The Queen v. Gulf Canada Ltd., 92 DTC 6123, [1992] 1 CTC 183 (FCA)

Hugessen, J.A.:—This is an appeal and a cross-appeal from a decision of McNair, J. rendered October 25, 1990. By that decision, the trial judge allowed in part the taxpayer's appeal from its assessments for the 1974 and 1975 taxation years.

The Crown's appeal contests McNair, J.'s interpretation of the definitions of “taxable production profits from mineral resources in Canada" and "taxable production profits from oil or gas wells in Canada" which were, at the relevant times, found in sections 124.1 and 124.2 of the Income Tax Act, R.S.C. 1952,

c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act"):

124.1(1) For the purposes of this Part, "taxable production profits from mineral resources in Canada" of a corporation for a taxation year means the amount, if any, by which the aggregate of

(a) where the corporation has production from a mineral resource in Canada operated by it, the amount, if any, included in computing its income for the year by virtue of subsection 59(2.1) and paragraphs 59(3.2)(b) and (c), less any deduction allowed in computing its income by virtue of subsection 64(1.1), and

(b) the amount, if any, of the aggregate of its incomes for the year from

(i) the production in Canada of

(A) petroleum, natural gas or related hydrocarbons, or

(8) metals or minerals to any stage that is not beyond the prime metal stage or its equivalent,

from mineral resources in Canada operated by it,

(ii) the processing in Canada of ores from mineral resources in Canada not operated by it to any stage that is not beyond the prime metal stage or its equivalent, and

(iii) a rental or royalty, the amount of which is computed by reference to the

amount or value of production from a mineral resource in Canada,

exceeds

(c) the aggregate of its losses for the year from those sources, computed in accordance with this Act, on the assumption that it had during the taxation year no incomes or losses except from those sources and was allowed no deductions in computing its income for the taxation year other than

(i) amounts deductible under any of section 66 (other than amounts in respect of foreign exploration and development expenses as defined therein) and subsections 17(2) and (6) and section 29 of the Income Tax Application Rules, 1971 where the corporation has no taxable production profits from oil or gas wells in Canada and, in any other case, such proportion of those amounts as may reasonably be regarded as wholly applicable to mineral resources in Canada,

(ii) the amount, if any, by which the aggregate of the losses referred to in paragraph 124.2(1)(c) exceeds the aggregate of the incomes referred to in paragraphs 124.2(1)(a) and (b),

(iii) such part of the aggregate of amounts deducted under section 65 for the year as is in respect of sources of income described in any of subparagraphs (b)(i), (ii) and (iii),

(iv) where no amount is deducted pursuant to subparagraph 124.2(1)(c)(iv) in computing its taxable production profits from oil or gas wells in Canada for the year, the amounts deductible or deducted, as the case may be, under subsections 66.1(2) or (3) and 66.2(2) for the year, and

(v) such other deductions as may reasonably be regarded as applicable to the sources of income described in any of subparagraphs (b)(i), (ii) and (iii).

(2) For the purposes of this section, a person who has an interest in the proceeds of production from a mineral resource in Canada under an agreement providing that he is to share in the profits remaining after deducting the operating costs of the mineral resource shall be deemed to be a person who operates the mineral resource.

(3) Income or loss from a source described in paragraph (1)(b) does not include income or loss derived from transporting or processing petroleum, natural gas or related hydrocarbons.

124.2(1) For the purposes of this Part, "taxable production profits from oil or gas wells in Canada" of a corporation for a taxation year means the amount, if any, by which the aggregate of

(a) where no amount is included in computing the taxable production profits from mineral resources in Canada of the corporation by virtue of paragraph 124.1 (1)(a) and the corporation has production from an oil or gas well in Canada operated by it, the amount, if any, included in computing its income for the year by virtue of subsection 59(2.1) and paragraphs 59(3.2)(b) and (c), less any deduction allowed in computing its income by virtue of subsection 64(1.1), and

(b) the amount, if any, of the aggregate of its incomes for the year from

(i) the production of petroleum, natural gas or related hydrocarbons from oil or gas wells in Canada operated by it, and

(ii) rentals or royalties, the amounts of which are computed by reference to

the amount or value of production from oil or gas wells in Canada,

exceeds

(c) the aggregate of its losses for the year from those sources, computed in accordance with this Act, on the assumption that it had during the taxation year no incomes or losses except from those sources, and was allowed no deductions in computing its income for the taxation year other than

(i) amounts deductible under any of section 66 (other than amounts in respect of foreign exploration and development expenses as defined therein) and subsections 17(2) and (6) and section 29 of the Income Tax Application Rules, 1971 to the extent that those amounts are not deductible pursuant to subparagraph 124.1 (1)(c)(i),

(ii) the amount, if any, by which the aggregate of the losses referred to in paragraph 124.1(1)(c) exceeds the aggregate of the incomes referred to in paragraphs 124.1(1)(a) and (b),

(iii) such part of the aggregate of amounts deducted under section 65 for the year as is in respect of sources of income described in subparagraphs (b)(i) and (ii),

(iv) where the corporation has production from oil or gas wells in Canada operated by it, the amounts deductible or deducted, as the case may be, under subsection 66.1(2) or (3) and 66.2(2) for the year, and

(v) such other deductions as may reasonably be regarded as applicable to

the sources of income described in subparagraphs (b)(i) and (ii).

(2) For the purposes of this section, a person who has an interest in the proceeds of production from an oil or gas well in Canada under an agreement providing that he is to share in the profits remaining after deducting the operating costs of the oil or gas well shall be deemed to be a person who operates the oil or gas well.

(3) Income or loss from the production in Canada of petroleum, natural gas or related hydrocarbons from an oil or gas well does not include income or loss derived from transporting or processing petroleum, natural gas or related hydrocarbons.

McNair, J. was of the view that the" production” referred to in subparagraph (1)(b)(i) of each of the sections was production in the narrow sense of extraction from the ground. As a result, he did not accept the Crown's view that taxable production profits (and consequently the taxpayer's base for the calculation of depletion allowance, petroleum profits abatement and corporate surtax) should be reduced by amounts representing, first, expenses in respect of long term scientific research not directly related to production and, second, capital cost allowance in respect of investments by the taxpayer in a project (Syncrude) for the extraction of oil from a mineral resource which was still some years away from production.

We are all of the view that McNair, J. reached the right conclusion and that the reasons he gave for doing so are unimpeachable. [1] While we are content to adopt those reasons, we wish to add a very few observations of our own which serve to reinforce his view of the proper interpretation of sections 124.1 and 124.2.

The structure of the two sections is clearly such as to identify and isolate income from certain specific and described "sources" of income and then to subtract therefore the aggregate of the losses from those same sources together with five specific and described categories of deductions". The most important of these for our purposes and the one upon which the Crown principally relies in support of its appeal, is subparagraph (c)(v): "such other deductions as may reasonably be regarded as applicable to the sources of income described in [the subparagraphs of paragraph (b)]”.

Again, for present purposes, the "source" of income described in paragraph (1)(b) of both sections which is of concern to us is the "production" of “petroleum, natural gas or related hydrocarbons” from mineral resources or oil or gas wells in Canada operated by" the taxpayer.

In our view, the texts of sections 124.1 and 124.2 themselves offer three strong arguments why the interpretation of" production" proposed by McNair, J. is the correct one.

First, the word "production" appears in three places in subsection (1) of each section. The first, in paragraph (1)(a), refers to situations where the corporation "has production" from a mineral resource or oil or gas well. Counsel for the Crown concedes (indeed as appears below he based an argument on the point) that the use of the present tense "has" in the context must be taken to mean that there is actual tangible production. It is likewise with the third use of the word "production" in subparagraphs 124.1(1)(b)(iii) and 124.2(1)(b)(ii) respectively: the amounts of the rentals or royalties there referred to could only be computed on the basis of production in the sense of physical extraction from the ground. The remaining use of the word "production" is the one in issue in the present case and appears in subparagraph (1)(b)(i) of both sections. There is a strong, indeed overwhelming, presumption that Parliament, having used the same word three times in the same subsection, intended it to bear the same meaning each time.

Second, the relevant “source” in paragraph (1)(b) of each section is described as production from a mineral resource or well "operated by” the taxpayer. The reference to operation cannot be for the purpose of identifying the relevant taxpayer (as for example by distinguishing between an "operator" and a non-operator") because subsection (2) in each case provides that anyone having an interest in the proceeds of production is deemed to be an operator. Thus the only reason for including the requirement that the resource be operated" must be that it be operating i.e., physically producing.

Third, as indicated earlier, the Crown has sought to draw an argument from the words “where the corporation has production from oil or gas wells in Canada operated by it" as they appear in subparagraph 124.2(1)(c)(iv). These words imply actual physical production and extraction and the suggestion is made that if” "production" in subparagraph (1)(b)(i) is limited in the same way there would be redundancy. Inclusio unius est exclusio alterius. Not only is the argument without merit but the quoted text actually supports the opposite conclusion. Production is not the only" source” referred to in paragraph (1)(b); rentals and royalties are also included. It is by no means inconceivable that a taxpayer could have income from the latter and not from the former. Such a taxpayer would not have production from oil or gas wells operated by it and one would not expect that it would be allowed to deduct Canadian exploration expenses (subsections 66.1(2) and (3)) and Canadian development expenses (subsection 66.2(2)) from its rentals or royalties. On the other hand, where the taxpayer does have production from oil or gas wells, such production becomes one of the identified "sources" in paragraph (1)(b) and the deduction of the expenses described in subparagraph 124.2(1 )(c)(iv) is permitted and is entirely consistent with the scheme of the sections (and indeed, of the Act) as a whole.

Finally, we would simply mention the Crown's argument to the effect that "production" simpliciter cannot be a "source" of income and that it is rather the business” of production which is in fact the source. To the extent that the argument is one of semantics, it is meritorious but sterile. It is true that the mere physical act of taking minerals or oil or gas from the ground does not and cannot produce income; when Parliament has described “production” as being a “source”, as it clearly has insections 124.1 and 124.2, it must be understood as the business of production. That does not, however, assist us in determining what is meant by "production" or what is included in the business; it certainly does not support the Crown's argument that production" comprises the whole of the upstream" end of the taxpayer's business, including exploration and development and whether or not there is any actual production, a contention for which there is no warrant whatsoever in the sections. The taxpayer, as an integrated oil company, also has refining, distribution and marketing as parts of its whole business, but it could not be seriously suggested that they, too, should be included in the concept of production as a source of income. As McNair, J. said, sections 124.1 and 124.2 set up their own separate scheme of inclusions and exclusions from income for purposes of the special incentive programs."

The appeal must fail.

By its cross-appeal, the taxpayer contests the trial judge's finding that subsurface lease rental payments made by it to various provincial governments in the years 1974 and 1975 should not be included in its earned depletion base as defined in Regulation 1205.

Despite the complexity and difficult interrelationship of the various legislative texts involved, there is, in our view, and with respect, a good deal less to this question than meets the eye.

For our purposes, it is enough to know that for this taxpayer the lease rental payments in question could only be included in the earned depletion base if they met the definitional requirements of either "Canadian exploration ex- pense” in paragraph 66.1 (6)(a) of the Act or "Canadian development expense" in paragraph 66.2(5)(a). In the latter case, to qualify for inclusion in the base, the expense would in addition, by the operation of Regulation 1205(a)(iii)(C), have not to be “an amount referred to in subparagraph 66.2(5)(a)(iii) of the Act". In order to give some semblance of grammatical clarity to the discussion which follows, which is not in fact complicated, we shall only refer to such parts of these various definitions as and when they are necessary.

First, as we read McNair, J.'s judgment, he found as a fact that the lease rental payments in question were not made for the purposes only of exploration, but rather "for the entire upstream sector of the business”, that is to say exploration, development and production. There was certainly evidence to support that finding since it appears that of the approximately four million acres that the taxpayer had in its land inventory in the years in question, only a small and undetermined proportion was the subject of actual exploration or drilling in any one year. That being the case, we certainly cannot say that the judge was wrong to find as he did.

As a matter of law, to qualify as a Canadian exploration expense, the rental payments in question would have to meet the definition in subparagraph 66.1(6)(a)(i) as an“. . . expense . . . incurred . . . for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas". We agree with the view, apparently accepted by the trial judge, that payments made to maintain an acreage inventory upon which exploration, development and production may or may not take place at some undetermined time in the future are not within that definition. We also agree with the statement of Mahoney, J., as he then was, in New Continental Oil Co. v. The Queen, [1976] C.T.C. 44, 76 D.T.C. 6038, at page 52 (D.T.C. 6043) that there is a distinction between "payments for the right to drill and explore" and "expen- sesincurred in drilling or exploring". Furthermore, we would, as a general rule, expect that for any expense to be said to have been incurred for the purpose of determining the existence etc. of petroleum or natural gas on a property, there would have to be at least some connection between that expense and work actually done on the ground. Accordingly, and while the rental payments made in respect of those parts of the acreage inventory upon which exploration activity actually took place in a taxation year might qualify as Canadian exploration expenses, we do not find it necessary to express an opinion on the point since no attempt was made by the taxpayer to quantify any such expenses, the amount of which would, in any event, be of minimal significance. We are quite satisfied that the purpose of the special treatment accorded by the legislation to exploration expenses was to encourage actual exploration and not to finance from public funds the accumulation of huge dormant inventories of subsurface rights. This view is further supported by the fact that the costs of such rights are, as noted below, included in development expenses where they receive a different, and less favourable, tax treatment.

This brings us to the question of whether the payments in question could qualify as a "Canadian development expense". The only possible relevant provision is in subparagraph 66.2(5)(a)(iii) :

. . . the cost . . . of any Canadian resource property . . . but not including any payment made to [a provincial government] . . . for the preservation of a taxpayer's rights in respect of a Canadian resource property.

[Emphasis added.]

By paragraph 66(15)(c), a Canadian resource property includes "any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons".

The result that flows from these texts when read together is that annual rental or other payments to provincial governments made for the purpose of keeping leases or licences to subsurface rights current are “not included” in Canadian development expenses. The trial judge so found and he was correct.

There remains one other category of payments made by the taxpayer which were not specifically mentioned by the trial judge. This is clearly because they were not in fact claimed by the taxpayer as forming part of the earned depletion base, but we think we should deal with them so as to complete the picture of our understanding of the statutory scheme involved. The evidence shows that for provincial government leases of subsurface rights the practice was to require a very large“ bonus” or lump sum payment at the very beginning of the term, generally as part of a public bidding process. Those payments would not be Canadian exploration expenses for the reasons already mentioned. However, they seem to qualify as Canadian development expenses under the definition in subparagraph 66.2(5)(a)(iii) quoted above: they represent the cost of a Canadian resource property, and being one time, "front end" payments they are not caught by the exclusion of payments to provincial governments "for the preservation of" the taxpayer's rights in the resource. They are, however, clearly excluded from the earned depletion base by the express language of Regulation 1205(a)(iii)(C).

In summary, to be included in the depletion base rental payments must be either Canadian exploration expenses or Canadian development expenses. They are not the former because their purpose was not exclusively or even primarily exploration, but rather the accumulation of an acreage inventory which might or might not be used to serve exploration, development and production in the future. Insofar as concerns annual rental payments to provincial governments, they are excluded from Canadian development expenses by words internal to the definition of that term; "bonus" payments to provincial governments, on the other hand, while they may be within the definition of Canadian development expenses, are excluded from the depletion base by words external to that definition but which are contained in the definition of the base itself. Accordingly, the cross-appeal too must fail.

The appeal and the cross-appeal will each be dismissed with costs.

Appeal and cross-appeal dismissed.