Allan P. Markin v. Minister of National Revenue, [1988] 1 CTC 2454, 88 DTC 1309

Tremblay, T.C.J.:—This appeal was heard on April 9, 1987 at the City of Calgary, Alberta.

1. The Point at Issue

The point at issue is whether the appellant, an executive employee at Merland Explorations Limited (hereinafter called "Merland"), is correct in the computation of his income, with respect to his 1982 taxation year, to include the amount of $389,760 as capital gain and not as income. The appellant received this amount in 1982 for the disposition of his right to receive the one-half of one per cent of the net profits of Merland following an incentive program for executive employees, instituted in 1978 by Merland to receive such profits from oil and gas properties.

The respondent, as main argument, considers the proceeds of disposition of the appellant’s right to the fund, created from the net profits of Merland, as a Canadian resource property and therefore, taxable.

In the alternative, the respondent considers the amount of $389,760 received by the appellant as a benefit received or enjoyed by the appellant in respect of, or by virtue of his office or employment or was on account or in lieu of payment of, or in satisfaction of, an obligation arising out of an agreement made by Merland with the appellant during the period that the appellant was in the employment of Merland within the meaning of paragraph 6(l)(a) or subsection 6(3) of the Income Tax Act (hereinafter called "the Act").

2. The Burden of Proof

2.01 The burden of proof is on the appellant to show that the respondent's reassessment is incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195; 3 D.T.C. 1182.

2.02 In the same judgment, the Court decided that the assumed facts on which the respondent based his reassessment were also deemed to be correct. In the present case, the assumed facts are described in paragraphs 5(a) to (c) of the reply to notice of appeal as follows:

5. In confirming the reassessment of the Appellant as he did and with respect to the matters here in issue he assumed, inter alia, that:

(a) the facts admitted;

(b) as an incentive to its employees Merland granted its executive employees,

including the Appellant, a net profits interest in oil and gas properties;

(c) the Appellant's net profits interest is a Canadian Resource property under paragraph 66(15)(c) of the Act and accordingly the amount of $389,760 received on the disposal of his net profits interest in 1982 is income in the hands of the Appellant.

3. The Facts

3.01 At the beginning of the trial, counsel for the parties produced an agreed statement of facts. It reads as follows:

1. Allan P. Markin ("the Appellant") is an individual resident in the City of Calgary, Alberta.

2. Between the years 1978 [corrected at trial to 1975] through 1982, the Appellant was employed by Merland Explorations Limited and certain affiliated corporations ("Merland").

3. In 1978, Merland instituted an incentive program for its executive employees. Under the incentive program, Merland granted certain of its employees, including the Appellant, a contractual right to receive one-half of one percent of the “net profits’ of Merland from its ownership and operation of certain properties which constituted “Canadian resource properties" for the purposes of paragraph 66(15)(c) of the Act ("the subject properties"). In respect of the Appellant, the subject properties constituted all “Canadian resources properties" which were acquired by Merland during the term of the Agreement. The term of the initial Agreement was one year, being the 1978 calendar year. (The initial Agreement, together with each subsequent Agreement by which the Appellant was granted a right to receive a portion of the profits of Merland, together with all amendments thereto, will be referred to herein collectively as "the Agreements").

4. By letter agreement [sic] dated March 25, 1980, Merland confirmed to the Appellant that identical Agreements for the calendar years commencing January 1st, 1979 and January 1st, 1980 had orally been entered into. This was confirmed by the Appellant.

5. By agreement dated March 12, 1981, Merland and the Appellant agreed to amend certain provisions of the Agreements then subsisting for the 1978, 1979 and 1980 calendar years to provide for the staggered vesting of the rights granted to the Appellant thereunder if he were terminated from his employment with Merland.

6. The Appellant and Merland entered a further agreement on January 1st, 1981, embodying substantially the same terms and conditions as had been contained in the Agreements which then subsisted for the 1978, 1979 and 1980 calendar years, as amended. The term of the Agreement dated January 1st, 1981 was for the 1981 calendar year.

7. By agreement dated December 1st, 1981, the Agreements which subsisted for 1978, 1979, 1980 and 1981, as amended, were further amended to essentially delete the provision in the March 12, 1981 agreement as to the Appellant's termination and to replace these provisions with further provisions which enlarge the previous rights of the Appellant to require Merland to purchase the Appellant's rights under the Agreements upon death, and thereby permit the Appellant to require the purchase of those rights in circumstances of the termination of the Appellant's employment with Merland.

8. The Appellant acquired his rights under the Agreements by virtue of his employment with Merland.

9. The Appellant terminated his employment with Merland in 1982.

10. On January 14, 1982 the Appellant secured a valuation of his rights under the Agreements.

11. On January 25, 1982 the Appellant, in accordance with the Agreement, exercised his option to require Merland to purchase, and thereby cancel, his rights under the Agreements.

12. On the basis of having acquired his rights under the Agreements at no cost, the Appellant reported that he had realized a capital gain in the amount of $389,760 in the 1982 taxation year, being the entire proceeds received upon the cancellation of his rights under the Agreements.

13. The Minister does not dispute the amount received by the Appellant in respect of the disposition of his rights under the Agreements during the Appellant's 1982 taxation year.

14. On March 20, 1985, the Appellant was reassessed by the Minister. The Minister disallowed the Appellant's claim that he had incurred a capital gain in respect of the disposition of his rights under the Agreements, but rather had received an amount which should be included in the Appellant's income under paragraph 6(l)(g) of the Act as a payment under an employee benefit plan.

15. The Appellant filed a Notice of Objection dated June 11, 1985 disputing the Minister’s reassessment.

16. The Minister accepted the Appellant's submission in respect of the legal basis of its original reassessment but confirmed the amount of the assessment on the basis that the disposition of the Appellant's rights under the Agreements constituted a disposition of a “Canadian resource property" and therefore included the amount received by the Appellant in his income pursuant to Sections 3 and 66.2 of the Act.

17. The Appellant is appealing from the foregoing reassessment.

3.02 Although the appellant terminated his employment with Merland on July 7, 1982, the appellant's right for that year was not repurchased.

3.02.1 Therefore, the agreement in force at the beginning of 1981 applies to the issue of this appeal. This agreement was made as of January 1, 1981. It reads as follows:

THIS AGREEMENT made as of January 1, 1981.

BETWEEN:

MERLAND EXPLORATIONS LIMITED,

MERLAND RESOURCES INC., and

MERLAND OIL & GAS, INC., each bodies

corporate, having offices at the City

of Calgary, in the Province of Alberta

(hereinafter collectively called the "Company")

OF THE FIRST PART

- and -

ALLAN P. MARKIN, of the City of

Calgary, in the Province of Alberta

(hereinafter called the "Employee")

OF THE SECOND PART

WHEREAS the Company is engaged in the business of acquiring, exploring and developing oil and gas properties as hereinafter defined; and

WHEREAS as an incentive to the Employee, the Company has agreed to grant to the Employee a net profits interest in respect of the oil and gas properties upon the terms and conditions hereinafter provided.

NOW THEREFORE THIS AGREEMENT WITNESSETH that in consideration of the premises and the mutual covenants of the parties hereinafter provided, the parties hereto hereby agree as follows:

1. DEFINITIONS

In this agreement the following terms shall have the meanings hereinafter in this clause ascribed to them, unless the context otherwise requires:

(a) "oil and gas properties" means lands in Canada and the United States containing or prospective of containing petroleum substances in which the Company acquires an interest during the term hereof;

(b) "petroleum substances" means any substances in which the Company acquires an interest under the documents of title demising or granting an interest to the Company in the oil and gas properties;

(c) "net profits" means the net profits attributable to the interest of the Company in the oil and gas properties as determined and calculated pursuant to clause 3 hereof.

2. GRANT OF NET PROFITS INTEREST

The Company hereby grants to the Employee an undivided one-half of one ('/2 of 1%) percent of the net profits, calculated as hereinafter provided, attributable to the interest of the Company in oil and gas properties.

3. CALCULATION OF NET PROFITS

(a) For the purposes of this agreement the net profits shall be calculated by the establishment and maintenance by the Company as of the date of this agreement of a joint account (hereinafter called the "joint account”) in respect to the oil and gas properties.

(b) To the joint account the Company shall credit the following:

(i) amounts received by the Company in payment of its share of petroleum substances produced from the oil and gas properties less any taxes, (but without deduction for income taxes), royalties, overriding royalties and other charges of a similar nature attributable to such share which were granted or created prior to the acquisition of an interest therein by the Company;

(ii) the Company's share of any bottom hole contributions, dryhole contributions and drilling incentive credits and all other types of governmental credits or grants received by the Company for the purpose of conducting exploration and drilling operations on the oil and gas properties;

(iii) the Company's share of any amounts received by the Company in payment upon the sale of geophysical information obtained by the Company in respect to the oil and gas properties;

(iv) the Company's share of any amounts received by the Company from the sale of equipment and/or other materials, the purchase price of which was debited to the joint account;

(v) the Company's share of any amounts received by the Company as operating income for the operation of wells on the oil and gas properties for other parties; and

(vi) any amounts received, by the Company in refund of any items charged to the joint account as a debit.

(c) To the joint account the Company shall charge as a debit:

(i) all charges and expenses incurred by or for the benefit of the Company in the acquisition, exploration, development and operation of the oil and gas properties, and the processing of petroleum substances produced therefrom, including all plant costs;

(ii) the reasonable and proper overhead costs of the Company attributable to the oil and gas properties which, in the case of oil and gas properties subject to a third party agreement, shall be the overhead costs provided for pursuant to such third party agreement and in all other cases shall be the reasonable and proper overhead charges as determined in the sole discretion of the Company;

(iii) the costs incurred by or for the benefit of the Company for third party services engaged in connection with the exploration, development and operation of the oil and gas properties;

(iv) the costs incurred by or for the benefit of the Company for acquiring, establishing and maintaining title to the oil and gas properties including rentals, legal costs and the cost of accounting or bookkeeping services attributable to the interest of the Company therein;

(v) interest on the debit balance in the joint account from time to time at the same rate from time to time applicable to repayable on demand borrowings by the Company from its Bank.

(d) If requested, the Company shall render to the Employee at reasonable intervals a full statement illustrating the status of the joint account, which statement if requested, shall be supported by invoices, receipts and billings evidencing the transactions reflected in the statement.

(e) Upon a credit balance being achieved in the joint account, subject to the provisions of clause 5 hereof, the Company shall pay to the employee within forty-five (45) days of the first calendar month thereafter and within forty-five

(45) days of each calendar month following in which a credit balance exists the Employee's above specified percentage share of any credit balance in the joint account as of the last day of such calendar month;

(f) The joint account shall be audited annually by the Company's auditors on each anniversary date of this agreement and the Employee shall be provided with a copy of their report in respect thereto;

(g) In those cases in which the oil and gas properties are subject to a third party operating agreement, all matters of accounting as between the parties shall be subject to the applicable provisions of such operating agreement and its accounting procedure.

4. ACQUISITION, EXPLORATION, DEVELOPMENT AND OPERATION OF THE OIL AND GAS PROPERTIES

It is understood and agreed that the acquisition, exploration, development and operation of the oil and gas properties shall be in the entire discretion and control of the Company and, in particular, without restricting the generality of the foregoing, the Company shall in its sole discretion determine whether any or all of the oil and gas properties are to be pooled or unitized and on what basis. Further, it is hereby agreed that the disposition by the Company of any oil and gas properties whether by farmout, sale, exchange, transfer or otherwise, shall be in the sole discretion of the Company and the net profits interest herein granted to the Employee shall be applicable only to the interest retained by the Company in such oil and gas properties, provided however, that if the Company receives a cash payment in consideration of any such disposition, such cash payment shall be credited to the joint account. Nothing in this agreement is intended to effect the right of the Company to mortgage or pledge the oil and gas properties as security for any loans obtained by the Company. In addition, it is not the intention of this agreement, either expressed or implied, to impose any obligation on the Company to explore and/or develop the oil and gas properties or any of them.

5. TERMINATION OF THE EMPLOYEE'S EMPLOYMENT

Notwithstanding anything in this Agreement otherwise contained, if the employment of the Employee is terminated howsoever, with or without cause, the Employee shall have no cause of action of whatsoever nature against the Company or any other party whomsoever arising out of this Agreement or the termination thereof, and:

(a) Effective as of the termination of the Employee's employment, the Employee shall have no net profits interest in any oil and gas properties thereafter acquired by the Company;

(b) In the event that the termination of the Employee's employment with the Company occurs for reasons other than any of those set out in subclauses (c) and (d) of this clause 5:

(i) within three (3) years from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall terminate and be of no further force and effect and the Employee shall have no interests whatsoever in the oil and gas properties or the proceeds of production therefrom;

(ii) after three years (3) but prior to the expiry of four (4) years from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall be reduced by forty (40%) percent of the amount otherwise payable;

(iii) after four (4) years but prior to the expiry of five (5) years from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall be reduced by twenty (20%) percent of the amount otherwise payable;

(iv) after five (5) years from the date of this agreement, the whole amount of the net profits interest hereinbefore granted the Employee shall be payable.

(c) In the event that the termination of the Employee's employment with the Company occurs:

(i) as a result of death of the Employee; or

(ii) as a result of the permanent mental or physical incapacity of the Employee to the extent of being unable to perform his duties with the Company,

the foregoing provisions of subclause (b) hereof shall not apply.

(d) In the event that the Employee's employment with the Company is terminated by the Company without legal cause and such termination occurs, first, within 180 days following acquisition of a controlling interest in the voting shares of the Company by a shareholder (other than a shareholder controlled by or associated with R.J. Adams and/or Walter J. Adams) not now holding such controlling interest, or secondly, within 180 days following the sale by the Company of all or substantially all of its assets, and such termination occurs:

(i) prior to the expiry of one (I) year from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall be reduced by eighty (80%) percent of the amount otherwise payable;

(ii) after one (1) year, but prior to the expiry of two (2) years from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall be reduced by sixty (60%) percent of the amount otherwise payable.

(iii) after two (2) years, but prior to the expiry of three (3) years from the date of this agreement, the net profits interest hereinbefore granted to the Employee shall be reduced by forty (40%) percent of the amount otherwise payable.

(iv) after three (3) years from the date of this agreement, the provisions of subclauses (ii), (iii) and (iv) of subclause (b) shall apply.

(e) In the event net profits become payable to the Employee within Five (5) years from the date of this agreement, so long as the Employee remains employed by the Company, the full amount of net profits shall be payable, the intent being that the foregoing provisions for reduction shall become effective only in the event of termination of employment as hereinbefore provided.

6, ASSIGNMENT OF NET PROFITS INTEREST;

(a) During the Employee's employment by the Company, the Employee shall not be entitled to assign, convey or otherwise dispose of any portion of the net profits interest hereinbefore granted without the prior written consent of the Company, except in the case of:

(i) an assignment by way of security for the Employee's indebtedness to a Canadian chartered bank;

(ii) an assignment to the spouse, issue (whether natural born or adopted)

and/or the personal representative or representatives of the Employee;

(iii) an assignment to a private limited company in which:

(I) all the issued-shares of the Employee's company are held, otherwise than by way of security only, exclusively by or for the benefit of the Employee and/or the personal representative or representatives of the Employee and/or the issue (whether natural born or adopted) or spouse of the Employee and the Company shall have received a certificate signed by the Employee and by the President or a Vice President and the Secretary of the Employee's company certifying as to the compliance with the provisions of this subclause (I);

(II) a majority of the voting shares of the Employee's company are held, otherwise than by way of security only, exclusively by or for the benefit of the Employee and/or the personal representative or representatives of the Employee;

(III) each holder of any share or shares of the Employee's company has delivered an undertaking in writing to the Company that he or she will not sell, transfer, assign or otherwise alienate all or part of his or her shares of the Employee's company nor permit the Employee's company to allot or issue any of its share other than to one or more of the persons referred to in subclause (Il) above or with the consent in writing of the Company.

(b) In the event the Employee's employment with the Company is terminated as a result of the death of the Employee:

(i) within one year from the date of the Employee's death, the personal representative of the Estate of the Employee may give written notice to the Company requiring the Company to purchase from the Estate of the Employee the net profits interest hereinbefore granted;

(ii) promptly upon receipt of the aforesaid notice, the Company shall request its auditors to engage the appropriate expert evaluators, as selected by such auditors, to determine the current market cash value of the Employee's net profits interest;

(iii) forthwith upon such determination and upon good and sufficient conveyances of such net profits interest in favor of the Company, such conveyances to be ina form acceptable to the Company, it shall pay to the personal representative of the Employee's Estate such sum so determined as hereinbefore provided, such payment to be made in cash unless the personal representative of the Employee's Estate requests that the payment be made over a term of years whereupon such payment shall be made over such time and in such installments and subject to such other terms as the Company and the Employee's personal representative may mutually agree upon.

(c) Subject to the provisions of subclause (b) hereof, if at any time after termination of the Employee's employment with the Company, the Employee, his heirs, executors, administrators, or permitted successors and assigns, (the "Seller") wishes to assign, sell or dispose of or has received an offer which he is willing to accept for the assignment, sale or disposition of all or part of his interest in all or part of the net profits interest, (the "Subject Interest"), the Seller shall give notice thereof to the Company. The Seller's notice shall contain the terms and conditions of the proposed assignment, sale or disposition, including the consideration to be received for the Subject Interest and, if applicable, the name of the offering party. The Company shall have the right for a period of twenty (20) days after receipt of the notice from the Seller (the “Notice Period") to elect in writing to acquire the Subject Interest from the Seller on the terms and conditions contained in the notice. If the Company elects to acquire the Subject Interest, it shall be obligated to acquire the Subject Interest in its entirety. If the Company declines or fails to elect within the Notice Period to acquire the Subject Interest, the Seller shall be free for a period of sixty (60) days next following the expiry of the Notice Period to assign, sell or dispose of the Subject Interest on the terms and conditions and to the offering party (if applicable) stipulated in his offer, but not after the said sixty

(60) day period, nor otherwise than as so stipulated without again complying with this clause.

If the consideration stipulated in the offer for the Subject Interest is one which cannot be matched in kind by the Company, the Seller may set out in his notice his bona fide estimate of the value in cash of the said consideration. If the Seller's notice did not include his bona fide estimate as aforesaid, the Company may request such estimate in which event the Notice Period shall be suspended until such estimate is received by the Company. In case of dispute as to the reasonableness of the estimate, the matter shall be referred to arbitration under the provisions of the Arbitration Act of Alberta, but the Notice Period shall not be extended by such referral to the dispute to arbitration. If the equivalent cash consideration determined by the arbitration is lower than the estimate submitted by the Seller, the cash consideration determined by arbitration shall be the sale price for the Subject Interest and the accounts of the Seller and the Company shall be adjusted accordingly. If the equivalent cash consideration determined by arbitration is higher than the estimate submitted by the Seller, the estimate submitted by the Seller shall be the sale price for the Subject Interest.

7. NATURE OF NET PROFITS INTEREST

It is expressly understood and agreed that the net profits interest hereinbefore granted is in the nature of a discretionary payment only and under no circumstances whatsoever is it to be treated as part of the salary, wage or other regular employment income of the Participant.

8. TERM

This agreement shall terminate upon the expiry of one (1) year from the date hereof or upon the termination of the employment of the Employee, whichever first occurs, and upon termination, each of the parties hereto shall be released from all obligations hereunder except those that have accrued prior to termination.

9, GENERAL

(a) Subject to the restrictions herein contained, this agreement shall enure to the benefit of and be binding upon the parties hereto and their respective successors and assigns;

(b) For the purposes of this agreement and in the determination of whether an oil and gas property has been acquired during the term hereof, such determination shall be made in the sole discretion of the Company;

(c) Each of the parties hereto shall from time to time and at all times hereafter do such further acts and execute and deliver all such further deeds and documents as shall be reasonably required in order to fully perform and carry out the terms of this agreement.

IN WITNESS WHEREOF the parties hereto have executed or caused this agreement to be executed as of the day and year first above written.

MERLAND EXPLORATIONS LIMITED PER: PER:

MERLAND RESOURCES INC. PER: PER:

MERLAND OIL&GAS, INC. PER: PER:

SIGNED, SEALED AND DELIVERED

IN THE PRESENCE OF:

ALLAN P. MARKIN

3.03 The letter dated January 25, 1982, sent to Merland by the appellant requiring the purchase of his rights, reads as follows:

I hereby give notice to Merland Explorations Limited (the "Company") requiring the Company to purchase from the undersigned the percentage share of the undersigned's net profits interests established pursuant to Agreements between the undersigned and the Company together with amending agreements thereto as follows:

January 1, 1978 - 100%

January 1, 1979 - 100%

January 1, 1980 - 80%

Yours very truly, Allan P. Markin

For those three years, the amount of the rights totalled approximately $305,000. The difference of approximately $85,000 ($389,760 - $305,000) applies to the 1981 fund of which a 60 per cent interest was purchased.

4. Law - Cases at Law - Analysis

4.01 Law

The main provisions of the Act involved in the present case are section 3, subsections 59(1.2) and 59(3.2), paragraphs 66.4(1)(a) and (b), subparagraphs 66(15)(c)(iv) and (vii), paragraphs 66.2(1)(a) and (b), and subparagraphs 66.2(5)(b)(iv) to (xii), 66.4(5)(b)(iv) to (viii). They shall be quoted in the analysis if required.

However, for the purpose of clarifying the legal point of view, counsel for the parties filed the following document entitled “Disposition of a Net Profits Interest", which refers to the provisions involved:

4.02 Cases at Law

Counsel for the parties referred the Court to the following cases at law:

1. Abbott v. Philbin, [1961] A.C. 352; [1959] 2 All E.R. 268; [1960] 2 All E.R. 763;

2. Hochstrasser v. Mayes, [1960] A.C. 376; [1959] 3 All E.R. 817;

3. Hurd v. The Queen, [1981] C.T.C. 209; 81 D.T.C. 5140 (F.C.A.);

4. Phaneuf Estate v. The Queen, [1978] C.T.C. 21; 78 D.T.C. 6001 (F.C.T.D.);

5. Ransom v. M.N.R., [1968] 1 Ex. C.R. 293; [1967] C.T.C. 346; 67 D.T.C. 5235;

6. Kirkby v. M.N.R., [1972] C.T.C. 2101; 72 D.T.C. 1109 (T.R.B.);

7. Laperrière v. M.N.R., [1984] C.T.C. 2829; 84 D.T.C. 1650 (T.C.C.);

8. Richstone v. M.N.R., [1972] C.T.C. 265; 72 D.T.C. 6232 (F.C.T.D.);

9. B & B Royalties Ltd. v. M.N.R., [1940] Ex. C.R. 90; [1940-41] C.T.C. 65; 1 D.T.C. 499-106;

10. Canpar Holdings Ltd. v. The Government of Saskatchewan, Court of Queen's Bench, Q.B.M. No. 796, pp. 1-20;

11. Harrington and Bibler Ltd. v. M.N.R., 42 Tax A.B.C. 374; 67 D.T.C. 1 (T.A.B.);

12. M.N.R. v. Wain-Town Gas and Oil Company Limited, [1952] 2 S.C.R. 377; [1952] C.T.C. 147; 52 D.T.C. 1138;

13. McDougall Ross v. M.N.R., [1950] Ex. C.R. 411; [1950] C.T.C. 169; 4 D.T.C. 775;

14. St. Lawrence Petroleum Limited, T. W. Bennett & al. v. Bailey Sel burn Oil & Gas Ltd. & al., [1963] S.C.R. 482;

15. Saskatchewan Minerals v. Keyes, [1972] 2 W.W.R. 108;

16. Johnston Testers v. M.N.R., [1965] C.T.C. 116; 65 D.T.C. 5069;

17. Vauban Productions v. The Queen, [1979] C.T.C. 262; 79 D.T.C. 5186 (F.C.T.D.);

18. M.N.R. v. Bartlett, [1972] C.T.C. 333; 72 D.T.C. 6293 (F.C.A.);

19. Mr. R. v. M.N.R., 2 Tax A.B.C. 364; 50 D.T.C. 398, (T.A.B.);

20. Technical Tape Corp. v. M.N.R., 35 Tax A.B.C. 389; 64 D.T.C. 428 (T.A.B.);

21. LaRue v. M.N.R., 32 Tax A.B.C. 281; 63 D.T.C. 553 (T.A.B.);

22. Louisiana Land v. Donnelly, 394 F.(2d) 273 (U.S.C.A. 5th);

23. Kirby Petroleum v. Commissioners of Internal Revenue, 326 U.S. 599 (U.S.S. Ct.);

24. Burton-Sutton Oil v. Commissioners of Internal Revenue, 328 U.S. 369 (U.S.S. Ct.);

25. Helvering v. O'Donnell, 303 U.S. 369 (U.S.S. Ct.);

26. Kanten v. M.N.R., [1985] 2 C.T.C. 2251; 85 D.T.C. 575 (T.C.C.);

27. Fowler v. M.N.R., 32 Tax A.B.C. 353; 63 D.T.C. 600 (T.A.B.);

28. Goldman v. M.N.R., [1953] 1 S.C.R. 211; [1953] C.T.C. 95; 53 D.T.C. 1096 (S.C.C.);

29. Kulka v. M.N.R., [1979] C.T.C. 2989; 79 D.T.C. 812 (T.A.B.);

30. Greiner v. The Queen, [1984] C.T.C. 92; 84 D.T.C. 6073 (F.C.A.).

4.03 Analysis

4.03.1 In paragraphs 8 and 9 of the reply to notice of appeal, counsel for the respondent gives the submissions of his client. These paragraphs read as follows:

8. He submits that in his 1982 taxation year, the Appellant received $389,760 on the disposition of a net profits interest which was a Canadian resource property or a right to or interest in a Canadian resource property as defined by paragraph 66(15)(c) of the Act and that, accordingly, was properly included by the Respondent in the Appellant's income pursuant to section 59(3.2)(c).

9. In the alternative, he submits that the $389,760 received by the Appellant was a benefit received or enjoyed by the Appellant in respect of or by virtue of his office or employment or was on account or in lieu of payment of, or in satisfaction of, an obligation arising out of an agreement made by Merland with the Appellant during a period that the Appellant was in the employment of Merland within the meaning of subsections 6(1 )(a) or 6(3) of the Act and was not proceeds from the disposition of a right in the nature of a capital asset.

4.03.2 Counsel for the appellant submits that the disposition of his client's rights can result only in a capital gain because the respondent's two submissions cannot stand.

4.03.3 The respondent's alternative submission cannot stand, according to the appellant, because if there is an advantage received from the employ- ment, it is first pursuant to paragraph 6(1)(a) of the Act. This paragraph reads as follows:

6. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from an office or employment such of the following amounts as are applicable:

(a) the value of board, lodging and other benefits of any kind whatever received or enjoyed by him in the year in respect of, in the course of, or by virtue of an office or employment, except any benefit

Pursuant to this provision, the benefit is taxable during the year it was received. In the present case, counsel for the appellant says the benefit was received each year the agreement was in force, that is in 1978, 1979, 1980 and 1981 when Merland granted the interest in the fund.

However, the year under appeal is 1982. To support his opinion, counsel for the appellant referred to the Abbott v. Philbin case (para. 4.02(1)). In that case, in 1954, the taxpayer received a stock option from his employer. He purchased it at a lower price than the fair market value. In 1956, he exercised this stock option and made a substantial profit. This profit was included in his income as employment income. The House of Lords said that if there was a benefit from employment, it occurred in 1954 when the property was given to the employee and not in 1956 when he sold this property with profit.

Counsel for the appellant also referred to the Hochstrasser case (para. 4.02(2)), to the Phaneuf case (para. 4.02(4)), and to the Ransom case (para. 4.02(5)). The courts all stand for the proposition that payments made by an employer to an employee do not necessarily constitute employment income.

4.03.4 The respondent's alternative pleading (para. 4.03.1(9)) also refers to subsection 6(3) of the Act to conclude that the profit resulting from the disposition of the appellant's rights constitutes employment income. This subsection reads as follows:

6. (3) An amount received by one person from another

(a) during a period while the payee was an officer of, or in the employment of, the payer, or

(b) on account or in lieu of payment of, or in satisfaction of, an obligation arising out of an agreement made by the payer with the payee immediately prior to, during or immediately after a period that the payee was an officer of, or in the employment of, the payer, shall be deemed, for the purposes of section 5, to be remuneration for the payee's services rendered as an officer or during the period of employment, unless it is established that, irrespective of when the agreement, if any, under which the amount was received was made or the form or legal effect thereof, it cannot reasonably be regarded as having been received

(c) as consideration or partial consideration for accepting the office or entering into the contract of employment,

(d) as remuneration or partial remuneration for services as an officer or under the contract of employment, or

(e) in consideration or partial consideration for a covenant with reference to what the officer or employee is, or is not, to do before or after the termination of the employment.

Counsel for the appellant contended that in the present case, "the amount received was based on a valuation of the appellant's interest in the fund, or in consideration for a covenant with reference to what the officer or employee is, or is not, to do before or after the termination of the employment. No evidence of that in any of the agreement" (TS, p. 22).

Counsel for the appellant then referred to the Laperrière case (para. 4.02(7)) and to the Richstone case (para. 4.02(8)). “In neither case", he said, "was the payment, which was properly referable to the surrender of property, included under 6(3)" (TS, p. 22).

4.03.5 In his submission, counsel for the respondent mainly based his contention on paragraphs 6(3)(b) and (d) of the Act to the effect that the amount of $389,760 was received in satisfaction of an obligation arising out of the agreement made by Merland to the appellant during the period that the appellant was in the employment of Merland.

4.03.5(1) Moreover, counsel for the respondent referred to a few cases at law.

The facts of the Kanten decision (para. 4.02(26)) rendered by Taylor T.C.J. of the Tax Court of Canada are summarized as follows at page 575 D.T.C.:

The taxpayer, while employed by Texas Gulf Inc., became entitled to a number of shares in the company under its ''Career Incentive Stock Plan”. In 1981 Texas Gulf was merged with another company and, as a result, it became impossible for the company to deliver the shares promised to its employees. In lieu thereof, the company paid its employees in cash the fair market value of the shares to which the employee was entitled at the time of the merger. The Minister included the amount so received by the taxpayer in his income and the taxpayer appealed to the Tax Court of Canada, contending that the amount should be treated as non-taxable damages for breach of contract.

Held: The taxpayer's appeal was dismissed. The Court found that the amount in issue was properly assessed as income from employment. The offer by the employer and the acceptance by the taxpayer of that amount was by virtue of his participation in the Plan, which Plan was open only to employees of the company on account of that employment.

In his conclusion, Taylor T.C.J. says at page 2256 (D.T.C. 579):

In the instant case, because the compensation received by Mr. Kanten took the form of money as opposed to shares of equivalent value, did not alter the fact that the basis for the obligation to pay anything, rested in the employment contract of the appellant.

4.03.5(2) The facts of the Goldman decision (para. 4.02(28)) are summarized as follows at pages 1096-97 D.T.C.:

Appellant was chairman of a shareholder's protection committee formed on the reorganization of a company which was in receivership. The appellant secured the appointment of B as the committee's legal counsel. B agreed to split with the appellant his counsel fee to be received from the company. The Minister added this amount received to the appellant's taxable income. The appellant contended that this amount was a gift from the counsel. The Minister's assessment was upheld in appeals to the Income Tax Appeal Board (50 D.T.C. 238) and the Exchequer Court (51 D.T.C. 519).

Held, that the appeal is dismissed. There is no doubt that both the appellant and the counsel intended that the money be paid to the appellant for services rendered as chairman of the committee. The counsel was a mere “conduit pipe" between the company and the appellant.

4.03.6 In my opinion, pursuant to the evidence adduced, the agreements involved in this appeal were made during a period that the appellant was in the employment of Merland. The appellant, indeed, had been working for Merland from 1975 to 1982 (para. 3.01(2)) and the agreements were made from 1978 through 1981.

Moreover, the second paragraph of the preamble of the agreement seems to me very significant of the employer-employee relationship. I quote:

Whereas as an incentive to the employee, the company has agreed to grant to the employees a net profits interest in respect of the oil and gas properties upon the terms and conditions hereinafter provided.

[Emphasis is mine.]

However, paragraph 7 of the agreement is not significant to determine whether the net profit is taxable as an employment income or not pursuant to the Act. This paragraph reads as follows:

7. Nature of Net Profits Interest

It is expressly understood and agreed that the net profits interest hereinbefore granted is in the nature of a discretionary payment only and under no circumstances whatsoever is it to be treated as part of the salary, wage or other regular employment income of the Participant.

It is the substance of the facts and the wording of the provisions of the Act which determine the yardstick of the nature of an income and not, above all, the wording of an agreement between two taxpayers. If, in a certain sense, the payment was not" . . . wage or regular employment income", it was still an income from employment.

4.03.7 However, the second problem is whether the amount is taxable in 1982 when the appellant received the amount or during each year 1978, 1979, 1980 and 1981 when Merland granted the interest in the fund.

Although it is provided in subparagraph 3(e) of the agreement quoted above (para. 3.02.1) that payment be made by Merland about every month to the appellant, of the “percentage share of any credit balance in the joint account”, it seems that no payment was made. It was up to Merland to decide to pay the percentage. The amount of $389,760 was the sole amount paid to the appellant.

However, at the end of each year 1978, 1979, 1980 and 1981, the appellant's right had a value. Paragraph 3(f) of the agreement is clear and it reads as follows:

The joint account shall be audited annually by the Company's auditors on each anniversary date of this agreement and the Employee shall be provided with a copy of their report in respect thereto;

One can say that the said right at the end of 1978, for instance, was an asset on the appellant's balance sheet and a liability on Merland's balance sheet. But it was not available to the appellant because, once again, in practice, it was up to Merland to decide to pay the percentage.

However, the amendment to the agreement made on December 1, 1981 enlarged the previous right of the appellant (see para. 7 of the agreed statement of facts, quoted at para. 3.01). From the said amendment, indeed, the appellant had the right to require Merland to purchase his right in the funds in the circumstances of the termination of the appellant's employment with Merland.

This amendment of the agreement made on December 1, 1981 deleted former clause 6 of the agreement. Subclause (b) of the new clause 6 reads as follows:

(b) At any time during employment with the Company or within three (3) years from the date of termination of such employment, the Employee, his heirs, executors, administrators or permitted successors and assigns (collectively called the "Employee"):

(i) may give written notice to the Company requiring the Company to purchase from the Employee the below described portion of the net profits interest hereinbefore granted, namely:

(1) if such notice is given between one (1) year and two (2) years after the date of this Agreement, a sixty (60%) percent share of such net profits interest;

(2) if such notice is given between two (2) years and three (3) years after the date of this Agreement, an eighty (80%) percent share of such net profits interest, that is, an additional twenty (20%) percent share; and

(3) if such notice is given three (3) years or later after the date of this Agreement, a one hundred (100%) percent share of such net profits interest, that is, an additional twenty (20%) percent share;

(ii) promptly upon receipt of the aforesaid notice, the Company shall request its auditors to engage the appropriate expert evaluators, as selected by such auditors, to determine the current market cash value of that portion of the Employee's net profits interest then being purchased;

(iii) forthwith upon such determination and upon good and sufficient conveyances of the purchased portion of the net profits interests in favor of the Company, such conveyances to be in a form acceptable to the Company, it shall pay to the Employee such sum so determined as hereinbefore provided, such payment to be made in cash unless the Employee requests that the payment be made over a term of years whereupon such payment shall be made over such time and in such instalments and subject to such other terms as the Company and the Employee may mutually agree upon.

The appellant's letter to Merland on January 25, 1982, (para. 3.03) is based on this amendment. It is obvious that a valuation of the appellant's right to the funds of the different years 1978, 1979, 1980 and 1981 was calculated as provided in the new subclauses 6(b)(ii) and (iii). As I see it, it is not the same value as at the end of each year.

At first glance, the difference between the two values should be considered as capital gain taxable in the year it was received, in 1982. However, the first value, i.e. the value of each fund at the end of each year, should be included in the income of each year as employment income. That is the contention of counsel for the appellant in referring to the Abbott v. Philbin case (para. 4.02(1)) summarized at paragraph 4.03.3.

In the said British case, the right involved concerned a stock option offered by the employer and paid at a lower price than the fair market value by the employee.

A recent decision, /.S. Robertson v. The Queen, [1988] 1 C.T.C. 111; 88 D.T.C. 6071, delivered by Dubé J. of the Federal Court, Trial Division, has a certain similarity with the Abbott v. Philbin case, except that the option price paid by the taxpayer was equivalent to the fair market value. The facts and the decision are summarized as follows at page 6071 D.T.C.:

The taxpayer was employed by an individual as a ranch manager. In 1974, the employer granted an option to the taxpayer to purchase shares of a certain company of which the employer was president. The option price was equivalent to or greater than the fair market value of the shares at the time the option was granted. The taxpayer exercised his option in 1980, at which time the fair market value of the shares exceeded the purchase price by $235,500. The Minister included this amount in the taxpayer's income as a benefit from employment pursuant to s. 6(1)(a) of the Act. The taxpayer appealed to the Federal Court - Trial Division, contending that the only provision in the Act which had the effect of including stock option benefits in employment income was s. 7(1)(a) and that this provision was inapplicable because the taxpayer's employer was not a corporation. The taxpayer also submitted that even if s. 6(1)(a) was applicable, then the value of any benefit obtained by him should have been included in his income in the taxation year in which the option was granted and not in the taxation year in which it was exercised.

Held: The taxpayer's appeal was dismissed. The Court found that he had received a benefit “in respect of" his employment in 1980 when the option was exercised. In 1974, the taxpayer received only an expectation of making a profit. That profit accrued to the taxpayer only when he exercised the option.

In the present case, the appellant, an employee, did not have an option but was waiting for the payment of that benefit. It is only with the amendment to the agreement on December 1, 1981, that the appellant had the right to require Merland to purchase his rights. Until that time, the appellant, who is an employee having an income taxable on the cash basis, could not be taxed for a benefit not yet received. It is only when he received payment for his rights in the funds, after requiring Merland to purchase them, that this employment income became taxable.

Therefore, I would dismiss the appeal on this respect.

However, despite this conclusion, it does not hurt to see the basis of the reassessment in paragraph 66(15)(c) of the Act.

4.03.8 The main contention of the respondent is that the $389,760 was a Canadian resource property (para. 4.03.1(8)) as described in paragraph 66(15)(c) of the Act. Counsel for the respondent agrees that only subparagraphs (iv) and (vii) are in dispute. They read as follows:

66.(15) . ..

(c) “Canadian resource property" of a taxpayer means any property acquired by him after 1971 that is

(iv) any rental or royalty computed by reference to the amount or value of production from an oil or gas well in Canada, .. . .

(vii) any right to or interest in any property (other than property of a trust) described in any of subparagraphs (i) to (vi) (including a right to receive proceeds of disposition in respect of a disposition thereof);

It is admitted that in the present case, the crux of the matter is whether the appellant received a "royalty" pursuant to subparagraph (iv) or "any right to" or “interest in” pursuant to subparagraph (vii).

4.03.9 After reading the numerous cases at law referred to by counsel for the parties concerning the definition of “royalty”, it is obvious that one of the main elements of the royalty in reference to mines and wells is that the person who receives the royalty must be the owner of the properties: mines or wells. Moreover, the royalty varies in amount according to the production.

In the present case, the appellant's rights in the fund created by Merland pursuant to the agreement does not give the appellant a right in the oil and gas wells. Merland owns those rights but not the appellant.

The fact that the net profit of oil and gas wells production is used as a yardstick in the accumulation of the fund is not sufficient to meet the wording of subparagraph 66(15)(c)(iv) of the Act and make the payment a royalty.

4.03.10 The American case at law, Helvering v. O'Donnell (para. 4.02(25)), has a certain similarity with the present case and confirms my point of view.

Counsel for the respondent was very honest in referring to that case, although he knew that it favoured the appellant's thesis.

In the said decision, there was no lessor-lessee relationship. Pages 371 and 372 read as follows:

Mr. Chief Justice Hughes delivered the opinion of the Court.

Respondent, Thomas A. O’Donnell, owned one-third of the capital stock of the San Gabriel Petroleum Company. By contract of January 9, 1918, he sold this stock to the Petroleum Midway Company, Ltd. As consideration, the Midway Company agreed to pay to respondent one-third of the net profits from the developments and operation of the oil and gas properties then owned by the San Gabriel Company and which the Midway Company agreed to acquire. That acquisition was made, the properties thus acquired were developed and operated, and one-third of the net profits thus derived were paid to respondent to August 4, 1926. With respect to such payments in the years 1925 and 1926, respondent claimed deduction for depletion, which the Board of Tax Appeals allowed, overruling the Commissioner of Internal Revenue. 32 B.T.A. 1277. The Circuit Court of Appeals affirmed the decision of the Board. 90 F. (2d) 907. We granted certiorari. 302 U.S. 676, ante, 522, 58 S. Ct. 121. See Helvering v. Bankline Oil Co. decided this day (303 U.S. 362, ante, 897, 58 S. Ct. 616).

The question is whether respondent had an interest, that Is, a capital investment, in the oil and gas in place. Revenue Act of (February 26), 1926, s. 204 (c) (2); s. 214

(a) (9) (44 Stat. at L. 9, 27, chap. 27, 26 U.S.C.A. (1934 ed.) s. 113); Palmer v. Bender, 287 U.S. 551, 557, 77 L. ed. 489, 493, 53 S. Ct. 225; Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312, 321, 79 L. ed. 383, 388, 55 S. Ct. 174; Thomas v. Perkins, 301 U.S. 655, 661, 81 L. ed. 1324, 1328, 57 S. Ct. 911; Helvering v. Bankline Oil Co. 303 U.S. 362, ante, 897, 58 S. Ct. 616, supra. As a mere owner of shares in the San Gabriel Company, respondent had no such interest. Treasury Regulations No. 69, Art. 201. The ownership of the oil and gas properties was in the corporation. When the Midway Company acquired these properties from the San Gabriel Company and operated them, the Midway Company became the owner of the oil and gas produced. It was the owner of the gross proceeds or income upon which the statutory allowance for depletion was to be computed. Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312, 79 L. ed. 383, 55 S. Ct. 174, supra. The agreement to pay respondent one-third of the net profits derived from the development and operation of the properties was a personal covenant and did not purport to grant respondent an interest in the properties themselves. If there were no net profits, nothing would be payable to him. No trust was declared by which respondent could claim an equitable interest in the res. As consideration for the sale of his stock in the San Gabriel Company respondent bargained for and obtained an economic advantage from the Midway Company's operations but that advantage or profit did not constitute a depletable interest in the oil and gas in place. Palmer v. Bender, 287 U.S. 551, 77 L. ed. 489, 53 S. Ct. 225, supra; Helvering v. Bankline Oil Co. 303 U.S. 362, ante, 897, 58 S. Ct. 616.

The judgment of the Circuit Court of Appeals is reversed and the cause is remanded for further proceedings in conformity with this opinion.

Reversed. [Emphasis is mine.]

4.03.11 Concerning subparagraph 66(15)(c)(vii) quoted above (para. 4.03.8), one may contend that the words "interest in" are broad enough to include the appellant's right in the fund. I do not share that opinion. In my view, "interest" means “financial interest". It comes from the ownership in any property described in any subparagraphs (i) to (vi).

In my opinion, "property", in the present case, means wells. The appellant has no right in them. If "property" means “royalty”, there is no interest because there is no royalty in the present case.

Moreover, I state that the word "interest" is absent in the French version of the Act. The beginning of the two texts, indeed, reads as follows:

any right to or interest in any property . . .

tout droit afférent à un bien . . .

This is only a statement of fact. This lack in the French version has no particular consequence in the present case because of the conclusion I have already reached that the respondent's contention concerning paragraph 66(15)(c) cannot be retained.

4.03.12 Despite this last conclusion, as the amount of $389,760 was an employment income taxable in 1982 (para. 4.03.7), the reassessment must be maintained.

5. Conclusion

For the reasons given above, the appeal is dismissed.

Appeal dismissed.