Teitelbaum, J.:—The plaintiff, Westcoast Petroleum Ltd. (Westcoast) is appealing, by means of a trial de novo, reassessments of its 1978-79 income tax returns in which the Minister added to Westcoast's taxable income, for the 1978 taxation year a sum of $772,321 and for the 1979 taxation year the sums of $976,601 and $116,890.
Westcoast is an Alberta Corporation, with headquarters in Calgary. One of Westcoast's undertakings is the operation of a pipeline in British Columbia under the jurisdiction of that province's Ministry of Transportation. One of the functions of the British Columbia Ministry is to approve the tariffs which Westcoast may charge its shippers for the use of its pipeline. By changing these tariffs, Westcoast received for its 1978 taxation year a sum of $722,321 in excess of its authorized rate of return and a sum of $976,601 for 1979 in excess of its authorized rate of return.
After Westcoast received the notices of reassessment, dated May 19, 1982, it filed notices of objection to the said notices of reassessment. By a further notice of reassessment dated August 18, 1983, the 1979 adjustments were confirmed and by a notification of confirmation dated August 18, 1983, the 1978 adjustment was confirmed.
In the taxation years 1978 and 1979, the tarriffs charged by Westcoast to its customers remained at their then current levels.
During Westcoast's 1978 and 1979 taxation years, it set up a "rate stabilization reserve account" in its books and records in respect to the amount of $772,321 and $976,601, and in the 1979 taxation year, Westcoast added an interest factor of $116,890 to the "rate stabilization reserve account". The amounts of $772,321, $976,601 and $116,890 were not, according to Mr. Browning, Westcoast's Vice-President of Finance and Corporate Secretary, kept separately from other funds of Westcoast but were used by Westcoast in its everyday operations notwithstanding that, according to Mr. Laurence, Westcoast's past President, Westcoast had more than sufficient funds during the taxation years in issue to operate without the use of the funds. Westcoast admits to not reporting the amount of $772,321 as income in its 1978 tax return and did not report the amount of $976,601 as income, and deducted the amount of $116,890 in its 1979 tax return but reported these amounts as "accounts payable and accrued charges" under the current liabilities section of its balance sheet (Paragraph 5, statement of claim).
Westcoast, in its amended statement of claim, in paragraphs 6, 7 and 8 states its reasoning as to why the sums of $772,321 and $976,601 were not reported as income and why it was of the belief the sum of $116,890 is interest payable in respect of the 1979 taxation year on borrowed money used for the purpose of earning income.
6. The Plaintiff says that, notwithstanding the provisions of paragraph 12(1)(a) of the Income Tax Act, the sum of $772,321 recorded on its financial statements for its 1978 taxation year and the sum of $976,601 recorded on its financial statements for its 1979 taxation year were not received on income account and, therefore, were not properly included in the Plaintiff's taxable income for those taxation years because those amounts were received by the Plaintiff as a loan on which it was required to pay interest as described in clause 5 above. Accordingly, the Plaintiff was not legally entitled to retain such amounts for its own account at the time they were received.
7. In the alternative, the Plaintiff says that the sum of $772,321 recorded on its financial statements for its 1978 taxation year and the sum of $976,601 recorded on its financial statements for its 1979 taxation year were not required to be included in the computation of the income of the Plaintiff for those taxation years because paragraph 20(1)(m) of the Income Tax Act provides for a reserve for the full amount of those receipts.
8. The Plaintiff says further that the sum of $116,890 was interest payable in respect of the 1979 taxation year on borrowed money used for the purpose of earning income from the business within the meaning of paragraph 20(1)(c) of the Income Tax Act which is deductible in computing income for the said taxation year.
In the amended statement of defence, in paragraphs 7, 8 and 9, the defendant, Her Majesty the Queen (Crown) makes the following allegations as to why it is of the belief the sums of $772,321 and $976,601 is income and why the sum of $116,890 is not interest to earn income.
7. In reassessing the Plaintiff by Notices of Reassessment dated May 19, 1982, the Minister of National Revenue assumed, inter alia,
(a) the amounts of $772,321 and $976,601 were income from the Plaintiff's business in its 1978 and 1979 taxation years respectively,
(b) the said amounts were not reasonable amounts as a reserve in respect of goods or services that it was reasonably anticipated would have to be delivered or rendered after the end of the plaintiff's 1978 and 1979 taxation years,
(c) the said amounts were not outlays or expenses incurred by the Plaintiff for the purpose of gaining or producing income from its business in its 1978 and 1979 taxation years,
(d) the amount of $116,890 was not an outlay or expense incurred by the Plaintiff for the purpose of gaining or producing income from its business in its 1979 taxation year.
8. The Defendant further says that in 1978 and 1979 the amounts of $772,321 and $976,601 respectively were transferred or credited by the Plaintiff to a reserve or contingent account within the meaning of paragraph 18(1)(e) of the Income Tax Act.
9. The Defendant further says that the amount of $116,890 in 1979 was not payable by the Plaintiff in respect of the 1979 taxation year pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.
Westcoast called two ordinary witnesses and one expert witness to give evidence on its behalf. The Crown called one expert witness on its behalf.
The Issues
Westcoast makes three specific arguments in relation to the inclusion of the amount of $772,321 in its 1978 return as income and the amount of $976,601 in its 1979 return as income.
First, it claims the excess profits as a loan, since it alleges it was not legally entitled to retain such amounts for its own use at the time they were received. Hence, the amounts should not be included in income.
Secondly, if the amounts are not loans, they represent legitimate reserves for which the Income Tax Act (I.T.A.) provides a deduction from income which would offset any inclusion of these amounts in income.
Thirdly, if the amounts represent loans, Westcoast claims the interest is deductible as an expense since it relates to money borrowed for the purpose of earning income.
What must be decided is the character of the "excess" funds received by Westcoast for the 1978-1979 taxation years. Westcoast states these "excess" funds cannot be considered as income, in that the funds have not been earned, the funds are owing to the shippers/producers and thus the sum of $116,890 charged by Westcoast must be considered as an interest expense. Westcoast is of the belief that the sum of $116,890 is a legitimate legal interest expense as it is retaining "excess" funds owing to shippers/producers and until the excess sum is "repaid" to the shippers/producers, it must pay interest for the "excess" funds.
It is also Westcoast's submission that the funds could also be considered as deferred revenue not earned in 1978 and 1979 pursuant to paragraph 12(1)(e) or 20(1)(m) of the I.T.A.
At the commencement of the hearing, Westcoast made an amendment to the conclusion of the amended statement of claim by adding, after paragraph a) the following “by further allowing deduction of interest in the amount of $116,800.” The amendment was allowed.
Exhibits 1, 2 and 3 are filed by consent. Exhibits 4, 5 and 6 are filed by consent, subject to interpretation and inference to be made by the defendant.
Mr. Robert Howard Laurence (Laurence) was called by Westcoast as its first witness. Laurence was employed by Westcoast in 1974 as Vice-President, Exploration. He became President in 1976. He took early retirement in mid 1981.
Laurence explained that he is familiar with the pipeline operations of Westcoast and the structure of the tariff charges before 1976. The pipeline was constructed pursuant to terms of an agreement dated January 31, 1961 (Exhibit 2-1) and amended on September 26,1961 (Exhibit 2-2). Exhibit 2-1 is an agreement entered into by Westcoast Transmission Company Limited and Her Majesty the Queen in Right of the Province of British Columbia represented by the Minister of Commercial Transport (Minister). One of the obligations of Westcoast Transmission was to incorporate a company under the laws of British Columbia with the registered office being in the Province of British Columbia. The principal object of the corporation is the construction and operation of a pipeline and any extension thereto. The amending agreement, Exhibit 2-2, is between Westcoast Transmission, the Minister and the company incorporated pursuant to Exhibit 2-1, Western Pacific Products and Crude Oil Pipelines Ltd. (Westpack) Westpack & Westcoast Transmission became, in 1971, Westcoast Petroleum Ltd., the plaintiff in the present proceedings. A further amendment to Exhibits 2-1 and 2-2 took place on November 1, 1966 (Exhibit 2-3). The purpose, according to Laurence, of Exhibit 2-3, is to define the obligation of Westpack to expand the agreement of January 31, 1961 (Exhibit 2-1) to include a schedule of tariffs and to establish a review of tariffs, if requested by either party to the agreement on the 5th and 10th anniversary of the agreement. Exhibit 2-3 is the agreement governing the operation of the pipeline from October 1966. This agreement was in effect when Laurence became President of Westcoast.
The pipeline originated in Taylor, B.C., was 12 inches in diameter and terminated in Kamloops, B.C. near the Trans Mountain pipeline. In 1976, a small spur was built for Prince George, B.C. According to Exhibit 2-1, the capacity of throughput of the pipeline was to be not less than 75,000 barrels (of oil) per day. Laurence states that when originally built, the throughput was 45,000 barrels per day, that subsequent expansion to the pipeline increased the throughput by adding more horse power and more pumping stations.
Up to 1974, Westcoast confined its charges to a tariff in a tariff schedule set out in the agreement of 1961 (Exhibit 2-1) and changed in the agreement of 1966 (Exhibit 2-3). The tariff charged per barrel decreased as the throughput increased. It was a rigid fixed tariff (Exhibit 2-3, page 6). Westcoast could charge 66# per barrel for throughput of from 0 to 30,000 barrels per day but only 38¢ per barrel for throughput of from 70,001 to 75,000 barrels per day.
In September 1974, approximately two years before the review date fixed in Exhibit 2-3, Westcoast made a submission to the Minister for an increase in the tariff of 16# per barrel for oil being transported from Taylor, B.C. to Kamloops, B.C. and an increase of 9.5# per barrel for oil being transported from Taylor, B.C. to Prince George, B.C. Exhibit 4 is the submission made by Westcoast to the Minister. The submission is titled "For a Review of Existing Tariff Schedule". Laurence alleges that the reason for the request for an increase in tariff before the fixed review date was that it was determined and became apparent in 1974 that the production of oil in north east British Columbia had peaked in 1971 at approximately 70,000 barrels per day, that this amount decreased to approximately 58,000 barrels per day and the projection showed a declining curve. The decline would continue to shorten the “life” of the pipeline to approximately ten years from an original "life" of 30 years. Up to 1974, the pipeline throughput peaked at approximately 70,000 barrels per day and the projection showed a decline curve and the decline would continue to shorten the “life” of the pipeline to approximately ten years. From the peak of 70,000 barrels per day of throughput, there was a decline to 58,000 barrels per day in 1969 and a further reduction of throughput to approximately 48,000 barrels per day in 1974. The pipeline became utilized which would mean a "shortened life" for the pipeline. Therefore, Westcoast asked for an increase in tariffs two years before a scheduled review date. Laurence also gave as a reason for requesting an increase in tariffs the increased costs of environmental measures and inflation. In February 1975, the Minister granted an increase of 2# per barrel of oil throughput for oil from Taylor to Kamloops, B.C. and 1.5¢ per barrel of oil throughput from Taylor to Prince George, B.C. This was only an interim rate adjustment (Exhibit 5). The Minister also informed Westcoast, in Exhibit 5, that the interim rate of adjustment will maintain Westcoast's revenue "at a reasonable level pending a full review of your tariff application by the B.C. Energy Commission.”
A further interim adjustment was granted by the Minister, in a letter dated July 23, 1975, whereby Westcoast could charge 80¢ a barrel of oil to be transported from Taylor to Kamloops and 49.5# per barrel of oil to be transported from Taylor to Prince George (Exhibit 6). In Exhibit 6, the Minister proposed that a cost for service principle be adopted with regard to determination of interim tariffs commencing January 1976. The Minister suggests the recommended rate of return on equity in the rate base be 11.4 per cent plus depreciation calculated on annual throughput volumes.
In addition to the above, it is proposed that the cost for service principle be adopted with regard to determination of interim tariffs commencing in January 1976. The recommended rate of return on equity in the rate base for such an arrangement is 11.4%. At the same time it is proposed that depreciation charges will be related to the annual throughput volumes based on projected remaining lifetime volumes.
Consideration is also being given to the possibility of holding a public hearing in 1976 for the purpose of considering all aspects pertaining to the operation of the pipeline, and in particular the appropriate tariffs to be charged after November 1, 1976 in accord with the existing agreement.
(Exhibit 6)
Cost of service principle is defined by Laurence as the cost of operating the pipeline, both tangible and intangible, with a given rate of return plus depreciation determined on an annual throughput volume.
Laurence states that as regards depreciation, the original cost of the "plant" was depreciated on a straight line basis, 30-year life for the pipeline, but that it was changed to a throughput volume depreciation calculated on the remaining life of oil reserves. He states that the problem with this method is that it is most imprecise. It is impossible to know what are the remaining oil reserves and what amounts of oil will be continued to be shipped via the pipeline, the volume depending on the requirements of the refineries and what the shippers will ship. Laurence states that the concept is simple but lacks in precision in that, the oil reserves are constantly changing as are the requirements of the shippers.
Westcoast accepted the principle of the proposal contained in Exhibit 5. Exhibit 2-5 dated March 26, 1976 is the accepted proposal by the Minister. Westcoast was allowed a 27# per barrel depreciation rate as well as 80¢ per barrel of oil to Kamloops and 49.5# per barrel to Prince George.
This is to advise that I have no objection to the Company changing to a throughput method of depreciation, as of January 1, 1976. Based on discussions between our respective staffs the depreciation rate would be 27# per barrel until otherwise approved.
Throughput and revenue projections for 1976 indicate that the existing interim rates of .80¢ to Kamloops and .495¢ to Prince George will provide a rate of return on the rate base of approximately 10 /2%. As this is in keeping with your recent presentation to me I consider the existing rates to be adequate for 1976.
If the Company decides to retain the straight line basis of depreciation for 1976 it will be necessary to reduce the tariff to some lesser level consistent with a similar rate of return.
(Exhibit 2-5)
It is to be noted that it is the Minister who advised Westcoast that he had no objection to a change in the method of depreciation proposed by Westcoast and states he is satisfied with the existing tariff rates.
On April 15, 1976, Westcoast received a letter dated April 12,1976 informing it that the pipeline situation is to be referred for a review to the B.C. Energy Commission (Exhibit 2-8). In the spring of 1976, representatives of Westcoast met with the principals of the B.C. Energy Commission to ask for an interim upward adjustment. Westcoast was told that the Commission would hold a public hearing, which was scheduled for November 11 or 12, 1976 but was later deferred. The last proposed date for the hearing was to have been January 11 and 12,1977.
On May 17, 1976, the B.C. Energy Commission, by Order G-23-76, granted Westcoast an increase in its tariffs effective June 1, 1976. It is important to note that in G-23-76, it is stated:
PROVIDED however that the foregoing tariff is authorized on an interim basis pending a full determination of the matters referred to in said direction at a public hearing to be held by the Commission. The rates or a portion thereof hereby
authorized will be subject to refund together with interest at 9 per cent per annum thereon pending the result of such public hearing.
(Exhibit 2-12)
[Emphasis added. I
According to G-23-76, the rate increase is authorized on an interim basis pending determination of matters relating to capital structure, cost of service, traffic, tolls and tariffs and rate of return at a public hearing by the Commission. The order then states that the rates authorized in the Order dated May 17, 1976 or a portion thereof will be subject to refund together with interest at nine per cent per annum pending the result of the public hearing. No public hearing ever took place and Westcoast was never ordered to refund any of the sums it received from shippers as a result of this Order. Laurence alleges that Westcoast was of the opinion that any surplus was refundable and therefore he suggested a tariff cut when Westcoast realized that its return would be higher than that which was agreed to with the Minister (Exhibit 2-15).
I am of the view that a tariff reduction for future years is not a refund. The same shippers/producers may or may not ship the same quantities of oil as in the year in which the surplus was made. Therefore, the shipper which had shipped less oil in the following year or years would not get its "proper refund".
The Commission wrote back stating Westcoast is to continue to charge the tariff approved in Order G-23-76 (Exhibit 2-12) “with the excess revenue subject to refund with interest at 9% per annum" (Exhibit 2-16).
On August 13, 1976, an order, G-30-76, was issued by the Commission allowing for a reduction in the tariffs to be charged shippers (Exhibit 2-19). Subsequently, Westcoast made representations to the Minister to take away jurisdiction from the Commission and to keep the jurisdiction within his own department. During this time, Westcoast worked out an agreement acceptable to all shippers on tariff determination. Since only the shippers could have an interest on tariff determination and they were satisfied with the agreement arrived at with Westcoast, Westcoast suggested that the public hearing as proposed by the Commission is no longer necessary. By January 1977, Laurence was advised that the Minister would keep complete jurisdiction over Westcoast's pipeline operation. From May 26, 1977, Westcoast never heard further from the Commission.
Laurence states Westcoast was concerned about the refund to be made as mentioned in order G-23-76 (Exhibit 2-12) because the order does not give any indication as to how the refund should be made. The agreement, he states, with the shippers was that any surplus be factored into subsequent tariffs having the effect of increasing, in future years, the price received by the producer for the oil transported (Exhibit 2-17, page 2, last full paragraph).
Laurence states the consensus at the August 1976 meeting with the shippers/producers was that by lowering the tariff "the surplus which Westcoast had received would eventually find its way back to the producers". Westcoast has no contracts with producers. It only deals with shippers. Exhibit 2-17 is a letter written by Westcoast to shippers who may also be producers. The letter was written following the meeting where Westcoast made proposals for tariff determination. In Exhibit 2-17 memorandum dated September 13, 1976, on page 3 paragraph (d) is found the proposal made by Westcoast to the shippers/producers. The essence of the proposal is to establish a formula for tariff determination on a cost of service basis acceptable to the shippers/producers. It was proposed that any excess or shortfall would be carried forward. Seven of eight responses agreed to the formula according to Laurence.
(d) Because of the variables which are inherent in our pipeline operations, it is probable that actual revenue generated could either fall short or exceed to some extent the amount required to achieve the agreed upon rate of return. Accordingly, Westcoast would propose that a semi-annual financial review take place each year for the purpose of allowing the Company to adjust these tariffs, if required, to achieve this return. In addition, any excess or short-fall in revenue determined on an annual basis would be carried forward and factored into revenue requirements and tariff determinations for the succeeding year. At the end of each year a financial report, including a forecast of the ensuing years' operations and proposed tariffs, would be forwarded to each of the Producers and the Minister of Transport and Communications.
(Exhibit 2-17, Memorandum dated Sept. 13, 1976, page 3, paragraph (d))
The above proposal was approved by the Minister. From 1976 to the time Laurence left Westcoast on early retirement, mid 1981, it was the method used to calculate tariffs although no semi-annual financial review ever took place with the shippers nor was any excess carried forward and factored into revenue requirements and tariff determination for the succeeding year. Westcoast also failed to send a financial report at the end of each year to the shippers. It also failed to send a forecast of the ensuing years operations and proposed tariffs. What was sent were notifications of tariff changes.
There is no mention of interest in the proposal but the issue of interest was raised by the Minister. Interest was accrued in respect of the surplus as of the 1979 year.
Laurence admitted that although the above approved proposal speaks of a semi-annual financial review take place for the purpose of allowing West- coast to adjust the tariffs, it never took place with the producers/shippers, it only occurred internally. He states the tariffs were not adjusted semiannually but only as required. There was no change in the tariff from October 1, 1977 to November 1, 1979. There was no semi-annual adjustment nor is there any commitment, he states, to make a semi-annual adjustment. He also admits that financial statements were not sent out to the producers/ shippers although this is stated in the proposal above mentioned.
In summary, Laurence states, in his testimony, that it was his understanding of the agreement with regard to any surplus amounts received by Westcoast from the operation of the pipeline, that because Westcoast could never predict with any accuracy what the throughput would be in any given year and what repairs to the pipeline would be required in any given year, this left Westcoast in a position that it could not predict what its revenues would be. It was his understanding that if Westcoast had a higher rate of return than what was allowed, the surplus is a refundable surplus, an obligation to the shippers/producers and if the revenue was less than the permitted amount, the revenue could be made up in subsequent years by higher tariff charges.
Laurence is of the opinion that the proposal found in Exhibit 2-17 memorandum of September 13, 1966, paragraph (d) was not followed with the producers/shippers “as it could not achieve anything". It was only effective or put into operation with the agreement of the Minister, the agreement of the shippers was not required.
In cross-examination Laurence explained, in part, the operation of the pipeline. The shipper tenders the oil for transportation. The shipper pays the cost of transportation in accordance with the tolls (tariffs) then in effect. The shipper is billed in accordance with the rates then in effect. In the event that the shipper does not pay the amount of the invoice within ten days, the carrier, Westcoast, would have the legal right to sell the oil as Westcoast retains a lien on the oil in the event of non-payment. Subsequent to 1975, the tariff was determined on a cost of service basis, the shipper tenders its oil for shipment and pays the charges in accordance with the published tariff. The shipper is notified by Westcoast of a tariff change (Exhibit 2-34). Exhibit 3-3 is a schedule of Westcoast's charges. These charges remained in effect to November 1, 1979. For the taxation year 1978 and to October 1979 taxation year, the shipper would pay charges in accordance with the schedule found in Exhibit 3-3. All notifications of tariff changes must be approved by the Minister only. All tariff adjustments are conditional on the Minister’s approval. The approval of the shippers as to any tariff adjustments was not sought.
Laurence admits that there never was a cash refund to the shippers in 1977,1978 and 1979. In fact, Westcoast never made a cash refund to any one of the shippers/producers. Westcoast had a surplus in 1978. It also had a surplus in 1979 (Exhibit 3-4). The 1978 surplus was not factored into the 1979 tariff charges. There was no surplus factored into the 1978, 1979 and 1980 years. There was no change in the tariff from November 1,1979 to 1983. The shippers were not advised that in 1979 Westcoast had a surplus of $186,922.
The surplus money according to Laurence was never used by Westcoast in the operation of its business in that Westcoast had more than sufficient funds at the time to operate its business. Laurence believes, and this was confirmed, that the surplus funds were never segregated from the company's funds and kept in a separate bank account.
Laurence is of the opinion that although there was no reduction in the tariff to the end of 1978, he believes Westcoast could have made one. Westcoast decided not to make a reduction as Westcoast thought it not necessary to do so. This statement was later retracted by Laurence. He then states that no reduction was made because at that time Westcoast's (financial) position was not known due to two breaks in the pipeline and the costs that would be incurred in the repairs to the pipeline and to maintain an ongoing security for the pipeline.
The evidence of Laurence is such that I am satisfied that Westcoast had full discretion as to what to do with the surplus funds. Westcoast could decide if it would or would not factor into the subsequent year or years any surplus it retained. It is correct to say that the Minister had to approve a tariff change but it was always Westcoast that would initiate any tariff change. The shippers were simply notified of the tariff change.
In fact, Westcoast never told the shippers of any surplus it retained. I am satisfied that an agreement existed with the Minister that the surplus would be, eventually, factored into future tariffs but no agreement exists as to when this was to be done. It was all left to the discretion of Westcoast.
As further evidence of Westcoast's discretion with the use of the surplus funds is the evidence of Laurence that Westcoast did not use the surplus funds in its operations as it had its own funds. If this is so, why would Westcoast keep the surplus funds, pay nine per cent interest for the surplus funds as if these funds were a loan and not tell the shippers of the existing surplus. Surely if at the end of 1978 a tariff reduction could have been made but was not made, as Laurence states “it is not necessary to make", this clearly indicates a discretion as to when a reduction of tariffs will be made. If the surplus is to be considered a debt, an obligation to refund or repay, surely the repayment would have been done as soon as possible by Westcoast.
Ronald Charles Browning was employed by Westcoast on January 1, 1980. In 1980, he was hired as the company Treasurer. He now is the company's Vice-President of Finance and its Corporate Secretary. It was he who prepared the financial statements and tax returns for the taxation year 1979. He has looked at the accounting practices of Westcoast including its pipeline operation and he concluded that the method of accounting used in the previous (1978-79) two years was appropriate. With regard to the pipeline operation, the income “was basically the allowed rate of return set by the governing body, any deficit would be made up by tariff increases at future dates and any surplus would be used up through lower future tariffs”.
The adjustments were recorded in a payable-receivable account. The witness prepared the rate stabilization account, 1976 to 1986 found in Exhibit 3-4. Exhibit 3-4 shows the balance in the rate stabilization account for the years 1976 to 1986 including interest from 1979 to 1986.
Westcoast received its audited statement (Exhibit 1, page 44) as at December 31, 1979. In the liability column is the surplus retained by Westcoast. The surplus forms part of Westcoast's liabilities. There was no advice from Clarkson Gordon, Westcoast's auditors, that the financial statements should be qualified because of this.
The surplus amounts shown in Exhibit 3-4 would be communicated to the Minister, Browning states, at least once per year and, on occasion, 2 or 3 times per year.
Exhibit 3-12 are calculations to demonstrate the effect of various tariffs on the surplus held by Westcoast. It shows a surplus revenue as of December 31, 1978 of $772,000 then projects the revenue required which is based on the rate of return, operating expenses and taxes. The projected surplus revenue is based on total revenue of $10,059,000.
Mr. Browning states that for the years 1980-81-82 the tariff receipts were deficient before the calculation of interest. This resulted in the surplus declining. He then went on to describe that in 1982 the throughput was forecast at 9.8 million barrels which was a decrease of 1 million barrels from the previous year. He states that if this had occurred there would have been a reduction in the surplus account as there would have been insufficient revenue to meet the rate of return Westcoast was entitled to, which would have resulted in a deficit. In 1983, there is a substantial increase in the surplus because of increased throughput which was not projected nor did the predicted reduction in production of oil occur. Westcoast had predicted a throughput of 9.5 million barrels but found, at the end of the year, a throughput of 10.8 million barrels. This accounted for the increase in the surplus.
The forecasts of throughput, according to Browning, is made by Westcoast from information it obtains from its shippers. Westcoast plays, according to this witness, no part in the forecasts.
The surplus money was accounted for in a reserve account but was not in a separate bank account, it being included in Westcoast's funds. He admits that the shippers were billed in accordance with the approved tariff. A shipper would normally be invoiced twice a month for transportation of oil.
With regard to the interest factor the witness states that interest was deducted as an expense. A book entry was made to this effect but Westcoast kept the money in its general account. The interest, although not paid out, was compounded. It would enable Westcoast to lower tariffs in subsequent years if there was found to be a sufficiently high surplus.
Browning states that in 1980-81-82, the tariffs fell far short of the required revenues and in this manner he states the shippers were paid back "by not increasing the tariffs the shippers were paid back". He does not know if the Minister would have allowed an increase in tariffs even if Westcoast showed a surplus.
I am satisfied from Mr. Browning's evidence and it corroborates Laurence, that it is not in Westcoast's complete discretion to increase tariffs. The Minister must give his consent to any tariff change. The evidence shows that it is Westcoast who, at its discretion, initiates the process to request an increase. Westcoast therefore decides, when, if at all, it reduces the tariff or leaves it as its then rate which may or may not reduce the amount of funds held in the surplus account. Westcoast, in its discretion, decides if it will or will not factor into the tariffs to be set the surplus it is holding.
Mr. Henry Richardson Lawrie (Lawrie) was called by Westcoast as its expert witness. Lawrie is a chartered accountant with the firm of Price Waterhouse. Counsel for the Crown agreed that Lawrie can be considered an expert witness.
It was agreed that Lawrie's report should be admitted as having been read. Deleted from the report is paragraph "g" on pages 7 and 8, a portion of paragraph (i) on page 15 and the words “and, if the pipeline were sold or abandoned", from paragraph (ii) on page 16. These deletions, according to Lawrie, in no way change his opinion as stated in his report.
Lawrie's report is filed as Exhibit 7. In pages 1 to 8 to the end of paragraph 4, Lawrie lists the facts upon which he based his report. He states that after listening to the evidence of Laurence & Browning he saw no reason to make any changes to his report. The facts, in preparing his report which he judged to be material are:
(1) Westcoast had to receive the Minister’s approval in setting tariffs
(2) Westcoast was entitled to earn a permitted rate of return subject to the approval of the Minister
(3) Westcoast was required to account for the tariff receipts in excess of permitted rate of return and to take the excess receipts (surplus) into acocunt in setting tariffs in subsequent years.
(4) Westcoast was required to accrue interest on the surplus and to take that amount into account in setting tariffs in subsequent years
(5) The producers involved, in the majority, agreeing to such an arrangement
(6) Westcoast did all of the above.
The questions that Lawrie is asked to answer are:
(a) Did the amounts of $722,321 (or $852,321) and $976,601 constitute revenues of Westcoast for the 1978 and 1979 years, respectively, in accordance with generally accepted accounting principles?
(b) If such amounts did not constitute revenues, what do they constitute under generally accepted accounting principles?
(c) Was the interest of $116,890 accrued at December 31, 1979 an expense for 1979 in accordance with generally accepted accounting prnciples?
(Exhibit 7, pages 10 & 11)
Lawrie is of the opinion that the amounts of $772,321 for the taxation year 1978 and $976,601 for the taxation year 1979 do not constitute revenues for Westcoast in accordance with generally accepted accounting principles, that these sums represent a debt or liability.
Lawrie believes that the above mentioned sums are not revenue. He states that in order for the above mentioned sums to be revenue, the money must have been earned “meaning, there is nothing requiring the company (Westcoast) to pay it back".
He is of the belief that Westcoast has a debt or liability because the amounts in issue had to be paid back or accounted for, to be paid back including accrued interest. On page 15 of Exhibit 7, Lawrie has this to say as to why the amounts in issue are to be considered a debt or liability:
By definition, those amounts should be considered to constitute a debt or liability. They represented "a sum of money owed by one person (the debtor—Westcoast) to another (the creditor—the shipper(s)). They are payable at some fixed or determinable future date; that is, the following year by reducing the tariffs which would otherwise be permitted and collected in that year. The amounts also have the characteristic of a liability in that interest is to be accrued on them.
As will be seen, I am satisfied that Lawrie erred when he based his opinion on the assumption that the amount of the surplus represented a sum of money owed by Westcoast to the shippers. I am satisfied the shippers never had the legal right to claim any of the surplus from Westcoast.
In speaking of whether the amounts in issue are revenues, Lawrie states:
By definition, the amounts might possibly be considered to constitute revenues. However, if they were revenues, those revenues were not earned in those years because Westcoast was not entitled to them, but was to account to and report the amounts to the Ministry and the shippers in the following years, take the amounts into account in setting subsequent tariffs (i.e. reduce what would otherwise be charged), accrue interest on the amounts and likely pay the amounts and the interest to, or for the benefit of, the shippers.
The definition, "unearned revenues", is not really appropriate. To the extent a portion of the tariff was repayable, it constituted a debt or liability.
(Pages 15 and 16, Exhibit 7)
Here again there is an apparent error in the assumptions of Lawrie. Westcoast was never and never did account to and report to the shippers of any surplus.
The witness states that he concluded that if the money in issue is revenue, it would be unearned and be deferred revenue because Westcoast had an obligation to account for the sums and to, in effect, repay the sums in issue. The sums in issue are deferred because the amounts exceeded the allowed rate of return, the amounts had to be accounted for in subsequent tariffs and therefore had to be repaid. He states there is no essential difference between unearned revenue and deferred revenue.
With regard to the issue of interest, Lawrie states, at page 16 of his report:
Interest of $116,890 accrued at December 31, 1979 was an expense for 1979 in accordance with generally accepted accounting principles.
Interest has to be calculated at 9% per annum and, if the balance was a payable, credited (added) to such balance. The other side of the credit would be a charge— a charge to interest expense. (If the balance was a receivable, the opposite situation would apply and interest receivable and income would be recorded.)
In the report under discussion found on pages 25, 26 and 27, Lawrie is of the belief that revenue should not be recognized as revenue until it is earned, that is, that Westcoast has the right to keep the revenue and not pay it back “directly or indirectly”. He states a cash receipt collected with the rendering of services is not "recognizable revenue if it must be or is likely required to be returned or repaid". He does say “In some such cases, receipts are recognized as revenue, but at the same time, a "reserve" or provision is required to be made to reflect the fact that a portion of such revenue is subject to return or repayment".
I am satisfied that Mr. Lawrie bases his entire opinion on the assumption that Westcoast, if it collects more than its permitted rate of return must repay directly or indirectly the excess (surplus) to the shippers.
In the case of Westcoast and the shippers, the amount of tariff revenue earned ina year is dependent on the permitted rate of return as approved by the Ministry. If tariffs collected exceed those so permitted, that excess does not constitute revenue, but rather a payable to the shippers. If tariffs collected are less than those permitted, Westcoast has a receivable equal to the deficiency and the revenue for the year is equal to the tariffs collected plus the tariffs receivable.
(Page 26, Exhibit 7)
For accounting purposes, the form or manner in which something is received or paid does not change its basic character; a basic accounting rule is that substance, not form, be followed. Accordingly, collecting the tariff by charging the shippers for the service does not mean that the tariff (or certainly not all of it) represented revenue. Similarly, reducing what could be collected from the shipper in the form of a tariff in the following year does not mean that that net amount represented reduced revenue.
(Page 27, Exhibit 7)
He also states that it is his opinion that specific identification of the individual creditors is not always a requirement under general acceptable accounting principles to record a liability. In the present case the shippers can be identified. He states that for accounting treatment of Westcoast, he knows of no reason to go beyond the group of shippers if this is legal. He believes Westcoast need not go to the producers. He also states that he would have provided the same accounting opinion as given by Clarkson Gordon (Exhibit 1, page 44) that is:
In our opinion, these financial statements present fairly the unconsolidated financial position of the company as at December 31, 1979 and 1978 and the results of its unconsolidated operations and changes in its financial position for the years then ended in accordance with generally accepted accounting principles applied on a consistent basis during the years.
He states any other treatment of the funds in issue would have meant a qualified opinion on his part.
He admits that if repayment was made, that is, legally discharging the debt or liability by payment to the shippers then the accounting treatment that followed the present form could be wrong. He also states that if, as a matter of law, the sum in issue is not a liability, he believes the accounting treatment of making it a liability is more valid. He then tried to qualify his answer by stating that a company can have unasserted claims against it but if the conclusion, from, I assume accountants and lawyers, is that the company will have to pay the claims, general accounting principles dictate that the claims must be shown. I am satisfied that such a claim might possibly be considered a contingent liability and not set up as a debt or liability. It is only a possible debt or liability. He admits that a contingent liability can be noted or put into the balance sheet with an explanation on the probability of having to pay the claim.
He states he arrived at his conclusion, found on page 28 of his report, that the sums in issue are debts or liabilities for Westcoast without seeking a legal definition of a liability but nevertheless concluded it was a liability. He is of the belief that a legal opinion is not necessary. He also states that, using the definitions of earned and earned revenue found on page 13 of Exhibit 7 and the definition of "earn" found on page 14 of Exhibit 7, if Westcoast had performed what was asked of it, it would “generally” be entitled to the revenue if it charged a fee for the service. If Westcoast used the revenue after it provided the service, that revenue would have been earned. He admits that Westcoast transported oil, that it billed for its service, the amount of the invoice was based on a tariff, the shipper paid for the service and the money was not segregated (he claims this is immaterial) but he maintains nevertheless this is not totally revenue because Westcoast had the obligation to repay a portion of the revenue in subsequent years. He acknowledges that the customer is the shipper and that Westcoast had no obligation to account to the shipper. He believes the only reason one cannot consider the sums received by Westcoast as earned revenue is the obligation of Westcoast to repay to the shippers a portion (the surplus) of the revenue. He admits that his answers on page 15 (ii) of Exhibit 7 “By definition, the amounts might possibly be considered to constitute revenue" and on page 16 "The definition 'unearned revenues' is not really appropriate. To the extent a portion of the tariff was repayable, it constituted a debt or liability” is his own opinion on liability and not that of a lawyer.
It is the opinion of this witness that the tariff figure is not the real figure in determining revenue. He also acknowledges that the shipper does not know the amounts in the surplus account, the times of "draw down" and that an accountant for a shipper could not note its portion of any surplus as a receivable on the shippers' financial statements.
William Grant Stephen (Stephen), a chartered accountant, testified as the Crown's expert witness. His conclusions differ with that of Lawrie. He is of the opinion that the sums in issue are earned revenues for Westcoast in 1978-1979 and that the amount of interest is not an expense to earn income. His report is filed as Exhibit 8.
Counsel for Westcoast agreed that Stephen can be considered an expert witness.
Stephen, in arriving at his opinion, states he examined Exhibits 1, 2 and 3, followed the assumptions found in (v) and (vi) of Exhibit 8, page 2, relating to legal liability (he requested a legal opinion) looked at the CICA handbook, looked at the authorities (text book), looked at pronouncements in the United States and examined a series of Public Utility Reports.
When Exhibit 8 was submitted as evidence and as read, counsel for plaintiff objected stating any opinion based on Exhibit 8-6, Report of Ontario Hydro for 1986, on Exhibit 8-7, Report of Manitoba Hydro July 8, 1988 and Exhibit 8-8, Nova Scotia Power Corporation March 31, 1986, are not admissible and should be deleted as being hearsay. I rejected the objection. Experts may rely on hearsay evidence in stating their opinion. It is simply a matter for the Court to decide how much weight should be given to such evidence. The report, Exhibit 8, was allowed to be filed as read.
Stephen's opinion is to be found on page 12 of Exhibit 8-1:
Based on the information described above, it is my opinion that the amounts received by Westcoast pursuant to a tariff charged to its customers for services rendered by it in its 1978 and 1979 taxation years, and the "interest factor” in the 1979 taxation year, which were recorded by Westcoast in an account referred to as the Rate Stabilization Account should have been recorded in Westcoast's books of account as a reserve arising from appropriations of retained earnings and not as a liability and an expense or revenue reduction.
He states that the analysis used in arriving to his opinion was that:
1) he attempted to determine whether the amount transferred to the rate stabilization account was revenue
2) he attempted to determine whether this amount was an expense
3) he attempted to determine whether this amount was a liability
and he then examined the criteria of a reserve and he concluded the account should be a reserve. In determining whether the amounts in issue are revenues, he states he is of the belief that, in the present case, revenue of Westcoast is the throughput times the relevant charges. Revenue is defined by the Canadian Institute of Chartered Accountants (CICA) as increases in economic resources flowing to a company. He states that if one were to deduct the amount put into the Rate Stabilization Account (RSA), the definition of revenue "does not follow”.
An expense is defined by the CICA as decreases in economic resources which take place in ordinary revenue activities of an entity. He states the transfer of the sums in issue to the RSA is not an expense. The earnings in excess of the desired level is not a decrease in Westcoast's economic resources as, he claims, there is no requirement to refund the difference between the actual and the desired return. He concluded there was no requirement to make a refund due to the legal opinion he obtained wherein he was told the money did not have to be refunded.
The evidence of Westcoast's witnesses confirmed the assumption made by Stephen that the surplus funds did not have to be refunded. In fact, no refund was made in the taxation years in issue nor could the shippers claim a refund.
In discussing the issue of liabilities, the witness lists three types and concludes none of the three are applicable in the present case. He lists the three types of liabilities as:
1) Legal
2) Equitable
3) Constructive
On pages 7, 8 and 9 of Exhibit 8 is a detailed discussion of each of the liabilities. He concludes there is no legal liability "that as a matter of law no legal action could have been commenced against the plaintiff (Westcoast) on behalf of the plaintiff's customers who paid the tariff in effect in the 1978 and 1979 taxation years to recover or have paid out any part of the amounts credited by the Plaintiff to the Rate Stabilization Account". He also assumed that Westcoast could not recover, by an action any "revenue deficiencies”. Counsel for Westcoast questioned the witness as to what he means when he states "no legal action could have been commenced". Counsel for Westcoast submits anyone may "commence an action”. I am satisfied that what was meant to be said was that such an action would, in the opinion of legal counsel, not be successful.
The witness also concluded, after studying the text Accounting Theory, fourth edition, by Eldon S. Hendriksen, that no equitable or constructive liability exists. The witness states that an equitable obligation is one where payment is required to keep good business relationships. In the present case, this did not exist as the shippers were not aware of the surplus and were not made aware of same. He states that Westcoast had, in his opinion a great deal of discretion with regard to the surplus. He gives as an example of Westcoast's discretion the fact that it is Westcoast who prepared for the Minister the forecast of throughput and expense and it is Westcoast that decided what would be included in the forecast. The witness also states that in order to have a liability one must be in a position to know the amount of the liability and when it must be paid, that it must be payable at a determined time. In the present case, the timing of reducing the tariffs or of not raising the tariffs is entirely at the discretion of Westcoast.
Stephen admits that his statement that the money received becomes revenue was an assumption given to him by the Crown. He admits that there are situations when amounts charged is not to be considered as revenue such as prepaid rent or insurance costs. He also admits that a charge made by one part to another is not necessarily revenue in the year when the charge is made. I find that this adds little to the present case. In the examples given by counsel for Westcoast, no service has yet been performed. In the present case, Westcoast performed the service for which it obtained payment.
Stephen is of the opinion, contrary to the opinion of Lawrie, that the amount of funds received by Westcoast in excess of what is allowed, the permitted rate of return, can be income. He states that the general practice is that whatever a company earns (on the tariff) is earnings. He so concludes because of his own expertise working with utility companies and as confirmed in Tabs 6, 7 and 8 of Exhibit 8.
The witness further states that he concluded that the revenues are increases in economic resources for Westcoast because Westcoast did not have to pay out any funds in the 1978 and 1979 taxation years and that there was no clear mechanism that the surplus would have to be paid out.
Mr. Stephen is of the view that the certificate, Exhibit 1, page 44, is incorrect. He states he would not have given such a certificate if he were to have audited the plaintiff company.
It is obvious that there is a serious difference of opinion between the two experts.
Plaintiff submits that the issue is to determine whether the revenue of Westcoast was determined in accordance with general accounting principles (GAP).
a) an amount equal to permitted rate of return and recovery of allowable costs
or
b) an amount equal to cash collected and received or receivable with respect to billings.
It is Westcoast's submission that it is the a) alternative that is the correct one. It states that all that the tariff mechanism is, is a means to collect cash. That cash collected need not always be revenue. Westcoast only included in its income part of the amount of the revenue it received, that is, the permitted rate of return and the costs incurred in operating the pipeline plus the depreciation. Counsel submits that it is well established that income determination starts with subsection 9(1) of the Income Tax Act (I.T.A.). This section states:
9. (1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.
According to plaintiff, income is profit and that the Courts have held that since there is no definition of profit in the I.T.A., general accounting principles must apply (see Dominion Taxicab Association v. Minister of National Revenue, [1954] C.T.C. 34 at 37 and 38; 54 D.T.C. 1020).
Plaintiff submits that Lawrie looked at the facts provided and gave an opinion from an accounting point of view that where the tariff collected is in excess to the permitted rate of return and costs, the excess represented an obligation and thus a liability was created.
Stephen does not agree. He states that no obligation has been created in the tax year basing himself on the assumption that no legal obligation has been created between Westcoast and the shippers of oil in the pipeline.
I am satisfied that no legal obligation has been created whereby Westcoast would have to repay the surplus funds it is holding to the shippers who paid these funds and which funds were the cause of the surplus.
In essence, it is plaintiff's submission that because it will one day have to either lower its tariffs or keep the same tariffs although its costs have increased, or raise its tariffs by a percentage less than required to ensure it receives its permitted rate of return, it is in effect returning to the shippers and thus the producers the surplus funds it holds. I do not agree.
Counsel for Westcoast refers to the case of Kenneth B.S. Robertson Limited v. M.N.R. [1944] Ex. C.R.-170; [1944] C.T.C. 75; 2 D.T.C. 655 not for the facts of the case but for the principle to be found therein. At [C.T.C.] pages 90 and 91, Thorson J. states:
It seems equally clear that if income is received in any one year it is taxable in that year, even although it has not yet been earned, and it follows that the appellant was not entitled to make any deduction from income received by it in any year on the ground that it was not earned in such year.
This does not, however, dispose of this appeal, for the question remains whether all of the amounts received by the appellant during any year were received as income or became such during the year. Did such amounts have, at the time of their receipt, or acquire, during the year of their receipt, the quality of income, to use the phrase of Mr. Justice Brandeis in Brown v. Helvering (supra). In my judgment, the language used by him, to which I have already referred, lays down an important test as to whether an amount received by a taxpayer has the quality of income. Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment? To put it in another way, can an amount in a taxpayer’s hands be regarded as an item of profit or gain from his business, as long as he holds it subject to specific and unfulfilled conditions and his right to retain it and apply it to his own use has not yet accrued, and may never accrue?
Plaintiff submits this is exactly where they are in the present case.
With respect, I cannot agree. Westcoast's right to the money is absolute and under no restriction for the time that the money is in its possession. The evidence is clear that at no time did Westcoast make any refund of the surplus funds. All that Westcoast was obliged to do, if it had an excess of funds, that is, a sum greater than its permitted rate of return, was, eventually to factor the surplus into its tariffs in subsequent years. The money it had collected for the transportation of oil was used by Westcoast as if it was absolute property of Westcoast. No evidence was made to convince me that Westcoast was restricted in the use of the surplus funds.
It is further submitted by Westcoast that if I do not find that the surplus sum is a liability, and I do so find, but a receipt for services to be performed then, normally, pursuant to paragraph 12(1)(a) of I.T.A. the amounts should be included in income except for subsection 20(1)(m) which provides for a reasonable reserve for services to be rendered after the end of the taxation year.
12. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:
(a) Services, etc., to be rendered — any amount received by the taxpayer in the year in the course of a business
(i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, or
(ii) under an arrangement or understanding that it is repayable in whole or in part on the return or resale to the taxpayer of articles in or by means of which goods were delivered to a customer;
20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto
(m) Reserve in respect of certain goods and services — subject to subsection (6), where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer's income from a business for the year or a previous year, a reasonable amount as a reserve in respect of
(i) goods that it is reasonably anticipated will have to be delivered after the end of the year,
(ii) services that it is reasonably anticipated will have to be rendered after the end of the year,
(iii) periods for which rent or other amounts for the possession or use of land or chattels have been paid in advance, or
(iv) repayments under arrangements or understandings of the class described in subparagraph 12(1)(a)(ii) that it is reasonably anticipated will have to be made after the end of the year on the return or resale to the taxpayer of articles other than bottles;
Plaintiff submits that since paragraph 12(1)(a) requires the inclusion of the surplus funds in its income then the total sums in issue for the taxation years 1978 and 1979 would be a reasonable reserve, in that, the only way Westcoast can appropriate any portion of the surplus is by delivery of the product in future years at a sufficiently low tariff so that the revenue does not yield the permitted rate of return.
I am satisfied that the alternative submission of Westcoast that the sums in issue are a reserve in respect of services not yet rendered must fail. Westcoast has already performed the services, but has simply charged too much for them. The fact that Westcoast may use the excess profits to lower the rate on future performance of its services to the same or different customers is not identical to receiving the entire sum of surplus money for an as yet unperformed service in one year and then performing the service in the following year.
Furthermore, paragraph 18(1)(e):
18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
(e) Reserves, etc. — an amount as, or on account of, a reserve, a contingent liability or amount or a sinking fund except as expressly permitted by this Part
denies deductions for any reserve not expressly provided elsewhere in Part 1 of the I.T.A. The only provision that could have applied in paragraph 20(1)(m) and I have decided that this section is not applicable to the circumstances of this case.
Because paragraph 18(1)(e) denies deductions for reserves to cover contingencies, any reserve that is deductible must be in respect of a binding liability. I am satisfied that there is no binding liability to repay any excess sums Westcoat had collected for the delivery of oil to its shippers. The evidence clearly indicates that Westcoast was paid for the delivery of the oil in accordance with a tariff set by Westcoast, in the main, and approved by the Minister. The shippers were informed by Westcoast as to what the tariff would be for the delivery of a barrel of oil. They had no part to play in the setting of the tariff (Exhibits 2-43, 2-33 and -34). The shippers paid the sums invoiced to Westcoast in its ordinary course of business as an oil transmission company. I am also satisfied the funds paid were paid to Westcoast "without strings attached”. The shippers were never made aware of any surplus held by Westcoast.
A case which I believe is almost on “all fours" with the present one is that of Northern and Central Gas Corporation v. The Queen, [1985] 1 C.T.C. 192; 85 D.T.C. 5144 (F.C.T.D.). The [C.T.C.] headnote from that report attests to the similarities between that case and the present one:
On August 1, 1977 the Ontario Energy Board authorized a rate increase for natural gas to allow the plaintiff to recoup increased costs it would incur, as of that date, in purchasing gas from Trans Canada. The plaintiff thus stood to gain from the sale of gas held in storage on July 31, 1977. The Board's policy was that such gain resulting from increased prices be "passed-on" by the plaintiff to its customers. The Board agreed that the “passing on”be delayed until February 1978 so that it would benefit a different mix of customers than if implemented in the summer months. The plaintiff sold some of its stored gas in November and December 1977 resulting in an inventory gain of $255,340. The plaintiff did not include this amount in its income claiming that it was a liability owed to its customers. The Minister included the amount in the plaintiff's 1977 income on the grounds that there was no legal obligation, as of December 31, 1977 to pay out the amount and that it was a contingent liability within the meaning of paragraph 18(1)(e) of the Act.
Madame Justice Reed examined the jurisprudence relating to paragraph 18(1 )(e) and concluded that although the company knew how much it would be required to repay at the end of the taxation year, the obligation to repay that amount did not arise until the following year when the Ontario Energy Board finally ordered the company to make the repayment. As she says, at page 199:
The fact that the amount of the liability was ascertainable and that the probability of its not becoming payable was very small (almost infinitesimally small) does not affect the nature of the liability . . . There was no legal liability on the plaintiff at the end of 1977 to "refund" the sum to its customers.
With the exception of the paragraph 20(1)(m) argument made by Westcoast, and I have already dealt with this issue, the plaintiff in the Northern and Central Gas case made the same submissions as Westcoast is making in the present case. As Madame Justice Reed states, at page 199:
The plaintiff argues that the $255,340 received by it should not be considered as income in its hands because the plaintiff had no absolute right to the funds; the plaintiff knew it was going to be required to pass that gain on to its customers; it didn't matter that the specific customers to whom it would accrue could not be identified; it was a clear liability, definite and measurable (the inventory gain (part sold) plus interest from August 1, 1977, to December 31, 1977).
Westcoast made the same submission. It stated the surplus received by it should not be considered as income in its hands because Westcoast had no absolute right to the funds; that Westcoast knew it was going to be required to pass that gain onto its customers because of it only being permitted to earn a specified rate of return; it didn't matter that the specific customers to whom it would accrue could not be identified, the group of shippers was identifiable, it was a clear liability as it would, in the future, have to adjust its tariffs to "use up" its surplus.
As Madame Justice Reed found, so do I find.
Madame Justice Reed states at page 200:
The plaintiff had a legal and absolute right to the use of the money when it was received. There were no restrictions in its right to the money; there were no unfulfilled conditions precedent. The money was clearly income in the hands of the plaintiff when received. Could the amount then be considered as an expense of making income because the plaintiff had a known and measurable liability to its customers at the end of 1977. The problem the taxpayer has to meet is that while the amount it expected to pay was definitely ascertainable there was no existing legal obligation at the end of 1977 requiring payment.
[Emphasis added.]
As I have stated, Westcoast could use the surplus funds in any manner it wished to. The funds were not segregated. Westcoast knew it would, eventually, have to adjust its tariffs. No adjustment was made for a number of years. It was at its discretion as to when it would eventually factor any surplus it had into tariff charges in subsequent years. There was no legal obligation to the shippers since they had no right to claim the repayment of any surplus moneys paid by them to Westcoast for the transportation of oil.
The following statement of Madame Justice Reed at page 201 is equally applicable in the present case:
There is no doubt that the plaintiff could anticipate that it would be required to “refund” the inventory gain to its customers by virtue of a February 1978 decision. There is no doubt that an accountant would deem it necessary to reflect this fact in the books of the company but it cannot be said to be an expense for tax purposes. It was a reserve for a contingency liability. The fact that the amount of the liability was ascertainable and that the probability of it not becoming payable was very small (almost infinitesimally small) does not affect the nature of the liability (refer: Guay case, (supra). There was no legal liability on the plaintiff at the end of 1977 to “refund” the sum to its customers.
Conclusion
Generally, the Income Tax Act does not allow the deduction of reserves from income. However, where amounts are put into reserve accounts to cover liabilities which are legally binding and ascertainable in the taxation year but which may not be enforced until a later date, such amounts in certain circumstances may be deducted from income. In the present appeal, although the amounts are ascertainable, I am satisfied from the evidence presented that there is no legally binding obligation to the shippers to "refund" any surplus at the end of any taxation year. The surplus funds are not "loans" to Westcoast. The surplus funds are sums collected by Westcoast from its "customers" for a service performed by it in accordance with an approved tariff and in the ordinary course of its business. The interest paid by Westcoast to itself for an alleged loan is not, therefore, an expense in accordance with the Income Tax Act.
Plaintiff’s appeal is dismissed with costs in favour of the Crown.
Appeal dismissed.