Dubé, J:—This case was heard on common evidence with British Columbia-Yukon Railway Company v Her Majesty the Queen, T-3633-75, and these reasons for judgment apply to both cases. The basic issue is the allocation of income between two Canadian railway companies and one American railway company for the taxation year 1970.
The plaintiff company (hereinafter “BYR”) and four other wholly owned subsidiaries of the White Pass and Yukon Corporation Limited, including the British Columbia-Yukon Railway Company (hereinafter “BCYR”) and Pacific and Arctic Railway and Navigation Company (hereinafter “PARN”), an American company, provide an integrated railroad, ship and truck transportation system from Whitehorse, Yukon, through British Columbia, down to a terminal at Skagway, Alaska, USA.
The “White Pass and Yukon Route’’, as it is known, is 110.8 miles long: 90.4 miles over Canadian soil and 20.4 miles within Alaska. BYR owns and operates the Yukon track, from Whitehorse to the British Columbia border; BCYR owns and operates the railway through the British Columbia section; and PARN owns and operates the line from the Alaska border down to its terminal facilities at Skagway on the Pacific Coast. The maintenance facilities for the whole system are located at Skagway along with a general freight wharf and a bulk terminal.
For the 1970 taxation year BYR, BCYR and PARN used a method of allocation of income between the two Canadian companies on the one hand and PARN on the other hand which was described as follows in the Agreed Statement of Facts.
4.1 Costs and expenses incurred were allocated by allocating each expense classification on a specific identification basis where possible, or on a pro rata basis where the cost or expense item could not be allocated on a specific identification basis;
4.2 Property used was allocated on the basis of situs for immovable property and time spent in each country for movable rail property (36.4% for the US Company and 63.6% for the Canadian Companies);
4.3 23.6% of the aggregate working capital of the group of Companies was allocated to the transportation system, based on an allocation of gross receipts; this was allocated between the Canadian Companies and the US Company on the basis of the allocation of operating costs;
4.4 A rate of return of 8% was applied to the amounts determined under 4.2 and 4.3, to produce the following:
| the Canadian | the US |
| Companies | Company |
| Operating Expenses | $2,890,553 | $2,472,701 |
| Return on Property | 949,980 | 613,640 |
| Return on Working Capital | 31,852 | 27,352 |
| $3,872,385 | $3,113,693 |
| Percentages | 55.4% | 44.6% |
4.5 These percentages were used to allocate gross operating incomes between the Canadian Companies and the US Company, being based on an apportionment of the aggregate of:
1. Costs and expenses
2. Return on property
3. Return on working capital
By Notice of Reassessment dated May 23, 1974, the Minister reassessed the incomes by using a different allocation based upon an average of the percentages of these three items
1. operating expenses as allocated by the plaintiff
2. an 8% return on property
3. equated track mileage
The method used by the Minister allocated 65.46% of income to the Canadian group and 34.54% to the US company, whereas the method used by the railway group resulted in the allocation of 55.4% to the Canadian group and 44.6% to the US company.
In the case of BYR the Minister’s reassessment resulted in an increase of income tax of $41,196.22 plus interest, and in the case of BCYR an increase of $8,946.86 and interest. The two Canadian railways are appealing the Minister’s reassessments. The grounds for the appeal are stated in paragraph 9 of the Statement of Claim.
The Plaintiff claims that the allocation procedure used by the Department of National Revenue was not in accordance with any ordinary business, commercial or accounting principles, was not in accordance with the said US Regulation 1.863-4, and, by adding an allocation for equated track mileage, distorts the allocation in favour of Canada because most of the Railway track lies in Canada. The Plaintiff claims that the logical allocation should be based on (a) the investment in immovable property in each of Canada and the US, and (b) the level or activity or cost of service performed in each of Canada and the US. The first gives due weight to the preponderance of track miles in Canada and, at the same time, the preponderance of the maintenance and wharf facilities in the US. The second gives due weight to the preponderance of track maintenance and running costs in Canada, and at the same time, the preponderance of wharf costs and equipment maintenance costs in the US. To impose on to these two allocations an added weighting for equated track miles accentuates only the Canadian preponderances; to then average the percentages further accentuates the weighting in favour of Canada. The method used by the Department of National Revenue therefore distorts the income allocated to Canada unreasonably and without any foundation on ordinary business, commercial or accounting principles, so that the said Reassessment is not in accordance with sections 3 and 4. or any other sections of the (old) Income Tax Act.
The equated mileage formula used by the Minister, in conjunction with the operation expenses allocation and the 8% return on property, is based on Income Tax Regulations 406(1) and 406(3) which read:
406. (1) Notwithstanding subsections (3) and (4) of section 402, the amount of taxable income that shall be deemed to have been earned in a taxation year in a particular province by a railway corporation is, unless subsection
(2) applies, one-half the aggregate of
(a) that proportion of the taxable income of the corporation for the year that the equated track miles of the corporation in the province is of the equated track miles of the corporation in Canada, and,
(b) that proportion of the taxable income of the corporation for the year that the gross ton miles of the corporation for the year in the province is of the gross ton miles of the corporation for the year in Canada.
(3) For the purpose of this section, ‘the equated track miles’’ in a specified place means the aggregate of
(a) the number of miles of first main track,
(b) 80% of the number of miles of other main tracks, and
(c) 50% of the number of miles of yard tracks and sidings, in that place.
It is agreed by both parties that neither US Regulation 1.865-4, nor Canadian Regulation 406 is mandatory, or even directly applicable, in the instant case, since the former deals with a taxpayer “carrying on the business of transportation service between points in the US and points outside the US’’, and the latter deals with railway corporations operating between Canadian provinces. The allocation in issue here is between income in Canada by two Canadian railways, and income in the US by an American railway. Both counsel have found no similar case and neither the Income Tax Act nor the Regulations offer formulae which are directly applicable to the situation.
In the absence of any special direction from the Act, then income must be determined in accordance with ordinary business and commercial principles.
The formula used by the railway group was proposed to them by their accountants Clarkson, Gordon & Co. The partner of that firm responsible for the railways, Kenneth L Ingo, a chartered accountant, appeared as a witness. Some extracts from his Memorandum of Allocation of Operating Income, filed as an exhibit, bear reproduction.
The method used by the companies during 1970 is based on the formula for the allocation of income of a taxpayer carrying on a transportation business between points in the United States and points outside the United States, as prescribed in paragraph 1.863-4 of the Regulations to the US Internal Revenue Code. The provisions of this Regulation are set out in their entirety on Appendix A to this memorandum and are summarized briefly below.
Essentially the Regulation provides that income is allocated on the basis of the aggregate of the following:
1. Costs or expenses incurred in the transportation business, 2. Return on property used in the transportation business, and 3. Return on working capital used in the transportation business.
To develop the allocation of income in accordance with the provisions outlined above, the required information was assembled in the following series of steps:
1. Each of the companies’ expense classification has been allocated to Canada or the United States on either a specific identification or a pro rata basis. As the companies’ internal statement of operating expenses is prepared using a mixture of US and Canadian funds, it was necessary to first of all convert the items to Canadian funds. Appendix B contains the details of these allocations and conversions.
2. The property used in the transportation business was allocated to the two countries on the basis of:
(a) situs, in the case of immovable property, and
(b) time spent in each country, in the case of movable rail property (ie United States 36.4% and Canada 63.6%).
Assets carried in US funds in the companies’ accounts were re-stated in Canadian funds, using the average rate of exchange prevailing for the year. 3. A portion of the companies’ aggregate working capital was allocated to the railway transportation business on the basis of gross receipts, the formula being:
Gross receipts from railway transportation business X 100% Total gross receipts
This formula resulted in 23.6% of the companies’ total working capital being allocated to the railway transportation business. The amount so determined was then apportioned between the two countries on the basis of operating costs previously allocated to the countries.
4. The return on property and working capital used in the railway transportation business was calculated by using a rate of 8% and applying it to the amounts determined in 3 and 4 above. This is the rate of return stipulated in the afore-mentioned Regulation.
An American chartered accountant, Karl H Loring, a partner with the firm of Ernst & Ernst based in Los Angeles and specialists in international tax practice, testified as an expert on behalf of the plaintiff. The following two paragraphs from his affidavit reflect his opinion on the two different methods of allocation.
I have considered the method of allocation of income and deductions set forth in the memorandum of Clarkson, Gordon & Co, a copy of which is attached hereto, which is also described in the Agreed Statement of Facts filed in this case, and it is a method which conforms generally to the requirements of Regulation Section 1.863-4, which allocation, in my opinion, would be acceptable to the Internal Revenue Service.
I have considered the method of allocation of income set forth in the Agreed Statement of Facts used by the Minister of National Revenue in making his reassessment. It appears not to be a method which conforms to the requirements of Regulation Section 1.863-4, and in my opinion departs so radically therefrom, that it would not be acceptable to the Internal Revenue Service. In particular, it would seem to me unlikely that the Internal Revenue Service would accept a formula, which apparently double-counts physical assets by including the immovable property both in the expense allocation and return on capital computations, and again as track mileage, particularly where the ratio of track mileage in the two jurisdictions is so disproportionate.
Of course it is not for the accountants to decide the issue. There is, moreover, a statutory presumption of validity in favour of an assessment and the onus to show that the assessment is erroneous lies on the taxpayer who attacks it. But, as stated by Thorson J in Mandel v The Queen, [1976] CTC 545, 76 DTC 6316, at page 565 [6330], “While the Court must be mindful of this principle it must in its effort to apply the law objectively keep a watchful eye on arbitrary assumptions on the part of the tax authority.’’ Where the Income Tax Act does not provide a particular system of accounting, the validity of a formula depends on whether or not it tells the truth about the taxpayer’s income.
Track mileage, by itself, does not reflect the true equation in this case. The twenty miles through Alaska ascend from sea level to an altitude of 2,885 feet at White Pass on the Alaska-British Columbia border. From that point it climbs merely another 30 feet in altitude and travels more or less on a plateau downwards to Whitehorse, 2,080 feet from sea level. The rail route through Alaska was the most difficult to build and remains the most expensive to maintain, with tunnels, bridges, and heavier snowfalls. From five to six locomotives are required to pull the train up the White Pass and these locomotives as well as most of the rolling stock and all the maintenance facilities are owned by the American railway and located in Alaska.
It is therefore obvious that merely equating the track mileage would be unfair and unequitable. But the Minister is not basing his allocation merely on track mileage. He is superimposing the track mileage equation upon the other formula which already includes the mileage equation. That, of course, gives undue weight to the preponderance of track mileage in Canada.
Moreover, the Minister’s formula further distorts the income allocation by adding percentages instead of adding the actual amounts. That method unfairly allows the same percentage rating to unequal amounts. For instance, for the US company, the costs and expenses ($2,472,701) are four times the amount ($613,640) allocated on US immovable property, yet both items each rate a percentage. In other words, the Minister’s formula is faulty in that firstly it double-counts the immovable property of the taxpayer, and secondly it further distorts the allocation by averaging the percentages instead of the actual amounts of expense and property allocation. On the other hand the taxpayer’s method of allocation is in accordance with sound accounting practice and is an accurate reflection of the taxpayer’s income.
The appeai is allowed and plaintiff’s tax reassessment for 1970 is referred back to the Minister for further reassessment in accordance with these reasons, with costs in favour of plaintiff.
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