Gaz Métropolitain Inc. v. R., [1999] 2 CTC 2116, 98 DTC 1751, 1998 CanLII 227

Archambault T.C.J.:

Gaz Métropolitain Inc. (“GMI”) is challenging assessments made by the Minister of National Revenue (“the Minister”) for the 1987 and 1988 taxation years. The Minister included $2,803,650 received as a government grant for the purchase of servitudes in its income for 1987 pursuant to s. 12( l)(x) of the Income Tax Act (“the Act”). The parties filed a consent to judgment in respect of this first appeal. For 1988, the Minister, in calculating GMI’s taxable income, disallowed the deduction of $2,836,655 as noncapital losses from a subsidiary, GNC Québec Ltée (“GNC”). These losses were sustained before control of GNC was acquired by GMI.

In disallowing this deduction the Minister relied on s. 88(1.1)(e) of the Act. He maintained that GMI was not carrying on the same business as GNC. In the Minister’s submission, GMI’s principal activity was the sale of natural gas and that of GNC was the conversion of vehicles to natural gas.

GMI argued that GNC’s principal activity was the sale of natural gas as a fuel for vehicles and that the conversion of vehicles to natural gas was merely a secondary activity of its business of selling natural gas. This activity was one aspect of the creation of the infrastructure necessary for selling natural gas as a fuel.

Facts

GMI carries on a business selling natural gas to residential, commercial and industrial customers. Distribution is primarily by pipeline, which is why the business is regulated by Quebec’s Régie du gaz naturel (“the Régie”). GMI has about 1,500 employees.

To promote wider consumption of natural gas in Quebec GMI has adopted various strategies. It has negotiated with the Régie for permission to offer grants to potential customers to help them convert to natural gas. To help them purchase the equipment necessary for this conversion, GMI offers its customers either financing or the option of renting the equipment. To carry out the conversion work GMI may offer its own services or put its potential customers in touch with independent technicians. Finally, GMI is involved in certain scientific research and experimental development work to develop new technologies favouring the adoption of natural gas as an energy source.

Robert Normand, who was GMI’s vice-president of finance from 1976 to 1997, estimated that 90 to 95 percent of GMI’s gross receipts come from the sale of natural gas and that the remainder come from incidental activities, such as installation and conversion services.

In the early 1980s Canadian government policies were designed to ensure greater security of supply and wider diversification of energy sources for Canada. Some programs encouraged Canadians to change their fuel oil heating equipment for natural gas equipment.

Oil supply problems and the sharp rise in oil prices combined with rising estimates of world gas reserves encouraged several countries to develop policies favouring the use of natural gas as a fuel for vehicles. Italy and New Zealand played an important part in this movement. At the time in question, Italy had half a million vehicles running on natural gas. To be used as a fuel for vehicles, natural gas must be compressed and stored in one or two gas cylinders.

GMI wanted to start selling natural gas as a fuel. It undertook a research and development program. It learned from its research that Italy manufactured the best equipment in the industry. The first stage of GMI’s strategy was to convert its own truck fleet to natural gas and so acquire some experience.

The second stage was to create the infrastructure for a distribution network so as to reach consumers. This infrastructure involved a network of vehicle conversion centres and a network of public filling stations. These filling stations had to be equipped with compressors to fill consumers’ gas cylinders. The creation of this infrastructure raised technical problems and required considerable resources. To solve these problems GMI decided to take on partners. As indicated in the notes to its 1981 to 1986 financial statements, GNC was incorporated on September 1, 1981 to develop the market for natural gas as a fuel, set up conversion centres, develop a filling station network and even open a training school. [1] Fifty percent of this company’s shares were purchased by CNG Fuel System Ltd. (“CNG Fuel”), a subsidiary of the Nova group, 25 percent by the Société québécoise d’initiative pétrolière and the remaining 25 percent by GMI. GNC began operating in mid-1982 and its fiscal year ended on December 31.

GMI’s overall strategy in acquiring an interest in GNC was to increase its volume of natural gas sales by about 20 to 25 percent. GNC’s purpose in creating vehicle conversion centres was to encourage increased sales of nat- ural gas for use as a fuel. The operation of conversion centres was not a separate business for GNC but an incidental activity which was essential to the sale of natural gas.

The conversion centres were set up gradually. Initially the conversions were carried out in centres owned by GNC. Franchised businesses later played an increasing part in this activity. In 1985, 48 percent of conversions were carried out by GNC centres and 52 percent by franchisees. In the first quarter of 1986, 77 percent of conversions were carried out by franchisees.

To set up the filling station network GNC entered into joint ventures with three oil companies: Ultramar, Gulf and Shell. GNC held 50 percent of the joint ventures. In 1985 gross receipts amounted to $878,145 and costs to $986,154. Assets stood at $1,865,177 and liabilities at $2,084,152. These figures represented GNC’s share. In 1986, 19 public filling stations were operated by three oil companies, two by independent distributors and one by GNC, making a total of 22 public filling stations. GNC also sold natural gas directly to private filling stations, such as those for taxi fleets.

In mid-1984 GNC prepared a submission for the government of Quebec to persuade it to convert its vehicle fleet to natural gas and to promote projects to convert school and urban transportation vehicle fleets. This submission also sought to induce the government not to tax natural gas sold as a fuel at a level that would have the effect of reducing the difference between natural gas and gasoline prices to less than 50 percent. Unfortunately for GNC, it was unable to achieve its first objective.

To encourage consumers to convert to natural gas GMI paid $900 for each conversion while the federal government paid an additional $500 up to March 1987. Mr. Normand stated that in order to be able to offer this $900 subsidy, GMI had to obtain permission from the Régie and that the Régie would not have given it permission to do so if there were not a reasonable expectation of profit from the sale of natural gas as a fuel. The Régie would not have permitted a situation in which all the consumers indirectly subsidized the market for natural gas for use as a fuel. [2]

In its tax returns for 1982, 1983 and 1984 GNC described the type of business it was in as follows: [TRANSLATION] “vehicle retrofitting”. In

its 1985 and 1986 returns it described its activities as follows: [TRANSLATION] “selling natural gas for vehicles and vehicle retrofitting”. For 1985, 80 percent of its income came from conversion and 20 percent from natural gas sales. For 1986 income from conversion dropped to 71 percent and that from the sale of natural gas rose to 29 percent. According to Mr. Normand, GNC made a profit on the resale of its natural gas. However, he could not give a figure for this profit because there was only one accounting system for both sales of natural gas as a fuel and conversion activities. It is impossible to break down the fixed costs between these two activities.

From 1982 to 1985 GNC had only losses. The amounts of these noncapital losses were as follows:

1985 $ 720,534

In 1986 GMI and its partners reviewed GNC’s operations. They found that a new strategy had to be adopted to make the distribution of natural gas for use as a fuel profitable. The income statement for 1985 shows that natural gas sales and receipts from conversion services had produced a gross profit of $884,333 on sales of $3,387,379. However, fixed costs totalling $1,468,044 and GNC’s share — $108,009 — in the losses of the joint ventures resulted in a loss of $691,720. According to Mr. Normand, losses were to be expected in the first few years of operation because of the startup costs associated with this new activity, especially those incurred to create the network for distributing natural gas for use as a fuel.

Despite these disappointing results GMI still saw potential in the market for natural gas for use as a fuel. In view of the price differential favouring natural gas over gasoline and propane, Quebec was an attractive market for GMI. According to studies by a Canadian consulting firm, with 38 percent of the potential market Quebec was the largest market in Canada for natural gas as a fuel. According to those studies, there was a potential of some 450,000 vehicles operating on natural gas after five years. That would represent annual natural gas consumption of some 26 billion cubic feet. At the time GMI was selling about 125 billion cubic feet. In the early 1980s the Canadian Gas Association projected that about 120 filling stations would be opened in Quebec. Finally, a survey of users of natural gas as a fuel in the summer of 1985 indicated a fairly high level of satisfaction ranging from 84 percent for individuals to 88 percent for companies.

On September 29, 1986 GNC’s partners decided to transfer all their shares to GMI and when it was wound up GNC transferred its business to GMI. Of GNC’s 29 employees, only two were re-hired by GMI, which already had all the administrative staff it needed for the sale of natural gas as a fuel. GMI’s strategy would be to focus its efforts on the sale of natural gas to businesses with fleets of vehicles. Finally, the conversion centres would be operated for GMI by CNG Fuel, which would employ three of GNC’s employees. CNG Fuel was to provide its services for a period of 18 months following the winding-up of GNC. However, a little over 12 months later, on October 21, 1987, CNG Fuel decided to pull out and GMI informed all natural gas filling stations that it would continue to promote the development of the Quebec market for natural gas for use as a fuel. It also undertook to continue the compressor maintenance service.

GMI incorporated GNC’s operations selling natural gas as a fuel into its natural gas sales operations. There is no separate item in GMI’s financial statements that would show to what extent this activity of selling natural gas as a fuel produced profits or incurred losses. Nor is there any breakdown of fixed costs — such as administrative costs — between natural gas sales operations and the sale of natural gas as a fuel.

The agreement with the oil companies continued until 1993. From then on GMI continued to market natural gas as a fuel on its own. Its nine largest customers represented a fleet of some 500 vehicles. Although he could not corroborate this with an accounting analysis, Mr. Normand is convinced that the sale of natural gas as a fuel was a profitable activity for GMI after the winding-up of GNC because of the considerable reduction in fixed costs that resulted from the decision to focus of GMI’s efforts on businesses with large fleets of vehicles and because of the increase in the volume of longterm sales.

GMI continued to look for new markets for its natural gas for use as a fuel, including the lift truck market and the school and municipal transportation market. It also hoped that natural gas as a fuel would be more attractive to consumers once gasoline prices rose again.

The Minister’s auditor testified to explain his assessment. He filed his T20 report, and I quote the relevant paragraph explaining his position (Exhibit I-9 at p. 15):

[TRANSLATION]

We are of the view

• that GMI was not carrying on the same business as the subsidiary, since some of the operations were transferred to another business, which means that the nature of the business has changed;

• that GMI’s principal business is the selling of natural gas, not the conversion of cars to gas;

° that this activity is a separate business:

¢ that the taxpayer’s intention was not to make a profit from this activity, which was the principal source of GNC Québec’s losses; and

• that to give one example, an automobile manufacturing business (GM) is a separate business from one selling gasoline (Esso).

Our position is supported by an article from the 1989 Conference Report, 14:22, which clearly indicates that each activity must be considered as a separate business.

Conclusion

GMI did not carry on the same business and the losses cannot be claimed in 1988.

In his Reply to the Notice of Appeal counsel for the Minister stated that in arriving at his assessment the Minister had assumed certain facts, including that the conversion of vehicles to natural gas was a separate business from the sale of compressed natural gas for those vehicles. However, the auditor’s report indicates on the contrary that he considered GNC to be carrying on only a single business, but that there were two activities. He said the following at p. 14 of his report:

[TRANSLATION]

according to the 1985 T-2 return, the business from the subsidiary was divided into two activities: the conversion of vehicles to natural gas — 70 percent — and the distribution of natural gas to vehicles — 30 percent.

Counsel for the Minister added that the Minister had assumed that GMI had not carried on the business transferred by GNC for profit or with a reasonable expectation of profit throughout 1988. In his report, however, the auditor stated that it was impossible to determine whether there had been a reasonable expectation of profit because [TRANSLATION] “[GNC’s money-losing] business was merged into the parent company’s operations" (p. 14 of the report).

Analysis

Section 111 of the Act authorizes a taxpayer, in computing his or her taxable income, to deduct non-capital losses for the seven taxation years immediately preceding and the three taxation years immediately following the year. Section 111(8) of the Act defines a non-capital loss essentially as a taxpayer’s loss from a business or property. The Act also authorizes a parent company to deduct, in addition to losses which it has sustained itself, those of a subsidiary which was wound up and merged into the parent company. According to s. 88(1.1)(c), the subsidiary’s non-capital losses are deemed to be those of the parent company provided certain conditions are met, one of which is that the loss must not have been deducted by the subsidiary.

However, when such losses are attributable to a taxation year ending before the time when the parent company acquired control, ss. 88( 1.1 )(e)(i) and (ii) of the Act provide that they may not be deducted by the parent company unless other conditions are met, namely that (1) the losses are from a business carried on by the subsidiary and the business is carried on by the parent company for profit or with a reasonable expectation of profit throughout a particular year, and (2) only to the extent of the total of the parent company’s income from the business for the particular year and from any other business substantially all of the income of which was derived from the sale, leasing, rental or development of similar properties or the rendering of similar services.

The first question to be answered is whether GMI carried on, throughout 1988, the business previously carried on by GNC. In order to answer it a clear understanding of the business carried on by GNC is necessary. The auditor concluded that GNC’s principal business was the conversion of vehicles to natural gas, since 70 percent of its income came from that activity. In the auditor’s submission, since GMI subcontracted the vehicle conversion activity to CNG Fuel on September 29, 1986, it had ceased carrying on GNC’s vehicle conversion business and the first condition accordingly could not have been met.

I do not feel that this analysis by the auditor is correct. To begin with, I am not persuaded that had GMI had ceased operating the conversion centres. Although GMI subcontracted the operation of the conversion centres to CNG Fuel the latter was operating them on GMI’s behalf. It is clear in law that a business can be carried on through an agent: see E.S.G. Holdings Limited v. The Queen, 76 D.T.C. 6158 (F.C.A.).

In any case, even if CNG Fuel had not been operating these centres on GMI’s behalf, GNC’s principal business was not the conversion of vehicles to natural gas. The evidence indicated rather that GNC’s primary purpose was to sell natural gas, and incidentally to supply services of converting vehicles to natural gas. While it is true that receipts came primarily from that activity at first, conversion would become a much less important activity in the longer term. Initially natural gas sales represented only a small percentage of GNC’s income. That percentage rose to 20 percent in 1985 and was nearly 30 percent at the time of the liquidation.

The auditor appears to have been too heavily influenced by information provided in summary form in GNC’s tax returns. I am persuaded that this information was intended more to indicate the percentage that the sale of various products or services might represent than to describe the real nature of its business. If the auditor had taken his inquiries further, he would certainly have realized that GNC’s primary purpose was the sale of natural gas. As GNC was just starting up its business and had to convert vehicles in order to create a market for its product,it [3] is not surprising that receipts came first from the conversion of vehicles to natural gas and that those receipts were higher than the receipts from the sale of natural gas. In the long term, however, these proportions would be reversed.

Encouraging the establishment of conversion centres operated by third parties is perfectly consistent with the strategy of depending more on the sale of natural gas as a source of income than on the conversion activities. I therefore conclude that GNC carried on a business of selling natural gas as a fuel and that the conversion operations were only an activity incidental to that business.

Even if it were assumed that GMI had ceased to provide these conversion services, which is contrary to my interpretation of the facts, would the result of that cessation be to substantially alter the business carried on by GNC? I do not think so. When a company abandons an activity incidental to its principal business, it continues to operate the principal business.

Having arrived at this definition of GNC’s business, it must be determined whether GMI carried on that business throughout 1988 and whether it did so for profit or with a reasonable expectation of profit. There is not really any doubt that GMI continued marketing natural gas as a fuel in 1988, but did it do so for profit or with a reasonable expectation of profit?

Market studies disclosed a long-term potential for the sale of natural gas as a fuel. The adjustments made by GMI in carrying out that activity after it purchased GNC’s business eliminated a number of fixed costs and led to economies of scale. GMI also focused on the sale of natural gas as a fuel to businesses with large fleets of vehicles. Finally, many of the start-up costs for marketing the new product had already been incurred.

Although we cannot say for certain, since these activities were merged with GMI’s other marketing operations, it is even possible that the marketing of natural gas as a fuel made a profit in 1988. It is thus reasonable to conclude that the losses deducted by GMI came from GNC and that GNC’s business was carried on by GMI throughout 1988 with at least a reasonable expectation of profit.

The second question must now be considered, namely whether the second condition contained in s. 88( 1.1 )(e)(ii) of the Act was met. As GNC’s business was merged with that of GMI it is impossible to determine what income came from the business transferred to GMI by GNC. It must therefore be determined whether GMI earned income from a business substantially all of the income of which was derived from the sale, leasing, rental or development of property similar to that sold, leased, rented or developed by GNC or from the rendering of services similar to those rendered by GNC.

To answer this question, it must be determined first what products were sold by GNC before the acquisition of control and second what products were sold by GMI during 1988. As was mentioned above, GNC was primarily involved in the marketing of natural gas as a fuel and also provided conversion services. Ninety or 95 percent of GMI’s income came from the sale of natural gas and the rest from incidental operations. As the evidence showed that GMI provided conversion services to its customers, it is reasonable to conclude that substantially all of its income came from the sale of natural gas and from conversion services.

Were the natural gas GMI sold and the conversion services it provided goods and services similar to the goods sold and services provided by GNC? I do not think there can be the least doubt that these were not only similar goods or services but in fact essentially identical goods. In my view, there is no significant difference between natural gas sold as an energy source for heating units, hot water heaters or gas ranges or as a fuel for vehicles. The services of converting vehicles to natural gas, if not identical, were at the very least similar.

The fact that GNC’s activities were incorporated into GMI’s activities and that it was not necessary to create a separate division to carry on those activities is certainly a very good sign not only that GNC was carrying on a business similar to GMI’s business but that the products it sold or the services it rendered were identical or at least similar.

I cannot help noting that, in applying s. 88 of the Act in the instant case, the Minister’s auditor appears to have lost sight of the raison d’étre of the anti-avoidance provisions contained in s. 88(1.1 )(e?) of the Act. Their purpose is to prevent taxpayers from acquiring control of companies more for the tax losses of those companies than for the business carried on by them. It seems clear that the purpose of s. 88 of the Act is to prevent a company whose principal activity 1s, for example, the sale of natural gas from buying a company whose principal activity is the manufacture of television sets unless the latter business is carried on for profit or with a reasonable expectation of profit, and the losses can be deducted only to the extent of the income from the television manufacturing business. However, can there be a better example of a business to which the anti-avoidance rule should not apply than one such as GMI, which acquired a business carried on by a company it had itself incorporated, though in a minority position, to promote the sale of its product, namely natural gas?

The conditions set out in s. 88( 1.1 )(e) of the Act have all been met. GMI is entitled to deduct the losses sustained by GNC before it acquired control; these losses amounted to $2,835,655.

For these reasons, GMI’s appeals from the assessments for the 1987 and 1988 taxation years are allowed without costs and the assessments referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the consent to judgment for the 1987 taxation year, on the basis that GMI’s non-capital losses include the non-capital losses of $2,835,655 from GNC and also on the basis that GMI is entitled to deduct the said losses in calculating its taxable income for the 1988 taxation year.

In view of the circumstances of these appeals, it would have been entirely appropriate to award costs to GMI, but GMI waived them.

Appeal allowed.