Edmonton Liquid Gas Limited v. Her Majesty the Queen, [1981] CTC 223, 81 DTC 5162

Maguire, D J:—Trial of this action came before me at Calgary, Alberta, on September 7, 1980. On conclusion of the trial, counsel for the plaintiff applied for and was granted leave to file a written argument covering the written and oral argument of counsel for the defendant.

Subsequent to the filing of plaintiff’s written argument and defendant’s reply thereto, plaintiff’s counsel requested permission to file a further reply by reason of alleged new arguments submitted by defendant in its reply.

The issues involved in this litigation are of some major importance and difficulty. In view thereof I granted the unusual permission of a further reply by plaintiff. All this has resulted in the lapse of considerable time. An agreed statement of facts covering almost all facts was filed as Exhibit P.1 with accompanying documents Appendix 1-6 marked as Exhibit P.2.

For the purpose of ready reference I set forth these agreed facts.

Statement of Facts

The parties have agreed to the following facts, (in addition to any other facts that may be adduced at trial).

(1) the plaintiff is a Canadian Corporation registered and carrying on business in the Province of Alberta and elsewhere, and is an affiliate of Dome Petroleum Limited (“Dome”).

(2) Dome entered into a letter agreement (“the Farmout Agreement”) with Gulf Oil Limited (“Gulf”) and Mobil Oil Canada Ltd. (“Mobil”) whereby Dome would cause to have drilled at its sole cost, risk and expense, an exploration well (“the Red Fox P21 Well”) under Northwest Territories Permit No 1652, in order to earn an undivided 33 working interest in the petroleum and natural gas rights, subject to the said Permit (“the Farmout Lands”). Attached hereto and marked as Appendix 1 is a copy of the said Farmout Agreement.

(3) It was a term of the Farmout Agreement, dated December 23, 1974, that Dome would, and did, pay to Gulf the sum of $3,800 no later than December 31, 1974, In payment for the costs of the well to be drilled.

(4) The plaintiff, together with other participants, being Steelgas Ltd. and Steelman Gas Ltd., entered into an Agreement (“the Participation Agreement”) with Dome, dated December 23, 1974, whereby Dome agreed to hold its interest under the said Farmout Agreement, and a drilling agreement to be negotiated, for the plaintiff as to an undivided 1272% interest, and other participants. Attached hereto and marked as Appendix 2 is a copy of the said Participation Agreement.

(5) Dome entered into an Agreement (“the Drilling Agreement”) with Gulf, dated December 31, 1974, whereby Gulf agreed to supply the rig and related facilities and services for the drilling of the well and supervise the drilling for the sum of $3,800,000. Attached hereto and marked as Appendix 3 is a copy of the said Drilling Agreement.

(6) The actual drilling of the said well commenced January 5, 1975, and drilling was completed on May 9, 1975, and subsequently the well was abandoned as a “dry hole”, incapable of commercial or any production. Further, no actual drilling was done under the said Farmout Agreement during the 1974 taxation year of the plaintiff, which taxation year coincided with the calendar year.

(7) For the purpose of computing its income for the 1974 taxation year, the plaintiff included in the computation of its Canadian exploration expense the sum of $475,000, which represented its share of the cost of such drilling of the said well.

(8) Dome further entered into a letter agreement (“the Alberta Farmout Agreement”) dated December 3, 1974, with Western Decalta Petroleum Limited and Pan Ocean Oil Ltd. whereby Dome would cause to have drilled an exploration well (“the Test Well”) under Alberta Crown Petroleum and Natural Gas Leases 103276 and 103278 to earn a working interest in the petroleum and natural gas rights. Attached hereto and marked as Appendix 4 is a copy of the said Alberta Farmout Agreement.

(9) The plaintiff, together with Steelman Gas Limited, entered into an agreement (“the Alberta Participation Agreement”) with Dome, dated December 3, 1974, whereby Dome agreed to hold its interest under the said Alberta Farmout Agreement, and an agreement with Czar Petroleum Resources Ltd., for the plaintiff as to an undivided 50% interest, and for Steelman Gas Limited as to an undivided 50% interest. Attached hereto and marked as Appendix 5 is a copy of the said Alberta Participation Agreement.

(10) Dome entered into an agreement (“the Alberta Drilling Agreement”) with Regent Drilling Ltd. (“Regent”), dated December 18, 1974, whereby Regent agreed to supply the rig and related facilities and services for the drilling of the well for the sum of $460,000, which was paid by Dome on December 24, 1974. Attached hereto and marked as Appendix 6 is a copy of the said Alberta Drilling Agreement.

(11) The actual drilling of the said well commenced December 18, 1974, and drilling was completed on March 15, 1975, when, at a depth of 11,250 feet, the well was abandoned as a “dry hole”, incapable of commercial, or any production. Further, the depth reached at 11:59 p.m. December 31, 1974, was 4,040 feet.

(12) For the purposes of computing its income for the 1974 taxation year, the plaintiff included in the computation of its Canadian exploration expense the sum of $230,00, which represented its share of the cost of such drilling of the said well.

(13) On the basis of the number of feet actually drilled in 1974 and 1975 respectively, of the said sum of $230,000, the sum of $82,595 is attributable to the actual drilling done in 1974 and the balance of $147,405 is attributable to the actual drilling done in 1975.

(14) In computing its income for the 1974 taxation year, the plaintiff deducted in respect of its cumulative Canadian exploration expense the amount of $673,554.

(15) On April 17, 1978, the Minister of National Revenue reassessed the plaintiff in respect of the 1974 taxation year and with respect to the said sum of $673,554, disallowed the deduction by the plaintiff of the amounts of $475,000 and $147,405 respectively, inter alia, on the basis, that these amounts related to actual drilling done during the 1975 taxation year and not during the 1974 taxation year.

Plaintiff is a subsidiary or an affiliated company of Dome Petroleum Limited (Dome). Dome kept all records of this subsidiary and performed all required business matters on its behalf. The name Dome appears throughout the record and documents. This must be understood as being applicable to plaintiff in respect to its percentage interest in the two undertakings and contracts relative thereto, entered into by Dome and giving rise to the matters in issue.

Dome also entered into the two contracts here involved on behalf of participating companies Steelgas Limited and Steelman Gas Limited. See Participation Agreement P2, Appendix 2.

It is not disputed that the burden of proof, challenging the assumptions of the Minister of National Revenue (the Minister), or one or more thereof, or that if the assumptions were justified, they do not of themselves support the assessments made against plaintiff, rests upon the plaintiff.

The issues involved concern two undertakings entered into by Dome, in part for and on behalf of plaintiff in respect to “the Red Fox P21 Well”, agreed facts Nos 2, 3, 4 and 5) and the “Regent” well (agreed facts 8, 9 and 10).

Plaintiff’s expenditures in respect to the drilling, etc., of these two wells were respectively $475,000 and $230,000 (agreed facts 7 and 12). Payment of the said sum of $475,000 was made by Dome on December 31, 1974, and said sum of $230,000 on December 24, 1974.

Drilling of the Red Fox well commenced January 5, 1975, and of Regent on December 18, 1974.

No drilling on “Red Fox” well took place in 1974. Drilling on “Regent” commenced December 18, 1974, and an allowance or deduction was allowed as exploration expense based on days drilled in 1974 in relation to total drilling time. No issue arises on the correct allowance as so computed.

The Minister raises no issue re the claim for deductions as Canadian Exploration expense save in respect to the year or years such are allowed as deductions. No other section of the Income Tax Act is brought in issue.

In other words the Minister admits that the deduction re Red Fox well is available for the taxation year 1975, and that in respect to the Regent well, deduction of the actual expenditure in 1974 was allowed, the balance being available as a deduction in 1975.

I first consider the relief claimed in respect to the “Red Fox” well.

Pursuant to contracts later referred to in detail, Dome, for three subsidiary corporations, including the plaintiff, paid to Gulf Oil Canada Limited (Gulf) on December 31, 1974, for the projected Red Fox well, the sum of $3,800,000. Plaintiff’s contribution to this total sum was $475,000. Participation agreement, Appendix 2 P2.

Plaintiff, in its 1974 income tax return, claimed this expenditure as a “Canadian Exploration Expense” under the provisions of subparagraph 66.1 (6)(a)(i) of the Income Tax Act. The Minister of National Revenue disallowed the deductions as available to plaintiff for the year 1974. Appeal from that disallowance is one of the issues in this litigation.

Briefly stated the position taken by the parties is:

1. Plaintiff contends that this expenditure comes within subsection 66.1 (6)(a)(i) of the Act, or, in the alternative, within said subparagraph 66.1 (6)(a)(ii), and in either event is a deductible expense incurred in the year 1974.

2. Defendant contends the expenditure comes within the latter subsection and is available as a deduction only for the taxation year 1975.

Plaintiff’s taxation year is the calendar year.

The first agreement, termed a letter agreement, is Appendix 1 to Exhibit P2 filed, is addressed to Dome by Gulf and Mobil Oil Canada Ltd. It is termed a “Farmout” agreement to Dome. Clause 2 of this agreement, in part, reads:

1. Dome will be operator during the drilling of the test well, provided that Dome undertakes, upon the acceptance of this letter agreement by Dome, to execute an agency agreement whereby Gulf is appointed operator on Dome’s behalf for the drilling of the test well.

Clause 3 of said letter agreement, in part reads:

Dome agrees that no later than December 31, 1974, Dome shall pay to Gulf the sum of Three Million Eight Hundred Thousand Dollars ($3,800,000). Such payment shall be applied by Gulf to the costs of the drilling of the test well and for standby time to the next drilling season.

The evidence of the witness Forseth is that an initial letter agreement is common in the oil exploration, etc., business and that a formal agreement is later entered into.

The formal agreement here is Appendix 3 of Exhibit P2. This bears date of December 31, 1974, but the evidence is that it was executed at a later unspecified date.

Plaintiff intends that its expenditure of $475,000 is a Canadian exploration expense within subparagraph 66.1 (6)(a)(i), which reads:

any expense including a geological, geophysical or geochemical expense incurred by him (other than an expense referred to in subparagraph (ii) ) 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.

The letter agreement, followed by the formal agreement, provide for the drilling of a “test well”. This term cannot be interpreted as defining solely a purpose within said subparagraph (i).

Paragraph 4(b) of the letter agreement in referring to completion “including the well head” establishes the intent and hope of the parties that the test well would become a productive oil or gas well.

Following careful consideration of the evidence and all able arguments submitted by both counsel, I must conclude that subparagraph 66.1 (6)(a)(i) is not here applicable, but that subparagraph (ii) applies. This finding excludes subparagraph (i) by the exclusive provision appearing therein.

Subparagraph (ii) reads:

(ii) any expense incurred in drilling or completing an oil or gas well in Canada, building a temporary access road to the well or in preparing the site in respect of the well,

(A) incurred by him in the year, or

(B) incurred by him in any previous year and included by him in computing his Canadian development expense for a previous taxation year,

if, within six months after the end of the year, the drilling of the well is completed and

(C) (inapplicable)

(D) it is reasonable to expect that the well will not come into production

in commercial quantities within twelve months of its completion.

The well was abandoned as a dry hole subsequent to May 9, 1975.

Counsel for plaintiff submitted that the words “an oil or gas well”, appearing in subparagraph (ii) necessarily meant a producing well and thus this subsection did not apply to the wells here involved. I cannot accept this interpretation. Clause (D) of this subsection in its terms includes in this subparagraph provision for a deductible expense for a dry hole.

Defendant contends that the advance payment of $3,800,000 by Dome to Gulf was payment to Gulf as agent of Dome, to be used in the later expense of drilling, etc. as incurred. This is the language used in clause 2 of Appendix 1, reading:

Dome undertakes to exercise an agency agreement whereby Gulf is appointed Operator on Dome’s behalf for the drilling of the test well.

In clause 3 of said appendix it is provided:

Dome shall pay to Gulf the sum of Three Million Eight Hundred Thousand Dollars ($3,800,000).

Such payment shall be applied to the cost of the drilling of the test well and for standby time to the next drilling season.

The agency is also referred to in clause II of said index.

The words and terms used must be applied in accordance with their normal proper meaning.

This advance payment, under all the circumstances, cannot, in my opinion, be deemed a Canadian exploration expense as at the date of the advance, December 31, 1974. It comes within such expense as it is used for the designated purpose, namely in the year 1975.

I am also of the opinion that the expenditure would properly come within Said subparagraph 66.1 (6)(a)(ii). This subparagraph limits deductible expense to that actually incurred in the year (ii)(A).

The issue re Regent well has a different factor. The full advance for drilling of the well was made in 1974 and drilling commenced in December of that year, being completed in January 1975. As stated above, the Minister allowed a deduction of a proportionate part of the total expense as an explorative expense incurred in 1974.

Here again if this expenditure is one coming within subparagraph 66.1 (6)(a)(ii) and not within subparagraph (i), the Minister is correct. Regent well was described as an exploratory well, namely to determine at least the existence or availability for commercial production of oil or gas. This on first view might appear to come within subparagraph 66.1 (6)(a)(i) but effect must be given to the excluding wording reading “other than an expense referred to in subparagraph (ii)”. These two subparagraphs must be read and interpreted to obtain not two available alternatives but with two separate bases for establishing an exploration expense.

Each counsel submitted arguments oral and written advancing points supporting their main arguments. I do not consider it necessary to review these points.

The date of payment of the $3,800,000 by Dome to Gulf was made because it was considered that payment that year with allowable exploration expense against the 1974 taxable income of plaintiff, made the proposed total drilling expense economically worthwhile. This cannot be found effective to determine the main issue.

It follows that I conclude that the reassessment of April 17, 1978, by the Minister of National Revenue in respect to the 1974 taxation year disallowing the claimed exploration expense of $475,000 re the Red Fox well and $147,405 relative to total claimed expense of the Regent well was correct and is affirmed.