DEVON CANADA CORPORATION, Appellant, v. HER MAJESTY THE QUEEN,, 2018 TCC 170

Dockets: 2013-1066(IT)G 2013-1327(IT)G BETWEEN: DEVON CANADA CORPORATION, Appellant, and HER MAJESTY THE QUEEN, Respondent . Appeals called for hearing on May 1 and 2, 2017, at Calgary, Alberta and on October 30 and 31, 2017 and November 1, 2017, at Toronto, Ontario. Submissions filed by the Appellant on August 14, 2017 and October 16, 2017 and by the Respondent on September 22, 2017. By: The Honourable Justice Don R. Sommerfeldt Appearances : Counsel for the Appellant: Al Meghji, Edward Rowe, Pooja Mihailovich, Joanne Vandale Counsel for the Respondent: Luther P.

Chambers, Q.C., Patrick Vézina, Vincent Bourgeois JUDGMENT These Appeals are allowed and the reassessment and the determination of a loss that are the subject of these Appeals are referred back to the Minister of National Revenue for reconsideration and reassessment or redetermination, as the case may be, in accordance with the attached Reasons, and, in particular, on the basis that the Surrender Payments (as defined in the Reasons) were eligible capital expenditures (as defined in subsection 14(5) of the Income Tax Act , as it read in 2001). Costs are awarded to the Appellant.

The Parties shall have 30 days from the date of this Judgment to reach an agreement on costs, failing which the Appellant shall have a further 30 days to file written submissions on costs, and the Respondent shall have yet a further 30 days to file a written response. Any such submissions are to be limited to 10 pages in length. If the Parties do not advise the Court that they have reached an agreement and if no submissions are received within the foregoing time limits, costs shall be awarded to the Appellant in accordance with the Tariff. Signed at Ottawa, Canada , this 20th day of August 2018. " “Don R.

Sommerfeldt” " Sommerfeldt J. Citation: 2018 TCC 170 Date: 20180820 Dockets: 2013-1066(IT)G

2013-1327(IT)G BETWEEN: DEVON CANADA CORPORATION, Appellant, and HER MAJESTY THE QUEEN, Respondent. REASONS FOR JUDGMENT Sommerfeldt J. I. INTRODUCTION [ 1 ] These Reasons pertain to two Appeals brought by Devon Canada Corporation ( " “Devon” " ) in respect of:

a) a reassessment (the " “Reassessment” " ), as set out in a Notice of Reassessment dated September 3, 2008, issued by the Canada Revenue Agency (the " “CRA” " ) on behalf of the Minister of National Revenue (the " “Minister” " ), in respect of the taxation year of a predecessor, Numac Energy Inc. ( " “Numac” " ), that ended on February 11, 2001; and

b) a determination of a loss (the " “Determination” " ), as set out in a Notice of Determination of a Loss dated July 31, 2008, issued by the CRA on behalf of the Minister, in respect of the taxation year of a predecessor, Anderson Exploration Limited ( " “Anderson” " ), that ended on October 14, 2001. [ 2 ] In the context of two corporate takeovers, by Anderson of Numac on or about February 12, 2001 and by Devon Energy Corporation ( " “DEC” " ) of Anderson on or about October 15, 2001, Numac and Anderson made payments (the " “Surrender Payments” " ) to various individuals who held options to acquire shares of the respective corporations. [ 3 ] In computing its income for the taxation year ended on February 11, 2001, Numac deducted the Surrender Payments (the " “Numac Surrender Payments” " ) paid by it to its option holders who had elected to surrender their unexercised options to Numac in exchange for a cash payment calculated by reference to the difference between the takeover-bid price of a Numac share and the exercise price of the particular option.

In computing its income for the taxation year ended on October 14, 2001, Anderson deducted the Surrender Payments (the " “Anderson Surrender Payments” " ) paid by it to its option holders who had elected to surrender their unexercised options to Anderson in exchange for a cash payment calculated by reference to the difference between the takeover-bid price of an Anderson share and the exercise price of the particular option. II. ISSUES [ 4 ] As set out in the pleadings, the issues in these Appeals were, in essence:

a) In computing Numac’s income for the taxation year ended on February 11, 2001, was Numac entitled to deduct the Numac Surrender Payments pursuant to subsection 9(1) of the Income Tax Act (the " “ ITA ” " ), [1] or was that deduction precluded by paragraph 18(1)(

a) or (

b) of the ITA ?

b) If the Numac Surrender Payments were on account of capital, within the meaning of paragraph 18(1)(

b) of the ITA , were they eligible capital expenditures, within the meaning of subsection 14(5) of the ITA , so as to be deductible in part pursuant to paragraph 20(1)(

b) of the ITA , read in conjunction with subsection 111(5.2) of the ITA ?

c) Were the Numac Surrender Payments deductible pursuant to subparagraph 20(1)( e )(

i) of the ITA ?

d) In computing Anderson’s income for the taxation year ended on October 14, 2001, was Anderson entitled to deduct the Anderson Surrender Payments pursuant to subsection 9(1) of the " ITA " or was that deduction precluded by paragraph 18(1)(

a) or (

b) of the ITA ?

e) If the Anderson Surrender Payments were on account of capital, within the meaning of paragraph 18(1)(

b) of the ITA , were they eligible capital expenditures, within the meaning of subsection 14(5) of the ITA , so as to be deductible in part pursuant to paragraph 20(1)(

b) of the ITA , read in conjunction with subsection 111(5.2) of the ITA ?

f) Were the Anderson Surrender Payments deductible pursuant to subparagraph 20(1)( e )(

i) of the ITA ? [ 5 ] By letter dated April 25, 2017, counsel for Devon advised the Court that Devon would no longer be advancing the arguments that it had previously made in respect of issues

a) and

d) above. In other words, Devon implicitly acknowledged that the Surrender Payments

were not deductible under subsection 9(1) of the ITA . III. FACTS [ 6 ] The Parties filed a Statement of Agreed Facts – Partial (the " “SAFP” " ), [2] a two-volume Joint Book of Documents (the " “JBOD” " ) [3] and a Supplementary Joint Book of Documents. [4] Unless otherwise indicated, the following facts are taken from the SAFP. A copy of the SAFP is attached as Appendix A to these Reasons. A. Parties [ 7 ] Devon was formed as the result of a number of amalgamations.

Numac and Anderson were two of the corporations that participated in some of the amalgamations to form Devon. [ 8 ] On or about February 12, 2001, Anderson (through a subsidiary) acquired all of the issued and outstanding shares of Numac by way of a takeover bid (the " “Numac Acquisition” " ), described below. [5] [ 9 ] Before February 12, 2001, Numac was a public corporation, the shares of which were listed and traded on the Toronto Stock Exchange (the " “TSE” " ) and the American Stock Exchange.

After the Numac Acquisition, the Numac shares were delisted from trading on those stock exchanges. [ 10 ] Numac, together with its subsidiaries, was engaged in the active business of exploring for, producing and selling natural gas and other hydrocarbons in Canada.

Numac and its successors, including Devon, continued to carry on this business after the Numac Acquisition. [ 11 ] On or about October 15, 2001, DEC (through a subsidiary) acquired all of the issued and outstanding shares of Anderson by way of a takeover bid (the " “Anderson Acquisition” " ), described below. [6] [ 12 ] Before October 15, 2001, Anderson was a public corporation, the shares of which were listed and traded on the TSE and the New York Stock Exchange.

After the Anderson Acquisition, the Anderson shares were delisted from trading on those stock exchanges. [ 13 ] Anderson, together with its subsidiaries, was engaged in the active business of exploring for, producing and selling natural gas and other hydrocarbons in Canada. Anderson and its successors, including Devon, continued to carry on this business after the Anderson Acquisition. B. Stock Option Plans

(1) Numac Stock Option Plan [ 14 ] Before the Numac Acquisition, Numac had an employee stock option plan (the " “Numac SOP” " ), which had come into existence before 2001. The Numac SOP was to be administered by the Numac Board of Directors, or a special committee thereof, appointed from time to time.

At all relevant times, the Numac SOP was administered by the Compensation Committee of the Board of Directors of Numac. [ 15 ] The Numac SOP provided for share option agreements (the " “Numac SOAs” " ), with attached terms and conditions, to be entered into between Numac and its directors, officers and key employees (the " “Numac Optionees” " ), to grant them options to purchase common shares of Numac for an option price specified in the SOAs and described therein as the " “exercise price.” " The Compensation Committee of the Board of Directors of Numac decided which of the Numac employees would receive options to acquire Numac shares in a given year. [ 16 ] The Numac SOP provided that the Compensation Committee of Numac’s Board of Directors could " “in its sole discretion, determine the time during which options shall vest.” " Although the terms of the Numac SOAs varied, each SOA provided for vesting limitations, which had to be satisfied before the options could be exercised to acquire shares of Numac.

Specifically, the vast majority of Numac SOAs provided that the options granted thereunder would vest in three equal parts (that is, one-third of the grant) on the first, second and third anniversaries of the date of grant. Upon satisfaction of those limitations, a Numac Optionee could exercise a vested option by paying to Numac the exercise price specified in the applicable SOA. [ 17 ] The Numac SOP provided that the exercise price of an option was to be fixed by the Compensation Committee at the time the option was granted.

The Numac SOP also provided that the exercise price could not be less than the closing price of the common shares of Numac on the stock exchange on which the shares were traded on the last trading day before the grant of the option. [ 18 ] All of the Numac SOAs also provided that:

a) in the event of an amalgamation, arrangement, merger or other consolidation of Numac with another corporation (other than a wholly-owned subsidiary of Numac), the vesting of unvested options was accelerated such that the Numac Optionees had the right to exercise their options at that time; and

b) in the event of a formal bid being made to acquire more than 25% of the outstanding voting shares of Numac, and if Numac’s Board of Directors recommended acceptance of the offer, the vesting of unvested options was accelerated and such options could be exercised for the sole purpose of tendering the shares to the bid. [ 19 ] The terms and conditions of the Numac SOAs provided that the Board of Directors of Numac had the discretion to permit

unexercised options to be surrendered to Numac for cash equal to the amount by which the fair market value of the shares at the time of the surrender exceeded the exercise price, [7] but the Numac Optionees did not otherwise have the right to surrender and cash out their options. Before the Numac Acquisition, Numac’s Board of Directors had not previously exercised the discretion to permit the Numac Optionees to surrender their options for cash. [ 20 ] The Numac SOP and the Numac SOAs provided that the options were not assignable by the Numac Optionees.

The Numac SOP also provided that, if a Numac Optionee ceased to be a director, officer or full-time employee of Numac, the option would terminate on the expiry of the period determined by the Compensation Committee of Numac’s Board of Directors, which was to be no more than six months after that cessation. The terms and conditions of each Numac SOA further provided that, if a Numac Optionee’s employment was terminated without cause within 60 days of an amalgamation, merger or other consolidation of Numac with any one or more corporations, any unexercised option would terminate and become null and void.

(2) Anderson Stock Option Plan [ 21 ] Before the Anderson Acquisition, Anderson had an employee stock option plan (the " “Anderson SOP” " ), which had come into existence on or about December 31, 1994. It was amended and restated as of February 10, 1999, and further amended and restated on February 13, 2001. [ 22 ] The Anderson SOP provided that:

a) the Board of Directors of Anderson had the authority to: i . grant to Anderson’s officers, members of management and employees (the " “Anderson Optionees” " ) options to purchase a number of Anderson’s common shares designated by the Board of Directors at the exercise price specified in the option grant; ii . fix the exercise price, which had to be equal to the closing price of the common shares on the TSE on the date of grant; iii . designate the period during which those options could be exercised, with the caveat that such period would not exceed ten years from the date of option grant; and iv . specify the vesting limitations that were required to be satisfied before the options could be exercised;

b) options granted under the plan were not assignable;

c) on the termination of an Anderson Optionee’s employment with Anderson, unexercised options were terminated;

d) in the event of a takeover of Anderson, any options that had not vested would immediately vest, giving the Anderson Optionees the right to exercise their options at that time; and

e) in connection with the exercise of options, the Anderson Optionees could, at the sole option of the Board of Directors, be entitled to obtain a loan from Anderson on terms prescribed in the Anderson SOP. [ 23 ] Options granted under the Anderson SOP were governed by stock option agreements (the " “Anderson SOAs” " ) between Anderson and the Anderson Optionees. The Anderson SOAs provided:

a) for a five-year expiry date of the particular option from the date of the grant of the option;

b) for a vesting limitation that had to be satisfied before the options could be exercised to acquire shares of Anderson; and

c) for the options to vest in three equal parts (that is, one-third of the grant) on the first, second and third anniversaries of the date of grant. Upon satisfaction of those limitations, an Anderson Optionee could exercise a vested option by paying to Anderson the exercise price specified in the applicable Anderson SOA. [ 24 ] Neither the Anderson SOP nor the relevant options granted pursuant to the Anderson SOAs gave the Anderson Optionees the right to unilaterally surrender their options in return for cash payments.

However, the Board of Directors of Anderson had the discretion to permit vested unexercised options to be surrendered to Anderson for cash equal to the amount by which the fair market value of the shares at the time of their surrender exceeded the exercise price. [8] Before the Anderson Acquisition, the Board of Directors of Anderson had not previously exercised the discretion to permit the Anderson Optionees to surrender their unexercised options to Anderson for cash. [ 25 ] The Anderson SOP was administered by the Board of Directors of Anderson, which had full and final discretion to interpret the provisions of the Anderson SOP and to prescribe, amend, rescind and waive rules and regulations to govern the administration and operation of the plan.

C. Numac Acquisition

(1) Anderson Acquires Numac [ 26 ] On or about January 17, 2001, Anderson and Numac entered into a Pre-Acquisition Agreement, pursuant to which:

a) Anderson expressed its intention to acquire all of Numac’s outstanding common shares, including any Numac shares that could

become outstanding pursuant to the exercise of outstanding options under the Numac SOP, in consideration for a cash payment of $8.00 for each Numac share;

b) Numac represented that all option entitlements held by the Numac Optionees under the Numac SOP would accelerate and vest as a result of Anderson making the offer to acquire all of Numac’s outstanding shares, and that it would give immediate notice of the offer to all Numac Optionees;

c) the parties agreed that all options granted under the Numac SOP that were tendered to Numac for exercise, conditional on Anderson's takeover of Numac, would be deemed to have been exercised concurrently with the take-up of Numac shares by Anderson;

d) the parties agreed that, to the extent that the Numac Optionees did not exercise their options and tender the shares acquired to the Anderson offer, Numac was permitted to agree with the Numac Optionees that, in lieu of such persons exercising their options, Numac would pay to such Numac Optionees the difference between the purchase price for the Numac shares under the offer and the exercise price of their options, in exchange for the termination of their options;

e) Numac represented that all persons holding options were entitled to exercise their options and tender their Numac shares under Anderson’s offer, and that Numac’s Board of Directors would not, before the completion of the offer, grant additional options pursuant to the Numac SOP; and

f) Numac agreed to use commercially reasonable efforts to encourage and facilitate the Numac Optionees to either exercise their options and deposit all of the Numac shares issued in connection therewith under the offer, or to surrender all of their Numac options for cancellation. [ 27 ] The closing price of the Numac common shares on the TSE on January 17, 2001 was $6.40 per share. [ 28 ] By news release dated January 19, 2001, Anderson announced that it was mailing to Numac’s shareholders its formal offer to purchase all of the issued and outstanding common shares of Numac for cash consideration of $8.00 per share. [ 29 ] On January 19, 2001, Anderson Acquisition Corp ( " “Anderson Acquireco” " ), an indirect wholly-owned subsidiary of Anderson, on behalf of Anderson, offered to purchase all of the Numac common shares at a price of $8.00 in cash for each share.

On January 23, 2001, Numac’s Board of Directors issued to Numac shareholders a Directors’ Circular pursuant to which the Board recommended acceptance of Anderson Acquireco’s offer. [ 30 ] By letter dated January 25, 2001, Numac advised the Numac Optionees that:

a) Anderson Acquireco’s offer to purchase all of the outstanding Numac common shares had triggered the acceleration of the unvested options;

b) they could elect to receive a cash payment from Numac for the value of their options, determined as the difference between $8.00 per share and the applicable exercise price (less applicable withholding tax) (the “Numac Cash Election”), or they could exercise their options by paying the applicable exercise price and acquiring the shares, and then tender the shares to the offer (the “Numac Exercise Election”); and

c) if a Numac Optionee failed to act on either alternative, that Numac Optionee would be deemed to have made the Numac Cash Election. [ 31 ] In the letter dated January 25, 2001, the Numac Optionees were also advised that:

a) in order to facilitate the realization by the Numac Optionees of the value of their options, Numac agreed to purchase the options of the Numac Optionees who chose the Numac Cash Election;

b) a Numac Cash Election would become effective only if and when Anderson Acquireco took up the common shares of Numac under its offer and, if it did not take up and pay for the Numac common shares, Numac’s offer to purchase their options would be withdrawn, the Numac Optionees would not receive any payment for their options, and the options that had accelerated would revert to their previous vesting arrangements in accordance with the terms of the Numac SOP; and

c) the Numac Exercise Election would be effective only if Numac was satisfied that Anderson Acquireco’s offer would be completed and Numac deposited a letter of transmittal provided by the Numac Optionees together with their Numac Exercise Elections, whereupon the Numac Optionees would receive payment for their common shares of Numac by cheque at the price of $8.00 per share, and if Anderson Acquireco did not take up and pay for the Numac common shares under its offer, the options that had been accelerated would revert to their previous vesting arrangements in accordance with the terms of the Numac SOP, and the certified cheques, bank drafts or money orders delivered in satisfaction of the exercise price would be returned to them. [ 32 ] Upon the closing of the Numac Acquisition on February 12, 2001, Numac shareholders tendered, and Anderson Acquireco acquired, 95,250,604, or approximately 98%, of the then outstanding Numac common shares, and the remaining 1,415,008 common shares that were not tendered were acquired through the compulsory share acquisition provisions in the Alberta Business Corporations Act (the “ ABCA ”). [9] [ 33 ] As a result of the acquisition of control of Numac by Anderson Acquireco on February 12, 2001, Numac’s taxation year (the " “Numac Taxation Year” " ) that would otherwise have included that date was deemed to end on February 11, 2001.

(2) Numac Surrender Payments

[ 34 ] During the Numac Taxation Year, options to acquire 7,228,829 Numac common shares were surrendered by the Numac Optionees who had made the Numac Cash Election. After the Numac Acquisition, Numac made cash payments (defined above as the " “Numac Surrender Payments” " ) in the aggregate amount of $20,844,041 to the Numac Optionees who had made the Numac Cash Election. [ 35 ] The Numac Surrender Payments made to the respective Numac Optionees were reported by Numac (or its successor) on the T4 slips issued to those optionees and were included in computing their employment income for the purposes of the ITA .

D. Other Facts Relevant to Numac [ 36 ] On April 1, 2001, Anderson Acquireco amalgamated with Numac to form Numac Energy Inc. ( " “Numac Amalco” " ). [ 37 ] On September 1, 2003, Numac Amalco amalgamated with Devon Amalco [10] to form Devon Canada Corporation (defined above as " “Devon” " ), the Appellant in these Appeals. [ 38 ] In computing Numac’s income under the ITA for the Numac Taxation Year, Numac Amalco (as successor to Numac) deducted the Numac Surrender Payments, relying on subsection 9(1) of the ITA .

By means of the " Reassessment " , notice of which was dated September 3, 2008, the Minister reassessed Devon (as successor to Numac), to disallow the deduction of the Numac Surrender Payments. Devon (as successor to Numac) objected to the Reassessment by means of a Notice of Objection filed on November 27, 2008.

The Minister confirmed the Reassessment by means of a Notice of Confirmation dated March 14, 2013. [ 39 ] In its Notice of Appeal, Devon (as successor to Numac) claimed, in the alternative, that the Numac Surrender Payments were deductible as eligible capital expenditures at the time of the acquisition of control pursuant to subsection 111(5.2) and paragraph 20(1)(

b) of the ITA , or as expenses under paragraph 20(1)(

e) of the ITA . E. Anderson Acquisition

(1) Devon Acquires Anderson [ 40 ] On August 31, 2001, " DEC " , which was a US public company, and Anderson entered into a Pre-Acquisition Agreement, pursuant to which:

a) DEC expressed its intention to acquire, either itself or through a subsidiary corporation, all of Anderson’s outstanding common shares, including any Anderson shares that could become outstanding pursuant to the exercise of outstanding options under the Anderson SOP, in consideration for a cash payment of $40.00 for each Anderson share;

b) Anderson represented that all option entitlements held by Anderson Optionees under the Anderson SOP would accelerate and vest as a result of DEC making the offer to acquire all of Anderson’s outstanding shares, and that it would give immediate notice of the offer to all Anderson Optionees;

c) the parties agreed that all options granted under the Anderson SOP that were tendered to Anderson for exercise, conditional on DEC’s takeover of Anderson, would be deemed to have been exercised concurrently with the take-up of Anderson shares by DEC;

d) the parties agreed that, to the extent that any Anderson Optionees did not exercise their options under DEC’s offer, Anderson was permitted to agree with those Anderson Optionees that, in lieu of those Anderson Optionees exercising their options, Anderson would pay to those Anderson Optionees the difference between the purchase price for the Anderson shares under the offer and the exercise price of their options, in exchange for the termination of their options; and

e) Anderson represented, among other things, that all persons holding options were entitled to exercise their options and tender their Anderson shares under DEC’s offer, and that Anderson’s Board of Directors would not, prior to the completion of the offer, grant additional options pursuant to the Anderson SOP. [ 41 ] The closing price of the Anderson common shares on the TSE on August 31, 2001 was $26.40 per share. [ 42 ] On September 6, 2001, Devon Acquisition Corporation ( " “DAC” " ), a wholly-owned Canadian subsidiary of DEC, offered to purchase all of the Anderson common shares at a price of $40.00 in cash for each share.

On September 6, 2001, Anderson’s Board of Directors issued to Anderson’s shareholders a Directors’ Circular pursuant to which the Board recommended acceptance of DAC’s offer. [ 43 ] By memorandum dated September 25, 2001, Anderson advised the Anderson Optionees that:

a) the Anderson SOP provided for the acceleration of unvested options in order to provide the Anderson Optionees with the opportunity to tender to DAC’s offer the Anderson shares issuable on the exercise of unvested options;

b) Anderson’s Board of Directors had exercised its discretion under the Anderson SOP to permit the Anderson Optionees to elect either to receive a cheque for their options or to follow the traditional method requiring the optionees to exercise their options and to forward payments for the shares to Anderson by a certified cheque or bank draft;

c) the Anderson Optionees were required to complete an election form and to return it to a specified employee of Anderson;

d) if the Anderson Optionees desired to participate in the offer, they had two alternatives (both of which required the completion of the election form) for dealing with their vested and unvested options: i . they could make an election (the " “Anderson Cash Election” " ) to surrender their options to Anderson in consideration for a cash payment equal to the value of their surrendered options, which was equal to $40 a share less the particular option exercise price, or

ii . they could make an election (the " “Anderson Exercise Election” " ) to exercise their options and tender the shares to DAC’s offer. [ 44 ] In the memorandum dated September 25, 2001, the Anderson Optionees were also advised that, if DAC did not take up and pay for the Anderson common shares under its offer:

a) the Anderson Cash Election would not take effect, Anderson’s offer to purchase their options would be withdrawn, they would not receive any payment for their options, their options would continue to exist and would be subject to the terms of the Anderson SOP, and the options that were accelerated would revert to their previous vesting arrangements; and

b) the Anderson Exercise Election would not take effect, the exercise of their options would be deemed not to have occurred, the certified cheques or bank drafts delivered by the Anderson Optionees to Anderson in payment of the exercise price would be returned to them, and the options that were accelerated would revert to their previous vesting arrangements. [ 45 ] On the closing of the Anderson Acquisition on October 15, 2001, Anderson shareholders tendered, and DAC acquired, approximately 97% of the then outstanding Anderson common shares, [11] and the remaining 3% of the shares that were not tendered were acquired through the compulsory share acquisition provisions of the

Canada Business Corporations Act . [12] [ 46 ] As a result of the acquisition of control of Anderson by DAC, on October 15, 2001, Anderson’s taxation year (the " “Anderson Taxation Year” " ) that otherwise would have included that date was deemed to end on October 14, 2001.

(2) Anderson Surrender Payments [ 47 ] During the Anderson Taxation Year, options to acquire 3,291,445 Anderson common shares were surrendered by the Anderson Optionees who had made the Anderson Cash Election. After the Anderson Acquisition, Anderson made cash payments (defined above as the " “Anderson Surrender Payments” " ) in the aggregate amount of $59,842,894 to the Anderson Optionees who had made the Anderson Cash Election.

By reason of an acquisition-of-control condition that was triggered in respect of the operating line of credit that Anderson had with a major financial institution, Anderson was no longer able to access that line of credit.

As a result, DAC lent Anderson sufficient funds to take care of its immediate cash needs, including the cash Anderson needed to make the Anderson Surrender Payments. [ 48 ] The Anderson Surrender Payments made to the respective Anderson Optionees were reported by Anderson (or its successor) on the T4 slips issued to those optionees and were included in computing their employment income for the purposes of the ITA . F. Other Facts Relevant to Anderson [ 49 ] DAC and Anderson amalgamated on October 18, 2001 to form Devon Acquisition Corporation ( " “Devon Amalco” " ).

On October 25, 2001, " Devon Amalco " continued under the ABCA [13] and changed its name to " “Devon Canada Corporation.” " [14] [ 50 ] As indicated above, on September 1, 2003, Devon Amalco and Numac Amalco amalgamated to form Devon Canada Corporation (defined above as " “Devon” " ), the Appellant in these Appeals. [15] [ 51 ] In computing Anderson’s income under the ITA for the Anderson Taxation Year, Devon Amalco (as successor to Anderson), deducted the Anderson Surrender Payments, relying on subsection 9(1) of the ITA .

On July 31, 2018, the Minister issued the " Determination " to Devon (as successor to Anderson) for the Anderson Taxation Year, to disallow the deduction of the Anderson Surrender Payments. Devon (as successor to Anderson) objected to the Determination by means of a Notice of Objection filed on October 28, 2008.

The Minister confirmed the Determination by means of a Notice of Confirmation dated February 4, 2013. [ 52 ] In its Notice of Appeal, Devon (as successor to Anderson) claimed, in the alternative, that the Anderson Surrender Payments were deductible as eligible capital expenditures at the time of the acquisition of control pursuant to subsection 111(5.2) and paragraph 20(1)(

b) of the ITA , or as expenses under paragraph 20(1)(

e) of the ITA . IV.

SUMMARY OF ORAL EVIDENCE A. Fact Witnesses

(1) Brent Snyder [ 53 ] Counsel for Devon called Brent Snyder and Michael Perlette as fact witnesses. [ 54 ] Mr. Snyder is a professional geologist, who has worked in the oil and gas industry since 1983. After working as a geophysical technician for the first year and a half of his career, he took a position as a geologist with Texaco Canada Ltd. ( " “Texaco” " ) where he worked from 1984 to 1989. After Imperial Oil Limited ( " “Imperial” " ) acquired Texaco in 1989, Mr. Snyder worked as an exploration geologist for Esso Resources ( " “Esso” " ) for approximately two years. [16] [ 55 ] Mr.

Snyder testified that there were certain advantages to working for a larger oil company, such as Texaco or Esso. In particular, they offered competitive salaries and usually had attractive benefit packages, including a defined benefit pension plan. As well, the larger oil companies generally provided better training. However, in the 1990s it was generally acknowledged that greater rewards could be found by working for one of the junior oil and gas companies, which tended to be nimble and entrepreneurial and had more attractive

compensation packages, which included not only a competitive salary but also bonuses and stock options, which were significant motivators. It was Mr. Snyder’s experience that, where any of his employers had a stock option plan, the employer posted its daily stock price on the computer screen of each employee in order to enhance the motivation. Mr. Snyder indicated that it was common in the 1990s for geoscientists to begin their careers with a large company and then move to a junior oil and gas company. In keeping with this trend, Mr.

Snyder left Esso in 1991 and took a position with Murphy Oil Canada ( " “Murphy” " ). [ 56 ] In the 1990s , Mr. Snyder worked for several independent oil and gas companies, specifically Murphy, Richland Petroleum ( " “Richland” " ) and Ulster Petroleum ( " “Ulster” " ). He stated that he was granted stock options at Richland and Ulster. Nothing was said one way or the other in respect of Murphy. [ 57 ] In May 2000, Anderson acquired Ulster, whereupon Mr. Snyder became an employee of Anderson. His compensation package at Anderson included a salary, bonuses and stock options. [ 58 ] Mr.

Snyder stated that corporate acquisitions were not uncommon in the oil and gas industry in Alberta in the 1990s and early 2000s. In some acquisitions there was concern on the part of employees, particularly those employed by the target corporation, that they might lose their jobs as a result of the acquisition. That concern was less prevalent among the professionals, including geologists and other geoscientists, as they knew that their professional knowledge and credentials would be needed even after the acquisition. [ 59 ] Mr.

Snyder indicated that, in most of the corporate takeovers, the acquiror usually paid a premium above the market price to acquire the shares of the target. This was attractive for employees of the target who held options, as the higher price was reflected in the amounts paid to buy out the stock options. When Anderson purchased Ulster in 2000, Mr. Snyder realized a modest gain, as his Ulster stock options were cashed out. [ 60 ] Several themes were prominent in the testimony given by Mr. Snyder:

a) Stock options were a very common feature of the compensation packages offered by the junior oil and gas companies in Alberta in the 1990s.

b) Stock options were used by junior oil and gas companies to attract talent.

c) Corporate acquisitions or takeovers were not uncommon in the oil and gas industry in Alberta in the 1990s and early 2000s.

d) A corporate takeover typically resulted in the stock options of the target corporation being subject to accelerated vesting, and optionees possibly being offered cash payments for the surrender of their options. [ 61 ] When the acquisition of Anderson by DEC was formally announced, there was " “a bit of concern” " among the employees of Anderson as to what would become of them, " “[b]ut it was different this time.” " [17] The reason for the difference was that, when DAC (DEC’s acquiring subsidiary) acquired Anderson in October 2001, DEC’s Canadian operating subsidiary, known as Northstar Energy Corp. ( " “Northstar” " ), had approximately 200 to 250 employees, while Anderson had approximately 700 to 800 employees.

The employees of Anderson anticipated that DEC would need to retain them in order to manage and operate the assets of Anderson. [ 62 ] However, DEC, which was based in Oklahoma City, was not then well known in Calgary. Therefore, some of the employees of Anderson were not certain that they wanted to remain with Anderson after the acquisition.

At that time, many of the oil and gas companies in Calgary were competing for employees, so the employees of Anderson were confident that they could readily find employment elsewhere if they decided not to stay with Anderson. [18] [ 63 ] To address the concern that employees of Anderson might decide to go elsewhere, Larry Nichols, the president and chief executive officer of DEC, the parent of DAC, came to Calgary to meet with all of Anderson’s employees. He told them that they (as well as Anderson’s assets) were one of the reasons for which DAC had bought Anderson.

In addition, he assured them that DEC would let the former employees of Anderson " “continue to run the show” " in Canada. [19] [ 64 ] When Anderson acquired Ulster in May 2000 and Mr. Snyder became an employee of Anderson, he was granted 24,000 Anderson stock options. A year later, in May 2001, one-third of those options vested. Mr. Snyder exercised the vested options, acquired 8,000 shares of Anderson and sold those into the market. At approximately the same time, he was granted an additional 24,000 options by Anderson. [ 65 ] When Devon made its takeover bid for Anderson in October 2001, Mr.

Snyder could have exercised his 40,000 options and then sold the shares into the offer. However, exercising his options would have required a cash outlay in excess of $1,000,000. Therefore, it was much more attractive for him to accept the cash surrender alternative made available by Anderson. [20]

(2) Michael D. Perlette [ 66 ] At the time of the hearing, Michael Perlette , a petroleum engineer, had worked in the oil and gas industry for approximately 33 years. When he testified, he was the manager of business development and corporate planning for Devon, a position that he had held since 2012. [ 67 ] After obtaining a bachelor of science degree in petroleum engineering, Mr. Perlette was employed as an engineer by Amoco Canada ( " “Amoco” " ), [21] which was a large integrated oil and gas company. In January 1998, he moved to Canadian 88 Energy ( " “Canadian 88” " ), a junior oil and gas producer.

By moving from Amoco to Canadian 88, Mr. Perlette avoided the possibility of receiving an international assignment, and, instead, was able to remain in Alberta. He had less security and more risk at Canadian 88, but he also had higher compensation, particularly as he was able to participate in Canadian 88’s stock option plan. He regularly received and exercised stock options, which permitted him to do well financially. In 2000, Mr. Perlette left Canadian 88 and moved to Northstar, which, by then, had been acquired by DEC. [22] At Northstar he worked on acquisitions and divestitures.

He was compensated by salary, a savings plan, a bonus and participation in Devon’s stock option plan. As DEC’s stock prices were steadily increasing throughout the early 2000s,

Mr. Perlette benefitted from his participation in the stock option plan. [ 68 ] As Mr. Perlette worked in Devon’s acquisitions and divestitures group, he participated in the process of evaluating Anderson when Devon was contemplating whether to make a takeover bid. Mr. Perlette stated that in mid-2001 there was a decline in the price of natural gas, which led to a decline in the trading price of the shares of Anderson. The acquisition team at Devon recognized the value of Anderson’s position in the Western Canadian Sedimentary Basin, particularly its natural gas reserves and undeveloped properties.

Devon perceived that there was an opportunity to make a takeover bid for Anderson, as Devon realized that the value of Anderson was greater than that attributed to it by the marketplace. Devon was also interested in the assets in northeast British Columbia which were owned by Numac, which had recently been acquired by Anderson. Ultimately, those assets were retained, operated and worked first by Anderson and then by Devon. [ 69 ] In addition, Devon also recognized the value attributable to Anderson’s employees, who had a good reputation and who were very nimble.

Northstar had direct experience working with Anderson on joint properties, primarily in the foothills, where the Northstar employees and their Anderson counterparts were working well together. Devon/Northstar saw Anderson " “as a company with quality people running a quality business.” " [23] When Devon decided to acquire Anderson, the former wanted not only the hard assets of the latter, but it also " “wanted what the company was, and that was the people, the management, the ability to run as a company.” " [24] [ 70 ] Mr.

Perlette suggested that sometimes markets tend to overreact, which may create an opportunity to acquire a quality viable business at a time when the market might feel otherwise. [25] More specifically, at a time when the Anderson shares were trading at approximately $26 per share, Devon formed the view that the shares were actually worth $40 per share, which was the price offered in its takeover bid. [ 71 ] Mr. Perlette stated that the Anderson Optionees whose options were in the money were cashed out. The Anderson executives who were retained by Devon were granted Devon stock options. B.

Expert Witness [ 72 ] Scott Munn testified as an expert witness. Mr. Munn has more than 20 years of experience as an executive compensation consultant. Mr. Munn obtained a Bachelor of Arts degree in economics from the University of Western Ontario in 1990, [26] a Master of Business Administration degree from the Schulich School of Business at York University in 1996, and a Chartered Financial Analyst designation in 2001. He worked at Mercer (Canada) Ltd. from 1996 to 2008. Since 2008 he has been a partner at Hugessen Consulting. [ 73 ] Counsel for the Crown acknowledged that Mr.

Munn was qualified to provide an expert opinion for the purposes set out in his report. [ 74 ] There was no dispute , and I find, that Mr. Munn was qualified to provide an expert opinion concerning executive and non-executive compensation and compensation practices among companies in the Canadian oil and gas sector. In particular, he was asked to provide his opinion on typical compensation practices among small and medium-sized upstream oil and gas companies in the period from the 1990s to 2001. [ 75 ] Mr. Munn’s opinion is summarized and paraphrased as follows: [27]

a) In Mr. Munn’s opinion, typical compensation practices in the oil and gas industry during the relevant time period of the early 1990s to the mid-2000s included the following: i . Grants under long-term incentive programs ( " “LTIP” " ), particularly in the form of stock options, were an essential part of attracting the key talent required to maintain high-performing operations, especially for small/mid-cap exploration and production companies. ii . Stock options were part of the regular, ongoing costs incurred in the normal course of business to compensate employees for their service. iii .

On the date of a grant, stock options were given to employees to complement cash compensation and other entitlements (e.g., pension, saving plans, etc.) and were in respect of then current service. [28] iv .

At the time of a change of control, the " “in the money” " value of a stock option was a contractual right of the employee in respect of past service, and any payment received to compensate for the " “in the money” " value of the option was in respect of that past service. [29] v . the stock options granted by Numac to its employees and surrendered to Numac in connection with the acquisition by Anderson; and vi . the stock options granted by Anderson to its employees and surrendered to Anderson in connection with the acquisition by DAC. [30]

b) Based on Mr. Munn’s review of the agreements, resolutions, correspondence and other documents provided to him in respect of the Numac and Anderson SOPs, it is his opinion that each of the above factors applied to: [ 76 ] One of the documents reviewed by Mr. Munn was a copy of the minutes of a meeting of the Board of Directors of Numac held on September 17, 1993. Although the meeting predated the taxation years in issue, the minutes of the meeting illustrate the competitive nature of the employment market in the oil and gas industry in Alberta in the 1990s. The following is an excerpt from those minutes in respect of Numac’s " “inaugural share option proposal” " [31] :

Mr. McKeough [a director of Numac and chairman of the Compensation Committee] advised that the Compensation Committee had a considerable amount of discussion and debate on the issue of share options and indicated that their preferred course of action would be for a full compensation program to be in place with all relevant information available before options would be granted. Mr.

McKeough and the Compensation Committee recognized the need, however, to move ahead with the options, given that the market was very competitive and given that staff attrition rates within the Corporation had increased significantly over the last year. [32] [ 77 ] In the " “Analysis” " portion of his report and in his testimony, Mr. Munn made a few additional points, some of which are summarized and paraphrased below:

a) From the early 1990s to the early 2000s, stock options were the dominant and most prevalent form of long-term incentive in the Canadian oil and gas sector, particularly among small and mid-cap publicly traded companies. [33]

b) During the same period, granting long-term incentives in the form of stock options (rather than a mix of incentives) and accelerating the vesting of all the options when an employer/issuer experienced a change of control were mainstream compensation practices and were part of the competitive pay environment. [34]

c) From 1994 to 2001 in Alberta, particularly Calgary, the unemployment rate fell, making it difficult for employers in the oil and gas sector to attract and retain employees, which led to aggressive compensation programs, particularly the use of stock option plans with a vesting schedule. [35] [ 78 ] During cross-examination, Mr. Munn and counsel for the Crown engaged in an exchange concerning the value of a stock option on the date of grant, in the context of Mr.

Munn’s opinion, as summarized in clause 75(a)iii above, to the effect that, on the date of a grant, stock options were given to employees to complement cash compensation and other entitlements and were in respect of current service. [36] Counsel for the Crown suggested that, if the market value of an optioned share were to drop below the option’s exercise price, the option would not have any value. [37] Mr.

Munn acknowledged that, when a stock option is granted, if the exercise price is equal to the then market value (i.e., if the option is issued " “at the money” " ), there is no imbedded value at that point in time. However, he said, in receiving the option, there is a significant opportunity, which is valuable. Even though it is very difficult to put a value on the opportunity, it is worth something and employees are willing to accept that as a form of compensation, even though there is a risk that the market value of the optioned share may decrease. [38] Mr.

Munn suggested that the concept might be described as contingent value. [39] [ 79 ] At the hearing, the Crown did not call any fact witnesses or expert witnesses. The Crown read into evidence numerous answers given by an officer of, or counsel for, Devon during the examination for discovery. V. ANALYSIS [ 80 ] It is the position of Devon that the Surrender Payments were eligible capital expenditures, as defined in subsection 14(5) of the ITA , and were deductible in part pursuant to paragraph 20(1)(

b) and subsection 111(5.2) of the ITA , as those provisions read in 2001. Alternatively, Devon submitted that the Surrender Payments were deductible under paragraph 20(1) (

e) of the ITA . A. Eligible Capital Expenditure [ 81 ] To assist in resolving the issues pertaining to Devon’s submission that the Surrender Payments were eligible capital expenditures, it is helpful to consider the historical context for the introduction in 1972 of the provisions that became

section 14 of the ITA . The editors of the Canada Tax Service describe this context as follows: Under the pre-1972 Act there were a number of types of expenditures for which no deduction was available notwithstanding that they had been incurred for the purpose of earning income from a business. The expenditures were capital in nature, having been made to produce an advantage to the business of enduring benefit, and thus were not deductible as an item of expense in the year incurred.

Yet, the taxpayer was not allowed to deduct the cost over a number of years by way of depreciation, because the expenditures were not made to acquire an asset described in the Income Tax Regulations in respect of which capital cost allowance was granted. Such expenditures (commonly referred to as “nothings”) were often made to acquire assets of an intangible nature: eg, goodwill, customer lists, franchises for an unlimited period, etc. Other capital expenditures might not have related to any particular asset or perhaps were made in connection with an asset which the taxpayer did not own.

For taxation years after 1971 and before 2017, former

section 14 and paragraph 20(1)(

b) together ensure that a portion of the cost of assets and expenditures within this category of “nothings” was recognized as a business expense deductible over a period of time. [40] No longer relying on its original position that the Surrender Payments were deductible in their entirety, Devon now asserts that 75% of the Surrender Payments were deductible as eligible capital expenditures under paragraph 20(i)(

b) and subsection 111(5.2) of the ITA . On the other hand, the effect of the Reassessment and the Determination issued by the CRA was, in a sense, to treat the Surrender Payments as " “nothings” " in respect of which no tax recognition was available. [ 82 ] Given that

section 14 of the ITA was repealed effective as of January 1, 2017, it is helpful to reproduce the definition of " “eligible capital expenditure” " in subsection 14(5) of the ITA , as it read in 2001: " “eligible capital expenditure” " of a taxpayer in respect of a business means the portion of any outlay or expense made or incurred by the taxpayer, as a result of a transaction occurring after 1971, on account of capital for the purpose of gaining or

producing income from the business, other than any such outlay or expense (

a) in respect of which any amount is or would be, but for any provision of this Act limiting the quantum of any deduction, deductible (otherwise than under paragraph 20(1)( b )) in computing the taxpayer’s income from the business, or in respect of which any amount is, by virtue of any provision of this Act other than paragraph 18(1)( b ), not deductible in computing that income, (

b) made or incurred for the purpose of gaining or producing income that is exempt income, or (

c) that is the cost of, or any part of the cost of, (

i) tangible property of the taxpayer, (ii) intangible property that is depreciable property of the taxpayer, (iii) property in respect of which any deduction (otherwise than under paragraph 20(1)( b )) is permitted in computing the taxpayer’s income from the business or would be so permitted if the taxpayer’s income from the business were sufficient for the purpose, or (iv) an interest in, or right to acquire, any property described in any of subparagraphs (

i) to (iii), but, for greater certainty and without restricting the generality of the foregoing, does not include any portion of (

d) any amount paid or payable to any creditor of the taxpayer as, on account or in lieu of payment of any debt or as or on account of the redemption, cancellation or purchase of any bond or debenture, (

e) where the taxpayer is a corporation, any amount paid or payable to a person as a shareholder of the corporation, or (

f) any amount that is the cost of, or any part of the cost of, (

i) an interest in a trust, (ii) an interest in a partnership, (iii) a share, bond, debenture, mortgage, hypothecary claim, note, bill or other similar property, or (iv) an interest in, or right to acquire, any property described in any of subparagraphs (

i) to (iii)[.] The above definition sets out a number of criteria that must be satisfied for an outlay or expense to constitute an eligible capital expenditure. Those criteria will be discussed below.

(1) In Respect of a Business [ 83 ] The opening words of the definition of “eligible capital expenditure” indicate that the particular outlay or expense must be in respect of a business. [41] An indirect link between the outlay or expense and the business is sufficient to satisfy this requirement. [42] [ 84 ] After Numac was acquired by Anderson on February 12, 2001, Numac continued to carry on the business which it had been carrying on before the Numac Acquisition. [43] After the amalgamation of Numac and Anderson Acquireco on April 1, 2001, Numac Amalco continued to carry on the business previously carried on by Numac. [44] In carrying on that business, Numac and its successors continued to use most of the assets owned by Numac before the Numac Acquisition, and Numac and its successors continued to employ most of the employees who had been employed by Numac before the Numac Acquisition. [45] [ 85 ] After Anderson was acquired by DAC on October 15, 2001, Anderson continued to carry on the business which it had been carrying on before the Anderson Acquisition. [46] After Anderson and DAC amalgamated on October 18, 2001, Devon Amalco continued to carry on the business that had been carried on by Anderson before the Anderson Acquisition. [47] In carrying on that business, Anderson and its successors continued to use most of the assets which had been used by Anderson before the Anderson Acquisition and continued to employ most of the employees who had been employed by Anderson before the Anderson Acquisition. [48] [ 86 ] The Surrender Payments were made to employees who had been granted their options while working in the businesses of their respective employers and who, for the most part, continued to work in those businesses after the respective acquisitions.

Accordingly, I am of the view that the Surrender Payments were made by Numac and Anderson in respect of their businesses.

(2) On Account of Capital [ 87 ] As indicated in the above statutory definition, to constitute an eligible capital expenditure, an outlay or expense must be made or incurred on account of capital. [ 88 ] Devon initially took the position that the Surrender Payments were made on income account and were deductible pursuant to the ordinary rules applicable for the purpose of computing profit in accordance with

section 9 of ITA . However, before the commencement of the hearing, and again in his opening statement, counsel for Devon advised the Court that, by reason of the decisions of the Federal Court of Appeal in Kaiser Petroleum and Imperial Tobacco , Devon was no longer pursuing that argument. Those two cases had held that similar cash payments made as consideration for the surrender of the particular stock options in question were outlays of capital. [49] [ 89 ] In a memorandum dated October 31, 2012 from " “HQ – Appeals Branch” " of CRA’s Tax & Charities Appeals Directorate to the

Chief of Appeals of the Calgary North Tax Services Office, it was stated that " “both the taxpayer [i.e., Devon] and CRA agree that the cash payments were capital in nature.” " [50] [ 90 ] In the Further Amended Replies filed by the Crown on April 24, 2017, at a time when Devon had not yet conceded that the Surrender Payments were not deductible under subsection 9(1) of the ITA , the Crown submitted " “that if the cash surrender payments were made for the purpose of gaining or producing income from [Numac’s or Anderson’s, as the case may be] business, within the meaning of paragraph 18(1)(

a) of the Act , they were payments or outlays on account of capital whose deduction was prohibited by paragraph 18(1)(

b) of the Act , in that they were made for the purpose of the reorganization or reshaping of [Numac’s or Anderson’s, as the case may be] capital structure.” " [51] As well, in his opening statement, counsel for the Crown, in acknowledging Devon’s concession concerning the subsection 9(1) issue, seemed to acknowledge that the Surrender Payments were on capital account. [52] [ 91 ] Accordingly, for the purposes of these Appeals, I find that the Surrender Payments were outlays or expenses made or incurred by Numac and Anderson on account of capital.

(3) Purpose of Gaining or Producing Income [ 92 ] Another criterion that must be met in order for an outlay or expense to constitute an " eligible capital expenditure " in respect of a business is that the outlay or expense must have been made or incurred by a taxpayer for the purpose of gaining or producing income from the business (which I will, for the sake of brevity, call the " “income-gaining purpose” " ). The statutory definition of " “eligible capital expenditure” " does not require that the income-gaining purpose be the only purpose, or even the primary purpose, of the outlay or expense.

It will suffice if the income-gaining purpose is one of the purposes of the outlay or expense. [ 93 ] Before reviewing the evidence concerning the purposes of the Surrender Payments, I will review a few legal principles that may be applicable here. [ 94 ] In the B.C. Electric Railway case, Justice Abbott stated the following in the context of then paragraph 12(1)( a ) [now 18(1)( a )] of the ITA : Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made " “for the purpose of gaining or producing income” " comes within the terms of Section 12(1)(

a) whether it be classified as an income expense or as a capital outlay. Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or a capital outlay. [53] The significance of the above statement is that it confirms that a capital outlay may have an income-gaining purpose. [ 95 ] The facts of the Kaiser Petroleum case bear some similarity to the facts of these Appeals.

In that case, Ashland Oil Canada Ltd. ( " “Ashland” " ), shortly before being taken over by Kaiser Resources Ltd., made a sizable payment to various employees who held options entitling them to purchase shares of Ashland. The Federal Court of Appeal concluded that the payment made by Ashland to its employees for the surrender of their options was made on capital account, rather than income account. The question of whether the payment may have been an eligible capital expenditure was not before the Court.

The Crown argued that Ashland’s purpose in terminating the particular stock option agreement at the time of the takeover was not to compensate its employees, but rather was to restructure Ashland’s capital. In determining that the payment made by Ashland to its employees was an outlay of capital, the Court made the following comments (among others): 19. … [Ashland], in buying out rights under the plan, parted with an asset (the purchase price) and effected a sterilization of future issues of shares.

The disbursement made was a once and for all payment which had a direct effect on the capital structure of the corporation. In fact, the stock option plan was later cancelled. Although the plan originated as a form of compensation and immediate compensation was one reason for its termination, … it does not follow that the payment, from the point of view of [Ashland], had the character of an operating expenditure.

What is important is not the purpose pursued by [Ashland] but what it did and how it did it…. 21. … There is, however, evidence that compensation was one element pursued when the termination of the stock option plan took place. Nevertheless, the compensation was made by means of a reshaping of the capital structure of [Ashland’s] organization. This feature, in my view, dominates the whole set of circumstances revealed by the evidence and constitutes the guiding element under the test set out in the B.P.

Australia Ltd. case.... [54] While the Federal Court of Appeal in Kaiser Petroleum did not consider whether the particular payment was an eligible capital expenditure, the Court did indicate that, in applicable circumstances, a payment made by a corporation, in the context of a takeover, to eliminate stock options held by its employees, may have a compensation-related purpose, even though the payment also reshaped the capital structure of the corporation. [ 96 ] There are also similarities between the facts of the Imperial Tobacco case and the facts of these Appeals.

In that case, Imasco Limited ( " “Imasco” " ) had previously issued stock options to its employees. Subsequently, and shortly after British American Tobacco p.l.c. ( " “BAT” " ) had approached Imasco to discuss a proposed " “going-private” " transaction, Imasco’s board of directors passed a resolution to amend Imasco’s employees stock option plan so as to give option holders the right to surrender their options for a cash payment equal to the amount by which the fair market value of the particular optioned shares exceeded their exercise price.

After the amendment was enacted, Imasco’s board passed a resolution to accelerate the vesting of the options, and BAT and Imasco proceeded to implement the going-private transaction. Consequently, many of Imasco’s employees surrendered their options for cash, and Imasco, in computing its income, deducted the aggregate of the cash surrender payments. The Crown took the position that paragraph 18(1)(

b) of the ITA precluded the deduction of those payments, as they were made in the context of a reorganization of Imasco’s capital. Imasco

argued that the cash surrender payments were best characterized as employee compensation, such that they should be deductible as ordinary business expenses for the purpose of computing profit, as required by

section 9 of the ITA . The Federal Court of Appeal concluded that the cash surrender payments were outlays on account of capital, and thus were not deductible in computing profit for the purpose of

section 9 of the ITA , notwithstanding that the stock option plan had been entered into to provide a form of employee compensation. [55] For the purpose of these Appeals, the following comment by the Federal Court of Appeal is relevant: It is reasonable to infer … that this amendment [to permit option holders to surrender their options for cash] was one of the steps taken by Imasco to facilitate the going private transaction. Imasco contended that the amendment was made to ensure that option holders were treated fairly if the going private transaction was completed.

That is also consistent with the documentary evidence. I see no conflict between the objective of facilitating the going private transaction and the objective of treating option holders fairly. [56] The above statement suggests to me that, even though the cash surrender payments in Imperial Tobacco facilitated the going-private transaction and were outlays on account of capital, they were also made for the purpose of treating option holders fairly, which was an employee-compensation-related purpose.

This implies that the cash surrender payments in that case were made for the purpose of gaining or producing income, even though they were on account of capital and were made for the additional purpose of facilitating the going- private transaction. [ 97 ] In ONEnergy Inc. , the corporate taxpayer had been carrying on a telecommunications business unsuccessfully.

In the course of winding up its business, it sold its assets, providing an opportunity for its directors to cause the corporation to use some of the sale proceeds to make payments to themselves and to certain other executives, shareholders, employees and personal holding companies (collectively, the " “Former Executives”) " to cancel options and share appreciation rights that they held and to pay bonuses to themselves. Subsequently, the shareholders of the corporation caused the corporation to sue the Former Executives to recover what the shareholders considered to be overpaid remuneration.

In the subsequent tax litigation (which dealt with GST), the issue was whether the civil litigation costs incurred by the corporation in pursuing its claim against the Former Executives were incurred in the course of a commercial activity. In describing the litigation brought by the corporation against the Former Executives, the Federal Court of Appeal stated: The disputed amounts were paid to the Former Executives for their cancelled options and SARs and as a bonus.

The options and SARs would have been part of the compensation or remuneration payable to the Former Executives and the bonus would also be remuneration paid to these persons. Although the legal basis for the claim against the Former Executives may be a breach of fiduciary duty, the result of that breach (if established) would be an overpayment of remuneration.

Therefore, in my view, the litigation should be characterized as a claim for overpaid remuneration. [57] The above statement indicates that the options were part of the compensation or remuneration package made available to the Former Executives, possibly implying that, if income tax were to have been in issue, one of the purposes of the payment for the cancellation of the options would have been to gain or produce income. [ 98 ] Returning to the facts of these Appeals, the evidence of Mr. Snyder, Mr. Perlette and Mr. Munn established that:

a) The Numac SOP and the Anderson SOP were important features of the compensation packages offered by Numac and Anderson respectively.

b) The SOPs were used by Numac and Anderson to attract and retain talent.

c) When options were granted to employees of Numac and Anderson, the employees viewed the options as part of their compensation for their current service, notwithstanding that they had not yet exercised the options.

d) When Numac was taken over by Anderson, and when Anderson was taken over by Devon, the employees of Numac and Anderson respectively expected that there would be accelerated vesting in respect of their options and that the " “in the money” " value of those options would constitute compensation for their service for the period between the grants of the particular options and the respective takeovers.

e) The business carried on by Numac when it was taken over by Anderson, and the business carried on by Anderson by when it was taken over by Devon, continued to be carried on by the respective amalgamated corporations resulting from those takeovers.

f) The assets owned by Numac when it was taken over by Anderson, and the assets owned by Anderson when it was taken over by Devon, continued to be owned and operated by the respective amalgamated corporations that resulted from the takeovers. [ 99 ] Based on the legal principles established in B.C.

Electric , Kaiser Petroleum , Imperial Tobacco and ONEnergy , as summarized in paragraphs 94 to 97 above, and having regard to the evidentiary findings summarized in the preceding paragraph, it is my view that the Surrender Payments were made or incurred by Numac and Anderson respectively in respect of their businesses for the purpose of gaining or producing income from those businesses.

The Surrender Payments may have been made, as well, for other purposes, such as facilitating the takeovers or revising the capital structure of the corporations, but those other purposes do not negate that one of the purposes of the Surrender Payments was to gain or produce income from the respective businesses of Numac and Anderson.

(4) Exceptions [ 100 ] As indicated in the statutory definition of " “eligible capital expenditure” " quoted in paragraph 82 above, that definition excepts an outlay or expense described in paragraph (a), (

b) or (

c) of the definition. None of those three exceptions is relevant to these Appeals.

(5) Exclusions

(

a) Cost of Right to Acquire Certain Property [ 101 ] After itemizing the three exceptions referenced above, the statutory definition of " “eligible capital expenditure” " goes on to state that, " “for greater certainty and without restricting the generality of” " the preceding portion of the definition, the term does not include any portion of any amount described in paragraph (d), (

e) or (

f) of the definition. [58] Paragraphs (

d) and (

e) are not applicable here. However, paragraph (

f) might possibly be applicable. The relevant portion of the text of paragraph (

f) reads as follows: (

f) any amount that is the cost of, or any part of the cost of, … (iii) a share … or other similar property, or (iv) an interest in, or right to acquire, any property described in any of subparagraphs (

i) to (iii)[.] As a stock option is a right to acquire one or more shares, it is the position of the Crown that the Surrender Payments were the cost of rights to acquire shares. [59] Devon takes the position that Numac and Anderson did not acquire the options held by their respective employees, such that the Surrender Payments were not the cost of the options. [60] (

b) Meaning of " “Cost” " [ 102 ] Although paragraph (

f) of the definition of " “eligible capital expenditure” " excludes an amount that is the cost of a share or a right to acquire a share, the word " “cost” " is not defined in the ITA , [61] either for the purpose of the statute as a whole or for the purpose of former

section 14 specifically. (

i) Text [ 103 ] The key word in the text of paragraph (

f) of the definition of " “eligible capital expenditure” " is " “cost.” " Several cases have considered the meaning of the word " “cost.” " In Stirling , the Federal Court of Appeal stated: As we understand it, the word " “cost” " in those sections means the price that the taxpayer gave up in order to get the asset ; it does not include any expense that he may have incurred in order to put himself in a position to pay that price or to keep the property afterwards. [62] [ Emphasis added. ] In commenting on the decision of the Federal Court of Appeal in Stirling , Justice McNair stated the following in Bodrug Estate : I have no problem with the submission of counsel for the plaintiffs that the cost of an asset is not restricted to the actual purchase price paid therefor.

It seems clear that the cost of property may include brokerage fees, legal fees, commissions and other expenses incurred in connection with the acquisition of the property . In my view the decision in Stirling does not necessarily restrict such an extended definition of the term " “cost”.

" However, I am of the opinion that it is clear authority for the proposition that the cost of an asset for the purposes of capital gains computation is limited to the costs of acquisition of that asset or, as Pratte, J. put it, " “the price that the taxpayer gave up in order to get the asset. ” " [63] [ Emphasis added. ] In Canada Trustco , the Supreme Court of Canada stated: Textually, the CCA [i.e., capital cost allowance] provisions use “cost” in the well-established sense of the amount paid to acquire the assets . Contextually, other provisions of the Act support this

interpretation. Finally, the purpose of the CCA provisions of the Act, as applied to sale-leaseback transactions, was, as found by the Tax Court judge, to permit deduction of CCA based on the cost of the assets acquired . [64] [ Emphasis added .] A close reading of the three excerpts quoted above makes it clear that, textually, the word " “cost” " contemplates an acquisition of an asset or other property. [ 104 ] Before continuing the analysis of the meaning of " “cost,” " I would like to make a few more comments about the Bodrug Estate case. In that case, Mr.

Bodrug owned the control block of shares in the capital of Canadian Hidrogas Resources Ltd. ( " “Hidrogas” " ). When Hidrogas entered into an employment agreement with a Mr. Cohen, Mr. Bodrug granted to NIR Oil Ltd. ( " “NIR” " ), a corporation owned by Mr. Cohen, an option to purchase 340,000 of the Hidrogas shares owned by Mr. Bodrug at a price of $0.65 per share. Later, after the employment agreement had been terminated by Mr. Cohen and after NIR had exercised the option in part, so as to acquire 30,000 of the Hidrogas shares owned by Mr. Bodrug, Mr.

Bodrug purported to cancel the option agreement in respect of the remaining 310,000 Hidrogas shares. NIR commenced legal proceedings against Mr. Bodrug, seeking specific performance of the option agreement. The parties settled that litigation on the basis that Mr. Bodrug would pay NIR the amount of $1,320,000 in consideration for NIR releasing and surrendering all its rights under the option agreement. As well, as part of the settlement, Mr. Cohen and NIR agreed to sell to Mr.

Bodrug their previously acquired shares of Hidrogas for $7 per share, the approximate price at which Hidrogas shares were then trading on the Toronto Stock Exchange. Unbeknown to NIR and Mr. Cohen, when they signed the settlement agreement, Mr. Bodrug was aware of an impending takeover bid with respect to the shares of Hidrogas, at a price of $15.50 per share. NIR and Mr. Cohen subsequently sued Mr. Bodrug again, and were ultimately awarded damages pursuant to the Alberta insider–trading legislation.

Subsequently, in computing the capital gain that arose by reason of the deemed disposition of the Hidrogas shares at the time of Mr. Bodrug’s death, his estate added the amount of the damages to the " ACB " to Mr. Bodrug of his Hidrogas shares. The only issue before the Federal Court – Trial Division and the Federal Court – Appeal Division was whether the amount of the damages formed part of the ACB to Mr. Bodrug of his Hidrogas shares at the time of his death. The case did not deal with the treatment of the $1,320,000 that had been paid by Mr. Bodrug to NIR pursuant to the settlement agreement.

However, based on comments contained in the reasons given by the trial judge, it appears that, in assessing the estate, the CRA had added the amount of $1,320,000 to the ACB to Mr. Bodrug of his Hidrogas shares (which included the shares that he had acquired from Mr. Cohen and NIR). [ 105 ] I do not think that the Bodrug Estate case is authority for the proposition that, in these Appeals, the Surrender Payments were the

cost of an interest in, or right to acquire, the shares that were the subject of the Numac SOAs and the Anderson SOAs. First, the issue of whether the $1,320,000 paid by Mr. Bodrug for the release and surrender of NIR’s rights under the option should be added to the ACB to him of his Hidrogas shares (including those acquired from Mr. Cohen and NIR) was not before the Court, but was merely mentioned by the trial judge as being the treatment given to that amount by the CRA. Second, the option granted by Mr. Bodrug to NIR related to shares that had previously been issued by Hidrogas to, and were still owned by, Mr.

Bodrug. In the present Appeals, the stock options were granted by Numac and Anderson respectively (i.e., the employers and the potential share issuers), and related to treasury shares that had not yet been issued. Third, the Bodrug Estate case said nothing about whether the option originally granted by Mr. Bodrug to NIR was, pursuant to the settlement agreement, acquired by Mr. Bodrug, and, if so, whether the $1,320,000 formed part of the cost to Mr. Bodrug of the option (as distinct from the previously issued shares that were the subject of the option).

Thus, the facts of the Bodrug Estate case are distinguishable from the facts of these Appeals. (ii) Context [ 106 ] The context of the ITA supports the proposition that the word “cost” contemplates an acquisition of property. For instance,

section 54 of the ITA defines the term “adjusted cost base” ( " “ACB” " ). For property other than depreciable property, the ACB to a taxpayer of a property at any time is the cost to the taxpayer of the property adjusted, as of that time, in accordance with

section 53 of the ITA . Thus, that definition contemplates that a taxpayer, after incurring a cost to acquire a property, may hold that property and might, while holding the property, participate in various transactions that could result in adjustments to the original cost. The definition of the term “cost amount” in subsection 248(1) of the ITA contains various provisions for various types of property. Paragraph ( d.1 ) of the definition indicates that the cost amount to a taxpayer of a loan or lending asset at any time is the amortized cost of the property to the taxpayer at that time, and paragraph (

f) of the definition states that, in any case not covered by the preceding statutory provisions, the cost amount to a taxpayer of a property at any time is the cost to the taxpayer of the property as determined for the purpose of computing the taxpayer’s income, except to the extent that that cost has been deducted in computing the taxpayer’s income for any taxation year ending before that time. Hence, both of those provisions use the word “cost” in a context contemplating that a particular property may be acquired and held for a period of time by a taxpayer. Furthermore, as indicated in the above quotation from Canada Trustco , contextually, various provisions of the ITA support the

interpretation that the word " “cost” " means the amount paid to acquire an asset. [65] (iii) Purpose [ 107 ] I will discuss my understanding of the purpose of paragraph (

f) of the definition of " “eligible capital expenditure” " in paragraph 124 below, after first discussing certain characteristics of the options, the legal nature of the transactions in which the Surrender Payments were made and the impact of the doctrine of merger in respect of those transactions. (

c) Non-Assignability and Non-Transferability of Options [ 108 ] It is the position of Devon that no options or shares were acquired by Numac or Anderson in exchange for the Surrender Payments, such that the Surrender Payments cannot be considered to comprise any part of the cost of acquiring options or shares. [66] As support for this proposition, Devon noted that the options were generally not assignable or transferable. [67] In this regard, the Numac SOP provided that each option was personal to the optionee and was not assignable. [68] As well, the various SOAs between Numac and the employees to whom options were granted provided that the options were not assignable by the employee. [69] [ 109 ] While the Numac options were not assignable or transferable, the Numac SOAs conferred on the directors of Numac the discretion to permit an unexercised option to be surrendered to Numac upon payment of an amount (payable in cash, Numac common shares or a combination thereof) equal to the fair market value of the Numac shares that would be issued if the option were to be exercised less the amount of the applicable exercise price. [70] Therefore, it seems that the non-assignability and non-transferability of the options did not preclude those options from being surrendered by their holders to Numac. [ 110 ] Turning to the Anderson options, the Anderson SOP provided that " “No right or interest … in or under the Plan … is assignable or transferable … except by bequeath [ sic ] or the laws of descent and distribution.” " [71] As will be discussed be

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