Supreme Court of Canada
Bennett
and White v. The King, [1949] S.C.R. 287
Date: 1948-10
05
Bennett And White Construction Company Limited Appellants;
and
The Minister of National Revenue Respondent.
1948: May 3, 4; 1948: October 5.
Present: Rinfret C.J., and Rand, Kellock, Estey and Locke JJ.
ON APPEAL FROM THE EXCHEQUER COURT OF CANADA
Revenue—Income Tax—Deductions from Income—Payments by
construction company to obtain working capital to guarantors of bank
loans—Whether "disbursements or expenses not wholly, exclusively and
necessarily laid out or expended for the purpose of earning income", s.
6(1) (a). Whether "payments on account of capital", s. 6(1)
(b)—Income War Tax Act, R.S.C., 1927, c. 97.
Held: That payments by a construction company to obtain
necessary working capital for its operations, to guarantors of bank loans, are
"disbursements or expenses not wholly, exclusively and necessarily laid
out or expended for the 'purpose of earning the income" within the meaning
of s. 6(1) (a), and therefore not allowable deductions under the Income
War Tax Act, R.S.C., 1927, c. 97. They are "payments on accounts of
capital" within the meaning of s. 6(1) (b).
Montreal Coke and Manufacturing Co. v. Minister of
National Revenue [1944] A.C., 127 followed.
Judgment of the Exchequer Court of Canada [1947] Ex. C.R. 474,
affirmed.
APPEAL from the judgment of the Exchequer Court of
Canada, O'Connor J., , dismissing the appeal of the appellant
with costs and affirming an assessment made under the provisions of the Income
War Tax Act and Excess Profits Tax Act for the years 1941 and 1942.
James L. Lawrence and Ross Tolmie for
the appellant.
L. St. M. Du Moulin and J. D. C. Boland
for the respondent.
The judgment of the Chief Justice and Locke, J. was
delivered by:
Locke J.:—The
appellant is incorporated by letters patent under the Dominion Companies
Act. Its declared objects are many in number including the carrying on of a
contracting and construction business and that of financial agents and brokers
but, of these, its activities have
[Page 288]
been confined to the former. Its authorized capital stock
when incorporated in 1925 was $100,000: this was later increased to $250,000,
of which as of October 31, 1942, shares to the par value of $136,320 had been
issued.
Joseph G. Bennett was one of the original incorporators and
a large shareholder. In the year 1934 Bennett informed his sons, John G. and A.
G. Bennett that he wished to substantially retire from the business and the
sons then acquired larger interests in the company and carried on the business.
A. G. Bennett found when he applied to the bank for a loan that the company's
credit was very low and asked his father to give a guarantee to the bank to
enable the company to borrow money for its business purposes and it was arranged
that he would do so for a consideration and this was agreed upon as being an
annual amount equal to the amount of interest paid to the bank. One of the
amounts required at this time was for a deposit of $15,000 for a tender on the
Calgary Administration Building. During the years 1934 to 1939 inclusive Joseph
G. Bennett continued his guarantees to the bank. In 1937 and thereafter John G.
Bennett gave his guarantees. A. G. Bennett guaranteed the loans for the year
1938 and thereafter. In June of 1940 Joseph G. Bennett died and thereafter his
widow gave her guarantees to the bank. In respect of these guarantees varying
amounts were paid to all of the persons named during the years 1935 to 1940
inclusive and apparently the sums so paid were allowed by the Department of
National Revenue as expenses of the business.
Apparently no written agreement was made at any time
concerning these payments but on June 19, 1935, a resolution of the Executive
Committee of the company fixed "the rate of interest" to be paid to
Joseph G. Bennett for his guarantee at five per cent on the amounts borrowed.
Similarly in 1940 the payments to be made to the guarantors for the fiscal year
ending October 31, 1940, were authorized by the directors and designated as
interest and like resolutions were passed by the Board in the years terminating
on October 31, 1941, and 1942. For the fiscal year ending on October 31,1941,
$20,969.34 were paid to the guarantors and for the year following $23,984.15
and these were disallowed by the Department, giving rise to the present
litigation.
[Page 289]
In the interval between the giving of the first guarantee by
Joseph G. Bennett and those given in later years the business of the company
was largely increased. In the year 1938 contracts undertaken by it amounted to
$1,116,652.15. In 1940, 1941 and 1942, due to the company obtaining large war
contracts, these amounts were respectively $3,267,148.13, $3,581,019.49 and
$4,458,108.59. The bank loans and overdrafts secured by the guarantees which
when given by Joseph G. Bennett in 1935 had approximated some $46,000 totalled
as of the date of the preparation of the balance sheet in 1940 some $588,000,
in 1941 some $534,000 and in 1942 $505,000. Upon these advances interest was
paid to the Bank of Montreal in amounts slightly in excess of the amount paid
to the guarantors: such interest was claimed as a deductible expense and
allowed by the Department. A. G. Bennett, vice-president of the company, giving
evidence at the trial said that it was not possible for the company to carry on
its business without substantial loans from the bank and these could not be
obtained without having satisfactory guarantors: he estimated that without the
loans from the bank the company could not have done more than twenty-five per
cent of the business which was carried on during these years. In view of the
comparatively small subscribed capital of the company, it is apparent that this
would be so. The evidence is not very clear as to all of the purposes for which
these large amounts were required: a statement filed, however, shows that as of
October 31, 1940, approximately $196,000 was deposited on contracts that were
either completed or in progress and as of October 31, 1942, the total amount of
funds so deposited approximated $122,000. These, it was shown, were amounts
paid as deposits to ensure the company's performance of contracts undertaken
and were presumably retained until the completion of the work in accordance
with the terms of the various contracts. In addition to these large sums which
were thus rendered inactive for extended periods, the moneys were required for
payrolls, the purchase of materials and, part of it at least, for the purchase
of bulldozers and other equipment, though to what extent they were used for this
latter purpose is not disclosed.
While the amounts paid to the guarantors were described as
interest in the various resolutions which authorized their
[Page 290]
payment, this was clearly inaccurate. Interest is paid by a
borrower to a lender: a sum paid to a third person as the consideration for
guaranteeing a loan cannot be so described. Sec. 6(a) prohibits the
deduction of disbursements or expenses not wholly, exclusively and necessarily
laid out or expended for the purpose of earning the income and the first matter
to be determined is whether amounts such as these, paid to enable the company
to obtain the necessary working capital for its operations by way of loans from
the bank, are properly so described. In Addie v. Commissioners of
Inland Revenue , the Lord President, considering the
meaning to be assigned to the expression "money wholly and exclusively
laid out for the purposes of the trade" in the Income Tax Act of
1918 (8 & 9, Geo. V, cap. 40) said in part:
It is necessary, accordingly, to attend to the true nature
of the expenditure, and to ask oneself the question, Is it a part of the
Company's working expenses; is it expenditure laid out as part of the process
of profit earning? Or, on the other hand, is it a capital outlay; is it
expenditure necessary for the acquisition of property or of rights of a
permanent character, the possession of which is a condition of carrying on its
trade at all? It was pointed out by Lord Davey in the case of Strong v. Woodifield
,
and it has long been recognized, that in order to make deduction of a
disbursement admissible "it is not enough that the disbursement is made in
the course of, or arises out of, or is connected with, the trade, or is made
out of the profits of the trade. It must be made for the purpose of earning the
profits".
In Tata Hydro-Electric Agencies Ld., Bombay v. Income
Tax Commissioner , the appellant company sought to have
deducted from its profits as an expense twenty-five per cent of the annual
commissions earned by it which it had agreed to pay as part of the purchase
price of the agency under which the amounts became payable. Under the Indian
Income Tax Act of 1922 the deduction was allowable if it had been incurred
"solely for the purpose of earning income, profits or gains" in the
business. In delivering the judgment of the Judicial Committee upholding the
disallowance of the claim Lord Macmillan said in part, p. 695:—
Their Lordships recognize, and the decided cases show, how
difficult it is to discriminate between expenditure which is, and expenditure
which is not, incurred solely for the purpose of earning profits or gains. In
the present case their Lordships have reached the conclusion that the payments in
question were not expenditure so incurred by the
[Page 291]
appellants. They were certainly mot made in the process of
earning their profits; they were not payments to creditors for goods supplied
or services rendered to the appellants in their business; they did not arise
out of any transactions in the conduct of their business. That they had to make
those payments no doubt affected the ultimate yield in money to them from their
business, but that is not the statutory criterion. They must have taken this
liability into account when they agreed to take over the business. In short,
the obligation to make these payments was undertaken by the appellants in
consideration of their acquisition of the right and opportunity to earn
profits, that is, of the right to conduct the business, and not for the purpose
of producing profits in the conduct of the business.
and approved the above quoted statement of the Lord
President in Addie's case . In Montreal Coke and Mfg. Co. v.
Minister of National Revenue , the right of the appellant company to
charge as a disbursement expenses incurred in redeeming certain of its bonds
before maturity and borrowing again at lower rates of interest and less onerous
conditions as to payment, these including the payment of premiums on
redemption, disbursements on account of exchange, discount to underwriters and
legal and other expenses, was considered. The passage from the judgment of Lord
Macmillan quoted in the judgment of the learned trial judge clearly points out
the distinction to be drawn between expenditures made in providing capital for
an enterprise and those for the carrying on of the trade from which its
earnings are derived. I think the character of the payments in the present case
does not differ in essence from those which were disallowed in the Montreal
Coke case. They were, in my opinion, simply expenditures incurred in
obtaining the capital to make the large deposits required, to purchase
equipment and generally to finance the operations. A sum expended as interest
for the use of capital is clearly to be distinguished from expenditures such as
these, being the cost of obtaining guarantees without which the loans would not
have been made by the bank, expenditures of the same character as the cost of
floating issues of bonds or debentures or of selling shares for the purpose of
obtaining capital.
Sec. 6(b) prohibits the deduction of "any
payment on account of capital". The subsection did not appear in the Income
Tax Act of 1917: it was enacted by cap. 52, Statutes of 1923, sec. 3, and
was not taken from the English Act. While the expression "any payment on account
of
[Page 292]
capital" is capable of meaning any return of capital, I
think it obvious that this cannot have been intended since no statutory
prohibition of deducting amounts so paid could be required. In Montreal Coke
and Mfg. Co. v. Minister of National Revenue supra, 94, Duff C. J.
and Kerwin J. were of the opinion that the deductions there claimed were
payments on account of capital within the meaning of this subsection. I am of
the opinion that expenditures such as these made by reason of the necessity of
obtaining working capital are payments of the same nature.
The appeal should be dismissed with costs.
Rand J.:—The
company carries on general construction work. In doing so, its current outlays
are in part financed by temporary bank loans. For the years in question the
bank required as collateral the guarantee of three shareholders who held a
controlling interest in the company. These persons in turn agreed to give the
guarantees on terms that they should be paid a sum equal to the amount of interest
in each year paid to the bank. In calculating the net profit of the business
for income tax purposes, the company, in addition to the interest paid to the
bank, deducted the amounts so paid to the guarantors. The latter deductions
were disallowed and the question is whether the company is entitled to have
them restored.
The case for the company is that the payments were
"wholly, exclusively and necessarily" paid out to earn the income. In
a remote sense that is so; but the same can be said for almost every outlay in
the organization of the company. The conception of the statute however is an
earning of income through the use of capital funds which in one form or another
constitute the means and instruments by which the business is prosecuted; but
that providing or organizing them must be clearly differentiated from the
activities of the business itself has been lately reaffirmed by the Judicial
Committee in Montreal Coke and Manufacturing Co. v. Minister of
National Revenue .
The acquisition of capital may be by various methods
including stock subscriptions, permanent borrowings through issues of
securities, or term loans; and ordinarily
[Page 293]
it should make no difference in taxation whether a company
carried on financially by one means or another. In the absence of statute, it
seems to be settled that to bring interest paid on temporary financing within deductible
expenses requires that the financing be an integral part of the business
carried on. That is exemplified where the transctions are those of daily buying
and selling of securities: Farmer v. Scottish North American Trust
;
or conversely lending money as part of a brewery business: Reid's Brewery v.
Mail .
Now the Crown has allowed the deduction of interest paid to
the bank, and it must have been either on the footing that the day-to-day use
of the funds was embraced within the business that produced the profit, or that
the interest was within section 5, paragraph (b). But setting up
that credit right or providing the banking facilities is quite another thing
from paying interest; it is preparatory to earning the income and is no more
part of the business carried on than would be the work involved in a bond
issue. The lender might insist on being furnished with premises near the scene
of the works; it might exact any other accommodation as the price of its
willingness to provide funds; but all that would be outside the circumference
of the transactions from which the income arises. Within the meaning of the
Act, the premiums create part of the capital structure and are a capital
payment: Watney v. Musgrave . They furnish a credit
apparatus to enable the business to be carried on, and although they affect the
distributable earnings of the company, they do not affect the net return from
the business. That was the view of O'Connor J. below and I
agree with it.
I would, therefore, dismiss the appeal with costs.
Kellock J.:—For
the reasons given by my brother Locke I am of opinion that the amounts sought
to be deducted by the appellant fall within section 6(a) of
the Income War Tax Act and are therefore not deductible in ascertaining
the taxable income of the appellant.
I would dismiss the appeal with costs.
[Page 294]
Estey J.:—The
appellant borrowed funds from the Bank of Montreal under a line of credit
secured by the personal continuing guarantee of three of its shareholders.
These shareholders received in consideration of their giving that guarantee an
amount in each year equal to the interest paid to the bank in the same period.
In the year 1941 the guarantors were paid $20,813.06, and in the year 1942,
$23,455.07. These amounts were not allowed as deductions in computing the
profits by the taxing authorities. In the Exchequer Court this disallowance was
confirmed.
The appellant contends that its borrowings from the bank
under the security of the guarantee were not capital nor were the payments made
to the guarantors part of its "financial arrangements", but rather
that these payments to the guarantors were disbursements "wholly,
exclusively and necessarily laid out or expended for the purpose of earning the
income" and therefore should be deducted under the provisions of para.
6(1) (a) of the Income War Tax Act, (1927 R.S.C., c. 97).
The appellant, incorporated by Dominion letters patent dated
February 25, 1925, carries on a general construction business in the provinces
of British Columbia, Alberta and Saskatchewan. As early as 1934 its paid up
capital and surplus was such that in relation to the volume of business
available it required additional funds. These funds were advanced in 1934 by
the Bank of Montreal under a line of credit of $10,000 secured by a personal
continuing guarantee by the founder of the company, J. G. Bennett. In 1935 the
guarantee was raised to $90,000, and in 1938 to $150,000. In the latter year J.
G. Bennett and his two sons, A. G. Bennett and John G. Bennett, were the
guarantors. In 1940 it was raised to $300,000. In that year J. G. Bennett died
and when later in the same year the amount was raised to $370,000 the guarantors
were Mrs. Mabel Bennett, widow of J. G. Bennett, and her sons, A. G. Bennett
and John G. Bennett. This last guarantee continued throughout the fiscal years
1941 and 1942 and all payments here in question were made to the guarantors in
consideration of this guarantee.
The first guarantee given in 1934 was obtained in order that
the appellant company might have sufficient funds to undertake "some
prospective business that was offering."
[Page 295]
No other reason was suggested for the $90,000 or $150,000
guarantees. Then came the war and the government required "plants, air
fields and that sort of thing." These had to be constructed, the appellant
desired a share of that business, and as the vice-president stated, "it
was necessary to get this money in order to carry those projects on." He
made it clear that the bank would not have granted the line of credit without
the guarantee, and without the funds so available the company would "not
have been able to do 25 per cent of the business" that it did in 1941. The
guarantee was therefore the asset which the company purchased to enable it to
borrow the necessary funds.
The importance and position of this line of credit in the
finances of the company is evidenced by the following figures: At the end of
the fiscal year October 31, 1941, the paid-up capital of the company was
$104,060, while at the same date the bank loan under the guarantee was
$424,882.50. At the end of the appellant's fiscal year October 31, 1942, the
paid-up capital was $136,320, and the bank loan at the end of that year was
$273,050. Moreover, at the end of each fiscal year October 31, 1935, to October
31, 1942, the appellant company showed an overdraft at the bank. In 1941 at the
end of its fiscal year this overdraft was $109,978.09, and in 1942 it was
$232,721.80. These figures support what was stated at the trial that the
appellant's "paid-up capital and surplus has never been large, compared
with the magnitude of its operations." In these circumstances it appears
to have been the settled policy of the company to provide for its expansion by
funds made available under these guarantees.
The money borrowed under this line of credit was treated as
capital and the interest paid to the bank allowed under sec. 5(1) (b),
which provides:
5. (1) "Income" * * * shall * * * be subject to the
following exemptions and deductions:—
* * *
(b) Such reasonable rate of interest on borrowed
capital used in the business to earn the income as the Minister in his
discretion may-allow * * *
No exception is taken to this allowance of interest upon
capital by the appellant and it is therefore not an issue in this appeal.
[Page 296]
This was not a borrowing of money on a temporary or
short-term basis such as is necessary and incidental to the ordinary and usual
transactions in the course of the appellant's business. In effect this line of
credit made available to the appellant for an indefinite period the ability to
borrow funds for the purpose of accepting contracts beyond the volume its
paid-up capital and surplus would permit. The provision for the cancellation of
the guarantee, having regard to the relation of the guarantors to the company,
and the practice since 1934, does not detract from the conclusion that this
line of credit provided a long-term basis upon which the company might obtain
the funds it required.
In Scottish North American Trust v. Farmer,
Lord Johnston stated at p. 698:
It may be well said that if money is borrowed on a permanent
footing as from year to year, the capital of the concern is in a commercial
sense enlarged thereby, and the business extended, whereas no commercial man
would consider that his banking facilities were part of his capital, or the
consideration he paid for them anything but an expense of his business.
That the bank computed the interest from day to day, that
payments were made on account thereof as funds were available, and if
construction contracts were at any time not available this loan in the normal
course would be paid in full, do not of themselves require, under the authorities,
the description of the borrowing under this line of credit as temporary. These
factors are here but the details of the way in which the loan was dealt with
and do not affect its character, as evidenced by the reason therefor and the
use thereof to expand and increase its business. A company engaged in the
construction business may from time to time find it necessary to borrow on a
temporary basis as necessary and incidental to its business, but the evidence
does not establish that such obtained in this case. The learned trial Judge
held that the sums as borrowed were capital and the evidence fully supports his
finding.
The appellant's position is similar to that of the taxpayer
in The European Investment Trust Co., Ltd. v. Jackson ,
where it was engaged in the business of financing the purchase of automobiles.
Its paid-up capital was relatively small and when that and the proceeds of a
[Page 297]
loan, admittedly capital, from the Finance Corporation of
America, were exhausted, in order to finance further purchases it was arranged
that the Finance Corporation of America would make further advances. It was
contended that the interest on these further advances should be deducted in
computing the profits. These advances were made as required by the taxpayer and
were repaid by amounts as received from the purchasers. They were described by
the taxpayer as short loans and the interest was computed upon monthly
statements. The commissioners found as a fact that the proceeds of these
additional advances were "employed or intended to be employed as capital
in the trade" and that therefore the interest paid could not be deducted
in computing profits. On appeal this decision was affirmed. The taxpayer in
that case, as the appellant here, when its capital was exhausted found it
necessary to borrow in order that further contracts or a larger volume of
business might be accepted.
The Jackson case was decided since that of Scottish
North American Trust v. Farmer, supra, so much relied upon by the
appellant. The taxpayer in that case was engaged in the buying and selling of
securities. In the course of its business it purchased securities in New York
in amounts beyond its available cash. Arrangements were made with a New York
banker for an overdraft (for a period a line of credit was arranged). The
interest paid on this overdraft was held to be a deductible expense. In the
Court of Sessions1 their lordships stressed that these were
short-term loans, or as stated by the Lord President:
I cannot see how a temporary accommodation in the course of
business ever is or ever can be capital.
Then in the House of Lords Lord Atkinson pointed out that
the money was borrowed in a "fluctuating temporary manner" and the
daily borrowing and lending of money being part of their business is not to be
treated as capital. Moreover, in discussing this case in the Jackson case,
Romer L.J., pointed out that in the Farmer case the money was found by
the commissioners not to be capital and after reviewing that decision and
others in relation thereto, concluded that in each case:
* * * it is a question of fact whether the capital money
borrowed is or is not capital employed in the trade within the meaning of this
subparagraph, and if the Commissioners have decided, as a question of fact,
that it is, then this Court cannot interfere.
[Page 298]
In Ascot Gas Water Heaters, Ltd. v. Duff ,
it was held that the commission paid for a guarantee of an existing debt was
deductible in computing the profits as an expense wholly and exclusively laid
out for the purpose of the trade, while the commission on a guarantee of a loan
for further capital facilities was not deductible. It appeared in the facts
stated that "further expansion is only possible if an adequate long-term
credit is obtainable and sufficiently large liquid assets in the form of
reserves are formed." A commission of 3 per cent per annum was paid
to the guarantor and the loan supported by this guarantee made in 1935 was due
in 1953. See also Bridgwater v. King .
In Southwell v. Savill Brothers, Ltd. ,
expenditures incurred to obtain new licences and therefore to extend the
business were held to be capital expenditures.
The funds borrowed were therefore capital and the payments
made to the guarantors constituted a part of the "financial arrangements"
of the appellant. They are in principle identical with those dealt with by the
Privy Council in Montreal Coke and Mfg. Co. Ltd. v. Minister of
National Revenue , where the expenses of refinancing a
bond issue in order to effect a low rate of interest and other savings were
disallowed under sec. 6(1) (a). Lord Macmillan stated at p. 133:
It is important to attend precisely to the language of s. 6.
If the expenditure sought to be deducted is not for the purpose of earning the
income, and wholly, exclusively and necessarily for that purpose, then it is
disallowed as a deduction. If the expenditure is a payment on account of
capital it is also disallowed * * *
And again:
Expenditure to be deductible must be directly related to the
earning of income.
And further:
Of course, like other business people, they must have
capital to enable them to conduct their enterprises, but their financial
arrangements are quite distinct from the activities by which they earn their
income. No doubt, the way in which they finance their businesses will, or may,
reflect itself favourably or unfavourably in their annual accounts, but
expenditure incurred in relation to the financing of their businesses is not,
in their Lordships' opinion, expenditure incurred in the earning of their
income within the statutory meaning.
The disbursements of the guarantors here in question were
made not as interest on the money borrowed but as
[Page 299]
the purchase price for the guarantee that made borrowing
under the line of credit possible. The appellant upon obtaining this line of
credit was enabled to complete its financial arrangements at the bank, which
enabled it to undertake the larger volume of business. Sums borrowed under such
circumstances are capital and the sums paid are not deductible under the
provisions of 6(1) (a).
The judgment of the Exchequer Court should be affirmed and
this appeal dismissed with costs.
Appeal dismissed with costs.
Solicitor for the appellant: J. L. Lawrence.
Solicitor for the respondent: E. S. MacLatchy.
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