Federal Court of Appeal Decisions

Date: 20011105

Docket: A-694-99

A-695-99

A-696-99

A-697-99

Neutral citation: 2001 FCA 333

CORAM:        LINDEN J.A.

SHARLOW J.A.

MALONE J.A.

BETWEEN:

                                                         MOBIL OIL CANADA, LTD.

                                                                                                                                                       Appellant

                                                                                 and

                                                        HER MAJESTY THE QUEEN

                                                                                                                                                   Respondent

                                            Heard at Toronto, Ontario, September 19, 2001

                                   Judgment delivered at Ottawa, Ontario, November 5, 2001

REASONS FOR JUDGMENT BY:                                                                               SHARLOW J.A.

CONCURRED IN BY:                                                                                                         LINDEN J.A.

                                                                                                                                              MALONE J.A.

Date: 20011105

Docket: A-694-99

A-695-99

A-696-99

A-697-99

Neutral citation: 2001 FCA 333

CORAM:        LINDEN J.A.

SHARLOW J.A.

MALONE J.A.

BETWEEN:

                                                         MOBIL OIL CANADA, LTD.

                                                                                                                                                       Appellant

                                                                                 and

                                                        HER MAJESTY THE QUEEN

                                                                                                                                                   Respondent

                                                        REASONS FOR JUDGMENT

SHARLOW J.A.

[1]                 The issue in these appeals is whether the payments Mobil Oil Canada Ltd. made to the Province of Saskatchewan in 1977, 1978, 1979 and 1980 pursuant to section 4 of the Road Allowances Crown Oil Act, R.S.S. 1978, c. R-23, are deductible in computing its income for those years under the Income Tax Act, S.C. 1970-71-72, c. 63. Mr. Justice Nadon held that they are not deductible: Mobil Oil Canada Ltd. v. Canada (1999), 176 F.T.R. 98, [2000] 1 C.T.C. 10, 99 D.T.C. 5709, [1999] F.C.J. No. 1501 (F.C.T.D.). The appellant now appeals to this Court.

Road Allowance Crown Oil Act

[2]                 The Road Allowances Crown Oil Act came into force on April 1, 1959 (S.S. 1959, c. 53) and was repealed on June 21, 2000 (S.S. 2000, c. 16).    It was amended in 1979 but the amendment did not make any changes that are relevant to this appeal. The main provisions (after the 1979 amendment) read as follows:

3. In every producing oil reservoir one and eighty-eight one-hundredths per cent of the recoverable oil shall be deemed to be within, upon or under road allowances and shall be the property of the Crown.

4(1) Except as provided in section 5, every owner producing oil shall be liable to pay and shall on or before the last day of each month pay to the minister one per cent of the value, calculated on the average prevailing well-head price, of the oil produced, free and clear of any deductions, during the preceding month.

(2) For the purposes of subsection (1), "average prevailing well-head price" means the price of a cubic metre of the oil produced from a well, calculated by taking the total sale price of all cubic metres of oil from the well sold during the month in respect of which the average prevailing well-head price is to be calculated, and deducting therefrom the cost of transporting the oil from the well or battery to the point of sale, and dividing the difference so obtained by the number of cubic metres of oil sold at the point during the said month.

5(1) Instead of payment as required by section 4, the minister may elect to receive payment in kind for all or any portion, as designated by him, of one per cent of the oil produced during the month in respect of which payment is to be made, by taking delivery of such oil or designated portion thereof; and where the minister so elects, the owner shall deliver such oil or such designated portion thereof at the time and place and in the manner specified by the minister.

(2) Where under subsection (1) the minister requires oil to be delivered at a place other than the place of production of the oil and is satisfied that the proceeds of the sale by the owner of eighty-eight one-hundredth of one per cent of the oil produced during the month in respect of which payment is to be made are not sufficient to cover the cost of production during that month of the oil declared by section 3 to be the property of the Crown and the cost of delivery as required by the minister, the minister may authorize the owner to make such deduction from the quantity of oil to be delivered as the minister deems just and reasonable.

(3) Where under subsection (1) the minister elects to take delivery of a portion only of one per cent of the oil produced during the month in respect of which payment is to be made, section 4 shall apply mutatis mutandis with respect to payment for the balance of the said one per cent of the oil of which the minister does not require delivery.

6. Subject to compliance with section 4 or 5, every owner producing oil may retain and dispose of oil declared by section 3 to be the property of the Crown to the extent of eighty-eight one-hundredths of one per cent of the oil produced, or the proceeds of the sale thereof, for his own use and benefit.

7. Every owner producing oil shall on or before the fifteenth day of each month submit to the minister, upon a form approved by him, a statement showing the oil produced during the preceding month.

8. The sale, purchase, acquisition, transportation, processing or handling of oil in violation of this Act is prohibited.

9. Every person who contravenes any provision of this Act is guilty of an offence and liable on summary conviction to a fine of not less than $10 nor more than $10,000; but neither a prosecution nor the enforcement of a penalty under this Act shall suspend or affect any remedy for the recovery of any amount payable, or oil in lieu thereof, under this Act.

10. Notwithstanding any prosecution under this Act, the minister may commence and maintain an action to enjoin the violating of any provision under this Act.

[3]                 The Road Allowances Crown Oil Act permitted the Province to collect revenue equal to 1% of the value of all oil produced in the Province. While it was in force, the Province of Saskatchewan was the owner of 1.88% of all oil produced in Saskatchewan: Imperial Oil Ltd. v. Placid Oil Co, [1963] S.C.R. 333, (1963) 39 D.L.R. (2d) 244, (1963) 43 W.W.R. 437.

[4]                 The Province did not automatically take delivery of its share of the oil production, but simply reserved the right to elect under section 5 to do so. A producer of oil for which no election was made had the right to sell the Province's 1.88% share and retain the proceeds of sale in excess of 1% of the value of the oil produced. As long as no election was made, all costs of production were borne by the producer, including the costs relating to the Province's share.

Facts

[5]                 In each of the years 1977 to 1980, Mobil produced oil from properties in Saskatchewan that were subject to leases pursuant to which the appellant had the right to take or remove oil. Substantially all of Mobil's oil production in Saskatchewan was from properties subject to Crown leases. The record does not disclose whether all or part of Mobil's Saskatchewan oil production for the years 1977 to 1980 was governed by leases that predated the 1959 enactment of the Road Allowances Crown Oil Act.

[6]                 The record contains a typical Crown lease as in effect during the years under appeal. It is dated October 26, 1977. Clauses 2 and 3 of the typical Crown lease read as follows:

2.            The Lessee shall, at the times and in the manner prescribed in the Petroleum and Natural Gas Regulations, in effect from time to time, make or cause to be made to the Minister at Regina, Saskatchewan, all payments and returns required by the said Regulations as the same may be amended, revised or substituted from time to time.

3.            The Lessee shall pay all rates, taxes and assessments whatsoever that may be charged or payable during the term hereof in respect of the leased lands or the operations hereunder.

[7]                 The Petroleum and Natural Gas Regulations, 1969, Sask. Reg. 8/69, contain stipulations for the payment of various amounts, including an annual rent and a royalty on the oil produced from the leased property. Regulation 71 reads as follows:

71.     The grantee shall at all times fulfil, perform, observe and comply with The Mineral Resources Act and The Oil and Gas Conservation Act and the regulations under the Acts, and every other statute or regulation that is or may, by future enactment or amendment in any manner whatsoever, be applicable to his operation, plant, works, business or undertaking.

Clause 13 of the lease gave the Minister the right to cancel the lease in the case of any default or non-performance on the part of Mobil of any obligation or condition in the lease.

[8]                 During the years under appeal, Mobil's rights under its various oil leases brought Mobil within the definition of "owner" as defined in subsection 2(d) of the Road Allowances Crown Oil Act, which reads as follows:

2. In this Act:

(d) "owner" means a person who has a right to drill into an underground reservoir and produce therefrom oil or gas or oil and gas and to appropriate the oil or gas he produces either to himself or others or to himself and others [....].

[9]                 The Province did not elect to take delivery of its share of Mobil's oil production. Therefore Mobil, having made the required payments under section 4 of the Road Allowances Crown Oil Act, was entitled to sell the Province's 1.88% share of the oil it produced during those years and retain the revenue.

Question to be determined on appeal

[10]            It is not disputed that all of the proceeds of sale of Mobil's oil production for the years 1977 to 1980, including the Province's 1.88% share, was correctly included in Mobil's income for those years. There is, however, a dispute as to the deductibility of Mobil's payments to the Province pursuant to section 4 of the Road Allowances Crown Oil Act. The payments were $551,034 (1977), $646,254 (1978), $731,526 (1979), and $822,178 (1980). The Crown's position is that paragraph 18(1)(m) of the Income Tax Act prohibits the deduction.

[11]            Paragraph 18(1)(m) was first enacted in 1974. Before its enactment, provincial resource taxes and royalties were fully deductible in computing income under the Income Tax Act. Increases in the value of oil and gas in 1973 and 1974 prompted some provinces to increase provincial levies on the production of those resources. The federal government, being concerned about the erosion of the federal tax base from those increases, wished to limit the relief available under the Income Tax Act for provincial resource taxes and royalties. The then Minister of Finance, in his budget speech of May 6, 1974, said this:

... I am proposing that revenues derived by provincial governments in respect of production from a petroleum or mineral resources should no longer be deductible in computing the income of the operator of the resource.

[12]            This was accomplished by a number of amendments to the Income Tax Act, some of which are described as follows in J.V. Krukowski, Canadian Taxation of Oil and Gas Income, 2^nd ed. (Don Mills, Ont: CCH Canadian Limited, 1987) at page 162:

The federal government achieved disallowance of deductions for provincial oil and gas levies through four sets of provisions. The first provision requires a taxpayer to include in income the value of any production that vests in the Crown (paragraph 12(1)(o)). The second provision disallows most amounts paid to the Crown on account of oil, gas or mineral production or to maintain an oil, gas or mineral lease (paragraph 18(1)(m)). The third provision, or rather group of provisions, sets aside any income tax advantage that a taxpayer would obtain through dealing with the Crown at prices lower than fair market value (subsection 69(6) to (10)). The fourth provision allows companies to shift the burden of disallowance by ignoring the reimbursement of non-deductible levies when computing taxable income (section 80.2).

These limitations on federal income tax relief were offset in part by a statutory deduction called the resource allowance (paragraph 20(1)(v.1)).

[13]            As a preliminary point, I note that Mobil indicated in its written argument in this appeal, and in its argument before the Trial Judge, that there is an issue as to whether paragraph 12(1)(o) of the Income Tax Act required the payments to be included in Mobil's income. In the course of argument it became clear that all of the proceeds of sale of the oil production, including the Province's share, are correctly included in Mobil's income pursuant to section 9 of the Income Tax Act and paragraph 12(1)(o) can have no application to this case.

[14]            I turn now to the question of whether the deduction of the payments is prohibited by paragraph 18(1)(m). For the years under appeal, paragraph 18(1)(m) of the Income Tax Act read as follows:

[15]            This appeal must fail if two conditions are met:

(1)        the payments are "a royalty, tax (other than a tax or portion thereof that may reasonably be considered to be a municipal or school tax), lease rental or bonus or as an amount, however described, that may reasonably be regarded as being in lieu of any such amount", and

(2)        the payments are within the scope of subparagraphs 18(1)(m)(iv) or (v).

First condition: What is the nature of the payment?

[16]            With respect to the first condition, the Crown concedes that the payments are not lease rentals or bonuses and cannot reasonably be considered to be school or municipal taxes. The Crown argues that they are either royalties, taxes or amounts that may reasonably be regarded as in lieu of royalties or taxes. The Trial Judge held that the payments are either royalties or amounts that may reasonably be regarded as in lieu of royalties. In light of this finding, he did not consider whether the payments are taxes.

[17]            The Income Tax Act does not define "royalty", and there is no jurisprudence that offers a comprehensive definition. Mobil relies on the following definition, which appears in Black's Law Dictionary, 5^th ed. (St. Paul, Minn: West Publishing Co., 1979) at page 1195:

Compensation for the use of property, usually copyrighted material or natural resources, expressed as a percentage of receipts from using the property or as an account per unit produced. A payment which is made to an author or composer by an assignee, licensee or copyright holder in respect of each copy of his work which is sold, or to an inventor in respect of each article sold under the patent. Royalty is share of product or profit reserved by owner for permitting another to use the property. In its broadest aspect, it is share of profit reserved by owner for permitting another the use of property. [...]

In mining and oil operations, a share of the product or profit paid to the owner of the property. [...]   

[18]            It is common ground that this definition is appropriate to describe the Canadian usage of the word "royalty" in the commercial context. Certainly it is consistent with the usage of the word "royalty" in the Canadian oil and gas industry. Typically, in contractual arrangements between landowners and oil and gas producers, the owner grants the producer the right to drill for, produce and take the resource, reserving a "royalty interest" which entitles the owner to a portion of the oil or gas produced, payable in kind or in money or both (J.B. Katchen and R.W. Bowhay, Taxation of Canadian Oil and Gas Income, Don Mills, Ont.: De Boo Publishers, 1986, at pages 1-12 to 1-13). In that context, a "royalty" is the means by which the owner of the resource shares in its production (J.B. Ballem, The Oil and Gas Lease in Canada, 2^nd ed., Toronto: University of Toronto Press, 1985, at page 127).

[19]            It is argued for Mobil that the payments in issue in this case are not royalties within the meaning encapsulated by the authorities referred to above. I summarize Mobil's argument as follows. The word "royalty" means a payment made for the right or privilege to explore for, bring into production, take or dispose of oil or gas. The payments are not "royalties" within that meaning, because Mobil's right to take the oil from the various properties in Saskatchewan were derived from leases that operate independently of the Road Allowances Crown Oil Act. Those leases, and only those leases, stipulate the consideration that Mobil must pay to the Province, as the owner of the oil, for the right to take the oil. What Mobil had to pay the Province under the Road Allowances Crown Oil Act was paid for something other than the right to take the oil from the property. It would follow, according to Mobil's argument, that payments made to the Province under the Road Allowances Crown Oil Act are not royalties.

[20]            In my view, Mobil's proposed definition incorrectly assumes that the word "royalty" as used in paragraph 18(1)(m) is limited to its meaning in the commercial context. It must be borne in mind that paragraph 18(1)(m) deals fundamentally with payments to the Crown. It is therefore appropriate to recall that the word "royalty" in its original sense refers to Crown prerogatives or Crown rights. That meaning of "royalty" was applied in Attorney-General of Ontario v. Mercer (1883), 8 App. Cas. 767 (P.C.) to the interpretation of section 109 of what is now the Constitution Act, 1867, which reads as follows:

[21]            The word "royalty" is still used in Canada to describe a payment that is required by a provincial statute to be paid to the province as a share of the production of a resource. Typically, in the case of a resource that the province owns, there is a provincial statute that authorizes the granting of a lease subject to the payment of royalties. The Saskatchewan Mineral Resources Act, R.S.S. 1978, c. M-16 is an example of such a statute. However, there is no authority that suggests that the word "royalty" must be limited to amounts paid pursuant to such an arrangement. In the context of payments to a province, the word "royalty" may describe any share of resource production that is paid to the province in connection with its interest in the resource.

[22]            Under theRoad Allowances Crown Oil Act, Mobil had the right to sell its entire oil production for the years under appeal, including the Province's 1.88% share, upon paying the Province an amount equal to 1% of the total value of the production. In my view, that 1% payment is a royalty even though it was the Road Allowance Crown Oil Act itself that created the Province's 1.88% proprietary interest. I conclude, therefore, that the payments in question are "royalties" within the meaning of paragraph 18(1)(m) of the Income Tax Act.

Second condition: To what do the payments relate?

[23]            With respect to the second condition, it is necessary to consider only subparagraph 18(1)(m)(v). In support of its position that the payments are not within the scope of subparagraph 18(1)(m)(v), Mobil argues that the payments represent the Province's net share of its 1.88% ownership in the oil produced, and that Mobil had no rights in respect of the Crown's 1.88% share.

[24]            I do not read subparagraph 18(1)(m)(v) as imposing any condition as to the ownership of the oil with respect to which the payments were made. In my view only two questions need be asked. The first question is whether Mobil had the right to take or remove the oil from the property. The answer to that question must be yes. Mobil owned the leases that were the legal source of its right to take or remove the oil. The fact that the production of the oil triggered certain obligations under the Road Allowances Crown Oil Act did not derogate from Mobil's right under the leases to take or remove the oil. The second question is whether the payments may reasonably be considered to relate to the exercise of Mobil's right to remove the oil from the ground. The answer to that question must also be yes. Section 4 of the Road Allowances Crown Oil Act expressly ties the exercise of that right to the obligation to make the payments. It follows that the payments are within the scope of subparagraph 18(1)(m)(v).

Conclusion

[25]            The Trial Judge correctly concluded that in computing Mobil's income for 1977, 1978, 1979 and 1980 under the Income Tax Act, paragraph 18(1)(m) prohibits the deduction of the payments made to the Province of Saskatchewan pursuant to section 4 of the Road Allowances Crown Oil Act. These appeals should be dismissed with costs.

"K. Sharlow"

J.A.

"I agree

A.M. Linden J.A."

"I agree

B. Malone J.A."