The case highlights the importance of allocating a sustainable value to assumed obligations, rather than leaving it to the Minister or the courts.
Daishowa-Marubeni International Ltd. sold the assets of its two timber mill divisions to Tolko Industries and Seehta Forest Products Ltd. Each sale agreement included a provision whereby each purchaser assumed Daishowa’s silviculture (i.e., reforestation) liabilities.
At the time of closing of the Tolko deal, the current reforestation liability was estimated to be around $2 million, and the long-term (i.e., 8-14 years) liability was estimated to be over $9 million. The amounts in the Seehta deal were $560,000 and $2.4 million, respectively.
In both deals, based on input from tax advisors, the purchase price did not specifically include the assumption of the reforestation obligations. The purchase agreements simply provided that the purchasers would assume the reforestation obligations.
The Minister, however, assessed Daishowa by including the amounts of the estimated silviculture liabilities — $11 million in the Tolko deal and $2,996,380 in the Seehta deal. Daishowa argued that no such amounts should be included, and that if any amount was included, Daishowa was entitled to an offsetting deduction from income.
Tax Court decision
TCC Justice Campbell J. Miller noted that Daishowa admitted in its pleadings that it received a benefit when the purchasers assumed the silviculture obligations. Given this admission, the TCC concluded that the assumption was part of the consideration paid for the timber assets, notwithstanding that Daishowa “took great pains to have that element of the deal removed from the definition of purchase price in the agreement.”
As noted, the taxpayer also argued that the value was so uncertain that it would be improper to bring any amount into the proceeds of disposition (citing the decisions in Northland Pulp and Timber Ltd., Burnco and Harysh).
The TCC, however, ruled that those cases should not be broadly interpreted as supporting a general principle that if an amount is uncertain it is never to be subjected to the tax regime: “The better approach is to consider the circumstances surrounding the uncertainty, the nature of the amount itself and the element of the tax regime to which it is to be subjected.” (para. 38)
That being said, the amount required to be included was a lesser amount than that assessed by the Minister based on the current and discounted future silviculture obligations. In the case of the Tolko deal, this was the current reforestation liability of $2,057,498, plus the future obligations, subject to an 80% discount rate. The same principles applied on the sale to Seehta.
Daishowa argued instead that if any amount falls into proceeds of disposition, then it was entitled to an offsetting deduction because it incurred an income expense by paying Tolko with assets (the forest tenures) to assume the reforestation liability. The TCC held that the expense was on capital account, since the Province of Alberta would not permit the sale unless the purchaser assumed the liabilities. Therefore, it was part and parcel of the forest tenures and more of an enduring benefit than a current expense.
Daishowa appealed the TCC decision, claiming that no amount should be included in the proceeds of disposition and that an offsetting deduction against income was available. The Crown cross-appealed on the basis that it was not open to the TCC judge to apply a discount factor to arrive at values for the obligations other than those agreed to by the parties.
The FCA heard the case on 3 May 2011 and rendered its written decision a little over four months later. Interestingly, was it was a split 2-to-1 decision. The majority allowed the appeal in part and allowed the Crown’s cross-appeal.
FCA Justice Marc Nadon, writing for the majority, found that the TCC judge made no error in finding that, with respect to the Tolko deal, the reforestation liabilities should be included in the proceeds of disposition. Daishowa had admitted that it received a benefit by virtue of Tolko’s assumption of the reforestation obligations. The majority emphasized that the sale price of a property includes any consideration received by a seller from a buyer, including cash, property and the assumption of liabilities.
On the issue of the valuation of the obligations in the Tolko deal, the majority found, based on the proper interpretation of the purchase and sale agreement, the parties had attributed a specific and agreed-to value of $11 million for the reforestation liability.
The FCA rejected Daishowa’s argument, and the TCC’s decision, that the $11 million was simply an estimate and not an agreed-upon value. Further, subsection 13(21) of the Income Tax Act simply provides that the “proceeds of disposition” of property includes “the sale price of property that has been sold” and does not consider whether the liability the purchaser assumes is absolute or contingent.
Thus, the majority found that the TCC judge was wrong to discount the long-term portion of the liability. The agreed-upon value of the assumed liability was $11 million for the Tolko deal and that amount was to be included in the proceeds of disposition. As a result, the Crown’s cross-appeal was allowed.
With respect to Daishowa’s argument that it was entitled to an offsetting current deduction against income, the majority found that the TCC judge was correct in his reasoning that no such offsetting deduction was allowed. The reforestation liability was part of a capital transaction and Daishowa received an enduring benefit by being relieved of a long-term reforestation liability. Like the TCC judge, the FCA majority also made note of the fact that under Alberta law, the purchaser of timber assets was required to assume the reforestation liability, thus lending support to the finding that the assumption was on account of capital.
Daishowa made a further argument that a portion of the $11 million proceeds of disposition should be allocated to goodwill instead of to timber resource property. The majority noted that the parties had admitted that no value was attributed to goodwill; therefore, all of the proceeds of disposition at issue were to be allocated to timber resource property. Daishowa’s appeal in respect of the Tolko deal was dismissed and the Crown’s cross-appeal was allowed, resulting in Daishowa having to include in income proceeds of disposition of $11 million.
With respect to the Seehta deal, the majority determined that the TCC judge’s reasoning was inadequate because he treated the Seehta deal in exactly the same way as the Tolko deal without addressing the factual differences, including the differences in the wording of the purchase and sale agreements. As a result, the majority partially allowed Daishowa’s appeal by sending the case back to the TCC judge for findings of fact and a reconsideration of the issues with respect to the Seetha deal.
In his dissenting judgment, FCA Justice Robert Mainville found that the reforestation liabilities should not be included in proceeds of disposition. His rationale was that the reforestation liabilities were not separate consideration but were integral to the assets and part of the same consideration provided for the assets. Daishowa received a lower price on the sale of the timber properties, not additional consideration as a result of the assumption of the reforestation liabilities. Thus, those reforestation liabilities were not proceeds of disposition.
While Justice Mainville could have stopped there, he went on to consider the valuation of the reforestation obligations. He agreed with the majority that the TCC judge could not discount the long-term liabilities. However, he found that whether or not the parties agreed on the value of the obligations did not affect whether they were part of the proceeds of disposition.
Further, he explained that, unlike the majority, the Seehta deal should be treated in the same manner as the Tolko deal. In his view, the purchase and sales agreements and related documentation could not impact on his basic conclusion that the assumption of this type of obligation was not included in “proceeds of disposition.”
This decision has a significant impact on the tax treatment of the assumption of obligations. As the FCA majority suggested, the amounts to be included as proceeds of disposition will depend on what is provided for in the agreement of purchase and sale.
It’s important for taxpayers selling assets to carefully consider the wording in the contract and any related documentation, and clearly define what they are agreeing to and whether the value of any assumed liabilities is included. In many cases, it will be reasonable to apply a discount to contingent obligations, and it will be important to obtain an expert valuation opinion to sustain the agreed-upon value.
The taxpayer has until 22 November 2011 to file a leave to appeal application with the Supreme Court of Canada. The split decision enhances the likelihood the Supreme Court will hear the case, but the challenge will be to convince the court that the issue is of national importance. In the meantime, taxpayers with similar issues should not settle with the CRA prior to determining whether a successful leave application has been filed and, if so, the outcome of the appeal.
We note that had Daishowa accepted the TCC decision, it would have been required to include 20% of the estimated reforestation liabilities as proceeds. If the FCA decision stands, Daishowa will be required to include 100%. Sometimes, the decision to pursue a dispute such as this carries significant risks.
Of course, the case still has to go back to the TCC judge to make findings of fact relating to the Seehta deal.