Capilano International Inc. v. The Queen, 95 DTC 915, [1996] 1 CTC 2254 (TCC)

Mogan J.T.C.C.— These appeals are concerned with the right to deduct investment tax credits under subsection 127(5) of the Income Tax Act in the taxation years 1987, 1988 and 1989. Unless otherwise specified, all other statutory references in these reasons for judgment will be references to that Act. The relevant terms are defined in subsection 127(9). The amount of investment tax credits available to a taxpayer at the end of a taxation year depends upon his cost of “qualified property” and certain other kinds of property. For the purposes of these appeals, the relevant words taken from the definition of qualified property are as follows:

127(9) “qualified property” of a taxpayer means property...that is

(a) ...or

(b) prescribed machinery and equipment acquired by the taxpayer after June 23, 1975,

that has not been used, or acquired for use or lease, for any purpose whatever before it was acquired by the taxpayer and that is

(c) to be used by him in Canada primarily for the purpose of

(i)...

(vii) exploring or drilling for petroleum or natural gas,

Having regard to the particular equipment in question, the parties are in agreement that all of the conditions have been met except for the question of whether that equipment was “to be used by the appellant in Canada primarily for the purpose of exploring for petroleum or natural gas .

At all material times, the appellant was in the business of performing geophysical services for the oil and gas industry in western Canada. Specifically, it did seismic exploration. This is done by sending a sonic wave into the ground by some form of vibration and then recording the manner in which the sonic wave bounces off the different underground formations. The sonic wave can be created by an underground blast of dynamite or by a pad which is vibrated at ground level. When the energy waves come back and are “read” on special equipment, they provide a type of picture of the subsurface. The special equipment is known as seismic equipment and it is widely used in exploring for petroleum or natural gas. There is very little drilling done today without prior seismic work.

The appellant is one of about 25 seismic contractors operating out of Calgary but providing services in any area where there is a serious quest for oil and gas. Most of the work performed by the appellant is for large oil companies who invite tenders for seismic exploration within a particular area of land. The appellant will submit a tender and hope to obtain a contract. In 1986, the appellant had been in the seismic exploration business for many years operating exclusively in Canada. It was using conventional recording equipment which had been developed in the early 1970s and was then late in its developmental life. There was in 1986 more recent seismic equipment (referred to as “telemetry equipment”) which gave a much better reading of the subsurface. The conventional equipment permitted a maximum recording of 120 channels or traces at one time whereas the telemetry equipment permitted up to 1,000 channels or traces to be recorded. Also, the conventional equipment recorded its images in an analogue format which had to be transformed into digits but the telemetry equipment recorded directly in a digital format. In summary, the telemetry equipment provided a much greater amount of information to be interpreted and the end result was available in less time. As might be expected, the telemetry equipment was much more costly than the conventional equipment. Prior to 1986, no seismic companies in Canada had acquired the telemetry equipment.

In 1986, the Kingdom of Jordan had decided to conduct fresh exploration for oil and gas. Canada had agreed to provide expertise in the form of international aid through the Canadian International Development Agency (“CID A”). In 1987, CID A asked Petro-Canada to administer the aid program. The overall purpose was to provide technical assistance to Jordan and to create projects for Canadian companies. About six companies (including the appellant) submitted bids to Petro-Canada for the seismic work in Jordan. The appellant’s bid was based upon the use of its conventional seismic equipment. Petro-Canada asked the appellant to present a revised bid taking out the conventional equipment and putting in the most recent telemetry equipment. The appellant submitted a revised bid as requested but it did not own any telemetry equipment when it submitted the revised bid. Petro-Canada accepted the revised bid and the appellant agreed to perform the seismic explorations in Jordan.

Exhibit A-5 is a 23-page agreement (plus three schedules) made as of September 1, 1987 between Petro-Canada and the appellant covering the seismic work to be performed in the Kingdom of Jordan. Schedule A to that agreement contains the following description of telemetry equipment:

1. Sercel 368 Telemetry recording system configured at 520 channels in and 240 channels out at 2 ms. sample. All mounted on 4 x 4 A-T-400 buggy with special Capilano built recording hut.

Michael V. Little, the president of the appellant and the only witness to testify, stated that the Sercel 368 Telemetry Recording System was the most modern “state-of-the-art” seismic equipment in 1987. On the strength of this contract with Petro-Canada, the appellant went out and purchased a “Sercel 368” at a cost of $1,779,150 (U.S.) or approximately $2,500,000 (Canadian). The appellant would not have purchased the Sercel 368 in 1987 if it had not been awarded the Petro-Canada contract. Exhibit A-7 is a financing agreement dated August 19, 1987 between the appellant and the Province of Alberta Treasury Branch under which the appellant was granted capital financing up to the limit of $6,800,000 to assist in the purchase of equipment which would be needed if the appellant were successful (as it was) in obtaining the Petro-Canada contract for work in Jordan.

The appellant knew before 1987 that it would have to replace its conventional equipment with telemetry equipment in order to retain its clients in Canada but the replacement costs were high. The appellant used the Petro-Canada contract for work in Jordan as an opportunity to acquire this more costly equipment in circumstances which provided an assured flow of revenue over a 2-year period. The compensation payable to the appellant by Petro-Canada was a set monthly fee based on one year but the parties expected the contract to run for 2 years. If the contract lasted for ‘one year or less, Petro-Canada was required to pay a “penalty” of $2,000,000 over the second year. If it lasted more than 12 months but less than 24 months, the $2,000,000 penalty was reduced by one-twelfth for each month worked exceeding 12. This penalty provision was expressed as follows in Schedule A (page 7) to Exhibit A-5:

E. Early Termination Surcharge Payable By PCI

Unless the contract operations are terminated under the provisions of Clause 6(b) in the agreement, the following surcharges will apply:

(i) For contract operations that last less than 12 months, an early termination surcharge of $2,000,000 will be assessed. In addition, for each month of non-operations less than 12 months, $343,000 per month will be assessed.

(ii) For contract operations that last less than 24 months but greater than 12 months, an early termination surcharge of $2,000,000 will be assessed. This surcharge will be reduced by $166,667 for every month that the contract operations exceed 12- months.

Any standby period occurring after commencement of operations in Jordan will be considered an operations period insofar as surcharge computations are concerned.

According to Mr. Little’s evidence, the guaranteed minimum payments of $343,000 per month for the first 12 months plus $2,000,000 for the second 12 months (if contract operations lasted less than 24 months) were adequate financial security to borrow not only the cost of the Sercel 368 but other amounts required to transport a seismic exploration team to Jordan. I have already referred to the financing agreement (Exhibit A-7) which is dated August 19, 1987, 13 days prior to the appellant’s agreement with Petro-Canada. Schedule 3(a) to Exhibit A-7 contains the following provision at page 5:

THE FOLLOWING UNDERTAKINGS TO BE PROVIDED BY PETROCANADA ARE TO FORM PART OF OUR DEBENTURE SECURITY/OR THE CONTRACT AND/OR BOTH, AS DECIDED UPON BY OUR LEGAL COUNSEL:

(A) Irrevocable commitment to return all equipment F.O.B. Calgary, Alberta from Jordan if for any reason the project is discontinued by Petro-Canada such as war, etc. or if deemed unsuitable to continue for reasons stated above by Capilano Geophysical Ltd.

(B) Payments to Capilano to continue for 12 months if project abandoned for reasons stated in (A) above, with penalty of $2,000,000 to be paid at end of first year contract.

(C) Penalty payment of $2,000,000 to be paid to Capilano Geophysical Ltd. if contract not extended by Petro-Canada beyond the first year.

(D) Petro-Canada to pay all the cost of the mobilization of all equipment and personnel to and from Jordan.

The appellant relies on the above provisions in the financing agreement to support its claim that it was always the appellant’s intention to bring the Sercel 368 back to Canada for use in Canada to service its Canadian clients. Mr. Little stated that seismic equipment has a useful life of 10-15 years. It does not wear out but becomes technologically obsolete as better equipment is developed.

Exhibit A-23 is a letter confirming the appellant’s purchase of the Sercel 368 and its obligation to pay 10 per cent of the cost by September 30, 1987. The appellant took delivery of the Sercel 368 at Calgary in early November 1987 and used it on two small contracts for its Canadian clients before sending it to Jordan. The appellant did a one-day test for Canterra Energy Ltd. (one of its best customers at the time) to compare the results from a Sercel 368 with the results from conventional equipment. The fee for this one-day test was only $5,000. The appellant did a more extensive seismic test with its new Sercel 368 for another customer at a fee of approximately $100,000. After these two test contracts in Canada, the equipment was sent to Jordan.

Under paragraph 11(b) of the agreement with Petro-Canada (Exhibit A-5), the appellant was required to maintain a separate set of books, records and accounts for the Jordan project. Also, under paragraph 25, the appellant was required to maximize Canadian content with respect to employment, supplies, services and common carriers for equipment and personnel. The appellant’s basic equipment for the Jordan project was sent from Calgary to Montreal by rail and truck, and went from Montreal by ship in mid-November 1987 to Aqaba. The telemetry equipment was sent from Calgary to Jordan by air cargo primarily for safety reasons but also to avoid sea air. Before the Jordan project, the appellant had about 30 full-time employees in Western Canada and up to 200 part-time employees in the field. The Jordan project required 25 full-time employees who all came from the Calgary area and who all came back when the project ended.

Altogether, the appellant had equipment costing about $6,000,000 in Jordan including trucks, a repair shop, a bunk house, cooking facilities and the seismic equipment. For the operation of this equipment and the maintenance of its personnel, the appellant was paid about $750,000 per month. This was much higher than they could earn in Canada with the same equipment and personnel but their overhead in Jordan was also much higher. The Jordan project was attractive because it was long term at no financial risk; the appellant was paid in Calgary in U.S. dollars; the cost of shipping the equipment in and out of Jordan was reimbursed by PetroCanada; and there were no customer complaints.

The appellant was informed in August 1989 that the project in Jordan would end in September, about three months short of 2 years. When the project ended, the appellant sent most of its equipment back to Canada. The heavy equipment came back by boat and rail while the telemetry equipment was sent by air. It sold some equipment in Jordan like heavy trucks and camp equipment (bunk houses and cooking facilities) which were not required for the appellant’s operations in Canada or were too costly to ship back. The Sercel 368 and related equipment was brought back to Canada, however, because it could earn significant revenue for many years until it became obsolete.

The telemetry equipment was packed; sent by air cargo from Jordan; and unpacked in 7 or 8 days. The appellant knew that the Sercel 368 could be put to work in Canada immediately after its return from Jordan. Exhibit A-24 is a schedule showing the use of the appellant’s Sercel 368 for the period December 14, 1989 to March 29, 1990 indicating that the equipment was in continuous use in Alberta and British Columbia throughout that period. There was a high demand for the Sercel 368 in that period because it was the preferred equipment of the appellant’s customers and, being the winter months, it was the busy time for seismic exploration. Knowing that the Sercel 368 had an expected business life of 10-15 years and that the Jordan project would last only 2 years, Mr. Little stated that it was always the appellant’s intention to bring the Sercel 368 back to Canada and use it in Canada primarily for the purpose of exploring for petroleum or natural gas.

On May 15, 1990, the appellant entered into a purchase and sale agreement with Input/Output Inc. (Exhibit A-18) with respect to the purchase of new telemetry equipment. In the opinion of Mr. Little, from the summer of 1987 to the spring of 1990, Input/Output had surpassed Sercel in the quality of its telemetry equipment. Also, Input/Output were anxious to give their new equipment more exposure in Canada with a prominent seismic company and so they allowed the appellant a trade-in value for its Sercel 368 equal to 80 per cent of its cost. Mr. Little referred to the appellant’s deal with Input/Output as an equipment swap (old equipment for new equipment) in which the appellant received almost a full credit (80 per cent) for the cost of its older equipment. This was especially attractive to the appellant because it was a chance to acquire new and better equipment at a very small cost. In June 1990, the Sercel 368 was in fact traded in for the new Input/Output telemetry equipment.

It appears to me that it was the trade-in of the Sercel equipment for the Input/Output equipment in June 1990 which caused Revenue Canada to question the character of the Sercel equipment as “qualified property” within the meaning of subsection 127(9). In other words, was the Sercel 368 acquired by the appellant to be used “in Canada primarily for the purpose of exploring for petroleum or natural gas?” The Sercel 368 was owned by the appellant for approximately 32 months (November 1987 to June 1990) and, within that time, it was in Jordan for approximately 22 months. Therefore, it was used by the appellant in Canada for only 10 months.

The evidence given by Mr. Little, the president of the appellant, was not contradicted. I therefore make the following findings of fact: (i) in 1986/87, for seismic exploration, the recently developed telemetry equipment gave a much better reading of the subsurface than the conventional equipment then used by the appellant; (ii) the appellant would eventually have to acquire telemetry equipment to satisfy the needs of its clients and to be competitive; (iii) the telemetry equipment was significantly more expensive than the conventional equipment; (iv) the Petro-Canada contract for work in the Kingdom of Jordan gave the appellant an opportunity to acquire telemetry equipment in circumstances which would permit its continuous use for a 2-year period at a generous monthly rent; and (v) the working life expectancy of new telemetry equipment in 1986/87 was at least 10 years.

In 1987, the appellant had performed its seismic exploration services only in Canada for Canadian clients. There is no doubt in my mind that when the appellant purchased the Sercel 368 in the fall of 1987, it had a bona fide reasonable expectation of using that equipment in Canada for at least 8 years after the expiration of the 2-year contract in Jordan. The question is whether the appellant’s intention and reasonable expectation in the fall of 1987 is as important as the actual use of the Sercel 368 during its 32 months of ownership. In Setrakov Construction Ltd. v. Minister of National Revenue, [1989] 2 C.T.C. 2147, 89 D.T.C. 396 (T.C.C.), the issue was whether a certain “Caterpillar” tractor was “qualified property” under subsection 127(10) of the Act for the purpose of investment tax credit. Teskey J.T.C.C. stated at page 2150 (D.T.C. 397):

To determine the first issue the Court must interpret the words “to be used by him”. The Court is of the opinion that the important element is the intention of the purchaser at the time of purchase. The Court accepts as authority for this the decision of the Newfoundland Supreme Court in Stead Lumber Co. v. Lewis, (1958) 13 D.L.R. (2d) 34, 37 C.B.R. 24 (Nfld. T.D.), wherein it interpreted the words “furnished to be used” as found in the Mechanics Lien Act of that province. The Court finds that at the time the “Cat” was purchased, the appellant intended to use it in Canada primarily for exploring for petroleum or natural gas. The only reason the appellant did not actively use the equipment for this purpose is that exploration work in his trade area was halted by the oil companies.

Dragon Construction Ltd. v. Minister of National Revenue, [1989] 2 C.T.C. 2265, 89 D.T.C. 464 (T.C.C.), was another case involving section 127 and investment tax credits with respect to excavation equipment. In that case, Rip J.T.C.C. stated at page 2268 (D.T.C. 462-63):

The appellant must determine at the time the equipment is acquired whether it can reasonably expect that its present lessees, or the lessees to whom the equipment will be leased, will use it principally for the purpose of construction in Canada. The question of whether it can reasonably be expected that the equipment will be used in this way is a conclusion as to the future which must be made at the time the equipment is acquired.

And finally, in Produits L.B. (1989) Ltée v. R. (sub nom. Produits L.B. (1989) Ltée v. Canada), [1993] 2 C.T.C. 2625, 93 D.T.C. 1541, Lamarre Proulx J.T.C.C. stated at page 2633 (D.T.C. 1547):

However, according to two recent decisions of our Court, it is the purchaser’s intention at the time of acquisition of the property that counts, not the use of that property. The decisions were in Setrakov Construction v. Minister of National Revenue, [1989] 2 C.T.C. 2147, 89 D.T.C. 396 (T.C.C.), and Dragon Construction Ltd. v. Minister of National Revenue, [1989] 2 C.T.C. 2265, 89 D.T.C. 464 (T.C.C.). I agree with these decisions of our Court that the actual usage is not a condition set by the Act. What is a condition is that the equipment be acquired for the purposes of use in the context of manufacturing and processing activities.

In my view, these three cases have construed the legislation in a reasonable manner consistent with the plain meaning of the words. There is no doubt that, at the time of acquisition, the Sercel 368 was intended to be used exclusively in Canada for many years after the end of the two-year contract in Jordan. On the evidence, I cannot conclude that the Sercel 368 was to be used primarily in Jordan even if the word “primarily” could be construed as modifying the place of use. In my opinion, however, the word “primarily” in paragraph 127(9)(c) modifies only the purpose for which the equipment was to be used; and that purpose was always exploring for petroleum or natural gas.

Prior to 1992, the appellant had not done any work outside Canada except for the work in Jordan from the fall of 1987 to the fall of 1989. Therefore, when the appellant acquired the Sercel 368 in November 1987, its only expectation was to use that equipment in Canada after the Jordan contract. The purpose of acquisition can be determined only at the time of acquisition. Given the fact that the working life of the Sercel 368 was at least 10 years, I find that in 1987 the Sercel 368 was to be used by the appellant “in Canada primarily for the purpose of exploring for petroleum or natural gas” as those words appear in subparagraph 127(9)(c)(viii) of the Act. In particular, I note that the statute does not state “to be used exclusively in Canada”. The short-term immediate use in Jordan did not prevent the appellant from holding at the time of acquisition a bona fide intention to use the equipment in Canada primarily for exploration. My conclusion would probably be different if the working life expectancy of the equipment were significantly shorter than 10 to 15 years and if the term of the Jordan contract were significantly longer than two years. In those circumstances, the telemetry equipment would be more like the Excavators “B” and “C” referred to in Dragon Construction cited above.

Starting in 1992, the appellant did some seismic exploration work for its own clients outside Canada. In 1994, approximately 55 per cent of the appellant’s revenue was earned from work in Canada; 36 per cent was earned from work in the USA; and nine per cent was earned from work in Mexico and South America. None of this work outside Canada was on the horizon when the Sercel 368 was acquired in November 1987. When this appeal was heard (August 1995), the appellant owned 10 seismic units manufactured by Input/Output which were in constant use and five conventional seismic units which were idle because they were technologically obsolete.

Notwithstanding the fact that the appellant owned the Sercel 368 for only 32 months and, during that period, the equipment was in Jordan for 22 months, I find that the appellant has satisfied the condition in subsection 127(9) and the Sercel 368 was “qualified property”. The appeals for 1987, 1988 and 1989 are allowed with costs. According to a statement made by the appellant’s counsel at the opening of the hearing, the parties have agreed on the financial results if the appeals are to be allowed. Relying on that statement, I refer the assessments back to the Minister of National Revenue for reconsideration and reassessment on the following basis:

1. The appellant purchased “qualified property” (within the meaning of subsection 127(9) of the Act) on which no tax credit was previously allowed at an aggregate cost of $4,813,007 over three years:

STAT

2. This equipment was retained or disposed of as follows:

Not Shipped to Jordan	$ 123,687
Shipped to Jordan
Sold to GECO in Jordan	667,137

Returned to Canada and not traded to Input/Output 1,290,727

Returned to Canada and traded to Input/Output	2,731,456
Total	$4,813,007
Total

3. The amount of $123,687 is eligible for a five per cent investment tax credit of $6,184 or an investment tax credit refund of $2,473 (based on 40 per cent) in the appellant’s 1988 taxation year.

4. The following investment tax credits and consequential investment tax credit refunds are allowed in addition to that in item 3 above:

		Investment	Investment Tax
		Tax Credit	Credit Refund
	Equipment	(Rate)	(40%)
1987	$3,367,393.00	$168,369.65 (5%)	$67,347.86
1988	1,319,314.00	65,965.70 (5%)	26,386.28
1989	2,300.00	69.00 (3%)	22.60

If the parties are not in agreement with the financial results as set out above, I will hear further submissions.

Appeal allowed.