide business purpose for the transaction, s. 137 may be found to be applicable depending upon all the circumstances of the case.
After stating that 137 was the former number of section 245 he submitted that the learned justice’s statement showed that the business purpose can have a role in the analysis of that provision.
He referred to page 558 (C.T.C. 305, D.T.C. 6314), of the Stubart Investments Ltd., supra, quoting Lord Wilberforce in W.T. Ramsay v.
Inland Revenue Comrs. (H.L. (E.)), [1981] 2 W.L.R. 449, at page 459,
To say that a loss (or gain) which appears to arise at one stage in an indivisible process, and which is intended to be and is cancelled out by a later stage, so that at the end of what was bought as, and planned as, a single continuous operation, is not such a loss (or gain) as the legislation is dealing with, is in my opinion well and indeed essentially within the judicial function.
Mr. Justice Estey referred to the statements of Lord Fraser of Tullybelton, at page 469 of the Ramsay judgment as follows,
Each of the appellants purchased a complete prearranged scheme, designed to produce a loss which would match the gain previously made and which would be allowable as a deduction for corporation tax (capital gains tax) purposes. In these circumstances the court is entitled and bound to consider the scheme as a whole: see Inland Revenue Commissioners v. Plummer [1980] A.C. 896, 908 and Chinn v. Hochstrasser [1981] 2 W.L.R. 14. The essential feature of both schemes was that, when they were completely carried out, they did not result in any actual loss to the taxpayer. The apparently magic result of creating a tax loss that would not be a real loss was to be brought about by arranging that the scheme included a loss which was allowable for tax purposes and a matching gain which was not chargeable.
Counsel then referred to Mr. Justice Estey having quoted Lord Fraser of Tullybelton in Furniss (Inspector of Taxes) v. Dawson et al., [1984] A.C. 475, [1984] 1 All E.R. 530 (H.L.), and quotes at page 562 (C.T.C. 307, D.T.C. 6316) as saying,
The true principle of the decision in Ramsay was that the fiscal consequences of a preordained series of transactions, intended to operate as such, are generally to be ascertained by considering the result of the series as a whole, and not by dissecting the scheme and considering each individual transaction separately.
He then referred to the appellants as having purchased a complete prearranged scheme designed to produce $16,000,000 of deductible expense, no amount approaching these sums having been expended by them, followed by the act of deferring receipt of the PIPs and followed by the put arrangement by virtue of which the appellants disposed of all their partnership interests.
Discussion and conclusion
It is my view that a specific section of the Act with incentive intent clearly provided for the deduction of the total exploration expenses incurred by a partnership. The four partnerships of which the appellants were members did, in fact, incur the $16,000,000 of exploration expense which the appellants seek to deduct. The expenses were not created by some imaginative scheme. They were intended to be incurred, they were incurred, they were allocated to the appellants exactly in accordance with the terms of the limited partnership agreements and so became their "share" as provided in subparagraph 66.1(a)(iv). The Act is so constructed that these amounts claimed by the appellants cannot be deducted by any other person. Based upon my findings above, the deduction of such expenses by the appellants is clearly authorized by statute.
In the Federal Court of Appeal, Pratt C.J., in his reasons for judgment in the Alberta and Southern Gas case said at page 396 (D.T.C. 5248),
subsection 245(1) is applicable to every class of deductible expenses. Even if, reading the Act as a whole, I came to a different conclusion, I should feel constrained to hold that subsection 245(1) does apply to deductions such as those otherwise permitted by section 66....
I read that as meaning "potentially applicable" or as being available.
The learned justice goes on to say, after referring to specific deduction sections,
These provisions for deduction and taxation of capital amounts seem to me to have the obvious purpose of encouraging taxpayers to put money into such resource properties and keep it there. That being what the provisions seem to have been intended to encourage, as it seems to me, a transaction that clearly falls within the object and spirit of section 66 cannot be said to unduly or artificially reduce income merely because the taxpayer was influenced in deciding to enter into it by tax considerations.
My conclusion in respect of this question will be stated together with my conclusion in respect of the fifth question.
Fifth question
Where the transactions under which the appellants acquired and sold limited partnership interests in the partnerships within the object and spirit of section 66.1 of the Act?
Appellant's position
Counsel referred to a document entitled "The National Energy Program 1980 issued by Energy, Mines and Resources Canada" and read from page 39 thereof the following:
The major incentives available to date for exploration have been delivered through the income tax system. Thus only taxpaying firms and individuals have been able to make immediate use of these incentives. A new system is required to provide incentives not only to those, but to other Canadian investors.
He then referred to a document introduced as an exhibit described as Revenue Canada, Taxation memorandum written by an official of Rulings Directorate, Resource Industries Section, Head Office, Revenue Canada, Taxation dated July 12, 1989 which refers to, inter alia, subparagraph 66.1 (6)(a)(iv) including in the definition of "Canadian exploration expense" a taxpayer’s share of those expenses incurred by a partnership, if at the end of the fiscal period of the partnership, the taxpayer was a member thereof.
The memorandum continues as follows:
It has been our position that any amounts determined under the aforesaid subparagraphs will be considered to have been incurred by the partner on the last day of the partnership’s fiscal period.
Based on the above analysis, and prior to the general anti- avoidance rule ("GAAR"), we have issued favourable rulings and opinions to the effect that ’’warehousing” arrangements as described hereunder would be acceptable for tax purposes.
These warehousing arrangements could take various forms, for example:
(i) A limited partnership enters into flow-through share agreements with resource companies. Subsequently, investors purchase limited partnership units near the fiscal year-end of the partnership. These members invariably acquire their investments in the partnership after the resource expenses have been incurred and renounced by the resource companies, but in time to have their share of those expenses allocated to them from the partnership;
Another document, being the response from the Acting Director, Current Amendments and Regulations Division of Revenue Canada Taxation, read in part, with respect to (i) above,
We have been informally advised that the first scenario is not offensive because the flow-through share agreement is entered into before the actual expenses are incurred.
Counsel then referred to a document dated November 10, 1994 entitled Finance Department releases evaluation of flow-through shares. It reads, in part, as follows:
Flow-through shares are one way for mining and petroleum companies to finance their exploration and development activities in Canada. These equity instruments receive special tax treatment and are issued by means of agreements between resource companies and their investors. An investor who purchases a flow-through share from a mining or petroleum company under such an agreement receives an equity interest in the company plus the right to income tax deductions associated with new expenditures on exploration and development
...Although flow-through shares are available to all mining and petroleum companies, the mechanism is designed to be of principal benefit to nontaxpaying junior exploration companies, that is, companies which are unable to fully utilize income tax deductions for exploration and development and whose access to alternative sources of financing is limited.
For investors, flow-through shares are an alternative type of resource investment which offer substantial liquidity, are tax- advantaged relative to other forms of risk capital and, depending on how investments in flow-through shares are structured, can reduce the risk associated with mining and petroleum investments.
Flow-through shares are designed to support economic and social policy by:
—encouraging additional exploration and development in Canada; -promoting equity investments in mining and petroleum companies; and -assisting junior (typically non-taxpaying) exploration companies....
... The time period for empirical analysis was principally from 1987 to 1991, but goes back to 1983 in some cases.
The evaluation found that flow-through shares addressed an actual need and were consistent with government priorities during the evaluation period.
Counsel then asked whether, if this type of transaction was fully contemplated and actively supported by the Government of Canada,
how could it possibly be found to be outside the object and spirit of the Act?
Respondent" s position
Respondent’s counsel said that when the provisions of subsection 66.1(6) are read as a whole with the object and spirit and purpose of the allowance provision in mind, the accounting result that the scheme produced should not avail the appellant of the benefit of the deduction. He referred to the third guideline of Mr. Justice Estey at page 580 (C.T.C. 317, D.T.C. 6324) of the Stubart decision, namely,
(c) "the object and spirit" of the allowance or benefit provision is defeated by the procedures blatantly adopted by the taxpayer to synthesize a loss, delay or other tax saving device, although these actions may not attain the heights of "artificiality" in section 137.
In essence, respondent’s counsel with respect to this argument, relied on the unusual steps that had been taken and stated that the appellants did not fall within the clear meaning of the income tax provisions.
Discussion and conclusion
Of the 24 different meanings of ’’spirit" in The Oxford English Dictionary, Second Edition, Volume XVI, only the tenth sheds any light on the meaning of the word "spirit" as it could possibly be used in legal analysis. Part C thereof reads,
The broad or general intent or meaning of a statement, enactment etc. Used in contrast to Letter.
After the exposition of arcane examples which would do nothing to enlighten even the most compulsive legal pedant, one finds,
1982 Church Times 15 Jan. 20\2 It is...neither in the letter nor spirit of these resolutions for anyone...to act in a way which has the effect of forcing one view upon those who hold the other.
This seems to suggest that the resolutions being examined were not so clear as not to admit the possibility of a construction inconsistent with the objective that the words thereof were selected and arranged to express. It is my view that, in this situation, one need not devote effort to attempting to determine the "spirit" of legislation whose incentive objective is not only readily apparent but is clearly endorsed by governmental scribes.
The object of the Act with respect to the resource industries is clearly to provide incentive deductions to encourage exploration and development. The vehicles created by the oil and gas industry to take advantage thereof are the products of legislation specifically permitting same. That has resulted in the arrangements under examination in this case. Respondent’s counsel refers to the "unusual steps" that had been taken. They are unusual in the sense of not being available to other industries but they are not unusual having regard to resource industry practice. In light of the common use of such structures in the extractive industries and in view of the express governmental acceptance of such structures referred to above I conclude that the transactions under which the appellants acquired and sold limited partnership interests were within the object of the Act. As indicated above, I do not find an analysis of the word "spirit" to be of assistance in this context since it would add nothing to what is the obvious object or purpose of the legislation under examination. Based on this finding and upon my discussion of the fourth question I conclude that the deductions made by the appellants herein do not unduly or artificially reduce their respective incomes.
Sixth question
Were the appellants within the meaning of subparagraph 66.1 (6)(b)(ix) entitled to receive any "assistance" as defined in paragraph 66(15)(a. 1) in respect of any of the E in the 1987 taxation year of the partnerships thereby reducing the amount of the E pool for the purposes of deduction entitlement?
Appellant's position
Appellants’ counsel referred to section 3 of the PIP Act which reads as follows,
3. On application to the Minister for an incentive by a qualified person who establishes in the application in the form and manner prescribed that the applicant, or another person associated with the applicant in the manner and to the extent prescribed, has, or, to the extent and in the circumstances prescribed, is deemed to have, incurred on or after April 1, 1986 and before January 1, 1988 eligible exploration expenses in respect of a prescribed activity on Canada lands, the applicant is, subject to such terms and conditions as are prescribed, entitled on the requisition of the Minister to a Crown share incentive in the amount of 25 per cent of the specified portion of the eligible exploration expenses.
Counsel then referred to section 4 of that Act the relevant portions of
which he quoted as being,
On application to the Minister for an incentive by a qualified person
subject to section 5 and to such terms and conditions as are prescribed, entitled on the requisition of the Minister to an incentive in the amount determined in accordance with section 7, 8 or 9, whichever is applicable.
...Appellants’ counsel referred to paragraph 12(g) of the respondent’s amended reply which describes one of the issues as
alternatively, if the appellant is entitled to deduct any amount in respect of Canadian exploration expense whether that amount must be reduced pursuant to subparagraph 66.1 (6)(b)(ix) or paragraph 66.1 (9)(g) of the Act.
He said that, in short, the question 1s whether the appellants were entitled to the PIPs and whether they could reduce the appellants’ claim in the 1987 taxation year. He stated that no requisitions had been made and that no notices of entitlement had been issued prior to December 15, 1987 with respect to more than $10,322,000 of E. His position was that if the appellants had been entitled to the assistance, the expenses would have to have been reduced by that sum. He stated that the provisions of the Act required application, requisition and, in certain circumstances, approval of the Minister. He pointed out that legislation was sought and obtained by Northcor to "grandfather" the use of flow-through shares for this particular project, and that one of the conditions of that grandfathering was that ministerial approval was required. He submitted therefore that in the appellants’ circumstances there were three requirements. He reviewed Mr. Alston’s evidence that approvals were not automatic, that the Minister had to be satisfied that the expenses were bona fide, that the Minister sometimes performed an audit, sometimes waited until after the fact to perform such audit, sometimes gave entitlements and sometimes revoked them at a later date. Mr. Alston said that, on occasion, negotiations with the PIA as to whether certain expenses would or would not be accepted had to be made. He stated that the respondent’s position that an application alone was necessary to obtain entitlements was untenable.
Counsel also queried the necessity of language in the statute respecting a "requisition" if in fact that were not necessary. He referred to Webster’s Dictionary which defines "requisition" as
the act of formally requiring or calling upon someone to perform an action,
or
as a written request for something authorized but not made available automatically.
He referred to Canadian Tax Report of February 5, 1981 setting forth the text of a Department of Finance Release dealing with proposed legislative changes and read the following portion,
Mr. MacEachen also clarified how the petroleum incentive payments will be treated by Revenue Canada under the Income Tax Act. He stated that the incentive payments will reduce the deductions for exploration and development expenditures only after the company or individual becomes entitled to receive the grant-that is, after all the requirements for receiving an incentive payment have been completed.
and
Industry representatives had expressed concern to the Energy Minister that their cash flow would be adversely affected if their eligible tax deductions for exploration and development expenses were reduced before the incentive grants were actually received.
and
Mr. Lalonde said the new clarification will contribute significantly to the financing of oil and gas exploration and development since the expense will be reduced for tax purposes only at such time as the investor files an application and becomes eligible for the incentive grants. He said the industry had indicated to him that such an interpretation would facilitate the raising of funds for oil and gas exploration....
He concluded his submission in this regard by stating that the PIA knew about this practice and referred to the exhibited letter from that Administration to Northcor dated December 14, 1987. That letter confirmed that no entitlement to Northcor for Petroleum Incentives for exploration costs incurred drilling the Narwhal F-99 well subsequent to 1986 and prior to December 15, 1987 in excess of $10,322,000 had arisen.
Respondent’s position
Respondent’s counsel submitted that the full amount of PIPs in respect of $16,000,000 of exploration expenses (assuming the appellants are entitled thereto) should be applied in reduction of that sum. He stated that the partnerships had no right to the PIPs. He advanced the argument that if the partnerships were not entitled to receive the PIPs until after December 14, 1987 then
the expenses which those grants paid had not yet been incurred by the partnerships until the grants became payable. Hence, they would not be expenses incurred by the partnership in the fiscal period ending December 14, 1987...but they’d be expenses incurred in a subsequent period for purposes of paragraph (iv) of 66.1(6)(a).
He then advanced the following theory, namely:
And if the payments have not yet arisen by the end of the fiscal year of the partnership, they have not yet themselves incurred those expenses because that’s the way they were liable to pay them is by means of the.... Only if Petroleum Incentives Program grants became payable, did they become liable to incur those expenses. Because any other kind of expenses would have fallen outside of the terms of the share subscription agreement.
The share subscription agreement is premised on the position that these are Canadian exploration expenses under the Income Tax Act, 80 per cent of which will be reimbursed by Petroleum Incentives Program grants and that 80 per cent, as I say, is the means by which the partnerships, and the only means by which, they are liable to pay them. And so they don’t incur them until they get the entitlement to the program grants.
Counsel then submitted that the full amount of the PIPs in respect of $16,000,000 of E (assuming the appellants are entitled thereto) should be applied to reduce that sum. He said that there was an entitlement to the PIPs despite the lack of notices of entitlement on December 14, 1987. He referred to section 3 of the Petroleum Incentives Program Act, reading in part as follows:
On application to the Minister for an incentive by a qualified person...the applicant is...entitled on the requisition of the Minister to a Crown share incentive....
He then referred to a letter written by the Minister of Energy, Mines and Resources to the president of Northcor Energy Ltd. dated September 10, 1987 reading as follows:
I wish to confirm my approval, pursuant to subsection 5(2) of the Petroleum Incentives Program (PIP) Act and section 13.8 of the PIP Regulations, of expenses incurred in respect of the Narwhal F-99 well. This approval is subject to the condition that no amendments be made to the financing agreement, effective May 26, 1987, between Northcor and Chevron Canada Resources Limited except where the Petroleum Incentives Administration is notified of any such amendment and approves it in writing. The present approval shall apply to all participants in the Narwhal F-99 well.
Counsel’s thesis was that since this represented the final approval from the Minister nothing further remained to be done. He stated that all but one application was submitted by October 1987 and that, approval having been received, the partners were entitled on the requisition of the Minister to a Crown share incentive. He argued that this was not a payment at the discretion of the Crown but was one of statutory entitlement and that the word "requisition" had no significance other than describing the procedure for payment. He stated that entitlement to the PIPs arose by the making of an application for same, describing it as analogous to the rendering of an account.
Counsel then referred to the case of West Kootenay Power and Light Co. Ltd. v. The Queen, [1992] 1 C.T.C. 15, 92 D.T.C. 6023 (F.C.A.), which dealt with whether the appellant was obliged to take amounts into income which had been earned but were not billed at its year end. The learned justice in that case discussed accounting methods and referred to the matching of revenue and expenditures. He concluded, on the facts and with reference to accounting principles, that the appellant had a clear legal right to payment and though sums were not yet billed they had to be included in income. He said that this thinking should apply to subparagraph (ix) of paragraph 66.1(6)(b). He stated that the bulk of the PIP grants were allowed on December 17 and that such allowance showed that the notices of entitlement issued on December 27 could have been issued earlier but were deliberately held back pursuant to the correspondence from the Petroleum Incentive Administration dated December 14, 1987 which stated, in part,
...this will confirm that no notices of entitlement have been issued to Northcor Energy Ltd. for petroleum incentive grants...in excess of $10,322,000.
Counsel also submitted that subparagraph (ix) should be read so that the word ’’assistance” would be modified by the words "can reasonably be related to Canadian exploration activities” and that this indicated an obvious legislative attempt to require amounts that might not be receivable or "legal entitlements as of the year end" to be deducted by virtue of such legislation.
Discussion and conclusion
I discount the first two arguments presented by respondent’s counsel.
The pertinent wording of section 4 of the Petroleum Incentives Program Act applicable to the discussion of this issue reads as follows,
the applicant is...entitled on the requisition of the Minister to an incentive in the amount determined in accordance with....
"Minister” is defined in that Act to be the Minister of Energy, Mines and Resources. Although no evidence was produced with respect to the procedure followed by the PIA, it would be surprising that monies would be paid by the Government of Canada to an applicant for same without requisition therefor being made by some responsible authorized person. It seems illogical, having regard to government procedures, that simple approval of an application could result in the issue of cheques in substantial amounts without appropriate procedures being observed. I do not find the fact that the appellants did not advance the receipt of the PIPs to their 1987 taxation year to be of any assistance to the respondent’s position. The West Kootenay Power and Light Co. Ltd. case dealt with accounting principles applicable to commercial transactions and provides no guidance for the resolution of this issue. I agree with appellants’ counsel that the phrase "on the requisition of the Minister" has no meaning if the respondent’s argument that payment of incentives is automatic after approval is obtained, is accepted.
Subparagraph 66.1(6)(b)(ix) refers to,
...any assistance that he has received or is entitled to receive in respect of any Canadian exploration expense incurred after 1980 or that can reasonably be related to Canadian exploration activities after 1980....
In my opinion, respondent’s counsel’s argument that this provision should be read so that the word "assistance” would be modified by the words "can reasonably be related to Canadian exploration activities” could only be valid if the word "assistance” would also be modified by the words "in respect of any Canadian exploration expense". That leaves the words "that he has received or is entitled to receive" without meaning. That makes no sense. I agree with appellants’ counsel that the phrase "any assistance that he has received or is entitled to receive" modifies both "in respect of any Canadian exploration expense incurred after 1980" and "that can be reasonably related to Canadian exploration activities after 1980". To read this provision in the manner proposed by respondent’s counsel would oblige one to ignore the rule that the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act as set out at page 87 of professor Driedger’s Construction of Statutes (2nd ed. 1983).
I conclude that the appellants were not, within the meaning of subparagraph 66.1(6)(b)(ix) entitled to receive any "assistance" in the 1987 taxation year of the partnerships.
Seventh question
Was the interest held by each appellant in each of the partnerships aforesaid an "exempt interest" within the meaning of subsection 96(2.5) with the result that by virtue of subsection 96(2.4) it would not be a "limited partner" as defined therein? If it were not a "limited partner", by virtue of subsection 96(2.2) it would not have an "at-risk amount" and there would be no amount determinable under subsections 66.8(1) and (3) that would reduce the appellants’ E determined under subsection 66.8(1) for the purpose of subparagraph 66.1(6)(a)(iv).
Appellants ’ position
Appellants’ counsel stated that respondent admitted that Northcor had commenced drilling operations in early June 1987 and that same continued until October 1987, all subsequent to preliminary work conducted earlier in that year. He further stated that, as above set forth, the respondent’s witness, on examination for discovery, accepted the fact of wind-down activities continuing until the end of the 1987 fiscal period. He referred to subsection 96(2.5), as amended, as follows,
an exempt interest in a partnership at any time means...an interest in a partnership that was actively carrying on business on a regular and a continuous basis immediately before June 17, 1987 and continuously thereafter until that time....
He then referred to section 66.8, to which subparagraph 66(l)(a)(iv) is subject and pointed out that if an appellant had an exempt interest there would be no "at-risk amount" and section 66.8 would have no effect upon the appellants’ share of partnership Canadian exploration expense.
He referred to Canadian Dredge and Dock Co. v. M.N.R., [1981] C.T.C. 2212, 81 D.T.C. 154, in which the Tax Review Board found that a reduction in scale of the company’s operations did not mean that the taxpayer discontinued that business. The Minister of National Revenue alleged that the appellant, which was in the marine construction business, had ceased to carry on that business in that all of its current revenues were from rentals, it had no current marine contracts, its administrative office was reduced to a trailer, it had disposed of its major fixed assets, it had substantially reduced the use of its warehouse and its permanent personnel had been reduced to two employees.
Counsel then referred to Carland (Niagara) Ltd. v. M.N.R. (1964), 34 Tax A.B.C. 386, 64 D.T.C. 139 in which the Tax Appeal Board stated that it is not necessary that there be sustained activity before it can be maintained that a business is carried on and that there may be and often are periods of quiescence in almost any business enterprise.
He also referred to CIR v. The South Behar Railway Co. (1925), 12 T.C. 657, at page 712 where Sumner L.J., said
as long as her trade debts remained undischarged, there would seem to be a presumption that a company continues to carry on business as long as it is engaged in collecting debts periodically falling due to it in the course of its former business. Business is not confined to being busy; in many businesses long intervals of inactivity occur.
Counsel then referred to Household Products Co. v. M.N.R. (1964), 34 Tax A.B.C. 441, 64 D.T.C. 164, in which a company whose business was selling household goods, made a proposal to its creditors under the Bankruptcy Act. That proposal was accepted and new working capital was obtained by the issue of preferred shares and the company’s only activity thereafter was the collection of accounts receivable. In response to the Minister’s contention that the company was not carrying on business, the Tax Appeal Board held that since the collection of accounts receivable formed part of the business which was previously carried on, there was no interruption in the business, even if one of its two main activities (the selling of household goods) did cease to exist.
Counsel concluded by stating that the appellants’ situation was analogous in that although the partnerships’ drilling activities ceased on October 1, 1987, a part of those activities, namely the wind-down activities and the financing activities, continued to be carried on until at least December 14, 1987 and thereafter until all the PIPs had been received and the affairs of the partnerships had been concluded.
Respondent's position
At the hearing, respondent’s counsel said, with obvious reference to the partnerships,
They have not continously carried on business until December 14, 1987. The business ended when the well proved unsuccessful, and the business ended before December 14, 1986. And that, of course, is the actively carrying on a business; they weren’t actively carrying on business, in my submission, after October.
In a subsequent written submission on this issue respondent’s counsel submitted that the business of the partnerships was not drilling and testing the well but only the financing of that activity in exchange for rights to purchase shares of Northcor in accordance with terms of the agreement. He wrote further, that while the Agreement, in each case, provided that Northcor was the agent of the partnership for the purpose of incurring Canadian exploration expense, it did not provide that Northcor was carrying on business as agent of the partnership.
Discussion and conclusion
Dealing firstly with the respondent’s written submission, I have found that Northcor was the agent of the partnerships to incur E on their behalf and in that capacity was carrying on business on behalf of the partnerships.
With respect to the submission made at the hearing, I accept Mr. Alston’s evidence with respect to the activities conducted by the partnerships prior to June 17, 1987 and his evidence respecting activities carried on by the partnerships at the end of their fiscal periods. I attach some weight to Mr. Nowoselski’s acceptance of a written statement of activities carried on by the partnerships as set forth above. This being the only evidence before me I cannot accept the respondent’s position. I conclude, therefore, that the appellants held interests in partnerships that were actively carrying on business on a regular and continuous basis throughout the period specified in 1987. The word "actively" was not commented on by counsel. However, as long as the partnerships were conducting some activities they could not be said to be conducting them inactively. Northcor did not cease being the partnerships’ agent just because the well was dry. Further, the evidence did not indicate any interruption in the conduct of the described activities. I find, therefore, that each partnership was actively carrying on business on a regular and continuous basis.
Accordingly, each partnership interest owned by the appellants was an "exempt interest" within the meaning of subsection 96(2.5) with the result that he was not a "limited partner" as defined in subsection 96(2.4) and would not have an "at-risk amount" by virtue of subsection 96(2.2). This results in no amount being determinable under subsections 66.8(1) and (3) that would reduce the appellant’s E under subsection 68(1) for the purpose of subparagraph 66.1(6)(a)(iv).
In summary, the appellants became members of four limited partnerships on the last day of their 1987 fiscal periods in which such partnerships incurred E. Their partnership interests were "exempt interests" within the meaning of the Act. The transactions were not a sham. The Act provided specifically for the deduction of expenses of a partner at the end of a partnership’s fiscal period. There being no other person entitled thereto, and with a deduction being clearly contemplated by the legislation, the deduction claimed fell within the object of the incentive provisions discussed. The partnerships were not entitled to and did not received any PIPs in the 1987 fiscal period. The deductions made by the appellants’ deductions did not unduly or artificially reduce their income. Each appellant declared the capital gain arising on the disposition of its interests in the four partnerships.
I conclude that each appellant was entitled, in its 1987 taxation year, to deduct the amounts aforesaid as "cumulative Canadian exploration expense" within the meaning of subsection 66.1(3) and paragraph 66.1(6)(b) of the Act.
The appeals are allowed with costs to the appellant.
Appeals allowed with costs.