Sedgewick Co-operative Association Ltd. v. The Queen, 83 DTC 5455, [1984] CTC 14 (FCTD)

Strayer, J:—This is an action by way of an appeal by the plaintiff against an assessment made by the Minister of National Revenue with respect to its 1980 taxation year. The facts were agreed to be as follows.

The plaintiff is a co-operative association duly incorporated under the laws of Alberta, with a membership of approximately 1,682. During the year in question the total value of its sales and services was $2,571,144. Of this, $2,339,402 or 91 per cent represented business done with its members. Its business income, prior to any payment of patronage dividends, was $132,815. During this same year it realized a taxable capital gain of $5,906 from the disposition of real property which had been used or held in connection with the plaintiffs business.

While the parties are agreed on the foregoing facts they have each at various times asserted two different ways of applying the Income Tax Act thereto, with the result that four possible methods were described in the pleadings and in argument. These varying approaches all relate essentially to the application of two sections of the Income Tax Act', section 135 which deals with permissible deductions from the income of co-operative corporations of certain amounts paid out in patronage dividends, and section 125 which allows small businesses a tax deduction equivalent to 21 per cent of active business income. I shall deal in turn with the issues related to each of these sections.

Section 135

The relevant parts of section 135 provide as follows:

Deduction in computing income

(1) Notwithstanding anything in this Part, there may be deducted, in computing the incme of a taxpayer for a taxation year, the aggregate of the payments made, pursuant to allocations in proportion to patronage, by the taxpayer

(a) within the year or within 12 months thereafter to his customers of the year, and

(b) within the year or within 12 months thereafter to his customers of a previous year, the deduction of which from income of a previous taxation year was not permitted.

Limitation where non-member customers

(2) Notwithstanding subsection (1), if the taxpayer has not made allocations in proportion to patronage in respect of all his customers of the year at the same rate, with appropriate differences for different types or classes of goods, products or services, or classes, grades or qualities thereof, the amount that may be deducted under this section is an amount equal to the lesser of

(a) the aggregate of the payments mentioned in subsection (1), and

(b) the aggregate of

(i) the part of the income of the taxpayer for the year attributable to business done with members, and

(ii) the allocations in proportion to patronage made to non-member customers of the year.

As indicated above, the plaintiff did nine per cent of its business with non-mem- bers and 91 per cent with its members. It had actually paid patronage dividends to its members during the year in question in the amount of $179,668 but had paid no dividends to non-member customers. Thus the relevant limitation on the amount of patronage dividends which the plaintiff could actually deduct from its income is found in subparagraph 135(2)(b)(i).

The dispute now with respect to the application of subparagraph 135(2)(b)(i) is as to whether the allowable deduction from income should be 91 per cent (that is, the proportion of business done with members in 1980) of net income (that is, business income of $132,815 plus taxable capital gains of $5,906) or just of business income ($132,815). Calculated the former way, the allowable deduction would be $126,236. Calculated the latter way it would be $120,862. The plaintiff, both in its tax return and in its pleadings, asserts that the former method is correct. The Minister in his assessment also accepted that position as correct, but in the present pleadings on behalf of the Crown the defendant now asserts that the latter method is correct. While the defendant now takes a position which would support a higher assessment than that made by the Minister in his assessment of July 13, 1981, the defendant does not ask for an increase in that assessment but only asks for dismissal of the appeal.

As an initial objection the plaintiff argued that the defendant could not appeal from its own assessment previously made by the Minister. Counsel cited in support of this proposition Harris v MNR, [1965] 2 Ex CR 653 at 662 (affirmed on other grounds, [1966] SCR 489); and R v Scheller, [1976] 1 FC 480 at 497-88 (FCTD). It seems to me that these cases are distinguishable. In the Harris case the Minister’s assertions would, if accepted, have required the court to order an increase in the amount of tax payable. In the present case the defendant is not asking for the tax to be assessed higher; it is simply asserting that the appeal should fail because the law if anything would require a higher assessment than the one against which the plaintiff appeals. With respect to the Scheller case, it does, I think, only stand for the proposition that if the Minister has admitted through the assessment that certain facts exist, he cannot later withdraw that admission. In the present case a question of law is involved as to the proper interpretation of section 135. Even if the Minister’s assessment were based on a certain view of the law the court cannot be prevented, by this “admission” or otherwise, from coming to its own conclusion as to what the law means. Counsel for the plaintiff argued that the failure of the Minister to assert in the assessment or in a reassessment the position now taken by the defendant had the effect of denying the plaintiff administrative remedies that would ahve been available to him such as the filing of an objection. While it is true that the defendant, by not taking this position until its pleading in this court, did preclude the use of these administrative remedies, the plaintiff now has the full opportunity to argue the issue in court and I fail to see where it suffered any irreparable prejudice by being obliged to deal with the issue here for the first time.

With respect to the issue itself, the plaintiff refers to subparagraph 135(2)(b)(i) which provides that where a co-operative has done some business with nonmembers, the permissible deduction is limited to “the part of the income of the taxpayer for the year attributable to business done with members .. This phrase is defined in paragraph 135(4)(d) as follows

(d) [‘‘Income of the taxpayer attributable to business done with members”]

“income of the taxpayer attributable to business done with members” of any taxation year means that proportion of the income of the taxpayer for the year (before making any deduction under this section) that the value of the goods or products acquired, marketed, handled, dealt in or sold or services rendered by the taxpayer from, on behalf of, or for members, is of the total value of goods or products acquired, marketed, handled, dealt in or sold or services rendered by the taxpayer from, on behalf of, or for all customers during the year.

It is contended that the term “income” here must be taken in its normal meaning to include the whole of the net income of the corporation including both its “business income” and its taxable capital gains. The plaintiff says that in the absence of some qualifying words the reference to “income” must be taken to be a reference to the income of the taxpayer as computed in accordance with Part I of the Act and there is no justification for reading into the term “income” the word “business”. Counsel for the plaintiff further pointed out that income tax form TZS(16) with respect to the patronage dividend deduction also confirms this interpretation in that it describes the item to which the percentage of member customer business is to be applied as “net income before patronage dividend deduction”. It does not refer to “business income”. This of course cannot alter the legal position of the parties but it may be relevant to finding a rational interpretation for section 135.

The defendant, on the other hand, asserts that one must look at the whole scheme of the Income Tax Act and if one does so it is apparent that the deductions referred to in subparagraph 135(2)(b)(i) can only be made from “income from business or property” and therefore only such income should be used as a base for calculating, on the basis of the percentage of member business, the amount of deductible patronage dividends.

In making this argument, the defendant contends that the scope of deductions under subparagraph 135(2)(b)(i) is limited by sections 18 and 20 of the Act. Section 18 generally limits‘the kind of deductions which may be made “‘in computing the income of a taxpayer from a business or property”. Section 20 provides in part as follows:

20. (1) Notwithstanding paragraphs 18(l)(a), (b) and (h), in computing the taxpayer’s income for a taxation year from business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(u) such amounts in respect of payments made by the taxpayer pursuant to allocations in proportion to patronage as permitted by section 135.

Thus, the defendant argues that the deductions as referred to in section 135 must be deductions only from income “from a business or property” as specifically authorized by subsection 20(1). It is further argued that, according to section 9 of the Act, income from a business or property is the “profit therefrom” and does not include any capital gain.

On the basis of the foregoing, then, the defendant appears to argue that if section 135 only authorizes the deduction of patronage dividends from income from business or property, which does not include capital gains, then the capital gains may not be included in the base income of the co-operative to which the percentage of member business is applied in order to calculate the deductible amount of patronage dividends.

The defendant further reinforces this argument by referring to subsection 135(7) which provides that patronage dividends paid to the patrons of a cooperative, other than those in respect of consumer goods or services, are taxable in the hands of the recipient. The defendant argues that if capital gains may also be distributed by consumers’ co-operatives, then they would escape taxation completely since the patronage dividends would be deductible from the income of the co-operative and would not be taxable in the hands of the recipients since they would be distributed on the basis of the recipients’ purchases of consumer goods and services. On the other hand, capital gains of a producers’ co-operative would be taxable in the hands of the recipient producers because they would not enjoy the exemption allowed in subsection 135(7) to purchasers of consumer goods and services.

Whether capital gains of a co-operative can be included in its income base for the purpose of calculating deductible patronage dividends is a question which has apparently not yet been authoritatively answered in the courts. The Income Tax Act is, in my view, far from precise on the point. I have come to the conclusion, however, that the proper interpretation of section 135 is that it allows the inclusion of capital gains in that income base to which the percentage of membership business is applied in order to calculate the deductible amount of patronage dividends. More specifically, as regards the present case, this means that the plaintiff was entitled to add the taxable capital gain of $5,906 to its business income before patronage dividend deduction, in the amount of $132,815, and apply to the total of these two figures, $138,721, the percentage of business transacted with members, namely 91 per cent, in order to claim a total patronage dividend deduction of $126,236.

In reaching this conclusion I have started with the wording of subparagraph 135(2)(b)(i) which, for present purposes, limits the deductible patronage dividends to “the part of the income of the taxpayer for the year attributable to business done with members’’. The income is defined in paragraph 135(4)(d) as “that proportion of the income" that the value of goods sold, etc, to members is of the total value of goods sold, etc by the co-operative (that is, including sales to both members and non-members). The reference in this definition to the goods sold, etc, is only for the purpose of fixing the deductible “proportion’’ of the “income’’ of the co-operative. That “income’’ presumably is to be calculated on the basis of the general rules provided by the Income Tax Act. Section 3 of that Act says that the income of a taxpayer includes, inter alia, its taxable capital gains.

While counsel for the defendant is no doubt correct in arguing that subsection 20(1) only deals with deductions from income “from a business or property’’, which would not incude capital gains, I am not convinced that section 135 is dependent on paragraph 20(l)(u) for its operation. It seems to me that the main purpose of subsection 20(1) is to create an exception to the general rule in paragraph 18(l)(a) that a taxpayer cannot deduct from his income from a business or property any outlay or expense except to the extent that it was made or incurred for the purpose of gaining or producing income from the business. A patronage dividend is not, at least in the normal sense, an expense incurred for the purpose of producing income. Therefore to the extent that section 18 would preclude a deductible patronage dividend to reduce business income, section 20 makes it possible. But section 135 starts with the words “Notwithstanding anything in this Part” (that is, Part I where section 20 is also found) and it independently provides a general right to deduct from income the amounts of patronage dividends as defined therein. It must be kept in mind throughout that subsection 135(1) provides that “there may be deducted, in computing the income of a taxpayer . . . the payments made, pursuant to allocations in proportion to patronage . . .”. Similarly, as noted above, paragraph 135(4)(d) says that the income attributable to business done with members “means that proportion of the income” of the taxpayer. The word “business” does not precede the word “income” in either of these critical provisions.

As noted above, counsel for the defendant argued that such an interpretation would mean that capital gains by a consumers’ co-operative would never be taxable if they were distributed to the patrons of the co-operative. I do not find this particularly anomalous. The capital gains in question here are relatively small in relation to the volume of business and are simply incidental to the operation of the co-operative to its members. Similarly, no doubt, a co-operative could earn other sums of money, such as interest on its bank accounts, which might find their way into patronage dividends. It is unrealistic to insist that the only sums which may be regarded as “income” for the purpose of declaring a patronage dividend are precisely those sums earned through mark-up in the sale of goods to consumers. Indeed, the Act does not attempt to prescribe that a given consumer may only receive tax free patronage dividends of an amount strictly limited to mark-up on the specific purchases made by him. Consumer co-operatives can exercise considerable discretion in categorizing different kinds of goods and assigning to each a somewhat arbitrary percentage of patronage dividend depending, perhaps approximately, but not precisely, on the margin of profit involved in handling different kinds of merchandise. A member of a consumers’ co-operative belongs in order to acquire consumer goods more cheaply. He might, to achieve a similar result, arrange with a retailer to give him a discount in return for undertaking to do all business with him, or he might for example purchase from a wholesaler if he had the proper connections to do so. If instead he uses the vehicle of a consumers’ co-operative and if in the process of supplying his consumer needs at cost the co-operative incidentally makes some money which further reduces the costs of doing business, that money should be available for distribution on a tax free basis to the consumer just as is the money made from the mark-up on the price of goods sold to that consumer. If it is not distributed, then it is of course taxable.

Section 125

There remains the question of the proper basis for calculation of the small business tax deduction as provided in subsection 125(1). This subsection provides in part as follows:

125. (1) There may be deducted from the tax otherwise payable under this Part for a taxation year by a corporation (other than a corporation that carried on a nonqualifying business in Canada in the year) that was, throughout the year, a Canadian- controlled private corporation, an amount equal to 21% of the least of

(a) the amount, if any, by which the aggregate of

(i) the aggregate of all amounts . . . which is the income of the corporation for the year from an active business . . .

The plaintiff now argues that in computing “active business income” for the purposes of this section, the deductible amount of patronage dividends (which I have determined above to be $126,236) should be subtracted from the total income of the co-operative corporation. This would leave a base of $12,485, (minus charitable donations) on which to apply the 21 per cent prescribed by subsection 125(1) in order to calculate the authorized tax reduction. The plaintiff contends that there is no indication in subsection 125(1) that the income referred to therein can be only business income, and thus there is no reason to calculate the permissible patronage dividend deduction on, or to subtract it from, only the business income rather than the total income, in establishing the base on which the 21 per cent can be applied. In other words, the plaintiff says that section 135 governs permissible deductions both for the purposes of determining the total taxable income of the co-operative and for the purposes of determining its active business income under section 125.

The defendant, on the other hand, argues that paragraph 20(l)(u) applies in computing the base figure for the purposes of section 125, so as to limit the application of the permissible patronage dividend deduction so that it may be used to reduce only business income, with the amount of the permissible patronage dividend deduction being calculated as the member-business percentage of that business income. In the present case on this basis the permissible patronage dividend deduction would be 91 per cent of $132,815, that is $120,862. This latter amount, deducted from the business income of $132,815, would leave an active business income of $11,953 according to the defendant.

I have concluded that the defendant’s position in respect to the application of section 125 is correct. I do not believe that the base for calculation of the permissible patronage dividend deduction from total income, as provided in section 135, is in this case the same base as should be used under section 125 to calculate the “income . . . from an active business” for the purpose of applying the small business tax reduction. I am satisfied that when subparagraph 125(l)(a)(i) refers to “income . . . from an active business” it is referring to “business income” as defined elsewhere in the Act. Section 9 provides that income from a business is the profit therefrom for the year. This does not include capital gains as such. Section 18 then provides that certain outlays or expenses may not be deducted in computing income from a business. But subsection 20(1) provides that, notwithstanding paragraphs 18(l)(a), (b) and (h), certain deductions are permitted. As provided by paragraph 20(1 )(u), among the permitted deductions are such patronage dividends calculated on the proportion of member-business as prescribed by section 135. Because in order to calculate the tax reduction as authorized by subsection 125(1) it is necessary to use business income as the base, paragraph 20(l)(u) is the appropriate authority for the deduction of patronage dividends. In the present case this means that the income on which the permissible patronage deduction must be calculated is the business income which is $132,815. Applying to that figure the percentage of member-business as required by subparagraph 135(2)(b)(i) the permissible patronage dividend deduction from business income would be 91 per cent of $132,815, that is $120,862. Then, to ascertain the income of the co-operative from an active business, for the purposes of calculating the tax reduction pursuant to subparagraph 125(l)(a)(i), it is necessary to subtract from the business income of $132,815 the patronage dividend deduction of $120,862, leaving an active business income of $11,953. The small business tax reduction would then be 21 per cent of that amount, namely $2,510.

In reaching a conclusion as to the proper disposition of costs in this matter I have kept in mind that each party has succeeded in part. I have also noted that the parties regarded this as a test case in which the decision might govern the disposition of several other cases.

ORDER

It is therefore ordered and adjusted that the assessment be referred back to the Minister for reconsideration and reassessment in accordance with the principles set out in the reasons for judgment, provided that no such reassessment shall exceed the amount assessed in the notice of assessment of July 13, 1981. There will be no costs awarded.