Farmers Mutual Petroleums Limited v. Minister of National Revenue

Judgment of the Court

J.:-These are appeals from judgments of the Exchequer Court' which refused to permit the appellant, in computing its income, in the years 1959 and 1960, t to deduct, in respect of legal expenses, the respective amounts of $80.10 and $10,623.43, and in respect of expenses claimed by the appellant as exploration and drilling expenses, the respective amounts of $53,273.38 and $143,- 581.10.

The facts involved in respect of these two matters are distinct from each other, so I will deal with each of the items separately.

Legal Expenses:

The appellant was incorporated under the laws of the Province of Saskatchewan on December 1, 1949, for the object, inter alia, of acquiring mineral rights and exploring for petroleum and natural gas.

Following its incorporation the appellant began a vigorous and successful campaign to acquire mineral rights from land owners. The system followed by the appellant was to acquire the fee simple title to minerals from land owners who had previously granted leases of their petroleum and natural gas rights to major oil producing companies. Those leases were uniform and standard. They were for a period of ten years providing to the land owner an annual rent of ten cents per acre and reserving a royalty of 121 percent to the land owner in the event of a producing well or wells being brought into existence.

The land owner transferred to the appellant his entire estate and interest in the mineral rights, including all benefits from the existing lease. In return, he received one share of the capital stock of the appellant for each acre transferred and a trust certificate as evidence that the appellant thereafter held in trust for him one-fifth of the mines and minerals and the benefits therefrom.

In this manner the appellant acquired the mineral rights in approximately 750,000 acres in Saskatchewan and issued approximately 2,500 trust certificates. The appellant received as income four-fifths of the rentals payable thereon and four-fifths of any royalties from producing lands.

In 1955 when oil was discovered in south eastern Sas- , katchewan many of the land owners instituted actions in the Court of Queen's Bench of Saskatchewan for declarations that the agreements between them and the appellant M were induced by fraudulent misrepresentation and were accordingly void, and for orders revesting in the land owners the mineral rights and the interest in the leases which had been transferred and assigned to the appellant. In all about 250 such actions were begun, the pleadings being virtually identical in all cases.

The appellant successfully defended such of those actions as came to trial so that it remained possessed of the mineral rights and benefits under the contracts above described. None of the lands involved nor any of the actions commenced were lost by the appellant nor did the appellant lose any of the income which it was receiving from the lands. The legal expenses so incurred by the appellant coistitute part of the amounts that were claimed by it as a deduction from income and that were disallowed by the Minister.

After the appellant had succeeded in some cases in the courts, many of the land owners formed a mineral owners' protective association to advocate and obtain legislative relief. A "Royal Commission on Certain Mineral Transactions" was appointed by the Saskatchewan Government to inquire into allegations that many owners of freehold mineral rights in Saskatchewan had been deprived of such rights by means of fraud or misrepresentation. This Commission recommended that a Board be constituted for the purpose of achieving, if possible, the voluntary re-negotiation of contracts whereby the owners were deprived of their freehold mineral rights through misrepresentation, whether innocent or fraudulent.

The Mineral Contracts Re-negotiation Act, was enacted to implement the recommendations of the Commission. Further legislation, of a similar tenor was proposed in 1960.

The appellant employed counsel to make representations on its behalf opposing the proposed legislation, suggesting 6a variations in the terms thereof and making representations to the Board later established pursuant to legislation enacted with respect to contracts entered into by it which LIMD. were sought to be re-negotiated.

The learned trial judge confirmed the Minister's position and held that the legal expenses incurred were a "payment J. on account of capital" made "with a view of preserving an asset or advantage for the enduring benefit of a trade". The decision of the learned trial judge was based upon the judgment of this Court in Minister of National Revevenue v. Dominion Natural Gas Company Limited . Counsel for the appellant sought to distinguish the Dominion case and also contended, in the alternative, that that case would have been decided differently today on the same facts in view of changes which have since occurred in the relevant provisions of the Income Tax Act.

The relevant provisions of the Income Tax Act, R.S.C. 1952, c. 148, are as follows:

Section 12(1)(a) and (b) were derived from s. 6(1) (a) and (b) of the Income War Tax Act, R.S.C. 1927, c. 97, which provided as follows:

Counsel for the appellant advanced the proposition that legal expenses incurred to protect a right to income 'are deductible regardless of whether the protection of that right also involves preserving a capital asset. The appellant, he said, immediately upon its acquisition of title to the mineral rights from a land owner had the right to receive and retain as its income four-fifths of the acreage rental payable by the lessee of the mineral rights. The legal expenses incurred were to protect that income. In the

Dominion case, that which was protected was a franchise which, in itself, did not produce income.

In my opinion, this proposition is not valid, because is directly contrary to the intent of paras. (a) and (b) of s. 12 when read together. To be deductible for tax purposes an outlay must satisfy at least two basic tests:

(1) It must be made for the purpose of gaining or producing income (s. 12(1) (a)).

(2) It must not be a payment on account of capital

(s. 12(1) (b)).

Both of these tests must be satisfied concurrently to justify deductibility. In British Columbia Electric Railway

Company v. Minister of National Revenue', Abbott J. said at p. 137:

It can certainly be said that the appellant, in resisting the lawsuits launched against it, was seeking to protect its income, because it was seeking to protect the assets from which its income was derived. It can, therefore, be argued that the expenses were properly deductible under s. 12(1) (a). This is not contested by the respondent. The object and purpose of the lawsuits, however, was to compel the restoration to the land owners of the mineral rights which the appellant had purchased. The learned trial judge has found, and the evidence establishes, that those rights were items of fixed capital, and were so regarded by the appellant. At the time the litigation occurred, the sum total of the mineral rights acquired by the appellant, all of which were of the kind involved in the litigation, represented all of the appellant's capital assets. The appellant did not trade in them, but intended to retain them perpetually.

It was to protect those capital assets from attack that the legal costs of the litigation were incurred, and, to quote the words of Dixon J. (later Chief Justice) in Halistroms Pty. Ltd. v. Federal Commissioner of Taxation', referring to the costs of defending title to land:

The fact that the leases acquired by the appellant, along with the mineral rights, were more immediately connected with the production of income than was the franchise involved in the Dominion case does not affect the matter in principle. It is relevant in relation to the application of s. 12(l) (a), but in relation to s. 12(1) (b) we must ask the question, was this outlay for the purpose of preserving a capital asset? In my opinion it clearly was and, if that is so, s. 12(1) (b) prevents its deduction.

With respect to the second submission respecting the Dominion case, while s. 12(1) (a) of the present Act is less restrictive than was s. 6(1) (a) of the Income War Tax Act, s. 12(1)(b) of the Income Tax Act is essentially the same as was s. 6(1) (b) of the Income War Tax Act. In my opinion, for the reasons which I gave in the recent case of British Columbia Power Corporation Limited v. Minister of National Revenue , the Dominion case has established the proposition that legal expense incurred with a view of preserving an asset of advantage for the enduring benefit of the trade is a capital expenditure and is not deductible.

I agree with the learned trial judge that the legal expenses involved in opposing the proposed legislation and in appearing before the Board created by such legislation are subject to the same considerations. They are not different in kind from the costs of the litigation in the courts. Exploration and Drilling Expense

Scurry-Rainbow Oil Limited, hereinafter referred to as

"Scurry", became a major shareholder in the appellant. Scurry was the successor in title to Canadian Pipe Line

Producers Ltd. in respect of an agreement, dated May 19, aNISTE 1954, to which the latter company was a party along with

Canada Southern Petroleum Ltd., West Canadian Petroleum Ltd., Trans Empire Oils Ltd. and British Empire Oil

Co. Ltd. Under the terms of that agreement the entire legal and beneficial interest in certain Crown petroleum and natural gas permits covering approximately 1,500,000 acres in British Columbia would be held jointly by the parties.

The beneficial interest acquired by Scurry was 22 percent of the reservations covered by the agreement.

Canada Southern Petroleum Ltd. had been named as manager-operator under the terms of the agreement, but it was succeeded by Phillips Petroleum Corporation, hereinafter referred to as "Phillips". Under the agreement the parties agreed to conduct a seismic program, and, contingent upon its results, to drill a well for the joint account and at the joint expense of the parties in proportion to their interests. The manager-operator was given sole and exclusive management and control of the exploration, drilling and production operations on the land.

The parties had the right to receive progress information and to inspect and examine the books and records of the manager-operator. There was also provision for meetings and consultation and for surrender, sale or assignment of all or part of a party's interest in the lands.

Paragraph 11 of the agreement governed the matter of costs and expenses:

COUR SUPRtME DU CANADA the attached Accounting Procedure. Joint-Operators agree that they will promptly reimburse the Manager-Operator for Joint-Operators' proportionate share of all such costs and expenses within the time limited by the said Accounting Procedure.

On January 2, 1959, Scurry and the appellant entered INERF into an agreement, which, after certain preliminary recitals REVENUE referring to the agreement of May 19, 1954, read as fol- Martland J. lows:

AND WHEREAS the parties hereto desire to enter into this Agreement whereby Farmers Mutual shall have the right to acquire certain interests in the said lands subject to the terms and conditions as hereinafter provided.

NOW THEREFORE THIS AGREEMENT WITNESSETH that Farmers Mutual hereby agreed to pay all costs which may be incurred by Scurry-Rainbow in the performance of its obligations with respect to the seismic program referred to herein. Scurry-Rainbow agrees that upon the completion of the said seismic program on the said lands and the payment by Farmers Mutual of all costs which would have been incurred by Scurry-Rainbow on this seismic program, Farmers Mutual shall have earned an undivided Three (3%) Percent interest in the said lands and the interests owned by Scurry-Rainbow and Farmers Mutual shall thereafter be:

SCURRY-RAINBOW OIL LIMITED ..........

interest FARMERS MUTUAL PETROLEUMS LTD. .....

3% interest Scurry-Rainbow agrees to execute any and all further documents required in order to vest the interest aforesaid in Farmers Mutual in the event that the seismic program herein is completed. After Farmers Mutual shall have earned the Three (3%) Percent interest referred to herein, Scurry-Rainbow agrees to grant and hereby grants to Farmers Mutual the option to earn an additional Eight (8%) Percent interest in the said lands on the condition that Farmers Mutual agrees to pay and pays Scurry-Rainbow's entire cost of drilling the well referred to herein. After the said well shall have been drilled and Scurry-Rainbow's share of the costs paid by Farmers Mutual, Scurry-Rainbow agrees to execute any and all further documents required in order to vest the Eight (8%) Percent interest in Farmers Mutual.

Under the terms of the 1954 agreement, Phillips, as manager-operator, conducted a seismic program and carried on a -drilling program. Phillips invoiced Scurry for its proportionate share of these expenses. On receipt of an invoice, Scurry would usually send an invoice to the appellant for the amount Scurry was required to pay to Phillips, and Scurry would pay Phillips. On two occasions Scurry sent the Phillips' invoice to the appellant, which paid Phillips directly.

- On October 5, 1959, the appellant elected to exercise its option, under its agreement with Scurry, to earn the additional 8 per cent interest in the lands by paying Scurry's entire cost of drilling the well.

R.C.S.

Section 83A(3) of the Income Tax Act, at the relevant times, provided as follows:

(3) A corporation whose principal business is

(a) production, refining or marketing of petroleum, petroleum products or natural gas, or exploring or drilling for petroleum or natural gas, or mining or exploring for minerals, may deduct, in computing its income under this Part for a taxation year, Martland J. the lesser of

(i) the drilling and exploration expenses, including all general geological and geophysical expenses, incurred by it on or in respect of exploring or drilling for petroleum or natural gas in Canada, and

(ii) the prospecting, exploration and development expenses incurred by it in searching for minerals in Canada, as were incurred after the calendar year 1952 and before the end of the taxation year, to the extent that they were not deductible in computing income for a previous taxation year, or

(d) of that aggregate, an amount equal to its income for the taxation year

(i) if no deduction were allowed under paragraph (b) of subsection (1) of section and

(ii) if no deduction were allowed under this section, minus the deductions allowed for the year by subsections (1), (2) and (8a) of this section and by section 28.

The question in issue is as to whether the moneys paid by the appellant pursuant to its agreement with Scurry were deductible in computing the appellant's income tax, as being "drilling and exploration expenses ... incurred by it on or in respect of exploring or drilling for petroleum or natural gas in Canada". The learned trial judge held that they were not deductible by the appellant. His reasons for so holding are summaiized in his judgment as follows: The submission on behalf of the appellant, as I understand it, is that by the agreement between Scurry and the appellant dated January 2, 1959 the appellant reimbursed Scurry for its outlay for exploration and drilling expenses. Since an expense cannot be incurred by a party who is truly reimbursed, therefore it cannot be said that the expenses were incurred by Scurry but rather they must have been incurred by the appellant which was out of pocket in the precise amount of the expenses and that Scurry was merely the conduit between the appellant and the manager-operator.

In my opinion the agreement between Scurry and the appellant is not susceptible of such interpretation. The substance of that transaction, as I see it, was that the appellant purchased an interest in lands from Scurry and that the price to be paid therefor was determined and measured by the cost of the exploration and drilling expenses incurred by Scurry. It was a condition precedent to any payment to Scurry by the appellant that Scurry should have incurred exploration and drilling expenses and I can (6g I am in agreement with these conclusions. Exploration and drilling expenses were incurred in respect of the work carried on by Phillips as manager-operator under the 1954 agreement. This work was done by Phillips on behalf of all the parties to that agreement as well as on behalf of itself, and a portion of the expense was incurred by Phillips, as agent for Scurry.

The 1954 agreement contained provision for an assignment of interest by the parties to it, but there was no assignment of interest effected by Scurry in favour of the appellant. The appellant did not acquire any contractual rights under that agreement, and Phillips had no right to require the appellant to assume any obligation to pay any part of the exploration and drilling expenses which, as manager-operator, Phillips had incurred.

The 1959 agreement between Scurry and the appellant, after referring to the 1954 agreement, recites that the parties "desire to enter this agreement whereby Farmers Mutual shall have the right to acquire certain interests in the said lands". The obligation of the appellant was to pay "all costs which may be incurred by Scurry in the performance of its obligations with respect to the seismic program referred to herein". The appellant was thereby to acquire a 3 percent interest in the lands. It also obtained an option to earn an additional 8 percent interest by paying Scurry's entire cost of drilling the well.

The position is, therefore, that the appellant did not itself incur exploration or drilling costs in respect of land in which it had an interest. What it did do was to pay for a contractual right to acquire an interest in lands on which exploration and drilling had taken place by paying expenses already incurred by Scurry in connection therewith. The payments made by the appellant were not in respect of expenses which it had incurred in respect of exploration or drilling. They were payments of expenses which had been

Statutes and regulations cited

Income Tax Act
- Section 12(1)(a)
- (b)
- s. 6(1)
- s. 12
- s. 12(1)
- s. 12(l)
- s. 12(1)(b)
- section 28
Unresolved citations
- paras. (a)
- (b)
- paragraph (b)
- subsection (1)
- subsections (1)
- (2)