Penn West Petroleum Ltd. v. The Queen

Penn West Petroleum Ltd. v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2007-04-11
Neutral citation
2007 TCC 190
File numbers
2003-3539(IT)G
Judges and Taxing Officers
Donald G.H. Bowman
Subjects
Income Tax Act
Decision Content
Dockets: 2003-3539(IT)G
2003-3541(IT)G
BETWEEN:
PENN WEST PETROLEUM LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeals heard on January 29, 30 and 31, 2007 at Calgary, Alberta.
Before: The Honourable D.G.H. Bowman, Chief Justice
Appearances:
Counsel for the Appellant: Barry R. Crump and
Heather DiGregorio
Counsel for the Respondent: William L. Softley and
John O'Callaghan
____________________________________________________________________
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1996 and 1997 taxation years are dismissed with costs.
Signed at Ottawa, Canada, this 11th day of April 2007.
"D.G.H. Bowman"
Bowman, C.J.
Citation: 2007TCC190
Date: 20070411
Dockets: 2003-3539(IT)G
2003-3541(IT)G
BETWEEN:
PENN WEST PETROLEUM LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Bowman, C.J.
[1] These appeals for the appellant's 1996 and 1997 taxation years were heard together. They arise from the application of subsection 103(1) of the Income Tax Act as a result of a transaction that took place in the appellant's 1996 taxation year.
[2] The parties have entered into a statement of agreed facts ("SAF"). It is attached as Appendix A to these reasons. Appendix B is Tab 51 of the agreed book of documents, a series of schematic diagrams of agreed transactions. There is virtually no dispute on the basic factual background.
The Issue
[3] The facts leading up to the transaction giving rise to the assessments are somewhat complex but the issue itself turns out to be fairly simple. I shall briefly state it in this paragraph. The appellant became a partner in the Penn West Petroleum partnership with two of its subsidiaries. Penn West Petroleum partnership owned oil and gas properties including properties in the Blueberry area of British Columbia. These properties were previously owned by PetroCanada, who transferred them to two of the partners (or their predecessors) of the Penn West Petroleum partnership. The Blueberry properties were subject to rights of first refusal ("ROFRs") held by Phillips Petroleum Resources Ltd., Suncor Inc. and B.C. Star Partners. Penn West knew that the ROFRs were an encumbrance on the property and it recognized its obligation to convey the Blueberry properties to the holders of the ROFRs if they chose to exercise their rights. PetroCanada gave notice to Phillips of the conveyance of the properties to the partnership. Penn West was reluctant to convey the properties directly to Phillips (possibly because of the adverse effect such a sale would have on its Canadian oil and gas property expense pool ("COGPE")). Phillips in any event objected to the price stated in PetroCanada's ROFRs notices. Penn West therefore suggested that Phillips acquire the property indirectly by becoming a partner in the Penn West Petroleum partnership. Under the Penn West Petroleum partnership agreement it was provided that where property of a partnership was conveyed to a partner any income or loss of the partnership arising from such distribution was to be allocated to the party to whom the property was distributed. This is what happened. The Blueberry properties were distributed to Phillips. Under the partnership agreement the tax consequences of this distribution, specifically the erosion of the COGPE, went with the property and it was Phillips who suffered the reduction of its COGPE and not Penn West. The respondent contends that this result contrevenes section 103 of the Income Tax Act. The Minister allocated to the appellant as a partner in the Penn West Petroleum partnership its pro rata share of the proceeds and as a consequence reduced its COGPE proportionately.
The Facts
[4] In the following summary of the facts I shall use the same abbreviations as in the SAF. Effective April 1, 1993, PetroCanada transferred certain oil and gas properties (the "TroCana assets") to a partnership, Trocana Resources. That partnership consisted of PetroCanada and Trocana Resources Inc. ("TRI"), its wholly owned subsidiary. That partnership was dissolved on November 30, 1993. A 97% interest in the properties was transferred to PetroCanada and 3% to TRI.
[5] The next step was the formation of 594159 Alberta Ltd. ("594), of which 1% was owned by PetroCanada and 99% by 552792 Alberta Inc. ("552"). Counsel for the appellant informed me that 552 was owned by one Murray Edwards, who was at arm's length with PetroCanada. This statement was not disputed by the respondent.
[6] Effective February 17, 1994, PetroCanada sold to 594 its interest in the TroCana assets for $155,050,000 and its shares in TRI to 552 for $14,750,000. Thus, 594 and TRI, the two subsidiaries of 552, owned respectively 97% and 3% of the TroCana assets. They formed the TroCana partnership on February 21, 1994 and rolled their interests in the TroCana assets into the TroCana partnership under subsection 97(2) of the Income Tax Act. In return, 594 received 145,500,000 partnership units and TRI received 4,500,000 units.
[7] The effect of the election to have subsection 97(2) apply was that the deemed cost of the oil and natural gas tangibles transferred by 594 and TRI were $14,425,313 and $413,555 respectively. The deemed cost of the resource properties (oil and natural gas leases) was nil. 594's interest in the partnership was 97% and TRI's was 3%.
[8] Since the TroCana partnership agreement of February 21, 1994 between TRI and 594 is one of the documents that is central to the issue in these appeals, I shall reproduce certain of its provisions:
3.5 ALLOCATIONS
All Net Profits, Net Losses, taxable income and tax losses of the Partnership and all other items of income, gain, loss, deduction, recapture and credit of the Partnership, which are allocable for the purposes of the Income Tax Act shall be allocated to the Partners in accordance with their sharing ratios set forth under Section 3.10. All Net Profits and Net Losses shall be determined by the Managing Partner in accordance with generally accepted accounting principles.
. . . . .
3.10 SHARING RATIO
Allocations and distributions to Partners under this Agreement shall be made based on the Partner's respective sharing ratio, such sharing ratio to be determined by the Partners at the end of each fiscal year of the Partnership in accordance with the number of Units each Partner owns relative to the total number of Units outstanding for the Partnership.
. . . . .
3.15 INCOME AND LOSS FOR INCOME TAX PURPOSES
Subject to Section 3.5 all income and loss for income tax purposes of the Partnership, proceeds of disposition of Canadian resource properties (as defined in the Income Tax Act) which are received or receivable by the Partnership, crown royalties payable by the Partnership on production of petroleum substances, Canadian exploration expense, Canadian development expense, Canadian oil and gas property expense and investment tax credits (all as defined in the Income Tax Act) arising from the expenditures of the Partnership and all other amounts which are separately allowable for the purposes of the Income Tax Act or any other applicable provincial legislation shall be allocated among the Partners in accordance with there Partnership Interests and all such allocations shall be made as of the end of each fiscal year of the Partnership.
[9] Article 9 dealt with redemption of units.
9.1 REDEMPTION OF UNITS
A Partner may, upon notice to the Managing Partner, cause the Partnership at the Partner's cost to redeem all or a part of that Partner's Units, if all such Units, then except for one Unit which will be held by such Partner pursuant to the provisions of Section 9.3 hereof, (the "Designated Units") in exchange for a specified interest in any one or more of the Partnership Properties designated by such Partner (the "Designated Properties") on the basis of:
(a) the satisfaction of the Managing Partner that the Designated Units represent a percentage of all Units which equals the percentage of all Partnership Properties represented by the Designated Properties (the "Percentage"), all as determined on the basis of relative fair market value;
(b) upon entering into such agreements in respect of the distribution of the Designated Properties in form and substance satisfactory to the Managing Partner; and
(c) the Designated Properties shall include a promissory note of the Partnership in an amount equal to the Percentage of the working capital of the Partnership at the time of distribution.
9.2 METHOD OF DISTRIBUTION
The rights of distribution under Section 9.1 may be exercised by any Partner giving notice to the Managing Partner of its election to have the Partnership redeem the Designated Units and of the specification of the Designated Properties. The Managing Partner will have up to 10 days from receipt of such notice to accept or reject such notice. Upon acceptance of such notice by the Managing Partner, the election is irrevocable by such Partner. The effective date of the election will be the first day of the month following receipt of the notice or such other date as may be agreed to by the Managing Partner. The Managing Partner will cause the Designated Properties to be conveyed by an agreement in form and substance satisfactory to the Managing Partner to be prepared and submitted to the Partner for execution together with any election forms required by the Income Tax Act. After the conveyance, subject to Section 3.17 hereof, the retiring Partner will have no further interest in the Partnership or any of its remaining assets in respect of the Designated Units. The redemption and conveyance will be carried out pursuant to any tax deferral provisions of the Income Tax Act which are available at the date of such transfer and all parties agree to co-operate in doing all things and executing all documents necessary therefor. Upon any distribution of Designated Properties pursuant to this Article 9, the proceeds of disposition, income or loss, credit and expenses that arises in the Partnership will be allocated in accordance with the provisions of Section 3.17 hereof.
9.3 ALLOCATIONS
Notwithstanding Section 9.2, if there is a distribution of Designated Properties pursuant to Section 9.1 those Partners who receive Designated Properties shall be deemed to remain Partners and holders of the number of Designated Units for so long as is necessary to effectively cause the allocation of the amounts referred to in Section 3.17. After the allocation of the amounts referred to in Section 3.17, the one Units which is held by any Partner exercising its rights under Section 9.1 hereof to have all of its Units, except one, redeemed will be acquired by the Partnership for $1.00 and will be cancelled without the payment of any other consideration therefor or any act by either the Partner or the Partnership.
. . . . .
3.17 DISTRIBUTION OF PROPERTY
Where an interest in any one or more of the Partnership Properties is distributed to a Partner pursuant to Article 9 hereof:
(a) any income or loss realized or deemed to be realized as a result of such distribution by the Partnership for purposes of the Income Tax Act and, in the case of Canadian resource properties, any proceeds of disposition deemed to be received by the Partnership, in respect of such distribution shall be allocated to such Partner to whom such distribution is made, subject to any agreement between the Managing Partner on behalf of the Partnership and the specific Partner to whom such allocation is to be made; and
(b) amounts of the Partnership which are relevant for income tax purposes and which are otherwise allowable pursuant to Section 3.15 hereof, shall be allocated to such Partner to the extent of any Units redeemed on the basis of the proportion such amounts relative to the portion of the fiscal year of the Partnership ending on the last day of the month following the effective date of the election in respect of redemption of Units under Section 9.2, subject to any agreement between the Managing Partner on behalf of the Partnership and the specific Partner to whom such allocation is to be made.
[10] Effective April 22, 1994, the appellant acquired from 552 the common shares of 594 and all the shares of TRI for $14,750,000 in cash and common shares.
[11] To recapitulate the situation on April 22, 1994, then, the appellant had the common shares of 594 and all the shares of TRI who, through the TroCana partnership owned the TroCana assets. PetroCanada, as the result of its sale to 594 of the TroCana assets owned 10,000,000 preferred shares of 594 and was owed by it $145,050,000 by way of promissory notes and debentures.
[12] These arrangements were reorganized by, inter alia,
(a) the appellant giving PetroCanada 1,403,508 special warrants for common shares of the appellant in exchange for the 10,000,000 preferred shares of 594 owned by PetroCanada;
(b) the appellant giving PetroCanada subsidiary, Chancellor, 1,955,828 special warrants in exchange for the $18,000,000 second debenture of 594 held by PetroCanada.
[13] The Penn West Acquisition Agreement dated April 22, 1994 contained other provisions but they do not appear to be germane to the issue in this case. It is sufficient to say that following the various transactions contemplated by the Penn West Acquisition Agreement, TRI and 594 became wholly owned subsidiaries of the appellant at a cost of about $170,000,000. The parties agree that the acquisition of the TroCana assets significantly increased the value of the appellant's shares and that the TroCana assets were independently valued at about $253,000,000.
[14] Effective July 1, 1994, the appellant transferred its oil and gas properties to the TroCana partnership pursuant to an election under subsection 97(2) of the Income Tax Act in return for partnership units. The name of the partnership was changed to Penn West Petroleum partnership.
[15] The partnership agreement was amended six times. The first three amendments were the following:
(a) No. 1: to change the name of the partnership and to reflect the appellant's becoming a partner with 85,000,000 units.
(b) No. 2: to reflect 594's contribution of additional assets for 598,290 more units.
(c) No. 3: to reflect the fact that 626360 Alberta Ltd. ("626") a wholly owned subsidiary of the appellant became a partner of Penn West Petroleum after 626 acquired the shares of 594 and 594 wound up and distributed its assets to 626, including its 146,098,290 units in the partnership.
[16] On January 31, 1995, 626 and the appellant amalgamated. As noted above, some of the TroCana assets, known as the Blueberry assets, were subject to ROFRs in favour of Philips, Suncor and B.C. Star. PetroCanada gave notice to these companies that it had sold its interest in the Blueberry assets to 594.
[17] The ROFR exercise prices were stated in the notices and are set out in paragraph 29 of the SAF. Suncor, Philips and BC Star objected to the exercise prices contained in the notices. PetroCanada issued a new notice.
[18] On December 29, 1994, the appellant sent a letter of agreement to Phillips that contained an offer to sell units of Penn West Petroleum to Philips. The agreement, which was accepted by Phillips, is central to the issue in this case.
[19] Clauses 1 to 7 of the agreement read as follows:
1. In this letter, the following terms and phrases will have the following meanings:
a. "Assets" means the Partnership's entire and beneficical right, title, estate and interest in the Blueberry Interest and the Pipeline Interest;
b. "Blueberry Interest" means the entire pretroleum and natural gas and related interests of the Partnership within the geographic area as outlined on Schedule "A" hereto including:
i. all wells, facilities, equipment and material related thereto;
ii. all gross overriding royalty interests received by the Partnership in respect thereof; and
iii. miscellaneous interests related to such assets and production therefrom excluding the Westcoast raw gas transmission, plant processing capacity and transportation service with respect to production from the Blueberry Interest,
subject only to lessor royalties, Crown lessor royalties and those encumbrances and royalties assumed pursuant to the Petro-Canada Sale and specifically described and set forth in Schedule "B" hereto;
c. "Petro-Canada Sale" means the sale of certain assets including the "Assets" to Alberta pursuant to a Petroleum, Natural Gas and General Rights Conveyance made as of February 17, 1994 and ultimately conveyed to the Partnership; and
d. "Pipeline Interest" means the entire interest acquired by Alberta pursuant to the Petro-Canada Sale (and now held by the Partnership) in the pipeline operated pursuant to a Pipeline Operating Agreement dated July 31, 1969 and amended by a Clarification Agreement dated April 1, 1993, including without limitation the Aitken Creek lateral.
2. Penn West Petroleum Ltd. ("Penn West") anticipates that certain units of Penn West Petroleum (the "Partnership") presently constituted between Penn West, 594159 Alberta Ltd. ("Alberta") and TroCana Resources Inc., will become vested in its wholly owned subsidiary 626360 Alberta Ltd. (the "Vendor") upon the liquidation of Alberta. A portion of such units (the "Units") entitle the holder to 5.27%, as adjusted, of Partnership revenue. Subject to the terms set out herein, Penn West, as agent for the Vendor, hereby offers to sell the Units to Phillips Petroleum Resources Ltd. (the "Purchaser") effective as at January 20, 1995. The purchase price of the Units (the "Purchase Price") will be $14,500,000 as adjusted payable by a promissory note (the "Promissory Note") as follows:
a. the Promissory Note will be non-negotiable and non-assignable;
b. the principal amount and interest will be secured by a pledge of the Units (the "Security") which Security will be released on satisfaction of the promissory note;
c. the principal amount and interest may be prepaid at any time;
d. the principal amount and interest will be due on February 24, 1995; and
e. the principal amount will bear interest at the CIBC prime rate until February 24, 1995 and at the CIBC prime rate plus 2% thereafter.
3. We understand that the Purchaser had expressed an interest in purchasing the Assets presently owned by the Partnership for cash consideration. Unfortunately, the Assets are not for sale by the Partnership on that basis. In considering the advisability of purchasing the Units, the Purchaser should note that the Agreement by which the Partnership is governed (the "Partnership Agreement") contains in Section 9.1 provisions that a partner may request a redemption of his units in consideration for a share of the Partnership's assets. Such request must be accepted by Penn West, as managing partner of the Partnership. As part of any purchase of the Units from the Vendor, Penn West is prepared to represent that, if the Purchaser were to request a redemption of the Units during the period commencing on or after February 1, 1995 and ending March 1, 1995 and request a conveyance of the Assets in redemption therefore [sic] in accordance with Section 9.1. Penn West, as managing partner of the Partnership, would accept such redemption on the basis requested, subject to the terms of this letter and the entering into of a definitive redemption agreement with the Partnership and agreement that, upon any such redemption, the redemption price of the Assets will be allocated as to 90% to petroleum and natural gas rights, 10% to tangibles and a nominal amount to any other assets. In the event that the Purchaser requests such a redemption in accordance with this Agreement and the Partnership Agreement and such redemption does not occur, Penn West, as managing partner of the Partnership, and Alberta, as a partner of the Partnership, will cause the redemption by the Partnership of the Units for an amount equal to the Purchase Price plus any amount of interest payable under the Promissory Note to the date of redemption.
4. The Partnership Agreement provides presently that in the event that the Purchaser were to redeem its Units and request a distribution to it of the Assets that any proceeds of disposition deemed to be received by the Partnership will be allocated to the Purchaser for tax purposes to reflect such distribution. If for any reason such allocation is disallowed by the governing tax authority in whole, or in part, prior to December 30, 1999, upon it being finally determined by a court of competent jurisdiction or by agreement between the taxing authority and Penn West, the Purchaser agrees to pay an amount to the Partnership equal to 7% of the amount not so allocated as additional consideration for the distribution to the Purchaser of the Assets. It is acknowledged and agreed that the amount of the proceeds of disposition to be allocated to the Purchaser under the Partnership Agreement in respect of the distribution of the Assets shall not be in excess of 90% of the Purchase Price.
5. The Purchaser shall not be liable to pay an amount under clause 4 hereof as additional consideration for the distribution of the Assets in respect of any income (the "Excess Income") allocated to the Purchaser for income tax purposes for the fiscal period of the Partnership commencing February 1, 1995 other than the proceeds of disposition related to the distribution of the Assets.
Penn West will be liable for and shall indemnify Purchaser in respect of any income tax payable by Purchaser on the Excess Income computed on the assumption that the Purchaser is fully taxable.
6. If the Purchaser does not redeem the Units prior to June 30, 1995, the Purchaser will grant to Penn West an option to purchase the Units exercisable on or after June 30, 1995 and prior to June 30, 1998 at the Purchase Price.
7. Penn West covenants that it will cause the Partnership Agreement to be amended as necessary to reflect the provisions of this Agreement.
[20] What it boils down to is this: Phillips, on behalf of itself and Suncor and B.C. Star wanted the Blueberry assets and the appellant knew that it could insist on getting them because of the ROFRs. The appellant knew that for the partnership to sell the Blueberry assets directly to Phillips would erode its proportionate share of the COGPE. It therefore invited Phillips to acquire units in the partnership. This would enable Phillips to avail itself of the provisions in the TroCana partnership agreement relating to redemption of units, distribution of assets and specifically article 3.17 which is set out above. It essentially attributes to a partner to whom property of the partnership is distributed the income tax consequences of such distribution.
[21] On January 30, 1995, 626 sold 12,416,030 partnership units to Phillips for $14,168,716 and Phillips gave 626 a promissory note in that amount. Phillips became a partner with 12,416,030 units. Effective January 30, 1995, the partnership agreement was amended to reflect the addition of Phillips to the partnership. It was also amended to delete sections 9.1 and 9.3 and substitute new provisions as follows:
2.2 The provisions of Section 9.1 are hereby deleted and substituted with the following:
9.1 Redemption of Units
Notwithstanding any other provision of this Agreement, a Partner may, upon notice to the Managing Partner, cause the Partnership to redeem all or part of that Partner's Units (the "Designated Units") in exchange for a specified interest in any one or more of the Partnership Properties designated by such Partner (the "Designated Properties") on the basis of:
(a) the satisfaction of the Managing Partner that the Designated Units represent a percentage of all Units which equals the percentage of all Partnership Properties represented by the Designated Properties (the "Percentage"), all as determined on the basis of relative fair market value; and
(b) upon entering into such agreements in respect of the distribution of the Designated Properties in form and substance satisfactory to the Managing Partner.
2.3 The provisions of Section 9.3 are hereby deleted and substituted with the following:
Notwithstanding Section 9.2, Section 96(1.1) of the Income Tax Act shall be applicable if there is a distribution of Designated Properties pursuant to Section 9.1 and those Partners who receive Designated properties shall be deemed to remain Partners pursuant to such Section 96(1.1) for income tax purposes until the next fiscal year end of the Partnership.
[22] On February 17, 1995, Phillips sent a notice to the appellant as managing partner of the partnership electing to have its units redeemed on February 24, 1995. On February 24, 1995, Phillips paid 626 $14,255,086.94 in satisfaction of the promissory note. By February 24, 1995, 626 and the appellant had already amalgamated.
[23] Also, on February 24, 1995, Phillips, the partnership, the appellant and TRI executed an agreement under which the Blueberry assets were tranferred to Phillips in satisfaction of Phillips' interest in the partnership. The value of the petroleum and natural gas rights was allocated to Phillips in the amount of $12,751,844.40 and the tangibles in the amount of $1,416,870.60.
[24] Paragraphs 41 to 44 of the SAF describes how the disposition of the Blueberry assets was allocated for financial statement purposes and for income tax purposes. Schedules A and B of the replies to the notice of appeal are as follows:
SCHEDULE "A"
REVISED COGPE
Penn West
Northern Reef
TroCana
Phillips
(Original %)
85.96%
12.37%
1.67%
0.00%
COGPE
$40,678,528
$5,853,809
$ 790,288
($12,751,844)
Revised POD*
__(11,836,261)
________0
(243,560)
(672,203)
Revised COGPE
$ 28,842,267
$5,853,809
$546,560
n/a
* Allocation made on the basis of 92.82%, 0%, 1.91% and 5.27%, respectively.
SCHEDULE "B"
REDUCTION TO APPELLANT'S COGPE CLAIM
1996
1997
Unrestricted
Unrestricted
Beginning Balance
$22,589,990
$46,289,031
Attributed from Partnership (revised)
28,842,267
36,734,902
____________
____________
Balance before claim
51,432,257
83,023,933
Claim (10%)
(5,143,226)
(8,302,383)
____________
____________
Ending Balance
$46.289,031
____________
$74,721,540
____________
Original COGPE Claim
6,326,582
9,367,657
Revised COGPE
(5,143,226)
(8,302,393)
Reduction to COGPE claim
$ 1,183,626
$ 1,065,264
[25] At the risk of over simplification what happened was this. When the Blueberry assets were distributed to Phillips in satisfaction of its partnership share there was, under subsection 98(2), a deemed disposition of them and a corresponding reduction of the COGPE which, in the absence of article 3.17 of the agreement, would have been allocated among the partners in accordance with their respective interests in the partnership: the appellant 36.08%; TRI 1.91%; 626 56.74% and Phillips 5.27%. After the amalgamation of the appellant with 626 the appellant's percentage interest became 92.82%. These percentages will have changed as the result of the addition to the partnership of a new partner, Northern Reef Exploration Ltd. as of August 30, 1995. I have been unable to reconcile the percentage interest of Northern Reef in the amended agreement no. 6 of 3.50% and that shown in the reply of 12.37%. This was not explained to me and I shall ignore it as it does not bear on the question involved here. Schedule A to the reply shows the appellant with an 85.96% interest.
[26] The question is whether the entire deemed proceeds of the disposition of the Blueberry assets can be allocated to Phillips for tax purposes by reason of article 3.17 despite the fact that for balance sheet purposes Phillips had only a 5.27% interest.
[27] The Minister of National Revenue, in determining the appellant's COGPE entitlement, allocated the Blueberry proceeds of disposition in accordance with the partners' respective partnership interests on the basis that to allocate the proceeds in a manner different from that provided in the partnership agreement (apart from article 3.17) contravened subsection 103(1) of the Income Tax Act. That subsection reads:
(1) Where the members of a partnership have agreed to share, in a specified proportion, any income or loss of the partnership from any source or from sources in a particular place, as the case may be, or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of any of the members thereof, and the principal reason for the agreement may reasonably be considered to be the reduction or postponement of the tax that might otherwise have been or become payable under this Act, the share of each member of the partnership in the income or loss, as the case may be, or in that other amount, is the amount that is reasonable having regard to all the circumstances including the proportions in which the members have agreed to share profits and losses of the partnership from other sources or from sources in other places.
[28] The agreement upon which we must focus consists essentially of sections 3.17 and 9.1 as amended by the partnership amending agreement together with the letter agreement between the appellant and Phillips of December 29, 1994. Can it be said that the principal purpose for these contractual provisions "may reasonably be considered to be the reduction or postponement of the tax that might otherwise have been or become payable under [the Income Tax] Act"?
[29] Counsel for the appellant argued that there was no agreement to which subsection 103(1) could apply. Specifically he contends that one cannot "piggybank" the letter agreement onto section 3.17 of the partnership agreement. At the time of the letter agreement of December 29, 1994, Phillips was not a partner. It became a partner on January 30, 1995. When Phillips became a partner, the letter agreement continued to be in effect and from January 30, 1995 onwards the arrangement between the partners consisted of the contractual relations that subsisted between them in their entirety and it is to those contractual relations that one must look in determining whether subsection 103(1) applies. The proposition that one must look at all the contractual relations is self evident but if one wants authority there is ample and it is of ancient vintage. In O'Donohoe v. Stammers, (1884) XI S.C.C. 358, Ritchie C.J. said at 375:
Numerous authorities might be referred to, I think it only necessary to cite one. Ridgway v. Wharton (1)
The Lord Chancellor says:
The authorities lead to this conclusion, that if there is an agreement to do something, not expressed on the face of the agreement signed, that something which is to be done being included in some other writing, parol evidence may be admitted to show what that writing is, so that the two taken together may constitute a binding agreement within the statute of Frauds.
* * * * * *
Then, my Lords, there was a case of Dobell v. Hutchison, (2) which went exactly upon the same principle. There, the defendant having put up a thing for sale by auction, the plaintiff entered into a written agreement, signed by himself, to purchase it upon certain specified terms. It turned out that Hutchison, the defendant, had not a title which authorized him to sell, and consequently, that he could not complete the sale; but, in the correspondence which took place afterwards, several letters referred to the terms which had been signed by Dobell, the plaintiff, as being the terms which were then subsisting between them, and the Court of Queen's Bench held that, parol evidence being given to show what the terms were to which Hutchison referred in his letters, the two might be taken together, so as to bind Hutchison, and to show that that was the written paper, signed by the plaintiff, to which he referred as being the terms of the contract.
______________________
(1) 6 H. L. 257. (2) 3 A. & E. 355.
[30] Let us start then with the partnership agreement as a whole. It is unexceptionable with the possible exception of section 3.17. Normally where property of a partnership is distributed to a partner the partnership is deemed to have disposed of the property at its fair market value. Subsection 98(2) of the Income Tax Act reads:
(2) Subject to subsections (3) and (5) and 85(3), where at any time after 1971 a partnership has disposed of property to a taxpayer who was, immediately before that time, a member of the partnership, the partnership shall be deemed to have disposed of the property for proceeds equal to its fair market value at that time and the taxpayer shall be deemed to have acquired the property at an amount equal to that fair market value.
[31] This would reduce the partner's COGPE by reason of paragraph (a) of the description of F in the definition of cumulative Canadian oil and gas property expense in subsection 66.4(5). I need not set out the elaborate algebraic formula in the definition of COGPE. It is sufficient to say that if a partnership disposes of Canadian resource property the proceeds of disposition reduce the partner's COGPE in proportion to the partner's partnership share by reason of subsection 64.4(6). The assessments against Penn West do just that. How then does section 3.17 alter this result? It provides that the proceeds of disposition deemed to be received by the partnership in respect of the distribution by the partnership to a partner of Canadian resource property shall be allocated to the partner to whom the property is distributed.
[32] A point that was not argued was whether the members of a partnership can, as a matter of law, contractually alter the incidence of taxation in a manner that binds the Minister without changing the civil consequences. It seems clear that partners can agree among themselves simply as a matter of contract that different sources of income can be allocated to different partners. If we assume for example a partnership that carries on several businesses - say, real estate rentals, share trading, consulting and house building - I can see no legal impediment to the partners agreeing that the income from one business can be allocated to one partner and the income from another business can be allocated to another partner. In Lindley & Banks on Partnership, Eighteenth Edition, the following appears at pp. 897-898: (footnotes omitted)
(c) Other agreements reached between partners. It follows from the foregoing that any agreement which seeks to alter a partner's status or entitlement ex post facto can quite properly be implemented as between the partners, whether for accounting purposes or otherwise, but will not bind the Revenue. Thus, where partners agreed to re-allocate the firm's income between themselves several years after it arose, so as to obtain the maximum benefit from available tax reliefs, the re-allocation was held to be of no effect vis-à-vis the Revenue.
On the other hand, a bona fide agreement which governs the partners' present and future relationship and which does not seek to have any retrospective effect will be equally valid as between the partners themselves and as between them and the Revenue, provided that its terms are adhered to. Thus, it is, for example, open to the partners to agree that the entirety of a capital allowance or balancing charge accruing in respect of a particular partnership asset will be enjoyed or borne by one or more of their number; or even that one partner will indemnify the others against a particular partnership liability, without affecting the deductibility of that liability in computing the profits of the firm for tax purposes. Significant tax advantages can often be obtained from careful planning, coupled with the use of such agreements.
[33] The situation described in the above passage is not exactly what we have here. Section 3.17 seeks to allocate what are purely notional proceeds of disposition arising as the result of a deeming provision of the Income Tax Act, subsection 98(2). That provision deems the partnership to have disposed of the property for proceeds equal to its fair market value. Section 3.17 of the partnership agreement seeks to provide that the deemed disposition that the Income Tax Act dictates falls on the partnership can be shifted contractually to one of the partners even though as a civil matter nothing has changed. I have serious reservations as to whether this can be achieved as a matter of law. Obviously partners can contractually divide up a real pie any way they like but I have a conceptual difficulty in seeing how a pie that exists only because the Income Tax Act deems that it exists and belongs to the partnership can, by agreement, be given to one of the partners along with the tax consequences that flow from that notional ownership. Let us compare the effect under section 3.17 with the following hypothetical example. Three partners A, B and C would, in the normal course, share profits equally. To achieve a particular tax result, they agree that two thirds of the partnership income is to be allocated to partner C. They can obviously do that if the arrangement is genuine and legally binding and is not a sham. Partner C can keep the two thirds share of the partnership income. If the division is unreasonable and tax motivated, the Minister can allocate some of the income back to A and B under subsection 103(1). This affects the incidence of tax but does not alter in any way the civil consequences of the agreement between the partners. What must be emphasized, however, is that subsection 103(1) is premised upon the existence of a legally binding agreement with genuine civil consequences. Here I am faced with the Minister's applying subsection 103(1) to what is, as a civil matter, arguably a legal impossibility. Obviously the Minister's assessments were premised on the contractual arrangements doing what they purported to do. I am aware that the concerns that I have tentatively expressed about the legal efficacity as against the Minister of section 3.17 of the partnership agreement, the purpose of which is to transfer to a partner to whom partnership assets are distributed the tax effect of a notional disposition that the Income Tax Act visits upon the partnership, may possibly not be consistent with the administrative practice expressed in two departmental rulings contained in tabs 49 and 50 of the joint book of documents. Moreover, I heard no representation from counsel on the point and I saw no evidence of the accounting treatment. The financial statements were not put in evidence and I do not know how a distribution of partnership property to a retiring partner is treated for accounting purposes. One problem on which I would need some argument is this: it seems at least highly artificial if not legally impossible to allocate a deemed receipt to one partner particularly where such a deemed receipt would in all probability not find its way into the profit and loss statement for accounting purposes. One might ask parenthetically why then is it not just as problematic to allocate to the partners their pro rata shares of the deemed proceeds, in this case 5.27% to Phillips and 92.82% to the appellant?
[34] I considered calling counsel back because they both argued the cases on the basis that section 3.17 was at least legally effective, the sole question being whether subsection 103(1) applied. The court is of course not bound by agreements or assumptions by the parties on matters of law (see L.I.U.N.A. Local 527 Members' Training Trust Fund v. The Queen, 92 DTC 2365 at 2368 to 2369). It may well be that in accounting for partnership income for tax purposes deemed receipts or other notional amounts that the Income Tax