[OFFICIAL ENGLISH TRANSLATION]
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Citation: 2003TCC121
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Date: 20030310
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Dockets: 2000-50(IT)G
2002-1888(IT)G
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BETWEEN:
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RONA INC.
(formerly Groupe Rona Dismat Inc.),
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Archambault, J.T.C.C.
[1] Rona Inc. has appealed from assessments made by the Minister of National Revenue ("the Minister") concerning the 1992 to 1998 taxation years inclusive. In computing Rona's income, the Minister disallowed the deduction of professional fees paid to legal counsel, accountants and stockbrokers. The services provided by these professionals dealt with studies on the acquisition[1] of shares in competitor corporations, the acquisition of ownership interests in joint ventures in order to open superstores, and the acquisition of assets. Rona has argued that these amounts are income expenses incurred in the normal course of its operations, whereas the Minister has argued that they are capital outlays. The Minister therefore included these amounts in the acquisition cost of assets subsequently acquired or in the amount of Rona's cumulative eligible capital. Of course, the Minister allowed the deduction provided for in paragraph 20(1)(b) of the Income Tax Act ("the Act"). The only issue is whether these amounts are current or income expenses or capital outlays.[2]
Facts
Background facts
[2] Rona is a Canadian corporation that does business in the Canadian market selling and distributing hardware, construction, renovation and gardening products. During the relevant period, Rona sold and distributed its products by means of three types of stores. Firstly, there were affiliated stores owned by independent dealers who were required to purchase over 90 per cent of their products from Rona. Secondly, there were franchised stores owned exclusively by independent dealers (or to independent dealers and Rona jointly). These stores were required to purchase 100 per cent of their products from Rona and were subject to commercial concession agreements ("contrat de concession commerciale") stricter than the agreements governing the stores affiliated with Rona. Thirdly, there were "corporate" stores, owned by Rona or subsidiaries of Rona. In 1994, 85 per cent of shareholders in Rona were affiliated dealers; the remaining shareholders were Rona executives or former dealers. Rona's income was derived from selling its products to these stores and obtaining "volume discounts" from its suppliers. The amount of these discounts varied depending on the volume of the products purchased and could account for as much as 20 per cent of Rona's gross income.
[3] In the mid-1990s, 90 per cent of Rona's sales figures came from Quebec and 10 per cent from Ontario. In order to deal with the arrival of giant competitors, such as the United States corporation Home Depot, Rona considered that it needed to become a dominant player in its market and to increase the number of its sales outlets. During the relevant period, its business plan was to expand its business considerably by increasing its market share not only in Quebec but also in other parts of Canada, particularly by opening superstores, seeking franchised and affiliated stores, and acquiring "corporate" stores, mainly outside Quebec.
[4] Although we shall later see how this expansion was carried out in part during the relevant period, the results confirm the success of Rona's strategy: its market share in Quebec increased from 25 per cent in 1995 to 33 per cent in 2002, and its market share in Canada increased from 4 per cent or 5 per cent in 1995 to 11 per cent in 2002. It should be noted that during the relevant period, there was, and still is today, a significant fragmentation of the market for hardware, renovation and gardening products. In 2001, the four main active players in the Canadian market had approximately 49 per cent of this market; it is estimated that 5,000 independent dealers shared the rest of this market.
[5] Claude Guévin, Rona's vice-president of finance and administration and the only witness to testify at the hearing, stated that he and the executives who worked in Rona's administration offices spent between 50 and 60 per cent of their time developing the business and that approximately 20 travelling employees[3] worked exclusively on this aspect. Essentially, these persons' work was made up of four main activities, in proportions that could vary from one employee to another: (1) making the management of existing stores more effective; (2) seeking new affiliated stores; (3) opening new superstores; and (4) simply acquiring competitor corporations.
[6] The strategy Rona used in opening superstores was to interest one or more affiliated dealers in a joint venture, in which Rona might hold a 30 per cent interest (of common voting shares), and finance this joint venture in part by purchasing preferred shares on which dividends were paid. The affiliated dealers who invested in this joint venture had the option of buying back the shares held by Rona, essentially at their book value, if this buyback was made within the first two or three years after the interest had been acquired. After that time, a premium was applied to the purchase price of these shares. In general, according to Mr. Guévin, Rona's joint venture partners bought back Rona's interests within three years. In some cases, instead of forming a new joint venture, Rona might invest directly in the affiliated dealer's capital stock in order to finance the construction of the superstore. However, the affiliated dealer could exercise the same purchase option by buying back Rona's ownership interest in the affiliated dealer's company.
[7] In developing new sales outlets, Rona not only used the services of its own employees but also retained the services of outside professionals, particularly public accountants, legal counsel, and stockbrokers. These persons were to conduct due diligence checks of the businesses Rona was considering acquiring (or forming) or in which Rona might acquire an ownership interest. During the five relevant taxation years, Rona considered 12 acquisition transactions and paid fees totalling $957,133 to its professionals. Since it is these fees that are at issue, I shall now analyse the nature of the services these professionals rendered for each of the 12 acquisition transactions contemplated.
MatcoRavary Inc. ("Matco")
[8] During its 1994 fiscal year, Rona paid professional fees in the amount of $7,906 to the legal firm Lavery, De Billy and $11,500 to the accounting firm Raymond Chabot Martin Paré ("RCMP"). At that time, Matco, a publicly held corporation, operated five Rona-affiliated stores in the Montréal area (without using the Rona name). In its Notice of Appeal (docket 2000-50(IT)G), Rona described these fees as follows:
[TRANSLATION]
These professional fees were incurred as part of the due diligence check conducted during [Rona]'s purchase of the shares in Matco. This purchase made it possible to open a new, super sales outlet. After [Matco] encountered financial difficulties, on July 30, 1995, [Rona] took back the assets of the Rona l'Entrepôt store [a large store] located in Ville St-Laurent that were held by [Matco], in order to maintain this sales outlet.
[9] Since, in his testimony, Mr. Guévin gave only a general description of the services rendered by the professionals concerned, we must analyse the actual invoices for professional fees in order to better understand the services rendered. As well, none of the professionals who rendered these services came to testify to describe these services. According to theMarch 16, 1994,invoice issued by Lavery, De Billy, the services were all rendered during the period from February 7 to 10, 1994, and included in particular "checking various contracts, minute books, and other documents" at the offices of Matco; making checks with the Commission des valeurs mobilières du Quebec, the Montréal Stock Exchange, and Matco representatives; and "writing the due diligence check report" on February 10, 1994. According to the March 30, 1994, invoice issued by RCMP, it drew up a plan for conducting a due diligence check of Matco and audited the Matco accounting records prepared by Harel, Drouin and associates.
[10] Also adduced in evidence was the February 11, 1994, agreement on Rona's purchase of shares in the capital stock of Matco. Matco accepted the conditions of this purchase that same day. Under this agreement, Rona purchased 1.2 million common shares, representing 26.54 per cent of "voting and participating" shares in Matco, for $3,000,000. This subscription agreement does not give Matco any option to purchase the shares held by Rona. According to Mr. Guévin, that situation was exceptional and was probably due to the fact that Matco was a publicly held corporation. Rona still holds these shares in Matco.
François Lespérance Inc. ("Groupe Lespérance")
[11] According to Rona's Notice of Appeal, (docket 2000-50(IT)G), the [TRANSLATION] "professional fees were incurred as part of the due diligence checks and the negotiations involving the opening of a Rona l'Entrepôt store in co-operation with Groupe Lespérance". Rona's purpose was to make an investment similar to the investment made in Matco. The money invested in Groupe Lespérance was to be used to finance the construction of a superstore in Laval. During the 1994 taxation year, Rona paid professional fees for this project of $11,900 to RCMP and of $54,823 to Lavery, De Billy.
[12] The June 30, 1994, invoice issued by RCMP indicates only one due diligence check of Groupe Lespérance. The July 22, 1994, invoice issued by Lavery, De Billy describes professional services rendered during the period from May 20 to July 13, 1994, for a subscription of shares. This description includes the following: due diligence check of the Groupe Lespérance companies, in particular, reviewing the minute books of the companies in the group; reviewing documents pertaining to the buildings owned by these companies (legal titles, mortgage deeds, subleasing agreement, offers to purchase and to lease); reviewing and summarizing various contracts and undertakings; making a check at the registry office; reviewing documents pertaining to trade-marks; analyzing collective agreements and individual employment contracts; checking for any legal proceedings initiated by or against Groupe Lespérance; making environmental assessments of certain properties; and assisting and negotiating in order to purchase shares in Groupe Lespérance, including writing an agreement to govern collateral undertakings, a draft legal opinion, and draft escrow agreements.
[13] As well, on August 22, 1994, the stock brokerage firm Burns Fry issued an invoice in the amount of $50,000 for valuation services. The Minister disallowed the deduction of $25,000, which, according to Rona's Notice of Appeal, has do to with [TRANSLATION] "a mediation regarding the value of the shares in the Lespérance matter". No explanation for this reduction of the professional fees for the valuation was provided. However, this outcome can likely be explained, at least in part, by the fact that this acquisition project was abandoned because of the failure in negotiations regarding the commercial concession agreement that was to govern the operation of the superstore.
GroupeSodisco
[14] On December 8, 1994, Rona accepted an offer by Lévesque Beaubien Geoffrion Inc. ("Lévesque Beaubien") to provide exclusive financial consulting services to Rona involving the future acquisition of a corporation whose name was deleted in the agreement. Since this corporation was most likely Groupe Sodisco, a publicly held corporation, Rona would have had to make a takeover bid for shares. Lévesque Beaubien's services were to be rendered in three phases. In phase one, Lévesque Beaubien was to develop an acquisition strategy, if necessary seek partners that might be interested in joining Rona, conduct a preliminary financial analysis in order to set a range of values, and prepare a briefing book for the negotiation of an acquisition agreement with this publicly held corporation. In phase two, Lévesque Beaubien was to co-ordinate the steps to be taken with the main shareholders or the board of directors in order to discuss the acquisition of the corporation. In phase three, as part of the takeover bid, Lévesque Beaubien was to assist in developing a public communication strategy, in writing a takeover bid circular, and so forth. As well, Lévesque Beaubien was to assist in restructuring Rona's capital so that, at some point, Rona could become a publicly held corporation.
[15] The agreement set out the terms and conditions governing Lévesque Beaubien's consulting fees, of which $30,000 was payable on signature of the agreement and $30,000 on the day preceding the first official contact with the board of directors. Lévesque Beaubien invoiced the first instalment of $30,000 on November 13, 1994, and the second one on April 11, 1995. Mr. Guévin stated that this project had been abandoned.[4]
Réno-DépôtInc.
[16] During the fall of 1995, Rona retained the services of professionals for the purpose of acquiring either the shares in Réno-Dépôt, a competitor with five superstores, or certain assets of Réno-Dépôt. In 1996, Rona paid $204,350 in professional fees to Ernst & Young, $45,823 to Lavery, De Billy, $48,318 to Desjardins Ducharme, and $105,000 to Nesbitt Burns, for total professional fees of $403,491. The first professional fees invoice issued by Ernst & Young covers a period ending on October 28, 1995. The two other invoices issued by this accounting firm cover the period from October 28 to December 31, 1995. Because this acquisition project was abandoned, the amount invoiced is higher than the amount actually paid.
[17] The invoices issued by Desjardins Ducharme cover the period from October 18, 1995, to January 31, 1996. The invoices issued by Lavery, De Billy cover the period from November 7, 1995, to February 26, 1996. Unlike the invoices issued by Ernst & Young, the invoices issued by the legal firms provide a detailed description of the services rendered. Those services were for an acquisition project and included, in particular: discussions of a share transfer (October 19, 1995);[5] the schedule of transactions for the takeover bid, the restructuring of Rona, the incorporation of a holding company bringing the participating dealers together, and going to the offices of the Commission des valeurs mobilières du Quebec (November 13, 1995); the preparation of a questionnaire concerning the environmental assessment (November 14, 1995); the examination of legal titles to property, a conversation concerning the commercial concession agreement, and the preparation of a request for advance ruling concerning competition (November 15, 1995); a meeting with the experts and the representatives of the shareholders in Réno-Dépôt (November 17, 1995); a conversation concerning the "corporate structure" for tax planning purposes (November 27, 1995); tax planning concerning the Quebec Stock Savings Plan (December 6, 1995); the writing of a letter of amended agreement (December 11, 1995); the examination and review of the documents prepared by Nesbitt Burns pertaining to the transaction's financing (December 13, 1995); a conversation concerning media releases and the examination of precedents concerning certain aspects of the takeover bid (January 12, 1996); the writing of an exclusion clause to be included in the draft letter of intent (January 22, 1996); and examination of the proposed new structure (January 31, 1996). The last service indicated was rendered on February 26, 1996, and, according to the description, was for telephone discussions on the status of the negotiations with the other party and on the date of the filing of prior notice.
[18] Although the service agreement between Nesbitt Burns and Rona is dated December 6, 1995, it indicates that Nesbitt Burns had performed work since early November. Under this service agreement, Nesbitt Burns agreed to provide services that included: working with Rona on the financial analysis and the valuation of Réno-Dépôt, in particular, by selecting a range for the determination of the acquisition cost; providing advice on financing methods; assisting in the negotiation and writing of the escrow agreement; assisting Rona in conducting the due diligence check; preparing a takeover bid circular; and forming a group with the members of the Canadian stock exchanges in order to solicit acceptance of the bid.
[19] Like the Sodisco takeover bid, the Réno-Dépôt takeover bid did not take place, and no explanation was given as to why this project was abandoned.
Inovaco Ltée
[20] Early in 1997, Rona wished to open a superstore in the Gatineau area. To this end, Rona decided to invest in the capital stock of Inovaco, one of its affiliated dealers, which owned a small store in that area. That store, following partial demolition, was to be converted into a superstore. The plan was carried out: Rona invested $3,000,000 in Inovaco's capital stock, thus obtaining a 33 per cent ownership interest. Under a commercial concession agreement, Inovaco became a Rona franchisee. Inovaco was also entitled to buy back Rona's interest, which it did within the two or three years following completion of the project.
[21] Rona exercises control over this franchisee not only under the 20-year concession agreement, but also under a 20-year lease granted by Rona to Inovaco for the lot on which the store is located.
[22] The invoice for $13,500 issued by RCMP is dated April 25, 1997; the invoices issued by Desjardins Ducharme totalling $11,422 are dated March 11, April 7, and June 25, 1997. Desjardins Ducharme's services were rendered during the period from February 6 to May 21, 1997. The services described in that firm's invoices relate mainly to due diligence checks, particularly of Inovaco's "corporate status", and with matters of labour law, real estate law and environmental law. Those services also dealt with clauses to be inserted in the share purchase contract, a conversation [TRANSLATION] "concerning the share subscription agreement and the wording of the statements and guarantees in order to reproduce them in the lease" (March 19, 1997), the [TRANSLATION] "review of the summaries of the documents concerning financing with the National Bank of Canada" (March 21, 1997), the study of certificates of location (March 24, 1997), and a conversation about the negotiation meeting scheduled for the following week (April 3, 1997).
Beaver Lumber
[23] Very little evidence was adduced at the hearing about the project of acquiring Beaver Lumber, a corporation operating mainly in Ontario. Mr. Guévin was unable to provide that corporation's sales figures. However, it is certain that its sales figures were in excess of $100 million annually. In its Notice of Appeal (docket 2002-1888(IT)G), Rona claims that during the 1998 taxation year, it paid $23,100 to Ernst & Young, $8,521.67 to the consultant Paul R. Crocker, and $67,349 to the stock brokerage firm Société Générale (Canada) [TRANSLATION] "as part of the abandoned project to acquire the Beaver Lumber chain. That project would have made it possible for [Rona] to increase its market share in Ontario." The only documentary evidence adduced was a March 14, 1997, invoice for $25,000 issued by Société Générale with no description of the nature of the services rendered, and the June 9, 1998, invoice issued by Ernst & Young describing services rendered from May 1 to 24, 1998, and indicating in particular $16,000 in professional fees for the project to acquire Beaver Lumber. On that point, reference is made to meetings held in Toronto and Montréal. That invoice does not describe the nature of the services rendered.
RevyHome Centres Inc. ("Revy")
[24] In 1998, Rona was exploring the possibility of opening superstores in western Canada with the Revy group. In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid $8,400 to Ernst & Young and $70,000 to Société Générale (Canada). Adduced in evidence was an invoice dated February 5, 1999, for $87,500 in professional fees issued by Société Générale, which merely indicated that it was an [TRANSLATION] "invoice for the BC project" and describing certain disbursements for travel expenses, one of the destinations being Vancouver.
[25] Among the invoices issued by Ernst & Young, the invoice dated January 8, 1999, is for professional fees in the amount of $2,500 regarding a number of discussions with Rona management. The invoice dated December 2, 1998, under the heading "Revelstoke", indicates professional fees in the amount of $5,500 for the [TRANSLATION] "preparation of the presentation to Revelstoke, a number of discussions with Société Générale [and the] presentation at the November 27 meeting".
[26] Mr. Guévin simply stated that this project was never completed. However, three years later, the shareholder in Revy reached an agreement to sell some of the Revy stores to Rona. According to an October 25, 2002, prospectus concerning a new issue of 11,120,000 common shares in Rona for $150,120,000, on June 6, 2001, Rona had acquired most of Revy's assets: 51 stores and three distribution centres in five provinces (Ontario, Manitoba, Saskatchewan, Alberta and British Columbia) of which the annual retail sales totalled approximately $816 million annually.
Ferlac Inc.
[27] During the summer of 1998, Rona wished to open two superstores in the Alma and Jonquière area. Negotiations were opened with Ferlac, which owned five stores affiliated with the Rona group. This project was not completed as planned. Instead, Rona opened a "corporate" store and entrusted the management of this store to Ferlac. In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid professional fees in the amount of $20,700 to Ernst & Young and in the amount of $7,007 to Desjardins Ducharme as part of a project to acquire an ownership interest in Ferlac. The evidence adduced included a July 6, 1998, invoice issued by Ernst & Young for $12,000 regarding the Ferlac project with no further description than the fact that these professional fees covered the period from May 25 to June 27, 1998. Regarding the legal fees paid to Desjardins Ducharme, there is a July 8, 1998, invoice describing services rendered during the period from June 22 to July 3, 1998, essentially for the [TRANSLATION] "preparation and writing of a draft memorandum of agreement for the acquisition by Rona Inc. of an ownership interest in Ferlac Inc."
Consideration of takeover bid of Matco
[28] In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid professional fees in the amount of $57,960 to Ernst & Young and in the amount of $19,116 to Lavery, De Billy regarding a possible takeover bid of Matco. As is noted above, Matco owned five Rona-affiliated stores. Matco was planning to stop purchasing its products from Rona and in order not to lose five sales outlets, Rona considered taking over Matco. Matco having dropped its plan to purchase its products elsewhere, the takeover bid was not pursued. Invoices for professional fees include the July 6, 1998, invoice issued by Ernst & Young for $45,000 covering the period from May 25 to June 27, 1998, and the June 19, 1998, invoice issued by Lavery, De Billy covering the period from March 25 to June 9, 1998. Analysis of this last invoice shows that this legal firm initially considered the possibility of ceasing business relations and shows that a formal notice was drafted. Afterwards, it appears that the possibility of a takeover bid was considered followed by a confidentiality agreement.
Cashway Building Centre ("Cashway")
[29] In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid $5,513 to the consultant Paul R. Crocker in 1998 [TRANSLATION] "for reviewing the possibility of acquiring the Cashway Building Centre chain in order to increase its market share in Ontario. The negotiations were successful and the acquisition was made in 2000." At that time, that chain owned 66 sales outlets and one distribution centre and its sales figures was approximately $294 million. Also at that time, Rona had 40 affiliated dealer sales outlets in Ontario. In his June 8, 1998, invoice covering the weeks of May 18 and 25 and June 1, 1998, Mr. Crocker described his services as drawing up a confidential report on a certain number of Cashway stores.
Loyola Schmidt ("Loyola")
[30] In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid $15,575 to Ernst & Young [TRANSLATION] "as part of the analysis of the Loyola Schmidt business, a store that displayed the 'Rona Le Rénovateur' banner, and the possibility of converting this store into a 'Rona le Rénovateur Régional' store. [Rona] had therefore requested a written opinion on the fair market value of the business as at September 30, 1998." The January 8, 1999, invoice from Ernst & Young indicates that the firm drew up a [TRANSLATION] "written opinion on the fair market value as at September 30, 1998" and made disbursements for [TRANSLATION] "a valuation of the Loyola Schmidt lot and buildings". Apparently the amount of the professional fees was subsequently reduced. It is unclear whether the transaction being considered was carried out.
GroupeLespérance
[31] In its Notice of Appeal (docket 2002-1888(IT)G), Rona states that it paid $28,350 to Ernst & Young [TRANSLATION] "as part of the valuation of the Lespérance business, a large store chain on Montréal's north shore that in 1995 had left the [Rona] group and in 1998 had indicated that it wanted to return to the Rona group. [Rona] and Lespérance were therefore considering the possibility of opening superstores in the area by means of joint ventures." Groupe Lespérance had sales figures of approximately $60,000,000 annually and a good reputation. A three- or four-year contract was then signed in 1998. Later, in 2002, a 10-year commercial concession agreement ("contrat de concession commerciale") was signed.
Analysis
[32] The provisions relevant to resolving the issue raised by these appeals are paragraphs 18(1)(a) and 18(1)(b) of the Act, which read as follows:
Section 18: General limitations.
(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
General limitation
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;
Capital outlay or loss
(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;
The first paragraph presents no problem since the respondent has not argued that the expenses incurred by Rona were incurred for a purpose other than the purpose of gaining or producing income from the business. However, the respondent has argued that paragraph 18(1)(b) applies to the professional fees paid by Rona during the relevant period. Resolving these appeals therefore raises the classic issue of the distinction between income expenses and capital outlays. The courts have often been called upon to settle disputes of this type and have repeatedly set out principles and tests designed to achieve this objective. In Oxford Shopping Centres Ltd. v. The Queen, [1980] 2 F.C. 89 (affirmed by the Federal Court of Appeal, 81 DTC 5065), Thurlow A.C.J. provides an excellent summary of the relevant general principles. It is worth reproducing what he writes at pages 96 to 100:
I turn now to the tests by which the question may be resolved. In British Columbia Electric Railway Company Limited v. M.N.R.[6], Abbott J. put the position under the former provisions of the Income Tax Act, which are not materially different from the relevant provisions presently in effect, as follows:
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 s. 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. The principle underlying such a distinction is, of course, that since for tax purposes income is determined on an annual basis, an income expense is one incurred to earn the income of the particular year in which it is made and should be allowed as a deduction from gross income in that year. Most capital outlays on the other hand may be amortized or written off over a period of years depending upon whether or not the asset in respect of which the outlay is made is one coming within the capital cost allowance regulations made under s.11(1)(a) of The Income Tax Act.
...
The general principles to be applied to determine whether an expenditure which would be allowable under s. 12(1)(a) is of a capital nature, are now fairly well established. As Kerwin J., as he then was, pointed out in Montreal Light, Heat & Power Consolidated v. Minister of National Revenue [[1942] S.C.R. 89 at 105, [1942] 1 D.L.R. 596, [1942] C.T.C. 1, affirmed [1944] A.C. 126, [1944] 1 All E.R. 743, [1944] 3 D.L.R. 545], applying the principle enunciated by Viscount Cave in British Insulated and Helsby Cables, Limited v. Atherton [[1926] A.C. 205 at 214, 10 T.C. 155], the usual test of whether an expenditure is one made on account of capital is, was it made "with a view of bringing into existence an advantage for the enduring benefit of the appellant's business".
Ten years later in M.N.R. v. Algoma Central Railway, Fauteux J. (as he then was), speaking for the Court, put the matter thus [at pages 449-450]:
Parliament did not define the expressions "outlay ... of capital" or "payment on account of capital". There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B. P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia [[1966] A.C. 224], by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said, at p. 264:
The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.
In Canada Starch Co. Ltd. v. M.N.R., Jackett P. (as he then was) after citing the Algoma case summarized the distinction thus:
For the purpose of the particular problem raised by this appeal, I find it helpful to refer to the comment on the "distinction between expenditure and outgoings on revenue account and on capital account" made by Dixon J. in Sun Newspapers Ltd. and al. v. Fed. Com. of Taxation [(1938) 61 C.L.R. 337] at page 359, where he said:
The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.
In other words, as I understand it, generally speaking,
(a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition to such an entity, structure or organization, is an expenditure on account of capital, and
(b) on the other hand, an expenditure in the process of operation of a profit-making entity, structure or organization is anexpenditure on revenue account.
Applying this test to the acquisition or creation of ordinary property constituting the business structure as originally created, or an addition thereto, there is no difficulty. Plant and machinery are capital assets and moneys paid for them are moneys paid on account of capitalwhether they are
(a) moneys paid in the course of putting together a new business structure,
(b)moneys paid for an addition to a business structure already in existence, or
(c)moneys paid to acquire an existing business structure.
In my opinion, however, from this point of view, there is a difference in principle between property such as plant and machinery on the one hand and goodwill on the other hand. Once goodwill is in existence, it can be bought, in a manner of speaking, and money paid for it would ordinarily be money paid "on account of capital". Apart from that method of acquiring goodwill, however, as I conceive it, goodwill can only be acquired as a by-product of the process of operating a business. Money is not laid out to create goodwill. Goodwill is the result of the ordinary operations of a business that is so operated as to result in goodwill. The money that is laid out is laid out for the operation of the business and is therefore money laid out on revenue account.
In the B. P. Australia case, Lord Pearce had cited [at page 261] as "a valuable guide to the traveller in these regions" the discussion in Sun Newspapers Ltd. v. The Federal Commissioner of Taxation, in which Dixon J. said:
There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.
and
the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely.
Lord Pearce also cited [at page 262] the following passage from the judgment of Viscount Radcliffe in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd.:
Again, courts have stressed the importance of observing a demarcation between the cost of creating, acquiring or enlarging the permanent (which does not mean perpetual) structure of which the income is to be the produce or fruit and the cost of earning that income itself or performing the income-earning operations. Probably this is as illuminating a line of distinction as the law by itself is likely to achieve, but the reality of the distinction, it must be admitted, does not become the easier to maintain as tax systems in different countries allow more and more kinds of capital expenditure to be charged against profits by way of allowances for depreciation, and by so doing recognise that at any rate the exhaustion of fixed capital is an operating cost. Even so, the functions of business are capable of great complexity and the line of demarcation is sometimes difficult indeed to draw and leads to distinctions of some subtlety between profit that is made "out of" assets and profit that is made "upon" assets or "with" assets.
Later in his reasons, Lord Pearce expressed the view cited by Fauteux J. (as he then was) in the Algoma case and then proceeded [at page 264]:
Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. That answer:
depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured employed or exhausted in the process:
per Dixon J. in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation [(1946) 72 C.R.L. 634, 648]. As each new case comes to be argued felicitous phrases from earlier judgments are used in argument by one side and the other. But those phrases are not the deciding factor, nor are they of unlimited application. They merely crystallise particular factors which may incline the scale in a particular case after a balance of all the considerations has been taken.
Lord Pearce then went on to consider the three matters referred to by Dixon J., in the Sun Newspapers case. The first of these was the character of the advantage sought, including its lasting qualities and that of recurrence as well as the nature of the need or occasion for it. Under this head, he considered as well the test of whether the expenditure was from fixed or from circulating capital, how the expenditures should be treated on the ordinary principles of commercial accounting and whether the amounts were spent on the structure within which the profits were to be earned. He also considered the manner in which the benefit was to be used, the second of the matters suggested by Dixon J., and the third, that is to say, the method of payment.
[Emphasis added.]
[33] Before analysing the facts of the present case in light of these general principles, it is worth recalling certain more specific and equally relevant comments made in cases involving marketing and business development expenses. In particular, let us consider the following comments made by my colleague Mogan J.T.C.C. in Graham Construction Engineering (1985) Ltd. v. Canada, [1997] T.C.J. No. 343 (QL) (97 DTC 342), at paragraph 9 (DTC, at page 345):
There is no doubt that certain costs (e.g. advertising) incurred for the purpose of expanding an existing business are deductible as current expenses in computing income. Similarly, certain other costs incurred to expand a business (e.g. the purchase of shares to acquire a new subsidiary carrying on a similar business) are an outlay of capital and not deductible.
[Emphasis added.]
[34] Next, we have the statement[7] by Dixon J. in Sun Newspapers Ltd.[8] that expenses incurred in order to purchase a competitor are capital outlays.
[35] Lastly, we have the comments by Lord Pearce in B. P. Australia referring to a lump sum paid by B. P. Australia to retailers in order to fund improvements to the service stations. Lord Pearce writes as follows, at page 224:
The third consideration suggested by DIXON, J. (55) namely the method of payment, does not point very clearly in either direction. An advance payment for a period is not unusual in many revenue matters (e.g., purchase of stock). These payments were not current payments made annually over the period of benefit, but on the other hand it was clear that they would have to be made again at intervals of a few years. In a lasting company of this nature recurrent five yearly payments certainly cannot be said to have a "once for all" quality. Had the payments been for one or two years they would point towards revenue; had they been for twenty years they would point towards capital: but the actual period of time for which these particular payments were made, as in the consideration of the nature of the advantage (above), gives no indication which could outweigh the indications given by other considerations.
[Emphasis added.]
[36] These principles shall be applied to the relevant facts in the present case. First of all, "the character of the advantage sought" by Rona must be determined. The evidence has established that Rona decided to increase its market share by increasing the number of its sales outlets, in order to better counter and deal with new competition, particularly the arrival on the Canadian market of the United States giant Home Depot. According to the analysis of each of the 12 acquisition transactions here considered by Rona for which it paid substantial professional fees ($957,133), Rona's strategy involved three separate scenarios. In scenario one, Rona encouraged the construction of superstores that were to be owned by franchised dealers; examples are the transactions involving Groupe Lespérance (1994 and 1998), Inovaco (1997), Revy (1998), and Loyola (1998).[9] In scenario two, if the first scenario proved to be impracticable, Rona would be prepared to acquire these superstores itself as "corporate" stores; clear examples are the transactions involving Matco (1994) and Ferlac (1998). In scenario three, Rona could increase the number of its sales outlets by simply acquiring competitors; examples in particular are the takeover bids or outright acquisitions considered of Sodisco, Réno-Dépôt, Beaver Lumber, Cashway and Matco. This was not a new scenario: in 1988 Reno had acquired Dismat Inc., thus adding to its network 97 retail stores representing $165 million in additional sales figures.
[37] Regardless of the scenario chosen, the advantage Rona sought through its growth strategy was the lasting expansion of its business structure, that is, its distribution network. The transactions considered in scenarios two and three are obviously permanent in nature. In acquiring Dismat in 1988, which operated 97 retail stores having a turnover of $165 million, Rona permanently expanded its business structure. This was also the case when it succeeded in acquiring Cashway, which operated 66 sales outlets having a turnover of approximately $294 million. Once Rona had made the Cashway (and Dismat) stores a part of its distribution network, it had acquired a significant number of sales outlets, which, because of their loyalty to the Rona network, would not result in additional costs. The initial costs of acquisition were "once for all" expenses. Because these sales outlets were henceforth owned directly or indirectly by Rona, it did not need to pay additional professional fees to acquire them.
[38] Based on the analysis of the 12 acquisition transactions considered by Rona, expenses incurred in order to acquire sales outlets were recurrent during the relevant period. However, the recurrence of such expenses does not mean that they must be treated as income expenses, since Rona had engaged in an extensive acquisition program. Engaging in a planned phase of expansion of the business structure over a lengthy period by adding new sales outlets does not make a capital outlay an income expense. Obviously, for example, if Rona had simply decided to acquire 25 new "corporate" superstores over a 10-year period, the acquisition cost of each of these stores would obviously have been considered a capital outlay. To incur these expenses two or three times per year does not change their nature. Authors Hogg, Magee and Li point out in their book Principles of Canadian Income Tax Law[10]: "The expenditures laid out to purchase new machines, trucks, etc., are recurring [for large businesses], but they are capital expenditures because each provides an enduring benefit to the business." Here, the acquisition cost of the shares in Cashway (and in Dismat) is clearly a capital outlay.
[39] The superstores[11] acquired following the transactions involving Matco in 1994 and Ferlac in 1998 also conferred obvious permanent advantages on Rona. My comments on the acquisition of Cashway also apply to the acquisition of the superstores themselves. It is clear that the acquisition cost of these stores is a capital outlay.
[40] Clearly, the addition of franchised stores to Rona's distribution network does not create the same permanent advantage the acquisition of competitors or "corporate" stores creates. Unlike the right of ownership of the "corporate" stores acquired by Rona (directly or through corporations), commercial concessions have a specific duration. That said, they are usually of long duration. Thus the economic advantage sought by Rona is very much like the advantage Rona gains in acquiring "corporate" stores, and this objective is one that may reasonably be achieved. Indeed, by signing 20-year commercial concessions and leases, as was the case, according to the evidence, with the franchised-store Inovaco located in Gatineau, Rona is entitled to have that franchisee as a customer for a period of not less than 20 years. As Lord Pearce acknowledged in B. P. Australia Ltd., such a duration "would point towards capital".[12] As well, as the lessor of the lot on which the superstore is built, Rona is right in expecting that the commercial concession will be renewed for an additional period. Once the advantages of the commercial concession and the lease have been acquired, professional fees to acquire these advantages will no longer need to be paid throughout the first 20-year period. Of course, other fees may arise when these contracts are renewed. The duration of the advantage obtained and the absence of a need to incur further expenses for 20 years suggests that capital outlays are involved.
[41] Although in the 1998 transaction involving Groupe Lespérance the initial period was only three or four years, the contractual relation between Groupe Lespérance and Rona could reasonably be expected to be longer. From a [TRANSLATION] "practical and business point of view", I think it can reasonably be expected that dealers do not change their affiliations as often as they change their shirts. There are costs inherent in changes of affiliation. As well, in fact, the parties subsequently signed a 10-year concession agreement. I need not add that 85 per cent of the shareholders in Rona are affiliated dealers and this is another incentive for them to keep their affiliation with Rona. In any case, the evidence has not established any precariousness or randomness in Rona's contractual relations with its affiliated dealers or franchisees.
[42] It must also be noted that the advantage conferred by the concession agreements is far more long-lasting than the advantage that might have been obtained by numerous marketing campaigns aimed at attracting new customers for Rona's products. It is quite clear that marketing campaigns cannot create lasting advantages and must necessarily be recurrent.
[43] In conclusion, regardless of whether the sales outlets were "corporate" stores or franchised stores, the advantage that was sought and could reasonably be obtained was an enduring connection to Rona's business structure.
[44] The fact that Rona acquired an ownership interest in Inovaco's capital stock merely for a short period is not relevant. Essentially, that transaction was a means of financing the construction of the superstore, and was designed to confer a long-term advantage-adding a large new sales outlet to Rona's distribution network for an extended period. That new sales outlet resulted in expanding Rona's permanent structure.
[45] Thus far, the analysis has dealt almost exclusively with the direct acquisition costs of stores and competitors and little has been said about the fees. The reason for this situation is quite simple. The nature of the fees depends on the purpose of the services that were rendered. If the professional fees involve current transactions, they are income expenditures. If the fees involve the expansion of the business structure, they are capital outlays. For example, if fees are paid for negotiations with respect to a marketing campaign, they are income expenses. However, if fees are paid in order to acquire a competitor, they are capital outlays. What needed to be determined first is the nature of the transactions conducted by Rona in order to characterize the nature of the professional services required for these. Here, the professional services were retained for transactions in which franchised stores, or "corporate" stores to be constructed or already owned by competitors were to be acquired. The purpose of these services was to confer on Rona an advantage [TRANSLATION] "for the lasting benefit of [its] business". Therefore, the fees for those services are capital outlays, and the parties agree that those fees must be included in the costs of the assets acquired by Rona.[13]
[46] However, some of the projects considered were abandoned. There is no asset the cost of which the related expenses incurred can be included. In these circumstances, must we conclude that the expenses incurred for these transactions should be considered income expenses? The answer to this question is provided by the Federal Court of Appeal in Firestone v. Canada, [1987] 3 F.C. 200 (87 DTC 5237). MacGuigan J. states these issues as follows, at page 210 (DTC, at page 5241):
Counsel for the appellant acknowledged in the course of argument that the costs of the investigation of opportunities in relation to the four operating companies actually acquired were capital expenditures, and made it clear that they had in fact been capitalized here. . . . However, he submitted that the investigation costs of the other fifty-odd opportunities that did not lead to acquisitions must be regarded rather as expenditures of an operating nature.
[Emphasis added.]
[47] At the same page, MacGuigan J. concludes as follows:
I find it impossible to accept this contention. It seems to me that all of the expenditures relating to the investigation of opportunities must be considered on the same footing. They were the same kinds of expenses, and they were made for the same purpose. They were, in effect, all part of the same venture-capital business which, the appellant strenuously urged, existed from 1969 on. It makes no sense to separate off the few which led to acquisitions from the many that did not. All were equally part of the appellant's plan of assembly of business assets. It was only to be expected, and indeed was the premise of the appellant's investigative method, that some possibilities would on examination turn out to be good risks, others too poor to be proceeded with. In my view, the very common-sense approach for which the appellant contended vitiates his attempted distinction.
[Emphasis added.]
[48] In Brooke Bond Foods Ltd. v. The Queen, [1984] 1 F.C. 601, Decary J. adopted the same approach. At page 604, he writes:
The fact the project was abandoned does not alter the nature of the expense, which remains an outlay on account of capital. As Thorson P. of the Exchequer Court wrote in Siscoe Gold Mines Ltd. v. Minister of National Revenue, [1945] Ex.C.R. 257; 2 DTC 749, at page [266 Ex.C.R.]:
The fact that it was decided to abandon the option and not to acquire the [mining] claims cannot change the character of the disbursements. They were losses incurred in connection with a capital venture.... I think it is clear that an expenditure incurred for the purpose of enabling a taxpayer to decide whether a capital asset should be acquired is an outlay or payment on account of capital....[14]
Counsel for the plaintiff relied on the judgments of Noël A.C.J. in Bowater Power Company Limited v. Minister of National Revenue, [1971] F.C. 421; 71 DTC 5469; [1971] C.T.C. 818 (T.D.), and Pigott Investments Limited v. Her Majesty the Queen, [1973] CTC 693; 73 DTC 5507 (F.C.T.D.). We are of the view,
with respect, that the facts of these two cases are very different from those in the case at bar.[15]
[Emphasis added.]
[49] Consequently, the abandonment of the 1994 project to open a store in co-operation with Groupe Lespérance and the 1998 projects to open stores in co-operation with Revy and perhaps with Loyola does not change the nature of the amounts that would otherwise have been capital outlays. Before 1972, these capital outlays would have been considered "nothings". Since 1972, these amounts have been included in the cumulative eligible capital.
[50] The same reasoning applies to all the projects to acquire competitors, particularly Sodisco in 1994, Réno-Dépôt in 1996 and Beaver Lumber in 1997. I have no doubt that, if these transactions had been completed, their purpose would have been to expand Rona's business structure or organization. All the relevant related expenses would then have been included in the acquisition cost of the shares in the businesses concerned.
[51] The takeover bid of Matco considered in 1998 deserves special comments in light of its particular circumstances. It should first be recalled that the primary purpose of this takeover bid was to keep Matco in Rona's distribution network. The consideration of a bid to take over Matco clearly shows that the contractual relation with that corporation was a significant asset for Rona. In my opinion, the purpose of this takeover bid was to preserve Rona's business structure, and the related expense is therefore a capital outlay. I consider it appropriate to apply the reasoning followed in M.N.R. v. Dominion Natural Gas (1940), 1 DTC 499-133, and Her Majesty the Queen v. Jager Homes Ltd., F.C.A., No. A-792-83, January 28, 1988 (88 DTC 6119). In this last decision, Urie J., writing for the Federal Court of Appeal, states as follows at page 15 (DTC, at page 6124):
... To use the words of Dixon J. in the Sun Newspapers case, supra, "The expenditure in question is a large non-recurrent unusual expenditure made for the purpose of obtaining an advantage for the enduring benefit of the appellants' trade ..." In other words, the payments for legal fees were made to preserve the business entity, structure or organization not as the kinds of expenditures which are made to earn profits from the operation of such business entities.
[Emphasis added.]
Lastly, if the takeover bid had been made and had succeeded, the professional fees would have been included in the acquisition cost of the shares in Matco. Therefore, it is not appropriate to adopt a different reasoning simply because the project was abandoned.
[52] In my opinion, all the fees paid by Rona to acquire new sales outlets are capital outlays and may not be deducted as income expenses in computing Rona's income.
[53] For all these reasons, the appeal by Rona concerning the 1992 taxation year is allowed and the assessment is referred back to the Minister for reconsideration and reassessment on the basis that the amount of the expense the Minister should have disallowed is $34,000 and not $36,380. The appeals concerning the 1993 to 1998 taxation years are dismissed. The respondent is entitled to her costs.
Signed at Ottawa, Canada, this 10th day of March 2003.
J.T.C.C.
Translation certified true
on this 17th day of July 2003.
Sophie Debbané, Revisor
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