On May 23, 2013, the Supreme Court of Canada (“SCC”) released its decision in Daishowa-Marubeni International Ltd. v. R. (2013 SCC 29) (“Daishowa”). Rothstein J., writing for a unanimous court, introduced the decision by posing the age-old question “If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?” Members of the tax community have found this quote to be particularly entertaining.
In its decision, the SCC addressed whether an estimate of the cost of reforestation obligations assumed by purchasers on the acquisition of two separate forest tenures should be included in the vendor Daishowa’s proceeds of disposition for tax purposes.
In finding for the taxpayer, thereby overturning the Federal Court of Appeal (the “FCA”) decision, the SCC concluded that the obligation to reforest areas harvested in accordance with a forest tenure “are a future cost embedded in the forest tenure that serves to depress the tenure’s value at the time of sale. […] They are not a liability that can be separated from the forest tenure, the assumption of which would form part of the sale price of the tenure.” The SCC also found that the proceeds of disposition did not depend on whether the purchaser and the vendor agreed to a specific estimate of the cost of the reforestation obligations, but simply factored into the determination of the fair market value of the forest tenures. The SCC further held that estimates by Daishowa of its cost of future reforestation for accounting purposes were irrelevant, and served a different purpose than for income tax.
Daishowa operated two timber divisions (High Level Division and Brewster Division) in Alberta, each of which held a forest tenure that allowed it to cut and remove timber from certain lands owned by the Province of Alberta. The High Level Division’s forest tenure arose pursuant to a Forest Management Agreement with the Province of Alberta. The Brewster Division’s forest tenure arose from timber quotas issued by the Province of Alberta.
Both the Forest Management Agreement and the timber quotas imposed regulatory obligations on the owner of such tenures to undertake certain reforestation activities, over time, after a timber harvest, in accordance with the Forests Act (Alberta). The reforestation obligations typically remain outstanding for a period of 8 to 14 years from the date of cutting, and the transfer of the forest tenure required a purchaser to assume the reforestation obligations.
In 1999 and 2000, Daishowa sold its High Level and Brewster Divisions, together with the respective forest tenures, in two separate transactions. The purchase price for the High Level Division was approximately $180 million less $11 million being an estimate of the contingent reforestation obligation assumed by the purchaser, subject to a purchase price adjustment if the estimated reforestation obligation exceeded $11 million. The purchase price for the Brewster Division was approximately $6.1 million and the purchaser agreed to assume all the reforestation obligations of Daishowa related to this division. No estimate was provided for the reforestation obligations in the sale agreement for the Brewster Division. Daishowa’s accounting estimate of such reforestation obligations was approximately $3 million.
In its income tax returns for the 1999 and 2000 taxation years, Daishowa did not include in the proceeds of disposition of the two divisions any amounts in respect of the assumed reforestation obligations. In reassessing Daishowa the Minister of National Revenue (the “Minister”) increased the reported proceeds of disposition by the amount of assumed reforestation obligations.
Lower Court Analysis and Decisions
At the Tax Court of Canada (the “TCC”), Daishowa made several arguments with respect to the reassessed proceeds of disposition. Specifically, Daishowa argued that, at the time the transaction closed, the fair market value of the reforestation liabilities was not determinable, and therefore no amount should be included as proceeds of disposition. Alternatively, Daishowa argued that, if the fair market value could be determined, such fair market value would be less than the $11 million and $3 million estimate reassessed by the Minister. In the further alternative, Daishowa argued that it should be entitled to a deduction from income for tax purposes equal to the amount of the assumed liabilities on the basis that Daishowa had paid each of the purchasers with assets to assume such liabilities.
The TCC found that the assumed reforestation obligation should be included as proceeds of disposition. However, the TCC accepted Daishowa’s alternative argument that something less than the $11 million and $3 million estimate upon which the Minister reassessed tax should be proceeds of disposition.
Interestingly, based upon its review of the relevant Alberta legislation, the TCC indicated that the reforestation liabilities were actually assumed and did not simply or automatically pass with the forest tenures. Specifically, the TCC noted that the Province of Alberta will not approve a transfer of forest tenures unless a purchaser assumes the reforestation obligation, contrary to the “suggestion that the liability, simply by the operation of Alberta statutes, flows with the property; in other words, whoever owns the forest tenures is legally responsible for the reforestation obligation.”
The majority of the FCA, on appeal by Daishowa, and cross-appeal by the Minister, concluded that the entire fair market value of the reforestation liabilities assumed by the purchasers should be included in proceeds of disposition as part of the consideration the purchaser paid to Daishowa in accordance with the terms of the sale agreement. The FCA also concluded that the contractually negotiated estimate of the assumed reforestation liabilities for the High Level Division, and the dollar amount of the assumed reforestation liability determined by Daishowa’s auditors, should not be disturbed.
The dissenting judgment of Mainville J.A. at the FCA concluded that no amount in respect of the reforestation obligation should be included in proceeds of disposition. Mainville J.A. expressed the view that the liabilities were “inextricably linked” to the forest tenure and depressed their fair market value since the purchaser was required to assume the reforestation obligation to obtain the requisite provincial government approvals for the purchase. On this basis, the High Level Division assets were only worth $169 million and not $180 million. The assumption of the reforestation obligations were not a separate and distinct consideration for the forest tenures.
SCC Analysis and Decision
The SCC decision appears to correct the conflict or inconsistency stemming from the majority decision of the FCA and the TCC decision, both of which acknowledge that the purchaser of a forest tenure must be liable for the reforestation obligation relating to such property. Notwithstanding this acknowledgement, they effectively separated the property, and its fair market value, from the reforestation obligation, in assessing a fair market value to that reforestation obligation
The SCC agreed with Mainville J.A. in differentiating the assumption of a reforestation obligation from the assumption of an existing debt of the vendor, such as a mortgage on a building, which does not affect the value of the property it encumbers.
The SCC noted that the “effect of Alberta’s scheme is to imbed the reforestation obligations into the forest tenure, such that the obligations cannot be severed from the property itself. As such, the reforestation obligations are simply a future cost tied to the tenure that depresses the value of the tenure… [which] would decrease the amount such a prospective purchaser would be willing to pay.”
Although not relevant to this decision, the SCC acknowledged in obiter, certain submissions made by an intervener in the appeal, the Canadian Association of Petroleum Producers (“CAPP”). In its oral submissions, CAPP suggested that in the mining of oil and gas, statutory obligations to reclaim mined land may be so physically connected to the process of mining itself that the obligations cannot be separated from the property right. Specifically, the SCC stated that it “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.”
With respect to Daishowa’s argument that the assumed reforestation obligations should not be added to proceeds of disposition because the obligations were a contingent liability, the SCC concluded that such arguments were misplaced, and caused confusion in the courts below. The SCC reiterated that “the cost of reforestation is not a distinct existing liability of the vendor [and the] assumption of the cost of reforestation would thus be excluded from proceeds of disposition independent of whether the cost is absolute or contingent.”
The SCC compared the reforestation obligation to the sale of a building in need of repair, noting that “the purchaser’s assumption of the future cost of repairing the building is not part of the sale price of the building regardless of whether the purchaser is certain he will have to spend a specific amount on repairs in the future – such that the cost is absolute – or the requirement for repairs depends on some future event – such that the cost is contingent.” The certainty or likelihood of the cost of repairs may affect the sale price a purchaser is willing to pay, but does not affect whether the cost of repairs is part of the proceeds of disposition.
Takeaways from Daishowa Decision
The SCC decision seems logical, and corrects the asymmetrical treatment advocated by the Minister and permitted by both the TCC and the FCA, wherein the vendor would otherwise be taxed on the amount of the assumed obligations added to the proceeds of disposition while the purchaser’s adjusted cost base of a forest tenure would not include the estimated reforestation obligations assumed.
However, the SCC decision leaves some uncertainty with respect to the scope of liabilities which may be considered embedded (in whole or in part) rather than simply being assumed as a distinct existing liability. No doubt, this will be the subject of future cases, particularly in light of CAPP’s submissions. The seeds have been (re)planted!