McGraw-Hill Ryerson Ltd. v. The Queen, 80 DTC 6211, [1980] CTC 280, aff'd 82 DTC 6142, [1982] CTC 167 (FCA)

Mahoney, J:—The issue in this action, and in actions Nos 3515-79 and 3518-79, is whether, in its 1973, 1974 and 1975 taxation years, the plaintiff was engaged in manufacturing or processing books so as to be entitled to claim the deduction from tax provided in section 125.1 of the Income Tax Act. The three actions were tried together on common evidence. There is no dispute that books can be the subject of manufacture or processing. The defendant says that, because the plaintiff did not itself do the typesetting, printing and binding necessary to the metamorphosis of any of the books it published in Canada from their conceptual to their tangible states, the plaintiff did not manufacture or process books. The defendant says further that, if the plaintiff processes anything, it is the information contained in the books, not the books themselves, and that, since it retains the copyright to that information, it does not sell what it has processed. There is no issue as to the plaintiff’s qualified activities if it is found to have manufactured or processed books at all. Neither, in that event, is there any issue as to the proper application of the complicated formulae for calculation of the deduction.

In the circumstances, it is unnecessary to set out the lengthy provisions of section 125.1 and the Regulations made under it. Suffice it to say, the section provides for deduction, from the income tax otherwise payable by a corporation, of an amount determined with reference to the corporation’s active business income from “the manufacturing or processing in Canada of goods for sale or lease’’. The Act does not define “manufacturing or pro- cessing” although paragraph 125.1(3)(b) does provide certain exclusions from the term. Of these, the defendant pleads subparagraph (x).

“manufacturing or processing’’ does not include

(x) any manufacturing or processing of goods for sale or lease, if, for any taxation year of a corporation in respect of which the expression is being applied, less than 10% of its gross revenue from all active businesses carried on in Canada was from

(A) the selling or leasing of goods manufactured or processed in Canada by it, and

(B) the manufacturing or processing in Canada of goods for sale or lease, other than goods for sale or lease by it.

This invocation of subparagraph 125.1(3)(b)(x) appears a tautology of its basic defence. The defendant admits in pleading that between 47.48% and 49.33% of the plaintiff’s total sales revenues in the years in issue came from the sale of books published by it in Canada. If, in so publishing them, the plaintiff manufactured or processed the books at all, it escaped the de minimis exclusion of the subparagraph.

In addition to publishing and selling its own books, the plaintiff sells the books of other publishers and is agent, in Canada, for foreign publishers. About 90% of its own publications are textbooks. The remaining 10% comprise general interest books including novels, which frequently are presented to the plaintiff as complete manuscripts; textbooks are different.

Textbooks are published in response to the market. They become obsolete with curriculum changes. The plaintiff watches the market carefully and, when the need for a new textbooks is foreseen, one of its sixteen sponsoring editors is assigned to locate a suitable author, usually from within the academic community. One of the functions of the plaintiff’s sales staff, which is constantly in contact with educational institutions, is to identilfy Suitable authors. Many sponsoring editors are graduates of the sales force. Others are former teachers.

Once a prospective author is identified, the sponsoring editor obtains an outline of his material and a sample of his writing and, if that is satisfactory, a contract is entered into whereby it is agreed that the manuscript will be delivered by a certain date, copyright is assigned to the plaintiff and provision is made for certain payments to the author. The sponsoring editor continues to work with the author, setting a schedule to meet the completion date and reviewing the manuscript as it becomes available, chapter by chapter, commenting on and returning it to the author with suggestions. Photographs proposed to be incorporated in the book are obtained by the author or the sponsoring editor. The amount of guidance afforded varies with the needs of each author. A manuscript usually goes through at least two drafts before acceptance for publication.

When it is considered that a manuscript is ready to proceed further toward publication, it is handed over by the sponsoring editor for copy editing and production. The copy editor, seeing it for the first time, skims through it for its gist and then reads the manuscript very carefully, editing it for grammar, organization and the like. The copy editor pulls out sample pages of the manuscript showing every typographical eventuality and turns these over to a book designer for typographical design. The book designer establishes the typographical layout and a design checklist which is related to the sample pages by a system of symbols.

The plaintiff has nine copy editors and three book designers. Those nine copy editors do about 90% of its copy editing. There are two or three freelancers to whom it turns when the work load requires. Likewise, its employee designers do its design work except in cases of heavily illustrated publications where the number of diagrams and drawings create an unusual demand on their time. Typically, there are 50 or 60 books at this stage of publication at a given time.

The copy editing and book design proceed simultaneously and, as the design becomes firm, a printer is selected. A specification is drawn. Textbooks fall into a limited number of categories so, for economy, the plaintiff has a number of standard specifications calling for the same kinds of paper and binding material. Other requirements, such as dimensions, quantity, colors and so on, vary. Quotations are invited from between four and six printers with whom the plaintiff deals regularly. The quotations are reviewed and the printing contract awarded.

The printing contract covers typesetting and binding. The plaintiff does none of its own typesetting, printing or binding. The sample pages and design checklist are sent to the printer. They are set and galley proofs of the sample pages are returned. The typographical design is finally approved and, when copy editing is complete, the entire manuscript, design, checklist and sample galley proofs, with changes indicated, are sent to the printer. The manuscript is set and full galley proofs returned. Copies are passed to the author and copy editor who indicate corrections.

A paste-up is done for an illustrated book and explicit instructions given as to its layout. The paste-up is done by the copy editor who cuts up a galley proof and reassembles it, page by page, with copies of the illustrations, marking it for spacing and showing every detail of how each page should be put together.

Corrections by the copy editor and author are incorporated in a master galley proof and, with the paste-up, it is delivered to the printer. The printer produces a reproduction paste-up using the master galley proof and following the placing and spacing instructions on the paste-up. The resulting page proofs are returned to the plaintiff.

The page proofs should be a properly aligned version of the paste-up. Again, the copy editor checks the page proofs and makes any changes that ought to be made including anything due to the printer’s failure to follow previous instructions. There ought not, at this stage, be many changes. If there are many, the printer may have to produce another set of page proofs; otherwise, he will take the reproduction pages of which the page proofs are copies, arrange them in the right configuration for folding and photograph them. Methodology varies with the number of colors to appear in the final product. From the film, the printer produces a paper proof, or vandyke.* This is a one color proof which shows, by varying shades of that color, the placement of the different colors to appear in the book. This is the publisher’s last chance to make corrections. Again, if they are numerous, a

The term “vandyke” derives from the fact that, formerly, page proofs were produced in shades of brown, a color combination favoured by the barbate painter of that name. Today, they are usually shades of blue but the term survives.

second vandyke may be required. Once the plaintiff approves the vandyke, the printer makes the plates and prints the book. Any remaining errors are the publisher’s, not the printer’s, responsibility.

While the content of the proposed book is being brought to the vandyke Stage, the cover goes through a parallel process. Initially, one of the plaintiff’s artists does rough cover designs. These are circulated throughout the company. A rough design is approved and refined and eventually the final art is approved. This is provided to the printer who produces a proof, or series of proofs as may be necessary, until, ultimately, the cover too goes to press. Contents and covers are bound together and the finished books are then delivered to the plaintiff for warehousing, sale and distribution.

The entire process, from identification of the need for a new textbook to its availability in the market place, consumes several months. In the case of “Physics”, a secondary school text used as example in evidence, the contract with the four authors was signed in May, 1977, calling for delivery of the manuscript by October 1, 1977. The quotation from the successful printer was dated January 24, 1978. The plaintiff’s purchase order for 7,500 copies issued to the printer March 14 and delivery was required by September 15, 1978.

The work of the printer is entirely mechanical. The plaintiff maintains complete control over the content, design and physical qualities of each book it publishes. Printers’ representatives call regularly on the plaintiff to deliver proofs and receive instructions respecting work in progress. The plaintiff’s representatives do not visit the printing plants except, rarely, when an unusual production problem arises.

The plaintiff does not sell only the information contained in the books its sells any more than an automobile manufacturer sells only the transportation capability of the vehicles it sells. The plaintiff sells the books. These books are goods. It may be that it is the information content that gives a book its value, as it is the transportation capability that gives a motor vehicle its value, but the subject matter of sale is the book, as it is the vehicle. The textbooks the plaintiff publishes itself are goods manufactured and processed in Canada for sale. In the ordinary meaning of the words “manufacturing” and “processing”, the plaintiff’s activities with respect to a cover and a manuscript, from the point in time it is turned over, by the sponsoring editor, to the copy editor to the point in time the vandyke is returned, approved, to the printer, are integral elements of physically manufacturing or processing a book. The plaintiff, in publishing books, does manufacture or process, in Canada, goods for sale.

The reassessments of the plaintiff’s income tax returns in respect of its 1973, 1974 and 1975 taxation years will be referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the plaintiff is entitled to a deduction from tax in each of those years, pursuant to section 125.1 of the Income Tax Act in respect of its manufacturing and processing profits, of an amount based on the qualified activities carried on by the plaintiff as permitted by section 5202 of the Income Tax Regulations. The plaintiff will be entitled to its costs to be taxed. Taxation under Tariff B shall be on the basis that the three actions were a single Class III action throughout.