T-647-74
Sigma Explorations Ltd. (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Collier J.—Calgary, January 20;
Ottawa, April 3, 1975.
Income Tax—Deductions—Plaintiff claiming outlays for
purchase of data—Whether sham—Whether capital outlay
not for purpose of gaining or producing income—Income Tax
Act, R.S.C. 1952, c. 148, s. 137(1).
Plaintiff, a subsidiary of G.T.S., an American corporation
which had developed a system of digitizing well log informa
tion, paid $60,000 for seismic data. Far less was realized from
the sale of this data than plaintiff had forecast, in fact, only
$33,565. The second outlay by plaintiff concerned well log
information developed by G.T.S. It was thought that plaintiff,
as a well-known Canadian firm, could maximize profits by
marketing this information as principal, rather than agent of
G.T.S. Plaintiff purchased 5,000 such logs by agreement with
its parent for $214,000. Which 5,000 logs plaintiff would select
would depend on demands of potential customers. Hopes of
profit were over-optimistic. Three years later, plaintiff can
celled the agreement, and wrote off the cost of the logs, which
had been treated as deferred cost in 1970 and 1971, as a
business loss. The Minister re-assessed plaintiff's 1969 income,
disallowing the deduction of $60,000 as a capital outlay exclud
ed under section 12(1)(b) of the Income Tax Act, but permit
ting capital cost allowance. He further disallowed the deduction
in respect of the logs, claiming it was (1) a sham, or, (2) not
deductible because it would unduly or artificially reduce
income (section 137(1)), or (3) a capital outlay, and not for the
purpose of gaining or producing income. Plaintiff appealed.
Held, allowing the appeal, both amounts are proper deduc
tions. (1) To constitute sham, parties must intend not to create
rights and obligations which they appear to be creating; here,
there was no dissembling, masquerading or lack of bona fide
intention. (2) Under section 137(1), the test is objective, while
the evidence is often subjective. While an expenditure may
reduce income, if reasonable, for legitimate business purposes
and not primarily intended to minimize tax, then no matter
how drastic the reduction of income, it cannot be said to be
unreal. The expenditure for the rights to the logs did not have
an undue or artificial effect on plaintiff's 1969 income. (3) The
practical and commercial aspects of the transaction must be
considered; simply because both outlays turned out to be
unremunerative does not prevent their deduction if they were
laid out to gain or produce income. The expenditures were not
made to create an advantage for plaintiff's enduring benefit,
but to bring into inventory information which plaintiff reason
ably expected to market quickly and profitably.
Snook v. London and West Riding Investments, Limited
[1967] 1 All E.R. 518, agreed with. M.N.R. v. Cameron
[1972] C.T.C. 380; Shulman v. M.N.R. [1961] Ex.C.R.
401; Algoma Railway v. M.N.R. [1968] S.C.R. 447; Brit-
ish Columbia Electric Railway Company Limited v.
M.N.R. [1958] S.C.R. 133 and The Queen v. Jones
Tobacco Sales Co. Ltd. [1973] F.C. 825, followed.
Algoma Railway v. M.N.R. [1967] Ex. C.R. 88 and
British Insulated Cables, Limited v. Atherton [1926] A.C.
205, applied.
INCOME tax appeal.
COUNSEL:
J. G. McDonald, Q.C., for plaintiff.
F. J. Dubrule, Q.C., and B. J. Wallace for
defendant.
SOLICITORS:
McDonald & Hayden, Toronto, for plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
COLLIER J.: The plaintiff ("Sigma") appeals a
re-assessment by the Minister of National Reve
nue of income tax for its 1969 taxation year. In its
return, the plaintiff sought to deduct, from taxable
income, two outlays. One was for an amount of
$60,000 paid on the purchase of certain seismic
data from a bankrupt company hereafter called
"Angus". The second was for an amount of $214,-
000 paid by the plaintiff to its parent company,
G.T.S. Corporation, pursuant to an agreement
concerning 5000 digitized Canadian well logs.
In respect of the outlay for the Angus data, the
Minister disallowed the claimed deduction on the
basis it was an outlay of capital and therefore
excluded by paragraph 12(1)(b) of the Income
Tax Act'. The Minister did, however, in his re
assessment, permit a capital cost allowance for this
purchase. In respect of the outlay made pursuant
to the agreement concerning digitized well logs,
the Minister disallowed the claimed deduction on
three grounds:
(a) The alleged outlay was a sham.
(b) If not a sham, it was not deductible because
it would unduly or artificially reduce the plain
tiff's income (subsection 137(1)).
(c) Alternatively, it was a capital outlay and
not one made for the purpose of gaining or
producing income.
The plaintiff was incorporated under Alberta
law on November 2, 1966. It is essentially a
geophysical corporation. The major portion of its
revenue (at the relevant times here) is generated
from seismic surveys carried out on its own
account in Alberta and other places in Canada. It
sells the information so obtained to other compa
nies. Additionally, the plaintiff carries out seismic
surveys for individual customers. As well, the com
pany obtains revenue as a broker by purchasing
seismic information and selling it to companies or
persons interested in that information.
The plaintiff itself has never owned gas or oil
leases or developed on its own account gas or oil
properties. The primary reason for not venturing
into those activities is because it is considered
unethical for a geophysicist, or in this case a
geophysical company, to launch into the actual oil
and gas business in competition with its customers.
The seismic or geophysical data acquired by the
plaintiff (other than on a custom basis for an
individual customer) is stockpiled by it for possible
sale to others.
The financial statements for the year ending
November 30, 1968 (Exhibit 5) and the thirteen-
month period ending December 31, 1969 (Exhibit
6) illustrate the operations of the plaintiff com
pany. In 1968 it recorded a net revenue of approxi
mately $46,000 from commissions on the sale of
R.S.C. 1952 c. 148 and amendments.
seismic data. The revenue from data sales derived
from seismic surveys carried out by the plaintiff on
its own account was approximately $410,000. The
cost of the surveys was approximately $303,000. In
1969 the gross revenue from sales of data was
approximately $632,000. The cost of the data was
approximately $545,000. The revenue arising from
data sales as a result of seismic surveys shot by the
company was approximately $664,000. The cost,
including amortization expense, was approximate
ly $282,000.
Mr. Rabey, the president of the plaintiff com
pany, said all this seismic data has, after a short
period of time, little value. He estimated that five
years after gestation, the probabilities are it would
have no value. Nevertheless, the company does not
destroy or discard any data it has in its stockpile
even though it may be, from day to day, relatively
valueless. There is always the chance the informa
tion may have to be upgraded in some way. It
may, at any time, be called for by some future
customer. It was his view that seismic data only
acquires value when someone wants to buy that
particular information. I accept all this evidence.
The defendant has categorized, and argued that
the $214,000 outlay was a "sham". I therefore
think it desirable, at this stage, to comment on
credibility. In my estimation, Mr. Rabey was a
trustworthy and honest witness. The same remarks
apply to Mr. Walsh. Their testimony on material
facts was, I find, acceptable, and consistent with
all reasonable inferences and probabilities to be
drawn from the other evidence.
I resume my narrative. In January or February
of 1969, G.T.S. Corporation, an American com
pany, also in the seismic data-marketing business,
was considering the expansion of its business
activities to Canada. It had developed a system of
digitizing well log information. The well log data
was put on a digital magnetic tape. The tapes were
to be used with computers. Exhibit 17 accurately
describes its activities:
GTS Corporation is primarily engaged in the translation of
older seismic data and well logs into a digital format that is
compatible with present-day computer equipment and
techniques.
The plaintiff was interested in the digitized well
log system as an exploration tool. It had merger
discussions with G.T.S., as well as with another
company in a similar business. Ultimately, an
agreement was made to merge with G.T.S. The
formal agreement, Exhibit 38, was entered into on
August 6, 1969. G.T.S. purchased the issued and
outstanding shares of the plaintiff company from
their owners, Mr. Rabey and Mr. James Fowlie.
The practical result of this transaction was that
the plaintiff became a subsidiary of G.T.S.
In October of 1969 the plaintiff purchased the
Angus data. Angus had spent approximately
$3,000,000 to assemble, over a period of time, the
information. Angus went into bankruptcy. The
plaintiff estimated it might realize potential reve
nue of $100,000 from the sale of the Angus infor
mation to customers. It purchased the data for
$60,000. Looking at this transaction from a practi
cal business point of view, the plaintiff, to my
mind, brought this data into its inventory. From
that same point of view, however, its forecasts of
potential sales proved wrong. It, in reality, realized
only $33,565 in gross revenue up to and including
1973.
I turn now to the transaction between G.T.S.
and the plaintiff. G.T.S. had developed a digitized
well log library including 20,350 digitized Canadi-
an well logs. These wells were located in Alberta,
British Columbia, and the Northwest Territories.
G.T.S. and its subsidiary had come to the conclu
sion, based on a market survey and its own investi
gations, that a profitable volume (12 million dol
lars) of sales of digitized well log information
could be made to Canadian companies. It was
decided the venture should be handled by the
plaintiff on its own account rather than as an
agent. The thinking was that Sigma had become
well known from its Alberta base, to the major
Canadian oil and gas companies, and that more
profit could be realized by its active participation,
as principal rather than agent, in the marketing of
the digitized well log data. An agreement, dated
November 13, 1969, was signed. It was changed
and superseded. The first agreement for some
reason remained in corporate files. I find nothing
unusual in that fact. It is not uncommon in the
business, world that superseded documents are
retained, either deliberately or by accident. The
effective agreement is dated November 24, 1969
(Exhibit 13). I set it out:
GTS CORPORATION (herein "GTS") hereby sells to SIGMA
EXPLORATIONS LTD. (herein "Sigma") and Sigma hereby pur
chases copies of 5,000 digitized Canadian well logs owned by
GTS, in accordance with the following stipulations:
1. Sigma shall have the right to select the 5,000 well logs
from the library of digitized Canadian well logs owned by
GTS.
2. GTS will reproduce the logs selected, in tape form (tape
to tape), and ship same to Sigma in Calgary, Alberta,
Canada, at the expense of GTS, all insurance to be paid by
Sigma.
3. Sigma will pay GTS the sum of $214,000 (base price) for
said copies, payable as follows:
a. $107,000 upon the execution of this agreement.
b. $107,000 after June 30, -1970, at the option of Sigma,
but in no event later than December 31, 1970.
c. A royalty of 23 per cent of the gross sale price from
sales of reproductions made by Sigma of such logs. Royal
ty payments shall be due on the 15th day of every fourth
month following the execution of this agreement and cov
ering sales made by Sigma during each successive three-
month period hereafter.
THUS DONE AND SIGNED THIS Twenty-Fourth (24th) day of
November, 1969.
The purchase figure of $214,000 was based on a
cost of approximately $40 per log of taping the
information. What was being sold was, from a
realistic business viewpoint, not the physôÿal tapes,
but the right to reproduce and market the com
mercially valuable information on them.
The plaintiff did not have in mind, before it
entered into the agreement, any particular 5000
logs. Nor, immediately following the signing of the
agreement, did it select any particular 5000 logs.
That selection, naturally, would depend on the
demands of its customers and the particular infor
mation those potential customers might be inter
ested in.
Unfortunately the high hopes of substantial
profit return to the plaintiff flowing from the
operation of Exhibit 13 were never realized. Mr.
Rabey said, and his evidence was uncontradicted,
there was a down-turn in the industry. Oil and gas
companies were, to some extent, cutting back.
More important, perhaps, many companies did not
have computer facilities required to extract the
necessary information from the log tapes. Even
though the earlier market survey had indicated
there was a lucrative potential market, cold reality
proved there was no market.
Whether, in respect of both the Angus and the
digitized well log transactions, there was bad busi
ness judgment or unrealistic projections, is, to my
mind, not particularly determinative. I am satis
fied on the evidence of Mr. Rabey and Mr. Walsh
when viewed with and tested against the other
objective evidence (mostly documentary) that the
intentions of the plaintiff and G.T.S. were real and
bona fide. Those plans were simply to earn income
from the sale of information contained in the
Angus data and the Canadian well log library. In
the latter situation, if the market had been there,
the plaintiff had the right to bring, from time to
time, particular information into its inventory.
I shall complete the history of the outlay of the
$214,000. The only request for digitized data came
in 1970 from Chevron for three logs. The auditors
in 1972 advised the plaintiff to cancel the agree
ment of November 24, 1969, and to write off the
cost of the well logs. This was done partly because
of the position taken by the defendant but substan
tially, I find, on sound accounting and commercial
principles. The $214,000 had been treated as a
deferred cost in 1970 and 1971. The digitization
system was a new field with unknown risks. Even
tually in the third year, after no profit, proper
accounting procedure demanded that the fact of a
business loss be recognized.
It is convenient to deal firstly with the defend
ant's two submissions directed particularly to the
$214,000 outlay.
It is said the transaction was a sham; the plain
tiff received nothing of value; the parent and sub
sidiary were not at arm's length; the whole trans
action was merely a method of siphoning profits to
the parent company. I do not accept this conten
tion. It is contrary to the evidence of Mr. Rabey
and Mr. Walsh (and I have accepted their testimo
ny), and in my view no reasonable inference of
sham can be drawn from the other objective facts.
I accept the plaintiff's contention that there were
sufficient restrictive conditions in the merger
agreement (Exhibit 38) preserving the indepen
dence of Sigma in respect of the making of expen
ditures, including of course the expenditure
impugned here. I refer particularly to clauses 9
and 15.
Financial sham has been described by Diplock
L.J. in Snook v. London and West Riding Invest
ments, Limited':
As regards the contention of the plaintiff that the transactions
between himself, Auto-Finance, Ltd. and the defendants were a
"sham", it is, I think, necessary to consider what, if any, legal
concept is involved in the use of this popular and pejorative
word. I apprehend that, if it has any meaning in law, it means
acts done or documents executed by the parties to the "sham"
which are intended by them to give to third parties or to the
court the appearance of creating between the parties legal
rights and obligations different from the actual legal rights and
obligations (if any) which the parties intend to create. One
thing I think, however, is clear in legal principle, morality and
the authorities (see Yorkshire Railway Wagon Co. v. Maclure
(1882) 21 Ch. D. 309; Stoneleigh Finance, Ltd. v. Phillips
[1965] 1 All E.R. 513; [1965] 2 Q.B. 537, that for acts or
documents to be a "sham", with whatever legal consequences
follow from this, all the parties thereto must have a common
intention that the acts or documents are not to create the legal
rights and obligations which they give the appearance of
creating.
That passage has been cited with apparent
approval by the Supreme Court of Canada in
M.N.R. v. Cameron 3 .
The transaction between the plaintiff and its
parent company, including the documents, were
not intended, in my opinion, to give to anyone the
appearance of creating rights and obligations dif
ferent from those the parties intended. There was
in this case no dissembling, masquerading, or lack
of bona fide intention.
z [1967] 1 All E.R. 518 at page 528.
3 [1972] C.T.C. 380. Other decisions where sham has been
considered are: Susan Hosiery Ltd. v. M.N.R. [1969] 2
Ex.C.R. 408; Concorde Automobile Ltée v. M.N.R. [1971]
C.T.C. 246 and Simard-Beaudry Inc. v. M.N.R. [1974] 2 F.C.
131.
The defendant relies also on subsection 137(1)
of the Income Tax Act. I conclude the prohibition
there is directed not only at sham transactions but
at something less, where the outlay, although real
and apparently bona fide, would unduly or artifi
cially reduce a taxpayer's income. I conclude fur
ther that the subsection is aimed at prohibiting
deductions in respect of transactions more tainted
than those resulting in unreasonable outlays other
wise deductible (subsection 12(2)), or in respect of
purchases not carried out at arm's length (subsec-
tion 17(1)).
Parliament has not defined the meaning of the
phrase "unduly or artificially reduce the income".
The taxpayer, in the carrying on of his business
affairs, is left to speculate on the arcane intention
of the legislators, and the perhaps unpredictable
attitude or opinion of the Minister in each
individual case. As I understand the process, ini
tially the Minister 4 reviews the evidence available
to him, and then by assessment or re-assessment
indicates his opinion that the particular disburse
ment would, if allowed, unduly or artificially
reduce income. If that legally undebated opinion
were conclusive or overriding, the Revenue
Department could indirectly control the nature,
purpose and amounts of a vast number of commer
cial expenditures. The test in deciding whether a
deduction is prohibited by subsection 137(1) must,
as I see it, be an objective one. The main source of
the evidence relating to it is commonly the taxpay
er. The evidence is therefore often subjective in
nature. An assessment of its weight and reliability
is of necessity required, but in the final analysis
the overall finding of undueness or artificiality (or
not) is a value judgment based 'on all the facts and
factors. Undoubtedly, many expenditures arith
metically reduce a taxpayer's income. The $214,-
000 outlay here certainly does that. If, however,
the expenditure is a reasonable one for legitimate
income-earning and business purposes, and not in
its true light a vehicle primarily to minimize tax,
then no matter how drastically income may be
diminished, I do not think the transaction can, or
ought to be, at the same time characterized as an
4i use "the Minister" in the technical and legislative, and not
in the practical, sense.
unreasonable reduction of income, or an unreal or
unnatural reduction 5 . In this case, it is my opinion
that when all the facts in the record (and the
reasonably probable inferences to be drawn from
them) are viewed realistically and objectively, and
the evidence of the plaintiff's two chief witnesses
assessed and accepted as trustworthy and cogent
(as I have), then the expenditure for the rights to
some of the well log digitized data cannot be
described as having an undue or artificial effect on
the plaintiff's income for 1969.
The remaining issue (applicable to both outlays)
is whether, to use the words of Jackett C.J.
Is such an expenditure in substance "a revenue or a capital
expenditure"? 6
The well-known statement as to what is a capi
tal outlay is that of Viscount Cave L.C., in British
Insulated and Helsby Cables, Limited v.
5 The latter words are borrowed from the reasons for judg
ment of Ritchie D.J. in Shulman v. M.N.R. [1961] Ex.C.R.
410 at pages 424-425:
While the language of section 137(1) is not as clear and
explicit as, on first examination, it appears to be, I do not
regard any of it as surplus.
In my opinion the word "that" relates to "deduction". I
interpret "unduly" as relating to quantum and meaning
"excessively" or "unreasonably". In the context found here,
"artificially" means "unnatural",—"opposed to natural" or
"not in accordance with normality".
I construe subsection (1) as though it read:
In computing income for the purpose of this Act no
deduction that if allowed would unduly or artificially
reduce the income may be made in respect of a disburse
ment or expense made or incurred in respect of a transac
tion or operation.
In considering the application of section 137(1) to any
deduction from income, however, regard must be had to the
nature of the transaction in respect of which the deduction
has been made. Any artificiality arising in the course of a
transaction may taint an expenditure relating to it and
preclude the expenditure from being deductible in computing
taxable income.
6 Algoma Central Railway v. M.N.R. [1967] 2 Ex.C.R. 88 at
page 91.
Atherton':
But when an expenditure is made, not only once and for all, but
with a view to bringing into existence an asset or an advantage
for the enduring benefit of a trade, I think that there is very
good reason (in the absence of special circumstances leading to
an opposite conclusion) for treating such an expenditure as
properly attributable not to revenue but to capital.
The Supreme Court of Canada approved that
passage in British Columbia Electric Railway
Company Limited v. M.N.R. 8 . Abbott J. made
this comment:
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.
On the appeal to the Supreme Court of Canada
in the Algoma case 9 the Court said this:
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 Common-
weath of Australia, [1966] A.C. 224; [1965] 3 All E.R. 209, 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 indica
tions in the contrary direction. It is a commonsense apprecia
tion of all the guiding features which must provide the
ultimate answer.
As was said by Noël A.C.J. in The Queen v. F. H.
Tones Tobacco Sales Co. Ltd. 10 one must consider
the practical and commercial aspects of the trans
action in question, and not merely the legal
aspects.
Here, the circumstances that both outlays in
question turned out to be economically unsound
does not prevent their deduction if they were in
fact and law laid out for the purpose of gaining or
producing income. In my opinion the sums expend
7 [1926] A.C. 205 at pages 213-214.
s [1958] S.C.R. 133 at page 137.
9 [1968] S.C.R. 447 at pages 449-450.
10 [1973] F.C. 825 at page 834.
ed were not made with a view of bringing into
existence an advantage for the enduring benefit of
the plaintiff's business. From a practical and com
mercial point of view, the plaintiff's intention or
"view" was to bring into inventory information
which it reasonably expected to market quickly
and produce revenue or income.
Both amounts should therefore have been per
mitted as proper deductions in computing the
plaintiff's income. The appeal is allowed. The re
assessment of the plaintiff's tax for the years in
question is referred back to the Minister with the
direction that the plaintiff is entitled to deduct the
two amounts accordingly. The plaintiff is entitled
to its costs.
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