Canada Revenue Agency vs. SignalEnergy Inc. (Fortress Energy Inc.)

Background

In May 2008, Fortress Energy Inc. (“Fortress” or “the Company”) received notification from Canada Revenue Agency (“CRA”) that it would be performing an audit of a series of transactions that took place in 2003 that may have resulted in an “acquisition of control”. From July to September, 2008 an auditor reviewed the minute books and closing books of Fortress Energy Inc. as part of its audit process. On January 20, 2010, Fortress received a letter from the CRA (the “CRA Audit Letter”) proposing to deny the use of tax pools consisting of non-capital losses, SR&ED and other tax credits resulting from the 2003 conversion of SignalGene Inc. (“SignalGene”), a biotechnology company, into oil and gas company SignalEnergy Inc. (“SignalEnergy”). 

SignalEnergy was wound-up into Fortress in 2007. The basis by which the CRA denied the use of these tax pools was that Network Capital Inc. (“Network”) was deemed to have acquired control of SignalGene when it entered into a subscription agreement on November 6, 2003.  The subscription agreement allowed Network and clients of a wholly owned subsidiary of Network, Network Portfolio Management Inc. (“NPMI”), to acquire 45.24% of the voting shares of SignalGene, to nominate four board members and to assist in the transition to an oil and gas company. On November 2003 the SignalGene shareholders voted to appoint the directors, which included the four directors identified by Network Capital. The transaction between Network and SignalGene closed immediately thereafter. Network retained the services of Felesky Flynn LLP a Calgary based law firm specializing in tax law, to assist with structuring a transaction to ensure that the arrangement did not result in an “acquisition of control”.

Following the transaction, SignalEnergy became a successful oil and gas company with over $140 million of oil and gas assets. On February 1, 2006, SignalEnergy, received an unsolicited offer to acquire a substantial portion of its oil and gas assets for $100 million which closed on March 10, 2006. SignalEnergy used its available tax pools to reduce its taxable income from the proceeds of the disposition. SignalEnergy was reorganized on January 15, 2007 and became Fortress Energy Inc.

The CRA Audit Letter invited Fortress to correct errors or omissions of the Statement of Fact as summarized within the letter. Fortress provided a detailed response on March 26, 2010 (the “Fortress Response Letter”) indicating a number of errors of key facts and cited numerous court cases. The conclusion from which  clearly indicated that there was no “acquisition of control” by Network, and Fortress was entitled to use the tax pools. The response to the CRA Proposal Letter indicated among other facts that Network never acquired or had the right to acquire more than 50% of the voting and non-voting securities of SignalGene, Network Capital had nominated four directors to serve on the board of directors and the shareholders of SignalGene voted in favour of the proposed slate of directors and for the Company to transition into an oil and gas company. Fortress requested a meeting with the CRA Auditors to further discuss the errors of the Statement of Facts presented in the CRA Proposal Letter - the request for which was never granted.

On November 18, 2010 Fortress receive a letter from CRA (the “CRA Response Letter“) indicating it had reviewed the Fortress Response Letter of March 26, 2010 and essentially ignored the corrections to the Statement of Fact. On this basis the CRA expressed its intent to disallow Non-Capital Losses of $1,171,447, $2,385,827, $13,065,267, for the tax years 2004 2005, and 2006, respectively totalling $16,222,541 of Non Capital Losses. No other deductions were indicated to be disallowed.

On December 18, 2010 Fortress contacted the CRA Auditor to further discuss the matter. The CRA Auditor indicated the matter had been forwarded to the assessment branch of the CRA with no opportunity for further discussion.

On February 23, 2011, Fortress’ President and CEO was contacted by a Collections Officer at the CRA indicating that Fortress owed approximately $18 million of taxes and asked how it intended to pay. Mr. Bailey indicted that it had not yet received a Notice of Assessment and found it unusual that the CRA would be requesting payment before issuing a Notice of Assessment. Mr. Bailey also indicated the last correspondence received from the CRA did not indicate a magnitude of taxes payable of $18 million rather the tax losses proposing to be denied was $16 million giving rise to only $4.0 million of taxes payable.

On February 24, 2011, Mr. Bailey contacted legal council to discuss the overly aggressive stance of CRA wanting to collect on a large amount of tax not indicated in any prior correspondence and to attempt collection procedures prior to issuing a Notice of Reassessment. On this basis Fortress began to prepare an application to the Court of Queen’s Bench for protection under the Companies’ Creditors Arrangement Act (“CCAA”). Prior to doing so, Fortress was required to request the CRA issue the Notice of Assessment it was using to establish its claim. Fortress eventually received the Notice of Assessment on March 1, 2011, allowing it to apply for an Order from Court of Queen's Bench of Alberta under the Companies' Creditors Arrangement Act (Canada) which was granted on March 2, 2011.

The Notice of Assessment for $18,559,925 of taxes and penalties owing and received on March 1, 2011 indicated that tax deductions totalling $55 million were being denied.

Fortress was required to extend the Stay Order under CCAA on four separate occasions since the expiry of the original Order on March 31, 2011 (March 31, May 26, June 29 and September 29). On September 15, 2011, Fortress was verbally notified that the Appeals Division had concluded its review and it intends to vacate its Reassessment, 200 days following receipt of the original Notice of Reassessment.

On October 26th, 2011 Fortress' legal counsel received further verbal confirmation from CRA that it would be vacating its claim prior to the CCAA Extension deadline of October 28, 2011.  On October 27, 2011 Fortress' counsel received  revised Notices of Reassessment confirming that there are no income taxes payable or related penalties for the years ended December 31, 2004, 2005, and 2006, and April 19, 2007.

“There has been little doubt in our minds that the reassessment by CRA was without merit and that Fortress would be successful in defending its position. It is unfortunate that significant financial resources and considerable time was necessary to mount the defence against the CRA claim which proved to be without merit. The Company has been under the cloud of this claim since January 2010 and now that it is behind us we can look to the future to return to creating an active business”, said Mr. Bailey, President and Chief Executive Officer of Fortress.

Frequently Asked Questions

Why did the Fortress  file for CCAA?  How does this protect shareholders?

Upon receipt of the CRA Reassessment Notice, Fortress was required to pay 50% of the reassessed amount being approximately $9.0 million. CRA has vast powers of collection, and indicated its expectation of Fortress to immediately pay such amount. Fortress elected to protect shareholders interests by applying to the Court of Queen’s Bench for protection under CCAA. This allowed Fortress to maintain its business operations while it prepared to resolve the disputed claim by CRA.  Had Fortress not filed for protection under CCAA, CRA had the power to cease all liquid assets leaving Fortress without resources to defend against the CRA claim.

How much did it cost to defend the CRA Claim? What other collateral cost were incurred in the process of the defence?

The legal costs incurred to Fortress to defend the claim amount to approximately $1.0 million. 

These costs do not include:

1. The increased audit cost of a company in creditor protection.
2. Cease trade order issued from April 1, 2011 to April 29, 2011 due to the longer time required to issue the 2010 auditor's report. 
3. The increased costs of field operations as field service providers add a risk factor for a company in Creditor Protection and often require cash up front prior to performing services.
4. Suspension of trading by the TSX and the inability to become listed on the TSX Venture.
5. Opportunity costs of pursuing new business ventures as the assets of Fortress remained essentially frozen under CCAA while having to continue to incur general and administrative expenses required to maintain reporting issuer status and oil and gas operations.

 

Are there remaining tax claims against Fortress?

The Reassessment by CRA automatically triggers a tax claim by the Government of Alberta Tax and Revenue Administration (“TRA”).  In most cases the Government of Alberta follows the decisions of the CRA but Fortress must wait for a separate reassessment from the TRA to discharge any potential claim from the TRA. 

Will these proceedings affect any of the Fortress Tax Pool Balances?

Fortress has approximately $55 million of unused tax pools balances. None of these tax pools have been affected by the proceedings therefore available to be used to shelter future income tax payable.


What are the future plans of Fortress?


Fortress has been examining tight oil investment opportunities internationally utilizing horizontal drilling and  completion techniques involving multi-stage fracturing which have transformed the North American oil and gas industry.  Further announcements will be made in the near future as the opportunity progresses.


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