The Supreme Court of Canada (the SCC) recently released its decision and reasons in Daishowa-Marubeni International Ltd. v. Canada (Daishowa). The SCC's decision was favourable to the taxpayer. Although the facts of this case were restricted to the treatment of reforestation obligations, the decision will have a significant impact across various industry sectors, in particular the oil and gas industry with respect to environmental and reclamation obligations.
Summary of Facts
Daishowa-Marubeni International Ltd. (DMI) operated two timber divisions in Alberta, which were engaged in the business of harvesting logs and manufacturing finished timber. Each division held a forest tenure under which it was licensed to cut and remove timber from provincial Crown lands. Under the Alberta statutory regime, the forest tenures also imposed certain reforestation obligations to reforest the areas from which it had harvested timber. DMI was statutorily obligated to obtain the consent of the Province of Alberta prior to an assignment of any forest tenures, and such consent would only be provided if the purchaser assumed the future reforestation obligations.
In 1999 and 2000, DMI sold the two timber divisions, along with the corresponding forest tenures. In 1999, DMI sold its High Level Division to Tolko Industries Ltd. (Tolko). The sale agreement provided that C$20-million was allocated to the forest tenure, and that Tolko would assume the statutory reforestation obligations; the undiscounted cost of performing the reforestation obligations was estimated to be C$11-million, and the agreement provided for an adjustment to the purchase price in the event that the post-closing estimate of the reforestation obligations differed from the original estimate. In 2000, DMI sold the Brewster Lumber Division to Seehta Forest Products Ltd. (Seehta). The sale agreement also provided that Seehta would assume the statutory reforestation obligations; however, the agreement did not specify an estimated cost of the reforestation obligations.
For accounting purposes, in the years in which DMI harvested timber, it estimated on an annual basis the amount of future reforestation obligations arising in the year and claimed that amount as an expense against revenue. For tax purposes, DMI added the amount of the reforestation expense back into its income. As such, DMI did not claim tax deductions for the estimated future reforestation obligations that arose as it was harvesting timber. In the years in which the sales took place, DMI included in its income for accounting purposes the amounts previously claimed as expenses in order to reflect the fact that it no longer had any reforestation obligations in respect of those tenures. In its 1999 and 2000 income tax returns, DMI did not include any amount in its income to reflect the purchasers' assumption of the reforestation obligations.
The Minister of National Revenue (the Minister) reassessed DMI with respect to the 1999 and 2000 taxation years to include the undiscounted amount of the cost of the reforestation obligations in DMI's "proceeds of disposition" for tax purposes such that its proceeds of disposition was increased from C$20-million to C$31-million. DMI appealed that assessment.
Lower Court Decisions
The Tax Court of Canada held that the purchaser's assumption of reforestation obligations was properly included in the vendor's proceeds of disposition, and that the assumption of reforestation obligations was part of the consideration. Miller J. discounted the reforestation obligations under each agreement, reasoning that it was not appropriate to add the entire estimated cost of the reforestation obligations to DMI's proceeds of disposition.
The majority of the Federal Court of Appeal held that DMI was required to include the entire undiscounted estimated cost of the reforestation obligations in its proceeds of disposition in the case of the sale to Tolko (the matter was remitted to the Tax Court for redetermination with respect to the sale to Seehta). Mainville J.A. dissented, concluding that the reforestation obligations were inextricably linked to the timber resources and depressed the value of those properties; as such, they had been taken into account by the parties in arriving at the (lower) sale price of C$20-million.
In a unanimous judgment, the SCC held that DMI was not required to include the estimated cost of the reforestation obligations in its proceeds of disposition for tax purposes. The SCC began by acknowledging that as a matter of principle, the assumption of a vendor's liability by a purchaser may constitute part of the sale price, and therefore be part of the vendor's proceeds of disposition. The SCC gave the example of a property encumbered by a mortgage. If the purchaser pays cash and also assumes the vendor's mortgage, the sale price of the property would include the amount of cash received and the amount of the assumed mortgage; thus, the vendor's proceeds of disposition would include both amounts. The Minister argued that a forest tenure with reforestation obligations was akin to a property encumbered by a mortgage. DMI and industry interveners, namely the Canadian Association of Petroleum Producers (CAPP), argued that the sale of a forest tenure with reforestation obligations is comparable to the sale of a building in need of repairs. The SCC agreed with this analogy, stating that reforestation obligations, just like the need for repairs, have the effect of depressing the value of the property. In comparison, the vendor's indebtedness (for example, on a mortgage) does not affect the value of the property. The reforestation obligations, just like the cost of future repairs, are a future cost embedded in the property and do not form an additional part of the sale price of the property. Thus, the vendor would not be required to include the estimated costs assumed by the purchaser in its proceeds of disposition for tax purposes.
The SCC went on to explain that the reforestation obligations are embedded in the forest tenure by virtue of the policy and practice in Alberta. Under Alberta's regulatory scheme, a forest tenure cannot be sold without the consent of the provincial government, and such consent will only be given if the purchaser assumes the reforestation obligations. The Province of Alberta, as an intervener, took the position that after a transfer has been approved, the vendor is absolved of all liability for the reforestation obligations. The SCC held that by virtue of Alberta's statutory scheme, the reforestation obligations are "embedded" in the forest tenure, and cannot be severed from the property itself. As a result, the reforestation obligations are future costs which decrease the amount a prospective purchaser would be willing to pay. The SCC used the example of the High Level Division forest tenure, which had a value of C$20-million, and the reforestation costs had been estimated to be C$11-million. The SCC made it very clear that DMI did not have C$31-million of value to sell, stating that under no circumstances could DMI have received C$31-million for the forest tenure. The reforestation obligations, unlike a distinct existing debt, "were embedded in the [forest] tenure so as to be a future cost associated with ownership of the tenure".
The SCC also noted that the fact that the parties agreed to an estimated future cost of the reforestation obligations and that DMI estimated such future costs for accounting purposes was irrelevant, noting that any amount assigned to the reforestation obligations in the sale agreement was simply a factor in determining the fair market value of the forest tenures.
Although the SCC concluded that Alberta's regulatory scheme, which expressly prohibits the sale of a forest tenure without the assumption by the purchaser of the reforestation obligations, has the effect of embedding the reforestation obligations in the tenure, CAPP submitted that future obligations may be embedded in a property right even in the absence of a statutory or other governmental requirement. The SCC stated:
"While I need not decide that question on the record before me, I would certainly not foreclose the possibility that obligations associated with a 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 the property right without assigning those obligations to the purchaser."
Impact on the Oil and Gas Industry
While at first glance, this appears to be a favourable result for the oil and gas industry, this statement is not binding and does not create legal precedent. While the Court accepted the concept of an embedded liability, it did not go so far as to make a pronouncement as to whether other obligations, such as environmental obligations in the oil and gas industry which the purchaser is not explicitly required by legislation to assume, are also embedded in the property such that they cannot be separated from the property right. What must now be determined is whether there is a substantial difference between reforestation obligations, which by statute, must be assumed by a purchaser inorder to effect a sale of a forest tenure, and environmental obligations in the oil and gas context.
Environmental and Reclamation Obligations in Alberta
Under the Alberta Environmental Protection and Enhancement Act (EPEA), an operator has a duty to conserve and reclaim specified land. "Specified land" includes land that is being used or has been used or held for the construction or operation of a well, a pipeline, a battery, an oil production site, a plant, an exploration operation, and a mine. An "operator" includes a working interest participant in a well, a mine, an oil sands processing plant, a plant or facility, a holder of a surface lease, an approval or registration holder who carries on or has carried on an activity on or in respect of specified land pursuant to an approval or registration, or any person who carries on or has carried on an activity on or in respect of specified land other than pursuant to an approval or registration. Although there is no specific rule in the EPEA which prohibits the transfer of a property right without the assumption by the purchaser of reclamation obligations, it is clear that by virtue of the legislation, the purchaser does assume the reclamation obligations; as operator, the purchaser has the statutory duty to reclaim the land.
It is generally the practice of Alberta Environment and Sustainable Resource Development (AESRD) to hold the last or current operator responsible for reclamation. This practice has been recognized and accepted by the courts, as well as by the oil and gas industry. However, in contrast to the forestry industry, the vendor of an oil and gas property right is not completely absolved of liability upon the transfer of a property right to a purchaser. While the general practice of AESRD is to hold the current operator responsible, AESRD does have the discretion and ability to go after any previous holder of the property right. The "polluter pays" principle has been enshrined as one of the purposes of the EPEA, and recognizes the responsibility of polluters to pay for the costs of their actions. One of the tools regularly employed by AESRD is an environmental protection order (EPO), which may be issued for a variety of purposes, including reclamation, and EPOs have been issued to a historic operator years after the property had been transferred to a purchaser. For example, in Imperial Oil Ltd. (Re), Imperial Oil was held to be a "person responsible" for historic contamination under the EPEA. In that case, the development of Lynnview Ridge in Calgary had been operated as an Imperial Oil refinery and later transformed into a housing development. Soil contamination was eventually discovered, and 20 years after Imperial Oil had sold the land, Imperial Oil, as a "person responsible", was issued an EPO and required to assess the extent of the pollution and clean it up or properly manage its risks. Imperial Oil challenged the EPO, arguing that the liabilities associated with the EPO should be shared amongst subsequent owners of the land, but this argument was dismissed; as the source of the hydrocarbon contamination, Imperial Oil was the party responsible for the clean-up. This was a clear example of AESRD applying the "polluter pays" principle and holding a previous owner of the property responsible for the cost of remediation.
As argued by CAPP in Daishowa, the statutory duty to reclaim is so connected to oil and gas activities that this obligation cannot be separated from the property right itself. Essentially, under the Alberta regulatory regime, the purchaser acquires the oil and gas property on an "as is" basis, and generally, the current owner of the property right will be held responsible for the reclamation. Further, as a matter of accepted commercial practice, the estimated cost of future reclamation is factored in when arriving at the value and therefore the purchase price of an oil and gas property, and is generally not set apart as a liability distinct from the property right itself. Just as with the reforestation obligations in Daishowa, the reclamation obligations under the EPEA are future costs that cannot be severed from the property, and which simply serve to depress the value of the property. In fact, in the oil and gas industry, the reclamation obligations are so much a part of the asset that as a matter of commercial practice, there is generally no explicit assumption by the purchaser of reclamation obligations in the purchase and sale agreement.
An additional layer of uncertainty exists in the oil and gas industry with respect to certain contingent obligations, such as the remediation of potential gas releases or water and soil contamination. Unlike reclamation, these obligations are contingent in nature; they depend upon an event which may or may not occur. In Daishowa, the SCC considered and dismissed DMI's argument that the reforestation obligations should not be included in its proceeds of disposition because of their contingent nature, as this argument assumed that the reforestation obligations were not embedded in the forest tenure and would constitute proceeds of disposition if not for their contingent nature. However, the SCC did provide some useful comments with respect to contingent liabilities, again using the example of a sale of a building requiring repair. The SCC stated that the purchaser's assumption of the future costs of repairing the building is not part of the sale price, regardless of whether the requirement for repairs depends on some future event.The SCC held that an obligation which cannot be severed from the property should not form part of the vendor's proceeds of disposition, and it is irrelevant whether that obligation is contingent or absolute.
Potential remediation liabilities, just like reclamation and reforestation obligations, are embedded in the oil and gas property right, and they will decrease the sale price by affecting the amount the purchaser is willing to pay for the property right. Certain environmental remediation liabilities will be contingent in nature, as they may not be discovered during the due diligence process. For example, the effects of a hydrocarbon release may occur years after the property is transferred to the purchaser, with no indication of such an event at the due diligence stage. The liability for such future occurrences is assumed by the purchaser, and often, the purchaser will indemnify the vendor against these contingent liabilities. The assumption by the purchaser of such liabilities, just like reclamation obligations, is factored into the purchase price. These liabilities, although contingent in nature, are not distinct and severable; they are embedded in the oil and gas property right, and are future costs associated with the ownership of the property right.
As a matter of commercial practice, potential remediation liabilities are often dealt with in a purchase and sale agreement. Generally, the purchaser will assume the liability for any future contamination which may arise, and provide an indemnity to the vendor. Although these are contractual obligations, there are also statutory obligations in place. As discussed above, the practice of AESRD is to issue an EPO to the current owner of a property right for any contamination; however, AESRD may issue an EPO to a previous owner based on the "polluter pays" principle.
Practical Effect of Daishowa on the Oil and Gas Industry
Overall, it appears that the regulatory regime in Alberta with respect to reclamation and other environmental obligations is substantially similar to the regulatory regime in Daishowa. Although there is not an express prohibition of a sale of an oil and gas property right without the assumption by the purchaser of reclamation and other environmental obligations, the effect of the EPEAis to transfer the duty to reclaim and the responsibility for any remediation to the purchaser. The one major difference is with respect to the vendor's liability once the property right has been transferred. In the forestry context, once a forest tenure has been assigned, the vendor is absolved of all liability for reforestation obligations. In the oil and gas context, it is the general practice of AESRD to hold the current owner responsible for reclamation and remediation, but the "polluter pays" principle can and has been used to hold a previous owner responsible for those obligations. This difference provides an interesting twist, and bolsters the argument that the assumption by the purchaser of reclamation and other environmental obligations should not be included in the vendor's proceeds of disposition. In Daishowa, the Minister argued that the relief of DMI from the reforestation obligations constituted consideration for the assumption by the purchaser of those liabilities, and that DMI received a benefit on the assumption of the reforestation obligations by the purchaser. In the forestry context, perhaps the vendor does receive a benefit, as it is absolved of all future reforestation obligations. However, in the oil and gas context, it is arguable that the vendor is not receiving a benefit at all; based on the Alberta regulatory regime, the vendor may not be absolved of any future liability, and may one day be called upon to pay for reclamation or remediation costs.
The practical effect of Daishowa is that parties should use caution in drafting their purchase and sale agreements. It is likely that in Daishowa, the Canada Revenue Agency arguably adopted its assessing position because the parties identified an estimated future cost of reforestation. Parties should be aware of what obligations are being assumed by the purchaser, and whether such obligations are "embedded" in the property right itself. Where assumed obligations are embedded in the property right, parties should be cautious to treat them as such, rather than as separate and distinct liabilities. Although as a matter of commercial practice, the estimated costs of future reclamation and remediation are factored in when arriving at the fair market value of a property right, the purchase and sale agreement should provide for a single price for the property right, and as a matter of caution, should not allocate any amount to any embedded obligations which are assumed by the purchaser.