The British Yukon Railway Company (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Dubé J.—Vancouver, April 18, 19
and 21, 1977.
Income tax — Income calculation — Method to be used to
allocate income of international rail system among the
Canadian and American corporate components — Canadian
Regulation 406 and U.S. Regulation 1.863-4 not mandatory or
applicable — Ordinary business and commercial principles
apply — Income Tax Regulations, s. 406(1),(3).
The plaintiff is a subsidiary of a railway corporation operat
ing between Canada and the United States; it owns and oper
ates the Yukon portion of the track. The plaintiff's 1970
income was reassessed by the Minister in 1974. The accounting
formula used by the companies to allocate the system's income
had resulted in a lower allocation to the Canadian companies
than the formula used by the Minister.
Held, the appeal from the Minister's 1974 Notice of Reas
sessment concerning the 1970 allocation of income is allowed.
Neither U.S. Regulation 1.863-4 nor Canadian Regulation 406
is mandatory or even directly applicable to the situation. In the
absence of any special direction from the Act, then income
must be determined in accordance with ordinary business and
commercial principles. The validity of the formula depends on
whether or not it tells the truth about the taxpayer's income.
The Minister's formula is faulty in that firstly it double-counts
the immovable property of the taxpayer, and secondly it further
distorts the allocation by averaging percentages instead of
actual amounts of expense and property allocation. On the
other hand the taxpayer's method of allocation is in accordance
with sound accounting practice and is an accurate reflection of
the taxpayer's income.
INCOME tax appeal.
COUNSEL:
John G. Smith for plaintiff.
W Hohmann for defendant.
SOLICITORS:
Russell & DuMoulin, Vancouver, for plain
tiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
DUB J.: This case was heard on common evi
dence with British Columbia-Yukon Railway
Company v. The Queen, T-3633-75, and these
reasons for judgment apply to both cases. The
basic issue is the allocation of income between two
Canadian railway companies and one American
railway company for the taxation year 1970.
The plaintiff company (hereinafter "B.Y.R.")
and four other wholly owned subsidiaries of the
White Pass and Yukon Corporation Limited,
including the British Columbia-Yukon Railway
Company (hereinafter "B.C.Y.R.") and Pacific
and Arctic Railway and Navigation Company
(hereinafter "P.A.R.N."), an American company,
provide an integrated railroad, ship and truck
transportation system from Whitehorse, Yukon,
through British Columbia, down to a terminal at
Skagway, Alaska, U.S.A.
The "White Pass and Yukon Route", as it is
known, is 110.8 miles long: 90.4 miles over
Canadian soil and 20.4 miles within Alaska.
B.Y.R. owns and operates the Yukon track, from
Whitehorse to the British Columbia border;
B.C.Y.R. owns and operates the railway through
the British Columbia section; and P.A.R.N. owns
and operates the line from the Alaska border down
to its terminal facilities at Skagway on the Pacific
Coast. The maintenance facilities for the whole
system are located at Skagway along with a gener
al freight wharf and a bulk terminal.
For the 1970 taxation year B.Y.R., B.C.Y.R.
and P.A.R.N. used a method of allocation of
income between the two Canadian companies on
the one hand and P.A.R.N. on the other hand
which was described as follows in the agreed state
ment of facts.
4.1 Costs and expenses incurred were allocated by allocating
each expense classification on a specific identification basis
where possible, or on a pro-rata basis where the cost or expense
item could not be allocated on a specific identification basis;
4.2 Property used was allocated on the basis of situs for
immovable property and time spent in each country for mov
able rail property (36.4% for the U.S. Company and 63.6% for
the Canadian Companies);
4.3 23.6% of the aggregate working capital of the group of
Companies was allocated to the transportation system, based on
an allocation of gross receipts; this was allocated between the
Canadian Companies and the U.S. Company on the basis of the
allocation of operating costs;
4.4 A rate of return of 8% was applied to the amounts deter
mined under 4.2 and 4.3, to produce the following:
the Canadian the U.S.
Companies Company
Operating Expenses $2,890,553 $2,472,701
Return on Property 949,980 613,640
Return on Working
Capital 31,852 27,352
$3,872,385 $3,113,693
Percentages 55.4% 44.6%
4.5 These percentages were used to allocate gross operating
incomes between the Canadian Companies and the U.S. Com
pany, being based on an apportionment of the aggregate of:
1. Costs and expenses
2. Return on property
3. Return on working capital
By notice of reassessment dated May 23, 1974,
the Minister reassessed the incomes by using a
different allocation based upon an average of the
percentages of these three items
1. operating expenses as allocated by the
plaintiff
2. an 8% return on property
3. equated track mileage
The method used by the Minister allocated
65.46% of income to the Canadian group and
34.54% to the U.S. company, whereas the method
used by the railway group resulted in the alloca
tion of 55.4% to the Canadian group and 44.6% to
the U.S. company.
In the case of B.Y.R. the Minister's reassess
ment resulted in an increase of income tax of
$41,196.22 plus interest, and in the case of
B.C.Y.R. an increase of $8,946.86 and interest.
The two Canadian railways are appealing the
Minister's reassessments. The grounds for the
appeal are stated in paragraph 9 of the statement
of claim.
The Plaintiff claims that the allocation procedure used by the
Department of National Revenue was not in accordance with
any ordinary business, commercial or accounting principles,
was not in accordance with the said U.S. Regulation 1.863-4,
and, by adding an allocation for equated track mileage, distorts
the allocation in favour of Canada because most of the Railway
track lies in Canada. The Plaintiff claims that the logical
allocation should be based on (a) the investment in immovable
property in each of Canada and the U.S., and (b) the level or
activity or cost of service performed in each of Canada and the
U.S. The first gives due weight to the preponderance of track
miles in Canada and, at the same time, the preponderance of
the maintenance and wharf facilities in the U.S. The second
gives due weight to the preponderance of track maintenance
and running costs in Canada, and at the same time, the
preponderance of wharf costs and equipment maintenance costs
in the U.S. To impose on to these two allocations an added
weighting for equated track miles accentuates only the Canadi-
an preponderances; to then average the percentages further
accentuates the weighting in favour of Canada. The method
used by the Department of National Revenue therefore distorts
the income allocated to Canada unreasonably and without any
foundation on ordinary business, commercial or accounting
principles, so that the said Reassessment is not in accordance
with sections 3 and 4, or any other sections of the (old) Income
Tax Act.
The equated mileage formula used by the Minis
ter, in conjunction with the operation expenses
allocation and the 8% return on property, is based
on Income Tax Regulations 406(1) and 406(3)
which read:
406. (1) Notwithstanding subsections (3) and (4) of section
402, the amount of taxable income that shall be deemed to have
been earned in a taxation year in a particular province by a
railway corporation is, unless subsection (2) applies, one-half
the aggregate of
(a) that proportion of the taxable income of the corporation
for the year that the equated track miles of the corporation
in the province is of the equated track miles of the corpora
tion in Canada, and
(b) that proportion of the taxable income of the corporation
for the year that the gross ton miles of the corporation for
the year in the province is of the gross ton miles of the
corporation for the year in Canada.
(3) For the purpose of this section, "the equated track
miles" in a specified place means the aggregate of
(a) the number of miles of first main track,
(b) 80% of the number of miles of other main tracks, and
(c) 50% of the number of miles of yard tracks and sidings,
in that place.
It is agreed by both parties that neither U.S.
Regulation 1.863-4, nor Canadian Regulation 406
is mandatory, or even directly applicable, in the
instant case, since the former deals with a taxpay
er "... carrying on the business of transportation
service between points in the United States and
points outside the United States", and the latter
deals with railway corporations operating between
Canadian provinces. The allocation in issue here is
between income in Canada by two Canadian rail
ways, and income in the U.S. by an American
railway. Both counsel have found no similar case
and neither the Income Tax Act nor the Regula
tions offer formulae which are directly applicable
to the situation.
In the absence of any special direction from the
Act, then income must be determined in accord
ance with ordinary business and commercial
principles.
The formula used by the railway group was
proposed to them by their accountants Clarkson,
Gordon & Co. The partner of that firm respon
sible for the railways Kenneth L. Ingo, a chartered
accountant, appeared as a witness. Some extracts
from his memorandum of allocation of operating
income, filed as an exhibit, bear reproduction.
The method used by the companies during 1970 is based on
the formula for the allocation of income of a taxpayer carrying
on a transportation business between points in the United
States and points outside the United States, as prescribed in
paragraph 1.863-4 of the Regulations to the U.S. Internal
Revenue Code. The provisions of this Regulation are set out in
their entirety on Appendix A to this memorandum and are
summarized briefly below.
Essentially the Regulation provides that income is allocated
on the basis of the aggregate of the following:
1. Costs or expenses incurred in the transportation business,
2. Return on property used in the transportation business,
and
3. Return on working capital used in the transportation
business.
To develop the allocation of income in accordance with the
provisions outlined above, the required information was assem
bled in the following series of steps:
1. Each of the companies' expense classification has been
allocated to Canada or the United States on either a specific
identification or a pro-rata basis. As the companies' internal
statement of operating expenses is prepared using a mixture
of U.S. and Canadian funds, it was necessary to first of all
convert the items to Canadian funds. Appendix 13 contains
the details of these allocations and conversions.
2. The property used in the transportation business was
allocated to the two countries on the basis of:
(a) situs, in the case of immovable property, and
(b) time spent in each country, in the case of movable rail
property (i.e. United States 36.4% and Canada 63.6%).
Assets carried in U.S. funds in the companies' accounts were
re-stated in Canadian funds, using the average rate of
exchange prevailing for the year.
3. A portion of the companies' aggregate working capital
was allocated to the railway transportation business on the
basis of gross receipts, the formula being:
Gross receipts from railway transportation business x
100% Total gross receipts
This formula resulted in 23.6% of the companies' total
working capital being allocated to the railway transportation
business. The amount so determined was then apportioned
between the two countries on the basis of operating costs
previously allocated to the countries.
4. The return on property and working capital used in the
railway transportation business was calculated by using a
rate of 8% and applying it to the amounts determined in 3
and 4 above. This is the rate of return stipulated in the
aforementioned Regulation.
An American chartered accountant, Karl H.
Loring, a partner with the firm of Ernst & Ernst
based in Los Angeles and specialists in interna
tional tax practice, testified as an expert on behalf
of the plaintiff. The following two paragraphs
from his affidavit reflect his opinion on the two
different methods of allocation.
I have considered the method of allocation of income and
deductions set forth in the memorandum of Clarkson, Gordon
& Co., a copy of which is attached hereto, which is also
described in the Agreed Statement of Facts filed in this case,
and it is a method which conforms generally to the require
ments of Regulation Section 1.863-4, which allocation, in my
opinion, would be acceptable to the Internal Revenue Service.
I have considered the method of allocation of income set forth
in the Agreed Statement of Facts used by the Minister of
National Revenue in making his reassessment. It appears not to
be a method which conforms to the requirements of Regulation
Section 1.863-4, and in my opinion departs so radically there
from, that it would not be acceptable to the Internal Revenue
Service. In particular, it would seem to me unlikely that the
Internal Revenue Service would accept a formula, which appar
ently double-counts physical assets by including the immovable
property both in the expense allocation and return on capital
computations, and again as track mileage, particularly where
the ratio of track mileage in the two jurisdictions is so
disproportionate.
Of course it is not for the accountants to decide
the issue. There is, moreover, a statutory presump
tion of validity in favour of an assessment and the
onus to show that the assessment is erroneous lies
on the taxpayer who attacks it. But, as stated by
Thorson P. in Publishers Guild of Canada Limited
v. M.N.R. [1956-60] Ex.C.R. 32 at pages 49-50
and quoted by Walsh J. in Mandel v. The Queen',
"But while the Court must be mindful of this
principle it must in its effort to apply the law
objectively keep a watchful eye on arbitrary
assumptions on the part of the tax authority ...."
Where the Income Tax Act does not provide a
particular system of accounting, the validity of a
formula depends on whether or not it tells the
truth about the taxpayer's income.
Track mileage, by itself, does not reflect the true
equation in this case. The twenty miles through
Alaska ascend from sea level to an altitude of
2,885 feet at White Pass on the Alaska-British
Columbia border. From that point it climbs merely
another 30 feet in altitude and travels more or less
on a plateau downwards to Whitehorse, 2,080 feet
from sea level. The rail route through Alaska was
the most difficult to build and remains the most
expensive to maintain, with tunnels, bridges, and
heavier snowfalls. From five to six locomotives are
required to pull the train up the White Pass and
these locomotives as well as most of the rolling
stock and all the maintenance facilities are owned
by the American railway and located in Alaska.
It is therefore obvious that merely equating the
track mileage would be unfair and inequitable. But
the Minister is not basing his allocation merely on
track mileage. He is superimposing the track mile
age equation upon the other formula which
already includes the mileage equation. That, of
course, gives undue weight to the preponderance of
track mileage in Canada.
Moreover, the Minister's formula further dis
torts the income allocation by adding percentages
instead of adding the actual amounts. That
method unfairly allows the same percentage rating
to unequal amounts. For instance, for the U.S.
company, the costs and expenses ($2,472,701) are
four times the amount ($613,640) allocated on
U.S. immovable property, yet both items each rate
a percentage. In other words, the Minister's for
mula is faulty in that firstly it double-counts the
I [1977] 1 F.C. 673 at page 702.
immovable property of the taxpayer, and secondly
it further distorts the allocation by averaging the
percentages instead of the actual amounts of
expense and property allocation. On the other
hand the taxpayer's method of allocation is in
accordance with sound accounting practice and is
an accurate reflection of the taxpayer's income.
The appeal is allowed and plaintiffs tax reas
sessment for 1970 is referred back to the Minister
for further reassessment in accordance with these
reasons, with costs in favour of plaintiff.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.