Ethicon Sutures Ltd. v. The Queen, 85 DTC 5290, [1985] 2 CTC 6 (FCTD)

Cullen, J.:—This is an appeal by the appellant from the judgment of the Tax Court of Canada signed the 17th day of November 1983, whereby the appellant’s appeal in respect of its 1978 taxation year was dismissed.

At all material times, the plaintiff was a corporation incorporated, resident and carrying on business in Canada and was wholly owned by Johnson and Johnson, a corporation incorporated under the laws of the State of New Jersey, one of the United States of America. At all material times, the plaintiff was engaged in the business of manufacturing and distributing surgical sutures and instruments, and its head office was located at Peterborough, Ontario. The fiscal period of the plaintiff in issue was January 2, 1978 to December 31, 1978, its 1978 taxation year.

During the 1978 taxation year, the plaintiff had a foreign exchange gain in the amount of $119,030. The plaintiff reported a taxable capital gain of $59,515 in its 1978 taxation year, being one-half of the total amount of the foreign exchange gain. The defendant reassessed the plaintiff by notice of reassessment number 313121, dated February 21, 1980, treating the foreign exchange gain as an income gain rather than a capital gain, and the plaintiff objected by notice of objection dated April 23, 1980. The plaintiff's foreign exchange gain was realized as a result of purchases of term deposits in US currency.

The appellant had for some time purchased and held notes ranging in terms from four days to five months, which were described in its financial statements on its balance sheets under the heading “Current Assets’" as “Short Term Deposits” in the following year end amounts:

All term notes were purchased and held in Canadian dollars until sometime in 1977.1 n 1977 the $2,355,760 on deposit at year end was comprised of $550,000 in Canadian dollars and $1,650,000 in US dollars (expressed at their Canadian dollar equivalent of $1,805,760). At December 31, 1978 the remaining $896,001 on deposit was comprised of $505,000 in US dollars (Canadian dollars equivalent of $596,001) and $300,000 in Canadian dollars.

The term notes acquired in 1977 and 1978 which matured in the appellant’s 1978 taxation year, and gave rise to a foreign exchange gain in 1978 numbered some 48 transactions.

At the Tax Court hearing two witnesses were called by the plaintiff namely Mr Robert lan Bradley who was the secretary-treasurer of the plaintiff at the time of the hearing and Mr Peter J Simpson who was secretarytreasurer when the transactions in issue took place. Mr Bradley at that time had been in the position four months but had made himself aware of the circumstances by examining the corporate books and records.

The evidence, uncontradicted, is that each year the parent company, Johnson and Johnson, would meet with its subsidiaries in what they called a forecasting process. Each fall all the corporations world-wide participate in the preparation of what is called “the original forecast for the coming year”. One of the items discussed is the future payment of dividends. The appellant had a history of being a profitable company and over the course of the years Johnson and Johnson required the appellant to pay on a regular basis a certain percentage of the net income in the form of dividends. The appellant over the course of many years paid a dividend rate ranging anywhere from 65 to 90 per cent of net income after taxes. They were normally paid to Johnson and Johnson on a quarterly basis.

As described by Mr Bradley,

This process is a process that is really agreed upon from the Johnson and Johnson treasury people who are responsible for the utilization of the funds of the corporation world-wide and the individual operating companies, from which they draw their funds. At the request of the treasury staff of Johnson and Johnson, we would accumulate the required dividend amount during the entire course of the year. In other words, if I was anticipating having to pay a quarterly dividend by March 15th, I would, during the course of the year, start to set aside any excess funds so that I can anticipate having adequate funds on hand at the agreed-upon payment date to meet that liability. This is a practice that was followed by my predecessors and we continue to do it today. At the request of the corporation we would naturally want to earn as good a return as possible on the investment, but at the same time be conscious of safeguarding the investment. Therefore, the corporation would request that we put the money into short-term deposits.

And later,

Up until 1977, these excess funds were placed in Canadian dollar term deposits. This would be considered the most prudent investment by both the corporation and the local chief financial officer, again to the Johnson and Johnson Corporation. We would have the advantage of earning a reasonable return on our investment and at the same time be safeguarding the investment. During 1977, the Johnson and Johnson Corporation and its treasury organization changed its policy and requested that subsidiaries around the world hold excess funds in US dollar term deposits rather than in local currency term deposits.

The evidence to this point seems quite clear that the appellant was setting aside “excess funds to meet dividend payments determined at the meeting in the fall of the year before.

The waters, unfortunately for the appellant, become somewhat muddied and in my view the appellant falls short of meeting the onus of rebutting the respondent's assumptions as it is required to do under the Income Tax Act.

There is no clear, unequivocal answer to two questions at issue, namely, why was the fund established and why did Johnson and Johnson require the appellant to hold these funds in US dollars?

Mr Bradley’s evidence is that the deposits were excess funds to meet future dividend payments. He makes no mention that the funds were “for projected capital expenditure" as claimed in the statement of claim. Also, what weight can be given to Mr Bradley’s testimony when he was not privy to the discussions or meetings which concerned the policy of acquiring short term deposits in US dollars commencing in 1977. Again, although the appellant commenced business in Canada in 1963, it did not acquire short term deposits unteil 1975, and Mr Bradley didn’t know why. His research, surely, should have told him what Mr Simpson knew, namely, the appellant was not sufficiently profitable until that time. Mr Bradley, when asked by his counsel if he had been able to ascertain a reason for that particular policy said, “it is my understanding" that it is due to a ruling from the Financial Accounting Standards Board in 1976 or 1977 called FASB8. (Incidentally, an article by B J Arnold in the Canadian Tax Paper of July 1983 states this ruling was made in 1975). Knowing he was to be called as the main witness for the appellant something better than his “understanding" was called for. Later, in cross-examination, Mr Bradley admitted he did not know whether the accounting controversy in the US had anything to do with the reason for buying the term deposits in US dollars in 1977, when asked for any documentation relating to the policy except a telex sent to the appellant in 1978. This telex was from Johnson and Johnson's Director of treasury services to Ethicon's secretary treasurer Peter Simpson. This telex did not explain the reasons for requiring the appellant to buy US dollar deposits.

Mr Bradley’s evidence also indicates that when the appellant purchased inventory from its affiliates in the United States, all invoices were in US dollars. Exchange gains or losses from inventory purchases were included in results of operations currently.

Mr Simpson, who joined the appellant in 1971, stated that the requirement to have deposit certificates in US currency was due to the concern by Johnson and Johnson about “net asset exposure". Mr Simpson weakened the case for the “excess funds position" when in evidence he stated: “Yes I concur with the fact that they were earmarked primarily for use in payment of dividends" (emphasis is mine). And later, under cross-examination:

Q. Let me put this to you, you wouldn't disagree with Mr Bradley’s statement that some of this money went from time to time for inventory acquisition, and some went to capital expenditures and to various sources.

A. I would say some definitely went to the purchase of inventory.

And later,

Q. I am not going to pursue this whole question of comparing mature deposits to dividend payments, but you would agree that there is a difference in the quantum of short term deposits as compared to dividend payments made in 1978, for example, there is more US dollars dissipated than were spent on dividends out of the short term deposits?

A. I understand that.

Q. Do you agree?

Yes, I think I would have to agree.

One exhibit R-10 at the Tax Court hearing establishes that there were in the vicinity of 12 instances of 36 odd entries where funds from mature term deposits were used for something other than payment of dividends.

To be fair to Mr Simpson he follows up his answer emphasizing that payment schedules for dividends and capital purchases were more predictable as to when required, and "we believed that that was the main purpose of the US fund deposits".

It is necessary to mention Mr Klassen, who conducted negotiations with Revenue Canada concerning the reassessment for 1978. He was secretarytreasurer from April 1979 to October 1981. In a letter written November 19, 1979 to the respondent he indicated the acquisition of short term US dollar deposits was for the sole purpose of producing investment income, and no claim was made in the letter that US dollars were set aside in short term deposits to pay dividends or for projected capital expenditures. Surely, if that was the reason, ie dividend payment, it would have been front and centre in his representation. Again, the appellant’s notice of objection did not state that the US dollar short term deposits were acquired to make dividend payments. It would have been helpful to the Court to have had the evidence of Mr Klassen about the reasons for the acquisition of the short term deposits in US dollars.

Another inconsistency in the evidence is the fact that the requirement to pay dividends in US dollars was not followed in November 1978 when $400,000 of a $956,000 dividend was paid in Canadian funds. Also in 1978, a dividend of $413,466 was paid in US funds by purchasing US dollars at the Bank of Montreal. There were sizeable year end balances of short term deposits for 1976 and 1977. No explanation was offered why this occurred if the moneys were largely employed for payment of dividends.

It must also be noted that significant inventory purchases from the United States were made and in 1978 it totalled about $2.7 million. Some inventory payments were made from the short term deposits, so it can hardly be argued these were excess funds to the operation of the corporation.

One other point made by the respondent was that short term deposits were Classified on its balance sheet as “current assets" and so, in the opinion of the respondent, at least they comprised part of the “circulating assets" of the company. I did not have sufficient evidence to make that determination nor is it necessary in any event given the failure of the appellant to meet its heavy onus of rebutting the respondent's assumptions.

Although several authorities were cited by counsel for both parties, it is difficult to find an authority not distinguishable on its facts from the case at bar. Some principles do evolve, however, which are helpful.

To determine whether a foreign exchange gain is to be treated as income or capital, it is necessary to look at the nature of the underlying transaction which gives rise to the gain.

Where the foreign currency was acquired as a result of the taxpayer's trading operations, or for the purpose of carrying on trading operations, any gains will be treated as occurring in the course of the taxpayer's trade and will be treated as income.

Tip Top Tailors Ltd v MNR, [1957] CTC 309; 57 DTC 1232 (SCC)

Aluminium Union Limited v MNR, [1960] Ex CR 363; [1960] CTC 206; 60 DTC 1138; affd 63 DTC 1254 (SCC)

The Weatherhead Company of Canada Ltd v MNR, [1982] CTC 2839; 82 DTC 1831 (TRB)

Likewise, where the transaction is a speculation made in the hope of profit, it will be treated as an adventure in the nature of trade, and the gain will be taxed as income.

Salada Foods Ltd v The Queen, [1974] CTC 201; 74 DTC 6171

However, if the gain arises out of the investment of idle funds or the appreciation of a temporary investment, the gain will be treated as a capital gain.

McKinlay v Jenkins (1926), 10 TC 372 (KB); Atlantic Sugar v MNR, [1949] CTC 196; 49 DTC 602 (SCC)

Tip Top Tailors Ltd v MNR, supra

The appellant submits that the gain arose as an accretion to an investment made by the taxpayer of idle and surplus funds which were not needed for the day-to-day revenue-producing activities of the taxpayer, and is therefore a capital gain.

Citing M J Bonner, Member, in The Weatherhead Company of Canada v The Minister of National Revenue, [1982] CTC 2839; 82 DTC 1831, counsel for the appellant notes this comment from Bonner, Member: “I am not satisfied that the appellant has shown that the foreign exchange in question was a fund not employed in its ordinary day-to-day business operations.” However, like Bonner, Member, I too am not satisfied, and like Bonner, Member, “The Appellant, in making the deposits was simply managing cash flow in the manner which it found most effective, having regard to the exigencies of the business.” In the case at bar part of the deposits were used for inventory purchases, clearly therefore not surplus to needs nor solely for paying dividends or projected capital expenditures. The Weatherhead case is clearly distinguishable on its facts but the principles cited are applicable.

I am of course aware of the principle cited in Salada Foods Ltd v The Queen, [1974] CTC 201; 74 DTC 6171 by Urie, J that when a foreign exchange gain has been realized, the mode of its application (eg whether it is used to pay dividends or trade payables) has no bearing whatever upon whether the gain was of a capital or income nature. It is however a guide to buttress the decision made at the outset whether the fund is of a capital or income nature. Here I am satisfied the fund was not surplus, and was not of a Capital nature.

The principle of primary and secondary intention is also applicable here. The evidence from the appellant’s witness that the deposits were primarily earmarked for payment of dividends indicates clearly other intentions.

In Regal Heights Ltd v MNR, [1960] CTC 384 at 388; 60 DTC 1270 at 1272 Judson J, states:

There is no doubt that the primary aim of the partners in the acquisition of these properties and the learned trial judge so found, was the establishment of a shopping centre but he also found that their intention was to sell at a profit if they were unable to carry out their primary aim. It is the second finding which the appellant attacks as a basis for the taxation of the profit as income. The Minister, on the other hand submits that this finding is just as strong and valid as the first finding and the promoters had this secondary intention from the beginning.

I am satisfied the primary aim of the appellant was to use the funds for payment of dividends, but its secondary option and intention was to have money available from time to time to meet inventory payments.

To be considered capital in nature, the funds must be surplus, must be exclusively for dividend or capital expenditures, ie it must be a firm final dedication, and not enough if “earmarked primarily”.

It is true that the appellant maintained a bank account in American dollars, and one in Canadian dollars for the purpose of the day-to-day operations, but it clearly knew and took advantage of the fact that it also had access to term deposits in US currency to make inventory purchases.

One final note, namely, in the Annual Report of the appellant entitled, “Miscellaneous Income and Expense”, the $119,030 gain which is the subject of this appeal was identified as “Gains on Currency Transactions”. Currency transactions here are not capital gains.

For the reasons stated above this appeal is dismissed with costs to the respondent.

Appeal dismissed.