In Daishowa-Marubeni International Ltd. v. The Queen, 2013 SCC 29, Justice Rothstein marries tax philosophy and tax practice by asking and answering the question:
If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?1
The Court analyzes the difference for tax purposes between liabilities and embedded obligations, considers the law of contingent liabilities, the role of tax symmetry in the Income Tax Act (Canada) (the "Act"), the role of the agreement between the parties and the role of accounting treatment in reaching the conclusion that embedded obligations are not liabilities that form part of proceeds of disposition.
The relevant facts before the Court were as follows:
- Daishowa-Marubeni International Ltd. ("Daishowa") owned forest tenures in Alberta, giving it the right to harvest timber from designated provincial Crown lands.
- Daishowa was obliged under the Forest Act and the Timber Management Regulations to reforest areas from which it had harvested timber. Daishowa was required to obtain the consent of the Province of Alberta before any assignment of its forest tenures and such consent would only be provided if the purchaser assumed that reforestation obligation.
- Forest tenures in two of the areas in which Daishowa had reforestation obligations were sold to third parties in 1999 and 2000, with the reforestation obligations being assumed by the purchasers and provincial consents being provided in respect of those sales.
- In November 1999, as part of the sale by Daishowa of its High Level Division business to Tolko Industries Ltd., Daishowa sold forest tenures in that area. In the sales agreement, $20 million of the purchase price was allocated to the forest tenures. The sales agreement further provided that Tolko would assume the statutory reforestation obligations relating to lands previously harvested, quantified at approximately $11 million, with a mechanism for a post-closing final determination/estimate of these obligations and purchase price adjustment.
- In August, 2000, Daishowa sold its Brewster Lumber Division including forest tenures in that area to Seehta Forest Products Ltd. Under the sales agreement, Seehta assumed all reforestation obligations on the lands previously harvested, but there was no quantification of the reforestation obligations referenced in that agreement.
- In accounting for these obligations, Daishowa estimated on an annual basis future reforestation obligations arising in the year and claimed the amount as an expense against revenues for accounting purposes for the year, describing the offsetting entry as a reforestation liability its balance sheet. For income tax purposes, this reforestation expense was added back into income. In Daishowa's accounting records for the years of disposition of the tenures, the estimated cost of the reforestation obligation for Brewster Lumber tenures was approximately $3 million and the High Level reforestation obligation was $11 million. In the years of disposition, Daishowa increased its income for accounting purposes by the future reforestation obligation associated with these tenures that it had sold and in respect of which Daishowa no longer had an obligation.
- The Minister of National Revenue (the "Minister") reassessed Daishowa for its 1999 and 2000 taxation years to include in computing income as proceeds of disposition the reforestation obligation of $11 million in respect of the sale to Tolko and approximately $3 million in respect of the sale to Seehta.
Tax Court of Canada
In dealing with the reassessments, the Tax Court of Canada concluded that "the sale of Daishowa's business to Tolko was a single transaction, and the assumption of reforestation liabilities represented part of the consideration; however, the value of that consideration to Daishowa is less than the face value of the estimated amount of those liabilities."2 The Tax Court Judge, therefore, discounted the reforestation liabilities under the Tolko and Seehta agreements from $11 million and $3 million to $3.9 million and $1 million, respectively. The Tax Court Judge also stated that he saw "no difference in the fact situation of the Seehta matter to reach any different conclusion."3
Federal Court of Appeal
The majority of the Federal Court of Appeal4 agreed with the Tax Court Judge that the High Level reforestation obligation should be treated as part of the consideration paid by Tolko, but found no evidentiary support for the Tax Court Judge's decision to discount the amount of the liability under the Tolko agreement. In respect of the Seehta agreement, the majority found that the Tax Court Judge's reasons were inadequate and ordered the matter to be referred back to the Tax Court for reconsideration.
Justice Mainville stated in dissent that "it is neither reasonable nor correct to conclude that the compulsory assumptions of the responsibilities for future reforestation works by the purchasers were a "sale" or "disposition" of "liabilities" resulting in "proceeds of disposition" in the hands of Daishowa under the meaning of subsection 13(21) of the Act."5 Justice Mainville further stated that the reforestation obligation formed part of the forest tenures and had the effect of depressing the value of the forest tenures. Their value should, therefore, not be treated as proceeds of disposition.
Supreme Court of Canada
In a concise and well-reasoned decision, the Court adopted the essence of Justice Mainville's dissent and elaborated on it as follows:
1. Liabilities as Part of Consideration: As a starting point, Justice Rothstein accepted the general proposition that "the assumption of a vendor's liability by a purchaser may constitute part of the sale price and therefore part of the vendor's proceeds of disposition."6
With this foundation in place, the question then shifted to the nature of the reforestation obligation.
2. Nature of the Reforestation Obligation: In deciding the issue before it, the Court noted the need to distinguish between the assumption of a liability and the assumption of an embedded obligation that cannot be severed from the property and has the effect of depressing the value of the property. While the Minister attempted to analogize the reforestation obligation to property encumbered by a mortgage, Daishowa and industry intervenors offered a more appropriate analogy comparing the reforestation obligation to property in need of repair, with the repair obligation depressing the value of the property.
The Court agreed with the approach taken by Justice Mainville, Daishowa and industry intervenors and held that "[t]he effect of Alberta's scheme is to embed the 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."7 The Court found support for this position by considering the two analogies placed before it. The Court noted that (a) the value of the Tolko tenure was $20 million and (b) Daishowa could never receive $31 million for the forest tenure. In contrast, under the property encumbered by mortgage scenario, the Court noted that a vendor could always ask for and receive $31 million and the vendor could pay off the mortgage independent of value, reflecting the fact that the mortgage did not affect the value of the property as is the case with an embedded obligation.
The Court dismissed the Minister's argument that the reforestation obligations crystallized at the time of sale and must be considered part of the proceeds of disposition. Referring to an argument raised by the Canadian Association of Petroleum Producers ("CAPP"), that for the Minister to succeed there must be a distinct existing liability, the Court held that the reforestation obligations are not such a liability but represent future costs embedded in the forest tenures.
Critical to the Court's decision was the fact that the law required the embedded obligations to be assumed by the purchasers. Of specific note, however, is the obiter dictum by the Court as it relates to obligations that are not based on statute, regulation or government policy. In this regard, the Court stated:
In this appeal CAPP submits that future obligations may be embedded in a property right absent a legal requirement that precludes a vendor from selling a property without assigning the obligations. CAPP submits, using the example of the mining of gas and oil, that statutory obligations to reclaim mined land may be so physically connected to the process of mining itself that the obligations cannot be separated from property right. While I need not decide that question on 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.8
This comment by the Court may very well open the door for similar tax treatment to be extended to other obligations embedded in the relevant property.
3. The Role of Contingent Liability: The Court also addressed the issue raised by Daishowa that the reforestation obligation should not be added to the proceeds of disposition because the obligation was a contingent liability. The Court held that the question of contingent liability was misplaced as it assumes the existence of a distinct liability. Since the cost of reforestation was not an existing distinct liability, the Court held that the contingent liability argument was simply not relevant.
4. The Promotion of Tax Symmetry: The Court adopted a comment made by Justice Mainville that tax symmetry should be promoted and stated that, "[a]lthough not dispositive, ...an interpretation of the Act that promotes symmetry and fairness through a harmonious taxation scheme is to be preferred over an interpretation which promotes neither value."9 The Court noted that under the Minister's approach, had Tolko sold the tenures the very next day, it would have had proceeds of $31 million, of which $11 million would never have been received. This example illustrates the asymmetry of the Minister's approach.
5. The Role of the Agreement: The Court held that although Daishowa had agreed on a specific amount in respect of reforestation liabilities in the Tolko agreement, Daishowa's proceeds of disposition were not dependent on that agreed-upon amount. Instead, the reference to the reforestation obligation in the agreement was simply a means to arrive at the fair market value of the forest tenures of $20 million.
6. The Role of Accounting Treatment: In addition, the Court made an important observation on the role of the accounting treatment of amounts in such circumstances. The Court stated:
 It is also irrelevant that DMI estimated the cost of future reforestation to compute its income for accounting purposes. Although commercial and accounting principles allowed DMI to deduct reforestation obligations on a yearly basis and add back to income the deducted amounts at the time of the sale to provide a more accurate picture of its profit from year to year, as I have explained above, the Income Tax Act does not permit that approach; see V. Krishna, The Fundamentals of Canadian Income Tax (9th ed.), at pp. 171-72. This Court has recognized the distinct purposes of financial accounting and income tax calculation: Canderel Ltd. v. Canada,  1 S.C.R. 147, at para. 36. It would thus be an error to simply include DMI's accounting estimates in its proceeds of disposition.
In summary, the Supreme Court of Canada provided a thoughtful and clear statement of what is and what is not a liability for the purposes of determining proceeds of disposition. In the process, the Court stamped out the forest fires that could have spread from the lower court decisions.
1. Para. 1.
2. 2010 TCC 317 at para. 52.
3. 2010 TCC 317 at para. 52.
4. 2011 FCA 267.
5. 2011 FCA 267 at para. 137.
6. 2013 SCC 29, at para. 26.
7. 2013 SCC 29 at para. 31.
8. Para. 36 [emphasis added].
9. Para. 43.
Dentons is a global firm driven to provide you with the competitive edge in an increasingly complex and interconnected marketplace. We were formed by the March 2013 combination of international law firm Salans LLP, Canadian law firm Fraser Milner Casgrain LLP (FMC) and international law firm SNR Denton.
Dentons is built on the solid foundations of three highly regarded law firms. Each built its outstanding reputation and valued clientele by responding to the local, regional and national needs of a broad spectrum of clients of all sizes – individuals; entrepreneurs; small businesses and start-ups; local, regional and national governments and government agencies; and mid-sized and larger private and public corporations, including international and global entities.
Now clients benefit from more than 2,500 lawyers and professionals in 79 locations in 52 countries across Africa, Asia Pacific, Canada, Central Asia, Europe, the Middle East, Russia and the CIS, the UK and the US who are committed to challenging the status quo to offer creative, actionable business and legal solutions.
Learn more at www.dentons.com
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Specific Questions relating to this article should be addressed directly to the author.