Cudd Pressure Control Inc. v. Her Majesty the Queen, [1995] 2 CTC 2382, 95 DTC 559

Sarchuk J.T.C.C.:-Cudd Pressure Control Inc. (the appellant) is a corporation incorporated in the United States and was a resident there for purposes of the Canada-United States Reciprocal Tax Convention, 1942 (the 1942 Convention). The appellant was not at any material time a resident of Canada for the purposes of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the ’’Act”).

The appellant is a wholly-owned subsidiary of R.P.C. Energy Services Inc. (RPC), a United States public corporation which provides a variety of services to the oil and gas industry. The appellant itself carried on a business of providing technical services to the oil industry which included both emergency and scheduled hydraulic workover and snubbing services, coiled tubing, nitrogen services, wire line, hot-tapping, freezing, well control and firefighting.

During the 1985 taxation year the appellant was engaged by Mobil Oil Canada Limited (Mobil) to provide snubbing unit services on an offshore drilling rig located near Sable Island. Snubbing units are pieces of sophisticated equipment which are used under high pressure to either repair or control oil wells or to enhance their production. The appellant provided to Mobil two such snubbing units and the services of a number of its employees. It is not disputed that the appellant was carrying on business in Canada through a permanent establishment.

In computing its industrial and commercial profit from its permanent establishment in Canada for the purposes of Articles I and III of the 1942 Convention (Article I; Article III) for its 1985 taxation year ending June 30, 1985 the appellant sought to deduct, among other things, the amount of $2,516,690 in respect of rent for the snubbing units. The Minister of National Revenue (the Minister) in calculating the income of the appellant attributable to its permanent establishment in Canada disallowed the deduction of the "rent" for the units and assessed tax thereon under Part I of the Act at the rates provided therein.

The primary issue is whether in computing its industrial and commercial profit attributable to its permanent establishment in Canada pursuant to Article III the appellant can deduct the "rent" for the use in Canada of two snubbing units that it owned; and if such "rent" is properly deductible, what is the appropriate amount to be deducted?

The second issue to be determined is the applicable rate of tax under Part XIV of the Act to be applied to the appellant’s industrial and commercial profits.

Evidence

During the taxation year in issue the appellant’s business primarily involved the provision of specialized equipment and technical expertise and services to improve the flow or to resolve or contain a problem at a well site. According to Ronald Roles (Roles) the appellant’s operations manager, there were three major companies (the appellant being one) and three to five independents providing snubbing services in North America. The appellant and its major competitors all owned their own equipment and typically in the course of carrying on their business did not rent equipment to provide snubbing services but used their own.

In September 1984 the appellant was contacted by Boots & Coots Well Control Company (Boots & Coots) with respect to an underground blowout in an exploratory gas well being drilled by Mobil. Boots & Coots lacked the equipment required to undertake the contract, and with Mobil’s approval, requested the appellant to send a representative to assess the situation. Roles did so and in due course the appellant and Mobil entered into an oral agreement pursuant to which it was to provide the services required for a price of $15,000 (U.S.) per day. The appellant provided two snubbing units which it owned (the 600 unit and the 150 unit) and the services of a number of its employees to operate them for a period of approximately eight months. Work commenced on the Mobil job site on October 10, 1984 and was completed on June 27, 1985.

All snubbing units are custom made on an order basis by one of two manufacturers. The time for delivery from the date of order ranged from six months for a 150 unit to one year for a 600 unit. There is virtually no market for used snubbing units. In the taxation year in issue the appellant was the owner of the only 600 unit in the world in addition to a number of smaller units. According to Roles these units last indefinitely when properly maintained. This is particularly true of large snubbing units which are used infrequently. The 600 unit had been used no more than 30 to 40 days prior to the Mobil job and subsequently for approximately 120 days until the present time. The original cost to the appellant of the 600 unit (which was placed in service in May 1993) was approximately $650,000 (U.S.) and of the 150 unit (in service April 1982) was $284,000 (U.S.).

In computing its industrial and commercial profits from its permanent establishment in Canada for its 1985 taxation year, the appellant included in income all amounts billed to Mobil; deducted from income all direct labour costs, transportation costs, insurance and similar costs, certain additional labour costs and a portion of its general overhead expenses, and in addition sought to deduct $2,942,316 as an amount paid or credited to its parent R.P.C. Energy Services Inc. for "rental of equipment" used in the course of carrying on its business in Canada. The appellant concedes that of this amount the sum of $423,626 was in respect of rent actually paid by the appellant to third parties for equipment used exclusively in the appellant’s operations in the United States, thus only the balance, being $2,516,690, constituted the "rent" charge by the appellant to the permanent establishment for the use of the 600 and 150 snubbing units. [1]

Debra Herron, chief financial officer of RPC and its subsidiaries, had no recollection why the amount of $2,942,316 was presented in the appellant’s income tax return as an amount paid to RPC, since it was not actually paid, but was merely a notional amount. She testified that the "rent" was calculated on the basis of the rates quoted to its customers for unmanned standby use of such pieces of equipment, arbitrarily increased for the 600 unit because it was in use most of the time and reduced for the 150 unit because it was primarily on standby. [2] On this basis the appellant charged a per diem "rent" for the 600 unit of $5,000 (U.S.) and $1,700 (U.S.) for the 150 unit.

Testimony: appellant's experts

Mr. Kenneth Vallillee is a chartered accountant and a partner with Arthur Andersen & Co. in the audit and business advisory practice. [3] His opinion was sought as to the appropriate method of accounting which would be followed under generally accepted accounting principles (GAAP) in Canada to record charges from a head office to a branch location.

He testified that under GAAP, financial statements of a branch are prepared using separate accounting, one of the primary objectives of which is to determine the net profit that the branch would have earned if it had operated as an independent concern under similar conditions. In order to treat a branch as a separate accounting unit it must be thought of as a distinct business entity which has transactions with the head office and with independent third parties. Separate accounting is the best indication of overall business segment profitability. It was his opinion that deduction by the Canadian branch of the appellant of "rent" charged for use of the snubbing units was in accordance with Canadian GAAP for computing income of a branch operation.

With respect to related party transactions Vallillee’s view was that the value ascribed to the transaction and event should be close to an arm’s length "bargained" value. For these purposes accountants use variations of cost-based value, an arm’s length surrogate value such as a comparable uncontrolled price or a price determined by negotiation. In each case this is a matter of judgment in the circumstances of the particular transaction. In his opinion the use of a value that approximates an arm’s length bargained transaction will provide the most information as to the profitability of the branch and that the transaction in issue should be measured by an exchange amount that approximates an arm’s length surrogate value.

Mr. Robert D. Grace (Grace) holds a Masters degree in Petroleum Engineering and is a partner in Grace, Sherson, Moore and Associates. He was qualified as an expert witness in drilling operations and well control. He was asked to provide the appellant with an opinion as to the fair market rental price for a 150 snubbing unit and a 600 snubbing unit as of 1985. To do so Grace first used the appellant’s price schedule applicable in 1985 and its price schedule for 1992, each of which included the provision of a crew. He also obtained a current price schedule for manned snubbing unit services from Hydraulic Well Control (HWC), a competitor of the appellant and in addition, he was told by someone at HWC that it would rent snubbing units on an unmanned basis to reliable snubbing companies such as Cudd and Otis Engineering. Grace also considered an alternative for determining the daily market rental value by applying an "oil industry rental rule of thumb" of 1 per cent of the new price of the equipment to be rented.

It was his opinion that the fair market rental value on an unmanned basis of the 150 snubbing unit and the 600 snubbing unit in 1985 for services at the Mobil Oil Sable Island blow-out was $2,000 (U.S.) per day and $5,100 (U.S.) per day.

Testimony: respondent’s experts

Ms. Kathryn Holgate (Holgate) is a consultant associated with Stephen Johnson Chartered Accountants. She is a chartered accountant, a member of the Institute of Chartered Accountants of Alberta and holds a Masters degree in Business Administration from the University of Calgary.

In her opinion GAAP is an appropriate basis for the determination of the net profit of a branch. It was, however, her opinion that Vallillee took too narrow a view of GAAP in not addressing the question of whether in the facts of this case an independent enterprise would have purchased or rented the equipment. He also, in examining the rental option, failed to consider the circumstances surrounding the rental and particularly such matters as whether the equipment would have been rented on a daily or longer term basis. The consequence of the appellant reporting a notional rent based on a daily rental charge for a rental period of 278 days was a significant understatement of its net profit.

In her view the permanent establishment would have considered purchasing the equipment, leasing it under a capital lease, or leasing under an operating lease. Since the accounting treatment of a purchase or a capital lease are essentially the same, there were two real options to consider in accounting for the equipment: buy or rent.

The determination of profit in accordance with GAAP depends upon whether the permanent establishment purchased or rented the equipment. If it purchased the equipment, that equipment should be considered as having been purchased at fair market value at the time it entered Canada, depreciated during the period it was used and sold at the time it was returned to the United States. If it rented the equipment, two primary options for determining an appropriate transfer price are available, the comparable uncontrolled price method and the cost plus method. The choice should be made after considering the reliability of the available data. When the comparable uncontrolled price method is used it is important that comparisons be made for similar circumstances. When circumstances differ the market price must be adjusted to reflect such differences. The comparable uncontrolled price method should be used if the appellant was in the business of renting equipment to others and if there were a representative number of transactions in similar circumstances. On the other hand, the cost plus method should be used if Cudd was in the business of renting equipment to others but there were not a representative number of transactions in similar circumstances or if the appellant was not in the business of renting equipment to others.

Mr. Robert Svoboda (Svoboda) is a manager in the Financial Advisory Services Group, Coopers & Lybrand, Houston, Texas. He holds a Bachelor of Science in Mechanical Engineering from the Milwaukee School of Engineering and a Masters in Business Administration from the University of Wisconsin. He is a senior member of the American Society of Appraisers and serves as a faculty member for the Society. He has over 20 years of experience as a valuation consultant specializing in large complex assignments. Properties appraised include securities, intangible assets, machinery and equipment and real estate as well as entire businesses.

For this appraisal Svoboda utilized a cost approach and considered evidence based on sales of other similar assets to draw his conclusions. The income and sales comparison approaches were not employed because the appropriate data was not available. His conclusions were that the fair market value of the 150 snubbing unit was $175,000 and of the 600 unit was $475,000. He also concluded that the fair rental value for the 150 unit was $9,149 per month and for the 600 unit was $24,834 per month.

Appellant’s position

The appellant contends that the principal factual issue to be determined is whether the hypothetical independent enterprise that the 1942 Convention requires be assumed to exist, operating in Canada "engaged in the same or similar activities under the same or similar conditions" as the appellant, would have (a) rented the snubbing units on a daily basis, (b) entered into a capital lease to acquire the snubbing units, or (c) purchased the snubbing units outright.

It is the appellant’s submission that Articles I and III, on their ordinary and plain meaning, and given the liberal and extended rules of construction which are properly employed in interpreting treaties, [4] provide that for the purpose of calculating income subject to tax there is required a central hypothesis that the appellant’s permanent establishment in Canada be considered as an independent enterprise engaged in the same activity as the establishment under similar conditions. [5] It is also clear from the wording of paragraph 2 of Article III that the separate accounts method of computing the income of a permanent establishment should apply to all transactions in goods and services between the permanent establishment and its head office. Such transactions must be recorded on an arm’s length basis, giving rise to the exclusions and deductions in computing income that would be appropriate for a parent corporation and subsidiary.

The appellant contends that the object and purpose of paragraph 1 of Article III is to ensure that the net industrial and commercial profits attributable to the permanent establishment will be computed on the same basis as if it were a separate corporation independent of the head office of the enterprise and dealing as if it were an independent enterprise acting at arm’s length. Such an independent arm’s length enterprise, requiring immediate delivery of complicated and expensive machinery such as the snubbing units, for a single job of uncertain duration and which would be of little or no use to it after the completion of the job, would have acquired such machinery by following industry practice, 1.e., by renting it on a daily basis from the appellant at a fair market rental rather than purchasing it. This is particularly so because there was no market for snubbing units, there was no "on the shelf supply" and it was not foreseen that the units would be used for a lengthy period of time. Further, the only piece of equipment in existence with a large enough capacity was owned by the appellant and the manufacture of a new 600 unit would have taken about one year. Since the notional independent enterprise was to perform but one job in Canada it was submitted that such an enterprise would not have purchased this equipment for a single contract. The rental would be deductible to the independent arm’s length enterprise in computing its income for tax purposes.

Furthermore, the appellant’s business (as distinguished from that of the permanent establishment) involved the rental of oil field equipment generally and in respect of the snubbing units, supplying them on both a manned and on an unmanned basis to its customers and therefore renting them in the ordinary course of its business. Thus in light of the business practices of the appellant and of others in the industry a presumed rental on a daily basis is the only result that is consistent with the wording of paragraph 1 of Article III. Independent enterprises will seek to realize a profit and when providing equipment or services to each other will charge such prices as the open market will bear. This is consistent with paragraph 2 of Article III which confirms that the arm’s length principle required to be applied by paragraph 1 extends not only to "pricing" but also to "remunerations".

The appellant submitted that in dealing with the transfer of goods between parties acting at arm’s length the comparable uncontrolled price is the appropriate method to be used to determine fair market value. Reference was made to the 1979 OECD Report, "Transfer Pricing and Multinational Enterprises" which sets out methods for applying the "arm’s length principle" to non-arm’s length transactions, that is, each transaction should be carried out as if between parties in similar circumstances acting at arm’s length. The appellant relies on paragraphs 11 and 14 of this report which state that in dealing with the transfer of goods the "primary" method is the use of the "comparable uncontrolled price" in order to conform to the arm’s length principle.

The appellant also contends that the League of Nations Commentary and other travaux préparatoires to the 1942 Convention themselves contemplate in appropriate circumstances the making of notional deductions in computing income in the separate accounts of a permanent establishment. This, it was argued, is consistent with the evidence of Vallillee that deduction of a "rent” charge was in accordance with GAAP for computing income of a branch operation and that it was appropriate to match revenue received on a daily basis with a rental charge calculated on a daily basis. Accordingly the appellant calculated the income of its Canadian establishment in keeping with these principles.

Respondent’s position

The respondent’s primary position is that in calculating its profits under Canadian domestic law a branch is not entitled to deduct notional expenses. It is the Act which levies taxes on the income earned by the appellant and it is the rules found in the Act which must be followed in order to determine the amount of taxes which are payable by a taxpayer unless a provision of an international agreement specifically limits the application of those rules. [6]

The respondent argues that there is no provision under Canadian domestic law which would allow a branch office in computing its profits, to self-charge a notional expense or cost related to the use of assets owned by the head office. Under Canadian domestic law the most that a Canadian business would be able to deduct with respect to the equipment in question would be capital cost allowance pursuant to paragraph 20(1 )(a) of the Act. (See Twentieth Century Fox Film Corp. v. The Queen, [1985] 2 C.T.C. 328, 85 D.T.C. 5513 (F.C.T.D.)). Second, the amount claimed as "rent" is not an incurred expense within the meaning of Article III. The phrase "all expenses, wherever incurred" in that Article is not defined in the Convention. Under paragraph 18(l)(a) of the Act an expense may be deducted only if it was "made or incurred"; and a deduction in respect of the annual value of property is prohibited by paragraph 18( l)(d) of the Act unless the property was leased by a taxpayer and rent was paid. It is the respondent’s position that by virtue of sections 3 and 4 of the Income Tax Conventions Interpretation Act, R.S.C. 1985, c. 1-4 the aforementioned provisions of the Act are applicable in determining the meaning of the phrase "all expenses, wherever incurred" in Article III. It follows that in order to be incurred an expense must either be paid out by the taxpayer, or be an amount on which a liability is owing. The self charged notional expenses in this instance were never in fact paid or incurred and therefore there is nothing which is deductible from the earnings of the permanent establishment. [7] Furthermore, the arbitrary quantification of the ’’rent" as described by the appellant’s witness Herron is not sufficient to meet the ordinary meaning of the word "expense" as defined by the Federal Court of Appeal in Burnco and in Pickle Crow Gold Mines, both supra.

The meaning of the words "expenses incurred" are plain under domestic law and the 1942 Convention neither in its context nor by any express words requires a departure from Canadian domestic law principles. Thus notional expenses are not deductible in computing profit and the appropriate mechanism for determining the cost for the use of capital equipment in the Canadian jurisdiction is to claim capital cost allowance for the period of time it was used in Canada. The respondent’s submission is that the appellant fails to meet either the meaning of "expense" or the word "incurred" for the purposes of Canadian domestic law, 1.e., no amount was paid or payable anywhere, there was no obligation to pay it and indeed no expense was incurred. The respondent also argues that the appellant’s position is based on a flawed assumption that the permanent establishment would have rented the snubbing units in issue on a daily basis. What this ignores is that in determining whether an independent enterprise engaged in the same or similar activities under the same or similar conditions, it is also necessary to determine whether such a hypothetical enterprise would have the necessary capital assets to perform the services in Canada. The assertion that a hypothetical independent enterprise would have rented snubbing units to perform the Mobil contract is inconsistent with the evidence. The appellant is not a rental company, rather it is a service company to the oil industry and performs whatever services are required to oil and gas wells. As such it was required to have adequate equipment to meet the needs of its customers. Roles did know of a single company that did not own all of its own equipment. The appellant itself obtained the contract because a competitor, Boots & Coots, did not have the equipment to get the well under control.

The respondent contends that the permanent establishment would not have obtained the contract with Mobil unless it owned the required equipment. It is therefore wrong for the appellant to suggest that it (and by extension the hypothetical independent enterprise) does not have any capital structure already in place when it commences business in Canada. It follows, therefore, once it is established that the permanent establishment owns the asset, that the correct method to use for financial statement purposes is to record the asset at its fair market value at the time it came across the border and in the preparation of its income statement to deduct the depreciation for the use of that asset in generating income.

Conclusion

It is generally accepted that the Vienna Convention on the Law of Treaties^ [8] codifies previously existing public international law (Fothergill, supra). The principles set out in this Convention and what it says in Articles 31 and 32 regarding interpretation of treaties [9] are applicable to the issues at hand. Article 31 was the subject of the following comment by Mr. Justice Addy in Gladden Estate, supra, at pages 166-67 (D.T.C. 5191):

Contrary to an ordinary taxing statute a tax treaty or convention must be given a liberal interpretation with a view to implementing the true intentions of the parties. A literal or legalistic interpretation must be avoided when the basic object of the treaty might be defeated or frustrated insofar as the particular item under consideration is concerned.

While a treaty is to be given a liberal interpretation such construction cannot go beyond the words of the treaty. (The Queen v. Crown Forest Industries Ltd., [1994] 1 C.T.C. 174, 94 D.T.C. 6107 (F.C.A.), affirming [1992] 2 C.T.C. 1, 92 D.T.C. 6305 (F.C.T.D.).)

The issue before the Court is the proper determination of the net profit allocable to the permanent establishment pursuant to the Income Tax Act and to Articles I and III which read:

Art. I. An enterprise of one of the Contracting States is not subject to taxation by the other Contracting State in respect of its industrial and commercial profits except in respect of such profits allocable in accordance with the Articles of this Convention to its permanent establishment in the latter State.

Art. 111 1. If an enterprise of one of the Contracting States has a permanent establishment in the other State, there shall be attributed to such permanent establishment the net industrial and commercial profit which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions. Such net profit will, in principle, be determined on the basis of the separate accounts pertaining to such establishment.

In the determination of the net industrial and commercial profits of the permanent establishment there shall be allowed as deductions all expenses, wherever incurred, reasonably allocable to the permanent establishment, including executive and general administrative expenses so allocable.

2. The competent authority of the taxing State may, when necessary, in execution of paragraph 1 of this Article, rectify the accounts produced, notably to correct errors and omissions or to re- establish the prices or remunerations entered in the books at the value which would prevail between independent persons dealing at arm’s length.

3. If (a) an establishment does not produce an accounting showing its own operations, or (b) the accounting produced does not correspond to the normal usages of the trade in the country where the establishment is situated, or (c) the rectifications provided for in paragraph 2 of this Article cannot be effected the competent authority of the taxing State may determine the net industrial and commercial profit by applying such methods or formulae to the operations of the establishment as may be fair and reasonable.

4. To facilitate the determination of industrial and commercial profits allocable to the permanent establishment, the competent authorities of the Contracting States may consult together with a view to the adoption of uniform rules of allocation of such profits.

Protocol At the moment of signing the Convention for the avoidance of double taxation, and the establishment of rules of reciprocal administrative assistance in the case of income taxes, this day concluded between Canada and the United States of America, the undersigned plenipotentiaries have agreed upon the following provisions and definitions:

3. As used in this Convention:

(f) the term "permanent establishment" includes branches, mines and oil wells, farms, timber lands, plantations, factories, workshops, warehouses, offices, agencies and other fixed places of business of an enterprise, but does not include a subsidiary corporation. The use of substantial equipment or machinery within one of the Contracting States at any time in any taxable year by an enterprise of the other Contracting State shall constitute a permanent establishment of such enterprise in the former State for such taxable year.

The concern of tax treaties generally and the Conventions in issue in particular is double taxation and the prevention of fiscal evasion. Double taxation is avoided when parties agree by way of treaty that the source country continues to exercise its right to tax any income arising in its jurisdiction while the country of residence agrees to allow either a tax credit or an exemption for the income which was already taxed in the source country. Apportionment of tax revenues is accomplished under a treaty when each sovereign state limits its right to tax under domestic law by the terms of the treaty. The right of a source country to tax certain types of income is not by virtue of the treaty, but rather is by virtue of domestic law, as limited by the treaty.

The appellant contended that the Minister’s assessment was wrong because the presumed rental of the equipment in issue on a daily basis and the resulting deduction of notional rent is the only result consistent with the provisions of Articles I and III on their ordinary and plain meaning and considering the object and purpose of the treaty. Any inconsistency between the appellant’s approach and the Income Tax Act (such as the prohibition of the deduction of self-charged expenses) is irrelevant since section 3 of the Canada-U.S. Convention Act, 1943 provides that where there is an inconsistency between the treaty and the operation of any law of Canada the former shall prevail. [10]

To accept the appellant’s position it would be necessary to find that the independent enterprise concept set out in Article III overrides domestic law as to the calculation of profit. The primary purpose of Article III is to enable the source country, in this case Canada, to properly determine and allocate the net profits arising from the appellant’s Canadian business. There is no definition or limitation in Articles I or III of the phrases "net industrial and commercial profits" and "all expenses, wherever incurred". Thus it reasonably follows that in order to determine the profits allocable to the permanent establishment (the branch) reference must be made to the internal laws of the country in which the establishment is situated to determine whether the expenses claimed as a deduction are allowable. [11] The following comment from the article "Interpretation of Double Taxation Conventions" is germane:

When the source state applies the Convention, because its right to tax is limited by the Convention, it must characterize income and its source in order to determine in its "application" of the Convention whether and to what extent it can impose tax on such income and, if so, at what rate and on what basis. The source state must, therefore, under Article 3(2) apply, unless the context otherwise requires, its own internal law definitions of undefined terms in the application of the Convention for these purposes) [12]

[Emphasis added. I

No inconsistency between Article III and domestic law exists in this context.

The Minister’s position that the proper method of establishing a cost for the use of capital equipment such as the snubbing units in issue is for the appellant to claim capital cost allowance against the income from its per- manent establishment is correct. [13] This conclusion is consistent with the provisions of section 4 of the Income Tax Conventions Interpretation Act which provides that non-residents who carry on business in Canada through a permanent establishment are to determine their business profits attributable to that permanent establishment in accordance with the rules contained in the Income Tax Act for the calculation of income from a business. Paragraph 4(b) of this Act was intended to ensure that, in the computation of the income attributable to a permanent establishment, Article III is not to be construed as permitting deductions to be taken of a nature or kind that would not be deductible in calculating business income by Canadian taxpayers under the Act. [14] The appellant’s contention that paragraph 4(b) of the Income Tax Conventions Interpretation Act is limited only to ensure that in computing the profits deduction should not be taken for outlays and expenses which the Income Tax Act specifically precludes as deduction for taxpayers resident in Canada appears to be an unnecessarily restrictive reading of its language.

Reference should also be made to the Canada-U.S. Agreement Regarding Taxation of Offshore Drilling Rigs (1984). It is a subsequent interpretative agreement to which reference can properly be made. Although there is no jurisprudence in Canada to indicate whether the Courts would feel bound by such agreements, according to the general interpretative rule of the Vienna Convention, a Canadian court should "take it into account". [15] The agreement was reached for the purposes of avoiding double taxation and resolving difficulties which arise for U.S. residents engaged in Canadian offshore drilling activities, and applies to an offshore drilling rig that constitutes a permanent establishment of a U.S. resident. The term "drilling rig" includes all barge rigs, drillships, jack-up rigs, semi-submersibles and tender-assisted platform rigs (including any related equipment). Its significance is that with respect to equipment which is remarkably comparable to the snubbing units in issue the parties have agreed to the manner in which the costs with respect to such equipment may be dealt with, 1.e., by claiming "Canadian depreciation". It is true that a United States resident under this agreement may claim depreciation on the drilling rigs on a straight line basis (Part XI and Regulations provides for capital cost allowance on a declining balance basis) on an amount equal to the cost of the drilling rig (subsections 13(7) and (9) of the Act would establish the depreciation base at the fair market value at the time the drilling rig was brought into Canada) and that when the drilling rigs are returned to the United States, there is no deemed disposition (which is contrary to subsections 13(7) and (9) of the Act). Nonetheless, it may fairly be said that this agreement establishes the intention of the parties with regard to the appropriate deductions which may be claimed for Canadian income taxation in respect of the use of such equipment in Canada and their acceptance in this context of the capital cost allowance system. This agreement is fundamentally consistent with Canadian domestic law and impliedly negates the proposition that Article III permits in the present circumstances the deduction of self-charged expenses such as the notional rent claimed.

The appellant made reference to the Carroll report which contains a discussion of the prerequisites for an appropriate régime of allocation of income to reflect the income of a permanent establishment and in this context considered diverse methods of allocation including those that involve fictional or notional transactions. [16] It was argued that since the deduction of notional rent in computing income in the separate accounts of a permanent establishment is an analogous concept the deduction of such charges by the appellant in computing the profits of its Canadian permanent establishment was appropriate notwithstanding that such deductions would not normally be permitted pursuant to the provisions of the Income Tax Act.

A similar proposition was put forward by the appellant in Utah Mines Ltd. v. The Queen, [1992] 1 C.T.C. 306, 92 D.T.C. 6194 (F.C.A.). Hugessen J. summarized the argument as follows at page 307 (D.T.C. 6195):

Briefly put, the appellant taxpayer’s contention is based on an interpretation of the last sentence of paragraph 1 of Article III of the Canada-U.S. Tax Convention (S.C. 7 George VI, c. 21, as amended by 14 George VI, c. 27).

In the determination of the net industrial and commercial profits of the permanent establishment there shall be allowed as deductions all expenses, wherever incurred, reasonably allocable to the permanent establishment, including executive and general administrative expenses so allocable.

By the terms of the implementing legislation the provisions of the Convention prevail over domestic legislation in the event of inconsistency. The appellant says that the quoted sentence allows it, in the calculation of the profits of its Canadian establishment, to deduct "all expenses" that is to say all those which are reasonably deductible in accordance with Generally Accepted Accounting Principles, even though such deductions may not be permitted under the Income Tax Act.

[Emphasis added. ]

The Court did not agree. At pages 308-09 (D.T.C. 6196) Hugessen J. stated:

It is quite clear that the purpose of the Convention is to avoid double taxation of enterprises doing business in the two countries and, to that end, to provide for the equitable allocation of the profits of such enterprises as between the two contracting powers. That purpose appears most clearly from the preambles both to the original Convention and to the amending Convention of 1950.

[Emphasis added.]

and at page 309 (D.T.C. 6197):

Clearly that purpose was not, as the appellant would have us believe, to create for enterprises doing business and having permanent establishments in both countries a separate and different system of taxation from that prevailing for taxpayers doing business in only one or other of them.

The interpretation adopted by the learned Trial judge gives effect to the purpose of the parties to the Convention and does no violence to the language used by them. The interpretation proposed by the appellant, on the other hand, would have the effect of giving a U.S. taxpayer with a permanent establishment in Canada a more favourable tax treatment than its Canadian competitor engaged in the same business in this country. Such a result would not be in accordance with the policy expressed in the preamble to the Convention and indeed would be contrary to it. It would take much clearer language than a simple reference to "all expenses" to bring it about.

[Emphasis added.]

By virtue of Article I of the 1942 Convention a foreign enterprise is subject to taxation in Canada only on profits allocable to its permanent establishment. As the tax is on net income, it is necessary to show the gross income or profit allocable to the given establishment and the related expenses, losses and other deductions allowable under the law of the country in which the establishment is situated. The appellant has failed to meet either the meaning of ’’expense” or of "incurred” for the purposes of Canadian domestic law, i.e., with respect to the "rent" no amount was in fact paid or payable to anyone, there was no obligation to pay it and indeed no expense was incurred. In my view the amount of "rent" claimed by the appellant is not deductible in computing profit under the Act; thus it is not deductible in computing net industrial and commercial profit for the pur- poses of Article III. [17] The term "profit" must be given the meaning it has under Canadian law unless the context otherwise requires.

This conclusion gives effect to the intentions of the parties and to the object and purpose of the Convention. The interpretation proposed by the appellant in this case would have the anomalous effect of shifting the income of "the branch" to "the head office" rather than properly determining the net industrial and commercial profits of the permanent establishment. Furthermore, it would prevent a fair and equitable allocation of the profits between the two jurisdictions, a result clearly not intended by the parties to the Convention.

Had I concluded otherwise there is a further reason why the appellant’s position cannot be sustained. The use of substantial equipment or machinery within one of the Contracting States by an enterprise of the other Contracting State by definition constitutes a permanent establishment for the purposes of Article III. That Article requires that there shall be attributed to the permanent establishment the net industrial and commercial profit which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions. It is a fact that the permanent establishment acquired the use of the two snubbing units in issue from the appellant (the head office). The appellant’s basic proposition is that since the permanent establishment, treated as a hypothetical independent enterprise, dealing at arm’s length with its head office:

the only reasonable assumption to make in light of the facts is that it would have rented the snubbing units from the head office and also, as the head office is to be considered independent of the permanent establishment and was in the equipment rental business, the only reasonable assumption is that it would have rented, not sold the equipment.

The assumption that the permanent establishment would have rented is questionable.

First, the major premise for the appellant’s assumption is that it was in the business of renting equipment. It was argued that "the internal transfer on a temporary basis of the snubbing unit from the head office to the permanent establishment is of the same kind as transfers for which the appellant in the normal course of its business would have charged an arm’s length price to an independent party" it follows "that this internal transfer should be compensated for by charging a notional rent that would have been charged to an arm’s length third party". That premise is not supported by the evidence. The appellant was at all times a service company. It correctly perceived the need to have on hand the requisite equipment in order to deal with the needs of its customers and, consistent with industry practice, owned all of its equipment. While the appellant’s snubbing units were sometimes put on "unmanned standby" this does not in any sense of the word constitute a rental since, inter alia, the customer is not entitled to use the equipment itself. Furthermore, there is no proper basis in the evidence for reliance by the appellant upon leasing by HWC to third parties. No one from HWC testified and the appellant’s witness Grace had no first hand knowledge whether HWC rented snubbing equipment in 1985 and 1986 (if at all).

Second, the appellant’s hypothesis ignores how the Mobil contract was obtained. Mobil required the services of a company able to provide a 600 snubbing unit on a manned basis. No one other than an owner of a 600 unit could qualify. In 1985 there was no practice in the appellant’s trade for the leasing of equipment to or by competitors and snubbing units were simply not available for rent. In fact Boots & Coots’ failure to obtain the Mobil contract is graphic evidence of that circumstance. It did not even attempt to lease the 600 unit in order to compete for the Mobil contract. These are the real facts of the situation.

The general view of the fiscal committee of the League of Nations with respect to allocating incomes was that it was advisable to prescribe only general principles due to the diversity of national laws and the extreme complexity and variety of the individual cases which might arise. [18] Accordingly the selection of a method of allocation should depend, insofar as possible, on recognized methods of operation for the particular type of enterprise and upon practicability. [19] In this case hypothesizing an arm’s length transaction is complicated by the very uniqueness of the appellant’s business and the unusual nature of the specific transaction in issue. What does appear clear is that if the permanent establishment in Canada were an independent enterprise, as it must be considered to be, it would be necessary for it to have the requisite equipment in order to carry on its business. A logical hypothesis given the facts is that the permanent establishment had a capital structure in place. [20] It follows if for the purposes of the hypothesis required by Article III notional transactions are appropriate, that the more reasonable assumption would be that the branch (the permanent establishment) purchased the snubbing units from the head office (the appellant). Such an assumption creates a more logical régime for the allocation of income, an allocation truly reflecting the commercial profit of the permanent establishment in Canada.

At trial, counsel for the parties advised the Court that with respect to the issue of the tax rate applicable to the Part XIV tax base the Minister consents to judgment on the basis that the appropriate rate to be applied is 10 per cent. The appellant is entitled to no further relief. Costs to the respondent.

Appeal allowed.