Northcor Energy Ltd. v. R., [1998] 1 CTC 3178, 97 DTC 1060

Mogan T.C.J.:

The principal issue in this appeal is whether, in computing 1987 income, the amount of $1,161,035 may be deducted as a “Canadian exploration expense” as those words are defined in paragraph 66.1 (6)(a) of the Income Tax Act. Because Canadian exploration expenses play such an important role in the transactions underlying this appeal, such expenses will be referred to herein as “CEE” as they are also known in the petroleum and natural gas industry.

Some of the corporate ancestry of the Appellant is relevant because, although the taxation years under appeal are 1987, 1988 and 1989, the underlying transactions occurred in 1984 and 1985. In 1985, Northcor Resources Inc. was a wholly owned subsidiary of Northern Energy Ltd. (not the Appellant herein). The subsidiary will be referred to as “NRI” and the parent as “Northcor”. On May 11, 1987, NRI changed its name to NRI Holdings Limited. On December 29, 1987, NRI Holdings Limited was amalgamated with its parent, Northcor, to form the Appellant corporation. It is that amalgamation which permits the Appellant to conduct this appeal with respect to the taxation year of NRI which ended on March 31, 1987.

On December 31, 1985, the partners in a certain limited partnership described below assumed (correctly or incorrectly) that it had net CEE in the amount of $30,710,836. Acting on that assumption, the limited partnership allocated CEE of $25,428,572 to NRI because (i) December 31, 1985 was the last day of the 1985 fiscal period of the limited partnership;

(ii) at the close of business on that date there was only one limited partnership interest in the said limited partnership; (iii) that one limited partnership interest had been divided into one thousand equal fractional parts; (iv) NRI was the owner of 828 of the one thousand equal fractional parts; and (v) $25,428,572 represented NRI’s pro rata share of the assumed net CEE. When computing income for its taxation year ending March 31, 1987, NRI deducted CEE in the amount of $1,161,035 (being part of the $25,428,572). That deduction was disallowed by the Minister of National Revenue. This appeal is the result of the Minister’s disallowance.

The parties admit that Canadian exploration expenses are deductibe in computing income. The definition of “Canadian exploration expense” in subsection 66.1(6) of the Income Tax Act is lengthy and so I shall set out only the relevant parts:

66.1(6) In this section and sections 66, 66.2 and 66.4,

(a) “Canadian exploration expense” of a taxpayer means any expense incurred after May 6, 1974 that is

(i) any expense including a geological, geophysical or geochemical expense incurred by him (other than an expense incurred in drilling or completing an oil or gas well or in building a temporary accès 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,

(iv) subject to section 66.8, his share of any expense referred to in any of subparagraphs (i), (1.1), (ii), (ii.l), (iii) or (iii.l) incurred by a partnership in a fiscal period thereof, if at the end of that period he was a member thereof, or

(v) any expense referred to in any of subparagraphs (i), to (iii.l) incurred by the taxpayer pursuant to an agreement in writing with a corporation, entered into before 1987, 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,

but, for greater certainty, shall not include...

Many of the underlying transactions commence with persons who, in 1984, had no connection at all with the Appellant and its affiliated or ancestor corporations. On January 6, 1984, Albert Langard and 304854 Alberta Ltd. (an Alberta corporation) signed a three-page agreement (Exhibit A-9) establishing a limited partnership to be operated under the firm name “Forward 1984-3 Drilling Program”. For convenience, the limited partnership will be referred to herein as “the Partnership” because it is the only partnership involved in this appeal. In Exhibit A-9, 304854 Alberta Ltd. (“854”) was the general partner and Langard was the only limited partner. In accordance with paragraph 4 of Exhibit A-9, Langard as a limited partner made a contribution of $100 to the capital of the Partnership.

On October 1, 1984, Forward Resources Ltd. (an Alberta public corporation) entered into a share subscription agreement with the Partnership (Exhibit A-l). Forward Resources Ltd. later changed its name to “Exco Energy Ltd.” and will be referred to herein as “Exco”. At all relevant times in 1984 and most of 1985, Langard was the president and dominant shareholder of Exco. Also, Exco was the sole shareholder of 854 until May 1985 when Langard became the sole shareholder of 854. Under Exhibit A-1, the Partnership appointed Exco as its agent to incur CEE on behalf of the Partnership. Exco incurred substantial CEE in the winter drilling season from October 1984 to the spring of 1985 but, in the 13- month period from October 1, 1984 to October 31, 1985, no new investors purchased units in the Partnership. On October 31, 1985, the only capital contribution to the Partnership was the original $100 paid by Langard in January 1984 to acquire his limited partnership interest. By late spring and early summer 1985, Exco was in financial difficulty. On July 26, 1985, Exco made a proposal to its creditors under the Bankruptcy Act. The proposal was rejected by the creditors on October 9, 1985 and Exco was regarded a bankrupt from and after July 26, 1985. Deloitte, Haskins & Sells Limited was appointed Trustee in Bankruptcy for Exco.

It is the duty of the trustee in bankruptcy on behalf of the creditors to obtain the best value for the assets in the bankrupt estate. When Deloitte, Haskins & Sells Limited (“DHS”) became trustee in bankruptcy, it appeared from the records of Exco and the Partnership that there might be CEE in the range of $30,000,000 available for use (i.e. to be deducted in computing income) by limited partners. Exhibit A-12 includes unaudited financial statements of the Partnership as at December 31, 1985. Although those financial statements are dated December 31, 1985, it appears that they were prepared in the fall of 1985 because the affairs of Exco and the Partnership had been dormant since the insolvency of Exco in the late spring or early summer of 1985. According to Exhibit A-12, the available CEE were computed as follows on a page entitled “Statement of Deferred Exploration Expenditures”:

DHS claimed that the Partnership owed Exco some huge amount in the range of $30,000,000 as a result of the CEE which Exco had incurred as agent for the Partnership. The unaudited balance sheet of the Partnership (part of Exhibit A-12) shows a liability to Exco of $30,562,084 consistent with the CEE shown in the above table. DHS realized that there could be value in the available CEE (estimated at $30,000,000) if outside investors could be persuaded to purchase new units in the Partnership. It appeared that Langard (wearing many hats) was the person best able to sell those units. He was the only limited partner in the Partnership; he owned all of the issued shares of 854 (as of May 1985) which was the general partner; and he had been the president and dominant shareholder of Exco at the time of its bankruptcy. Accordingly, on November 1, 1985 a four-party agreement (Exhibit A-4) was signed among DHS, the Partnership, 854 and Lan- gard in his personal capacity. On page 9 of Exhibit A-4, Langard signed on behalf of the Partnership, 854 and himself.

The main purpose of Exhibit A-4 was to sell new interests or units in the Partnership to persons other than Langard prior to December 31, 1985 to raise funds to reduce the debt of the Partnership to Exco. Under Exhibit A- 4, Langard was to be paid a personal commission of 25% of a defined amount which, in general terms, seems to have been proceeds from the sale of new interests in the Partnership. Langard was unable to sell any new interests in the Partnership and so, in December 1985, he approached Northcor (an ancestor corporation of the Appellant as described above). This was the first involvement of the Appellant, through its ancestor corporations, in the underlying transactions of this appeal.

Jan Alston was legal advisor to the Northcor group of companies in 1985 and 1986 and was closely associated with the senior officers of Northcor throughout their negotiations with Langard in December 1985. He drafted almost all of the agreements and other documents (described below) in which Northcor or NRI was a signing party in the last few days of December 1985. Mr. Alston was the principal witness for the Appellant. He described Northcor as engaged in the business of exploration for and development of oil and gas properties, particularly in the frontier areas of Canada, taking advantage of the petroleum incentive grants under the National Energy Program in the mid 1980s. He knew of Exco which he regarded as a competitor of Northcor because it engaged in similar activities. Northcor had done exploration and incurred CEE as agent for a number of limited partnerships in transactions similar to Exhibit A-l in which Exco had agreed to incur CEE as agent for the Partnership. Mr. Alston explained how drilling funds and limited partnerships were used to “warehouse” CEE for prospective investors.

At this time it was common to finance drilling expenditures in this fashion. I think the primary reason was that typically, and especially under the Petroleum Incentives Program, with these 80 percent PIP grants that I have spoken about, for a junior company to go out and explore, incur Canadian exploration expenditures, really recognizing that the ability to get investors in was highly tax planning motivated. So that in fact it was pretty much at the end of the year, towards the end of the year, and I would say most of the activity would occur in November or December of any given year at the time, or between those times, when the company would be able to attract investors to invest in its activities.

So the problem was that they needed to find a place that we called in the industry to warehouse the Canadian exploration expenses; in other words, to collect them up in a vehicle where as long as somebody was brought into that, for example, into the limited partnerships prior to the fiscal year end of the limited partnership, that party would receive an allocation of the Canadian exploration expense proportion to their ownership in that partnership, and include that as a deduction in their tax return for that year.

So the arrangement that was typical at this time was what became generically known as a flow-through share agreement. The concept was to flow through the write-offs into the partnership. And the mechanics of doing that was that the exploration company incurred the Canadian exploration expense as agent, for, ... limited partnerships, and drilling funds, on behalf of that fund. So this was the mechanism to flow the write-offs into the limited partnership. And that agency relationship was always placed up front and recognized in all flow-through share agreements.

(Transcript pages 52-55)

As I understand Mr. Alston’s evidence, if CEE were incurred on “frontier lands” (the Northwest Territories, territorial waters off the east coast of Canada, etc.), the federal government financed 80% of such CEE under the Petroleum Incentives Program by the payment of amounts which were known as PIP grants. In a particular year, the exploration occurred first and was conducted by a corporation as agent for a limited partnership. The cost of the exploration was verified to the Petroleum Incentive Administration and the resulting CEE were “warehoused” in the limited partnership. Actual payment of most exploration costs was deferred until the arrival of the PIP grants which would have been assigned by the limited partnership as principal to the corporation as agent. Outside investors would purchase units in the limited partnership toward the end of the year providing enough capital to pay for the balance of the exploration costs over and above the expected PIP grants. At the end of the particular year, the limited partnership would allocate 99.9% of its CEE among the limited partners in proportion to their investment. Each limited partner would then deduct in computing income an amount of CEE in excess of his invested capital because all limited partners collectively could deduct all of the CEE incurred by the corporation as their agent even though 80% of such CEE would be paid with PIP grants. If the receipt of the PIP grants resulting from exploration in a particular year could be deferred until the following year, the limited partners would have more CEE to deduct in the particular year because the deductible amount of CEE was reduced by any PIP grants actually received.

The senior officers of Northcor saw the same potential value in the CEE incurred by Exco that DHS saw when it entered into the commission agreement (Exhibit A-4) with Langard, the Partnership and 854. After lengthy discussions with Langard and DHS, Northcor concluded that it could sell units in the Partnership by the close of business on December 31, 1985. On December 20, 1985, Northcor sent to DHS a number of draft agreements (Exhibit A-25) which Northcor regarded as necessary to do the transaction. Northcor was relying on its past successful experience in selling (in the last days of a calendar year) units in a limited partnership in which CEE had been warehoused earlier in the year. There were, however, a number of problems in Northcor’s attempt to sell new units in the Partnership.

The R.C.M.P. had seized all of the primary documents and records of Exco during its investigation of Exco or Langard for fraud. It was therefore difficult to verify the actual amount of CEE incurred by Exco as agent for the Partnership; and Northcor had to rely on secondary documents. Also, it was widely rumoured or perhaps known in the public domain that Exco or Langard was being investigated and certain prospective investors seemed reluctant to buy into an Exco/Langard transaction. Langard told Northcor that he would not be available in Calgary on December 31, 1985 but his presence in Calgary was crucial on that date if the Partnership units were to be sold before year end in accordance with Exhibit A-4.

To overcome the last problem and to give Northcor complete control of the Partnership, Northcor decided to take Langard out of the picture in a series of transactions which were all consummated in the last two or three days of December 1985. By written agreement (Exhibit A-15), NRI purchased from Langard for $100 his sole limited partnership interest in the Partnership. The consideration of $100 was the same amount which Langard had paid in January 1984 to acquire the sole limited partnership interest in the Partnership. The effective time for the transfer of the limited partnership interest was 12:00 noon on December 31, 1985. By written agreement (Exhibit A-18), Northcor purchased from Langard for one ($1.00) dollar all of the issued shares in 854. With these two transactions, having regard to the Partnership, Northcor and NRI acquired respectively all of the shares of the general partner (854) and the sole limited partnership interest.

By written agreement (Exhibit A-16), NRI purchased from Langard his rights to any commission upon the sale of interests in the Partnership derived from the agreement of November 1, 1985 (Exhibit A-4) among DHS, the Partnership, 854 and Langard. The consideration which NRI paid for those rights was $250,000. According to the evidence of Mr. Alston and Mr. Gary Bustin (Secretary-Treasurer of the Northcor Group of Companies in 1985/1986) the price of $250,000 was negotiated on the following rough estimates. Exhibit A-4 defined a “Maximum Amount” as 3% of the 1985 CEE incurred by Exco for the Partnership. All parties assumed that Exco had incurred $51,000,000 of such CEE but had received in 1985 about $21,000,000 in PIP grants leaving a balance of about $30,000,000 in net CEE for the partners. Three percent of $30,000,000 was about $1,000,000. Pursuant to paragraph 7 and 8 of Exhibit A-4, DHS and Langard were to share the $1,000,000 in a 75%-25% ratio and Langard’s share would be about $250,000. I do not read Exhibit A-4 as leading to the financial result described above but I accept the evidence of Messrs. Alston and Bustin as the two businessmen who were on the scene at the time actually negotiating the transaction. I find it interesting that Langard personally ended up with $250,000 while DHS as trustee for Exco ended up with nil because, in the overall scheme of things, there were no new limited partnership interests sold. The main purpose of Exhibit A-4 had been to sell new limited partnership interests.

According to the evidence of Messrs. Alston and Bustin, there were genuine attempts by Northcor and NRI to sell to outside investors new interests in the Partnership but, as the last days and hours of 1985 faded away, Northcor and NRI concluded that no such interests would be sold. Therefore, NRI decided that the one limited partnership interest which it had purchased from Langard would be divided into one thousand equal fractional parts. NRI retained 828 of those parts and the remaining 172 parts were sold to 10 parties (individuals or corporations) who were closely associated with the senior management of Northcor. Those 10 parties are listed in Exhibits A-21 and A-22. This was accomplished in the early afternoon of December 31, 1985 and Mr. Alston effected the registration of the appropriate changes in the names and numbers of limited partners in the Provincial Registry Office at Calgary before the close of business on December 31. See Exhibits A-19 to A-23 inclusive.

I am satisfied from the oral testimony of Messrs. Alston and Bustin and from many documentary exhibits that all of the transactions necessary for the Appellant’s success herein were completed by the close of business on December 31, 1985. In other words, before the end of 1985, the Appellant was in place as the owner of 82.8% of the only limited partnership interest in the Partnership. It was on the basis of this ownership that CEE of $25,428,572 was allocated to NRI; and NRI deducted CEE of $1,161,035 when computing income for its fiscal period ending on March 31, 1987.

The first issue in this appeal is whether there was any CEE in the Partnership on December 31, 1985 which could be allocated among the limited partners. The Appellant claims that there was CEE of $30,710,836 but the Respondent claims that the amount of CEE in the Partnership was restricted to $100 in accordance with Exhibit A-1. If the Appellant succeeds in principle on the first issue, the second issue is one of quantum because the Respondent claims that the CEE in the Partnership did not exceed $18,000,000.

Counsel for both parties agree that the determination of the first issue will depend upon an interpretation of Exhibit A-1 which is the Share Subscription Agreement. This agreement is not long. It is so important that I propose to set out below almost the entire agreement omitting only certain words which I think are not relevant. Exhibit A-l was in fact an agreement of October 1, 1984 between Forward Resources Ltd. and Forward 1984-3 Drilling Program. The names of the parties in Exhibit A-1 as set out below are changed respectively to “Exco” and “the Partnership” in order to be consistent with the nomenclature used in these reasons for judgment:

Between: Exco and the Partnership

WHEREAS the Partnership wishes to incur certain expenses which will qualify as Canadian exploration expense (“CEE”), as more particularly defined and described in paragraph 66.1(6)(a) of the Income Tax Act (the “Act”); and

WHEREAS the Partnership has agreed to incur CEE solely as consideration for the issuance of Preferred Shares in the capital stock of Exco, and Exco has agreed to issue Preferred Shares to the Partnership solely as consideration for the incurring of CEE all pursuant to the provisions of subparagraph 66.1(6)(a)(v) of the Act;

NOW THEREFORE THIS AGREEMENT WITNESSETH that in consideration of the mutual covenants and conditions herein contained the parties hereto agree as follows:

1. Agreement to Incur CEE and Agency

The Partnership hereby agrees to incur CEE from time to time solely as consideration for the issuance of Preferred Shares of Exco, and the Partnership hereby appoints Exco as the agent of the Partnership to incur such CEE on behalf of the Partnership.

2. Issuance of Shares

Exco agrees to issue to the Partnership one (1) Preferred Share of the capital stock of Exco for each Twenty-five ($25.00) Dollars of CEE incurred by the Partnership hereunder. The Preferred Shares shall be issued by Exco to the Part- nership only as and to the extent that Exco has incurred CEE as agent for the Partnership.

3. Nature of Expenses and Assignment of PIP Payments

The cost of all operations conducted by Exco as agent for the Partnership pursuant to this Agreement shall involve only those expenditures which qualify as CEE of which, for each Twenty-five ($25.00) Dollars of CEE incurred by the Partnership for one Preferred Share, Twenty ($20.00) Dollars will qualify for petroleum incentive payments under the Petroleum Incentives Program Act (“PIP Payments”) at a rate of eighty (80%) percent and which will amount to Sixteen ($16.00) Dollars, and Five ($5.00) Dollars, to be paid to Exco, will qualify as Canadian exploration and development overhead expense as defined in the Act. The Partnership hereby assigns to Exco, towards payment of the CEE agreed to be incurred by the Partnership, all PIP Payments earned by the Partnership hereunder.

4. Reporting

Exco shall, no later than 30 days after the date of receipt of any written request from the Partnership, advise the Partnership of the operations conducted by Exco as agent for the Partnership pursuant to this Agreement.

5. CEE

The parties hereto agree that any CEE incurred by the Partnership as provided herein, shall constitute the CEE of the Partnership only and not that of Exco, and Exco agrees that, in filing its income tax returns, it shall not be entitled to deduct any amount in respect of such CEE in the computation of its income.

6. Ownership of Assets

Subject to paragraph 5 hereof, the parties hereto agree that any assets acquired or earned by virtue of the Partnership incurring any CEE hereunder shall be solely the property of Exco and Exco shall be solely liable for any and all obligations resulting from such ownership.

7. Rights and Restrictions of Preferred Shares

8. Indemnity

Exco hereby indemnifies and saves harmless the Partnership from and against any liability, loss, damage, cost or expense which the Partnership may sustain or incur arising out of or in any way connected with the activities carried on by Exco as agent for the Partnership pursuant to this Agreement to the extent that such liability, loss, damage, cost or expense exceeds the amount of CEE agreed to be expended by the Partnership pursuant to this Agreement.

9. Maximum Amount of CEE To Be Incurred

The Partnership agrees to incur CEE pursuant to this Agreement up to a maximum amount of the net proceeds which are raised by the Partnership pursuant to any offering of its limited partnership units in connection with this Agreement.

10. Relationship of Parties

Nothing herein contained shall be construed so as to constitute any of the parties hereto as partners in relation to the conduct of operations.

11. General

... This Agreement shall be construed in accordance with the laws of the Province of Alberta.

The real dispute between the parties is based on paragraph 9 of Exhibit A-1. It is a fact that on December 31, 1985 the “net proceeds” which had been raised by the Partnership pursuant to any offering of its limited partnership units was nil. Relying on that fact, the Minister of National Revenue construes the opening words of paragraph 9 to mean that the Partnership agreed to incur nil CEE. The Appellant submits three arguments based on amendment, estoppel and ratification with respect to paragraph 9. First, paragraph 9 was amended by the conduct of the parties because the Partnership knew that Exco had incurred CEE in the range of $50,000,000 and the Partnership wanted that amount of CEE to be in the Partnership as an incentive for selling limited partnership units. Second, the Partnership induced Exco to incur CEE far in excess of the nominal capital of the Partnership. The commission agreement of November 1, 1985 among DHS, the Partnership, 854 and Langard (Exhibit A-4) contains the following recitals:

AND WHEREAS the Partnership is indebted to Exco in an amount equal to Expenditures made in 1984 and 1985 less Petroleum Incentive Payments (“PIPS”) accruing in connection with the Expenditures which have been received or paid to Exco (the “Indebtedness”);

AND WHEREAS the Partnership has agreed to sell units or other interests in the Partnership in order to raise funds which will be used to reduce the amount of the Indebtedness;

Following such inducement and recitals, the Partnership is estopped from denying its liability to Exco and, therefore, Exco incurred the CEE as agent for the Partnership. And third, by signing Exhibit A-4, the Partnership ratified the CEE already incurred by Exco as being an obligation of the Partnership.

All of the Appellant’s arguments are based on the principal/agent relationship between the Partnership and Exco in Exhibit A-1, and on the claim that (notwithstanding paragraph 9) the excess CEE incurred by Exco was accepted as an obligation by the Partnership through an amendment to the agreement or through estoppel or through ratification by the Partnership. In my opinion, even if such acceptance of the excess CEE as an obligation by the Partnership were established through amendment, estoppel or ratification, the Appellant’s arguments would all fail because of the undisputed fact that the Partnership did not reimburse Exco for any part of such CEE.

It is a basic rule in the law of agency that every agent has a right against his principal to be reimbursed for all expenses incurred in performing his duties as agent. Exco, as agent, had a right to be reimbursed by the Partnership for all CEE incurred over and above the PIP grants which were assigned to and received by Exco. Exco did not, however, receive one cent of reimbursement from the Partnership.

The transaction in Exhibit A-l is admittedly income tax motivated; Mr. Alston speaks of “warehousing” CEE in the Partnership through the year until outside investors arrive in the last days of the year. The right to deduct CEE in computing income is the important “property” which attracts outside investors. There is no doubt in this transaction that the CEE were incurred by Exco as agent for the Partnership but that does not mean that the important property derived from such CEE (i.e. the right to deduct in computing income) was “owned” by the Partnership as soon as such CEE were incurred by Exco. Because the right to deduct CEE is intangible property, I think that Exco had a lien on that intangible property until Exco was reimbursed by the Partnership. Bowstead on Agency (15th Edition - 1985) states at page 257:

An agent has a general or particular possessory lien on the goods and chattels of his principal in respect of all lawful claims he may have as such agent against the principal, for remuneration earned, or advances made, or losses or liabilities incurred, in the course of the agency, or otherwise arising in the course of the agency, provided -

(a) that the possession of the goods or chattels was lawfully obtained by him in the course of the agency, and in the same capacity as that in which he claims the lien;

(b) that there is no agreement inconsistent with the right of lien; and

(c) that the goods or chattels were not delivered to him with express directions, or for a special purpose, inconsistent with the right of lien.

The Canadian Encyclopaedic Digest (Western), Third Edition, contains the following statement in Volume 1, Agency, paragraph 235:

If the principal has not discharged the obligation of paying remuneration or indemnity, and the agent is in possession of goods belonging to the principal, the agent may be entitled to exercise a lien on such goods and retain possession of them until the principal satisfies the due claims of the agent...

Halsbury’s Laws of England, Fourth Edition, Volume I states at page 488 in paragraph 810:

Every agent has a lien on the goods and chattels of his principal in respect of all claims against the principal arising out of his employment, whether for remuneration earned, or for expenses or liabilities incurred, except where the right of lien is inconsistent with the contract between the parties, or with the special purpose for which the goods or chattels were entrusted to him.

These authorities speak of a lien on goods and chattels which are ordinarily tangible property. Because Exhibit A-1 was income tax motivated and conditional upon high risk exploration on frontier lands, the real value in this transaction was not the frontier lands but the amount of expenses (CEE) incurred by Exco as agent. I regard the intangible right to deduct those expenses (CEE) in computing income as a chose in action. I see no reason why an agent’s lien on goods and chattels should not apply also to a chose in action like the right to deduct CEE. Therefore, if Exco is not reimbursed by the Partnership for any part of the CEE incurred by Exco, I conclude that the right to deduct such CEE remains in Exco until at least part of the reimbursement is received from the Partnership.

My conclusion that the CEE remain in Exco subject to the agent’s lien is in conflict with paragraph 5 of Exhibit A-l (see above). For me, however, it is implicit in Exhibit A-1 that the Partnership is obliged to reimburse Exco for any CEE not covered by the PIP grants. One should remember that the terms of Exhibit A-1 were settled by parties not at arm’s length. On October 1, 1984, Langard was the president and dominant shareholder of Exco; he was the only limited partner in the Partnership; and Exco held all of the shares of 854 which was the general partner. In effect, Langard was the promoter of the Partnership as a drilling fund. As promoter, he provided an indemnity from Exco to the Partnership (paragraph 8) for the comfort of outside investors who were expected to purchase limited partnership units, but he failed to provide for Exco an explicit covenant from the Partnership to reimburse. If the terms of Exhibit A-1 had been negotiated by parties at arm’s length, Exco would have insisted on such a covenant. Having regard to all the terms of Exhibit A-1, I find that there was an implicit obligation on the Partnership to reimburse Exco for the CEE for the following reasons: 1. In paragraph 3, the Partnership assigns to Exco all of the PIP Payments “towards payment of the CEE agreed to be incurred by the Partnership”. This assignment by the Partnership “towards payment” implies that the Partnership will reimburse Exco for any remaining balance of the CEE.

2. In paragraph 1, the Partnership agrees to incur CEE as consideration for the issuance of shares and, in paragraph 2, Exco agrees to issue such shares for each $25.00 of CEE “incurred by the Partnership”. In corporate law, shares cannot be issued for no consideration. Exco could not expend its own funds on exploration, and then issue shares based on the expenditure of its own funds. Exco would have to receive funds from some outside person like the Partnership in order to provide the paid-up capital for the shares to be issued.

3. Paragraph 9 implies that any “net proceeds ... raised by the Partnership pursuant to any offering of its limited partnership units” will be used to reimburse Exco for any CEE incurred as agent for the Partnership.

When the Partnership failed to raise its own capital and to reimburse Exco for any CEE, the Partnership was in breach of its obligation to Exco under Exhibit A-l. Because the Partnership had breached the contract, Exco was entitled to retain the right to deduct all of the CEE (notwithstanding paragraph 5) until it was reimbursed or was satisfied with bona fide financial information that it had a reasonable and realistic expectation of being reimbursed. In fact, Exco was never reimbursed and never given that kind of expectation.

If I should be wrong in my application of an agent’s lien to the right to deduct CEE, I would interpret paragraph 9 of Exhibit A-1 as restricting to $100 the CEE incurred by Exco as agent for the Partnership. In my opinion, paragraph 9 was not amended by the conduct of the parties or otherwise, and the excess CEE was not ratified by the Partnership. When DHS (as Trustee) sued Langard, the Partnership, 854 and Mr. Lalji for $51,000,000 (Exhibit A-7 is the Statement of Claim), Messrs. Langard and Lalji filed a Statement of Defence (Exhibit A-8) in which they pleaded (in paragraph 4) that Exco breached Exhibit A-1 by incurring CEE in excess of the amount permitted under paragraph 9 of Exhibit A-l.

As stated above, it was difficult for NRI to verify the actual amount of CEE incurred by Exco because the R.C.M.P. had seized all of the primary documents and records of Exco. As a result of that difficulty, Mr. Alston explained how NRI had sought comfort from secondary sources. Specifically, Exhibit A-4 was a recent agreement of November 1, 1985 among DHS, the Partnership, 854 and Langard. Schedule “A”, attached to Exhibit A-4 and referred to in the definitions of “Hydrocarbon Properties” and “Maximum Amount”, contained a list of certain lands and the 1985 fiscal year expenditures incurred by Exco on those lands as agent for the Partnership. Schedule “A” showed aggregate expenditures of $51,096,371. The main purpose of Exhibit A-4 was to sell new interests or units in the Partnership to raise funds to reduce the debt of the Partnership to Exco. NRI relied on the fact that Deloitte, Haskins & Sells Limited (as Trustees in Bankruptcy of Exco) was a party to Exhibit A-4 and was affiliated with a prominent and highly regarded national accounting firm.

NRI had the unaudited financial statements of the Partnership as at December 31, 1985 (Exhibit A-12) prepared by Mr. Diamond Lalji, a chartered accountant. Exhibit A-12 was available to NRI during its negotiations with Langard in December 1985 because Exco and the Partnership had been dormant since the bankruptcy of Exco in July 1985. Mr. Lalji promised audited financial statements of the Partnership which were later delivered (Exhibit A-14) and dated April 30, 1986. NRI relied on Exhibit A-12 and the promise of Exhibit A-14. The concerns of NRI and its parent Northcor are summarized in the following testimony of Mr. Alston:

Well, the problem that was recognized with respect to this partnership was that there was the bankruptcy of the exploration company, Exco Energy, and that certainly complicated matters.

There were issues of the amount of petroleum incentive payments that may be coming through subsequently, and there were disputes in that regard.

There were issues related to the fact that the Canadian Exploration Expense was going into the partnership, that there were no shares there, so any sale of additional limited partnership units would be solely for the tax write-off that was in the partnership. Things of that nature. I think one can see that it was not a tidy straightforward situation.

Transcript pages 239-240

On the same subject, Mr. Alston later made the following statement:

Well, Northcor Energy needed to have confirmation that all the parties involved were recognizing that these expenses were in the limited partnership. We weren’t in any position to go into the offices of Exco or the trustee’s offices and to do our own homework, you know, at the base level. So we had to make a leap of faith I guess with what limited information we would be able to rely on.

Transcript pages 269-270

I can easily understand the concerns of the senior management of NRI and Northcor and their need “to make a leap of faith” because, on the bare bones of Exhibit A-15, NRI would acquire CEE in the amount of $30,000,000 by paying to Langard the sum of $100 for his limited partner- ship interest in the Partnership. Rather than look at Exhibit A-15 in isolation, it may be fairer to the Appellant to consolidate the three basic agreements which NRI or Northcor made with Langard at the end of 1985 because I am satisfied that not one of those agreements would have been signed without the other two. In Exhibit A-15, NRI purchased for $100 Langard’s limited partnership interest. In Exhibit A-16, NRI purchased for $250,000 all of Langard’s right to any commissions under the four party agreement of November 1, 1985 (Exhibit A-4). And in Exhibit A-18, Northcor purchased for $1.00 all of Langard’s shares in 854. The consolidated effect of these three agreements is that NRI and Northcor took over Langard’s entire position with respect to the Partnership for a total consideration of $250,101.

I cannot resist the conclusion that there was a generous amount of wishful thinking on the part of the NRI/Northcor management at the time of the transaction. How could they think that the Partnership would have CEE of $30,000,000 to allocate among its limited partners if the Partnership had partners’ capital of only $100 and had not paid one cent to any person (Exco or anyone else) with respect to such CEE? The simple creation of an agency relationship in Exhibit A-l is not conclusive in the Appellant’s favour. The unaudited financial statements of the Partnership (Exhibit A-12) ought to have given NRI more concern than comfort. (The audited statements (Exhibit A-14) were not available until long after December 1985). The presentation of the balance sheet in Exhibit A-12 should give rise to serious questions in the mind of any experienced business man or woman.

When the debt to Exco of $30,562,084 was shown on that balance sheet as a current liability, what were the prospects of paying that debt? If the debt to Exco could not be paid, was it appropriate to show any amount of “deferred exploration expenditures” as an asset? Was it premature to show “deferred exploration expenditures” of $30,562,084 as an asset when the Partnership had only $100 of partner’s capital and had not paid any amount to Exco with respect to such expenditures? Would it have been more appropriate to omit the “deferred exploration expenditures” as an asset and show a deficiency of partners’ capital? There was no expert accounting evidence in this appeal but it appears to me that if the Partnership had been able to raise its own capital and reimburse Exco, the balance sheet in Exhibit A-12 would not have shown a huge liability to Exco but would have shown a significant amount of partners’ capital and, as an asset, many issued shares of Exco. In the absence of any opinion from an expert accountant, I shall assume that Mr. Lalji’s decision to present “deferred exploration expendi- tures” as an asset in Exhibit A-12 was prompted more by the promoter’s desire to sell new limited partnership interests than by generally accepted accounting principles.

Even if I am wrong in my assumption, Messrs. Alston and Bustin and the other senior people at NRI and Northcor had considerable experience in “warehousing” CEE in limited partnerships and then selling units in those partnerships as drilling funds. See Central Supply Co. (1972) Ltd. v. R., (1995), 95 D.T.C. 434 (T.C.C.). In other words, Mr. Alston and his associates in NRI/Northcor were sophisticated in this kind of transaction and knew what they were doing. The balance sheet in Exhibit A-12 could have served as a red flag to the management of NRI/Northcor but, instead, they saw what they wanted to see when they looked at the deferred exploration expenditures as an asset of the Partnership. They chose to ignore the consequences to the Partnership if it failed to pay any amount to Exco with respect to those expenditures. They seem to have concluded on the basis of the agency relationship in Exhibit A-1 that the Partnership could get something for nothing!

I find that there were no Canadian exploration expenses (CEE) in the Partnership at any time in 1985, warehoused or otherwise. I have no doubt that in the oil and gas industry there have been many agency contracts between limited partnerships and exploration companies. The concept of using an agency contract to “warehouse” CEE in a limited partnership (portrayed as a drilling fund) during a calendar year pending the arrival of fresh investors at year end may be a very practical piece of business jargon to describe the availability of CEE to potential investors. The common use of such business jargon, however, does not mean that the CEE is or was in the limited partnership at any particular time during the year. The CEE will flow from the exploration company as agent to the limited partnership as principal only when real value (usually money-assigned PIP grants or partners’ capital) flows from the limited partnership to the exploration company. Otherwise, the CEE remains in the exploration company. It is not reasonable to conclude that the principal could acquire the right to deduct CEE without paying any consideration to the agent for such right. A valid agency agreement, standing alone, will not transfer CEE from the agent to the principal in the absence of any value flowing from the principal to the agent. I find against the Appellant with respect to the first issue in this appeal.

Having decided the first issue against the Appellant, it is not necessary for me to decide the second issue as to quantum but I will make the following observation. The Appellant’s claim that the Partnership had CEE of $30,710,836 at December 31, 1985 is based on Mr. Lalji’s audited financial statements of the Partnership (Exhibit A-14). According to the Statement of Deferred Exploration Expenditures in Exhibit A-14, there were gross exploration expenditures of $63,050,286 in 1984 and 1985. According to the Respondent, the Partnership had CEE of only $18,829,720 at December 31, 1985.

This last amount is computed as follows:

Mr. Lynch, an auditor from Revenue Canada, testified at length in this appeal and explained his schedules (Exhibits R-45 and R-46) which support the Respondent’s computation of CEE in the amount of $18,829,720. Mr. Lynch had access to the records of the Trustee in Bankruptcy (DHS) and stated that he could not find documents to support Mr. Lalji’s conclusion that there had been gross exploration expenditures of $63,050,286. Mr. Lynch had been able to determine that there were aggregate monthly exploration expenses of $51,177,069 from September 1984 to June 1985. The discrepancy of approximately $12,000,000 is significant.

There was evidence that Mr. Lalji was disciplined by the Institute of Chartered Accountants for the Province of Alberta in connection with some of his professional services rendered to Exco. To the extent that there is any conflict between computations performed by Mr. Lalji and relied on by the Appellant and computations performed by Mr. Lynch and relied on by the Respondent, I favour the computations performed by Mr. Lynch. I would rely on Exhibits R-45 and R-46.

The appeals are dismissed with costs.

Appeal dismissed.