Date: 20021104
Docket: 2001-4244-IT-G
BETWEEN:
INTERNATIONAL COLIN ENERGY CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Bowman, A.C.J.
[1] This appeal is from an assessment for the appellant's 1996 taxation year. The issue is the deduction of $1,223,598 paid to professional financial advisors, PowerWest Financial Ltd., which subsequently changed its name to ARC Financial Corporation ("ARC"). The denial of the deduction was based essentially upon the premise that the amount was not laid out for the purpose of gaining or producing income from a business or property and its deduction is therefore prohibited by paragraph 18(1)(a) of the Income Tax Act.
[2] I shall refer to the appellant as ICEC. ICEC's business at the time relevant to this appeal was drilling and exploring for oil and gas. The 1993 drilling season, which was in the winter, was reasonably successful but the 1994 season was not as the result of cost overruns and poor drilling results that did not produce the expected level of reserves and production.
[3] The reserves on the Kidney and Panny properties, which were contiguous, were declining by 1994. They represented about 60% of ICEC's total property. This meant declining cash flow and potential problems with its banker the Bank of Montreal ("BMO"). In 1990 ICEC had a credit facility of $100,000,000 with the BMO and in that year had used up $90,000,000 of that facility. In 1993 ICEC was producing upwards of 9,500 barrels of oil equivalent per day but it was declining due to pressure drops, principally in the Kidney/Panny field.
[4] Attempts were made to improve the appellant's position. At the technical level assistance was sought from an independent engineering firm who developed a water flood concept designed to stabilize and increase the pressure.
[5] On the financial level the vice president - finance, Mr. Paul David Wright, in 1994, converted part of the BMO facility into a long-term note by borrowing from a US insurance company. The proceeds of the long-term US debt were used to pay down the short-term BMO debt. Mr. Wright was concerned that some of the covenants under the long-term US debt were in danger of being violated and so he renegotiated the terms of that debt.
[6] As the result of declining income and cash flow the exploration budget had to be reduced. In short, reduced income led to reduced exploration which in turn led to reduced income: a classic vicious circle.
[7] In addition the President and Chief Executive Officer was dismissed and replaced.
[8] In an attempt to alleviate the worsening financial situation some assets, such as gas plants, were sold. This in turn resulted in a reduction of the company's credit facility by about $4.7 million each quarter.
[9] By the spring of 1995 the board of directors was receiving, to use the witness Mr. Wright's expression, a great deal of flak from the shareholders. This is not surprising. The company was obviously experiencing difficulties.
[10] About this time an offer was received by the board from PetroCorp Incorporated to acquire the shares of the appellant. The board decided to reject the proposal. I set out here the portion of the board meeting held on May 2 and 3, 1995 because it illustrates the type of thinking that led to the ARC transaction with which we are concerned here.
4. PetroCorp Proposal
The Chairman advised that he had received another proposal from PetroCorp Incorporated and distributed copies of the proposal. A lengthy discussion ensued and there was a unanimous consensus that the proposal should be rejected. The reasons for the Board's decision included that the offer was too low relative to the Corporation's current asset value per share; that the Corporation has invested in new management, a plan for remedial work on core assets and the disposition program which will all increase the value of the Corporation; that the current trading price of the Corporation's shares is artificially low and that PetroCorp is attempting to capitalize on the low price; that neither PetroCorp's proposal or its financial statements indicate that it would have the financing for its proposal and that PetroCorp's proposal has no other suggested benefits such as plans for a drilling and exploration program or a management team. For these reasons the Board also determined that it did not want to pursue negotiations with PetroCorp for a better offer. The Secretary was instructed to draft a rejection of the proposal for review.
[11] The next step in this saga was a board meeting on July 31 and August 1, 1995. Item 3 of the minutes reads:
3. Meetings with Shareholders
The Chairman reported on the meetings with shareholders which he, Mr. Mann, Mr. Wright and Mr. Ibach recently held in Chicago, Boston and New York City. He advised that they met with several shareholders in Chicago representing an aggregate of approximately 24% of the outstanding shares. Two shareholders, holding approximately 4% and 1.5% respectively were very unhappy and not receptive to management's story. They strongly urged management to employ an investment banker to sell the Corporation or find a merger candidate which would result in replacing current management. The other shareholders present were concerned about management's plan that required new equity and, although they did not seem to feel as strongly about a sale, supported the idea. The Chairman advised the Chicago group that the Corporation would be put up for sale if that was what a majority of the shareholders wanted. He also asked what they wanted to realize from such a sale and, after discussions, a figure of U.S. $8.00 per share was suggested, depending in part on whether it was a cash deal or a share deal and who the purchaser was. The shareholders at the meetings in Boston and New York City represented an aggregate of approximately 21% of the outstanding shares. They were more receptive to management's story. None of them brought up the idea of selling the Corporation, and neither did management. They had also intended to have another meeting with a 5% holder in New York and a meeting in Toronto with a 9% shareholder, but were unable to set up a meeting. A discussion ensued.
The Chairman was of the opinion that this is a bad time to sell the Corporation to realize maximum value for the shareholders; that U.S. $8.00 is not a realistic price to obtain at this time and that a sale may not be the choice of the holders of a majority of the shares. He therefore proposed to go back and talk to the persons attending the Chicago meeting on an individual basis and suggest that a sale may not be in their best interests at this time. He asked the Board to consider this course of conduct over night and discuss it at tomorrow's continuation of this meeting.
[12] On August 11, 1995 a further board meeting was held. It seems clear from Mr. Wright's evidence that it was only the small shareholders, holding about four percent or one and one half percent of the shares, who were asking that the company be sold. At that meeting the board agreed to proceed with its business plan in an attempt to maximize shareholders' value. It was determined to retain Sproule & Associates, an engineering firm, to prepare the ICEC's future reserve report.
[13] On October 30 and 31, 1995 a further board meeting was held. Item 4 reads
4. Corporate Merger Update
The Chairman advised that he had been approached by National Energy Group Inc. and Arch Petroleum Inc., which are both interested in pursuing the possibility of acquiring the Corporation. The Chairman has met with the management of NEG, who advise that NEG has acquired just under 5% of the Corporation's shares and has been speaking with other shareholders who hold or have acquired an aggregate total of around 30%, and he distributed a letter of intent received from NEG which it desires the Corporation to sign. Miles Bender, President and CEO of NEG, has requested an opportunity to meet the Board and make a presentation and it was agreed to meet with him at 11:00 a.m. on October 31st.
A lengthy discussion ensued about the future prospects of the Corporation and it was agreed that without the ability to raise additional financing through equity or debt, it will be necessary for the Corporation to make an acquisition for shares or merge with another company. It was therefore agreed that management would have discussions with Peters & Co. about retaining Peters & Co. to assist with identifying potential mergers or acquisitions, although Arch was introduced to the Corporation by Peters and they may have a conflict of interest if they have been retained by Arch. It was further agreed that no approach was to be made to any other company in a way which would suggest that the Corporation is for sale and that, in any event, all discussions relating to the subject matter will be conducted only by the Chairman. It was further agreed that either NEG or Arch could access the data room upon executing the Corporation's standard confidentiality agreement, but that the Corporation would not execute the letter of intent with NEG.
[14] On December 11 and 12, 1995 a meeting was held in which the board was advised that the draft report of Sproule & Associates concluded that the appellant had even lower reserves than had previously been believed. The board was also informed that management had decided to enter into an engagement agreement with PowerWest Financial Ltd. (ARC).
[15] ARC was chosen over two other potential financial advisors because they wanted only to sell the company whereas ARC was prepared to consider all alternatives. The proposal made by ARC contained the following.
C. PROPOSED SERVICES
PowerWest proposes to provide financial advisory services to Colin in three phases, as described below:
Phase One
(a) PowerWest would prepare a preliminary corporate valuation based on a preliminary Sproule Report and other information available to December 15, 1995; and
(b) PowerWest would summarize the above in presentation format, submit it to you and, upon request, meet with and present the results to the board of directors of Colin.
Phase Two
If the board of directors of Colin determines that it wishes to proceed with a review of strategic alternatives, PowerWest would advise Colin thereon, as follows:
(a) PowerWest would prepare (i) an update of the preliminary valuation with access to the final Sproule Report and (ii) a review of Colin's strategic position including both operating and financial considerations. The objective of the review would be to determine whether any specific activity within Colin's control could significantly impact Colin's value and/or growth prospects;
(b) PowerWest would prepare a review of strategic alternatives which would assess the relative merits of pursuing alternative business plans and/or transactions; and
(c) PowerWest would summarize the above in presentation format, submit it to you and, upon request, meet with and present the results to the board of directors of Colin.
Phase Three
In the event that the board of directors of Colin receives an acquisition/merger proposal which appears attractive and which they wish to pursue prior to implementation or completion of Phase Two, we could move right to paragraph (e) below. Otherwise, Phase Three would commence after Phase Two if the board of directors of Colin decides to pursue Phase Three, as follows:
(a) in the event that Colin receives an acquisition/merger proposal from one of the three parties currently expressing interest, PowerWest would assist Colin in negotiating and optimizing the terms of the transaction;
(b) in the event the board of directors of Colin decides to pursue a merger and/or sale process, PowerWest would implement a program designed to achieve the objective of the board including either (i) to maximize the value of Colin to be received in a sale or merger with a larger company or (ii) maximize the positive impact on Colin of merging with (acquiring) a smaller company;
(c) in the event that the board decides to pursue a financing, PowerWest would advise the board with respect to the terms of such financing. If PowerWest believes it would be most effective for Colin in placing such financing it would act as Colin's agent but otherwise PowerWest would recommend the service of an investment dealer;
(d) in the event the board of directors decides to sell assets, PowerWest would act as agent for Colin in the sale unless PowerWest felt that another agent could be more effective; and
(e) in the event that a fairness opinion on a transaction is requested by the board of directors of Colin, that would be issued to the shareholders of Colin, PowerWest would provide such opinion.
[16] The fees to be charged would be $35,000 for Phase One, $35,000 for Phase Two and, if the board decided to proceed with Phase Three, $25,000 per month plus an incremental transaction fee if a merger or acquisition took place. The transaction fee was in general a percentage of the "Total Value" of Colin (as defined). I shall set out later in these reasons the precise calculation of the incremental transaction fee.
[17] The engagement letter which resulted from the proposal combined phases one and two into Phase One and for ARC's work in Phase One a fee of $60,000 was paid.
[18] The engagement letter, which was dated December 13, 1995, reads in part as follows.
PowerWest will prepare a preliminary valuation of Colin that will rely on information provided to us, without conducting formal due diligence. Such valuation will be prepared from the points of view of both (i) Colin as a separate going concern exploration, development and production company, and (ii) a corporate sale of Colin. The valuation will be presented to Colin in presentation format during the week of January 8, 1996.
The broad strategic alternatives are to (i) continue the normal operations of Colin, (ii) enhance the normal operations of Colin with a financing or sale of assets, (iii) enhance value of Colin via merger or (iv) solicit offers for the purchase of all of the shares of Colin. PowerWest will analyze the main sub-alternatives under each of these broad alternatives.
PowerWest will evaluate each of the above-mentioned alternatives (including the steps required for implementation of each of them) in the context of your objectives and we will provide a discussion of the major risk factors in completing a particular plan, with a view to achieving maximum available values for all shareholders of Colin. PowerWest will present the conclusions of this assessment to Colin during the week of January 15, 1996.
The services described above constitute phase one ("Phase One") of, potentitally, a two-phase project. If Colin instructs PowerWest to pursue implementation of a sale or merger transaction (a "Transaction"), then phase two ("Phase Two") would commence. PowerWest's services in Phase Two, unless otherwise agreed with Colin, would be in the following areas, if and as requested by Colin:
(a) PowerWest would manage the overall Transaction process;
(b) PowerWest and Colin would work together to identify and evaluate third parties ("Third Parties") which are prospective acquirors or merger partners and which have the capability to complete the Transaction;
(c) PowerWest would prepare, with the assistance of Colin, an information document or documents in respect of the Transaction;
(d) PowerWest would solicit acquisition and merger interest from the Third Parties and, to enhance the dissemination of Colin information documents, would act as Colin's agent in the execution of confidentiality agreements, satisfactory in form to Colin and its counsel, with the Third Parties;
(e) PowerWest would represent and advise Colin in all material financial respects in discussions with Third Parties; and
(f) PowerWest would negotiate with Third Parties to receive the best possible offers of Transaction terms.
PowerWest will provide the financial advisory services described in Phase One and would provide the financial advisory services described in Phase Two if so instructed by Colin, as Colin's exclusive financial advisor, upon the terms and conditions set forth below. In addition, if Colin elects to pursue a financing or sale of assets, PowerWest would advise Colin with respect to such projects and may act as agent thereon on terms and conditions to be agreed at that time.
1. Colin will provide (and it is a condition precedent to the performance of our engagement that PowerWest will receive) by December 20, 1995:
(a) the most recent completed internal and independent engineering evaluations of the oil and natural gas reserves of Colin;
(b) the most recent evaluations of Colin's undeveloped acreage;
(c) audited financial statements of Colin for the year ended December 31, 1994, financial statements for the period ended November 30, 1995 and, as soon as they are available, audited financial statements for the year ended December 31, 1995;
(d) an estimate of tax pools available in Colin at December 31, 1995;
(e) upon request, such access by PowerWest to the senior officers of Colin as PowerWest may reasonably require in order to complete the terms of this engagement; and
(f) such additional information or data in respect of Colin as PowerWest shall reasonably require to complete the terms of its engagement including any additional information required to implement Phase Two.
PowerWest shall be entitled to rely upon all such information as being true, correct and complete in all material respects as of the date of delivery of same to PowerWest (except to the extent any such information is updated by other written information provided to PowerWest by Colin) and shall be under no obligation to independently verify the accuracy or completeness of any such information or updates of same.
2. Colin agrees to notify PowerWest promptly of any material change or material development that occurs in Colin's business, assets or affairs during the course of PowerWest's engagement.
3. In consideration of PowerWest providing financial advisory services hereunder, Colin shall pay to PowerWest the following fees, namely:
(a) work fees ("Work Fees") for the financial advisory services in Phase One of $60,000, with the first payment of $25,000 to be paid upon execution of this agreement by Colin and the final payment of $35,000 to be paid upon presentation of PowerWest's conclusions in Phase One;
(b) if Colin instructs PowerWest to provide its financial advisory services for Phase Two, Colin shall pay to PowerWest a retainer for the Phase Two financial advisory services in an amount to be agreed between Colin and PowerWest, with the first payment to be paid upon confirmation of instructions to PowerWest for Phase Two, pro-rated for the days remaining in the month of such confirmation, and subsequent payments payable on the first day of each month thereafter until closing of a Transaction or termination of this agreement as hereinafter provided;
(c) if a Transaction is completed, then, upon the closing thereof, Colin will pay a success fee (a "Success Fee") to PowerWest. Subject to paragraph 3(d) below, the Success Fee on any Transaction shall be calculated pursuant to the following formula:
(i) in the event that a Transaction is completed with one of the parties identified on Schedule A hereto without the implementation of a competitive managed sale/merger process by PowerWest, the Success Fee shall be 0.2% of Total Value (as hereinafter defined),
(ii) in the event that a Transaction occurs after PowerWest has implemented competitive managed sale process, the success Fee shall be 0.7% of Total Value;
"Total Value" shall be the acquisition price of all of the equity of Colin, plus any long-term debt and negative working capital of Colin, if working capital is negative, and less positive working capital, if working capital is positive. If the acquisition consideration includes publicly traded securities of another company, the value thereof for the purpose of calculating the equity component of Total Value will be the weighted average trading price of such securities in the period commencing immediately after the announcement of the Transaction and ending five days prior to the consummation of the Transaction. If the acquisition consideration does not consist entirely of cash or publicly traded securities, Colin and PowerWest will agree the value thereof for this purpose, failing which the parties shall submit the valuation for determination under the Arbitration Act (Alberta);
(d) in the event PowerWest is requested to provide, and provides, a fairness opinion on the terms of a Transaction, Colin shall pay to PowerWest a fee of $85,000, payable upon presentation of such opinion; and
(e) all fees invoiced hereunder will have the Canadian goods and services tax ("GST") added at the rate prescribed by law. PowerWest's GST Registration Number is R122195555.
[19] On February 12 and 13, 1996 a further meeting of the board was held at which it was decided to proceed with Phase Two. Officials of ARC presented their report of February 5, 1995 "Preliminary Assessment of Strategic Alternatives". This was a fairly comprehensive analysis of the economic climate in the energy field and the appellant's position within that industry.
[20] Several alternatives were considered, such as a sale of assets, an issue of common shares, a rights offering and a large private placement as well as simply continuing as before (the "going concern course").
[21] Under the heading "Merger" in the report the following points were emphasized:
¾ Potential general benefits of a merger:
" create a larger, stronger company
" potentially improved market trading prices
" potentially strengthen balance sheet and financing capability
" potential asset synergies and lower operating costs
" potential G & A efficiencies
" potential new core areas and upgraded capital program
" increase float for improved liquidity and access to capital markets
¾ Ideal merger candidate for International Colin:
" strong balance sheet
" complementary asset base
• lower risk prospects
• year round areas
" proven technical capability in the eyes of investors
" size in the $100 MM to $200 MM market cap range
" good "going concern" performance
" supportive shareholder base
¾ Objective of ideal merger would be to create a company with fundamentals for 1st quartile future performance
[22] The report also considered the alternative of a corporate sale. ARC's comments on a corporate sale were as follows.
¾ Broadly, we are cautiously optimistic about expected results from a corporate sale process
" excellent concentration, operatorship and working interests but unstable performance of Kidney and Panny adds some uncertainty
" Sproule report appears optimistic for Kidney 1996 production volumes
¾ Our conclusion with respect to most likely winning bid on a corporate sale is $6.50 to $8.50 per share
[23] By "corporate sale" it appears ARC was referring to a sale for cash of shares. Merger appears to have meant a merging of the appellant into another entity. The distinction however between a "corporate sale" and a "merger" is a little blurred. In ARC's preliminary conclusions it stated
"merger should be viewed as a variation of the corporate sale alternative".
[24] In its preliminary conclusions and recommendations ARC rejected all of the alternatives except those of corporate sale and merger. It stated:
ARC recommends that Colin initiate a corporate sale process
" likely the lowest risk/highest near-term reward alternative for shareholders
" seek offers in the form of a cash sale or merger into another company in exchange for strong securities.
[25] On February 14, 1996 the appellant issued a news release that it had retained ARC
"to review the strategic alternatives available to the Company to maximize shareholder value".
[26] Also on February 14, 1996 the appellant and ARC amended the engagement letter to provide for a success fee to be paid to ARC not only in the event of a sale or merger but also in the case of a refinancing.
[27] In March 1996 ARC sent a Confidential Information Memorandum to prospective partners. In Appendix A to that memorandum (Offering Procedures) under "Transaction Structure" the following appears:
The board of directors of Colin is receptive to a wide range in the types of proposals that it will consider for Colin including, but not limited to, a sale for cash or shares, a merger or a significant recapitalization of the Company and change of control. Bids conditional upon financing may be considered if evidence of financing ability is clearly demonstrated and the time required to complete the financing is reasonable. No commitments will be required of the eventual acquiror with respect to employment of any of the current staff of Colin. However, any severance payments will be the obligation of Colin and therefore effectively of the ongoing entity.
[28] On April 18, 1996 officials of ARC reported to the board of ICEC that they had received seven proposals and that they recommended pursuing only two, those of Cabre Exploration Ltd. and Morgan Hydrocarbons Inc. ARC was instructed to proceed with negotiations with these two companies. It is significant that the management of the appellant proceeded with due diligence with respect to the two companies. I consider this important because it demonstrates that the board was not looking to a mere sale of the shares but to an association with a company that would be beneficial to the business of the appellant. Mr. Wright's examination in chief on this point is instructive. Counsel referred him to the passage in the minutes concerning the due diligence that management was to perform and the following exchange ensued.
Q. Were you involved in that due diligence that is spoken of there?
A. Yes.
Q. And sir, would you describe to the Court what the nature of that due diligence of Cabre and Morgan was.
A. We conducted an operational, technical and financial review of both organizations, in isolation and in the context of combining them with Colin's assets, and tried to make an assessment of where the combined entity would sit in terms of the issues and problems that Colin itself was facing.
Q. Okay. So what kinds of things would you have looked at?
A. Well, from a financial side you're looking at the financial strength of the company, its reputation within the marketplace, the management itself. Operationally you're reviewing the properties, the nature of their operations, what they view as the reserve and production profile of these properties, their exploration opportunities and plans. You go through a full review of all aspects of the company.
Q. And the things that you were looking at, how were those things responsive to the problems of the company?
A. Colin had, you know, definite problem areas, and so we would look -- for instance, we had a rapid decline in the major oil field, and so we would look at the production profile of the two entities in question here, to see where their declining profile was and what their plans were. So you're always -- where their balance sheet was, in terms of debt to cash flow, how they fit in in terms of leverage ratios and so on as well.
...
Q. Now, Mr. Wright, earlier you testified that when you were doing the due diligence for Morgan and Cabre you spent time looking at their assets and all those other things, to see how responsive they were to the problems of the company. If the shares of International Colin were just going to be sold to either company, why worry about the particularities of those companies? Why not simply worry about who was giving us the most money? Why was it of concern to you?
A. Well, ultimately, I mean, the shareholders of Colin became shareholders of the new entity.
Q. Yes.
A. And so you come back, you come back to basic premise, exercise was to, you know, pick a course of action and a solution that was going to address the issues of the company, and that was our primary focus at the end of the day, to make sure that the entity known as Colin would be able to sort of survive and thrive in the new organization here. And so that -- you know, we're fulfilling our -- you know, the end of our process in that regard here, really.
[29] On April 25, 1996 ARC reported to the board and recommended that the Morgan proposal be accepted. Item 3 of the Minutes of that meeting read:
3. Internal Review
The Chairman asked management to report to the Board on their analysis of both companies. Mr. Mann discussed the technical review of Cabre's and Morgan's assets undertaken by the Corporation and advised that from a technical prospective it was management's opinion that Morgan's assets were more attractive than Cabre's. Mr. Wright discussed the respective financial and market positions of the two companies. It is his opinion that Cabre's financial position is stronger but there is more possibility for up-side in Morgan's shares.
[30] In the result the board approved the proposal of Morgan Hydrocarbons Inc. to acquire all of the issued and outstanding shares of the appellant for minimum consideration of common shares of Morgan on the basis of 1.975 shares of Morgan for each one share of the appellant. The press release announcing the transaction described it as a "business combination" between the appellant and Morgan. It contained the following statement:
P. David Williams, International Colin's Chairman & C.E.O. stated that "International Colin's shareholders have the opportunity to participate in a larger and financially stronger company, producing approximately 23,000 barrels of oil per day split evenly between light oil, heavy oil and natural gas". International Colin's shareholders will own approximately 32% of the combined entity.
[31] The Plan of Arrangement under the Alberta Business Corporations Act was approved by the Alberta Court of Queen's Bench. On June 27, 1996 at a meeting of shareholders of the appellant it was approved by the shareholders (99.6% in favour).
[32] The transaction was completed on a share for share exchange, the shareholders of the appellant became shareholders of Morgan, and the appellant continues to exist.
[33] A success fee of $1,057,694 was paid to ARC by the appellant. It was calculated as 0.7% of Total Value as defined in the engagement letter. The calculation was as follows.
Total Value equal to price of equity of the appellant plus long-term debt less working capital.
The weighted average of the Morgan shares was $4.17 per share.
The equity component was
4.17 X 1.975 Morgan shares X 12,868,021 Colin shares = $105,977,804
Plus long-term debt $63,310,000
Less working capital $3,903,000
Total Value $165,384,804
X 0.7% = $1,157,694
Less rebate of Phase Two fees paid
in February, March and April $100,000
$1,057,694
[34] To this amount was added GST of $74,039 for a total of $1,131,733. In addition $60,000 was paid for the Phase One work and out of pocket expenses of $5,903. The total, including the Phase Two fees that were rebated was $1,223,598.
[35] The appellant claimed $1,223,598 (plus, I presume, the GST) in computing its income for 1996. Later it asked that the amount be treated as an eligible capital expenditure and subsequently it again requested that it be treated as a current expense. The Minister disallowed the claim on the basis that the amount was not laid out for the purpose of gaining or producing income from a business or property and the deduction is not permitted by reason of paragraph 18(1)(a) of the Income Tax Act. Paragraph 18(1)(b) was not relied upon on assessing or in confirming the assessment. The respondent conceded at trial that the $60,000 Phase I fee was deductible.
[36] It is rather difficult to know whether the reply to the notice of appeal clearly raises the issue of paragraph 18(1)(b). In the original reply to the notice of appeal the Crown's case was put solely on the basis of paragraph 18(1)(a).
[37] An amended reply was filed and although no additional facts were alleged to support the argument that the payment was on capital account an extensive revision to parts B, C and D was made as follows.
B. ISSUES TO BE DECIDED
9. The issues are whether the ARC Payments are:
a) capital expenditures or current expenditures;
b) if they are capital expenditures, are they:
i) "outlays ... on account of capital" of the business of International Colin; (18(1)(b) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), as amended (the "Act"));
ii) "outlays ... made or incurred by [International Colin] on account of capital for the purpose of gaining or producing income from the business" of International Colin; (14(5) of the Act - definition of "eligible capital expenditure"); or
iii) "expenses re financing" as described in paragraph 20(1)(e) of the Act.
c) if they are current expenditures, are they:
i) expenses to be deducted in determining "profit from [International Colin's] business ... for" 1996; (9(1) of the Act); and
ii) "outlays ... made or incurred by [International Colin] for the purpose of gaining or producing income from the business or property" of International Colin; (18(1)(a) of the Act).
C. STATUTORY PROVISIONS RELIED ON
10. The Deputy Attorney General of Canada relies on sections 2, 3, 4, 9,14, 18, 20 and 248 of the Act, and regulation 1210 of the Income Tax Regulations.
D. GROUNDS RELIED ON AND RELIEF SOUGHT
11. He submits that the ARC Payments, were capital expenditures made for the benefit of the Appellant's shareholders and were not made in order that the Appellant might earn income. Accordingly, the ARC Payments are not "outlays ... on account of capital" of the business of International Colin as contemplated by paragraph 18(1)(b) of the Act, and no deduction is permissible.
12 Furthermore even if the ARC Payments were made on account of the business of International Colin, which is not admitted but denied, they are not "outlays ... made or incurred by [International Colin] for the purpose of gaining or producing income from the business or property" of International Colin and accordingly, are not an "eligible capital expenditure" pursuant to subsection 14(5) fo the Act and no deduction is permissible.
13. It is further submitted that based on the nature of the ARC Payments, they are not "expenses re financing" as described in paragraph 20(1)(e) of the Act.
14. In the alternative, if the ARC Payments are found to be current expenditures, then it is submitted that they are not expenses to be deducted in determining "profit from [International Colin's] business ... for" 1996 in accordance with subsection 9(1) of the Act.
15. Furthermore, even if it could be said that the ARC Payments were to be taken into account in determining the Appellant's business income, those expenditures are not "outlays ... made or incurred by [International Colin] for the purpose of gaining or producing income from the business or property" of International Colin and "no deduction shall be made in respect of" the ARC Payments pursuant to paragraph 18(1)(a) of the Act.
16. He also submits that any amounts that are allowed as a deduction to the Appellant require a corresponding adjustment to the Appellant's resource allowance pursuant to paragraph 20(1)(v.1) of the Act and regulation 1210 of the Income Tax Regulations.
17. He requests that the appeal be dismissed with costs.
[38] At trial it was still unclear whether the respondent was alleging in the alternative that the payment was on account of capital. I invited counsel for the respondent to amend the reply again to make it clear what the respondent was going to argue. He amended paragraph 11 to strike out "capital" in the first line. Paragraph 11 in the amended amended reply now reads
11.
He submits that the ARC Payments, were capital
expenditures made for the benefit of the Appellant's
shareholders and were not made in order that the Appellant might
earn income. Accordingly, the ARC Payments are not
"outlays ... made or incurred by [International
Colin] for the purpose of gaining or producing income from the
business or property" of International Colin: (18(1)(a) of
the Act) and not "outlays ... on account
of capital" of the business of International Colin as
contemplated by paragraph 18(1)(b) of the Act, and no
deduction is permissible.
[39] Paragraph 12 was also amended to read:
12. If the ARC payments are found to be on account of capital of the business of International Colin in accordance with paragraph 18(1)(b) of the Act, they are not "outlays ... made or incurred by [International Colin] for the purpose of gaining or producing income from the business or property" of International Colin and accordingly, are not an "eligible capital expenditure" pursuant to subsection 14(5) of the Act and no deduction is permissible.
[40] On the basis of the amended amended reply I do not think it is open to the respondent to argue that the payment is on capital account although that is what counsel sought to do in his written argument. He says in paragraph 33 of his written argument:
The question essentially becomes, what was the payment calculated to effect from a practical and business point of view? From this perspective, the Success Fee was calculated to maximize shareholder value by obtaining the highest price possible on the disposition of the shares of ICEC. It is on capital account and a deduction is proscribed by paragraph 18(1)(b).
[41] Even if it were open to the respondent to argue that the payment was on capital account, contrary to the statement in paragraph 11 of the amended amended reply that the payments were "'not outlays on account of capital' of the business of International Colin", I do not think the conclusion stated in the final sentence of this paragraph follows from the premise stated in the penultimate sentence. That statement, even if it were true, does not support the proposition that the payments were on capital account. Rather, it seems to be advanced in support of the view that they were not laid out to earn income from the appellant's business.
[42] The approach which I have always found useful in cases of this type is found in the statement of Justice Abbott in British Columbia Electric Railway Company Limited v. M.N.R., 58 DTC 1022 (S.C.C.) at pp. 1027-8:
Two questions arise on this appeal: (1) was the expenditure of $220,000 by appellant made for the purpose of gaining or producing income? and (2) if it was so made, was such payment an allowable income expense or was it a capital outlay?
The answer to both questions turns upon the effect to be given to s. 12(1)(a) and (b) of The Income Tax Act 1948, c. 52, as amended, which reads as follows:
12.(1) In computing income, no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,
(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part.
Section 12(1)(a) and (b) was first enacted in 1948 and it replaced s. 6(a) and (b) of the Income War Tax Act, which read as follows:
Sec. 6. Deductions not allowed. - 1. In computing the amount of the profits or gains to be assessed, a deduction shall not be allowed in respect of
(a) Expenses not laid out to earn income, - disbursements or expenses not wholly exclusively and necessarily laid out or expended for the purpose of earning the income;
(b) Capital outlays or losses, etc. - any outlay, loss or replacement of capital or any payment on account of capital or any depreciation, depletion or obsolescence, except as otherwise provided in this Act.
(The italics are mine.)
The less stringent provisions of the new section should, I think, be borne in mind in considering judicial opinions based upon the former sections.
Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made "for the purpose of gaining or producing income" comes within the terms of s. 12(1)(a) whether it be classified as an income expense or as a capital outlay.
Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or a capital outlay. The principle underlying such a distinction is, of course, that since for tax purposes income is determined on an annual basis, an income expense is one incurred to earn the income of the particular year in which it is made and should be allowed as a deduction from gross income in that year. Most capital outlays on the other hand may be amortized or written off over a period of years depending upon whether or not the asset in respect of which the outlay is made is one coming within the capital cost allowance regulations made under s. 11(1)(a) of the Income Tax Act.
[43] The approach outlined by Abbott J. is one that has traditionally been followed. One first asks the question "Was the payment made for the purpose of gaining or producing income from a business or property?" If the answer is no the question whether it is on capital account is irrelevant. If the answer is yes the application of paragraph 18(1)(b) must be considered. If the deduction of the payment is not prohibited under paragraph 18(1)(a), but is nonetheless caught by paragraph 18(1)(b), it must then be determined whether any of the specific provisions of the Income Tax Act that permit capital expenditures in a business context (such as the paragraphs in subsection 20(1)) apply. Indeed subsection 20(1) operates even if the payment is caught by both paragraphs 18(1)(a) and (b).
[44] The basic premise of the respondent's case is not that the payments were on capital account but rather that they were aimed at enhancing the value of the shares of ICEC and therefore had nothing to do with ICEC's income earning activities. In other words, the activities of ARC for which payments was made were analogous to a dividend or a shareholder benefit.
[45] Taking steps to improve the price of shares of a public company is a major preoccupation of boards of directors and senior officers. Yet it has never been suggested to my knowledge that the salary of the Chief Executive Officer was a non-deductible shareholder benefit just because he or she spends most of the working hours trying to find ways to improve the share price.
[46] Let us consider realistically what was happening here. ICEC was going through a difficult time. Reserves were declining. Income and cash flow were falling and this had an adverse effect on its ability to do exploration which might have increased its reserves. The line of credit was being reduced by the bank. Assets had to be sold to pay down the loan and this in turn reduced the company's income producing capacity. The company was in danger of being in breach of some of its covenants to the long-term creditors. Shareholders were openly unhappy at the company's performance. The board therefore had to do something. It considered alternatives and finally turned to ARC and gave it a broad mandate to consider all possible solutions. This is just what it did and the most attractive solution was to merge with Morgan. The Crown saw the fees to ARC as some type of selling commission that benefited only the shareholders - a fee for improving the share price. This was clearly neither the purpose nor the effect. There is no evidence that the price the shareholders received from Morgan on the share for share exchange (1.975 shares of Morgan for each Colin share) was enhanced by anything ARC did or that ARC even tried to get a better ratio. The shareholders got what they got. ARC's function was to find a suitable candidate for the merger. The question was posed by counsel for the respondent in his written argument "What was the payment calculated effect from a practical and business point of view?" (Dixon J. in Hallstroms Pty Ltd v. Federal Commissioner of Taxation, [1946] 72 CLR 634 at 648). It was intended to improve the ability of the appellant to earn income by combining its resources with that of another entity. If the shareholders' investment was improved by holding shares in a larger and commercially stronger entity, this was the result of an improvement in the income earning ability of the appellant within the larger combined entity. Obviously improved earnings enhance share prices and the value of the shareholders' investment. To say however that an expense that is calculated to improve a company's ability to earn income constitutes a form of disguised dividend or shareholder benefit because it may improve the value of the shares and is therefore non-deductible under paragraph 18(1)(a) strikes me as getting the cart before the horse.
[47] Patently here the services performed by ARC were intended to improve the appellant's income and the fees paid were laid out to earn income from the appellant's business. Accordingly the basic factual and legal assumption on which the Crown's case rests has been demolished.
[48] I shall mention briefly the argument that the payment is on capital account even though I do not think it is properly before the court. It is not necessary to discuss the myriad of authorities. They are well known and have been fully reviewed in Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46. Here no capital asset was acquired, nothing of an enduring benefit came into existence nor was any capital asset preserved.
[49] No doubt if I were intent on finding an excuse to dismiss the appeal I could endeavour to fit the case into some of the felicitous phrases chosen from the multitude that have been developed to describe capital expenditures. Estey J. in Johns-Manville (supra at p. 59) and Viscount Radcliffe in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd., [1964] A.C. 948 at p. 959 (quoted by Estey J.) warned against treating such phrases as definitive rather than descriptive. The court's function is to decide the case on the basis of the facts as disclosed in the evidence bearing in mind the business exigencies that necessitated the payment and the commercial objectives that it was designed to achieve.
[50] As Fauteux J. said in M.N.R. v. Algoma Central Railway, 68 DTC 5096 at p. 5097:
Parliament did not define the expressions "outlay ... of capital" or "payment on account of capital". There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, (1966) A.C. 224, by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said, at p. 264:
The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.
[51] Counsel for the respondent called as an expert witness, Kay Holgate, a chartered accountant and a specialist in Investigative and Forensic Accounting. Her conclusion was as follows.
2.1 Phase I Fee In our opinion, the proper treatment under GAAP for the Phase I fee dependent on the particular facts and circumstances is as follows:
1. If the "going concern" assumption is applied to ICEC, the Phase I service, which constituted a review of value and strategic alternatives, would be consistent with periodic long term planning and consequently the Phase I fee would be viewed as an expense of ICEC; or
2. If the "going concern" assumption did not apply to ICEC and the services provided fell within the responsibilities of ICEC's directors and officers, the Phase I fee would be considered an expense of ICEC; or
3. If the going concern assumption did not apply to ICEC and the services provided did not fall within the responsibilities of the directors and officers, the Phase I fee would not be a transaction related to the accounting entity of ICEC. In these circumstances, ICEC would be acting in an agency relationship on behalf of the shareholders and the Phase I costs would be considered a distribution of equity by ICEC.
Based on our analysis and understanding of the facts and circumstances of this matter, in our opinion, the Phase I fee should be considered an expense of ICEC.
2.2 Phase II Fee In our opinion, the transaction that gave rise to the Phase II fee was not associated with the normal business activity of the accounting entity, ICEC. Further, as ICEC was not directly a party to the underlying share exchange transaction, the related fees were not associated with the capital or financial structure of ICEC. Consequently, ICEC was apparently acting in an agency role in its agreement with ARC and the proper accounting treatment of the Phase II fee in accordance with GAAP is dependent of the particular facts and circumstances as follows:
1. If ICEC was acting on behalf of the shareholders of ICEC, the Phase II fee would be treated as a distribution of equity on behalf of the shareholders; or
2. If ICEC was acting on behalf of Morgan Hycrocarbon Inc. ("MHI"), the Phase II fee would be treated as deferred costs by ICEC. When the acquisition was completed the deferred costs would become part of the cost of the purchase of ICEC in the accounting records of MHI.
Regardless, in our opinion, the Phase II fee relates to the exchange of shares between MHI and the shareholders of ICEC, is not a cost related to ICEC's ordinary revenue generating activities and is therefore not an expense of ICEC.
[52] I do not of course question Ms. Holgate's expertise as a chartered accountant. She was an articulate and well qualified witness. However, with respect, I do not think that generally accepted accounting principles have anything to do with what has to be decided here. For one thing neither the factual premise that ICEC was acting of behalf of its shareholders, nor the alternative premise that it was acting on behalf of Morgan, has any foundation in the evidence. The board of directors was acting in the interests of the appellant. If this happened to be of some benefit to the shareholders or to Morgan it does not make the appellant their agent. Ms. Holgate was unable to point to any instance in which the accounting treatment which she advocated based upon the hypothetical agency relationship between a corporation and its shareholders or a potential acquiror had even been used. For what it is worth, there is a difference between practices that are generally accepted by accountants and what might be theoretically preferable.
[53] As was observed in Ikea Limited v. The Queen, 94 DTC 1112 (T.C.C.) aff'd 96 DTC 6526 (F.C.A.) aff'd 98 DTC 6092 (S.C.C.) generally accepted accounting principles are of limited assistance in determining what is income for the purposes of the Income Tax Act. Whether an expenditure is or is not an expense of a particular taxpayer is a determination that the court must make if it is relevant, but its deductibility is a matter of law.
[54] In Associated Investors of Canada Ltd. v. M.N.R., 67 DTC 5096, Jackett P. (as he then was) said at p. 5099:
Profit from a business, subject to any special directions in the statute, must be determined in accordance with ordinary commercial principles. (Canadian General Electric Co. Ltd. v. Minister of National Revenue, (1962) S.C.R. 3 [61 DTC 1300], per Martland J. at page 12.) The question is ultimately "one of law for the court". It must be answered having regard to the facts of the particular case and the weight which must be given to a particular circumstance must depend upon practical considerations. As it is a question of law, the evidence of experts is not conclusive. (See Oxford Motors Ltd. v. Minister of National Revenue, (1959) S.C.R. 548 [59 DTC 1119], per Abbott J. at page 553, and Strick v. Regent Oil Co. Ltd., (1965) 3 W.L.R. 636 per Reid J., at pages 645-6. See also Minister of National Revenue v. Anaconda Amercian Brass Ltd., (1956) A.C. 85 at page 102 [55 DTC 1220].)
[55] I have concluded therefore that the fees paid to ARC were laid out for the purpose of gaining or producing income from the appellant's business and if the question of capital were properly before the court that they are not outlays on account of capital.
[56] I should mention briefly an alternative argument advanced by the appellant that in any event even if the payment falls within paragraphs 18(1)(a) and 18(1)(b) it is still deductible under paragraph 20(1)(e) of the Income Tax Act which provides that notwithstanding paragraphs 18(1)(a), (b) and (h) there may be deducted in computing a taxpayer's income for a taxation year from a business or property ...
(e) such part of an amount that is not otherwise deductible in computing the income of the taxpayer and that is an expense incurred in the year or a preceding taxation year
(i) in the course of an issuance or sale of units of the taxpayer where the taxpayer is a unit trust, of interests in a partnership or syndicate by the partnership or syndicate, as the case may be, or of shares of the capital stock of the taxpayer.
[57] Was the expense "in the course of an issuance or sale ... of shares of the capital stock of the taxpayer?"
[58] The word "issuance" implies an issuance by the corporation of its own treasury stock. That is not of course what happened here. Here the sale was not by the corporation but by its shareholders. It may well be that even if the payment here is caught by paragraphs 18(1)(a) and (b) it falls broadly within the purpose of paragraph 20(1)(e). The question is however whether "in the course of the sale ... of the shares of the capital stock of the taxpayer ..." is to be restricted to a sale by the corporation of its own shares.
[59] There are respectable arguments on either side. It is arguable that "sale" by its juxtaposition with "issuance" means a sale by the company of its own shares and not a sale by shareholders of their shares. It is equally arguable that "issuance" by itself is quite broad enough to cover a sale by a company of its own shares and that there was no need to add the word sale if all that was meant was a sale by the company. Therefore "sale" must imply something else and the only thing it can refer to is a sale by the shareholders in the course of a corporate transaction of the type involved here where the interests of the corporation are affected. I find the argument attractive not only because it makes sense commercially but because the more restrictive interpretation requires reading into the statute words that are not there. In light, however, of my conclusion on the principal argument advanced in the case I express no concluded view on the point.
[60] The appeal is therefore allowed with costs and the assessment for 1996 is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the fees of $1,223,598 (together with associated Goods and Services Tax) to ARC Financial Corporation are deductible in computing the appellant's income.
Signed at Ottawa, Canada, this 4th day of November 2002.
|
"D.G.H. Bowman" |
A.C.J.COURT FILE NO.: 2001-4244(IT)G
STYLE OF CAUSE: Between International Colin Energy
Corporation and Her Majesty The Queen
PLACES AND DATES OF HEARING:
Edmonton, Alberta: July 31, August 1, 2002
Toronto, Ontario: September 6, 2002
REASONS FOR JUDGMENT BY: The Honourable D.G.H. Bowman
Associate Chief Judge
DATE OF JUDGMENT: November 4, 2002
APPEARANCES:
Counsel for the Appellant: Al Meghji, Esq.
Edward C. Rowe, Esq.
Counsel for the Respondent: J.E. (Ted) Fulcher, Esq.
David I. Bessler, Esq.
Mark Hesseltine, Esq.
COUNSEL OF RECORD:
For the Appellant:
Name: Al Meghji, Esq.
Firm: Donahue LLP
Calgary, Alberta
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
2001-4244(IT)G
BETWEEN:
INTERNATIONAL COLIN ENERGY CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on July 31 and August 1, 2002 at Edmonton, Alberta and
on September 6, 2002 at Toronto, Ontario, by
The Honourable D.G.H. Bowman
Associate Chief Judge
Appearances
Counsel for the Appellant: Al Meghji, Esq.
Edward C. Rowe, Esq.
Counsel for the Respondent: J.E. (Ted) Fulcher, Esq.
David I. Bessler, Esq.
Mark Hesseltine, Esq.
JUDGMENT
It is ordered that the appeal from the assessment made under the Income Tax Act for the 1996 taxation year be allowed with costs and the assessment be referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the fees of $1,223,598 (together with associated Goods and Services Tax) to ARC Financial Corporation are deductible in computing the appellant's income.
Signed at Ottawa, Canada, this 4th day of November 2002.
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"D.G.H. Bowman" |
A.C.J.