On May 23, 2013, the Supreme Court of Canada ("SCC") released its decision in Daishowa-Marubeni International Ltd. v. The Queen (2013 SCC 29). This case has been followed closely by the tax community since it concerns an issue of fundamental commercial importance: the tax treatment of liabilities and obligations assumed by a purchaser that relate to the asset being sold.
In a unanimous decision, the SCC overturned the decision of the Federal Court of Appeal ("FCA") majority and found in favour of the taxpayer that no portion of certain reforestation obligations assumed by the purchaser on the acquisition of certain timber harvest rights should be included in the taxpayer's proceeds of disposition.
While Daishowa is particularly important to the natural resources sector given the magnitude of reclamation obligations frequently inherited by a purchaser of mining, timber or oil and gas assets, the issue arises in asset acquisitions of all types, and so carries considerable significance to the tax community generally. The SCC's decision can be found at: http://scc.lexum.org/decisia-scc-csc/scc-csc/scc-csc/en/item/13071/index.do
In 1999, the taxpayer ("Daishowa") decided to sell two timber mill divisions situated in Alberta, including the rights to harvest timber on the surrounding land (which were "timber resource properties" for the purposes of the Income Tax Act (Canada)). Under the terms of the harvest rights, the owner was required to plant and manage a new crop of trees to replace those harvested. The applicable Alberta regulatory scheme provided that the reforestation obligations flowed with the ownership of the harvest rights and the transfer of the harvest rights required the consent of the province of Alberta, which would not approve a transfer unless the purchaser assumed the reforestation obligations.
Several interested parties submitted bids on the more valuable of the two divisions ("High Level")1. The winning bid offered $180 million, less an amount in respect of the long-term reforestation obligations associated with the harvest rights.
Based on tax advice it received from an accounting firm, Daishowa negotiated with the purchaser for a different structure in the purchase and sale agreement. In the final agreement, the purchase price for the property was stated as $169 million ($20 million of which was allocated to the harvest rights), with the purchaser inheriting the reforestation obligations and Daishowa representing that the estimated cost of fulfilling those obligations was $11 million. The parties agreed to have a reforestation statement prepared and audited by an accounting firm, and for Daishowa to make a payment to the purchaser if the amount determined in the statement was greater than $11 million (or the reverse if less than $11 million). The reforestation statement estimated the cost of reforestation at $11,296,225, resulting in a payment of $296,225 by Daishowa to the purchaser.
Daishowa did not include in its proceeds of disposition any amount relating to the reforestation obligations assumed by the purchaser on the sale of High Level. The Canada Revenue Agency reassessed Daishowa to increase Daishowa's proceeds of disposition for High Level by $11 million.
TAX COURT OF CANADA
The Tax Court of Canada ("TCC") (2010 TCC 317) held that some amount relating to the reforestation obligations should be included in Daishowa's proceeds. The TCC did not, however, accept that the $11 million reflected the value of those obligations for tax purposes. Instead, the TCC held that an amount equal to the current portion of the reforestation obligations (as determined for accounting purposes) plus 20 percent of the long-term portion should be added to Daishowa's proceeds. The TCC cited the uncertainty around the actual costs of reforestation and the Alberta regulatory regime as reasons for the significant discount.
Daishowa appealed, arguing that no amounts in respect of the reforestation obligations should be added to its proceeds; while the CRA cross-appealed, asking for the full $11 million to be included.
FEDERAL COURT OF APPEAL
The FCA majority (2011 FCA 267) approved the TCC's finding that the purchaser's assumption of the reforestation obligations on the High Level sale constituted consideration to Daishowa; however, the FCA majority disagreed with the TCC as to the appropriate amount to be included in Daishowa's proceeds of disposition.
As a starting point, the FCA majority acknowledged that, as a matter of principle, the phrase "proceeds of disposition" includes money received as well as other forms of valuable consideration, including liabilities of the vendor assumed by the purchaser. The majority went on to find that
- the purchaser's assumption of Daishowa's reforestation obligations constituted consideration which had to be included in Daishowa's proceeds of disposition for High Level, notwithstanding that the purchase price (as defined in the purchase and sale agreement) had been structured so as not to formally include the assumption of the liabilities,
- this conclusion was consistent with the conduct of the parties (even the unsuccessful bidders) and the wording in the bid documents that indicated the assumption of the reforestation obligations on the High Level sale formed part of the consideration, and
- the purchaser and Daishowa had quantified the value of the reforestation obligation at $11 million (noting in particular the exact dollar amount arrived at by the accountants), and accordingly, that was the amount to be added to Daishowa's proceeds of disposition.
The FCA dissenting judgement advocated for adding nothing to Daishowa's proceeds of disposition on the grounds that the reforestation liabilities were an inextricable part of the property and therefore the reforestation liabilities simply depressed the value of the property.
The FCA decision was reviewed in the October 2011 BLG Tax Law Bulletin.
SUPREME COURT OF CANADA
At the SCC, a nine-member bench unanimously found that Daishowa was not required to add any amount in respect of reforestation obligations to its proceeds of disposition for tax purposes.
The SCC acknowledged that as a matter of principle, the assumption of a vendor's liability by a purchaser may constitute part of the sale price and therefore part of the vendor's proceeds of disposition. The SCC illustrated this point with a simple example of a property that is encumbered by a mortgage: if the purchaser pays the sale price by paying some cash and assuming the mortgage, then the amount of the cash and the mortgage liability assumed should be included in the vendor's proceeds of disposition.
In Daishowa's case, however, the SCC found that the reforestation obligations associated with High Level were not a distinct existing liability comparable to a mortgage. Instead, the SCC found that
- the Alberta regulatory scheme had the effect of embedding the reforestation obligations in the harvest rights (i.e., they could not be separated from one another), and therefore the harvest rights were more analogous to property in need of repair than property encumbered by a mortgage,
- as such, the reforestation obligations depressed the value of the harvest rights (i.e. from $31 million to $20 million) and therefore Daishowa did not have $31 million of value to sell, and
- the fact the parties agreed to a specific estimate of future reforestation costs made no difference (in contrast to what the FCA suggested), rather the estimate was simply a factor in determining the value of the harvest rights.
On that basis, the SCC concluded that no amount in respect of the reforestation obligations should be added to Daishowa's proceeds of disposition. Most interestingly, the Court explicitly left open the possibility (without deciding) that obligations other than those that must, as a matter of law, be assumed by a purchaser of the property in order for the vendor to sell the property could be sufficiently embedded within a property such that the same analysis would apply.
The SCC observed that its conclusion was supported by the fact it resolved the asymmetry that would otherwise result as between Daishowa and the purchaser who, the CRA argued, should not be permitted to add any amount in respect of the assumed obligations to its cost of the harvest rights. In doing so, at paragraph 43, the SCC endorsed the view that "an interpretation of the [Income Tax Act] that promotes symmetry and fairness through a harmonious taxation scheme is to be preferred over an interpretation which promotes neither value".
The SCC also considered and dismissed Daishowa's argument that the contingent nature of the reforestation obligations supported excluding these amounts from its proceeds of disposition. The contingent or absolute nature of the liability was irrelevant in the SCC's view – what mattered was whether they were a distinct and severable liability, which they were not.
The differences in the approaches taken by the various courts that heard Daishowa may be attributed to confusion about what, in legal and economic terms, was actually being purchased and sold. The reasons of the TCC and the FCA majority are premised on the understanding that the High Level harvest rights had a value of something more than $20 million even though both acknowledged that under the Alberta regulatory regime, the purchaser was required to assume the reforestation obligations to complete the sale. The conduct of the parties, and in particular the taxpayer and CRA's agreed statement at trial that "if the purchaser had not assumed the reforestation obligations, the cash component of the sale price would have been higher"certainly encouraged the TCC and the FCA majority to view the reforestation obligations as separate obligations that could be severed from the property (like a mortgage) when, in fact, they were invariably obligations of the property's owner, and therefore inextricably linked to the property. A more accurate statement that would have reflected the actual legal and economic rights and obligations of the parties would have been something to the effect of: "if the harvest rights had not been subject to the reforestation obligations, the value of those rights would have been higher."
The SCC, on the other hand, clearly found that there was no more than $20 million worth of harvest rights after taking into account the future cost of reforestation obligations embedded in them. Having only $20 million of value to sell and dealing with an arm's length purchaser, Daishowa should logically have only received $20 million for those harvest rights, and this is demonstrably the correct result in every respect. On different facts Daishowa could have had property worth $31 million if, for example, it spent money prior to the sale addressing the reforestation obligations embedded in the property and thus enhancing the value of what it had to sell (in which case it would have received the appropriate tax recognition for the amounts it so spent). But those are simply not Daishowa's facts.
The SCC's decision in Daishowa is certainly welcomed by the tax community and will surely provide additional certainty on the tax treatment of assumed obligations. In addition, taxpayers and their advisors may take a few practice points from the case.
- When planning and negotiating a transaction, it is imperative that the parties have a complete understanding of what it is the vendor owns and the respective legal rights and obligations of the vendor and purchaser.
- The documentation should accurately reflect the parties' understanding at every stage of the transaction (including the bid documents), and in particular should characterize embedded liabilities and obligations (to the extent that they need to be explicitly addressed at all) as features of the underlying property rather than as something severable and distinct from that property.
- To the extent that a purchaser is inheriting embedded obligations that cannot be severed from the property, wherever possible it is preferable to express the purchase price as a net amount (e.g., $20 million) rather than a gross amount ($30 million) to be reduced by some estimate of an embedded liability or impairment that the purchaser is inheriting.
The SCC had little difficulty determining the correct tax result once the true nature of the transaction was made clear to it, as the 9-0 result illustrates. As such, Daishowa shows how important it is for parties to a commercial transaction to get tax input as early as possible and throughout each stage of the transaction. The clearer the parties' understanding of their respective legal rights and obligations and the more precisely these rights and obligations are expressed in the transaction correspondence and documentation, the less likely the tax authorities will view the transaction as something other than what the parties intended.
1 The sale of the second division ("Brewster") was also considered by the courts; however the focus on all three decisions was primarily on High Level and therefore the sale of Brewster is not discussed in any detail in this bulletin.
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.