Judgments

[1997] 3 F.C. 674

A-411-95

Her Majesty the Queen (Appellant) (Respondent)

v.

Central Supply Company (1972) Limited (Respondent) (Appellant)

A-412-95

Her Majesty the Queen (Appellant) (Respondent)

v.

Carousel Travel 1982 Inc. (Respondent) (Appellant)

Indexed as: Canada v. Central Supply Company (1972) Ltd. (C.A.)

Court of Appeal, Strayer, Linden and McDonald JJ.A.—Toronto, February 5, 6, and 7; Ottawa, June 2, 1997.

Income tax — Income calculation — Deductions — Appeal from Tax Court decision allowing deductions under Income Tax Act, s. 66.1 — Respondents purchasing interests in partnerships engaged in financing unsuccessful oil, gas exploration project on final day of partnerships’ fiscal year — Disposing of limited partnership interests next day — Income Tax Act, s. 245 prohibiting deductions in respect of disbursement, expense, made or incurred in respect of transaction, operation that if allowed would unduly or artificially reduce income — “Artificial”, “undue” referring to reduction of income, not expense — Application of majority opinion as to role of s. 245, 3 relevant considerations set out by F.C.A. in Canada v. Fording Coal Ltd. — (1) As not engaging in business exploration expense provisions designed to promote, respondents outside their intended object, spirit — (2) Transactions allowing respondents to claim cumulative Canadian exploration expense deductions far removed from normal commercial practice — (3) No business purpose attached to respondents’ participation in limited partnerships — Attempting to achieve unlawful tax avoidance.

This was an appeal from the Tax Court decision allowing the respondents’ deductions. The respondents claimed deductions of $10,000,000 (Central Supply Company) and $6,000,000 (Carousel) in the 1987 taxation year under Income Tax Act, subsection 66.1(3) and paragraph 66.1(6)(b). Subsection 66.1(3) then permitted a taxpayer, other than a principal-business corporation, to deduct the amount not exceeding the taxpayer’s cumulative Canadian exploration expense (CEE) as determined at the end of the year. The CEE deduction is a cumulative, continuing pool of expenses to which defined exploration expenses, such as seismic and drilling costs, are added and from which certain sums received or receivable are deducted. A “Canadian exploration expense” relates generally to expenses incurred for the purpose of drilling or completing an oil or gas well. The sums which are deducted from the “pool” include grants which the taxpayer is entitled to receive from the Government of Canada through the Petroleum Incentives Program Act which provides for the payment of 80% of “eligible exploration expenses” for “qualified persons” as part of a strategy to encourage investment in the industry. Paragraph 66.1(6)(a) sets out the conditions under which a taxpayer may incur CEE deductions.

On December 14, 1987, the respondents purchased interests in four limited partnerships which had been engaged in financing an unsuccessful oil and gas exploration project located off the east coast of Canada, thus resulting in the allocation to them of the deductions. By that time the partnerships were engaged solely in winding-up activities. December 14 was the final day of the fiscal year of each of the partnerships. The next day the respondents disposed of their limited partnership interests. The Tax Court allowed the deductions pursuant to subsection 245(1) on the ground that they arose from legitimate expenses which were allocated to the respondents according to the requirements of the Act. Income Tax Act, section 245, as it then was, prohibited deductions in respect of a disbursement or expense made or incurred in respect of a transaction or operation that if allowed would unduly or artificially reduce the income.

The issue was whether Income Tax Act, subsection 245(1) applied to disallow the deductions of cumulative Canadian exploration expense claimed in 1987.

Held (McDonald J.A. dissenting), the appeals should be allowed.

Per Linden J.A. (Strayer J.A. concurring): Judicial anti-avoidance devices have been sparsely used in Canada. Consequently, any meaningful distinction between lawful and unlawful tax avoidance must come mainly from legislative anti-avoidance measures. The former subsection 245(1) was one of a number of partial anti-avoidance measures in the Act which attempted to prevent specific kinds of anti-avoidance schemes or transactions, all of which were repealed in 1988 to make way for the new general anti-avoidance rule (GAAR). They indicated that, even prior to the new GAAR, Parliament intended to distinguish between lawful and unlawful tax avoidance. Thus, while it may not be their role to apply anti-avoidance doctrines as general principles of interpretation, Canadian courts must respect the existence of particular tax avoidance provisions in the Act.

This Court has articulated two conflicting visions of the role to be played by subsection 245(1). Strayer J.A. in Canada v. Fording Coal Ltd. set out three factors relevant to the determination of whether a taxpayer has unduly or artificially reduced its income: (1) whether the deduction sought was contrary to the object and spirit of the provision in the Act; (2) whether the deduction was based on a transaction or arrangement which was not in accordance with normal business practice; and (3) whether there was a bona fide business purpose for the transaction. McDonald J.A., in dissent, took a much more restrictive view of the application of subsection 245(1). He acknowledged the relevance of object and spirit analysis, but interpreted the object and spirit of the relevant provisions according to the plain words of the provisions themselves. He also held that if the transaction which gave rise to the deduction was in keeping with the relevant sections of the Act, then it could not be artificial under subsection 245(1). Despite this disagreement in the Federal Court of Appeal, the Supreme Court of Canada has denied leave to appeal. In the absence of specific direction to the contrary by that Court, Strayer J.A.’s reasoning was to be preferred.

Both “artificial” and “undue” refer to the reduction of income which occurs as a result of the deduction claimed, and not the expense giving rise to the deduction. The argument that a deduction which arises from a real expense cannot unduly or artificially reduce income fails to recognize this distinction. By searching beyond the manner in which the expense arose, and focussing instead on the effect of the deduction on the taxpayer’s income, the factors adopted by Strayer J.A. in Fording avoided this error. The cornerstone of Strayer J.A.’s reasons in Fording was the understanding that it was the undue or artificial reduction of income as it related to this taxpayer which is under scrutiny, and not the legitimacy of the expense, arrangement or ensuing deduction in the abstract.

The Supreme Court of Canada in Stubart Investments Ltd. v. The Queen did not reject the business purpose test invoked by Strayer J.A. as a factor in the application of subsection 245(1). Estey J. declared that the adoption of the business purpose test might result in judicial disallowance of transactions which are expressly contemplated by the legislature as part of a larger economic policy, only in response to the argument that the business purpose test should be used as a general interpretive principle. The implicit concern was improper judicial intervention into the realm of legislative policy. But where Parliament has specifically directed the Court to consider whether a particular deduction unduly or artificially reduces income, it is appropriate for the Court to evaluate evidence of business purpose, as an indicator of the legitimacy of the deduction. Consequently, the business purpose test is a relevant factor in the subsection 245(1) analysis.

Just because a transaction technically may fit within the parameters of the Act, does not mean that it cannot unduly or artificially reduce income. Subsection 245(1) applies where, notwithstanding the genuineness of the legal relationship established by the taxpayer, a deduction based on such a transaction would unduly or artificially reduce income. Parliament chose to enact subsection 245(1). By applying that provision in appropriate cases, the Court is not usurping the legislative will, it is obeying it. While this approach may entail a certain element of discretion in the application of subsection 245(1), this cannot be entirely avoided for the assessment of object and spirit, consistency with ordinary business practice and evaluation of business purpose must, of necessity, proceed on a case-by-case basis.

The deductions sought unduly and artificially reduced the respondents’ income pursuant to subsection 245(1). A result different from that arrived at by the Tax Court Judge followed from an application of the three factors in Fording. (1) The respondents’ attempted use of the exploration expense provisions fell outside their intended object and spirit. Respondents did not in any way engage in the business which the exploration expense provisions were designed to promote. None of the goals of the policy allowing for this type of flow-through share arrangement were achieved as a result of the respondents’ fleeting investment at a time when no exploration or mining was being carried out or contemplated. Furthermore, the purpose of the cumulative CEE provision was to allow taxpayers to deduct only what they had actually expended in an exploration project, and not the full cost of a project which, in fact, received 80% of its funding from the government. In this case, because government assistance was not subtracted from the cumulative CEE total, the respondents claimed a deduction of 100% of the exploration expense, despite the fact that the government ultimately compensated the partnerships for 80% of those expenses. The effect for the government was a cost of more than 100% of the actual cost of exploration. Parliament cannot have intended such an absurd result in enacting these provisions. Finally, the purpose for which the respondents took advantage of this practice had nothing to do with the reason for which it may have been condoned by the PIP Administration. The respondents completely failed to bring themselves within the object and the spirit of the Act. (2) The transactions which allowed the respondents to claim the cumulative CEE deductions were far removed from normal commercial practice. At the time the interests were purchased in the limited partnerships, no potential for profit could have existed. The exploration activities, the raison-d’être for the limited partnerships, had long since been abandoned. Despite this, the respondents paid $1,800,000 and $1,080,000 each for interests which, within twenty-four hours, were sold for a mere $137 and $228 respectively. In addition, it was contrary to normal business practice to ensure, by way of a sale agreement, that the limited partnerships not be entitled to receive any government assistance until after the date when it was anticipated that the respondents would exercise their rights under the agreement and remove themselves from the limited partnerships. The transactions constituted a tax scheme, not a business deal. (3) There was no business purpose attached to the respondents’ participation in the limited partnerships. What the respondents attempted to achieve was unlawful tax avoidance. Subsection 245(1) should be applied to disallow the deductions sought.

Per McDonald J.A. (dissenting): The transaction was not captured by subsection 245(1).

The first step in the analysis was to assess whether the deduction artificially or unduly reduced income. The proper point of comparison is the result of the transaction and not the transaction itself. The taxpayers were members of a partnership that legitimately incurred CEE through its agent with respect to drilling off Canada’s east coast. Under the CEE regime, only members of the partnership at the end of the partnership’s fiscal year may deduct CEE. The taxpayers were members of the partnership at the end of the fiscal year. The provisions of the Act specifically resulted in attribution of the CEE to them as members of the partnerships at the end of the partnerships’ fiscal year. Subsection 245(1) cannot apply to defeat deductions where they arise by specific operation of the Act. The losses incurred by the limited partnership were real and came about as the result of real exploration and development. They were not created by manipulation of the Income Tax Act. Where a deduction arises by specific operation of the Act, it is not artificial or undue. Had Parliament intended subsection 245(1) to override deductions that arise by specific operation of the Income Tax Act, it would have used specific language to that end. In the absence of such language, it cannot be assumed that Parliament would disallow with one provision that which it has specifically allowed with others. The taxpayers did not directly engage in mining exploration, but their direct participation was not required by the Act. The flow-through share regime in the Income Tax Act was created to allow investment by parties that may not have otherwise participated in the industry. The money spent to join the limited partnerships went to a company actively involved in mining exploration. While it may seem repugnant that these taxpayers are able to reap the benefit of expenses not directly incurred by them, their favourable tax position was a product of the Act’s own provisions.

In any case, the object and spirit of the legislation was consistent with this result. When assessing the object and spirit of legislation, the Court may look to normal business practice, whether the transaction had a legitimate business purpose, and Parliamentary intent. (1) These types of financing arrangements were normal business practice in the industry at the time. (2) The purpose of the transactions was to purchase CEE losses to use as deductions against income. The taxpayers never intended to become active participants in the oil and gas exploration market. They claimed the deduction in their capacity as limited partners in an entity which did legitimately incur CEE and was actively involved in oil and gas exploration. For the general partner in the limited partnership, the transaction had a valid business purpose and the taxpayers achieved their deductions by virtue of their membership in the limited partnership. Further, the taxpayers’ investments in the limited partnerships had the effect of providing needed capital. The business purpose of the transaction was to provide capital for the mining company. (3) Parliament created the flow-through share scheme to encourage investment in a risky enterprise, all for the sake of the national energy policy. Also, there was some political will to encourage exploration off Canada’s east coast and potentially invigorate a depressed economy. The government was aware that the Act permitted these types of arrangements. Set in context, these deductions fit in with Canada’s energy strategy at the time. The taxpayers’ deductions were not artificial or undue as they arose by specific operation of the Act and were not inconsistent with the object and spirit of section 66.1.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Income Tax Act, R.S.C. 1952, c. 148, s. 137(1).

Income Tax Act, R.S.C. 1952, c. 148 (as am. by S.C. 1970-71-72, c. 63), ss. 20(1)(c)(i), 55(1) (as am. by S.C. 1980-81-82-83, c. 48, s. 24), 66.1(3) (as enacted by S.C. 1974-75-76, c. 26, s. 36; 1986, c. 2, s. 17), (6)(a) (as enacted by S.C. 1974-75-76, c. 26, s. 36; 1980-81-82-83, c. 48, s. 34; 1986, c. 55, s. 12; 1988, c. 55, s. 42), (b) (as enacted by S.C. 1974-75-76, c. 26, s. 36; 1976-77, c. 4, s. 24; 1980-81-82-83, c. 48, s. 34; 1986, c. 2, s. 17; c. 55, s. 12; 1987, c. 46, s. 19), (7) (as enacted by S.C. 1974-75-76, c. 26, s. 36; 1977-78, c. 1, s. 30; 1980-81-82-83, c. 45, s. 34), 88(1) (as am. by S.C. 1973-74, c. 14, s. 27; 1974-75-76, c. 26, s. 52; 1977-78, c. 1, s. 43; 1980-81-82-83, c. 48, s. 48), 96(1) (as am. by S.C. 1984, c. 1, s. 43), (a), (c), (d) (as am. by S.C. 1987, c. 46, s. 32), (f), (g), (2.5) (as enacted by S.C. 1986, c. 55, s. 25), 245(1), 247(1) (as am. by S.C. 1986, c. 6, s. 125), (2) (as am. idem), 248(1) “taxpayer”.

Partnership Act, R.S.A. 1980, c. P-2, s. 1(d).

Petroleum Incentives Program Act, R.S.C., 1985, c. P-13.

Petroleum Incentives Program Regulations, SOR/82-666, s. 11 (as am. by SOR/83-639, s. 2; 83-683, s. 4; 84-77, s. 3; 84-861, s. 2; 85-354, s. 1; 85-636, s. 6; 86-32, s. 3; 86-459, s. 5).

CASES JUDICIALLY CONSIDERED

APPLIED:

Canada v. Fording Coal Ltd., [1996] 1 F.C. 518 [1996] 1 C.T.C. 230; (1995), 95 DTC 5672; 190 N.R. 186 (C.A.); leave to appeal to S.C.C. denied [1996] 3 S.C.R. viii.

DISTINGUISHED:

R. v. Alberta and Southern Gas Co. Ltd., [1978] 1 F.C. 454 [1977] CTC 388; (1977), 77 DTC 5244 (C.A.); affd [1979] 1 S.C.R. 36; [1978] CTC 780; (1978), 78 DTC 6566; 23 N.R. 622; Edmonton Liquid Gas Ltd v The Queen, [1984] CTC 536; (1984), 84 DTC 6526; 56 N.R. 321 (F.C.A.).

CONSIDERED:

Inland Revenue Commissioners v. Westminster (Duke of), [1936] A.C. 1 (H.L.); Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; (1984), 10 D.L.R. (4th) 1; [1984] CTC 294; 84 DTC 6305; 53 N.R. 241; Furniss v. Dawson, [1984] A.C. 474 (H.L.); Snook v. London & West Riding Investments, Ltd., [1967] 1 All E.R. 518 (C.A.); Front & Simcoe Ltd. v. Minister of National Revenue, [1960] Ex. C.R. 350; [1960] C.T.C. 123; (1960), 60 DTC 1081; Naiberg, I. v. M.N.R., [1969] Tax A.B.C. 492 (T.A.B.); Canada v. Continental Bank Leasing Corp., [1996] 3 F.C. 713 (1996), 25 B.L.R. (2d) 149; [1997] 1 C.T.C. 13; 96 DTC 6355; 199 N.R. 9 (C.A.); Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; (1987), 36 D.L.R. (4th) 197; [1987] 1 C.T.C. 117; 87 DTC 5059; 25 E.T.R. 13; 71 N.R. 134; Commissioners of Inland Revenue v. Burmah Oil Co., [1981] T.R. 535 (H.L.); Minister of National Revenue v. Leon, [1977] 1 F.C. 249 [1976] C.T.C. 532; (1976), 76 DTC 6299; 13 N.R. 420 (C.A.); Weston’s Settlements, In re, [1969] Ch. 233 (C.A.); Canada v. Antosko, [1994] 2 S.C.R. 312; [1994] 2 C.T.C. 25; (1994), 94 DTC 6314; 168 N.R. 16; Canada v. Mara Properties Ltd., [1995] 2 F.C. 433 [1995] 2 C.T.C. 86; (1995), 95 DTC 5168; 179 N.R. 363 (C.A.); revd [1996] 2 S.C.R. 161; [1996] 2 C.T.C. 54; (1996), 96 DTC 6309; 197 N.R. 308; Spur Oil Ltd. v. R., [1982] 2 F.C. 113 [1981] CTC 336; (1981), 81 DTC 5168; 42 N.R. 131 (C.A.); Canada v. Irving Oil Ltd., [1991] 1 C.T.C. 350; (1991), 91 DTC 5106; 126 N.R. 47 (F.C.A.); Howard de Walden (Lord) v. Inland Revenue Commissioners, [1942] 1 K.B. 389 (C.A.); The Queen v. Nova Corporation of Alberta (1997), 97 DTC 5229 (F.C.A.).

REFERRED TO:

The Queen v Daly (J J), [1981] CTC 270; (1981), 81 DTC 5197; 38 N.R. 494 (F.C.A.); Susan Hosiery Ltd. v. Minister of National Revenue, [1969] 2 Ex. C.R. 408; [1969] C.T.C. 533; (1969), 69 DTC 5346; Dominion Bridge Co Ltd v The Queen, [1975] CTC 263; (1975), 75 DTC 5150 (F.C.T.D.); Lagacé v. Minister of National Revenue, [1968] 2 Ex. C.R. 98; [1968] C.T.C. 98; (1968), 68 DTC 5143; Gregory v. Helvering, 293 U.S. 465 (1935); Ramsay (W. T.) Ltd. v. Inland Revenue Comrs., [1981] 2 W.L.R. 449 (H.L.); R v Esskay Farms Ltd, [1976] CTC 24; (1975), 76 DTC 6010 (F.C.T.D.); McKee (G) v The Queen, [1977] CTC 491; (1977), 77 DTC 5345 (F.C.T.D.); Shulman, Isaac v. Minister of National Revenue, [1961] Ex. C.R. 410; [1961] CTC 385; (1960), 61 DTC 1213; affd [1962] S.C.R. viii; Fell (D) Ltd et al v The Queen, [1981] CTC 363; (1981), 81 DTC 5282 (F.C.T.D.); Consolidated-Bathurst Ltd. v. Canada, [1987] 2 F.C. 3 [1987] 1 C.T.C. 55; (1986), 87 DTC 5001; 72 N.R. 147 (C.A.).

AUTHORS CITED

Arnold, B. J. and J. R. Wilson. “The General Anti-Avoidance Rule—Part 1” (1988), 36 Can. Tax J. 829.

Brussa, John A. “The New Environment for Investment in the Oil and Gas Industry: Income Tax Aspects of Investment” in Report of Proceedings of the Thirty-Seventh Tax Conference. 1985 Conference Report. Toronto: Canadian Tax Foundation, 1986.

Canada. Department of Finance—Release, 94-106, November 10, 1994.

Carten, Michael A. “How-Through Share Financing” in Income Tax Considerations in Corporate Financing, 1986 Corporate Management Tax Conference. Toronto: Canadian Tax Foundation, 1987.

Driedger, E. A. Construction of Statutes, 2nd ed. Toronto: Butterworths, 1983.

Energy, Mines and Resources Canada. The National Energy Program, 1980.

Gideon, K. and R. Kent. “Mrs. Gregory’s Northern Tour: Canadian Proposals to Adopt the Business Purpose Rule and the Step Transaction Doctrine” in Report of Proceedings of the Thirty-Ninth Tax Conference, 1987 Conference Report. Toronto: Canadian Tax Foundation, 1988.

Hogg, Peter W. and J. E. Magee. Principles of Canadian Income Tax Law. Scarborough, Ont.: Carswell, 1995.

McKee, James G. “The Income Tax Implications of Flow-Through Shares” [1988] Canadian Petroleum Tax Journal 107.

Timbrell, D. Y. “Of Shams and Simulacra” (1973), 21 Can Tax J. 529.

Ziegel, Jacob S. et al. Cases and Materials on Partnerships and Canadian Business Corporations, 3rd ed., vol. 1. Scarborough, Ont.: Carswell, 1994.

APPEAL from Tax Court decision allowing taxpayers’ claim for deductions under Income Tax Act, section 66.1 (Central Supply Co. v. Canada, [1995] 2 C.T.C. 2320; (1995), 95 DTC 434 (T.C.C.)). Appeal allowed.

COUNSEL:

Jagmohan S. Gill, Patricia Lee and Margaret J. Nott for appellant.

Paul L. Schnier and Robert Jason for respondents.

SOLICITORS:

Deputy Attorney General of Canada for appellant.

Fogler, Rubinoff, Toronto, for respondents.

The following are the reasons for judgment rendered in English by

Linden J.A.: This appeal [[1995] 2 C.T.C. 2320 (T.C.C.)] involves the effect, if any, of one of the former anti-avoidance provisions contained in the Income Tax Act. More particularly, the issue is whether the former subsection 245(1) should be applied so as to disallow deductions of cumulative Canadian exploration expense claimed in the 1987 taxation year by two taxpayers, Central Supply Company (1972) Limited (Central) and Carousel Travel 1982 Inc. (Carousel), pursuant to subsection 66.1(3) and paragraph 66.1(6)(b) of the Income Tax Act.[1] Each of the taxpayers purported to become a member of limited partnerships for twenty-four hours on the final day of the fiscal years of each of the partnerships. As a result of this brief participation, this transitory or fleeting involvement, Central claimed a deduction of $10,000,000 and Carousel claimed a deduction of $6,000,000, which deductions were challenged by the Minister in reassessments. The Tax Court of Canada allowed the deductions. As will be seen, I disagree with this conclusion.

Subsection 245(1), as it then was, read as follows:[2]

245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

The disposition of this appeal turns primarily on how this partial anti-avoidance provision ought to be interpreted and applied on the facts of this case. The parties to this appeal take fundamentally different positions on this issue. The Minister, in brief summary, has submitted that subsection 245(1) ought to be applied to disallow deductions which, even if they may appear to be permitted by some provision of the Act, are inconsistent with the object and spirit of the deduction provision, are inconsistent with ordinary business practice and exhibit no business purpose. In short, the taxpayers have argued, however, that subsection 245(1) cannot be applied where the deduction sought falls within the object and spirit of the provision and has arisen by operation of a specific provision in the Act.

I.          BACKGROUND

Prior to 1988, Canada had no general anti-avoidance rule (GAAR), unlike many other countries which did.[3] Furthermore, the spirit of Inland Revenue Commissioners v. Westminster (Duke of)[4] was the reigning judicial attitude toward tax avoidance schemes, save for some limited exceptions. In that case, Lord Tomlin of the House of Lords held that “[e]very man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be”.[5] Although the Supreme Court, in Stubart Investments Ltd. v. The Queen,[6] modified the strict and literal approach to interpretation espoused in Westminster with a more purposive approach which was cognizant of the “object and spirit” of the Act, it remained generally loyal to the Westminster rule. The legacy of Stubart continues as the proper approach to the interpretation of taxing legislation, but it sheds no direct light on the application of subsection 245(1) of the Act. The precursor to subsection 245(1), subsection 137(1) [R.S.C. 1952, c. 148], was not argued in Stubart, to which Estey J. adverted in his reasons on several occasions. As a result, the interpretation and application of subsection 245(1) cannot be much influenced by the Stubart case.

A brief survey of the judicial exceptions to the Westminster doctrine that have developed will assist our understanding of the role to be played by subsection 245(1) as a legislative curb on tax avoidance. Despite several attempts to expand the range of judicial tools for limiting avoidance schemes, only two of them have survived in Canada; these are the “ineffective transactions” doctrine and the “sham” doctrine. The “ineffective transactions” doctrine is applied to deductions or tax benefits when “the intended legal results [are] not achieved”; in such a case the taxpayer must be taxed according to the legal result which is actually produced.[7] As a result of their legal ineffectiveness, such transactions “do not come to be considered as shams or artificial transactions because their ineffectiveness prevents their even opening the door into the room where tax avoidance is the subject for discussion”.[8] In this sense, it may not be entirely accurate to characterize judicial prohibition of legally ineffective transactions as an anti-avoidance measure. Rather, it is the “obvious corollary to the general rule that tax is imposed according to the legal relationships on transactions established by the parties”.[9]

A sham is different from an ineffective transaction. A transaction is called a sham when an arrangement creates the appearance of certain rights and obligations which mask the true intent of the parties involved. This usually involves an element of deceit or even fraud. The classic description of a “sham” is found in Lord Diplock’s judgment in Snook v. London& West Riding Investments, Ltd.,[10] that which gives “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”.[11] As a result of its ability to disguise an underlying transaction, the remedy for a sham is to replace it with the transaction which actually underlies it. The sham doctrine has been incorporated into the Canadian common law. In Stubart, Mr. Justice Estey explained that, in Canadian law, deceit was the “heart and core of a sham.”[12] The requisite element of deceit, however, means that the “sham” doctrine is rarely invoked as an anti-avoidance device by courts, although it has been on occasion.[13]

In contrast to the ineffective transaction and sham doctrines, the other judicial anti-avoidance concepts which have surfaced have had little impact on the jurisprudential landscape. Among them are the “substance over form” doctrine, the “business purpose” test, and the “step transaction” analysis. First, despite the fact that the economic or commercial “substance” of a transaction often differs from its legal form, in many cases Canadian courts have held that the legal effect of a transaction is controlling of its substance. In Stubart, for example, the Supreme Court “accepted the legal forms (sale and agency agreement), although the commercial substance of the arrangement was that Stubart had not divested itself of the business”.[14] In other cases, however, courts have demonstrated a willingness to overcome the legal formalities of a transaction in order to characterize it for tax purposes according to its substance.[15] In particular, Bronfman Trust v. The Queen[16] constitutes a substantial exception to the Supreme Court’s unwillingness to engage in substance analysis. Dickson C.J. concluded in that case that:[17]

Assessment of taxpayers’ transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer’s sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

On the facts, Dickson C.J. found that the Court could not disregard the direct and ineligible use of borrowed money in favour of the indirect and eligible use upon which the taxpayer sought to claim an interest deduction pursuant to subparagraph 20(1)(c)(i). Clearly, these differing views on the availability of substance over form analysis mean that the status of that analysis as a viable limit on tax avoidance is somewhat unclear at the present time.

Second, despite frequent discussion of it in tax law jurisprudence, the “business purpose” test was firmly rejected as a general interpretive principle by the Supreme Court in Stubart.[18] By contrast, the business purpose test has enjoyed a long and illustrious history in the United States jurisprudence.[19] More recently, the business purpose test has also taken root in the House of Lords’ jurisprudence, particularly in the context of assessing multi-step transactions. This is perhaps best reflected in Furniss v. Dawson[20], a House of Lords decision in which it was held that, where no business purpose existed for a particular step in a multi-step commercial transaction, the transaction should be treated, for tax purposes, as if the purely tax motivated step had not occurred.[21]

This Court’s decision in Minister of National Revenue v. Leon[22] has been the only serious attempt to give the business purpose test a central role in the arsenal of Canadian judicial responses to tax avoidance schemes. Heald J.A., writing for this Court, articulated the following proposition:[23]

It is the agreement or transaction in question to which the Court must look. If the agreement or transaction lacks a bona fide business purpose, it is a sham.

Heald J.A., was attempting to broaden the traditional “sham” doctrine by infusing it with the concept of bona fide business purpose. Despite increasing acceptance of the business purpose test in other jurisdictions, however, this effort was unsuccessful. Estey J. refused, in Stubart, to incorporate the business purpose test into Canadian law. He stated:[24]

I … reject the proposition that a transaction may be disregarded for tax purposes solely on the basis that it was entered into by a taxpayer without an independent or bona fide business purpose. A strict business purpose test in certain circumstances would run counter to the apparent legislative intent which, in the modern taxing statutes, may have a dual aspect. Income tax legislation, such as the federal Act in our country, is no longer a simple device to raise revenue to meet the cost of governing the community. Income taxation is also employed by government to attain selected economic policy objectives.

Since Stubart, the business purpose test, as a general principle of interpretation, has not been utilized in Canada. Further, without the assistance of the business purpose test, the potential for the “step transaction” analysis, which has evolved in the United Kingdon recently, is greatly circumscribed. In sum, judicial anti-avoidance devices have been sparsely used in Canada.

Consequently, any meaningful distinction between lawful and unlawful tax avoidance must come mainly from legislative anti-avoidance measures, not judicially created ones. This fact must be kept squarely in mind when interpreting the anti-avoidance provisions which are found in the Act, and to which I now turn.

The former subsection 245(1) was one of a number of partial anti-avoidance measures in the Act which attempted to prevent specific kinds of anti-avoidance schemes or transactions. Among them was, first, subsection 55(1) [as am. by S.C. 1980-81-82-83, c. 48, s. 24], which restricted capital gains or losses which artificially or unduly reduced income. This avoidance provision, which was first introduced in 1972, is described by Arnold and Wilson as “the counterpart of subsection 245(1)”.[25] Second, former subsection 247(1) [as am. by S.C. 1986, c. 6, s. 125] was enacted in order to control the use of dividend stripping schemes which sought to reduce the assets of a corporation so that tax on the distribution of the corporation’s income to individual taxpayers was also reduced.[26] Third, subsection 247(2) [as am. idem] provided the Minister with the power to characterize two corporations as being “associated with one another” for a particular taxation year if the Minister believed that “one of the main purposes for the separate existences of the corporations was to reduce tax”.[27] Fourth, and finally, subsection 245(1) was enacted in order to prevent undue or artificial reduction of income arising out of a deduction made “in respect of a disbursement or expense”. All of these anti-avoidance provisions were repealed in 1988 [c. 55] in order to make way for the new general anti-avoidance rule (GAAR).

Each of these anti-avoidance provisions was aimed at a particular subset of tax avoidance schemes. In this sense, and in contrast to the current GAAR, they can best be characterized as “partial” anti-avoidance rules.[28] Despite their partial nature, however, they indicate beyond question that, even prior to the new GAAR, Parliament intended to draw a line between lawful and unlawful tax avoidance. As a result, while it may not be the role of Canadian courts to apply anti-avoidance doctrines as general principles of interpretation, they must respect the existence of particular tax avoidance provisions in the Act. Estey J. pointed to this fact in Stubart.[29] Commenting on subsection 137(1), the predecessor of subsection 245(l), he held that:[30]

This instruction is, like the balance of the Act, introduced as well for the guidance of the courts in applying the scheme of the Act throughout the country. The courts may, of course, develop, in their interpretation of s. 137, doctrines such as the bona fide business purpose test; or a step-by-step transaction rule for the classification of taxpayers’ activities which fall within the ban of such a general tax avoidance provision.

Estey J.’s statement underscores the importance of fair judicial application of legislative restrictions on tax avoidance. This is a task which the courts must undertake keeping in mind that, although certainly permitted, in the words of Lord Denning, “[t]he avoidance of tax … is not yet a virtue”.[31]

The Westminster doctrine provided no insight into the means by which this judicial task ought to be accomplished.[32] As the House of Lords recognized in Commissioners of Inland Revenue v. Burmah Oil Co., the Westminster dictum:[33]

… tells us little or nothing as to what methods of ordering one’s affairs will be recognised by the courts as effective to lessen the tax that would attach to them if business transactions were conducted in a straight-forward way. The Duke of Westminster’s case was about a simple transaction entered into between two real persons each with a mind of his own …. The kinds of tax-avoidance schemes that have occupied the attention of the courts in recent years, however, involve inter-connected transactions between artificial persons, limited companies, without minds of their own but directed by a single master-mind.

It tells us nothing to assist in our approach to a legislated anti-avoidance provision such as subsection 245(1). In order to inject meaning into subsection 245(1), this Court must, therefore, employ concepts and ideas, as indicated by Estey J. in Stubart, which will assist in drawing a more subtle line between lawful and unlawful tax avoidance than the overly general Westminster doctrine is capable of doing.

With this background in mind, I turn now to the existing law on the interpretation and application of subsection 245(1).

II.         THE LAW

Although the Supreme Court has commented recently on the interpretation of specific taxing provisions and has remained true to the approach articulated in Stubart,[34] it has yet to decide the extent to which different considerations apply where Parliament has specifically provided for the policing of unlawful tax avoidance as it did in subsection 245(1). The recent case of Canada v. Mara Properties Ltd.[35] does not stand for the proposition that the Supreme Court has adopted a narrow approach to subsection 245(l). In Mara Properties, Marceau J.A. (Stone J.A. concurring) held that land acquired by a taxpayer did not become part of its inventory which could, when disposed of, be treated as a business loss. In dissent, McDonald J.A. would have allowed the taxpayer’s scheme on the grounds that it did not run afoul of either subsection 88(1) [as am. by S.C. 1973-74, c. 14, s. 27; 1974-75-76, c. 26, s. 52; 1977-78, c. 1, s. 43; 1980-81-82-83, c. 48, s. 48] or subsection 245(1). He reasoned that “the claimed loss … cannot be artificial because the loss is the product of a statutory deeming provision … to which effect must be given”.[36] On appeal, the Supreme Court agreed with the result reached by McDonald J.A. in an oral disposition of the case.[37] No reference was made, however, to whether the Court agreed with McDonald J.A.’s reasons on subsection 88(1) or with his interpretation of subsection 245(1). It is important to note also that subsection 245(1) was not argued before the Supreme Court.

This Court has, however, reflected on the application of subsection 245(1), most recently in Canada v. Fording Coal Ltd.[38] In applying subsection 245(1) to deductions taken by a taxpayer for cumulative Canadian exploration expense (CCEE) and cumulative Canadian development expense (CCDE), Strayer J.A., writing for himself and Décary J.A., set out three factors relevant to the determination of whether a taxpayer has unduly or artificially reduced its income. These were, first, whether the deduction sought is contrary to the object and spirit of the provision in the Act, second, whether the deduction is based on a “transaction or arrangement which is not in accordance with normal business practice”, and third, whether there was a bona fide business purpose for the transaction.[39] Strayer J.A., in conformity with Stubart, was careful to qualify the importance of a bona fide business purpose by stating that, although it “is not determinative of the artificiality of the deduction”, it “is certainly relevant”.[40]

On the basis of these three factors, Strayer J.A. found in Fording that attempted deductions for CCEE and CCDE unduly and artificially reduced the taxpayer’s income pursuant to subsection 245(1). Strayer J.A. disallowed the deductions notwithstanding the fact they had arisen through specific authorization of the Act. In support of this finding, he reasoned:[41]

… if subsection 245(1) has no application to deductions otherwise permitted by the Act then I can see no purpose or effect for this subsection. Nor should it be seen as a general provision which must be considered overridden by “special” provisions which permit deductions in certain circumstances. The Act must be read as a whole. It must be assumed that Parliament contemplated that deductions permitted under the criteria specified elsewhere in the Act could in some situations unduly or artificially reduce income, in which case they would be disallowed under subsection 245(1).

There has not been unanimous agreement on this approach, however. McDonald J.A., in dissent in Fording, took a much more restrictive view of the application of subsection 245(1). First, although he acknowledged the relevance of object and spirit analysis, McDonald J.A. interpreted the object and spirit of the relevant provisions according to the plain words of the provisions themselves.[42] The second feature of this restrictive view was articulated by McDonald J.A. as follows:[43]

To determine whether a deduction will cause an artificial reduction of a taxpayer’s income, it is necessary to examine the transaction which gave rise to the deduction in question. If that transaction is in keeping with the relevant sections of the Act itself, then it cannot be artificial under subsection 245(1).

This position is consistent with McDonald J.A.’s earlier view in Mara Properties. Marceau J.A. also took a similar view of subsection 245(1) in that case, although he did not decide on the basis of subsection 245(1).[44]

Despite this disagreement, leave to appeal to the Supreme Court in Fording has been denied, [[1996] 3 S.C.R. viii]. As a result, I am faced, on this appeal, with two conflicting visions of the role to be played by subsection 245(1). In the absence of any specific direction to the contrary by the Supreme Court, I prefer the reasoning of Strayer J.A., which, in my view, best captures the purpose for which this provision was enacted by Parliament.

In Spur Oil Ltd. v. R., Heald J.A. defined “undue” according to its dictionary meaning of “excessive”, and “artificial” as meaning “simulated” or “fictitious”.[45] These definitions were subsequently adopted by Mahoney J.A. in Canada v. Irving Oil Ltd.[46] The term “undue” can further be described as synonymous with “exaggerated” and “exorbitant”. The word “artificial”, might also be explained by adjectives such as “synthetic”, “inauthentic”, “concocted”, “abnormal”, “unnatural”, “fabricated”, “contrived”, “invented” and “disingenuous”. One need not go so far as “deceitful”, “fictitious”, “phony”, “falsified”, “fake”, or “fraudulent”, the concepts involved in a “sham” determination, but these ideas would certainly be included in the idea of artificiality. A comparison of these two groups of synonyms suggests that the “artificial” reduction of income erects a higher threshold for the application of subsection 245(1) than is required by the “undue” reduction of income. This is because the term “artificial” implies an element of fabrication which is not present in the term “undue”. Regardless of this difference, however, both of these words refer to the reduction of income which occurs as a result of the deduction claimed, and not the expense giving rise to the deduction. This distinction is, I believe, critical to a proper understanding of the purpose of subsection 245(1). The often-raised argument that a deduction which arises from a real expense cannot unduly or artificially reduce income fails to recognize this distinction. By searching beyond the manner in which the expense arose, and focusing instead on the effect of the deduction on the taxpayer’s income, the factors adopted by Strayer J.A. in Fording avoid this error.

The cornerstone of Strayer J.A.’s reasons in Fording is, however, the understanding that it is the undue or artificial reduction of income as it relates to this taxpayer which is under scrutiny, and not the legitimacy of the expense, arrangement or ensuing deduction in the abstract. Mahoney J.A. articulates this idea in Irving Oil when he states that, in order to fit within subsection 245(1), “a transaction or operation must have the effect of unduly or artificially reducing income; the artificiality of the transaction or operation itself does not determine the issue”.[47] In the words of Strayer J.A., “the central issue is the undue or artificial nature of the reduction of income, not the artificiality of the transaction in question”.[48] The tools for exploring this “central issue” are an analysis of the object and spirit of the particular provision, an assessment of whether the transaction accords with normal business practice and whether it has an identifiable business purpose.

Parliament has indicated its desire to set limits on the permissible scope of tax avoidance through the former subsection 245(1) and other similar anti-avoidance provisions. The particular criteria adopted by Strayer J.A. to assess the undue or artificial reduction of income constitute a sound mechanism by which courts can be true to this legislative goal. As discussed above, the terms “undue” and “artificial” focus on conduct which is “excessive” or “exaggerated” at best, and “simulated”, “synthetic” or “contrived” at worst. In enacting anti-avoidance laws such as subsection 245(1), Parliament indicated that it could not, in drafting specific taxing provisions, anticipate every conceivable manipulation of the wording of that provision. Avoidance schemes which are concocted to take advantage of the literal wording of taxing provisions are notoriously difficult to anticipate precisely because they do not seek to satisfy the intended object or spirit of the provision, nor are they anchored by a commercial logic or business purpose. For this reason, they often lie outside the bounds of what might reasonably be contemplated by the legislature in enacting a particular provision of the Act. In measuring tax avoidance schemes against these three factors, however, courts may effectively limit the kinds of arrangements giving rise to expenses or deductions provided by the Act to those which could reasonably have been intended by Parliament or, in other words, do not unduly or artificially reduce income.

It is wrong to say that Strayer J.A.’s invocation of the business purpose test as a factor in the application of subsection 245(1), was rejected in Stubart. In that case, where a taxpayer had devised a scheme to take advantage of the losses of an ailing subsidiary, section 137 of the Act (now section 245) was specifically not argued by the Attorney General. Instead, borrowing from the American approach, the business purpose test was argued as a general interpretive principle. It was in response to this argument that Estey J. declared that the adoption of the business purpose test might result in judicial disallowance of transactions which are expressly contemplated by the legislature as part of a larger economic policy.[49] The implicit concern is improper judicial intervention into the realm of legislative policy. Where, however, Parliament has specifically directed the Court to consider whether a particular deduction unduly or artificially reduces income, it is appropriate for the Court to evaluate evidence of business purpose, as an indicator, at least in part, of the legitimacy of the deduction. Estey J. specifically recognized this point in obiter when he offered the following advice to assist in interpreting the former section 137 of the Act:[50]

1.   Where the facts reveal no bona fide business purpose for the transaction, s. 137 may be found to be applicable depending upon all the circumstances of the case.

Consequently, in my view, following Strayer J.A. in Fording, it is clear that the business purpose test is a relevant factor in the subsection 245(1) analysis.

Turning to another underlying controversy surrounding subsection 245(1), I am unpersuaded that, just because a transaction technically may fit within the parameters of the Act, it cannot unduly or artificially reduce income. Legal effectiveness was one of three interpretive principles identified by the House of Lords in the Westminster case.[51] Certainly, the legal effectiveness of a transaction is critical to establishing the propriety of a deduction arising from the transaction. In cases where the wording of a specific tax provision is clear and unambiguous, it may even serve as a sufficient condition, as occurred in Stubart. To suggest, however, that legal effectiveness also enables a taxpayer to escape the application of subsection 245(1) would entirely eviscerate the effect of this provision. Strayer J.A. correctly explained the law in Fording when he stated:[52]

… this subsection applies where, notwithstanding the genuineness of the legal relationship established by the taxpayer, a deduction based on such a transaction would unduly or artificially reduce income.

Strayer J.A.’s conclusion on this point is unavoidable. In fact, to find otherwise would violate the very rationale which motivated Estey J. to reject reliance on the business purpose test or other judicial anti-avoidance doctrines as general canons of interpretation in Stubart.

Further support for the position that subsection 245(1) can be applied to disallow a deduction notwithstanding that it may literally come under a specific provision of the Act is found in a comparison of the Canadian law with that of other countries. In Stubart, Estey J. adopted a cautious attitude toward judicial anti-avoidance doctrines on the understanding that, in Canada, “the legislature has responded to the need for overall regulation to forestall blatant practices designed to defeat the Revenue” through various anti-avoidance provisions.[53] This, he noted, is in marked contrast to other jurisdictions such as the United States and the United Kingdom, in which no such legislative provisions had been enacted. In the absence of statutory control devices, judicially created anti-avoidance doctrines are understandable.[54] The implicit conclusion is that the Supreme Court’s reluctance to endorse the use of judicial anti-avoidance doctrines as general interpretive principles is premised on the fact that anti-avoidance measures are already in place within the legislative framework and that the use of such doctrines should primarily occur within the confines of such provisions. To carry this attitude of reluctance over to the interpretation of subsection 245(1) would seriously undercut the very basis on which it was justified.

International comparison suggests that although few countries rigorously enforce both judicial and legislative anti-avoidance rules, most countries actively employ at least one or the other. According to Arnold and Wilson:[55]

Although the two approaches are not mutually exclusive (for example, the Netherlands has a statutory general anti-avoidance rule and also applies the abuse of rights doctrine), most countries have adopted just one approach. For example, the United Kingdom and the United States have developed broad judicial doctrines but have not enacted any statutory general anti-avoidance rule. In contrast, Canada, Australia, and New Zealand have enacted statutory rules and have not adopted broad judicial anti-avoidance doctrines.

In conclusion, I reiterate simply that Parliament chose to enact subsection 245(1). By applying that provision in appropriate cases, this Court is not usurping the legislative will, it is obeying it.

Finally, I recognize that the approach which I am advocating may entail a certain element of discretion in the application of subsection 245(1). This cannot be entirely avoided for the assessment of object and spirit, consistency with ordinary business practice and evaluation of business purpose must, of necessity, proceed on a case-by-case basis. This case-by-case approach is often criticized for its lack of certainty, particularly by those whose brilliant tax structures are found by courts to be unlawful. As one American commentator pointed out, however, some uncertainty is “an inevitable part of modern taxing systems”.[56] Furthermore, such uncertainty exists mainly where taxpayers are engaged in probing the outer limits of the distinction between permissible and impermissible tax avoidance. In the light of this, as Lord Greene pointed out in Howard de Walden (Lord) v. Inland Revenue Commissioners, “[i]t scarcely lies in the mouth of the taxpayer who plays with fire to complain of burnt fingers”.[57] When you roll the dice, you do not always win; you may lose.

III.        THE RESPONDENTS’ ARRANGEMENT

In this case, the expense provisions upon which the respondents have relied in order to claim deductions of $10,000,000 and $6,000,000 each were subsection 66.1(3) and paragraph 66.1(6)(b) of the Act. Subsection 66.1(3) then provided that a taxpayer other than a principal-business corporation was entitled to deduct, in computing his income for a taxation year, the amount not exceeding the taxpayer’s cumulative Canadian exploration expense as determined at the end of the year. Cumulative Canadian exploration expense (”cumulative CCEE”) was defined in paragraph 66.1(6)(b). The Tax Court Judge [at page 2335] described the deduction as “a cumulative, continuing pool of expenses … to which defined exploration expenses such as seismic and drilling costs are added and from which certain sums received or receivable are deducted”. A “Canadian exploration expense” (“CEE”) is defined in paragraph 66.1(6)(a) [as enacted by S.C. 1974-75-76, c. 26, s. 36; 1980-81-82-83, c. 48, s. 34; 1986, c. 55, s. 12; 1988, c. 55, s. 42] of the Act and relates generally to expenses incurred for the purpose of drilling or completing an oil or gas well. The sums which are deducted from the “pool” include grants which the taxpayer is entitled to receive from the Government of Canada through the Petroleum Incentives Program Act [R.S.C., 1985, c. P-13] (the PIP) which provides payments for 80% of “eligible exploration expenses” for “qualified persons” as part of a strategy to encourage investment in this industry.[58]

Paragraph 66.l(6)(a)[59] sets out the conditions under which a taxpayer may incur CEE deduction as follows:

66.1 (6)(a) …

(iv) subject to section 66.8 his share of any expense referred to in any of subparagraphs (i), (i.l) (ii), (ii.l), (iii) or (iii.l) incurred by a partnership in a fiscal period thereof, if, at the end of that period he was a member thereof, or

(v) any expense referred to in any of subparagraphs (i) to (iii.1) incurred by the taxpayer pursuant to an agreement in writing with a corporation, entered into before 1987, under which the taxpayer incurred the expense solely as consideration for shares, other than prescribed shares, of the capital stock of the corporation issued to him or any interest in such shares or right thereto,

but, for greater certainty, shall not include

(vi) any consideration given by the taxpayer for any share or any interest therein or right thereto, except as provided by subparagraph (v), or

(vii) any expense described in subparagraph (v) incurred by any other taxpayer to the extent that the expense was,

(A) by virtue of that subparagraph, a Canadian exploration expense of that other taxpayer,

The steps by which the respondents allege to have brought themselves within subsection 66.1(3) and paragraph 66.1(6)(b) in order to claim the sizable deductions are somewhat complex. On December 14, 1987, the respondents purchased interests in four limited partnerships which had been engaged in financing an unsuccessful oil and gas exploration project called the “Northcor et al. Narwhal F-99 well”, located off the east coast of Canada.[60] The certificate of limited partnership filed for each specified that the partnerships were formed for a number of business purposes, including the acquisition, exploration, development, operation and sale of oil, natural gas and petroleum substances. The limited partnerships each entered into a “Share Subscription Agreement” which allowed Northcor Energy Limited (Northcor), a junior exploration company, to carry on drilling as an agent for the partnership and at the expense of the partnership. Each partnership agreed to fund Northcor for 20% of the exploration costs incurred by Northcor, and further agreed to assign its rights to government assistance.[61] The assignment of government assistance would cover the remaining 80% of exploration expense. Any government assistance applied for and received by Northcor as a result of the assignment would be paid to the partnerships.[62] As consideration, each partnership was granted the right to purchase shares in Northcor.[63] Finally, the agreements specified that the partnerships would incur the exploration expense for the purposes of subparagraph 66.1(6)(a)(v) of the Act.[64] The allocation of profit and loss, including the CEE and PIP payments, was to be determined at the end of the fiscal year in accordance with a 99.9% interest to the limited partners pro rated according to the interests held by each.[65]

By October 1, 1987, after $17,500,000 had been expended on behalf of the partnerships, it was determined that the drilling at the Narwhal F-99 well had been unsuccessful and abandonment operations were commenced. Following this, the partnerships were engaged solely in winding-up activities. On December 10, 1987, Encee, the owner of Northcor, purchased 20, 000 limited partnership interests in the four partnerships. On December 14, 1987, these interests were sold to 747942 Ontario Limited (747942) and a portion were resold to the respondents on that same day. Each time, the certificates of limited partnership were amended to reflect the new ownership of interests. The “Sale and Purchase Agreement” that was concluded between Encee and 747942 provided that the limited partnerships would not be entitled to any government grants prior to December 15, 1987.[66] At the same time that the “Sale and Purchase Agreement” was concluded between Encee and 747942, a “Put Agreement” was also executed which granted 747942 the right to compel a controlled subsidiary of Encee (NRI Holdings Ltd.) to purchase all of its partnership interests at any point until December 31, 1987, at $.01 per unit.[67] The subsequent agreements between 747942 and Carousel and Central, each titled the “Assignment and Novation Agreement Re: Sale and Purchase Agreement”, sold to the respondents portions of the interests held by 747942 on the last day of the 1987 fiscal year of the partnerships.[68]

Carousel purchased such interests in the partnerships as would result in $6,000,000 of the CEE being allocated to it at the end of the 1987 fiscal period, for a purchase price of $1,080,000. Central obtained interests in the partnerships as would result in $10,000,000 of the CEE being allocated to it at the end of the 1987 fiscal period, for $1,800,000.

On December 15, 1987, the respondent taxpayers exercised their rights under the Put Agreement and conveyed their limited partnership interests to NRI at the designated price per unit. Their names were deleted from the certificates of limited partnership twenty-four hours after they had been added to them. The PIP payments that had been postponed were later paid to NRI which had sufficient losses to shelter this revenue tax free.

The Tax Court Judge allowed the deductions sought by the taxpayer. His reasons are very briefly summarized in the following conclusion [at page 2363]:

In summary, the appellants became members of four limited partnerships on the last day of their 1987 fiscal periods in which such partnerships incurred [exploration expenses]. Their partnership interests were “exempt interests” within the meaning of the Act. The transactions were not a sham. The Act provided specifically for the deduction of expenses of a partner at the end of a partnership’s fiscal period. There being no other person entitled thereto, and with a deduction being clearly contemplated by the legislation, the deduction claimed fell within the object of the incentive provisions discussed. The partnerships were not entitled to and did not receive any PIPs in the 1987 fiscal period. The deductions made by the appellants’ deductions did not unduly or artificially reduce their income. Each appellant declared the capital gain arising on the disposition of its interest in the four partnerships.

The tenor of the Tax Court Judge’s reasons was that the deduction of an expense which actually and legitimately arises cannot be contrary to the plain wording or object and spirit of the Act, even if the deduction is claimed by a different taxpayer as a result of a pure tax avoidance scheme created especially for the purpose.

It is on the basis of this background that the respondents’ claim for deductions of $10,000,000 and $6,000,000 for exploration expenses incurred in relation to the Narwhal F-99 well must be considered.

IV.       ARGUMENTS ON APPEAL

The appellant Minister contends before this Court that the taxpayers’ scheme falls short of its intended result on three main grounds and three alternative grounds. First, it is submitted that subparagraphs 66.1(6)(a)(iv) and (v) do not apply to the respondents. Subparagraph 66.1(6)(a)(iv), although it refers to partnerships, cannot be read as an “allocation provision” for an expense incurred pursuant to subparagraph 66.1(6)(a)(v). In support, they cite the fact that subparagraph 66.1(6)(a)(iv) does not refer in any way to expenses incurred in subparagraph 66.1(6)(a)(v), the fact that it precedes rather than follows 66.1(6)(a)(v) and the fact that it is separated from subparagraph 66.1(6)(a)(v) by the disjunctive “or”. Instead, it is submitted, subparagraph 66.1(6)(a)(iv) deals with expenses directly incurred by a partnership rather than pursuant to an agreement with an exploration company, as occurred in this case. The respondents are also ineligible for the deductions under subparagraph 66.1(6)(a)(v), it is submitted, as this subparagraph refers to “taxpayers” and a partnership is not a taxpayer under the Act. Instead, the income and loss of a partnership is included as the income and loss of each of the partners pursuant to paragraphs 96(1)(a), (f) and (g). More specifically, in this case, paragraph 96(1)(d) [as am. by S.C. 1987, c. 46, s. 32] requires that income or loss of the partnership be computed with the CEE excluded. It is treated for tax purposes as if it was incurred directly by the partners at the end of the year.

Second, it is argued that the taxpayers did not become members of the limited partnerships on December 14, 1987 because they did not carry on business in common with a view to profit. The appellant takes the position that although Part 2 of the Partnership Act of Alberta establishes the limited liability of certain partners by restricting their ability to actively control the partnership, it does not otherwise excuse compliance by those persons with the definition of partnership contained in paragraph 1(d) of the Partnership Act. To this extent, the Minister argues, a limited partnership is the same as an ordinary partnership, and each new member must, upon entry into the partnership, satisfy the condition of carrying on business in common with a view to profit. Such did not occur, the Minister maintains, in this case, and so the respondents are not entitled to reap the tax rewards of the business which was once carried on by those partnerships.

Third, the Minister takes the position that subsection 245(1) should be applied to disallow the deductions on the ground that they unduly or artificially reduced the taxpayers’ income. He relies on Fording to argue in this case that the respondents’ twenty-four hour participation in the limited partnerships was contrary to the object and spirit of section 66.1, devoid of business purpose and contrary to ordinary commercial practice. The latter is evidenced, according to the appellant, by the fact that the respondents did not intend to carry on business in common with others for profit and could not expect that any potential for profit existed in their limited partnership interests. The appellant submits that the deductions taken by the respondents were contrary to the object and spirit of the legislation because they represented a cost to the government of more than 100% of the actual cost of exploration and because the respondents’ brief membership in the partnerships during their winding-up phase could not be characterized as an investment in a junior resource company, in keeping with the purpose of the legislation.

Fourth, and in the alternative, it is submitted that the partnerships could not incur more than 20% of the exploration expense associated with the Narwhal F-99 well because Northcor had no recourse against the partnerships for payment of the remaining 80% of exploration expense and, even if it did have such recourse, the partnerships’ liability for such expenses was contingent upon payment of PIP assistance. Fifth, and in the alternative, the Minister argues that the taxpayers were “entitled to receive” PIP payments pursuant to subparagraph 66.1(6)(b)(ix) during the 1987 fiscal year which ought to have reduced the cumulative CEE deduction taken despite the fact that payments had not yet been received. Sixth, and in the final alternative, it is argued that the taxpayers’ interests were not “exempt interests”, pursuant to subsection 96(2.5) [as enacted by S.C. 1986, c. 55, s. 25] of the Act, and so the deductions which the respondents could claim were limited to their “at-risk” amounts.

The respondent taxpayers, in summary, contend that they should be able to claim the cumulative CEE deductions because they brought themselves within the literal wording of subsection 66.1(3) and paragraph 66.1(6)(b) by purchasing and then reselling one day later interests in limited partnerships which had large exploration expenses remaining on the last day of the fiscal year in which they had been incurred. They maintain that their eligibility for cumulative CEE arises either under the conditions set out in subparagraph 66.1(6)(a)(iv) or (v). In support, they submit first that a partnership is a taxpayer within the meaning of the Act since a taxpayer is defined in subsection 248(1) as any “person” whether or not they are liable to pay tax, and paragraphs 96(1)(a) and (c) expressly characterize a partnership as a separate “person” for the purposes of calculating a taxpayer member’s income. The practice of treating a partnership as a taxpayer for the specific purpose of subparagraph 66.1(6)(a)(v) was adopted by Revenue Canada, it is submitted, in order to adopt the CEE rules to a situation in which a partnership entered into a flow-though share agreement. Irrespective of whether or not subparagraph 66.1(6)(a)(v) applies to partnerships, however, the respondents’ second submission on this issue is that they are entitled to a share of the partnerships’ CEE directly through subparagraph 66.1(6)(a)(iv). This entitlement, it is argued, is not dependent upon the partnership’s ability to incur exploration expense as a taxpayer pursuant to subparagraph 66.1(6)(a)(v).

In defence of the validity of their membership in the limited partnerships, the respondents contend, as a result of Part 2 of the Partnership Act, the requirement of carrying on business with a view to profit applies only to the general partner at the time the limited partnership was established. Part 2 of the Partnership Act, they argue, provides an express scheme for dealing with the continuity of limited partnerships, so that neither Part 1 of the Partnership Act nor the common law are relevant to deciding the effect of a change in membership. The only pertinent factor in this case, according to the respondents, is that they met the Alberta statutory requirements for membership in a limited partnership on December 14, 1987.

Finally, in response to the Minister’s position on subsection 245(1), the respondents do not allege that there was any legitimate business purpose for the transactions which resulted in the exploration expense deductions. The drilling operation in which the partnerships had invested, the Narwhal F-99 well, had been abandoned when the taxpayers purchased their limited interests. Instead, they submit that the motivation behind the arrangement, even if it is purely tax avoidance, is irrelevant as long as the legal requirements of the Act have been satisfied and the scheme fits within the object and purpose of the exploration expense provisions.

I need not decide whether the respondents were technically entitled to claim the deduction under subparagraphs 66.1(6)(a)(iv) or (v) because contrary to the decision of the Tax Court Judge, I am of the view that the deductions sought, although they may have arisen initially from legitimate expenses, unduly and artificially reduced the respondents’ income, pursuant to subsection 245(1). Nor must I decide the sophisticated issues of Alberta partnership law to determine whether they became valid members of the limited partnerships on December 14, 1987. Similarly, I am not required to decide any of the issues raised as alternative grounds by the Minister.

V.        APPLICATION OF SUBSECTION 245(1) TO THIS CASE

The Tax Court Judge refused to disallow the deductions pursuant to subsection 245(1) on the ground that they arose from legitimate expenses which were allocated to the respondents according to the requirements of the Act. In support of this conclusion he reasoned [at pages 2352-2353] that:

The expenses were not created by some imaginative scheme. They were intended to be incurred, they were incurred, they were allocated to the appellants exactly in accordance with the terms of the limited partnership agreements and so became their “share” as provided in subparagraph 66.1(6)(a)(iv). The Act is so constructed that these amounts claimed by the [respondents] cannot be deducted by any other person.

These reasons exhibit many of the features of the strict and narrow approach to subsection 245(1) which, contrary to the will of Parliament, denies subsection 245(1) any role as an anti-avoidance measure. A very different result is produced when the three factors enumerated in Fording to assist in distinguishing between lawful and unlawful tax avoidance are applied to the facts of this case, as Parliament intended.

First, I find that the respondents’ attempted use of the exploration expense provisions falls outside their intended object and spirit. The respondents have submitted, essentially, that their twenty-four hour participation in limited partnerships which were no longer engaged in development or exploration of any kind for the strict purpose of using the CEE incurred by those partnerships to their tax advantage somehow furthered Parliament’s objective of increasing exploration and development in Canada. The use of partnerships in order to take advantage of tax benefits may be a common practice which is not, in and of itself, problematic.[69]

In its efforts to implement specific economic polices through the taxation system, the federal government has intermittently introduced special tax incentives … designed to encourage, for example, exploration for oil and gas, Canadian feature films, construction of multi-unit residential buildings (MURB’s) and scientific and technologically oriented research and development. The basic incentive of these schemes is the allowance of a rapid expensing for tax purposes of the cost of items which would otherwise be capitalised and offset against income over a much longer period of time, and by allowing any resulting tax losses to offset income of the taxpayer from other sources. While a corporation can store such deductions if it does not have current income with which to offset the special writeoffs, a partnership will normally flow them directly through to the partners. This treatment avoids any loss because of the time value of money, and ensures that the losses are actually used up rather than being eventually lost because of limitations on their storage time.

The problem with the respondents’ participation in the limited partnerships for the purpose of obtaining this tax benefit, as I view it, is that the respondents have not in any way engaged in the business which the exploration expense provisions are designed to promote. The oil and gas industry and its consumers are no better off for the respondents’ so-called “investment” in the limited partnerships. The respondents rely on a 1994 statement of the Department of Finance which sets out the tripartite goals of this type of flow-through share arrangement. These are:[70]

(a) to encourage additional exploration and development in Canada;

(b) to promote equity investments in mining and petroleum companies; and

(c) to assist junior (typically non-taxpaying) exploration companies whose access to other sources of financing may be limited.

I fail to see how any of these goals has been achieved as a result of the respondents’ fleeting investment at a time when no exploration or mining was being carried out or contemplated.

The nature of the respondents’ participation in the limited partnerships falls even further from the mark if one takes into account the fact that a term of the partnership agreements was the suspension of the issuance of notices of entitlement to government grants applied for by the partnerships until after the end of the 1987 fiscal year. The purpose of the cumulative CEE provision was obviously to allow taxpayers to be able to deduct only what they had actually expended in an exploration project, and not the full cost of a project which in fact received eighty percent of its funding from the government. Subparagraph 66.1(6)(b)(ix) clearly intended this:

66.1(6)(b) …

(ix) any assistance that he has received or is entitled to receive in respect of any Canadian exploration expense incurred after 1980 or that can reasonably be related to Canadian exploration activities after 1980, to the extent that the assistance has not reduced his Canadian exploration expense by virtue of paragraph (9)(g),

In this case, however, because government assistance was not subtracted from the cumulative CEE total, the respondents claimed a deduction of 100% of the exploration expense associated with the Narwhal F-99 well, despite the fact that the government ultimately compensated the partnerships for 80% of those expenses. The effect for the government, as is argued by the appellant, is a cost of more than 100% of the actual cost of exploration. Such an absurd result could not have been the intention of Parliament in enacting these provisions.

Furthermore, whether or not the postponement of government grants may have been consistent with standard industry practice in order to entice investors during the early stages of a project by preserving cash flow, as the respondents submit, the purpose for which the respondents took advantage of this practice had nothing to do with the reason for which it may have been condoned by the PIP administration. I would also add that simply because other taxpayers may be trying to take similar tax advantage by manipulating this incentive provision does not legitimize the practice nor in any way influence the interpretation of the object and spirit of the provision.

Essentially, what the respondents seek to do is to use the legislation in a fashion so that the CEE are deducted from the income of their companies with taxable income, but to ensure that the government reimbursements of those expenses be credited to another company (NRI) which had sufficient losses to shelter this revenue from tax liability. As the Tax Court Judge himself described the scheme [at page 2335]:

In the oil and gas context, a taxpayer, other than a corporation whose principal business is in the oil and gas area, may deduct in, computing income, an amount not exceeding his “cumulative Canadian exploration expense”. This is a cumulative, continuing pool of expenses (”E pool”) to which defined exploration expenses such as seismic and drilling costs are added and from which certain sums received or receivable are deducted. One of such amounts required to be deducted for the taxation period herein was any grant under the PIP Act. In short, a taxpayer would add all E to his E pool and deduct statutorily described amounts therefrom. If the E pool at any year end was a positive amount the taxpayer could deduct same. If the E pool was a negative amount the taxpayer was obliged to include same in income.

The scheme in question here, however, does not involve a “pooling”: expenses were attributed only to a taxpayer in need of tax losses and PIP reimbursements of expenses were attributed only to another taxpayer with ample losses to shelter these revenues tax-free. The learned Tax Court Judge correctly described the legislative intent but did not demonstrate how this scheme could be within such intent.

For these reasons, this case is clearly distinguishable from R. v. Alberta and Southern Gas Co. Ltd. and Edmonton Liquid Gas Ltd. v The Queen,[71] both decisions of this Court in which it was held that taxpayer schemes which provided a tax advantage also fell within the object and spirit of economic policies advanced by Parliament through the Act. In Alberta and Southern Gas, Chief Justice Jackett held, on behalf of the Court, that a taxpayer was allowed to shield four million dollars from inclusion in his taxable income through a “carve-out” agreement involving investment in a “Canadian resource property” according to the Act. Pursuant to this agreement, the taxpayer paid $4,000,000 for the assignment of a “working interest” in lands from which it was already entitled to purchase natural gas according to a pre-existing contract. The taxpayer was to hold the interest in land until it received $4,000,000 plus interest or the equivalent in petroleum. The taxpayer received the amount of $4,000,000 plus interest one year later. Despite the fact that the “carve-out” agreement had an obvious tax benefit, the Chief Justice found that the tax scheme nonetheless advanced the object and spirit of the resource property provisions. He stated:[72]

These provisions for the deduction and taxation of capital amounts seem to me to have the obvious purpose of encouraging taxpayers to put money into such resource properties and keep it there. That being what the provisions seem to have been intended to encourage, as it seems to me, a transaction that clearly falls within the object and spirit of section 66 cannot be said to unduly or artificially reduce income merely because the taxpayer was influenced in deciding to enter into it by tax considerations.

Alberta and Southern Gas is similar to the case at bar in the sense that the taxpayer’s scheme was motivated by tax avoidance. It is distinguishable, however, because, unlike the scheme at issue in Alberta and Southern Gas, nothing about the respondents’ tax avoidance scheme was consistent with the purpose of promoting resource exploration in Canada.

Similarly, in Edmonton Liquid Gas, MacGuigan J.A. refused to apply subsection 245(1) of the Act to a deduction taken by a taxpayer who paid money to a drilling operator in 1974 for drilling which, in the case of one well, did not actually commence until the following year. MacGuigan J.A. found that the taxpayer ought to have been entitled to deduct the full amount paid to the drilling operator in the year in which it was expended because the evidence suggested that the taxpayer had the intention of actually engaging in well exploration. He concluded:[73]

There was nothing contrived or artificial in this corporate initiative. It was a good-faith response to what was in effect a new, or at least an unexpectedly renewed, Government policy, and was fully in accord with the object and spirit of the allowance provision.

The respondents in this case had no similar good faith intention to invest in resource exploration. As a result, the respondents, in my view, completely failed to bring themselves within the object and spirit of the exploration deduction provisions of the Act.

Second, the transactions which allowed the respondents to claim the cumulative CEE deductions are, I find, far removed from normal commercial practice. Clearly, at the time the interests were purchased in the limited partnerships, no potential for profit could exist. The exploration activities which were the raison-d’être for the limited partnerships had long since been abandoned. Despite this, the respondents paid $1,800,000 and $1,080,000 each for interests which, within twenty-four hours, were sold pursuant to a Put Agreement for a mere $137 and $228 respectively. In addition, as the appellant submits, it is contrary to normal business practice to ensure via the sale agreement that the limited partnerships not be entitled to receive any government assistance until after the date when it was anticipated that the respondents would exercise their rights under the Put Agreement and remove themselves from the limited partnerships.

In Irving Oil, Mahoney J.A. held that, although an arrangement was engineered solely in order to obtain a tax advantage, it nonetheless conformed with ordinary business practice and could not be caught by subsection 245(1). In that case, the taxpayer had effected a scheme in which its wholly owned subsidiary would purchase crude oil at a lower price and then sell to the taxpayer at fair market value. The Minister had disallowed the taxpayer’s deduction of its cost of purchasing oil to the extent that it exceeded the cost paid for the oil by the subsidiary. Mahoney J.A. rejected this assessment and reasoned [at page 360] that: “[s]ince the respondent paid Irvcal fair market value, it cannot be said that payment resulted in an excessive reduction of income”. On the facts of the case on appeal, however, there is no attribute of the transactions which gave rise to the respondents’ attempted CEE deductions which could be considered a normal business practice. It was clearly a tax scheme, pure and simple, not a business deal.

Third, and finally, it has been argued by the appellant, and virtually conceded by the respondents, that there was no business purpose attached to the respondents’ participation in the limited partnerships. The absence of business purpose is further support for the conclusion which is already well founded on the basis of the other indicators: the 1987 cumulative CEE deductions claimed by the respondents both unduly and artificially reduced their incomes and, as a result, should be disallowed.

The totality of these three factors leads inexorably to the conclusion that what the respondents have attempted to achieve in this case is unlawful tax avoidance. It is hard to imagine a more obvious case for the use of subsection 245(l) than this one. Any other result would make a mockery of Parliament’s intention to place some reasonable limit on the extent to which a taxpayer is entitled to “order his affairs so as that the tax … is less than it otherwise would be”. I must therefore conclude that, even if the respondents had been able to qualify as valid members of the limited partnerships which incurred the exploration expenses and could succeed in bringing themselves within the literal wording of subparagraph 66.1(6)(a)(iv) or (v), subsection 245(1) should be applied to disallow the deductions sought. On this basis, the appeal should be allowed with costs and the ruling of the Tax Court Judge set aside.

Strayer J.A.: I agree.

The following are the reasons for judgment rendered in English by

McDonald J.A. (dissenting): I have had the advantage of reading my brother Linden J.A.’s reasons for judgment, and I must respectfully disagree. I am of the view that this transaction is not captured by subsection 245(1) of the Income Tax Act and the decision of the Tax Court Judge should stand.

The facts have been outlined in detail in the decision of Linden J.A., so I need not revisit them. It is clear that this set of transactions was a tax avoidance vehicle. In effect, Northcor engaged in loss selling in order to raise capital. The named taxpayers in this case bought into the limited partnerships in order to take advantage of losses incurred by the limited partnerships through their agent. As I understand it, none of this is disputed by the parties. At issue is whether this type of transaction, though permitted by the provisions of the Income Tax Act, is caught by subsection 245(1). As I will explain, I am of the view that subsection 245(1) does not apply to deprive the taxpayers of their deductions as claimed.

As I have stated many times in the past, there is no crime in tax avoidance. Every taxpayer is entitled to structure his or her affairs so as to minimize his or her tax payable. I would go further and say that avoidance of tax, within the parameters of the Income Tax Act, is necessary for the tax system to function efficiently. The taxpayer’s role is to minimize the tax payable, while the tax collector’s role is to maximize the tax payable. As I see it, the role of the courts is to ensure that both taxpayers and tax collectors play by the rules.

The issue in this case is whether subsection 245(1) may be applied to disallow deductions where these deductions are permitted by the express terms of the Act and are not inconsistent with the object and spirit of the provisions. My brother Linden J.A. has come to the conclusion that although these deductions may be allowed by the provisions of the Act, the deductions must be disallowed as being “artificial or undue” under subsection 245(1). In reaching this conclusion, Linden J.A. points to an alleged lack of business purpose and further concludes that the transactions are inconsistent with the object and spirit of the provisions. As will be seen, I have come to entirely the opposite conclusion.

1.         Subsection 245(1)

For ease of reference, I reproduce the text of what was then subsection 245(1) of the Income Tax Act:

245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

The first step in the analysis is to assess whether the deduction artificially or unduly reduced income. This Court’s decision in Canada v. Irving Oil Ltd., [1991] 1 C.T.C. 350 (F.C.A.) suggests that the proper point of comparison is the result of the transaction and not the transaction itself. That is, the potential artificiality of the transaction is not determinative of the issue.

It must be remembered that the taxpayers in this case were members, albeit briefly, of a limited partnership that legitimately incurred Canadian Exploration Expense (CEE) through its agent. Paragraph 66.1(6)(a)(ii) of the Income Tax Act stipulates that CEE should be deducted by the person who incurred it. In this case, there is no dispute that the limited partnership incurred CEE through its agent with respect to drilling off Canada’s east coast.

Setting aside the issue of whether a partnership may properly be termed a taxpayer,[74] we may assume that in the ordinary course of events, the CEE regime would allow the entity which incurred the CEE to deduct it as an expense. In this case, the entity which incurred the expense was a limited partnership. Under the provisions of the Act, though, partnership income (and losses) cannot be claimed by the partnership, but must be attributed to the individual partners: subsection 96(1) [as am. by S.C. 1984, c. 1, s. 43]. Under the CEE regime, only members of a partnership at the end of the partnership’s fiscal year may deduct CEE: subsection 66.1(7) [as enacted by S.C. 1974-75-76, c. 26, s. 36; 1977-78, c. 1, s. 30; 1980-81-82-83, c. 45, s. 34].

In this case, the taxpayers were members of the partnerships at the end of the fiscal year. The provisions of the Act specifically resulted in attribution of the CEE to them as members of the partnerships at the end of the partnerships’ fiscal year. Other than joining the partnerships immediately before year end, the taxpayers did nothing to create this situation, as the attribution resulted by operation of the Income Tax Act. This is similar to the situation faced by this Court in Canada v. Mara Properties Ltd., [1995] 2 F.C. 433 (C.A.) where I was of the view that deductions could not be said to be artificial or undue where they arose by specific operation of the Act. On this point, my brother Marceau J.A. and I were in agreement.

This Court recently had the opportunity to revisit the issue of whether transactions could be said to be artificial or undue when they arise by specific operation of the Act in The Queen v. Nova Corporation of Alberta (1997), 97 DTC 5229 (F.C.A.). In that case, the Court was asked to consider the application of subsection 55(1) which denies losses that have been “unduly or artificially” reduced. The majority of the Court concluded that where the taxpayer’s losses arose by specific operation of the Act, the losses could not be said to be artificial or undue.

As pointed out by my brother Linden J.A., the majority decision in Canada v. Fording Coal Ltd., [1996] 1 F.C. 518 (C.A.) takes a different view. In that case, my brother Strayer J.A. for the majority was of the view that although the transactions met the formal requirements of the Act, the deductions created were “artificial or undue.” In dissent, I was of the view, again, that subsection 245(1) cannot apply to defeat deductions where the deductions arise by specific operation of the Act. I am not persuaded that my reasoning was in error.

I am further persuaded by the argument of counsel for the respondent as he sought to distinguish the majority decision in Fording Coal. It was counsel’s submission that there were no actual losses sustained in Fording Coal. That is, the losses in Fording Coal came about as a result of the transaction and were not actual tangible losses. In this case, by contrast, the losses incurred by the limited partnership were real and came about as the result of real exploration and development. These losses were not created by manipulation of the Income Tax Act. There is no dispute that there was actual exploration in this case, and actual losses were incurred on behalf of the limited partnership. I am persuaded that this is a sufficient distinction from the facts in Fording Coal that the majority decision in that case is not directly applicable to the case at bar.

The facts of this case lead me inexorably to apply the reasoning of this Court in Mara Properties and more recently in Nova Corporation: where a deduction arises by specific operation of the Act, it cannot be said to be artificial or undue. These taxpayers were partners in a limited partnership which incurred CEE. Under the Act, that CEE was then attributed to the taxpayers in their capacity as partners. I cannot see how this result can be said to be undue or artificial.

My brother Linden J.A. has said that to accept this approach is to “eviscerate” subsection 245(1). With respect, I am of the view that if Parliament had intended for subsection 245(1) to override deductions that arise by specific operation of the Income Tax Act, then Parliament would have used specific language to this end. In the absence of such language, I cannot assume that Parliament would disallow with one provision that which it has specifically allowed with others.

I will agree that these taxpayers did not directly engage in mining exploration. Their direct participation is not required by the provisions of the Act. In fact, the flow-through share regime in the Income Tax Act was created to allow investment by parties that may not have otherwise participated in the industry.[75]

The taxpayers in this case bought limited partnerships before the end of the fiscal year. The money spent to join the limited partnerships went to Northcor, a company actively involved in mining exploration. In my view, the system worked as was intended. While it may seem repugnant that these taxpayers are able to reap the benefit of expenses not directly incurred by them, their favourable tax position is a product of the Act’s own provisions.

Having concluded that the taxpayers’ deductions are permitted by the clear language and operation of the Act, there is little need to proceed further to consider whether the result of the transaction meets the object and spirit of the legislation. Subsection 245(1) cannot, in my view apply to deny these deductions where the deductions have come about by specific operation of Act. However, even if I am in error on this point, I am of the view that the object and spirit of the legislation are consistent with this result.

2.         Object and Spirit

There are several factors which a court may consider when assessing the object and spirit of legislation. The Court may look to normal business practice, may assess whether the transaction had a legitimate business purpose, and may look also to Parliamentary intent. These, among others, are factors which are important to consider when looking to the object and spirit of Income Tax Act provisions.

The Petroleum Incentives Program and the CEE regime were intended to encourage mining and exploration. The government at the time determined that income tax incentives, often in tandem with direct grants of funds to exploration companies, were the most effective way to encourage exploration of Canada’s natural energy resources. All of this was occurring against a backdrop of Canada’s national energy strategy. The sharp fluctuations in oil prices in the 1970s and 1980s had created an impetus to ensure that Canada could be self-sufficient in its energy production. By eliminating the need to rely on imported energy, it was thought, Canada could ensure its future and its independence.[76] It was believed that tax incentives such as the flow-through share regime would be effective vehicles to attract investment into the extremely risky exploration sector. In fact, the flow-through share program had its intended effect. In its press release dated November 10, 1994, the Finance Department noted that flow-through shares were of “special significance for junior mining companies” and had the effect of raising large amounts of equity-based financing for exploration.

(a)       Normal Business Practice

Upon hearing the evidence before him, the Tax Court Judge concluded that it was normal business practice to structure transactions such as the ones in the case at bar. While the use of limited partnerships was not regular, it was not uncommon, and it had been used as an effective vehicle to encourage investment in junior mining and exploration companies. In the words of the Tax Court Judge [at page 2356]:

The object of the Act with respect to the resource industries is clearly to provide incentive deductions to encourage exploration and development. The vehicles created by the oil and gas industry to take advantage thereof are the products of legislation specifically permitting same. That has resulted in the arrangements under examination in this case. Respondent’s counsel refers to the “unusual steps” that had been taken. They are unusual in the sense of not being available to other industries but they are not unusual having regard to resource industry practice.

Having reviewed the materials presented at trial and some literature on the intricacies of tax planning as it relates to the CEE scheme, I am led to the same conclusion reached by the Trial Judge: these types of financing arrangements were normal business practice in the industry at the time.

(b)       Business Purpose

I will state at the outset that I am hesitant to put too much stock in the application of a business purpose test. As noted by my brother Linden J.A., the business purpose test was firmly rejected as a general interpretative principle by the Supreme Court of Canada in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536. Certainly, though, there is room to assess whether the transactions entered into by the taxpayer had a legitimate business purpose as one factor to consider among many others.

For the taxpayers in this case, the clear purpose of the transactions was to purchase the CEE losses to use as deductions against income. There was no intention on the part of these taxpayers to become active participants in the oil and gas exploration market. This is not fatal for the taxpayer. As was held by Jackett C.J. in R. v. Alberta and Southern Gas Co. Ltd., [1978] 1 F.C. 454 (C.A.), at pages 462-463, affd [1979] 1 S.C.R. 36 and cited approvingly by the majority of the Supreme Court of Canada in Stubart (supra),

… a transaction that clearly falls within the object and spirit of [a given section of the Act] cannot be said to unduly or artificially reduce income merely because the taxpayer was influenced in deciding to enter into it by tax considerations.

What is most important here is that the taxpayers claimed the deduction incurred in their capacity as limited partners. The entity in which they were partners did legitimately incur CEE and was actively involved in oil and gas exploration. The money that these taxpayers spent to join the partnerships was paid to Northcor. Northcor’s purpose in selling the limited partnerships was presumably to raise capital which would then fund more exploration. For the general partner in the limited partnership, the transaction had a valid business purpose. The limited partnership, then, had a legitimate business purpose, and the taxpayers achieved their deductions by virtue of their membership in the limited partnership. Further, the taxpayers’ investments in the limited partnerships had the effect of providing needed capital to Northcor. The business purpose of this transaction was clear: the mining company wished to raise capital, and the taxpayers provided that capital.

(c)        Parliamentary Intention

It is always very difficult to look back into the past and ascertain what Parliament’s intention was at a specific point in time. With the benefit of hindsight, it is tempting to impose our own views of what Parliament’s intention should have been, rather than what it was. In this case, it is difficult to accept that the federal government was allowing taxpayers to take huge deductions for oil and gas exploration when these taxpayers were not actively involved in the industry. But, in my view, that was a natural consequence of the flow-through share regime.

Junior mining and exploration companies accumulated huge expenses in the process of exploring for oil and gas. Without significant revenues, these expenses could not be used in any productive way. Facing certain and sizeable losses, it is unlikely that many junior exploration companies would continue to explore Canada’s east coast. Realizing this, Parliament created the flow-through share regime which allowed these junior mining companies to effectively pass on their expenses to taxpayers who were able to use them. In exchange, the junior mining companies were able to raise much needed capital.

It was later recognized by Parliament that this regime had outlived its usefulness, and the provisions were changed to tighten the system. Until this realization, though, the regime was in place to encourage investment in a risky enterprise, all for the sake of the national energy policy. When you add into the mix that there was some political will to encourage exploration off Canada’s east coast and potentially invigorate a depressed economy, it no longer seems implausible that Parliament would have allowed deductions to be taken by taxpayers who were not actual players in the industry. This was, we must remember, an incentive scheme.

It was amply demonstrated before the Tax Court Judge and before this Court that the government was aware that the Act permitted these types of arrangements, and in fact it was an accepted means of raising capital for junior mining and exploration companies. Set in context, these deductions fit in with Canada’s energy strategy at the time.

For the foregoing reasons, I would dismiss the appeal. The taxpayers’ deductions are not artificial or undue, as they arise by specific operation of the Act and are not inconsistent with the object and spirit of section 66.1.

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