In Daishowa-Marubeni International Ltd. v Canada, 2013 SCC 29, the Supreme Court of Canada (“SCC”) held 9:0 that Daishowa-Marubeni International’s (“DMI”) proceeds from the disposition of two forest tenures should not include the reforestation obligations that were assumed by the purchasers. This decision overturned the findings of the Tax Court of Canada (“TCC”) and the Federal Court of Appeal (“FCA”) that the proceeds from disposition should include the reforestation obligations.
The decision of the SCC in the Daishowa case has been eagerly anticipated by tax practitioners and participants in the mining, oil and gas, and timber industries across Canada. The lower-court decisions have produced a great deal of uncertainty in these industries. Reportedly, a large number of reassessments with huge financial impacts have been made by the Canadian Revenue Agency using the lower court decisions in Daishowa as support.
As an example, a company may wish to transfer an oil and gas property to its wholly-owned subsidiary and relies on section 85 of the Income Tax Act to achieve the transfer on a tax-deferred basis. To obtain a rollover, the subsidiary pays for the property by the issuance of shares to the parent company and the parties elect under section 85 for the property to be transferred for deemed proceeds of a nominal amount. However, if the future cost of environmental reclamation must be included in the proceeds of disposition, the value of the assumed liability would be considered to be non-share consideration, or “boot.” Since the elected amount under section 85 cannot be less than the amount of boot, the transaction may result in an unintended gain.
Similarly, transfers to third parties were negatively affected as the vendor’s tax cost of selling its assets was uncertain.
DMI consisted of two divisions that each had a forest tenure that allowed them to harvest timber on land owned by the province of Alberta. These tenures included reforestation obligations. However, the future cost of reforestation was uncertain – the reforestation obligation would cease once the forests were able to regenerate to the “free-to-grow” stage, or natural processes such as forest fires or landslides made it impossible to achieve the regeneration standard. As a result, it was uncertain whether the reforestation costs would be incurred at all, or how much they would be.
In 1999 and 2000 DMI sold its divisions to Tolko Industries Ltd. (“Tolko”) and Seehta Forest Products Ltd. (“Seehta”) respectively. The Tolko agreement allocated $20 million of the sale price to the value of the forest tenure, with both parties agreeing that the cost of reforestation would be approximately $11 million. The Seehta agreement did not explicitly allocate any of the purchase price to the tenure nor estimate the cost of reforestation. Both agreements provided that the purchaser would assume DMI’s reforestation obligations, a necessary condition to receive consent for the transfer from the province of Alberta.
DMI did not include the liability assumed by the purchasers relating to the cost of reforestation in its income for 1999 or 2000. The Minister of National Revenue (“Minister”) reassessed DMI for both taxation years and found that DMI should have included the liability assumed relating to the cost of reforestation as part of the sale price under subsection 13(21) of the Income Tax Act (Canada). The Minister accepted the estimated $11 million reforestation cost in the Tolko agreement to be the appropriate cost and therefore found that DMI’s proceeds from disposition should be increased by that amount in 1999. Using DMI’s accounting records, the Minister determined the appropriate liability assumed relating to the cost of reforestation for the Seehta agreement was $2,996,380 and increased DMI’s proceeds from disposition by this amount for 2000.
Lower Court Decision
At trial the TCC ruled in favour of the Minister. DMI appealed the decision. At the FCA the majority found that the vendor’s proceeds of disposition should include the full cost of the assumed reforestation obligation. The majority of the FCA applied the principle that proceeds of disposition include the sale price, which includes all consideration received in the transfer including the assumption of a liability. The majority characterized the reforestation obligation as a liability. Therefore, the assumption of the liability was to be included in the proceeds of disposition. However, the TCC reduced the amount included as proceeds of disposition in respect of the liability to 20% of the accounting estimate, given the uncertainty as to the actual amount and timing of the future costs.
Both the Crown and the taxpayer appealed the decision to the FCA. The FCA characterized the obligation as a liability for two reasons. First, there were other bids for the divisions that had a separate portion of consideration for assuming the reforestation obligations. The second reason was that DMI had stated that if the purchasers had not assumed the obligation, the amount of the cash portion of the purchase price would have had to be greater. However, unlike the TCC, the FCA included the entire estimated cost of the reforestation obligation as proceeds of disposition to reflect the value that the parties to the purchase and sale agreements had themselves placed on the reforestation obligations.
The minority of the FCA, Mainville JA, was of the opinion that the cost of reforestation should not be included in the proceeds of disposition on the basis that the reforestation obligations were part of the tenure and could therefore not form a distinct part of consideration.
Unlike the majority of the FCA, the SCC, in a decision delivered by Rothstein J, unanimously ruled that the cost of reforestation should not be included in the proceeds of disposition. The SCC agreed with the FCA that, when the sale price includes the assumption of a vendor’s liability, the proceeds of disposition should include the assumption of that liability. However, the SCC found that the reforestation obligations were not liabilities, rather they were future costs embedded in the land tenures. This finding closely reflected that of the minority of the FCA.
The Minister submitted that the purchase of the tenures was similar to purchasing a building encumbered by a mortgage. The purchaser can pay for the building with cash, or can pay partly in cash, and also agree to assume the mortgage. If the purchaser agrees to assume the mortgage, then the appropriate proceeds of disposition would include the value of the mortgage. The SCC did not agree with this analogy. Instead, the SCC found that the purchase of the tenures and assumption of the reforestation obligations was similar to purchasing a building that needed repairs. The Minister acknowledged that in such a case the vendor’s proceeds of disposition would not include the repair costs because the cost of repairs cannot be severed from the building. As such, the value of the building is adjusted according to the repairs that are required. Similarly, the cost of reforestation was embedded in the tenure and could not be severed as a result of the province’s scheme surrounding forest tenures. The purchaser should consider the embedded reforestation obligation to be a future cost that decreases the value of the tenure. Including the reforestation costs in the proceeds from disposition would result in an overvaluation of the tenure.
Furthermore, the SCC was concerned with the asymmetrical tax treatment that would result if the obligations were treated as the Minister had proposed. The Minister wanted to include the cost of reforestation in the vendor’s proceeds of disposition but not allow the purchaser to include the cost of reforestation in its calculation of the adjusted cost base of the property. The SCC considered the Minister’s interpretation to be unfair because the sale price would be treated differently for the vendor and the purchaser.
The taxpayer had also submitted that the reforestation obligation should not be included in the proceeds of disposition because it was a contingent liability. The SCC stated that this argument was misplaced and appeared to have caused confusion in the courts below. The Court did state that even if an embedded obligation is “absolute”, such as if the cost of repairs to a building is known and certain to occur, it is not a liability that forms part of the proceeds of disposition. However, the inverse was not necessarily true. The Court stated that, “The argument is problematic because, in focusing on whether the reforestation obligations are contingent or absolute, it implicitly accepts that the cost of reforestation is a liability of the vendor that is not embedded in the forest tenure and would constitute proceeds of disposition but for the contingent nature of the liability.”
As a result, how the assumption of contingent liabilities (i.e., uncertain future costs that are not “embedded” in the transferred property) should be handled for tax purposes remains uncertain. Such liabilities often include pension funding obligations or other employee retirement obligations.
The key to determining the proceeds of disposition from a sale that includes the assumption of an obligation is characterizing that obligation. In this case, the SCC used two analogies, buying a building with a mortgage versus buying a building that needs repairs, to characterize the assumption of the reforestation obligations. The SCC concluded that because the reforestation obligations were embedded in the tenures, it was not correct to characterize them as a liability, and therefore found that the proceeds of disposition should not include the reforestation obligations that were assumed by the purchasers.