Edmonton Liquid Gas Ltd. v. The Queen, 84 DTC 6526, [1984] CTC 536 (FCA)

MacGuigan, J:—This is an appeal from a judgment of the Trial Division dismissing the appellant’s appeal from an assessment made by the Minister of Na- tional Revenue which disallowed the deduction in respect of its 1974 taxation year of the amounts of $475,000 and $147,405 as Canadian Exploration Expenses pursuant to subsection 66.1(2) of the Income Tax Act.

Edmonton Liquid Gas Limited, the plaintiff and appellant, is a Canadian corporation registered and carrying on business in the province of Alberta and elsewhere as a wholly owned subsidiary of Dome Petroleum Limited. Dome kept all records of this subsidiary and performed all required business matters on its behalf. Its taxation year coincided with the calendar year.

The issues here involve two undertakings entered into by Dome, in part for and on behalf of the appellant, in respect of the Red Fox P21 Well in the Northwest Territories and another test well in Alberta.

The Red Fox Well

By a farmout agreement among Dome, Gulf Oil Limited and Mobil Oil Canada Ltd dated December 23, 1974, Dome agreed to have drilled at its sole cost, risk and expense an exploration well (The Red Fox Well) on lands owned by Gulf and Mobil under permit in the Northwest Territories, whereby Dome would earn an undivided 33% per cent interest in the petroleum and natural gas rights subject to the permit. By the same agreement Dome agreed to execute an agency agreement pursuant to which Gulf would be appointed as operator on Dome’s behalf for the drilling of the Red Fox Well and Dome agreed to pay Gulf on or before December 31, 1974, the sum of $3,800,000 in partial payment of the costs of drilling the well and of standby time to the next drilling season. Dome further agreed to pay Gulf any costs to Gulf of drilling the well that were in excess of that sum.

By a further drilling agreement between Dome and Gulf dated December 31, 1974, Gulf agreed to supply the rig and related facilities and services for the drilling of the Red Fox Well as agent for, and, under the express authority, direction and control of, Dome for the sum of $3,800,000 plus the amount of any excess costs to Gulf. The agreement provided the procedure for the determination and payment of any such additional costs.

Pursuant to the terms of the farmout and drilling agreements, Dome paid Gulf the sum of $3,800,000 before December 31, 1974, of which $475,000 was on behalf of the appellant. Dome made a further payment to Gulf in final satisfaction of its obligations under the agreements during the appellant’s 1975 taxation year. No issue arises here with respect to this further payment.

The actual drilling of the Red Fox Well commenced on January 5, 1975, and was terminated on May 9, 1975, without success. The well was subsequently abandoned as a dry hole incapable of commercial production.

The Alberta Test Well

By a letter agreement dated December 3, 1974, among Dome, Western De- calta Petroleum Limited and Pan Ocean Oil Ltd, Dome agreed to commence the drilling of an exploration well before December 15, 1974 at a specified location on lands held by Western Decalta Petroleum Limited and Pan Ocean Oil Ltd under Alberta Crown Petroleum and Natural Gas Leases. On drilling of the well to contract depth, and upon completing or abandoning the well, Dome would thereby earn an undivided 50 per cent interest in the said lands.

By a further agreement dated December 18, 1974, with Regent Drilling Ltd, Regent agreed to supply the rig and related facilities and services necessary for the drilling of the Alberta Test Well in consideration of the payment by Dome on or before December 31, 1974, of the sum of $460,000, which sum was paid by Dome on December 24, 1974.

The actual drilling of the Alberta Test Well commenced December 18, 1974, and by December 31, 1974, had reached a depth of 4,040 feet. The well was terminated on March 15, 1975, at which time a depth of 11,250 feet had been reached. It was subsequently abandoned as a dry hole incapable of commercial production.

By an agreement dated December 3, 1974, Dome agreed to hold its interest in the Alberta farmout agreement inter alia for the appellant as to an undivided 50 per cent interest; as a result all rights and obligations of Dome were in fact those of the appellant as to its respective undivided interest. For the purposes of this appeal 50 per cent of the amounts paid by Dome under the Alberta farmout agreement and the Alberta drilling agreement are to be regarded as having been paid by the appellant.

Appellant’s Computation of Income

For the purposes of computing its income for its 1974 taxation year, the appellant included in the computation of its cumulative Canadian exploration expense, within the meaning assigned by paragraph 66.1(6)(b) of the Income Tax Act, the sum of $475,000 in respect of its share of the costs and of the Red Fox Well and the sum of $230,000 in respect of its share of the costs of the Alberta Test Well.

In computing its income for the 1974 taxation year the appellant deducted the sum of $673,554 pursuant to subsection 66.1(2), representing an amount equal to the lesser of its cumulative Canadian exploration expense at the end of the year ($706,199) and its income for the year as otherwise determined ($673,554). By reason of the said deduction the appellant had no taxable income for its 1974 taxation year.

Notice of Reassessment

By a notice of reassessment dated April 17, 1978, the Minister of National Revenue reassessed the appellant in respect of its 1974 taxation year by excluding from the computation of its cumulative Canadian exploration expense the sum of $475,000 in respect of the Red Fox Well and the sum of $147,405 in respect of the Alberta Test Well, representing that proportion of the amount payable to Regent that the number of feet drilled in 1975 is of the total number of feet drilled in 1974 and 1975. The Minister of National Revenue did not dispute the entitlement of the appellant to compute the balance of the amount paid to Regent in relation to its 1974 taxation year.

It is common ground that in making his assessment the Minister of National Revenue assumed inter alia:

(a) that the payment by Dome to Gulf in the amount of $3,800,000 was

an advance to Gulf, qua agent of Dome, for drilling costs to be incurred;

(b) that no portion of the amount of $475,000 was an amount incurred by

or on behalf of the plaintiff, in drilling a well in its 1974 taxation year;

(c) that Gulf, as agent for Dome, did not become liable to and did not pay the actual contractor for any drilling relating to the Red Fox Well in the plaintiffs 1974 taxation year;

(d) that the payment by Dome to Regent in the amount of $460,000 was in part a payment of drilling cost to be incurred;

(e) that of the amount of $460,000 advanced by Dome to Regent, no less than $147,405 was an expense incurred by or on behalf of the plaintiff in drilling a well during its 1975 taxation year;

(f) that the deduction of any portion of the amounts of $475,000 and $147,405 in computing the plaintiff's 1974 income would, if allowed, unduly or artificially reduce the plaintiffs income for that year.

Income Tax Act

The relevant provisions for that part of the 1974 taxation year after May 6, 1974, of the Income Tax Act were as follows:

66.1 (6)(a) “Canadian exploration expense” of a taxpayer means any outlay or expense made or incurred, or deemed to have been made or incurred, after May 6, 1974 that is

(i) any expense including a geological, geophysical or geochemical expense incurred by him (other than an expense referred to in subparagraph (ii)) 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,

(ii) any expense incurred in drilling or completing an oil or gas well in Canada, building a temporary access road to the well or in preparing the site in respect of the well,

(A) incurred by him in the year, or

(B) incurred by him in any previous year and included by him in computing his Canadian development expense for a previous taxation year,

if, within six months afer the end of the year, the drilling of the well is completed

and

(C) it is determined that the well is the first well capable of production in commercial quantities from an accumulation of petroleum or natural gas (other than a mineral resource) not previously known to exist, or

(D) it is reasonable to expect that the well will not come into production in commercial quantities within twelve months of its completion,

In his reasons for judgment, the learned Trial Judge came to the conclusion that the payments by the appellant to Gulf and Regent in 1974 were not expenses referred to in subparagraph (i) by reason of the words “other than an expense referred to in subparagraph (ii)” and that they were not expenses referred to in subparagraph (ii) in 1974 except with respect to that portion of the payment to Regent which relates to drilling done in 1974. In the result the learned Trial Judge affirmed the reassessment of the appellant’s 1974 taxation year by the Minister of National Revenue.

Traditionally, expenses incurred in exploration and development for oil and gas were regarded as expenditures on account of capital and they are therefore deductible in computing a taxpayer’s income only to the extent permitted by the Income Tax Act.

The Budget of May 6, 1974 as reintroduced on November 18, 1974, continued the 100 per cent write-off already allowed for exploration expenditures but introduced a 30 per cent write-off for development outlays. For principal-business corporations such as the appellant the new distinction between Canadian exploration expenses (CEE) as defined in section 66.1 of the Income Tax Act and Canadian development expenses (CDE) as defined in section 66.2 of that Act thus became critically important, and Dome’s intention to qualify here for a CEE in 1974 was admitted by the witness Raymond Forseth, a vice-president of Dome, to be an important factor in motivating Dome to enter into the arrangements here in what he said would otherwise have been “a very tough deal”.

It is common ground that the drilling in the case of both wells was not intended as a mere exploratory probe drilled only for the purpose of ascertaining information relating to an accumulation of petroleum or natural gas but that they were rather for the purpose of actually producing oil or gas, if found. However, the parties differed on their interpretation of the effect of paragraph 61.1(6)(a).

Subparagraph (i)

The appellant argued that subparagraph (ii) applies only in situations where oil or gas is discovered and that subparagraph (i) is intended to apply to dry wells as well as to the kind of primary exploratory work suggested by the words “geological, geophysical or geochemical expense”.

The learned Trial Judge held that the two subsections must be read and interpreted not as two options available to a taxpayer but as two mutually exclusive bases for establishing an exploration expense. With respect, that does not necessarily determine the issue since the primary question is whether it was subparagraph (i) or subparagraph (ii) that was intended to cover dry holes.

I believe the proper statutory interpretation is that proposed by the respondent and suggested by the appellant’s counsel in another context, M A Carten, Federal Income Taxation of Oil and Gas Operations, (1977) 15 Alta L Rev 455 at 472:

An interesting issue has arisen as to whether a test well is in fact an “oil or gas well” or whether it is an operation the cost of which will be treated as a geological expense, in which event it will not be subject to the timing rules relating to the characterization of expenses incurred in drilling an oil or gas well. The argument that these wells are really geological expenses is persuasive and has apparently been accepted by the Department of National Revenue for assessing purposes. The characterization will, it seems, depend on whether the well was drilled with an intention to produce oil or gas if found, in which case it is an “oil or gas well”, or whether the sole purpose of drilling was the obtaining of information, in which case the well is not an “oil or gas well”.

I am strengthened in my belief that this is the proper interpretation by the fact that a dry hole as such is not a term of art. It is rather an imprecise term for a well that does not produce in paying or commercial quantities rather than one that is totally dry. The most practicable kind of legal definition would appear to be that actually used in subparagraph (D) of (ii), a well that “. . . will not come into production in commercial quantities wtihin twelve months of its completion.” This would include a “dry” hole if such a hole were in a new field. Of course, if it were in a proven field, it would be a CDE and not a CEE at all. I therefore hold that the type of expenses which fall within the scope of subparagraph (i) are those of a primary exploratory type, including those of a geological, geophysical, or geochemical nature, and also including those of drilling exploratory oil or gas wells that were not intended to produce oil or gas if found. Since the appellant conceded in the course of argument that the exploratory wells here were intended for production if possible, these drilling costs could never quality as a CEE under subparagraph (i).

Subparagraph (ii)

I have already indicated the applicability of subparagraph (ii)(D) to the expenses of “dry” holes that had been intended for production, if successful. But the learned Trial Judge held that the advance payments here made by Dome were not a CEE as of the date of the advance, and become such only as used for the designated purpose: entirely in the 1975 year in the case of the Red Fox Well, partly in each year in the case of the Alberta Test Well.

In argument the respondent contended that the plain meaning of the phrase “in drilling” indicates an intention by Parliament to limit such deductions to an event that has occurred, namely, the event of drilling, and that such a construction also accords with the intention of Parliament to encourage exploratory drilling by a 100 per cent deduction in the year in which it is done and not to further year-end tax planning. On this submission the proper characterization of the expenditures disallowed here is that they were advances on account of costs to be incurred in the future.

In my view, the respondent places far too much weight on the notion of activity contained in the word “drilling”. It is of the nature of a gerund as a verbal noun to imply action, but it is too much to conclude that the action must have occurred. In fact, if it had been Parliament’s intention to indicate a completed event, it would undoubtedly have used the past tense, “in having drilled’’. In my opinion, Parliament did not intend by the phrase “in drilling” to make a reference to the timing of the event, but rather to say “in relation to drilling” or perhaps “in the process of drilling” (a connotation of action without specifying the timing).

What is most significant in the opening words of subparagraph (ii) “any expense incurred in drilling” is really the word “incurred”. That word has always had the meaning of “to become liable for or subject to”: see, eg, Black’s Law Dictionary; Words and Phrases, “Incur”. In Metropolitan Loan Corp v Wilson, [1946] Que SC 482, at 483, MacKinnon, J said “The words ‘incurred by him’ are synonymous with the words ‘for which he is liable’.” In Pickle Crow Gold Mines Ltd v MNR, [1955] Ex CR 55; [1954] CTC 390; 55 DTC 1001, at 60-61 [395], Cameron J had this to say:

. . . In this case, if the appellant is entitled to succeed I must first be satisfied that the expenses now claimed as deductible were “expenses incurred by the taxpayer”, that being one of the conditions laid down in the Regulations. It seems to me that these words are precise and unambiguous and that, therefore, no more is necessary than to expound them in their natural and ordinary sense. In my opinion, the words “expenses incurred by the taxpayer” have a natural and ordinary meaning of expenses either paid out by the taxpayer or which he has become liable to pay .. .

He goes on (p 61 [395]) to quote the definition in Corpus Juris to the same effect.

The cases most in point would appear to be those on the definition of income. The test of a taxpayer’s legal right to receive a sum of money was laid down by Thorson, J, in Kenneth BS Robertson Ltd v MNR, [1944] Ex CR 170; [1944] CTC 75; 2 DTC 655, [at] 182-3 [91]:

: . . Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment? . . .

On this basis the Court examined certain advance fees and held that they were not income in the hands of the taxpayer because he did not have an absolute right to them.

Similarly in the cases of Diamond Taxicab Association Ltd v MNR, [1952] Ex CR 331; [1952] CTC 229; and Dominion Taxicab Association v MNR, [1954] CTC 34; 54 DTC 1020; the Supreme Court of Canada held that the test of income was whether it had become the absolute property of the taxpayer rather than a deposit contingently received.

It would seem clear from these authorities that the proper test for defining expenses incurred by a taxpayer in a particular year must be cast in terms of the absoluteness of the transactions in which he engaged during that year: are the transactions absolute, with no contingencies as to disposition, use or enjoyment? has he retained any measure of control? is there, for instance, any element of refundability?

On the facts of this case any limitation on the absoluteness of the transactions would have to be found in terns of a right to recover the advance payments, and the parties do disagree on this point. With respect to the Red Fox Well, there was no contractual provision for the recovery by Dome of any portion of the initial payment in the event the costs to Gulf of drilling the well were less than $3,800,000 and the uncontradicted evidence of the witness Forseth was that these funds were not refundable to Dome under any circumstances. The respondent rightly observes that such a self-serving statement does not establish that as a fact, and argues for a contrary conclusion in the light of both the opening wording used by the parties in their agreement and the alleged fact that the drilling prepayment was requested by Dome itself for the purpose of obtaining a tax deduction in 1974. The Trial Judge, by reason of his different interpretation of paragraph (ii), did not have to make a finding on these points and did not do so.

In my view the mere assertion of an agency relationship does not define the exact character of the contracts entered into; the fact of agency wording is not therefore decisive but necessitates an analysis of the contracts.

The most succinct statement of the relevant part of the contract between Dome and Gulf is found in the letter agreement of December 23, 1974 (Appendix 1) as follows:

3. Dome shall use for the drilling of the test well a rig and camp presently under contract to Gulf in the MacKenzie Delta area provided that the selection of contractor and actual rig and camp used shall be at Gulf’s sole discretion. Dome agrees that no later than December 31, 1974, Dome shall pay to Gulf the sum of Three Million Eight Hundred Thousand Dollars ($3,800,000.00). Such payment shall be applied by Gulf to the costs of the drilling of the test well and for standby time to the next drilling season. Dome agrees to pay to Gulf the balance of the total costs of drilling the test well as required in this Agreement which shall without being restrictive include: a proportionate share of Gulf’s costs of operating the Gulf Swimming Point support facilities during the drilling of the test well together with an amount which represents reimbursement for all service, transportation and supply contracts engaged in servicing and supplying the drilling rig used in drilling the test well and all materials and supplies provided by Gulf and used in the test well. Dome agrees that Gulf may also charge the usual operator overhead rates during the period of such drilling of the test well. Dome shall be responsible for all costs, including insurance incurred in moving the drilling rig, camp and equipment to the test well site and from the test well site to barging site or to the next drill site in the vicinity chosen by Gulf, whichever is applicable. The risk and expense of any environmental damage and any fines connected therewith shall be Dome’s, excepting that caused by Gulfs gross negligence.

4. (a) If the drilling of the test well [sic] Dome encounters mechanical difficulties or sub-surface conditions which make further drilling impractical Dome shall have the right to abandon the test well and within 30 days commence or cause to be commenced a substitute well on the same location as allowed by this agreement for the drilling of the test well, and the said substitute well shall be considered to be the test well and shall be subject to all the terms and conditions of this agreement.

(b) Upon the test well being drilled to contract depth, and completed to and including the well head or to abandonment, as the case may be, all in accordance with the terms of this agreement, Dome shall have earned an undivided 33'/,% working interest in the farmout lands subject to the provisions of clause 9 below.

(c) In the event drilling conditions are encountered in the drilling of the test well that, in the opinion of the parties, makes further drilling unfeasible and the hole is subsequently terminated at a lesser depth than contract depth, the following conditions will prevail:

(i) If the test well is terminated at a depth less than 10,000 feet sub-surface, Dome shall have earned no interest in the farmout lands;

(ii) If the test well is terminated at a depth of, or greater than 10,000 feet subsurface and less than contract depth, Dome shall have earned a 25% interest in the farmout lands to the stratigraphic equivalent of the depth reached in drilling the test well subject to the provisions of clause 9 below,

and in no event shall Dome’s obligation under clause 3 hereof be changed solely by virtue of the termination of the drilling of the test well at such a lesser depth.

By clause 3 Dome agrees to pay $3,800,000 on account, to be applied to the cost of drilling the test well. It is clearly anticipated that the ultimate cost will be greater than $3,800,000 rather than less, but the end of clause 4 provides that, even if the test well is terminated at less than contract depth, Dome’s obligation under clause 3, which includes the obligation to pay $3,800,000, ‘‘in no event shall . . . be changed .. .”. This is clearly in keeping with the interpretation that Gulf’s right to the $3,800,000 was absolute, with no right of recovery in Dome in any circumstances.

In his cross-examination of Forseth at trial the respondent suggested that clause 208.4 of the formal agreement (Appendix 3) recognized the possibility of adjustments:

208.4 Advances

Dome may, at its election, pay to operator all or any portion of the estimated costs of drilling and completing the Test Well prior to the completion of the Test Well and in the event such payments are made a final accounting and adjustments shall be made as between Dome and Operator upon completing of the drilling and completing of the Test Well.

However, given that clause 208.4 refers to “completing the Test Well’’ as well as to drilling it, and in particular that drilling costs are defined in clause 101.5 as “all costs, charges and expenses applicable to the drilling and pre-completion testing of the Test Well’’ (emphasis added), it seems clear to me that any adjustments contemplated were in reference to the extra costs and not to those covered by the initial payment of $3,800,000, just as explained by Forseth.

I therefore find that the contract committed Dome to pay Gulf the sum of $3,800,000 absolutely and without the possibility of adjustment or refund.

With respect to the respondent’s allegation that the advance payment clause was requested by Dome, not only is there no direct evidence to this effect but it would not be relevant even if there were, except in relation to an argument based on subsection 245(1) of the Income Tax Act, which I shall consider below.

As to the Alberta Test Well, a formal contract was never drawn up and there is only the letter agreement of December 18, 1974, between Dome and Regent (Appendix 6), and there was no significant argument either at trial or on appeal as to its provisions. The letter is as follows:

December 18, 1974

Mr A R McPhee, President

405-603-7th Avenue SW

Calgary, Alberta

Dear Sir:

RE: Dome Czar et al Weald 6-11-52-21 W5M

This will confirm our arrangement under which Regent Drilling Limited (“the Contractor’’) will drill the above well for Dome Petroleum Limited (“Operator”) on a turnkey basis for the aggregate sum of $460,000, and will provide at Contractor cost in that connection (in addition to the other services, materials, equipment and supplies to be provided by the Contractor under the attached Drilling contract) all the materials, supplies and services provided for in Appendix 1 hereto, which shall supersede the Drilling Contract as to the items to be supplied by Operator and Contractor to the extent Appendix I is in conflict with the Drilling Contract.

It is recognized, however, that as the well is an exploratory well, Operator may require additional services from Contractor, such as the deepening of the hole, extra logging and testing services, etc. In addition, the turnkey price will not relieve Operator or Contractor from their respective liabilities for loss or damage to equipment, and responsibilities for blow-outs, etc under the Drilling Contract, with respect to all of which the provisions of the Drilling Contract shall prevail.

To the extent that additional services are required under the drilling contract, Operator will pay Contractor at the per hour, per foot or other applicable rates under the Drilling Contract, for the extra work or services to be performed or for the cost of additional materials and equipment supplied, as the case may be; and all such payments shall be made as extras to the turnkey price. Payment of turnkey price will be made in full on or before December 31, 1974.

In adjusting for extras, if any, an equitable allowance will be made to Operator for any decrease which may occur in any other services to be performed or materials to be supplied, if these are significantly less than indicated to Contractor in negotiating the Drilling Contract.

Please confirm this variation of the Drilling Contract by signing and returning to us a copy of this letter.

Yours very truly,

Douglas Boechler (signed)

D V Boechler

Manager, Drilling Operations

bmd

enc

Confirmed and accepted this

19th day of December, 1974.

REGENT DRILLING LTD.

Per: A R McPhee (signed)

APPENDIX I

DOME CZAR ET AL WEALD 6-11-5221 W5M

Services Included in Turnkey Price

and to be provided by Contractor

Rig and Camp and Move

Drilling — footage

Drilling — daywork

Mud and Chemicals

Water

Equipment Rentals

Coring

Testing D S T

Logging

Surface Casing Cementing

Abandonment Service or Production Casing Cementing

Camp and Crew Travel

My interpretation of this contract is that the payment of $460,000 was for the materials, supplies and services provided for in Appendix I which was thought to be a relatively certain amount, and for other services, materials, equipment and supplies, which was thought to be a somewhat uncertain amount. There was to be no recovery possible in either case, but Dome was to receive a credit for any decrease which might occur in the further services, if these were significantly less than indicated in negotiating the drilling contract. This is not a right of recovery, in that there was presumed to be a certainty of additional, as yet unpaid-for services, such as the deepening of the hole and extra logging and testing services. It is not even a general set-off, since any credit could divert a portion of the $460,000 to pay the drilling contractor only for something relative to the same well. Such a limited right of set-off does not affect the absoluteness of the appellant’s obligation to pay Regent in 1974 by rendering it a deposit contingently made: any contingency was with respect to the characterization of the payment, not with respect to the obligation to pay. It was therefore an expense incurred by the taxpayer in 1974.

Having concluded that the costs of both wells qualify as 1974 Canadian exploration expenses on the basis of section 66.1,1 must still consider the respondent’s argument that they must nevertheless be disallowed as artificial transactions under section 245 of the Income Tax Act.

Section 245

The respondent’s claim that the advance payment in 1974 was an artificial reduction of income is based on Forseth’s admission of Dome’s tax motivation in entering into the arrangement and on arguments with respect to the scope of subparagraph 245(1) of the Income Tax Act.

Subparagraph 245(1) reads as follows:

245 (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

Since the Government has frequently sought to disallow deductions on the basis of this provision, there is a ready body of law to which to refer. In The Queen v Alberta Southern Gas Co Ltd, [1978] 1 FCR 454; [1977] CTC 388; 77 DTC 5244, affirmed by the Supreme Court of Canada, [1979] 1 SCR 36; [1978] CTC 780; 78 DTC 6566; Jackett, CJ, held for this Court that where provisions of the Income Tax Act have the obvious purpose of encouraging taxpayers to enter into an expenditure of a particular kind, a taxpayer who otherwise falls within the object and spirit of the relevant provisions cannot be said to unduly or artificially reduce income because he was influenced to enter into it by tax considerations.

A recent decision of the Supreme Court of Canada, Stubart Investments Limited v The Queen, [1984] CTC 294; 84 DTC 6305, is directly in point. There, a corporate taxpayer, with the avowed purpose of reducing its taxes, established an arrangement whereby future profits were routed through a sister subsidiary in order to avail itself of the latter corporation’s loss carry-forward. The Government argued section 137 of the Act, the predecessor section of 245; but the Court unanimously upheld the appeal on the ground that the lack of a business purpose other than the reduction of tax was not a ground for disallowing the transaction. Estey, J speaking for the majority of the Court enunciated new interpretation guidelines (at pp 314-15 [6322-4]):

I would therefore reject the proposition that a transaction may be disregarded for tax purposes solely on the basis that it was entered into by a taxpayer without an inde- pendent or bona fide business purpose. A strict business purpose test in certain circumstances would run counter to the apparent legislative intent which, in the modern taxing statutes, may have a dual aspect. Income tax legislation, such as the federal Act in our country, is no longer a simple device to raise revenue to meet the cost of governing the community. Income taxation is also employed by government to attain selected economic policy objectives. Thus, the statute is a mix of fiscal and economic policy. The economic policy element of the Act sometimes takes the form of an inducement to the taxpayer to undertake or redirect a specific activity. Without the inducement offered by the statute, the activity may not be undertaken by the taxpayer for whom the induced action would otherwise have no bona fide business purpose. Thus, by imposing a positive requirement that there be such a bona fide business purpose, a taxpayer might be barred from undertaking the very activity Parliament wishes to encourage. At minimum, a business purpose requirement might inhibit the taxpayer from undertaking the specified activity which Parliament has invited in order to attain economic and perhaps social policy goals . . .

Nonetheless, some guidelines can be discerned for the guidance of a court faced with this interpretative issue.

1. Where the facts reveal no bona fide business purpose for the transaction, s 137 may be found to be applicable depending upon all the circumstances of the case. It has no application here.

2. In those circumstances where s 137 does not apply, the older rule of strict construction of a taxation statute, as modified by the courts in recent years (supra) prevails but will not assist the taxpayer where:

(a) the transaction is legally ineffective or incomplete; or

(b) the transaction is a sham within the classical definition.

3. Moreover, the formal validity of the transaction may also be insufficient where:

(a) the setting in the Act of the allowance, deduction or benefit sought to be gained clearly indicates a legislative intent to restrict such benefits to rights accrued prior to the establishment of the arrangement adopted by a taxpayer purely for tax purposes;

(b) the provisions of the Act necessarily relate to an identified business function.

This idea has been expressed in articles on the subject in the United States:

The business purpose doctrine is an appropriate tool for testing the tax effectiveness of a transaction, where the language, nature and purposes of the provision of the tax law under construction indicate a function, pattern and design characteristic solely of business transactions. Jerome R Hellerstein, “Judicial Approaches to Tax Avoidance”, 1964 Conference Report, p 66.

(c) “the object and spirit” of the allowance or benefit provision is defeated by the procedures blatantly adopted by the taxpayer to synthesize a loss, delay or other tax saving device, although these actions may not attain the heights of “artificiality” in s 137. This may be illustrated where the taxpayer, in order to qualify for an “allowance” or a “benefit”, takes steps which the terms of the allowance provisions of the Act may, when taken in isolation and read narrowly, be stretched to support. However, when the allowance provision is read in the context of the whole statute, and with the “object and spirit” and purpose of the allowance provision in mind, the accounting result produced by the taxpayer’s actions would not, by itself, avail him of the benefit of the allowance.

On the basis of this law, even if Forseth’s admission could be taken to mean that Dome had no other economic motivation for the advance payment in 1974 than the tax deduction it presumed to be available under subparagraph 61. l(6)(a)(ii), that would not be fatal to the appellant’s case. Earlier the Government had made a positive decision to continue to encourage exploration through a 100 per cent write-off for Canadian exploration expenses. The Minister of Finance put it this way in his address in the House of Commons on November 18, 1984 (House of Commons Debates, 1st Sess 30th Pari at 1425):

. . . Mr Speaker, in the May 6 Budget I proposed that the rate of write-off for expenditures on exploration and development for both petroleum and minerals be re- duced from 100 per cent to 30 per cent. At the time I felt that such a lower rate was appropriate in light of the existing circumstances of the natural resource industries. However, I have been persuaded by the arguments presented to me over the past several months by both large and small companies that exploration in Canada is becoming ever more expensive and risky. It is difficult, particularly for smaller companies to borrow exploration capital and therefore there is a heavy reliance on internally generated funds. On the other hand, expenditures on development are more similar to the capital expenditures incurred by other industries. Hence, for both petroleum and minerals I am proposing to restore the 100 per cent write-off for exploration expenditures but to retain the proposed 30 per cent rate of write-off for development outlays.

Dome responded quickly after November 18 to this newly enunciated government economic policy objective. The first agreement concerning the Alberta Test Well was dated December 3 and apparently fully executed by December 13. Actual drilling began on December 18 even before the letter agreement with Regent was fully executed on December 19. The Red Fox Well agreements were entered into as of December 31, and the actual drilling began five days later, on January 5. There was nothing contrived or artificial in this corporate initiative. It was a good-faith response to what was in effect a new, or at least an unexpectedly renewed, Government policy, and was fully in accord with the object and spirit of the allowance provision.

I would therefore allow the appeal with costs here and in the Trial Division and refer the appellant’s 1974 income tax assessment back to the Minister of National Revenue for reconsideration and reassessment accordingly.