Hidrogas Limited v. Minister of National Revenue, [1979] CTC 2605, 79 DTC 555

M J Bonner:—The appellant, in its return of income for the taxation year ending August 31, 1974, sought to deduct in computing income Canadian development expenses in the amount of $191,116 and Canadian exploration expenses in the amount of $1,837,643. The appellant is a subsidiary of Canadian Hidrogas Resources Ltd. During 1974 the appellant purchased from its parent a 12 /2% interest in certain petroleum and natural gas properties. It alleged in the Notice of Appeal that the purchase was made pursuant to a verbal agreement made in April of 1974, which agreement was confirmed in writing on August 29, 1974, and that the respondent, on assessing, had improperly determined and failed to allow deductions permitted by subsection 66.2(2) and subparagraph 66.2(5)(a)(iii) of the Income Tax Act. The respondent, on assessing, disallowed the Canadian exploration expense claimed.

The appellant appears to have changed its position at trial. Its counsel argued that the amount claimed as Canadian development expenses was not a Canadian development expense falling within subparagraph 66.2(5)(a)(iii) (in respect of which the deduction, as a component of cumulative Canadian development expense, is limited). He argued that the appellant’s 1.8 million dollar outlay or expense under the agreement with its parent was made or incurred before May 7, 1974, thus removing the expense from paragraph 66.2(5)(a) and bringing it under subparagraph 66(15)(b)(iii).

Evan Bodrug, chairman of the board of directors of the appellant company, was the only witness. His evidence was that the appellant had a successful year and had transferred substantial funds to its parent. It was originally anticipated that the transfer of funds would be by way of loan. The parent could not find funds to repay the appellant and it was decided instead to transfer resources. The decision to do this was taken at the end of April of 1974.

Mr Bodrug identified Exhibit A-1, a copy of a director’s resolution of the parent passed without meeting pursuant to the articles of association of the parent. It was stated to be dated and effective as of April 29, 1974. The relevant parts of the resolution read:

WHEREAS Canadian Hidrogas Resources Ltd has acquired various working interests to mineral rights in a number of producing and non-producing properties;

AND WHEREAS Canadian Hidrogas Resources Ltd is in the process of having further appraisal done on such working interests with a view to establishing a more accurate current value of such interests;

AND WHEREAS Hidrogas Limited, a wholly owned subsidiary of Canadian Hidrogas Resources Ltd, is desirous of obtaining a portion of such mineral interests from Canadian Hidrogas Resources Ltd to the extent of Two Million ($2,000,000) Dollars.

NOW THEREFORE be it resolved that the Company do convey to Hidrogas Limited a portion of its mineral interests which it holds in various producing and non-producing properties and the President of the Company is hereby authorized and directed to define and determine the mineral interests to be transferred to Hidrogas Limited after the reappraisal and reevaluation of the mineral interests held by Canadian Hidrogas Resources Ltd has been completed. The conveyance of such mineral interests to Hidrogas Limited shall be for a minimum consideration of Two Million ($2,000,000) Dollars and the President be and the same is hereby authorized and directed to enter into the necessary agreements with Hidrogas Limited in order to complete the transfer of mineral interests and set the terms of payment for same.

The evidence did not indicate whether, at that time, a corresponding resolution was passed by the appellant or whether the appellant, by any corporate act identifiable as its own, acquiesced.

Mr Bodrug identified as well Exhibit A-2, a conveyance of rights in certain Alberta Crown petroleum and natural gas leases. The conveyance was stated to have been made as of August 29, 1974. Mr Bodrug testified that when the auditors came around at the year-end all legalities were completed. He stated that in the case of small busy companies it was less common to set out in writing agreements between parent and subsidiary than in the case of contracts made between parties dealing at arm’s length.

The appellant has not, in my view, established that the expenses of acquisition of the properties was incurred by it before May 7,1974. The properties sold to the appellant by its parent comprised only a small part of the producing and non-producing mineral properties belonging to the parent on April 29th. If the properties were identified or selected prior to May 7th, no evidence to that effect was brought.

There was, I think, neither agreement made nor expense incurred before the vendor and the purchaser reached agreement on what property, what price and what terms. The evidence did not suggest that all elements of such agreement were settled before May 7th. Although the parent had the appellant’s money before May 7th, it had the money as a debtor and not as payee of an expense incurred in the acquisition by the appellant of any identifiable Canadian resource property. Whether or not on the facts shown it can be said that before May 7th an expense was incurred, it is plain that it cannot be said that before May 7th an expense was incurred that was the cost to the appellant of a Canadian resource property. The appellant can therefore not succeed on this branch of its appeal.

The appellant appeals as well from an assessment of income tax for its 1975 taxation year. The assessment, notice of which was dated September 12, 1977, was a nil assessment or, to be more accurate, a notification that no tax was payable. The issue raised in the Notice of Appeal for the 1975 taxation year was the disallowance of an expense claimed in the amount of $897,184.62. An explanation of adjustments attached to the notification that no tax was payable indicates that the respondent computed that the appellant suffered a 1975 loss of $605,324. The quantum of that loss was arrived at after disallowance of a total of $1,342,980 in expenses. The Notice of Assessment for the appellant’s 1974 taxation year indicates that the respondent, in computing taxable income, disallowed a 1975 loss, the claimed amount of which was greater than $605,324. Thus, while no appeal lies from the notification for 1975, it would appear that the deductibility of the $897,184.62 is properly in issue in respect of the assessment of tax for 1974.

The appellant purchased propane gas for purposes of resale in the ordinary course of its business. The vendor of the propane was McCulloch Gas Processing Corporation (hereinafter called “McCulloch”). The gas was purchased at McCulloch’s plants in the United States. The total of amounts invoiced by McCulloch to the appellant for propane exceeded the amount paid by the appellant by $897,184.62. A bundle of nearly 80 invoices sent by McCulloch to the appellant was introduced as Exhibit A-3. The propane was sold in liquefied state by the gallon. It appears that before June 13,1975, McCulloch invoiced the appellant for gallonage delivered by applying, on the invoice, two rates per gallon: (a) a lower rate which, when multiplied by the number of gallons, produced an amount indicated on the invoice as “payable immediately”, and (b) a higher rate which it appeared McCulloch would like to have been able to charge. The difference between the amounts arrived at by application of the higher rate and that arrived at by application of the lower rate was shown as a balance due with the following explanation:

THE BALANCE WILL BE IMMEDIATELY PAYABLE UPON RECEIPT OF AN EXPECTED FAVOURABLE RULING FROM THE FEA ON CERTAIN PROCEEDINGS PRESENTLY BEFORE THE FEA.

“FEA” is the Federal Energy Administration in the United States.

A letter dated June 13, 1975, from McCulloch to Hidrogas Inc, a company which I assume is a wholly-owned subsidiary of either the appellant or its parent, and which I assume acted as agent for the appellant in effecting the propane purchases, stated:

As you were advised by MGPC on certain invoices which you received in 1974, payments for natural gas liquid products were to be made in accordance with the following procedure:

(a) an amount payable immediately which reflected that price level which MGPC was limited to accepting as the maximum allowable according to the then existing 1974 FEA regulations 10 CFR Part 212, Subpart E.

(b) an amount payable upon receipt by MGPC of favourable pricing relief from the FEA.

During 1974, MGPC engaged in extensive and protracted administrative proceedings before the FEA in which MGPC demonstrated that the 1974 FEA regulations as they pertained to the pricing of natural gas liquid products were ill-suited to the sales of said products by independent natural gas processors such as MGPC. Said regulations were tailored to the operations of crude oil refiners only, who refine petroleum liquid products (propane, butane and natural gasoline) from crude oil. Consequently, independent natural gas processors, which extract said liquid products from a natural gas stream, experienced economic hardships due to the disproportionately low price levels at which their liquid products were sold vis-a-vis crude oil refiners.

Because MGPC believed the 1974 FEA regulations to be unlawful due to the aforementioned disparate treatment by the FEA of crude oil refiners and natural gas processors, your company was invoiced for liquid products which it received from MGPC on the basis of what was currently the permitted price levels under the 1974 FEA regulations (“payable immediately”); and, on the basis of what MGPC determined were valid price levels had said regulations properly accorded to natural gas processors pricing of liquid products on a parity basis with crude oil refiners.

On May 23, 1975, the Office of the General Counsel of the FEA issued Ruling 1975-6 entitled ‘‘Pricing of Natural Gas Liquid Products prior to January 1, 1975”. This ruling clarifies the fact that increased costs of natural gas shrinkage could be passed through as increased product costs pursuant to the provisions of Subpart E of the 1974 FEA regulations, and, generally, more clearly describes the application of the price rules of Subpart E in determining natural gas liquid product prices, before Subpart K (the current FEA pricing regulations for natural gas liquid products) became effective on January 1, 1975. In effect, this Ruling accords to MGPC a portion of the pricing relief which has been sought in its petitions to the FEA.

MGPC, having received the favourable pricing relief from the FEA upon which it premised its total invoiced amounts to your company under 1974 FEA regulations, submits the enclosed invoices for payment in accordance with its normal credit practices. The amounts reflected on these invoices represent the difference between the amount actually paid and collected and the full invoiced amount. Please be advised that the amounts set forth on the enclosed invoices have nothing to do with, but rather are in addition to, those amounts due to MGPC by your company which are presently the subject of litigation in MGPC v Canadian Hidrogas Resources, et al, No CV75 576EC.

A “Third Amended Complaint” dated July 5, 1977, in the United States District Court for the Central District of California between McCulloch as plaintiff, the appellant’s parent, the appellant, Hidrogas Inc, Mr Bodrug and a Regional Administrator of the Federal Energy Administration as defendants was introduced as Exhibit A-4.

In that complaint McCulloch seeks injunctive relief, declaratory relief and money damages against all defendants in the total amount of $897,184.62, $345,599.96 of which is for propane products sold and delivered between October of 1974 and February of 1975. The remainder of the money claimed relates to the period from May of 1974 through to October of 1974. The appellant is defending the action brought by McCulloch on the basis that the price increase imposed by McCulloch was one prohibited by United States law. It does not apparently share the McCulloch view of the effect of the May 23, 1975, ruling by the Federal Energy Administration as set forth in McCulloch’s letter of June 13th as follows:

In effect, this Ruling accords to MGPC a portion of the pricing relief which has been sought in its petitions to the FEA.

The action has not yet been tried.

The position of the respondent is that the deduction sought is one prohibited by paragraph 18(1 )(e) of the Income Tax Act. I accept the appellant’s contention that the mere fact that a taxpayer disputes liability does not make the liability contingent. On the other hand, the mere assertion of a claim against a taxpayer in respect of a transaction, the cost to the taxpayer of which is on current account, does not necessarily give rise to a current deduction in the amount claimed.

The case appears to be somewhat analogous to that considered by Rowlatt, J in H Ford & Co, Ltd v The Commissioners of Inland Revenue (1926), 12 TC 997. There the appellant was a seller of wheat. It sought to deduct the amount of a claim for a demurrage made against it by the purchaser arguing that the sum in question was deductible in the year in which the purchaser’s claim was asserted. As it turned out, the purchaser abandoned its claim in a later year. That fact was known at the time the appeal was heard. In that respect the case is distinguishable from the present case. At pages 1005 and 1006 Rowlatt, J said:

The business position must have been quite clear to them (the appellant). They would have said: ‘‘We do not know if we are going to get off” in point of demurrage, but there are a good many shots in the “locker yet, and we will not treat it as past praying for.” I am perfectly certain that is what they had in their minds, and I think the Commissioners are perfectly right in saying that what it was was not a loss incurred yet; it really was, in point of substance, and it should have been put as a contingent liability, because the chances, which have in fact eventuated, of its not proving an effective loss were quite considerable.

As I see it, the appellant, by its conduct in resisting McCulloch’s claim, denies the existence of a liability and in the absence of any indication that the appellant has no reasonable chance of ultimately succeeding, the deduction claimed should be regarded as an amount transferred to a contingent account within the meaning of paragraph 18(1)(e) of the Act.

I believe that this conclusion is supported as well by the decision in J L Guay Ltée v MNR, [1971] CTC 686; 71 DTC 5423 (aff’d [1973] CTC 506; 73 DTC 5373 (FCA)) (aff’d [1975] CTC 97; 75 DTC 5094 (SCC)). There the appellant, a building contractor, sought to deduct certain holdbacks as amounts payable to subcontractors. The amounts were payable on the thirty-fifth day following final approval by the architect of the work. No approval had been given at the end of the relevant fiscal period. At pages 693, 5427, Noël, ACJ, stated:

The procedure adopted by the appellant, of deducting from its income amounts withheld by it, which it may one day be required to pay its subcontractor, but which the latter may not claim until 35 days after the work is approved by the architect, is, as we have just seen, contrary to the rule that an expenditure may only be deducted from income for the period in which it was made, and this would suffice to dispose of the present appeal. However, as we have seen above, there is an additional reason for dismissing the appeal: this is that we are dealing with amounts withheld which are not only uncertain as to quantum if partial damages result from badly done work, but which will no longer even be due or payable if damages exceed the amounts withheld.

The claim asserted by McCulloch was not, in 1975, an actual cost of operation which, in the words used by Jackett, P, as he then was, in a footnote in Associated Investors of Canada Limited v MNR, [1967] CTC 138 at 146; 67 DTC 5096 at 5100:

... should only be charged against the receipts of the business in the year when the contingency is realized, and then only to the extent of the net outlay involved at that time.

The appeal must therefore be dismissed.

Appeal dismissed.