In Daishowa-Marubeni International Ltd. v. The Queen, 2013 SCC 29, Justice Rothstein marries tax philosophy and tax practice by asking and answering the question:
If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?1
The Court analyzes the difference for tax purposes between liabilities and embedded obligations, considers the law of contingent liabilities, the role of tax symmetry in the Income Tax Act (Canada) (the “Act”), the role of the parties’ agreement and the role of accounting treatment in reaching the conclusion that embedded obligations are not liabilities that form part of proceeds of disposition.
The relevant facts before the Court are as follows:
- Daishowa-Marubeni International Ltd. (“Daishowa”) owned forest tenures in Alberta, giving it the right to harvest timber from designated provincial Crown lands.
- Daishowa was statutorily obligated under the Forest Act and the Timber Management Regulations to reforest areas from which it had harvested timber. Daishowa was required to obtain the consent of the Province of Alberta prior to the assignment of any forest tenures and such consent would only be provided if the purchaser assumed that reforestation obligation.
- Forest tenures in two of the areas in which Daishowa had reforestation obligations were sold to third parties in 1999 and 2000, with the reforestation obligations being assumed by the purchasers and with province consents being provided to these sales.
- In November 1999, as part of the sale by Daishowa of its High Level Division business to Tolko Industries Ltd., Daishowa sold forest tenures in that area. In the sales agreement, $20 million of the purchase price was allocated to the forest tenures. The sales agreement further provided that Tolko would assume the statutory reforestation obligations relating to lands previously harvested, quantified at approximately $11 million, with there being a mechanism for a post-closing final determination/estimate of these obligations and purchase price adjustment.
- Similarly, Daishowa sold the Brewster Lumber Division including forest tenures in that area to Seehta Forest Products Ltd. in August 2000. Under the sales agreement, Seehta also assumed all reforestation obligations on the lands previously harvested, but there was no quantification of the reforestation obligations referenced in the agreement.
- In accounting for these obligations, Daishowa estimated on an annual basis future reforestation obligations arising in the year and claimed the amount as an expense against revenues for accounting purposes for the year, with the offsetting entry being a reforestation liability on the balance sheet. For income tax purposes, this reforestation expense was added back into income. In the Daishowa accounting records for the years of disposition of the tenures, the estimated cost of the reforestation obligation for Brewster Lumber tenures was approximately $3 million and the High Level reforestation obligation was $11 million. In the years of disposition, Daishowa increased its income for accounting purposes by the future reforestation obligation associated with these tenures that it had sold and for which Daishowa no longer had an obligation in respect of.
- In the 1999 and 2000 years, the Minister of National Revenue (the “Minister”) reassessed Daishowa to include into income as proceeds of disposition the reforestation obligation of $11 million in respect of the sale to Tolko and approximately $3 million in respect of the sale to Seehta.
History of Proceedings:
In dealing with these reassessments, the Tax Court concluded that “the sale of Daishowa’s business to Tolko was a single transaction, and the assumption of reforestation liabilities represented part of the consideration; however, the value of that consideration to Daishowa is less than the face value of the estimated amount of those liabilities.”2 The Trial Judge also stated that he saw “no difference in the fact situation of the Seehta matter to reach any different conclusion.”3 In this regard, the Trial Judge discounted the reforestation liabilities under the Tolko and Seehta agreements from $11 million and $3 million to $3.9 million and $1 million, respectively.
The majority of the Federal Court of Appeal4 agreed with the Trial Judge that the High Level reforestation obligation should be treated as part of the consideration paid by Tolko, but held that there was no evidentiary support for the Trial Judge’s decision to discount the amount of the liability under the Tolko agreement. In respect of the Seehta agreement, the majority found that the Trial Judge’s reasons were inadequate and the matter was referred back to the Trial Judge for consideration of the Seehta agreement in light of the FCA’s decision. Justice Mainville stated in dissent that “it is neither reasonable nor correct to conclude that the compulsory assumptions of the responsibilities for future reforestation works by the purchasers were a “sale” or “disposition” of “liabilities” resulting in “proceeds of disposition” in the hands of Daishowa under the meaning of subsection 13(21) of the Act.”5 Justice Mainville further stated that the reforestation obligation formed part of the forest tenures and had the effect of depressing the value of the forest tenures and should not be treated as proceeds of disposition.
In a well-reasoned Supreme Court of Canada judgment, the Court in essence adopted Justice Mainville’s dissent and held as follows:
- Liabilities as Part of Consideration: As a starting point, Justice Rothstein accepted the general proposition that “the assumption of a vendor’s liability by a purchaser may constitute part of the sale price and therefore part of the vendor’s proceeds of disposition.”6
With this foundation in place, the question then shifted to the nature of the reforestation obligation.
- Nature of the Reforestation Obligation: In deciding the issue before it, the Court referenced the need to distinguish between the assumption of a liability and the assumption of an embedded obligation that cannot be severed from the property and has the effect of depressing the value of the property. While the Minister attempted to analogize the reforestation obligation to a mortgage encumbered property being sold, Daishowa and industry intervenors provided a better analogy being that the reforestation obligation was more akin to property in need of repairs, with that repair obligation depressing the property value.
The Court agreed with the approach taken by Justice Mainville, Daishowa and industry intervenors and held that “[t]he effect of Alberta’s scheme is to embed the reforest obligations into the forest tenures, such that the obligations cannot be severed from the property itself. As such, the reforestation obligations are simply future costs tied to the tenure that depresses the value of the tenure.”7 The Court supported this position by carrying out an analysis of the two analogies placed before it. The Court noted that the value of the Tolko tenure was $20 million and Daishowa could never receive $31 million for the forest tenure. By contrast, under the property encumbered by mortgage scenario, the Court noted that a vendor could always ask for and receive $31 million and the vendor could pay off the mortgage independent of value, reflecting the fact that the mortgage did not affect the value of the property as was the case with an embedded obligation.
The Court dismissed the Minister’s argument that the reforestation obligations crystallized at the time of sale and must be considered as part of the proceeds of disposition. By reference to the argument raised by the Canadian Association of Petroleum Producers (“CAPP”) that for the Minister to succeed, there must be a distinct existing liability, the Court held that the reforestation obligations were not such a liability, but instead were future costs embedded in the forest tenures.
The foundation of the Court’s decision was that there existed a statutory requirement for these embedded obligations to be assumed by the purchasers. Of specific note, however, is the obiter dictum comment made by the Court as it related to obligations that are not grounded in a statute, regulation or government policy. In this regard, the Court stated:
In this appeal CAPP submits that future obligations may be embedded in a property right absent a legal requirement that precludes a vendor from selling a property without assigning the obligations. CAPP submits, using the example of the mining of gas and oil, that statutory obligations to reclaim mined land may be so physically connected to the process of mining itself that the obligations cannot be separated from property right. While I need not decide that question on record before me, I would certainly not foreclose a possibility that obligations associated with property right could be embedded in that property right without there being a statute, regulation or government policy that expressly restricts a vendor from selling property right without assigning those obligations to the purchaser.8
It will be interesting to see whether and how this comment by the Court will open the door for consideration of the tax treatment to be afforded to other obligations embedded in the relevant property.
- The Role of Contingent Liability: The Court also addressed the issue raised by Daishowa that the reforestation obligation should not be added to proceeds of disposition because the obligation was a contingent liability. The Court held that the question of contingent liability is misplaced in the sense that it pre-supposes that there exists some existing liability of the vendor not embedded in the forest tenures that may be considered proceeds but for the existence of a contingency. Since costs of reforestation was not an existing distinct liability, the Court held that the concept of contingent liability did not apply.
- The Promotion of Tax Symmetry: The Court adopted a comment made by Justice Mainville that tax symmetry should be promoted and stated that, “[a]lthough not dispositive, …an interpretation of the Act that promotes symmetry and fairness through a harmonious taxation scheme is to be preferred over interpretation which promotes neither value.”9 The Court noted that, under the Minister’s approach, Tolko would have had proceeds of $31 million, of which $11 would never be received, had it sold the tenures the very next day. This example highlighted the asymmetry in the Minister’s approach.
- The Role of the Agreement: The Court dismissed the agreement between the parties by addressing the specifics of the Tolko agreement. The Court held that regardless of the fact that Daishowa had agreed on the specific amount of the reforestation liabilities in the Tolko agreement, Daishowa’s proceeds of disposition were not dependent upon that agreed-upon amount. Instead, the reference to the reforestation obligation in the agreement was simply used to arrive at the fair market value of the forest tenures of $20 million.
- The Role of Accounting Treatment: In addition, the Court made a valuable statement on the role of accounting treatment of an amount in such circumstances. The Court stated:
 It is also irrelevant that Daishowa estimated the cost of future reforestation to compute its income for accounting purposes. Although commercial and accounting principles allowed Daishowa to deduct reforestation obligations on a yearly basis and add back to income the deducted amounts at the time of the sale to provide a more accurate picture of its profit from year to year, as I have explained above, the Income Tax Act does not permit that approach; see V. Krishna, The Fundamentals of Canadian Income Tax (9th ed.), at pp. 171-72. This Court has recognized the distinct purposes of financial accounting and income tax calculation: Canderel Ltd. v. Canada,  1 S.C.R. 147, at para. 36. It would thus be an error to simply include Daishowa’s accounting estimates in its proceeds of disposition.
In summary, the Supreme Court of Canada provided a thoughtful and clear statement of what is and what is not a liability for the purposes of determining proceeds of disposition. In the process, the Court stamped out the forest fires that could have spread from the lower court decisions.