14 July 1988 Income Tax Severed Letter 7-2819 - [Payments received by taxpayers from Hydro-Quebec]

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

July 14, 1988

Rulings Directorate T. Murphy 957-2747 SUBJECT: Payments received by taxpayers from Hydro-Quebec

This is in reply to your May 4, 1988 memorandum concerning the tax treatment of payments received by taxpayers from Hydro-Quebec.

All references herein to sections or components thereof are references to the Income Tax Act (the "Act") unless otherwise indicated.

Facts

Our understanding of the facts is as follows:

1. Hydro-Quebec is a joint stock company incorporated under the Hydro-Quebec Act (the "HQA"). Its shares are part of the public domain of Quebec and are allotted to the Minister of Finance of Quebec pursuant to section 3.3 of the HQA. In accordance with section 13 of the HQA, Hydro-Quebec is an agent of the Crown in the right of the province.

2. Pursuant to section 22 of the HQA, the objects of Hydro-Quebec are "...to supply power and to pursue endeavours in energy related research and promotion, energy conversion and conservation, and any field connected with or related to power or energy". Section 22.1 of the HQA provides that Hydro-Quebec may "...implement energy conservation programs; to that end, it may grant technical or financial assistance".

3. Pursuant to section 22.0.1 of the HQA, the rates and conditions upon which power is supplied are fixed by by-laws or by special contracts, and must be consistent with sound financial management. The log-laws and contracts are subject to the approval of the Quebec government.

4. The affairs of Hydro-Quebec are, pursuant to section 4 of the HQA, administered by a board of directors composed of not more than seventeen members appointed by the Quebec government for a term not exceeding five years.

5. In 1982 Hydro-Quebec initiated several marketing programs, targeted to specific customer groups, to increase its business. The objective of these programs is to stimulate greater demand for electricity through incentives which either encourage conversion to electricity from other sources of energy or subsidize the upgrading of equipment utilizing electricity. The incentives under the various marketing programs are available to both residential and industrial customers and include financial assistance to purchase or upgrade equipment using electricity, grants to convert from other sources of energy to electricity and rate discounts to assist investment in new technological processes. From 1982 to 1986 Hydro- Quebec invested over $300 million in grants under its marketing programs.

TAXPAYERS' POSITION

The various taxpayers involved have treated the Hydro-Quebec payments in one of the following manners:

(1) as an income inclusion or an expense reduction,

(2) as a reduction to the capital cost of depreciable property pursuant to subsection 13(7.1), or

(3) as a windfall.

Presumably, in the first case, the amounts were received to augment income or reduce expenses.

In the second case, the taxpayers have assumed that Hydro-Quebec is a public authority and acted as such when it made the grants, subsidies or other assistance with respect to their acquisition of depreciable property.

The third case 8180 deals with a grant, subsidy or other form of assistance received with respect to the acquisition of depreciable property. In this instance however, the taxpayers contend that Hydro-Quebec is not a public authority and that the agreements between themselves and Hydro-Quebec are the result of ordinary business contracts. They therefore feel that the payments made by Hydro-Quebec are in the nature of tenant inducements which, pursuant to paragraph 9(a) of 1T-359R2, are non-taxable capital receipts. The cases cited as authority for this position include:

(1) Ottawa Valley Power Company v. MNR, 69 DTC 5166 (Ex. Ct.)

(2) The Consumers' Gas Company Ltd. v. Her Majesty the Queen, 82 DTC 6300 (FCTD), aff'd 84 DTC 6058 (FCA) (re the 1971 to 1974 taxation years),

(3) The Consumers' Gas Company Ltd. (formerly Hiram Walker - Consumers Home Ltd) v. Her Majesty the Queen, 86 DTC 5008 (FCTD), aff'd 87 DTC 5008 (FCA) (re the 1975 to 1977 taxation years), and

(4) Canadian Pacific Limited v. Her Majesty the Queen, 76 DTC 6120 (FCTD), aff'd 77 DTC 5383 (FCA).

YOUR POSITION

In your opinion the payments received by the taxpayers from Hydro-Quebec should be included in their income pursuant to section 9. As in the case of French Shoes Ltd. v. The Queen, 86 DTC 6359 (FCTD), wherein part of the corporation's business activity was to sign leases under the best possible conditions, you feel that for the taxpayers involved here it was part of their business activities to negotiate with any of their suppliers, including Hydro-Quebec, to pay the least amounts for their power needs. You do not feel that the amounts are windfalls, based on the decisions in J.E. Cranswick v. Her Majesty the Queen, 80 DTC 6057 (FCTD), aff'd 82 DTC 6073 (FCA) and Federal Farms Ltd v. MNR, 66 DTC 5068 (Ex. ct.), aff'd 67 DTC 5311 (SCC).

You state that under GAAP the Payments received would be brought into income over a number of years. For income tax purposes, you propose to bring the amount into income in the year of receipt pursuant to section 9 as there is no specific statutory or jurisprudential rule which overrides section 9 in these circumstances.

In addition, you feel that Hydro-Quebec was not acting as a public authority in its dealings with the various taxpayers involved; We you feel that the agreements between Hydro-Quebec and the taxpayers are ordinary business contracts negotiated by both parties for business reasons. Therefore, in your opinion, subsection 13(7.1) is not applicable to reduce the capital cost of depreciable property The primary support for this position is the Ottawa Valley Power case and Valley Camp Ltd. v. MNR, 74 DTC 6337 (FCTD).

In your opinion, the present situations can be distinguished from the Consumers' Gas case, wherein Consumers' Gas did not benefit from the pipeline relocation and the work was done only at the request of and for the benefit of the party making the reimbursement, while in the present situations the taxpayers entered into agreements with Hydro-Quebec fully intending to benefit from them. You feel that the facts in the present situation closely parallel those in Valley Camp, wherein the reimbursements were determined to be income.

With respect to the comments mate in paragraph 9 of IT-359R2 and paragraph 5 of IT-174R , you point out that'

(1) In September 1983 we were asked by the Department of Finance Canada to retract paragraph 9(a) (and certain comments in paragraph 6) or postpone publication of the bulletin pending further clarification of the law.

(2) IT-359R2 deals only with payments between landlords and tenants in leasing arrangements and dose not specify the tax treatment of other categories of payments.

(3) Paragraph 5 of IT-174R states that where a person other than the taxpayer contributes to the taxpayer's acquisition of a property by reimbursing him for the costs the taxpayer has contracted for in connection with the acquisition of the property, the tax treatment to both the taxpayer and the other person will be determined on the basis of the facts of the case.

(4) As stated in French Shoes, an amendment to the Act, in this case the enactment of paragraph 12(1)(x) effective May 23, 1985, does not imply a change in law; in this case, it clarifies the law with respect to inducement payments.

In your opinion, the rationale behind subsection 13(7.1) is to reduce the capital cost of depreciable property for amounts that would otherwise be treated as non-taxable capital receipts or windfalls on the basis that there is no business relationship between the taxpayer and the government, municipality or other public authority involved. Therefore, if there is a business relationship between the taxpayers involved, the amount should be included in income.

In the present case, you have not made a distinction between income and capital items as you feel that all amounts are directly or indirectly related to the reduction of expenses; i.e. the initial outlay and the subsequent reimbursement of the capital cost of the depreciable property enables the taxpayers to enter into power rate agreements with Hydro-Quebec which result in lower power expenses.

OUR POSITION

We agree with you that the amounts are not windfalls. However, in our opinion it is not correct to maintain that all payments made by Hydro-Quebec to the taxpayers involved should be included in their income pursuant to section 9. We feel that the tax consequences flowing from a particular contract between a taxpayer and Hydro-Quebec will depend on the nature of the contract itself and the business activities of the taxpayer. Therefore, if a payment was made to supplement a taxpayer's income or to enable him to operate at a profit, to reduce expenses or to ensure a reasonable return to a taxpayer in respect of his capital investment the payment is considered to be income in nature. If however, the payment were made to reimburse or assist the taxpayer in respect of a capital outlay, the payment is considered to be capital in nature and is not required to be included in income.

Under GAAP, assistance related to capital expenditures is treated in one of two ways:

(A) deducted from the cost of the related fixed assets with any depreciation calculated on the net amount, or

(B) deferred and amortized to income on the same basis as the related depreciable fixed assets are depreciated.

While we agree with you that there is no specific rule which overrides section 9 we point out a similar argument was considered by the Federal Court of Appeal in Consumers' Gas (formerly Hiram) wherein the Court stated:

"The principal argument advanced by counsel for the appellant is disarmingly simple. He urges that the method employed by Consumers' Gas for financial statement purposes, which is, as stated, in accordance with generally accepted accounting principles, results in the disputed receipts being reflected in the income Statement. Hence, he argues, the treatment accorded for income tax purposes should also produce this result and the receipts should be treated as revenues.

With respect, it seems to me that this approach is flawed. It attempts to achieve the results produced by generally accepted accounting principles while rejecting the method...

Thus while it is true, as appellant argues, that accounting principles require depreciation on the net cost of capital assets always to be reflected in income, that is not the case for purposes of income tax. More particularly, on the facts of the present case, the receipts from third parties in respect of pipeline relocations are reflected in Consumers' Gas income for financial statement purposes solely because they go to reduce the cost of the assets upon which straight line depreciation is taken over seventy years. The receipts themselves, however, are not treated as income. They are reflected in income, albeit faintly, because good accounting, unlike income tax law, requires that depreciation be taken. It is common ground here that the cost of pipeline relocations is a capital outlay and that the receipts from third parties in respect thereof need not be taken into account in determining underpreciated capital cost for the purposes of calculating capital cost allowance. The mere fact that this results in such receipts not being reflected in income does not make them income. Absent some provision of the statute specifically bringing them into income, they continue to be treated, as required by generally accepted accounting principles, as capital receipts. The submission therefore fails."

Based on this reasoning, it would appear that even if the company had deferred and amortized the amount to income under option (B) above, the Court would have left the amounts received to be capital receipts.

After reviewing the decisions in Ottawa Valley, Valley Camp, Consumers' Gas, Consumers' Gas (formerly Hiram) and Canadian Pacific, one point which stands out is that in all these cases the payments were made by the customers to their suppliers.

In Ottawa Valley, the customer (Ontario Hydro) paid for the capital cost of improvements to power plant equipment owned by Ottawa Valley. In this case the Court held that the taxpayer was not entitled to claim CCA as the improvements had no capital cost. In contemplating possible alternative positions, the issue of whether the amounts received were income was raised. Mr. Justice Jackett stated:

"The straightforward sort of bargain that might have been expected when the appellant was approached by Hydra in 1955 was that Ontario Hydro would pay to the appellant, for the desired amendment to the supply contract, whatever it might cost the appellant to effect the necessary change in its plant ... In my view, the explanation is that, from a commercial point of view, if that had happened, there would be two aspects of the matter, viz.

(a) the appellant would have incurred capital costs for which it should have capital cost allowance, and

(b) the appellant would have received a payment from the purchaser of its power which should be taken into its revenues if it is part of the payment for what it has sold in the course of its business or should be regarded as a capital receipt if, in the circumstances, it should be so characterized...

In so far, however, as the capital additions and improvements were received as consideration for agreeing to deliver 60 cycle power at a price that was lower than would otherwise have been economic, I should be inclined to think that it was probably received on revenue account in accordance with the ordinary principles of commercial trading."

In Valley Camp, the customer (CN) paid Valley Camp a handling charge plus an annual payment equal to 10 3/4 percent of the final actual capital cost of the facilities required by Valley camp to service it. This latter payment was held to be income as the Court found:

"It is quite apparent that CN required the loading and unloading expertise of the appellant for which it was willing to pay charges not only for the actual handling of the pellets but also for the amount required to reimburse the appellant for the outlays it was required to make 'to provide' the facilities for the services to be performed ... The whole transaction was clearly a commercial one in which Valley Camp prudently insured the recovery of its expenditures for this apparently single purpose facility whereas CN assured itself of facilities provided and operated by experts, in part at least at a predetermined annual coat."

In the Consumers' Gas cases, the customers reimbursed Consumers for the costs it incurred in relocating its pipelines at their requests. The average number of requests was approximately 726 per year. In these eases' (one deals with the 1971-1974 years and the other with the 1975-1977 years), the courts found that the reimbursements did not reduce the capital cost of the pipelines add that they were not income receipts.

In your memorandum you refer to the Federal Court Trial Division decision of Mr. Justice Walsh (Consumers' Gas) wherein he noted that there was no revenue advantage to Consumers' Gas in relocating the pipelines; i.e. the company "surrendered no future profits for the contributions paid". At page 6309 he stated:

"I have concluded that Plaintiff in the present case was justified in considering that contributions received towards the relocation of ts pipelines done, not for its benefit, but for the benefit of the parties making the contributions, can be carried to a contributed capital account without passing through income."

In Canadian Pacific, the customers reimbursed the company for expenditures it incurred when the customers requested that it improve or build facilities to service them. As in the Consumers' Gas case, there were a significant number of such transactions each year. In this case, the issue as to whether or not the reimbursements received should be included in income was not raised. The court did however, find that in respect of transactions where the taxpayer made the capital-expenditures on its own account (re properties it owned), that the customer reimbursements did not reduce the capital coat of the depreciable assets.

In the present situation, the payments were made by the supplier, Hydro- Quebec, to its present and future customers. While we agree in general with your logic, we feel that your statement regarding the rationale behind subsection 13(7.1) and your argument that as all amounts are directly or indirectly related to the reduction of expenses they should be included in income in the year of revert is not in accordance with either Department policy or GAAP and would not likely succeed in the courts, i.e. with respect to the reimbursement or all or a portion or the capital cost of depreciable property, if we are unsuccessful in including the amount in the income of a supplier who receives a significant number of reimbursements each year. It is unlikely that the courts would accept that a customer who receives one (or a few) such reimbursement(s) should include the amount(s) in income. Note that the Federal Court of Appeal in Consumers' Gas (formerly Hiram) did not base it decision on the fact that the reimbursements did not add to the company's profits, which was the basis for the decision reached in the Federal Court Trial Division by Mr. Justice Walsh in Consumers' Gas.

We feel that the situation in Valley Camp is probably not analogous to the situation of the majority of taxpayers involved here. While both situations involve reimbursements of the capital cost of depreciable property, the substance of the reimbursements in Valley Camp was that the customer paid the company for services rendered (a similar argument was made by Mr. Justice Jackett in Ottawa Valley at page 5179). Here, no services are being rendered to Hydro-Quebec by its customers.

With respect to paragraph 9 of IT-359R2 , while we recognize that this bulletin deals specifically with leases, we feel that the principles contained therein can be applied to those taxpayers who received payments from Hydro-Quebec and we to not feel that this treatment deviates from the comments made in paragraph 5 of IT-174R .

As you have noted, prior to the decision rendered in French Shoes, the Department's position was that the comments in paragraph 9 of IT-359R2 were supported by jurisprudence and that a change in law would be required to tax such receipts. This position was upheld even though the Department of Finance Canada did not agree.

At the 1986 Tax Conference the Department was asked to provide an update on its current position on lease inducements received prior to May 23, 1985 in light of the decision in French Shoes. We replied:

"It is our opinion that this decision provides support for our position described in paragraph 9(c) of Interpretation Bulletin 359R2. It is not viewed as broadening our position to include into income every inducement payment received by a tenant. Our position on lease inducements received prior to May 23, 1985 continues to be as stated in paragraph 9 of IT-359R2 ."

Therefore, to include in a taxpayer's income a payment received from Hydro- Quebec you would have to prove that the negotiation of power supply contracts is a regular part of the taxpayer's business operation; i.e. done habitually for the purpose of producing a profit and not merely incidental to being in business. On a practical level, all prudent business people will negotiate with their suppliers to obtain the best deal or price possible. At what point in time the negotiations consume such continual time, attention and labour that they can be characterized as a regular part of the taxpayer business operations can only be ascertained from the facts of the particular case.

In your opinion, Hydro-Quebec was not acting as a public authority in its dealings with the taxpayers (its customers) involved here. If this is in fact the case, then subsection 13(7.1) would not be applicable and in our view the end result would be that such payments, which represent reimbursements of the capital cost of depreciable properties, would not be included in income and would not reduce the capital cost of the depreciable properties. Attached are copies of previous correspondence issued by our branch wherein we have stated that, in our opinion, Hydro-Quebec did act as a public authority in situations similar to those presented here.

OTHER ITEMS

Paragraph 12(1)(x)

You have indicated that you are concerned that paragraph 12)(1)(x) will not capture the Hydro-Quebec reimbursements made after May 22, 1985 as in your opinion, the Department will not be able to prove that the amounts were received "in the course of earning income from a business or property". You have also pointed out that paragraph 12(1)(b) only includes in income amounts receivable "in the course of a business" and is not applicable with respect to the amount receivable on the disposition of a capital property.

In our opinion, the receivable referred to in paragraph 12(1)(b) must arise from the business activities of the taxpayer, while the amount received pursuant to paragraph 12(1)(x) includes all amounts received in connection with the earning of income from a business or property.

XXXX

we are of the opinion that the contract represents a sale of know-how which, in accordance with the decisions reached in Canadian General Electric Company Limited v. Her Majesty The Queen, 82 DTC 6232 (FCTD), aff'd 87 DTC 5070 (FCA) and Canadian Industries Limited v. Her Majesty The Queen, 77 DTC 5138 (FCTD), aff'd 80 DTC 6163 (FCA), should be included in XXXX income pursuant to section 9 (if earned) and/or paragraph 12(1)(a).

We hope our comments are of assistance to you. As promised, your research material and files are hereby returned to you.

R.J. Kauffman A/Chief Leasing and Financing Section Financial Industries Division Rulings Directorate Attachments