BETWEEN:
and
____________________________________________________________________
Appeal heard on April 10 and 11, 2006, at Ottawa, Ontario
By: The Honourable Justice Campbell J. Miller
Appearances:
____________________________________________________________________
JUDGMENT
The appeal from the assessment of tax made under the Income Tax Act for the 1999 taxation year is allowed, and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the Appellant was carrying on business in Canada through a permanent establishment, and is entitled to salary and travel expenses as claimed.
Signed at Ottawa, Canada, this 21st day of April 2006.
BETWEEN:
GULF OFFSHORE N.S. LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
[1] Gulf Offshore N.S. Limited ("GONS") appeals the assessment of the Minister of National Revenue of its 1999 taxation year. GONS is a United Kingdomcompany, which, in 1999 entered a Charter Party Agreement with Allseas Canada Limited ("Allseas"). Pursuant to that agreement, GONS provided a fully-crewed vessel, the Highland Pride, to Allseas. The Highland Pride plied Canadian waters in 1999 for 88 days primarily supplying pipe to Allseas' pipelaying ships, the Lorelay and the Solitaire, both laying pipeline off the Nova Scotia coast near Sable Island. The Minister, relying on the Canada-U.K. Tax Convention, assessed GONS on the basis it was subject to Canadian tax, as it was carrying on business for those 88 days through a permanent establishment in Canada. It went on to disallow certain salary and travel expenses, interest expense and depreciation. GONS argues that it was not carrying on business through a permanent establishment, and, if it was, it was entitled to the full expenditures it claimed for salary and travel and for interest expense. It has dropped its claim for depreciation. I find that GONS was carrying on business in Canadathrough a permanent establishment in 1999, and that it is entitled to its claim for salary and travel expenses, but not for its claim for interest expense.
[2] Mr. Guthrie, an executive vice-president with GONS' parent company, testified for the Appellant. GONS was incorporated in the United Kingdomin 1990. The first objective listed in its Memorandum of Association reads:
(a)(i) To operate supply vessels and otherwise to provide transportation services from onshore supply bases and staging areas to offshore drilling and production operations in all parts of the world, including the delivery of men and materials to the sites of such operations, the towing and positioning of drilling rigs and the provision of assistance generally in connection with offshore drilling operations.
[3] In 1999, GONS owned and operated 27 supply vessels. The Highland Pride was one of those supply vessels. It was built in 1992 at a cost of £ 12,000,000, approximately £ 11,000,000 of which was borrowed. (There is some discrepancy between Mr. Guthrie's evidence in this regard and a schedule later provided by his counsel, which reflected borrowing considerably less than £ 11,000,000 and more in the neighbourhood of £ 6,500,000.). According to Mr. Guthrie, the moneys were borrowed pursuant to ten-year term loans. The Highland Pride was built specifically as a ship to carry pipe on deck for use in the laying of pipeline offshore. It also has capacity below-deck for carrying other supplies, including water and mud. It was exclusively a supply ship designed to work in a certain specific industry, with no capacity for anything else.
[4] In 1998, GONS entered a Charter Party Agreement[1] with the Canadian company, Allseas Canada Limited, to provide the Highland Pride for "sea transportation of pipes and other supplies (materials, equipment, marine gas oil, water, personnel, etc.) and other duties within the vessel's natural capacities and capabilities".
[5] The charter hire was £ 21,500 per day, excluding fuel and import duties. The agreement also stipulated that Allseas was to furnish to the Master all instruction and sailing directions and that the Master and the engineer were to keep full and correct logs. The Master, as captain, had final say on matters pertaining to the safety of the ship.
[6] An agent of Allseas, Holmes Maritime Inc., obtained a coastal trading license from Canada Customs. It stipulated the license was "to transport pipe joints and other material from load-out port to the installation area offshore Nova Scotia; and for pipelaying activities offshore SableIsland and between Country Harbour, Nova Scotia and SableIsland".[2]
[7] The Master, and indeed all the crew, were supplied by GONS. GONS contracted with Guernsey Ship Management Ltd. ("GSM"), a sister company set up as a labour company, to supply officers and crew to man the ship. It also obtained some ordinary seamen from an unrelated company called C-Mar.
[8] Pursuant to the management agreement between GONS and GSM, GSM would charge GONS a rate per day calculated monthly dependent on the rank of the employee. Standard rates would be set for each rank. Mr. Guthrie explained that GONS and GMS relied on standard rates, as GONS also managed other vessels and wanted to avoid any display of favouritism regarding the supply of personnel on its own ship. Mr. Guthrie referred to these standard rates as market rates.
[9] Mr. Guthrie introduced invoices from GMS to GONS for the relevant period. The invoice did not just cover the Highland Pride, but covered all ships under contract between GONS and GMS. A separate list indicated the breakdown amongst the ships. For example, the total invoiced amount for June 1999 was £ 1,235,100 for providing crew to all ships under contract. The supporting materials went on to identify the Highland Pride's portion as £ 25,730. To be clear, this does not represent what was ultimately paid by GONS to the employees, but it does represent what GONS paid to GMS. Mr. Guthrie's evidence was that, given the seniority of the Highland Pride crew, the amount paid to them by GMS would most likely have been higher than the amount billed by GMS to GONS, based on the standard rates. The Canada Revenue Agency auditor never received confirmation of the amounts ultimately paid to the Highland Pride crew, and consequently only allowed 50% of the salaries claimed.
[10] The Highland Pride worked for 88 days in 1999 transporting pipe and other material from Nova Scotia to the Allseas' two ships laying pipe off the coast of Nova Scotia within the Sable Islandoffshore area. It took approximately a day to sail from the Nova Scotia coast out to the site. When not sailing to or fro on its supply duties, the Highland Pride would stand by waiting for further instructions from Allseas.
[11] With respect to travel expenses, GONS handled those matters directly for the GMS employees travelling to and fro the Highland Pride. Mr. Guthrie presented invoices from OBC Travel for the month of July indicating £ 4,133 attributable to Highland Pride for travel services. This was supported by a list of names of crew members and the amounts allocated to each.
[12] GONS' financial statements included in its long-term liabilities a "note payable to ultimate holding company with interest at 9.5%".[3] This represents debt to GONS' parent company, arising from a 1998 refinancing. In 1998 the parent was able to arrange cheaper financing and therefore paid off subsidiaries' debts, consolidating all debts under one umbrella. The debt remaining on the Highland Pride original loan was part of this refinancing. Mr. Guthrie was unable to indicate the breakdown in this refinancing between the consolidation of debt, including the Highland Pride debt, and new money borrowed for the construction of new ships.
[13] In determining the amount of interest allocable to the Highland Pride, GONS took a percentage of the total interest on the refinanced debt for the relevant period, and multiplied that by a percentage equal to Highland Pride's revenue compared to total revenue from all vessels. So, for the 88 days in question, GONS total interest expense on the debt to its parent was £ 849,767. Highland Pride's revenue was 22.93% of all revenue for that period, and therefore the interest expense claimed by GONS was 22.93% of the £ 849,767 or £ 194,876, being $461,856 Canadian. Canada Revenue Agency disallowed the full amount of this interest expense on the basis there was nothing to relate any of the debt specifically to the Highland Pride.
[14] Issue - Was GONS carrying on business in Canadain 1999?
Analysis
[15] Subsection 2(3) of the Income Tax Act requires that a non-resident who carries on business in Canadaat any time in the year is subject to tax in Canada. The Canada-United Kingdom Tax Treaty (Article 7) relieves non-resident enterprises from tax in Canadaunless the income is derived through a permanent establishment. Article 27A of the Canada-U.K. Tax Treaty stipulates:
2. A person who is a resident of a Contracting State and carries on activities in the other Contracting State in connection with the exploration or exploitation of the sea bed and sub-soil and their natural resources situated in that other Contracting State shall, subject to paragraph 3 of this Article, be deemed to be carrying on a business in that other Contracting State through a permanent establishment situated therein.
[16] The starting point is therefore the question of whether GONS carried on business in Canada. The Appellant's counsel argued that GONS was not carrying on business according to the extended meaning of that phrase found in section 253 of the Act. With respect, I find it is unnecessary to rely on any extended meaning of the term, but by simply relying on an ordinary meaning of "carrying on business", I reach the conclusion that GONS was indeed carrying on business in Canada.
[17] The Highland Pride sailed Canadian waters for 88 days supplying pipe and materials to its customer Allseas. This was not an isolated transaction as the Appellant argued. This is what GONS did. It owned and operated supply ships in the oil and gas pipelaying industry. It entered contracts in the form of leases for the supply, not only of the equipment, the ship, but also of the crew to sail the ship. Pursuant to its contract with Allseas, it certainly took direction from Allseas as to where to pick up and deliver the supplies, but it was not Allseas that operated the ship - GONS did. GONS was carrying on business in Canada.
[18] Issue - Was GONS carrying on business in Canada through a permanent establishment?
[19] To address this issue requires analysis of Article 27A. GONS' argument on this issue was simply that it did not "carry on activities" in Canadaas required by Article 27A(2). It conceded, however, that if I found GONS did carry on activities in Canada, it was in connection with the exploration or exploitation of the seabed and subsoil and their natural resources. GONS' counsel suggested that I should avoid a literal or legalistic interpretation of the Treaty, and that to find that what GONS did constituted carrying on activities would be just such a literal or legalistic approach. All that it did, according to GONS, was enter a single passive lease. Because Allseas directed the activities of the Highland Pride, the Appellant argues that it was Allseas, not GONS, carrying on the activities. That is not how I view the transaction.
[20] The Appellant likened the situation to that of a bare-boat license, which it argued the Respondent accepts does not constitute the licensor carrying on activities. With respect, the provision of a fully-crewed, specifically designed supply ship, which is operated not by Allseas, but by GONS, is nothing at all like a bare-boat license. The Appellant analogized to a chauffeur limousine service, suggesting that it is the customer, who hires the chauffeured limousine in Canada and proceeds to instruct the chauffeur to take him into the United States, who is carrying on activities in the United States, not the chauffeur limousine business. This analogy does not help the Appellant. The limousine service is in the business of chauffeuring customers outside Canada - it is certainly carrying on activities outside Canada. Similarly, the Highland Pride, owned and operated by GONS, albeit under contract with Allseas, is carrying on its activities in Canada. The ship is owned, manned and operated by GONS; GONS' head office is in daily contact with the ship; the captain is not only in charge of the safety of the ship, he and his crew physically sail the ship; there was no evidence of any Allseas' personnel ever even stepping foot on the ship. For these reasons, I find GONS was not in the equipment rental business. It operated supply ships throughout the world, and while operating the Highland Pride in Canadafor the 88 days in question, it was certainly carrying on activities in Canada. It would be odd indeed to find that GONS was carrying on business in Canada yet not carrying on activities in Canada. Therefore, given there is no issue regarding whether such activities were in connection with the exploration or exploitation of the seabed, Article 27A applies and GONS is deemed to be carrying on business in Canadathrough a permanent establishment, and is therefore subject to tax in Canada.
[21] Issue - Is GONS entitled to the salary and travel and interest expenses it claimed?
[22] Salary and travel - By virtue of the Income Tax Act, the Income Tax Convention and Interpretation Act, and the Canada-United Kingdom Income Tax Convention, the taxable income of a business carried on through a permanent establishment is to be calculated as if the establishment were a separate business for the period it exists. The difficulty facing GONS is that it operated 28 vessels during the relevant period, and was billed by GMS for the provision of crew on all the ships. Yet, the supporting material did break down the costs, based on standard costing, allocated to each ship. Canada Revenue Agency does not find this an acceptable method, as it does not reflect what was ultimately paid to the crew of the Highland Pride. It does though reflect what GONS paid GMS. It is also, in my mind, a reasonable approach to the allocation of salary in the circumstances. I was not provided with any evidence to suggest this approach is contrary to well-accepted business principles. Standard costing is an acceptable means of allocating costs. Further, Mr. Guthrie testified that in the case of the Highland Pride, any variance between the amount of the GMS invoice allocated to the Highland Pride and the salaries ultimately paid to the crew of the Highland Pride would be a negative variance; that is, the actual salaries would have been greater. I accept that the evidence supports the salary claim made by GONS, though recognizing that GONS might have been more forthcoming with lists of crew members, periods worked and relevant standard costs applicable. I can appreciate Canada Revenue Agency's reluctance to allow the full amount without such specifics. On balance, I accept that the amounts claimed are supportable and reasonable, based on acceptable business principles and standard costing. Relying on this method yields a clear picture of the Highland Pride's expenses as if it were a separate business.
[23] GONS did not separate its salary and travel expenses. Mr. Guthrie testified that transporting crew to and fro the Highland Pride was GONS' responsibility. The travel agent's invoice addressed to GONS illustrates how travel costs were allocated amongst the ships. The July invoice indicated £ 4,133 allocated to Highland Pride, supported by a list of crew member's names and the flights and costs of those flights.
[24] Without a detailed breakdown between salary expense and travel expense, it is difficult to reconcile this evidence with GONS' travel claim, though the profit and loss statement provided for the 88-day period is backed up by computerized general ledger entries. The July billing from the travel agent of £ 4,133 does appear in the general ledger. On balance, I accept Mr. Guthrie's evidence and supporting exhibits that the travel expenses, along with the salary expenses, do accurately reflect such expenses of Highland Pride, as if it were a separate business.
[25] Interest Expense - In 1999, GONS was indebted to its parent to the tune of approximately £ 37,000,000. This arose from a refinancing a year earlier in which certain debts of GONS, including any remaining debt on the Highland Pride, were paid off, and new funds were advanced for additional ship construction. GONS allocated the interest on this debt amongst its ships on the basis of the revenue generated by the ship compared to total revenues. Does this provide an accurate reflection of the income/expense picture for the Highland Pride, as if it were operating as a separate business? I am not convinced it does. Unlike salary expenses, where it is known that so many crew operated the Highland Pride at certain standard costs, with respect to the debt I have no evidence as to what portion of the debt, if any, related to the operation of the Highland Pride. I know that in 1998 whatever amount was left owing on the original loan to construct the Highland Pride was paid out to the original lenders, and new financing with the parent was put in place. I also know the original £ 11,000,000, or lesser amount, was borrowed in 1992 as a term loan for 10 years. It was suggested by GONS in argument that it would be unrealistic to expect GONS to have kept track of the amount of the original loan paid out. I do not believe that is as onerous a task of recordkeeping as suggested.
[26] The Respondent's position is simply that there is nothing concrete to be able to track any of the interest expense directly to the Highland Pride. I agree. The basis relied upon by GONS to allocate interest expense bears no relation to amounts actually borrowed to finance a particular ship's operations. This is not an Informal Procedure case where I might be tempted to guesstimate what amount of debt specifically applicable to the Highland Pride remained owing in 1999. GONS should be able to provide me with the necessary evidence. It has not. I also do not accept its method of allocating interest as providing a clear picture of the Highland Pride's true interest expenses as if it were a separate business. The method may be appropriate for an internal allocation, but I do not find it acceptable for establishing expenses of the Highland Pride as a separate business. These interest expenses should relate directly to the operation of the Highland Pride. I have not been convinced they do.
[27] The appeal is allowed and referred back to the Minister for reconsideration on the basis GONS carried on business in Canadathrough a permanent establishment, and is entitled to salary and travel expenses as claimed.
Signed at Ottawa, Canada, this 21st day of April 2006.
"Campbell J. Miller"
Miller J.
COURT FILE NO.: 2004-3596(IT)G
STYLE OF CAUSE: Gulf Offshore N.S. Limited and
Her Majesty The Queen
PLACE OF HEARING: Ottawa, Ontario
DATE OF HEARING: April 10 and 11, 2006
REASONS FOR JUDGMENT BY: The Honourable Justice Campbell J. Miller
DATE OF JUDGMENT: April 21, 2006
APPEARANCES:
|
Counsel for the Appellant: |
Vern Krishna, Q.C. and Isabella Mentina |
|
Counsel for the Respondent: |
Peter Leslie and Martin Hickey |
COUNSEL OF RECORD:
Firm: Borden Ladner Gervais LLB
For the Respondent: John H. Sims, Q.C.
Deputy Attorney General of Canada
Ottawa, Canada