Gregory S. Fletcher v. Minister of National Revenue, [1992] 1 CTC 2261, 92 DTC 1273

Hamlyn, T.C.C.J.:—In his income tax return for the 1985 taxation year, the appellant claimed a "Canadian exploration expense" deduction in the computation of his income; subsequently, the respondent denied the deduction by way of the reassessment.

Facts

In the month of August 1985, Northcor Exploration Program 1985-12 Limited Partnership (the" limited partnership"), an Alberta limited partnership, entered into a flow through share agreement with Northcor Energy Ltd. ("Energy") whereunder Energy agreed to undertake and incur certain exploration expenditures, for and on behalf of the limited partnership as agent. The limited partnership acquired 100,000 first preferred series "D" shares of Energy.

This agreement was a special arrangement intended to comply with subparagraph 66.1(6)(a)(v) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

On December 23, 1985, the appellant who was a resident of Canada at all material times acquired 32 limited partnership units at a cost of $27,500 per unit in the limited partnership ($880,000 total).

On December 31, 1985, Energy and Bawden Western Oceanic Offshore Ltd. ("BWOOL") executed a letter of intent which stated, inter alia, that BWOOL “intends” to enter into a drilling agreement with Energy and "intends" to charter the drillship "NEDDRILL II”. The letter of intent reads as follows:

LETTER OF INTENT

THIS LETTER OF INTENT effective the 15th day of November, 1985.

BETWEEN:

BAWDEN WESTERN OCEANIC OFFSHORE LTD. (hereinafter referred to as BWOOL) -and-

NORTHCOR ENERGY LTD. (hereinafter referred to as Northcor)

WHEREAS BWOOL intends to charter the drillship, Neddrill 2, and

WHEREAS BWOOL intends to enter into a drilling agreement with Northcor,

NOW THEREFORE it is agreed that the main terms and conditions of such an agreement will be as follows:

1. DRILLSHIP

Drilling vessel Neddrill 2, as described in Neddrill's report on Northcor Narwhal project including the anticipated modifications as described therein.

2. CONTRACT FORMAT

Will be generally along the same lines as the BWOOL/Canterra contract with modifications as discussed.

3. CONTRACT PERIOD

Commencing November 15, 1985 with drilling to begin* April 1, 1986, with a minimum of 150 days.

*or as soon thereafter as can reasonably be accommodated.

4. FEES AND PAYMENT

(i) a. Operating rate: $156,000

b. Moving/Loading rate: $154,000

c. Standby rate: $154,000

d. Repair rate: $152,000

e. Long Repair rate: $136,000

f. Force Majure [sic] rate: $136,000

g. Drydock rate: $5,000

(ii) Holding Fee—November 15, 1985—$2,000,000

(iii) Early Termination Fee

Execution date to Dec. 31, 1985	$2,000,000
Jan. 1-15, 1986	$3,000,000
Jan. 16-31, 1986	$4,000,000
Jan. 31-Apr. 1, 1986	$6,000,000
5. DUTIES

Custom, import duties or similar duties during the Contract Period are for North- cor's account.

6. SUBJECTS

This Letter of Intent is subject to:

a. the necessary P.I.A. approvals being obtained

b. the drillship, Neddrill 2, with its modifications being acceptable to Northcor and COGLA

c. BWOOL being satisfied with respect to being provided with reasonable guarantees, such that satisfactory financing can be arranged.

The appellant maintains the limited partnership, through its agent Energy, incurred an expense in 1985 in the amount of $2,000,000 with BWOOL as a fee in respect of holding a drillship in Canada for certain months in 1985.

The appellant claimed Canadian exploration expenses" of $264,320, within the meaning of subparagraph 66.1 (6)(a)(iv) of the Act in his income tax return for his 1985 taxation year with respect to his share of the fee to hold the drillship in Canada.

As indicated the Minister of National Revenue reassessed the appellant and a notice of reassessment was sent dated May 24, 1989, wherein the Minister of National Revenue disallowed the deduction claimed by the appellant with respect to the fee to hold the drillship.

After a notice of objection filed by the appellant, the Minister of National Revenue issued a notice of confirmation:

. . . The amount of $264,320 claimed as a deduction from income is not deductible pursuant to subsection 66.1(3) of the Act as Northcor Exploration Program 1985-12 Limited Partnership did not incur Canadian exploration expenses, within the meaning of paragraph 66.1(6)(a) of the Act on your behalf.

Issue

The issue before this Court is whether the $2,000,000“ holding fee" expense as alleged to have been incurred by the Limited Partnership was actually incurred in respect of the drillship in the 1985 taxation year and consequently whether the $264,320 expense was properly allowable as claimed by the appellant within the meaning of subsection 66.1(3) and paragraph 66.1(6)(a) of the Act.

The appellant's position

The appellant relies on the provisions of subsection 66.1(3) and paragraph 66.1(6)(a) of the Act and asks this Court to find that the $2,000,000" holding fee" expense was incurred by the Limited Partnership in respect of the drillship in the 1985 taxation year and that the $264,320 was properly allowable as claimed by the appellant.

The respondent's position

The respondent submits that the $2,000,000 is not an outlay or expense within the meaning of paragraph 66(15)(g.2) of the Act and is therefore not a "Canadian exploration expense" within the meaning of paragraph 66.1(6)(a) of the Act as the fee would have been for services rendered after the 1985 taxation year.

The respondent further argues if the Court holds that the $2,000,000 “ holding fee" is a "Canadian exploration expense” there was no liability in 1985 for such expense and the expense was not incurred by the limited partnership in respect of the drillship in the 1985 taxation year. As such, the $264,320 was not properly allowable to the appellant within the meaning of subsection 66.1(3) and paragraph 66.1 (6)(a) of the Act.

Lastly, the respondent submits if there was liability for such expense in the 1985 taxation year it was a contingent liability and therefore not deductible pursuant to paragraph 18(1)(e) of the Act.

Significant findings of fact relating to this appeal from the evidence

Mr. Gregory Scott Fletcher, the appellant, is a landsman involved in the oil and gas industry invested in the limited partnership and his claim for "Canadian exploration expenses" as it relates to his appeal before this Court was disallowed by the Minister of National Revenue.

During the period in question before this Court, Mr. David Sells was the president of Energy and, in relation to the matters herein, acted and spoke for Energy.

Energy was a party to an agreement in relation to an oil and gas exploration off the East coast of Canada. Energy intended to fund this particular exploration with funds from the public sector (Petroleum Incentives Program grants) and funds from the private sector using individual Canadian investors.

To accomplish this end, Energy offered investors units in the limited partnership. Part of the role and the advantage to Energy in setting up the limited partnership was to warehouse the exploration costs, that is, to incubate the Canadian exploration expense" until the partnership units were sold. Thereafter the "Canadian exploration expenses" would flow through to the limited partnership by way of the flow through share agreement and then to the unit purchasers by way of the special tax treatment of partnership expenses. Mr. Sells, also confirmed another advantage to the limited partnership was the limited liability afforded to the unit holders in relation to the project as a whole. According to Mr. Sells the actual selling of the limited partnership units was not advantageous until "Canadian exploration expenses" had been incurred.

In this context, Energy exercised its option to conduct exploration by drilling off the East coast of Canada, more specifically in the South Whale Basin. The drilling was to take place under one mile of water and three miles into the earth. This was described by Mr. Sells as a risky adventure with a chance of success of one in fifteen. It was also described as a costly adventure (50 to 60 million dollars).

As indicated, part of the financing came from the Petroleum Incentives Program that could provide up to 80 per cent of eligible costs. It was Energy's belief that the proposed "Canadian exploration expense" qualified to receive petroleum incentives program grants.

According to Mr. Sells the biggest problem Energy faced was in finding a vessel appropriate to conduct the drilling proposals. Four vessels were surveyed; two were out of Canadian waters and not available, another was already on contract and the fourth, the NEDDRILL II, would be able to do the drilling but required modifications.

The NEDDRILL II was a ship of Dutch registry (Rotterdam) and negotiations as to the ship's suitability were conducted between Canada and the Netherlands. At that time, BWOOL had the NEDDRILL II under contract, drilling in Canadian waters (Hudson's Bay) on behalf of another company (Canterra).

BWOOL then entered into negotiations with Energy as to a drilling agreement while at the same time BWOOL negotiated with the NEDDRILL II owners as to the ship's use for the South Whale project. Part of the negotiations of both proposed agreements was a holding fee of $2,000,000 to hold the NEDDRILL II in Canadian waters. The appellant submits this holding fee was owing, notwithstanding the completion of negotiations for the drilling contract. However, the documentary and viva voce evidence does not make this point abundantly clear.

The manager of contracts for BWOOL during the period in question was Mr. Ron Parsons and his evidence was tendered. After leaving Hudson Bay, the NEDDRILL II went to Newfoundland to unload and then to await completion of the negotiations and the commencement of the ship's modifications. Mr. Parsons described the NEDDRILL II as being capable of doing the proposed contract providing the ship was modified at a cost of six to eight million dollars. He further stated that if the ship was not held after the completion of the Hudson Bay drilling it would go to warmer waters to do other drilling. He stated that the discussions between BWOOL and Energy were involved and it took considerable time to reduce all matters to an acceptable form. At least 14 attempts were made to arrive at a completed negotiation in relation to the proposed drilling contract between BWOOL and Energy. These successive attempts ended in failure.

During this period of negotiation, the letter of intent (see above) was signed by Mr. Parsons' immediate superior on behalf of BWOOL and by Mr. Sells on behalf of Energy.

Mr. Parsons said that while there was no document firmly showing the liability for the holding fee, as between BWOOL and the NEDDRILL IT owners, there was an understanding between BWOOL and the NEDDRILL ll owners that a holding fee would be paid without which the NEDDRILL II would leave for warmer waters. A telex (Exhibit R-5) from the NEDDRILL IT owners to BWOOL, however, does not lead to this contractual conclusion.

By the end of February 1986, the negotiations to arrive at an agreement between BWOOL and Northcor ended when the NEDDRILL II left Canadian waters.

On January 3, 1986, BWOOL invoiced Northcor for $2,000,000 and the invoice read as follows (Exhibit A-6):

Northcor et al Narwhal Dome

The following amount is invoiced per Clause 1102(a) and A1.1 of the Drilling Contract between Northcor Energy Ltd. and Bawden Western Oceanic Offshore Ltd.

TOTAL INVOICE AMOUNT $200,000,000

On January 3, 1986, Energy applied to the petroleum incentives program for $1,600,000 on the following basis (Exhibit A-7):

Enclosed please find our application for Petroleum Incentives Program grants for the Holding fee for the Neddrill Il, the vessel which will be used to drill the Narwhal Dome Well (project number 8626-N10-1E). This fee was due and payable on November 15, 1985 as per our contract with Bawden Western Oceanic Offshore Ltd., the Canadian agent for the Neddrill II.

Please note that the PIP grant is to be assigned in its entirety to Bawden Western Oceanic Offshore Ltd.

After the NEDDRILL II left Canadian waters BWOOL credited the account of Northcor in the following manner (Exhibit A-11):

TO CREDIT INVOICE NP-001—mobilization per preliminary agreement. Neddrill will not drill this well and have left Canada. Fee is no longer applicable.

TOTAL CREDIT: $200,000,000

No moneys were paid in account of the alleged debt.

LEGISLATION

FLOW THROUGH SHARE AGREEMENT

66.1(6)(a)(v)—any expense referred to in any of subparagraphs (i) to (iii.1) incurred by the taxpayer pursuant to an agreement with a corporation under which the taxpayer incurred the expense solely as consideration for shares, other than prescribed shares, of the capital stock of the corporation issued to him or any interest in such shares or right thereto.

66.1(3)—A taxpayer other than a principal-business corporation may deduct, in computing his income for a taxation year, such amount as he may claim not exceeding the amount, if any, by which his cumulative Canadian exploration expense at the end of the year exceeds the amount, if any, designated by him under subsection 66(14.1).

66(14.1) A corporation may designate for a taxation year, by filing a designation in prescribed form with the Minister on or before the day on or before which it is required to file a return of its income for the year under section 150, a particular amount not exceeding the lesser of

(a) its prescribed Canadian exploration expense for the year, and

(b) its cumulative Canadian exploration expense at the end of the year,

and the particular amount shall be added in computing its cumulative offset account immediately before the end of the year and deducted in computing its cumulative Canadian exploration expense at any time after the end of the year.

Canadian exploration expense

Paragraph 66.1(6)(a) of the Act read as follows:

(a) "Canadian exploration expense" of a taxpayer means any outlay or expense made or incurred after May 6, 1974 that is

(i) any expense . . . (other than an expense incurred in drilling or completing an oil or gas well or in building a temporary access road to, or preparing a site in respect of, any such well) for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas (other than a mineral resource) in Canada

(ii) any expense incurred before 1986 in drilling or completing an oil or gas well in Canada or in building a temporary access road to, or preparing a site in respect of, any such well, if within six months after the end of the year, the drilling of the well is completed and . . .

(11.1) any expense incurred after 1985 in drilling or completing an oil or gas well in Canada or in building a temporary access site in respect of any such road to, or preparing a well, if the drilling of the well is completed within six months after the end of the year

(11.2) any expense incurred by him after 1985 in drilling or completing an oil or gas well in Canada or in building a temporary access road to, or preparing a site in respect of, any such well . . .

Subparagraph 66.1 (6)(a)(iv) of the Act reads:

(iv) his share of any expense referred to in any of subparagraphs (i) to (iii.1) incurred by a partnership in a fiscal period thereof, if, at the end of that period he was a member thereof, or

Definition—Oil or Gas Well

Before 1986, paragraph 66(15)(g.1) provided the following definition of "oil or gas well”:

means any well (other than an exploratory probe) drilled for the purpose of producing petroleum or natural gas or of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas.

Definition—"Outlay" or "Expense"

Paragraph 66(15)(g.2) read as follows:

"outlay" or "expense" made or incurred before a particular time by a taxpayer, for greater certainty, does not include any amount paid or payable

(i) as consideration for services to be rendered after that time, or

(ii) as, on account or in lieu of payment of, or in satisfaction of, rent in respect of a period after that time.

Deduction—Reserves

Paragraph 18(1)(e) in 1985 read as follows:

(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part;

Jurisprudence

Canadian exploratory expenses

In Edmonton Liquid Gas Ltd. v. The Queen, [1984] C.T.C. 536, 84 D.T.C. 6526, the Federal Court of Appeal suggested at page 540 (D.T.C. 6530) that expenses which come within the scope of paragraph 66.1 (a)(i) are:

. . . those of a primary exploratory type, including those of a geological nature, and also including those of drilling exploratory oil or gas wells that were not intended to produce oil or gas if found.

In the same case, the Federal Court of Appeal also discussed at page 542 (D.T.C. 6530-31) the meaning of "incurred" in relation to expenses:

It would seem clear from these authorities that a proper test for defining expenses incurred by a taxpayer in a particular year must be cast in terms of the absoluteness of the transactions in which he engaged during that year: are the transactions absolute, with no contingencies as to disposition, use or enjoyment? has he retained any measure of control? is there, for instance, any element of refundability?

Jurisprudence

Interpretation of contracts

In Hendry v. Zimmerman, [1948] 1 W.W.R. 385, the Manitoba Court of Appeal stated at page 385: "Rules of interpretation are applicable only where there is no sufficient declaration by the parties of their own will and intention.”

In Phenix v. Travelers Fire Ins. Co., [1952] 2 S.C.R. 190 at 217, Estey, J. said: "When the parties are in agreement as to the meaning of a provision, a court, in the absence of compelling reasons to the contrary, should construe the document in accord therewith.”

In Clark's-Gamble of Canada Ltd. v. Grant Park Ltd., [1966] 57 W.W.R. 27, 64 D.L.R. (2d) 487, at 33, the Manitoba Court of Appeal quoted from Bank of New Zealand v. Simpson, [1900] A.C. 182, a decision in which Lord Davey said at page 187: Extrinsic evidence is always admissible, not to contradict or vary the contract, but to apply it to the facts which the parties had in their minds and were negotiating about.”

In Jackson v. Shipping Federation, [1955] 15 W.W.R. 311 (B.C.S.C.), Mclnnes, J. concluded that the law does not recognize a contract to enter into a contract. Thus, if execution is a condition or term of the bargain there will be no enforceable contract.

However, if memoranda including documents and letters are merely expressions of the desire of the parties as to the manner in which the transaction already agreed to will in fact go through, this will be a binding contract and the reference to a more formal contract will be ignored.

In the judgment of Kitsilano Enterprises Ltd. v. G.& A. Developments Ltd., [1990] 6 W.W.R. 38, it is stated at page 38:

In determining whether an agreement containing conditions is a binding agreement or merely an offer, it is necessary to look first to the conditions to see whether they are true conditions precedent which impose no obligation on any party to fulfil them.

Cushing v. Knight, [1912] S.C.C. [Vol XLVI] 555. Duff, J. said at page 560:

The fact that such a formal agreement was contemplated is, as Lord Cranworth said in Ridgeway v. Warton, 6 H.L. Cas. 238 strong evidence that the parties did not intend finally to bind themselves until that agreement should be completely constituted . . .

In Be-Vi Investment Corporation v. The Queen, [1975] C.T.C. 636, 75 D.T.C. 5444, Heald, J. stated the principles which the Court must apply when there is a conflict between direct evidence given by the taxpayers and the objective facts and circumstances established in evidence. At page 645 (D.T.C. 5450) Heald, J. quoted with approval Addy, J. in the case of Roy M. Power v. The Queen, [1975] C.T.C. 580, 75 D.T.C. 5388, at page 585 (D.T.C. 5391-92):

The issue of intention must therefore be resolved by a careful weighing of all of the admissible evidence which is in any way relevant to that issue and the person or body charged with finding the facts must refrain from considering each piece of evidence independently but must examine it in the light of all the other evidence both direct and circumstantial. . .

[Emphasis added.]

Analysis

Flow through shares

Flow through shares are shares of the capital stock of a corporation acquired by a taxpayer pursuant to an agreement with a corporation under which the corporation agrees to incur exploration and development expenses in an amount equal to the consideration for which the share is issued. The expenses are considered expenses of the taxpayer and not of the corporation.

The flow through share structure of the appellant was as follows:

(a) the appellant acquired 32 units of the Limited Partnership;

(b) the limited partnership had acquired 100,000 preferred shares of Energy;

(c) Energy and the limited partnership had a flow through share agreement,

and

(d) Energy had an arrangement with BWOOL by way of a Letter of Intent subject to conditions to enter into a drilling arrangement.

The factors surrounding the exploration expense raise certain conclusions. It would appear there was no written agreement beyond the letter of intent between BWOOL and Energy. No money was ever paid over by Energy to BWOOL. The transactions were recorded on the books of BWOOL and after the ship left Canadian waters, an internal credit was entered in favour of Energy for $2,000,000.

Canadian exploration expenses

A partnership is not a separate taxpayer but is treated as such for the purposes of calculating the income from the partnership. This income then flows to each partner according to predetermined shares of the partnership income.

Canadian exploration and development expenses are an exception to this general rule. Expenses are not deducted in calculating the income of the partnership but are considered, for tax purposes, to be the expenses of the partners.

The appellant in this case is claiming “Canadian exploration expense" pursuant to the Act that allows the partnership's expenses to be considered as the expenses of the partners.

Canadian exploration expenses must be incurred in respect of activities in Canada and, in general, is any expense incurred for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas in Canada.

In the definition of an“ oil and gas well” from the Act, an exploratory probe is excluded and this has the effect of including such expenses in exploration expenses rather than development expenses.

The Act makes it quite clear that expenses are excluded if amounts are paid or payable for services to be rendered i.e., an“ outlay” or "expense" made or incurred before a particular time by a taxpayer but does not include any amount paid or payable as consideration for services to be rendered after that time. Thus, if part or all of the $2,000,000 expenses are for services to be rendered after 1985, then ''part or all” of the expenses are not deductible in 1985.

In this case, the interpretation of the viva voce evidence as submitted by counsel for the appellant, urges the Court to conclude the holding fee was agreed between the parties BWOOL and Energy and had separate existence from the other negotiations, that is, the obligation to pay the holding fee was independent of the drilling contract. A reading of the draft agreements does not lead to this conclusion. A reading of the letter of intent does not lead to a conclusion of a separate existence. The holding fee as structured in the documents was part of the overall negotiations to arrive and drill at the drilling site. The overall view of the evidence suggests the holding fee was not simply for the 45 days between November 15 and December 31, 1985; the holding fee was for the whole period if there was a contract between the parties to drill.

The viva voce evidence and the letter of intent between BWOOL and Energy do not lead to the conclusion there was a separate and independent contract to pay the $2,000,000 holding fee. The holding fee was only payable if there was a concluded contract between BWOOL and Energy to drill at the South Whale Basin site. The fact that the NEDDRILL II left Canadian waters before the ship was obliged to stay extrinsically supports this conclusion.

It is also significant given the sums involved, no action for specific performance was launched by any of the parties. Nor does there appear to be any effort to insist that any alleged contract be performed.

It appears all the elements were going in one direction, that is, to arrive at two, obviously intertwined, but separate contracts to drill. However, until there was agreement all around no contracts could be concluded. When the NEDDRILL II left Canadian waters clearly everything was at an end—there was no contract in force to oblige the ship to stay and it follows because of the intertwining there was no contract between BWOOL and Energy to hold the ship and, until a drill agreement was concluded there was no absolute contract by Energy to pay to hold the ship.

There being no contract by Energy to pay to hold the ship during negotiations, no "Canadian exploration expense" was incurred in relation to the matters brought to this Court.

Decision

The appeal is therefore dismissed.

Appeal dismissed.