Her Majesty the Queen (Appellant) v. Allan McLarty (Respondent)
2006 DTC 6340
Federal Court of Appeal
April 27, 2006
Neutral Citation 2006 FCA 152
Court File No. A-85-05
Deductions — Cumulative Canadian exploration expense (“CCEE”) — Whether seismic data acquired by taxpayer and others was acquired in an arm's length transaction — Whether Minister's fair market valuation of seismic data was accurate — Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, ss.66(1), 66(12.1)(a), 66.1(6) "Canadian exploration expense", 67, 69(1), 251(1)(b).
In what was alleged to be an arm's length transaction (the “Acquisition Transaction”), the taxpayer and others acquired from Compton Resource Corporation (“CRC”) seismic data and other items (the “Data”) for $6,373,335. The Minister assessed the taxpayer for 1992 and 1994 on the assumption that the Data had a fair market value (“FMV”) of only $2,050,142 when it was acquired from CRC. The Minister therefore disallowed a $100,000 addition made by the taxpayer to his CCEE pool relating to his 1.57% interest in the Data. The amount of this addition had been calculated by the taxpayer on the assumption that the FMV of the Data, when acquired from CRC, was $6,373,335. The Tax Court of Canada allowed the taxpayer's appeal (2005 DTC 217), and the Crown appealed to the Federal Court of Appeal.
Held: The Crown's appeal was allowed. The Tax Court judge made no palpable or overriding error in concluding that (a)the taxpayer purchased the Data for exploration for petroleum or natural gas, as required by paragraph 66.1(1)(a) of the Act, and (b)the promissory note given as partial consideration by the taxpayer for his 1.57% interest in the Data was not a contingent liability, but was the equivalent of an incurred expense. However, the Tax Court judge erred in finding that the Acquisition Transaction was at arm's length. This transaction involved CRC, both as the vendor of the Data, and as the agent of the taxpayer and others involved as the purchasers of the Data. Also, the sole owner of CRC was the guiding mind behind both the vendor and the purchasers. Accordingly, the Tax Court judge did not reach any conclusions as to the FMV of the data at the time of the Acquisition Transaction, which he had found to be at arm's length, and, thus, not subject to the deeming provisions of subsection 69(1) of the Act. The matter was, therefore, referred back to a different Tax Court judge to determine whether the taxpayer could prove that the seismic material had an FMV in excess of the $2,050,142 figure used by the Minister in the assessments under appeal.
SEXTON, J.A. (EVANS and MALONE, JJ.A. concurring):
I. Introduction
[1] This is an appeal from McLarty v. Canada , [2005 DTC 217] 2005 TCC 55 [“McLarty” ], a decision of the Tax Court of Canada (the “TCC”). The respondent, Allan McLarty, invested $100,000 in proprietary seismic data as part of a joint venture. The purchase price comprised $15,000 in cash and a limited recourse promissory note in the amount of $85,000. Pursuant to this transaction, the respondent added $100,000 to his Cumulative Canadian Exploration Expenses (“CCEE”) pool. Subsequently, he claimed Canadian Exploration Expense (“CEE”) of $81,655 for taxation year 1992 and $14,854 for taxation year 1994. The Minister of National Revenue (the “Minister”) reassessed the respondent and found that the purchase price of the seismic data was in excess of fair market value (“FMV”). Consequently, the Minister disallowed additions to the respondent's CCEE account. The TCC allowed the respondent's appeals from the Minister's reassessments, permitting the respondent to claim the entire $100,000 as CCEE.
[2] The appellant, Her Majesty the Queen, challenges the decision below on three main grounds. First, she claims that, contrary to the findings of the TCC, the seismic data was not “for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas (other than a mineral resource) in Canada,” as required by the statutory definition of a CEE. Second, she alleges that the TCC erred in concluding that the respondent's promissory note was not an incurred expense, but a contingent liability. Third, she argues that the seismic data purchase was not an arm's length transaction. Because of this, the TCC should have determined that the respondent had failed to discharge his burden to establish that the FMV of the seismic data was in excess of the amount assumed by the Minister.
II. Factual Background
[3] The respondent's investment in the data in issue (the “Data”) can be traced to Ernie Sapieha (“Sapieha”), the sole owner, officer and director of Compton Resource Corporation (“CRC”). Sapieha had hoped to build an oil and gas exploration and development corporation and envisioned that an interest in a proprietary seismic database would be its cornerstone. Accordingly, he attempted to gather investors to join CRC in the purchase of such a database.
[4] Sapieha approached the respondent and others about participating in this joint venture (the “Joint Venture”). The respondent was presented with an offering memorandum (the “Memorandum”), which outlined the actions of the proposed Joint Venture. In part, the Memorandum stated:
(a)[t]he principle objectives of this offering are to provide subscribers with an opportunity to participate in the acquisition of, exploration for and development of Petroleum Rights while at the same time enabling investors to avail themselves of the income tax deductions and federal incentive programs which have been proposed to encourage petroleum and natural gas exploration developments; and
(b)[t]he primary purpose of the purchase of the Technical Data Base will be to analyze the data with a view to determining development and exploration prospects of the Joint Venture and to assist with the identification of producing PNG Properties for the Joint Venture to purchase. However, after a review and analysis of the Technical Data Base, some portion of the data may be licensed or sold to the industry in a manner and under circumstances consistent with industry practice.
[5] The Memorandum also explained that “The purchase price of the Technical Data Base [the Data] will not be higher than the lowest appraised value received from three experienced, independent valuators.” Indeed, before the Data was purchased, on behalf of the Joint Venture participants (the “Joint Venturers”), Sapieha obtained appraisals from Ray Jaskela in the amount of $39,787,800, Brian Curts in the amount of $41,930,760 and E.P. Webb in the amount of $34,405,000.
[6] The Data that they appraised was owned by CRC. It was a subset of a larger data library (the “Data Library”) that CRC had acquired from Seitel Inc. (“Seitel”) when it purchased its “seismic business” on December30, 1992. The total consideration paid by CRC for the “seismic business” was $21,000,000, $20,999,998 of which was allocated to the Data Library. This consideration was satisfied by $2,375,000 in cash and a debenture for $18,625,000. Seitel recorded the amount of the debenture as a contingent liability in its financial statements. The promissory note required that 60% of the revenues (net of commission) from the sale of licensed copies of the Data Library be applied towards it. Prior to this transaction, on June26, 1992, Seitel had obtained the Data Library from Canadian Hunter Exploration Ltd. (“Hunter”) for $2,388,000. That same day, Hunter had acquired the Data Library from Western Geophysical Ltd. (“Western”) for $2,750,000.
[7] Returning to the Joint Venture, Sapieha's control over the vendor of the Data, CRC, enabled him to dictate the price that the Joint Venturers were to pay for the Data. Sapieha set the purchase price of the Data by multiplying $21,000,000 by 30.35%, the total proportionate interest in the Data that the Joint Venturers were to acquire. The source of the figure of $21,000,000 is simply not clear. Obviously, $21,000,000 is not equal to any of the valuations that Sapieha obtained. Moreover, it has no logical connection to any of the prior sales of the Data. After all, CRC paid approximately $21,000,000 to Seitel for the entire Data Library, not just for the Data. Finally, there is no indication in the decision below that the respondent had any input into setting the price.
[8] After reviewing the Memorandum, the respondent entered into a subscription agreement on December31, 1992. As a result, the respondent acquired a 1.57% undivided interest in the Compton Resource Corporation1992/1993 Oil and Gas Investment Fund (the “Joint Venture”). That same day, the respondent and the other Joint Venturers entered into a joint venture agreement (the “Joint Venture Agreement”) with CRC. Under the Joint Venture Agreement, the Joint Venturers appointed CRC as their agent to, inter alia, purchase seismic data for the use of the Joint Venture. Pursuant to a Technical Data Base Purchase Agreement of December31, 1992, CRC — as agent, and on behalf of the Joint Venturers — acquired from itself a 30.35% undivided interest in the Data. The total consideration given by the Joint Venturers for the Data was $6,373,335, satisfied by $956,002 in cash and $5,417,333 by way of promissory notes in favour of CRC.
[9] The terms of the promissory notes were outlined in the admitted facts and included the following items:
(a)the Promissory Notes bear interest at a rate of 8% per annum on any unpaid portion of the principal sum;
(b)pursuant to the Joint Venture Agreement which is incorporated by reference into the terms of the Promissory Notes, the Individual Joint Venturers assigned to Compton sixty percent (60%) of the proceeds of the sales of licensed copies of the Venture Data and twenty percent (20%) of the cash flow from the drilling programs (the “Drilling Program”) carried on by the Joint Venture as repayment of the Promissory Notes, first to interest then to principal;
(c)the Promissory Notes are secured by sixty percent (60%) of the sale proceeds from the disposition of the proprietary interest in the Venture Data and an undivided twenty percent (20%) of the rights acquired by the Individual Joint Venturers pursuant to the Drilling Program (collectively, the “Security”), with no further recourse against other assets of the Individual Joint Venturers; and
(d)in the event that any portion of the Promissory Notes remain unpaid on the due date, Compton will appoint an independent trustee to sell the Individual Joint Venturers' interests in the Security, with such proceeds being applied to the unpaid portion of the Promissory Notes and any shortfall would be forgiven.
[10] These promissory notes included the respondent's note (the “Note”). It was in the amount of $85,000. The Note, along with $15,000 in cash, was the portion of the total consideration used to acquire the respondent's 1.57% undivided interest in the Data.
[11] In accordance with the Joint Venture Agreement, Sapieha began the process of setting up an oil and gas business. He established an office for CRC that included mapping services, a facility for the storing of well logs, geophysical software and other technical services. Subsequently, Sapieha began to put together an exploration team for CRC to analyze and review the Data for the Joint Venture.
[12] Carl Ringdahl (“Ringdahl”), an experienced geophysicist, was hired as part of the exploration team. According to Ringdahl, the team began reviewing the Data and “worked up the play” using all of the information available, including the existing wells. In the court below, Ringdahl also testified that he reviewed every seismic line systematically to ascertain whether there was an opportunity to develop a trend or play, and to decide whether to buy into a land sale.
[13] Meanwhile, the respondent filed his 1992 return of income claiming, inter alia, an addition of $100,000 to his CCEE pool in respect of his acquisition of an interest in the Data. In his 1992 and 1994 returns of income, the respondent claimed deductions of $81,655 and $14,854, respectively, as a result of drawing down his CCEE pool.
[14] By letter dated January6, 1997, the Minister proposed to reassess the respondent on the basis that the Data had a value of $2,050,142. Consequently, the Minister disallowed the respondent's additions to his CCEE account.
[15] The Appellant filed appeals to these Notices of Assessment. The court below allowed the appeals in their entirety. It is this decision that is on appeal to this court.
III. Statutory Regime
[16] Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the “Act”)
……
69(1) Except as expressly otherwise provided in this Act,
(a) where a taxpayer has acquired anything from a person with whom the taxpayer was not dealing at arm's length at an amount in excess of the fair market value thereof at the time the taxpayer so acquired it, the taxpayer shall be deemed to have acquired it at that fair market value;
……
251(1) For the purposes of this Act,
(a) related persons shall be deemed not to deal with each other at arm's length; and
(b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm's length.
...
IV. The Findings of the TCC
…
3) Arm's Length Transaction and FMV
[23] Paragraph69(1)(a) of the Act deems a taxpayer's acquisition to have been at FMV where, inter alia, the acquisition is from a vendor with whom the taxpayer was not dealing at arm's length. In considering the applicability of this provision to the case at bar, the TCC found that the appropriate relationship to assess was that between CRC and the respondent. Although Sapieha devised the plan and introduced the respondent to the Memorandum, the TCC determined that it was ultimately the respondent's decision to accept the terms of the Memorandum. The TCC did not see any evidence indicating that the respondent and CRC, through Sapieha, acted in concert without separate interests. Nor, in the mind of the TCC judge, was there any evidence that Sapieha unilaterally imposed the Data purchase on the respondent. The TCC also noted that there was no collusion to inflate the Data price because the respondent had accepted the terms of the Memorandum, including that limiting the purchase price to no higher than the lowest valuation. Therefore, in the opinion of the TCC, the purchase by the respondent of his interest in the Data was an arm's length transaction.
[24] In addressing whether the respondent's outlays for the Data were reasonable expenses within the meaning of section67 of the ITA, the TCC referred to Petro-Canada. In that case, this court confirmed the applicability of the test for reasonableness articulated in Gabco Limited v. M.N.R., 68 DTC 5210 (Exch. Ct.) at 5216:
It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable businessman would have contracted to pay such an amount having only the business consideration the appellant had in mind.
[25] In applying this test, the TCC highlighted the steps that Sapieha took prior to the Data purchase to determine an appropriate purchase price. Moreover, it found that Sapieha was unaware of previous sales of the Data and believed it was valued at $30,300,000. The TCC then outlined several reasons why this was not an appropriate case to question the participants' business judgment: the highly speculative nature of the oil and gas exploration industry, the fact that seismic data is very difficult to value and Sapieha's industry experience. Accordingly, the TCC found that this was not a situation where paying more than FMV would be unreasonable. The TCC concluded that a reasonable businessperson in the respondent's position would have paid at least $100,000 for his interest in the Data.
V. Issues
[26] There are three broad issues in this appeal:
…
- Was the respondent's purchase of an interest in the Data a non-arm's length transaction? If so, was the FMV of the Data in excess of the amount assumed by the Minister?
VI. Analysis
…
3) Arm's Length Transaction and FMV
a) Introduction
[41] Several issues arise with respect to the TCC's analysis of whether there was an arm's length transaction in this case, as well as its consideration of the reasonableness of the respondent's expenditures on the Data.
[42] It is helpful, in my view, to begin by reviewing the legal framework structuring the parties' arguments on this point. If there was an arm's length transaction, then the question becomes whether the respondent's expenditures on the Data were reasonable within the meaning of section67 of the Act. No issue of FMV arises if the respondent's expenses were reasonable. In the alternative, if there was a non-arm's length transaction in this case, then the deeming provision in paragraph69(1)(a) of the Act is triggered. That is, if the taxpayer acquired the asset for an amount in excess of the FMV, the taxpayer is deemed to have paid the FMV. In this scenario, the respondent bears the burden of establishing on a preponderance of the evidence that the FMV of his interest in the Data was higher than the FMV assumed by the Minister.
[43] Three issues arise with respect to the TCC's analysis of whether there was a non-arm's length transaction in this case. The first question is whether the court below selected the correct transaction to scrutinize in its paragraph69(1)(a) analysis. The second issue concerns the matter of which of the entities involved in that transaction needed to be at arm's length from each other to avoid the deeming provision in paragraph69(1)(a) of the Act. The third inquiry centres on whether the correct entities in the pertinent transaction were in fact at arm's length. If I conclude that they were not, then I must go on to consider the FMV of the respondent's interest in the Data.