Her Majesty the Queen v. Crown Forest Industries Ltd., [1994] 1 CTC 174, 94 DTC 6107

Heald, J.A. (McDonald, J.A., concurring):—This is an appeal from a judgment of the Trial Division wherein the appeal of the respondent from the reassessments by the Minister of National Revenue in respect of the respondent's 1987, 1988 and 1989 taxation years was allowed (Crown Forest Industries Ltd. v. Canada, [1992] 2 C.T.C. 1, 92 D.T.C. 6305).

The principal issue in the appeal is whether Article XII(2) of the Canada- United States Income Tax Convention 1980 [1] (the Convention) applies to certain rental payments made by the respondent to Norsk Pacific Steamship Co. (Norsk), thereby reducing the withholding tax rate of 25 per cent otherwise applicable pursuant to paragraph 212(1 )(d) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") [2] to ten per cent. The applicability of the Convention to effect a reduction in the rate of withholding tax from 25 per cent to ten per cent depends upon whether Norsk, the recipient of the rental payment, can be considered to be a resident of the United States for the purposes of the Convention. The answer to that question necessarily involves the application of Article IV.1 of the Convention, which provides:

Article IV—Residence.

1. For the purposes of this Convention, the term "resident of a contracting state" means any person who, under the laws of that state, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation or any other criterion of a similar nature, but in the case of an estate or trust, only to the extent that income derived by such estate or trust is liable to tax in that state, either in its hands or in the hands of its beneficiaries.

The Facts

The essential facts are not in dispute. [3] The respondent, a forestry company, is a British Columbia Corporation. In 1962, Norsk was incorporated as a Bahamas Corporation. In 1983, Fletcher Challenge Ltd. of New Zealand purchased shares in both companies from Crown Zellerbach of San Francisco and then changed the name of the respondent from Crown Zellerbach Canada Ltd. to Crown Forest Industries Ltd. Since its incorporation, Norsk's only office and place of business has been in the U.S. At its office in California, Norsk leases approximately 3,200 square feet of space and employs some 19 people with a monthly payroll of $75,000. Norsk has several subsidiary companies including one in Vancouver, British Columbia, through which the Canadian subsidiary operations are conducted. Norsk's income is totally derived from the shipping business. The transport of newsprint internationally is its primary source of income.

During each of the taxation years in issue (1987, 1988 and 1989), the respondent rented barges from Norsk which were registered in Canada and operated by the respondent. The respondent utilizes the barges in Canada for transporting wood chips to pulp mills. The barges are also used to move chips and finished goods to the U.S. On occasion wood chips are transported from the U.S. to Canada on the return voyage.

For the taxation years here in issue the only tax returns filed by Norsk with the U.S. Internal Revenue Service (I.R.S.) were on Form 1120F entitled ‘Income Tax Return of a Foreign Corporation’’. At no time has Norsk filed tax returns in any other country. In each of these returns, Norsk claimed the benefit of an exemption from U.S. federal income tax pursuant to the provi- sions of paragraph 883(a)(1) [4] of the U.S. Internal Revenue Code (the U.S. Code) because its income is derived from the operation of ships and because Norsk is organized in the Bahamas which grants an equivalent exemption to U.S. corporations. It is the appellant’s view that the rental payments made by the respondent to Norsk are subject to a withholding tax of 25 per cent pursuant to paragraph 212(1)(d) of the Income Tax Act as being "a rent, royalty or similar payment”. It is the respondent's position that the proper withholding rate is 10 per cent since the withholding tax of 25 per cent would only be exigible if the learned trial judge was in error in his finding that Norsk was a resident of the U.S.

The Decision of the Trial Division

After correctly identifying the issue as set out, supra, the trial judge quoted Article 1V.1 and then stated at page 3 (D.T.C. 6307):

The quest now becomes one of determining whether Norsk is liable to tax in the U.S.A. by reason of those criteria listed, or any other criterion of a similar nature.

[Emphasis added.]

After a careful review of the evidence, the relevant tax conventions and the applicable jurisprudence, he concluded at pages 7-8, (D.T.C. 6310-11)):

Now, none of the cited jurisprudence or teaching means to say that one may impart such a liberal interpretation as to be quite loose and to make up interpretations which range beyond the convention's own expressed words. No. It is the very words as expressed in the convention to which a liberal interpretation is given. It therefore cannot be an interpretation which is unsupported by those words as so expressed.

Such must be the conclusion of this case. The reason for which Norsk's income is effectively connected with a trade or business which it actively conducts in the U.S.A., is because Norsk's place of management is located in the U.S.A. where it conducts its trade or business. The expression "place of management” found in article IV.1, conjures, on the facts of this case, another "criterion of a similar nature” ["tout autre critère de nature analogue"], and that is: place of trade or business. If it were logically necessary to resort to the general analogous alternative expressed in article IV.1 of the Convention one would say, as the Court now holds: Norsk is a "resident" of the U.S.A. within the meaning of article IV.1 of the Convention because it is liable to tax under U.S. law by reason of its place of management and/ or by reason of its place of conducting its trade or business, which is in the U.S.A.

The sequence of deducing this obvious inference from the facts and law is short, and its reasoning presents no difficulty.

Discussion

It is suggested that there are two important errors in the reasoning of the trial judge. The first alleged error relates to the findings of fact. The appellant submits that Norsk's liability for U.S. tax arises because the trade or business which it conducts is effectively connected with the U.S. and not because its place of management is located in the U.S. [5] The second alleged error con- cerns the application of the Convention to the facts. In particular, the issue is whether Norsk is liable to tax in the U.S. by reason of its “domicile, residence, place of management, place of incorporation or any criterion of a similar nature".

A. The findings of fact in the Trial Division

The uncontradicted evidence which led the trial judge to find as he did on the factual questions relating to U.S. law may be summarized as follows:

(a) Norsk, a foreign corporation engaged in trade or business within the U.S., is liable to tax in the U.S. in the same manner as a domestic corporation on that portion of its income which is effectively connected with the conduct of its U.S. trade or business;

(b) that in determining whether the income of a foreign corporation is effectively connected with the conduct of its U.S. trade or business, various factors are to be considered including: the head office location, the place of management, the extent of the activity within the U.S., the employment of individuals, the use of resources, and the continuity of the conduct of the business over a period of time;

(c) that the place of management of the foreign corporation, albeit a principal factor, is not a factor which, in itself, would determine that the corporation's income is effectively connected with the conduct of its U.S. trade or business.

Concerning the appellant's objections to the findings of fact, the following considerations are, in my opinion, decisive. The sole issue at trial and on appeal is whether Norsk, the legal entity in question is liable to pay tax in the U.S. for any of the reasons enumerated in Article IV.1. The issue is not the general application of U.S. tax law but its application to Norsk in particular. Turning now to the circumstances of this case, the trial judge reviewed the expert evidence and based on that expert evidence, he found, as a fact, that, “The reason for which Norsk's income is effectively connected with a trade or business which it actively conducts in the U.S.A., is because Norsk's place of management is located in the U.S.A. where it conducts its trade or business." [6] (See page 8 (D.T.C. 6310) quoted, supra.) In my view, this finding of fact was reasonably open to him on this record. In any event, by no stretch of the imagination, can it be said that the trial judge made a palpable or overriding error in the findings of fact which he made. [7]

B. The application of Article IVT of the Convention to the facts

The trial judge found, inter alia, that (i) Norsk's place of management was a prime factor in its liability under U.S. law and (ii) foreign corporations are not liable to tax in the U.S. on the basis of their place of management alone. The question of law before us is whether the factual finding that Norsk's place of management is a prime factor in its liability to tax in the U.S. is sufficient to bring Norsk within Article IV. of the Convention. The appellant makes four submissions concerning this issue: (1) since foreign corporations are not generally liable to tax in the U.S. on the basis of their place of management, Norsk cannot be found liable on this basis; (2) the inclusion of the phrase "or a criterion of a similar nature" in Article IV.1 indicates a common basis for liability under that Article, specifically, liability to tax on a worldwide basis, and Norsk is not liable on this basis; (3) the finding that Norsk is liable to tax because its income is effectively connected with the conduct of its trade or business, is a criterion of a similar nature, and, as such, is tantamount to an amendment to the Convention; and (4) the interpretation given to Article IV.1 by the trial judge would lead to anomalous results.

1. Are foreign corporations liable to tax in the U.S. by reason of their place of management?

The appellant submits that a foreign corporation cannot be liable for tax in the U.S. by reason of domicile, residence, or its place of management. Likewise, Norsk was not incorporated in the U.S. and therefore cannot be liable on the basis of its place of incorporation. Thus, in the appellant's submission the only possible basis for qualification as a resident pursuant to Article IV would be by reason of a criterion of a similar nature.The evidence in this case establishes that Norsk is liable to tax in the U.S. by reason of the fact that it conducted a trade or business which is effectively connected with the U.S. However, that "reason" is not one of the four enumerated in Article IV.1 nor is it one of a similar nature since it contains none of the common elements earlier identified.

As I indicated earlier, this argument fails to take into account the particular circumstances which make Norsk liable. The wording of the Convention suggests that any inquiry into resident status must have regard for the basis of liability of a particular taxpayer rather than for the application of domestic tax law generally. The submission that foreign corporations cannot be liable to tax in the U.S. by reason of their place of management begs the very question that must be determined by this Court. Accordingly, the question is not whether, as a general rule, the U.S. imposes tax by reason of the foreign corporation's place of management, but whether, on these facts, Norsk is liable to pay tax by reason of its place of management.

2. Is it necessary for resident status that a corporation is liable to tax on 100 per cent of their worldwide income?

The appellant submits that it is implicit in the Convention that only those corporations that are liable to taxation on all of their worldwide income can be considered resident. The submission is based on the following argument. Not every person liable to tax is deemed to be a resident. The deemed residents are only those who are liable to tax "by reason of” one of four very specific criteria, namely: (1) his domicile, (2) his residence, (3) his place of management, and (4) his place of incorporation, and, as well, "by reason" of a generic criterion "of a similar nature" to the four enumerated ones. On this basis, it is the appellant’s view that it was the intention of the parties that very specific criteria be set out and that a common element in all of them is that each, of itself and standing alone, would form a basis for taxation, that each was readily and objectively identifiable and that each could be related to a specific location. It follows, says the appellant, that any criterion "of a similar nature" must also possess the same common elements. One of these elements is the imposition of taxation on 100 per cent of worldwide income (or property). Thus, to be a resident of the U.S. under the Convention, Norsk must be liable to tax on its worldwide income. Norsk was liable to tax only on its U.S. source income and therefore is not a resident of the U.S.

This argument must also be rejected. Only domestic corporations are liable for 100 per cent of their worldwide income. Thus, a necessary consequence of accepting the appellant’s interpretation, that only those corporations which are liable to tax on 100 per cent of their worldwide income meet the definition of "resident," is that the definition of "resident" (under U.S. law) would be restricted to domestic corporations. Moreover, foreign corpora tions with substantial operations in the U.S., and with U.S. source income would not be able to benefit from the Convention. Were this the intention of the contracting states, such a result could have been achieved simply by stipulating that only domestic corporations subject to tax on 100 per cent of their worldwide income are residents for the purposes of the Convention.

The interpretation of Article IV.1 advanced by the appellant is also inconsistent with a plain and literal interpretation of that Article. It is interesting to note that the O.E.C.D. Model Treaty (from which the Convention here in issue is adopted) contains an important qualification (1977 O.E.C.D. Model Double Taxation Convention on Income and on Capital—Article 3(1)):

Resident.

1. For the purposes of this Convention, the term “resident of a contracting state” means any person who, under the laws of that State, is liable to tax therein by reason of bis domicile, residence, place of management or any other criterion of a similar nature. But this term does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

[Emphasis added.]

It is apparent that if the qualifying clause, supra, had been included in the Convention in issue, Norsk could not possibly be considered a resident for the purposes of this Convention. Absent evidence of a contrary intent, I think it reasonable to conclude, firstly, that the drafters of this Convention were well aware of the O.E.C.D. clause and, secondly, that its omission from this Convention was intentional. The omission of this clause indicates that it was not the intention of the drafters to make liability to tax on a worldwide basis a necessary condition for resident status under the Convention.

3. Given the purpose of the Convention, does the decision of the learned trial judge amount to an amendment to the Convention?

The appellant's next submission is that the purpose of a Convention such as this is to avoid double taxation and for this purpose the contracting states voluntarily relinquish a portion of their Conventional fiscal jurisdiction. In the submission of the appellant, this ceding of jurisdiction is effected reluctantly and, as a consequence, the language employed is precise and not overly inclusive. The appellant impeaches the respondent's argument by urging that Norsk cannot rely on its place of management as a factor in determining Norsk's liability for tax since it does not fall under any of the criteria set out in Article IV. The fact that it was a factor employed in assessing a tax liability not falling under Article IV is irrelevant to the issue here being determined. Put another way, the submission is that, in reality, the trial judge found that tax liability caused by the conduct of a business effectively connected with the U.S. is similar in nature to tax liability caused by the place of management. Accordingly, it is said that such a consequence is tantamount to an amendment to the Convention.

A close examination of Muldoon, J.’s reasons for judgment reveals the basis for his finding that Norsk was a resident of the U.S. for the purpose of Article IV.1 of the Convention. (See passage quoted, supra, at page 8 (D.T.C. 6310).) That passage indicates that Norsk's liability to tax in the U.S. is by reason of its place of management, and that the trial judge would find Norsk to be liable by reason of a criterion of a similar nature only if it were “logically necessary". Clearly, however, it is not logically necessary to resort to a "criterion of a similar nature" to find Norsk liable on the facts of this case. Norsk's liability to tax in the U.S. is based on its income that is effectively connected with its trade or business in the U.S., which, in turn, is based primarily on its place of management. There is, therefore, no question as to whether the Convention was effectively amended by the trial judge.

A related submission by the appellant is that since certain countries impose taxes on corporations exclusively on the basis of their place of management, provisions like Article IV.1 are standard clauses found in international tax conventions which relate to those countries and their schemes of liability. If this submission were correct, however, the expression “place of management" would be superfluous in the context of a tax convention between the U.S. and Canada, since neither country imposes taxes solely on the basis of a corporation's place of management. In my view, the trial judge's interpretation of Article IV.1 effectively gives meaning to the expression “place of management" in a manner consistent with the facts.

4. Does the interpretation given to Article IV.1 by the trial judge lead to anomalous results?

The appellant's final submission is that a rejection by the Court of the appellant’s suggested interpretation of Article IV.1 would lead to anomalous results. This argument is made on the basis of the following factual scenario. A foreign corporation engaged in trade or business in the U.S. earns $100 of effectively connected income (taxable in the U.S.) and $1,000,000 of foreign source income (not taxable in the U.S.). The suggestion is that on the basis of the interpretation given to Article IV.1 by the trial judge, the foreign corporation would entirely escape tax liability in respect of that foreign source income. In my view, such reasoning is fallacious. Rejecting the “worldwide income" test as the only basis for tax liability does not mean that any corporation with U.S. source income is liable to tax in the U.S., and, thereby, becomes a U.S. resident under the Convention. The foreign corporation can still only acquire liability for payment of the U.S. tax by reason of any of the other criteria enumerated in Article IV.1, supra.

The appellant submits further, that another undesirable consequence of rejecting the suggested interpretation of Article IV.1 is that, under the interpretation proposed, Norsk could be considered a resident corporation in the U.S. and not pay any tax because of exemptions to which it was entitled, and still be able to benefit from the double taxation provisions of the Convention. It is important to observe that, while Norsk is exempt from tax on its U.S. income by virtue of the provisions of paragraph 883(a) of the U.S. Internal Revenue Code, it is still, nevertheless, liable to tax. The U.S. is entitled to tax corporations at whatever rate it deems appropriate. I can see no legal reason why the rate of tax (or the extent of deductions) should affect the characterization of a corporation as a resident. Indeed, a corporation that is resident may not pay any tax at all because of tax deductions or tax credits or pursuant to an exemption, as in the present case. Once a corporation is liable to tax in a contracting state (and thus resident in that State), the amount of tax that it pays, as a result of deductions, credits, or exemptions, is irrelevant. I conclude that the trial judge did not err in his interpretation of Article IV.1 as applied to the facts at bar. Accordingly, this submission by the appellant must also be rejected.

Conclusion

For all of the foregoing reasons, I conclude that the learned trial judge has not committed reviewable error. Therefore, I would dismiss the appeal with costs.

Décary, J.A. (dissenting):—1 am, with great respect, unable to subscribe in its totality to the reasoning of my brother Heald, J.A. and I have reached the view that this appeal should be allowed.

The evidence was to the effect: (a) that Norsk, as a foreign corporation in the United States, was liable to tax in the United States because it conducted a "trade or business which is effectively connected with the United States"; (b) that in determining whether a foreign corporation carries on a trade or business which is effectively connected with the United States, various factors are to be considered, including: the location of the head office, the place of management, the extent of the activity within the United States, the employment of individuals, the use of resources and the continuity over a period of time of the conduct of the business; (c) that the place of management, albeit a principal factor, is not a factor which in itself would determine that the corporation conducts a trade or business which is effectively connected with the United States; (d) that a foreign corporation is not liable for tax in the United States by reason solely of its domicile, of its residence or of its place of management.

That unchallenged evidence led the trial judge to the following conclusion at page 7 (D.T.C. 6310):

Such must be the conclusion of this case. The reason for which Norsk's income is effectively connected with a trade or business which it actively conducts in the U.S.A., is because Norsk's place of management is located in the U.S.A. where it conducts its trade or business. The expression “place of management” found in article IV.1, conjures, on the facts of this case, another "criterion of a similar nature" ["tout autre critère de nature analogue"], and that is: place of trade or business. If it were logically necessary to resort to the general analogous alternative expressed in article IV.1 of the Convention one would say, as the Court now holds: Norsk is a "resident" of the U.S.A. within the meaning of article IV.1 of the Convention because it is liable to tax under U.S. law by reason of its place of management and/ or by reason of its place of conducting its trade or business, which is in the U.S.A.

The sequence of deducing this obvious inference from the facts and law is short, and its reasoning presents no difficulty.

With respect, there are two major flaws in that "obvious inference".

The first one is factual. The reason for which Norsk is liable to tax in the United States is not because its place of management is located in the United States, but because the trade or business it conducts is effectively connected with the United States, that connection being established, amongst various factors, by Norsk’s place of management. The nuance is of major significance: liability to tax derives from Nork's trade or business, not from Norsk’s place of management which, in itself, does not make Norsk liable to tax in the United States.

The second one is legal. Article IV.T of the Canada-United States Income Tax Convention (1980) (the Convention) requires liability to tax to be caused by ‘‘domicile, residence, place of management, place of incorporation or any other criterion of a similar nature".

In interpreting a convention whose purpose is to avoid double taxation, one should be reminded that each contracting state, in adhering to the convention, voluntarily relinquishes at least part of the fiscal jurisdiction it would otherwise exercise over persons in its territory. Through a convention of the kind at issue here, both states agree to each collect less taxes from persons they expect might be liable to tax in both states. States do not readily abandon jurisdiction and their reluctance can be traced in the case at bar to the very specific words they have used to define the beneficiaries of the Convention, i.e., the "residents" of each state.

It is not every person liable to tax who is deemed to be a resident. It is, rather, a person liable to tax "by reason of" one of four very specific criteria, namely: his domicile, his residence, his place of management and his place of incorporation, or "by reason of" a generic criterion "of a similar nature" to the four enumerated ones. The parties obviously intended to set out very specific criteria, the common element of all of them being that each was in itself and standing alone a basis for taxation, that each was easily, readily and objectively identifiable and that each couid be related to a tangible location. Any criterion "of a similar nature" must, in my view, satisfy these common elements.

In the case at bar, it is agreed that in the United States a foreign corporation is not liable to tax by reason of its domicile, of its residence or of its place of management. And by its very nature it does not have a place of incorporation in the United States. The only way therefore through which Norsk could qualify as "resident" in United States law within the meaning of Article IV of the Convention, is if it were liable to tax by reason of a criterion of a similar nature.

We know from the evidence that Norsk is liable to tax in the United States by reason of the fact that it conducted a trade or business which is effectively connected with the United States. That "reason" is obviously none of the four enumerated, nor is it one of a similar nature because it possesses none of the common elements I have identified earlier.

To say that Norsk, which is not liable to tax by reason of its place of management, is liable to tax by reason of a criterion of a similar nature because its place of management is one of the factors to be considered in determining the very reason of its liability to tax, i.e., the conduct of a business . .. is to beg the question and try to enter through a door that has already been closed.

To say that the fact that the place of management is a factor in determining the very reason of Norsk's liability to tax (i.e., conducting a business . . .), renders Norsk liable to tax by reason of its place of management, is to transform a factor used in assessing a tax liability that does not fall under Article IV, into one of the four criteria recognized by the article. Had the contracting states intended to qualify as residents foreign corporations liable to tax by reason of the conduct of their business, it would have been very easy to add another criterion such as conduct of business or place of business. They did not, even though the criteria of “place of business" and "carrying on business" were well known to both contracting states for they used them in Article V of the Convention, "Permanent Establishment" and in Article VII, "Business Profits".

To say that tax liability caused by the conduct of a business effectively connected with the United States, is similar in nature to tax liability caused by the place of management, amounts in my view to an amendment to the Convention.

The appeal should be allowed with costs both here and below.

Appeal denied.

Her Majesty The Queen v. Kettle River Sawmills Limited and Elk Bay

[Indexed as: Kettle River Sawmills Ltd. v. Canada]

Federal Court of Appeal (Mahoney, Hugessen and Robertson, JJ.A.), November 12, 1993 (Court File Nos. A-1299/1300-92), on appeal from a decision of the Federal Court-Trial Division reported at [1992] 2 C.T.C. 276.

Income tax—Federal—Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

c. 63)—10(1), 13(1.1), (21)(d.1), 69—S.C. 1974-75-76, c. 26—6(1), (7), (9)—Income

In 1961, the taxpayer, K Ltd., obtained a timber sale contract which carried with it an allowable annual cut or quota of 690 "cunits" (a cunit being 100 cubic feet of timber). The licence ran for ten years to 1971 and thereafter was renewed annually. After May 6, 1974 (the date when the system of taxation of timber tenures in Canada was altered), K Ltd. acquired two further licences with a combined quota of 330 cunits. In its 1980 taxation year K Ltd. sold its business and transferred its existing licences which carried with them an allowable annual cut of 1,020 cunits. In its tax return K Ltd. treated the proceeds of disposition of its licences as a capital gain and the Minister reassessed it as income, being the proceeds of disposition of timber resource property. (The facts for the other taxpayer, E Ltd., involved different amounts and dates but the principles were exactly the same.) There were three issues to be determined in the appeal: (1) whether the quotas sold by the taxpayers were 'Timber resource property” within the meaning of the Income Tax Act, (2) if so, whether the quotas reflected in licences which, after May 6, 1974, were extended, renewed or substituted for earlier licences, were "acquired" at the date of such extension, renewal or substitution; and (3) if so, whether the capital cost of the timber resource properties at the time of the first extension, renewal or substitution thereof after May 6, 1974, was the fair market value of such property at the time of such extension, renewal or substitution. The judge of the Federal Court-Trial Division decided the first two issues adversely to the taxpayers. The third was decided in their favour. The Crown appealed the trial judge's finding on the third issue and the taxpayers supported that finding and questioned the finding on the first two issues.

HELD:

With respect to the first issue, the trial judge found that the quotas were timber resource properties because the quota could not be seen as an entity separate from the licence. Those reasons and the result were beyond reproach. With respect to the second issue, the proper construction of paragraph 13(21)(d.1) supported the trial judge's finding that licences which are extended, renewed or substituted after May 6, 1974 are "acquired" after that date. With respect to the third issue, the trial judge decided that the capital cost for those licences which were newly acquired after May 6, 1974 should be the amount that was actually paid for them. In this, he was clearly right. However, the trial judge erred in finding that the capital cost of the timber resource properties at the time of their first extension, renewal or substitution after May 6, 1974 was the fair market value thereof. In fact, the undepreciated capital cost of the taxpayers' timber resource properties should be calculated in accordance with the ordinary rules, i.e., actual cost less accumulated depreciation. In the result, the Crown's appeal was allowed and the Minister's assessment was confirmed except that it was referred back to the Minister for determination of the capital cost, if any, of the timber resource property disposed of, such determination to be in accordance with the ordinary rules. Appeal allowed.

Ingeborg E. Lloyd and I. Thomas Torrie for the appellant.

lan H. Pitfield and Lome Green for the respondent.

Cases referred to:

D'Auteuil Lumber Co. v. M.N.R., [1970] C.T.C. 122, 70 D.T.C. 6096.

Hugessen, J.A. (Mahoney, J.A. and Robertson, J.A. concurring):—

Introduction

These two appeals raise the question of the correct interpretation and application of a more than usually difficult provision of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") as it relates to the unique and unclassifiable system of timber tenures existing in British Columbia.

The appeals were heard together in the Trial Division and disposed of by a single set of reasons [Kettle River Sawmills Ltd. v. Canada, [1992] 2 C.T.C. 276, 92 D.T.C. 6525]. The trial judge identified six issues but by the time the matter reached us only three remained: [1]

1. Whether the "quotas" sold by the respondents were “timber resource properties" within the meaning of the Act;

2. If so, whether the quotas reflected in licences which, after May 6, 1974, were extended, renewed or substituted for earlier licences, were "acquired" at the date of such extension, renewal or substitution; and

3. If so, whether the capital cost of the timber resource properties at the time of the first extension, renewal or substitution thereof after May 6, 1974, was the fair market value of such property as at the time of such extension, renewal or substitution.

The trial judge decided the first two issues (as well as a number of others which are no longer in contention) adversely to the respondents. The third was decided in their favour. The Crown appeals the trial judge's finding on the third issue. The respondents support that finding but argue in the alternative that, if the trial judge was wrong on the third issue, he was also wrong on issues (1) and (2). Both logic and ease of comprehension dictate that we should deal with the three issues in the order stated.

The Law

Effective May 6, 1974, the system of taxation of timber tenures in Canada was altered. Thenceforward, such tenures, if they qualified as "timber resource properties", were to be treated as a sort of hybrid for tax purposes: they were viewed as Capital properties for the purposes of capital cost allowance (depreciation) but if they were sold the entire proceeds, to the extent that it exceeded the undepreciated capital cost, was to be taxed as income.

The definition of timber resource property is contained in paragraph 13(21)(d.1):

13(21 )(d.1 ) “Timber resource property".—"timber resource property" of a taxpayer means

(i) a right or licence to cut or remove timber from a limit or area in Canada (in this paragraph referred to as an "original right") if

(A) that original right was acquired by the taxpayer (other than in the manner referred to in subparagraph (ii)) after May 6, 1974, and

(B) at the time of the acquisition of the original right

(I) the taxpayer may reasonably be regarded as having acquired, directly or indirectly, the right to extend or renew that origina right or to acquire another such right or licence in substitution therefor, or

(II) in the ordinary course of events, the taxpayer may reasonably expect to be able to extend or renew that original right or to acquire another such right or licence in substitution therefor, or

(ii) any right or licence owned by the taxpayer to cut or remove timber from a

limit or area in Canada if that right or licence may reasonably be regarded

(A) as an extension or renewal of or as one of a series of extensions or renewals of an original right of the taxpayer, or

(B) as having been acquired in substitution for or as one of a series of substitutions for an original right of the taxpayer or any renewal or extension thereof;

Capital cost allowance was allowed to be taken on timber resource properties by the addition of Class 33 to what was then Schedule B (now Schedule I!) of the Regulations:

Class 33 (15 per cent)

Property that is a timber resource property.

The provision for the taxation of the proceeds of disposition of timber resource property as income was effected by adding subsection (1.1) immediately following the recapture provision in subsection 13(1):

13(1) Where depreciable property of a taxpayer of a prescribed class has, in a taxation year, been disposed of and the proceeds of disposition exceed the undepreciated capital cost to him of depreciable property of that class immediately before the disposition, the lesser of

(a) the amount of the excess, and

(b) the amount that the excess would be if the property had been disposed of for the capital cost thereof to the taxpayer,

shall be included in computing his income for the year.

(1.1) Notwithstanding subsection (1), where in a taxation year a timber resource property of a taxpayer has been disposed of, there shall be included in computing is income for the year the amount, if any, by which

(a) the proceeds of disposition thereof,

exceeds

(b) the undepreciated capital cost to him, immediately before the disposition, of depreciable property of a prescribed class in which the timber resource property was included.

Subsection 13(1.1) and paragraph 13(21 )(d.1 ), supra, were added to the Act respectively by subsections 6(1) and 6(7) of S.C. 1974-75-76, c. 26. Subsection 6(9) of that statute provided as follows:

6(9) Subsections (1), (7) and (8) are applicable in respect of timber resource properties acquired after May 6, 1974, subsection (2) is applicable in respect of amounts that become receivable after May 6, 1974 and subsection (3) is applicable after May 6, 1974.

The background of timber tenures in British Columbia

The trial judge heard considerable evidence, expert and otherwise, on the history of the development of timber tenures in British Columbia and on the situation of such tenures at the relevant times. He made the following findings of fact which have not been contested (C.T.C. 277-78, D.T.C. 6526-27):

In the late 1940s and 1950s the government of British Columbia developed in relation to Crown-owned timber lands a system conducing to sustained yields. There was established a system of Public Sustained Yield Units ("PSYU"). Each PSYU contained a specific area and calculations were done as to the annual growth in that area. In general terms a total allowable annual cut equivalent to that growth was to be permitted. It then became necessary to allocate the total allowable annual cut among timber operators. In effect the total allowable annual cut was prorated among the existing operators in the unit on the basis of their past annual cuts and this allowable annual cut came to be referred to as a quota. As the system developed in the 1960s the position of these "established operators" to continue to enjoy and exercise their quota became better protected by statute and by the exercise of ministerial discretion in granting licences. These established operators were recognized as having some form of entitlement (I use this neutral term at this point) to continue cutting each year in the amount of their allowable annual cut, an amount which was always subject to alteration by the Minister of Lands and Forests but which in practice was never reduced except generally on a pro-rata basis for all established operators in a particular PSYU. Established operators were notified each year of their allowable annual cut but this did not per se permit them to cut timber. They had to hold a timber sales licence (or in some cases later a timber sales harvesting licence) in order to be able to cut. A timber sales licence permitted them to cut whereas the holder of a timber sales harvesting licence still had to obtain a cutting permit which, according to the evidence, the forest service was in effect obliged to issue to the licensee. Licences would normally authorize cutting for several years but at an annual rate equivalent to the holder’s allowable annual cut. The licence or a cutting permit would specify the area in which cutting was to take place. Such licences could be renewed by the licensee if there was still timber remaining to be cut under it in the area to which it related. When there was no suitable timber left to be cut in his licence area the licensee could request the forest service to advertise for sale a licence to cut timber in another area within the PSYU. Through ministerial discretion only “established licensees", that is established operators who held or had held licences within the PSYU, could apply in this way for a new licence to be advertised for sale in respect of a new area within the PSYU. Sale was by sealed tender with bidders being expected to offer what they would be willing to pay in "stumpage", the royalty to be paid to the government per unit of timber cut and removed. An established operator, the applicant for the sale, would however have the right to meet or surpass any other bid which might be higher than his own initial bid. Further, all bidders except the established operator would be required to pay a non-refundable bidding fee of a substantial amount. It is not disputed that the net result of this system was, and apparently still is, that established operators with an allowable annual cut or quota were considered to have some form of ongoing entitlement to a licence somewhere within the PSYU to continue cutting at the rate of their allowable annual cut.

The particular facts relating to the tenures of the two respondents

There is a mass of evidence dealing with the historical process by which each of the two respondents came to be the possessor of timber quotas. Eliminating unnecessary details it can, for our purposes, be summarized as follows:

Kettle River

In 1961, Kettle River obtained Timber Sale Contract TSX 82868 which carried with it an allowable annual cut or quota of 690 "cunits" (a cunit is 100 cubic feet of timber; ten cunits or 1,000 cubic feet of timber is expressed as mcf). The licence originally ran for ten years to 1971 and thereafter was renewed annually.

After May 6, 1974, Kettle River acquired two further licences being timber sales licences TSL A04361 and TSL A05630 with a combined quota or allowable annually cut of 330 cunits.

In its 1980 taxation year Kettle River sold its business and transferred its existing licences which carried with them an allowable annual cut of 1,020 cunits (or 102 mcf).

In its tax return Kettle River treated the proceeds of disposition of its licences as a Capital gain and the Minister reassessed it as income, being the proceeds of disposition of timber resource property. Kettle River now agrees that the two licences acquired subsequent to May 6, 1974, were timber resource properties but there is still an issue between it and the Minister as to the original quota of 690 cunits.

Elk Bay

Elk Bay acquired a number of licences from as early as 1962. These were variously described over the years as timber sales contracts, timber sales licences and timber sales harvesting licences. Without going into detail it is enough to say that, by 1968, Elk Bay had an allowable annual cut, or quota, of 207 mcf which was then incorporated into a larger total quota in a series of new licences issued jointly to Elk Bay and Weldwood of Canada Ltd. Those licences were periodically renewed (with some variance in the allowable annual cuts) down to 1981 at which time Elk Bay sold its interests in the licences to Weldwood. In its 1981 tax return, Elk Bay treated the proceeds of this sale as a capital gain and the Minister reassessed on the basis that the entire proceeds, being from the disposition of a timber resource property, was income.

Issue 1: Are quotas timber resource properties?

The trial judge dealt with this issue succinctly and with force as follows (C.T.C. 281, D.T.C. 6529):

Notwithstanding the ingenious arguments of counsel for the plaintiffs, I am unable to see how the quota can be seen as an entity separate from the licence to which it entitles its holder. It is true that one may have a quota (as Elk Bay did for a certain period) without a licence but the quota by itself is useless. No one has suggested that one can have a licence without the quota because the licence is grante fon the annual harvesting of such quantity of timber as is permitted by the quota. The quota automatically goes with or becomes a term of the licence so that the purchaser of the licence acquires, in effect, the entitlement to cut at the rate specified in the quota and to apply for a new licence to cut at a similar rate should that become necessary. The evidence is clear that "sales" of quota are and must be effected by the sale (assignment) of licences. It is the licence which is being sold, an incident of which is the quota which constitutes a term of the licence and a right to apply for renewal or replacement of the licence. It appears that the value reflected in the price of an assignment of a licence from one private party to another mostly or entirely depends on the size of the quota. But the transaction between such parties is a transaction in licences. There was no evidence of these plaintiffs or any one else in the industry trading in quotas apart from licences.

I therefore conclude that a licence (to which, of necessity, a quota is attached) is an "original right", a right to cut or remove timber, and that the quota as an incident of the licence is part of that original right albeit the most valuable part.

To a large extent these appear to me to be findings of fact. Since they are based on the evidence and do not disclose any manifest error they should not be disturbed. To the extent that they deal with questions of law there is nothing that I can usefully add to the trial judge’s treatment of them which appears to me to be beyond reproach.

Issue 2: Are licences which are extended, renewed, or substituted after May 6, 1974, "acquired" after that date?

This issue involves the proper construction of paragraph 13(21)(d.1). That paragraph contains two subparagraphs joined by the disjunctive "or": accordingly, a right which meets the conditions of either subparagraph (i) or of subparagraph (ii) is a timber resource property.

Subparagraph (i) of itself presents no problem in the present circumstances: it posits as a condition in clause (i)(A) that the acquisition be after May 6, 1974. Manifestly, that condition is met in the case of the two licences totalling 330 cunits acquired by Kettle River after that date. Equally manifestly, those licences also meet the requirements set out in clause (i)(B) and are therefore timber resource properties.

The difficulty comes in respect of subparagraph (ii) dealing with extensions, renewals and substitutions; both clauses (ii)(A) and (ii)(B) are made to depend upon whether or not the right extended, renewed or substituted for is an “original right’. The use of that term drives the reader back to subparagraph (i) which tells us that the right it describes is "referred to" as an “original right”.

It is this reference back from subparagraph (ii) to subparagraph (i) which creates difficulty and serves as the foundation of the respondents' argument that no extension, renewal or substitution of a pre May 6, 1974 right which takes place after that date is an acquisition.

The text is not a model of clarity. As we have seen, subparagraph (i) itself imposes in clause (A) the condition that the right, to qualify as an "original right”, must have been "acquired by the taxpayer (other than in the manner referred to in subparagraph (ii)) after May 6, 1974”. But if rights which meet the requirements of clause (i)(B) are to be viewed as original rights only if acquired after May 6, 1974, there would appear to be no room for the operation of subparagraph (ii) which, as indicated, only applies to "original rights" as defined in subparagraph (i). To put the matter another way, if the reference back from subparagraph (ii) to subparagraph (i) is to be read as including the whole of the latter in the definition of “original right", it is difficult to see what purpose can be served by subparagraph (ii).

The answer, as it seems to me, and as determined by the trial judge, lies in the bracketed words in clause (i)(A): "(other than in the manner referred to in subparagraph (ii))". Those words do two things. First, they indicate that, in the language of the draftsperson, the process described in subparagraph (ii) is one resulting in a right being "acquired". Secondly, they have the effect of excluding from the meaning to be ascribed to the defined term “original right" in subparagraph (i) the time limitation imposed by clause (i)(A) while retaining the other conditions imposed by clause (i)(B).

This view of the proper construction of paragraph 13(21)(d.1) is further confirmed by the coming into force provision which is subsection 6(9) of the enacting statute, supra. That provision specifies that paragraph 13(21 )(d.1 ), which is enacted by subsection 6(9), shall be “applicable in respect of timber resource properties acquired after May 6, 1974" (emphasis added). That provision would not be necessary in respect of those timber resource properties described in subparagraph 13(21 )(d.1 )(i) for as we have seen it contains in clause 13(21 )(d.1 )(i)(A) its own built-in coming into force provision. Thus, its only scope is in respect of timber resource properties described in subparagraph 13(21 )(d.1 )(ii) and the word it employs to describe the process set out in that subparagraph is "acquired".

From the foregoing, it can be seen that I am in agreement with the views expressed by the trial judge on this point. He said at page 282 (D.T.C. 6530):

While there remain provisions in paragraph (d.1) unexplained to me I have concluded that the reasonable interpretation of it is that original rights may become timber resource properties if initially obtained, renewed, extended or substituted for earlier rights, after May 6, 1974. Among other things I can see no purpose in the coming into force section if it was not intended to fix a time for the commencement of the application of subparagraph (d.1)(ii) to the obtaining by extension, renewal, or substitution, of original rights. Subparagraph (d.1)(i) has its own coming into force provision with respect to initial acquisition: it only applies to such acquisitions after May 6, 1974. Subparagraph (d.1)(ii) on its face applies to original rights renewed, extended or substituted for at any time. The coming into force provision, subsection 6(9) of the 1975 Act, can therefore only have some meaningful application with respect to subparagraph (d.1 )(ii). The latter subparagraph does not by its terms have any starting date for its application and the coming into force provision must have been intended to provide that starting date, in effect making it the same as that provided in subsection (d.1 )(i).

It follows that in my view it is irrelevant whether the plaintiffs’ rights or licences to cut, the disposition of which gave rise to the sums in question, were extensions, renewals, or substitutions for original rights initially acquired before or after May 6, 1974.

and again at page 283 (D.T.C. 6531):

For completeness I would add, although the matter was not seriously disputed, that the original rights consisting of licences bearing quotas, where acquired after May 6, 1974, are the kind of original rights which meet the requirements of subclause 13(21 )(d.1 )(i)(B) as potential timber resources properties. That is, an established operator with a licence to harvest his quota could reasonably be regarded as having acquired the right to extend or renew such original right. In effect with his quota he would, as an established operator, have more than a reasonable expectation of renewing or replacing his licence. Similarly renewals or replacements of licences, no matter when originally acquired, would fall within subparagraph 13(21 )(d.1 )(ii) as they would be renewals or extensions of, or substitutions for, the right to cut the quota provided by the same licence prior to renewal or to licences replaced by new licences for cutting the same quota.

Issue 3: Was the capital cost of timber resource properties at the time of their first extension, renewal or substitution after May 6, 1974, the fair market value thereof?

This issue is stated in terms somewhat different from those in which it was formulated by the trial judge. He put the question as follows at page 280

(D.T.C. 6528): "Must the cost of such acquisition of such original properties be determined?". As so stated, the answer to the question is obvious for it is clear from subsection 13(1.1), supra, that the undepreciated capital cost of the timber resource properties must be known before any part of the proceeds of disposition can be determined to be in excess thereof and therefore required to be included in income. It is equally clear, however, that neither the trial judge nor the parties viewed the question as being quite such a simple exercise in the obvious. Rather, the real issue, and the one the trial judge in fact dealt with, was to know how the capital cost was to be determined in practice. From the facts of the case it appeared that both the respondents, and perhaps the industry generally, had incurred only relatively minor costs on the original acquisition of their quotas (such costs being related to advertising, "cruising" and the like) and had charged them off as expenses in the years in which they were incurred. Consistent with that practice, it also appeared that neither respondent had ever taken any capital cost allowance on such costs.

The learned trial judge decided that the capital cost for those licences which were newly acquired after May 6, 1974, should be the amount that was actually paid for them. In this, he was clearly right. He further decided, however, that for those licences which were based on quotas which had existed prior to May 6, 1974 and which were renewed after that date the capital cost should be based "on the market value of any licences immediately prior to their first renewal after May 6, 1974 where the use of the quota was continued through licence renewal rather than being assigned for value" (C.T.C. 286, D.T.C. 6533).

The trial judge appears to have based his finding on his understanding of the decision of the Exchequer Court of Canada in D'Auteuil Lumber Co. v. M.N.R., [1970] C.T.C. 122, 70 D.T.C. 6096, and on his view that the respondents had "given up" the market value of their quotas at the time that they applied for and obtained renewals of their licences. He was also of the view that this solution met the requirements of fairness for which the respondents had argued. In my respectful opinion, he was wrong on both counts and neither of the reasons advanced by him could serve as a proper basis for the conclusion to which he came.

In the first place, both tax law and the common use of language draw a clear distinction between cost and value. Cost means the money or money's worth which is given up by somebody to get something. It is generally viewed as an objectively determinable historical fact, the answer to the question "how much was paid?". Value, on the other hand, contains a far higher component of subjectivity and judgment. One of the classic tests involves positing a hypothetical buyer who does not have to buy and a hypothetical seller who does not have to sell. But there are many cases, notably where there is no readily determinable market, where not even that degree of objectivity is attainable. To put the matter at its simplest, cost is what you have paid for something, value is what another will give you for it; the two are not synonymous.

The Act also makes it clear in several places that cost and value are not the same. Perhaps the most obvious is subsection 10(1) dealing with the valuation of inventory where cost and fair market value are set in opposition one to the other:

10(1) For the purpose of computing income from a business, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.

[Emphasis added.]

Similarly, subsection 69(1) contains general deeming provisions for situations where properties are acquired or disposed of for excessive or inadequate consideration:

69(1) Except as expressly otherwise provided in this Act,

(a) where a taxpayer has acquired anything from a person with whom he was not dealing at arm’s length at an amount in excess of the fair market value thereof at the time he so acquired it, he shall be deemed to have acquired it at that fair market value;

(b) where a taxpayer has disposed of anything

(i) to a person with whom he was not dealing at arm's length for no proceeds or for proceeds less than the fair market value thereof at the time he so disposed of it,

(ii) to any person by way of gift inter vivos,

he shall be deemed to have received proceeds of disposition therefor equal to that fair market value; and

(c) where a taxpayer has acquired property by way of gift, bequest or inheritance, he shall be deemed to have acquired the property at its fair market value at the time he so acquired it.

Against this background it would require very clear language indeed to justify a finding that the reference in paragraph 13(1.1)(b) to "undepreciated capital cost" is intended to mean fair market value. There is simply no warrant for such a gloss on the language actually used.

The trial judge was, of course, perfectly right to read the D'Auteuil Lumber case as standing for the proposition that the cost of an asset to a taxpayer is what he has given up to get it. He was, however, with respect, wrong to think that these taxpayers, the respondents, had given up the fair market value of their quotas when they renewed their licences. indeed, far from giving them up, the respondents, by the renewal of their licences, were exercising and enjoying the rights which they had in virtue of their quotas. In D'Auteuil Lumber, the taxpayer had actually given up the right to compensation for expropriation but, as far as I can see, neither of these taxpayers gave up anything at all. The fact that they chose not to sell their quotas is no more an indication that they gave up the value thereof than is the fact that I choose not to sell my house or my car an indication that I have given up their value. As the trial judge himself said at page 285 (D.T.C. 6532), the respondents "rolled over" their quotas and that is a very different thing from giving them up.

This brings me to the fairness point which was argued by the respondents and accepted by the trial judge. It is based on the fact that gains from dispositions before December 31, 1971, of rights which were later to become timber resource properties were generally not taxable at all (I leave aside the case of a taxpayer who was trading in such rights); after that date such gains would only be taxable as capital gains on the amount of their increase in value since valuation day. With the introduction of the timber resource property provisions, effective May 6, 1974, these tax free gains are, on the Minister’s view, wiped out and the entire amount of the excess of the proceeds of disposition over the undepreciated capital cost is taxed as income. Since the original cost may have been (and in this case was) incurred many years before either 1971 or 1974, the respondents are being taxed on gains which were not taxable at the time they were being acquired (but not realized).

I start my consideration of this aspect of the case with the observation that any law which imposes a new tax is unfair on the view advanced by the respondents if the taxpayer is obliged to give up property which he had theretofore held free of tax. This is clearly wrong. All taxation involves the extraction from the taxpayer of property of which he would otherwise have had the free enjoyment. That the legislature may sometimes relieve against some of the more unfortunate consequences of the immediate application of a taxing statute (as was done for example by the concept of valuation day with the introduction of the capital gains tax in 1972) is surely due more to political reality than to any legal requirement. Fairness for taxation purposes can consist of no more than a presumption of an intention to treat in similar fashion all taxpayers who are similarly situated. I know of no acquired right not to be taxed.

That said, however, I have difficulty in seeing that there is anything unfair about the Minister’s view of the proper meaning to be given to the statute and its application to the facts of this case. The respondents disposed of valuable property at a freely negotiated price. They had acquired that property with pre-tax dollars, charging off as expenses against income all the costs of acquisition. That the law, whether through oversight or otherwise, would have allowed them, prior to 1972, to keep the entire proceeds of disposition tax free, and from 1972 to May 6, 1974, to pay only the reduced amount of tax applicable to capital gains, can surely not be regarded as an acquired right. A more appropriate description, in my view, would be a lucky loophole. The property having originally being acquired at the expense of the income stream, there is nothing unfair about treating the proceeds of disposition as income.

I conclude that the trial judge erred on the third issue. The undepreciated capital cost of the respondents” timber resource properties should be calculated in accordance with the ordinary rules, i.e., actual cost less accumulated depreciation.

Conclusion

In the formal judgments entered in each of these court files, the trial judge confirmed the Minister’s assessments with respect to the relevant taxation years (1980 for Kettle River, 1981 for Elk Bay) but referred them back to the Minister for determination of the capital cost on the basis previously indicated; i.e., fair market value. While I have found that disposition to be in error, it is not entirely clear to me that a determination of capital cost may not be necessary. Clearly that would be the case with regard to the rights newly acquired by Kettle River after May 6, 1974; it may also be that there are some other capital costs which can be justified by either respondent in accordance with the ordinary rules.

I would accordingly allow the appeal with costs both here and in the Trial Division (but one set of costs only), and would vary the judgments of the Trial Division to read:

The Minister’s assessment in respect of the relevant taxation year is confirmed except that it is referred back to the Minister for determination of the capital cost, if any, of the timber resource property disposed of, such determination to be in accordance with the ordinary rules.

Appeal allowed.