Regina News Ltd. and Mid-Western News Agency Ltd. v. MNR, 93 DTC 358, [1993] 2 CTC 2136 (TCC)

Christie, A.C.J.T.C.C.:—The taxation years under appeal by Mid-Western News Agency Ltd. ("Mid-Western") are 1981, 1982, 1983, 1984 and the taxation years under appeal by Regina News Ltd. ("Regina News") are 1981, 1982, 1983. These appeals were heard together.

The issue in Regina News is whether, in computing its business income for the years mentioned, it was authorized to deduct an inventory allowance under paragraph 20(1)(gg) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") [1] . The same issue obtains respecting Mid-Western and, in addition, there is the question whether certain interest it earned in its 1981, 1982, 1983, 1984 taxation years is Canadian investment income as defined by paragraph 129(4)(a) of the Act. The respondent says it is not.

The only witness at trial was Mr. Jack Shapiro, President of both appellants. They distribute publications of different kinds to about 1,000 retailers in Saskatchewan. Regina News is based in Regina and its territory is the southern half of Saskatchewan. Mid-Western covers the northern half from Saskatoon. The retailers are supermarkets, convenience stores, book stores, drugstores or any other outlet with a newsstand.

The publications consist of magazines and books. The principal suppliers of magazines including comics are Time Warner, Curtis Publishing Co., Murdock, Hearst, Kable News Co., McLean Hunter Co. and of books are Harlequin, Bantam Books, Penguin, Random House.

The appellants send publications to retailers for sale on commission, the former retaining ownership of them until they are sold by the retailer. This is commonly referred to as shipping on consignment. The appellants decide on quantities to be shipped. This is based on potential sales that are estimated from very accurate records of sale patterns that are prepared with the aid of computers. In what retailers receive there is a "built-in over-supply". This is primarily related to the importance of advertising in the publications. Where advertising is involved, publishers are much concerned with circulation and the over-supply is designed to capture every possible sale to maximize the advertisement readership. The result is that there are very substantial returns of unsold material by the retailers to the appellants or evidence from the retailers that such material has been demolished. The appellants, in turn, in support of claims for credit from their suppliers send evidence to the latter that the unsold publications have been destroyed.

At one time the appellants had contracts in writing with all of their suppliers, but over time such well established patterns regarding their relationships came about that those contracts fell by the wayside. Mr. Shapiro was only able to turn up two documents "that would indicate the pattern in the trade". One is headed “HARLEQUIN SALES CORPORATION—TERMS AND POLICIES—WHOLESALER TERMS AND SALE". It is undated and the witness estimated its vintage to date from the 60s or early 705. It consists of 12 numbered paragraphs that deal with such matters as a customer applying for a line of credit consenting to Harlequin conducting a credit investigation; providing that the account is non-transferable; notice of voluntary cessation of business, change of ownership or control will be given to Harlequin 90 days prior to the effective date; the nature of the statement to be sent by Harlequin each month; freight charges for shipping to customers to be pre-paid by Harlequin; details of how all shipments will be paid; the ramifications of Harlequin accepting late payments, partial payments or payments tendered contrary to its wholesaler account payment policy; that Harlequin’s count of returns shall be final; that a customer who ceases purchasing books from Harlequin has 120 days from the last shipment to return the books for credit; that the customer accepts the terms and conditions set out in the document; specifying the manner in which Harlequin may at any time cancel an account. Paragraphs 7 and 8 read:

7. All cover returns of unsold books must be authorized by a Harlequin representative before a proper credit will be issued to the customer. An account may only return for credit covers of books originally purchased by that account. Covers authorized for return shall be sent to the Harlequin Distribution Center in Buffalo,

NY. By accepting and giving credit for returned covers, Harlequin is repurchasing from the customer the books in question. All coverless books, therefore, become the sole property of Harlequin. The customer agrees that these coverless books are not to be sold and shall be destroyed according to the instructions issued by Harlequin.

8. Unauthorized returns and any full copy book returns sent to Harlequin Distribution Centre will not be accepted by Harlequin. All unauthorized returns and full copy book returns shall be shipped back to the customer and the customer will bear any freight charges incurred in the shipment of these unauthorized returns or full copy book returns.

[Emphasis in original.]

When Mr. Shapiro first became involved in the business of the appellants in 1950 the procedure as it related to paperback books was to return a large proportion of what was unsold to the suppliers in “full copy", but over the years this diminished because the cost of transportation from Saskatchewan to Toronto [2] made it uneconomical. Consequently only covers were returned. In his experience it was initially the practice with respect to magazines to return covers only. With the advent of computers it was possible to establish a "very firm audit trail" about the sale and return of magazines. This gave rise to the use of "affidavits" [3] to establish the destruction of unsold magazines.

Mr. Shapiro said that the Harlequin terms and policies document by and large reflects the relationship between Harlequin and the appellants. The appellants bought and paid for the books and obtained title to them. The books were then transferred on consignment to the retailers who were entitled to return them to the appellants. When books were returned by retailers, a Harlequin representative sometimes verified the appellants’ count thereof. This was hit-and-miss. He then issued an authorization to return the covers of a specified quantity of books to Harlequin. They were delivered by public carrier. A credit was issued to the appellants more or less immediately after receipt by Harlequin. The terms existing with other suppliers were similar to those applicable to the appellants and Harlequin.

The second document located is entitled "WARNER PUBLISHER SERVICES—AFFIDAVIT PRIVILEGES AGREEMENT”. Warner was the appellants’ biggest supplier. Eighty-five to 90 per cent was periodicals and 10 to 15 per cent paperback books. Time and Life were included as well as “a huge variety of general interest publications.” The affidavit privileges agreement came into use by the appellants about the middle of September or October 1983 in substitution for sending covers of publications.

The agreement relates to periodicals”, i.e. magazines and comics”. It is a form agreement consisting of nine clauses made between "Warner" and individuals or corporations who are a“ "distributor". The clauses may be summarized as follows:

1. Distributor warrants that it maintains destruction equipment that completely shreds or destroys periodicals so as to render the same unusable and unsalable as reading matter.

2. Distributor agrees to maintain accurate order and regulation on all periodical titles distributed by Warner.

3. Distributor agrees to submit, when credit is requested for off-sale copies of periodicals distributed by Warner to a distributor and unsold in the ordinary course of business, an affidavit or certificate in a form acceptable to Warner confirming that the off-sale copies have been shredded or destroyed. No failure by Warner to object to affidavit or certificate forms used by a distributor, or acceptance by Warner of returns submitted with such forms, shall waive Warner's right to require use thereafter of forms acceptable to it. Submission of a claim form by a distribution prior to destruction of periodicals shall constitute grounds for termination of the agreement. There follows a form of certification "deemed acceptable”. In addition to its being dated and signed on behalf of Mid-Western, it reads: “I certify that the titles, issues and quantities listed hereon are true and correct. I further certify that these periodicals have already been destroyed so as to render them unusable and unsalable as reading matter, as follows: In-House Destruction Method: Smith Industries, Vancouver, B.C. 5 blade cutter/sh redder."

4. A distributor shall permit Warner representatives, upon request, to audit off-sale copies of periodicals distributed by Warner prior to their destruction.

5. When a distributor has complied with the foregoing clauses Warner shall credit the distributor's account with the full amount theretofore charged by Warner for periodicals previously purchased by the distributor. If Warner thereafter determines that off-sale copies so credited have not been destroyed or mutilated so as to render them unusable and unsalable as reading matter, Warner has the right to debit the account of the distributor with the amount previously credited to such improper claim and to require repayment of the amount in full and to terminate its dealings with the distributor forthwith.

6. "Title to all off-sale copies of periodicals distributed by Warner to Distributor shall vest in and remain with Warner as of the close of business on, and from and after the date of issuance of credit by Warner to Distributor therefore, and any disposition thereafter of such copies by Distributor or any third party other than as authorized by Warner is illegal.”

[Emphasis in original.]

7. The provisions of a Warner Publisher Services policy statement (attached to the agreement) are part of the agreement to the extent that they are not inconsistent therewith. [4]

8. No waiver by Warner of any provision of this agreement shall preclude Warner from requiring compliance with such provision at a later date, nor shall any such waiver waive distributors’ other obligations under this agreement.

9. The agreement may be terminated by either party upon five days' prior written notice by mail to the other party.

The title to periodicals supplied by Warner passed to the appellants. The affidavit privileges agreement is the kind of agreement” entered into with other suppliers and again title to the publications passed from those suppliers to the appellants. With respect to books, the covers continued to be returned.

The business of the appellants produced a great deal of surplus cash that was invested in "short-term deposit receipts" [5] pending payment out as divi- dends. The dividends paid by Mid-Western during the years under review were: 1981—$150,000; 1982—$250,000; 1983—$608,000; 1984—$900,000. During the same years Regina News paid dividends in these amounts: 1981—$221,000; 1982—$195,000; 1983—$275,000; 1984—$698,000. The dividends were paid after the short-term investments were liquidated.

These questions were put to the witness by appellant's counsel and these answers given:

Q. And these funds (invested in the short-term) were not put back in the business; they were not necessary to reinvest them in any way?

A. No, in no way at all. We have never had to . . . . We have never had to reinvest them and we have never ever put money back into the business. We've never had to borrow money or we've never been in an overdraft position.

Q. You've borrowed no money at all—

A. None whatsoever. We've been very fortunate, there's no question.

The foregoing is substantially the evidence submitted in chief by the appellants respecting both matters in dispute.

In cross-examination these points were established. Seventy-five per cent of the materials supplied by the appellants to retailers consisted of magazines and comics; 23 per cent was paperbacks and two per cent children’s books.

When material was sent by the appellants to retailers it was accompanied by an invoice to be paid by a specified time. The invoice reflected the price of the material sent and any credit accumulated by the retailers. The difference was payable. The retailers in rural areas were given credit on the basis of returning covers of unsold publications to the appellants coupled with the contractual undertaking by the retailers to immediately destroy the balance of a publication on removal of its cover. Retailers were informed that: “It is illegal to sell coverless publications.” and they were requested to: “Please advise us of the name of any dealer known to you that sells or displays coverless publications.” The publications unsold by retailers in urban areas were retrieved by the appellants.

The appellants treated publications, the covers of which were in transit to their suppliers at year's end, which was March 31, and in respect of which they had not been credited, as being property in their inventories. Also included in their inventories were publications regarding which the covers had been returned to their suppliers, but for which the appellants had not received credit as of March 31. There may have been disputes between the appellants and their suppliers concerning one or two per cent of material returned, but Mr. Shapiro did not know whether this was included in the appellants' inventories. When the appellants used affidavits to claim credits from their suppliers the publications described in an affidavit sent by them on or before March 31, but in respect of which credit was not received until after that date, were treated as being entitled to the inventory allowance.

A sample affidavit was placed in evidence. It is a computer printout dated March 18, 1983, [6] entitled "affidavit of returns" addressed to Kable News Co., Mount Morris, Illinois, from the appellant Mid-Western. It consists of five pages. There are 22 or 23 lines on each page. The first line on page 1, which illustrates the pattern of the other lines, consists of these things in this order. First are two code numbers the nature of which is in evidence, but need not be gone into in these reasons. Next is the number of publications followed by title, month of issue, cost price per unit and total cost. The facts in the document are not supported by oath or solemn declaration nor is it signed. In response to the affidavit Kable News Co. sent Mid-Western a “return credit memo" dated March 31, 1983, i.e. some 13 days after the date of the affidavit.

Paragraphs 4 and 5 in each notice of appeal read:

4. The retail dealers return unsold periodicals to the appellant. The appellant sells these unsold periodicals back to its suppliers pursuant to the terms of the contracts between the appellant and its respective suppliers. Legal title to these periodicals passes from the appellant to the supplier when the supplier issues a credit for the periodicals.

5. The suppliers of the appellant would receive no benefit from the physical return of the unsold periodicals. Under the contract between the respective supplier and the appellant, the supplier is obliged to bear the cost of delivering the unsold periodicals. In order to avoid this expense, the shipper does not require the physical return of the periodicals. The appellant either returns the cover of the periodicals to the supplier or certifies by affidavit the quantity of periodicals sold back to the supplier. The remaining portion of each periodical is then destroyed by the appellant.

They are an accurate summation of the position taken by counsel for the appellants both in his opening remarks and in argument.

The issue to be determined is whether the appellants are entitled to an inventory allowance for publications the covers of which were sent to their suppliers on or before March 31, but for which credits were not issued to the appellants until after that date and publications described in affidavits sent to suppliers on or before March 31, but for which credit was not issued to the appellants until after that date. There was some reference to a relatively small number of books being returned to suppliers in the condition they were in when received by the appellants or to use the jargon of the trade "in full cover". Mr. Shapiro’s evidence in this regard is so nebulous that it is not possible to quantify this so no further reference thereto will be made in these reasons.

With respect to the Canadian investment issue Mr. Shapiro was cross- examined in relation to financial statements filed by Mid-Western with its returns of income for its 1981 to 1984 taxation years. It was established that during these years there was relatively minor borrowing by Mid-Western, but I am satisfied that the evidence-in-chief of the witness that no money was borrowed was an inadvertent oversight and not an attempt to mislead the Court in any way. It was also shown that at least some of the interest in issue for 1984 arose not out of term deposits, but under a new offer by Mid-Western's banker to pay special interest on funds to its credit in its current account which were beyond the appellant’s need for working capital.

Subsection 20(1)(gg) of the Act read:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a 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:

(gg) an amount in respect of any business carried on by the taxpayer in the year, equal to that portion of three per cent of the cost amount to the taxpayer, at the commencement of the year, of the tangible property (other than real property or an interest therein) that was

(i) described in the taxpayer's inventory in respect of the business, and

(ii) held by him for sale or for the purposes of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into or used in the packaging of, property for sale in the ordinary course of the business

that the number of days in the year is of 365.

In order for an inventory allowance to have been deductible in computing a taxpayer’s income there must be

1. tangible property,

2. described in the taxpayer's inventory in respect of his business, and

3. the property must have been held by him for sale in the ordinary course of the business.

In R. v. Langley, (1899) 31 O.R. 295 (C.A.), Boyd, C. said at page 300: "As put succinctly by Judge Chalmers in his edition of the Sale of Goods Act, page 2, the essence of sale is the transfer of the property in a thing from one person to another for a price.” In Black’s Law Dictionary, 6th (1990) edition “sale” is defined at page 1337: "A contract between two parties, called respectively, the ‘seller’ (or vendor) and the 'buyer' (or purchaser), by which the former, in consideration of the payment or promise of payment of a certain price in money, transfers to the latter the title and the possession of property." Subsection 3(1) of the Sale of Goods Act, R.S.S. 1978, c. S-1, provides:

A contract of sale of goods is a contract whereby the seller transfers or agrees to transfer the property in goods to the buyer for a money consideration called the price. [7]

Other provinces have legislated in the same way, e.g. Sale of Goods Act, R.S.O. 1990, c. S.1, subsection 2(1); Sale of Goods Act, R.S.B.C. 1979, c. 370, subsection 6(1).

In my opinion the publications relating to the covers or which were described in the affidavits cannot be regarded as being tangible property described in the appellants’ inventories in respect of their businesses and held by them for sale in the ordinary course of business. The covers merely identified publications that had otherwise been destroyed and the affidavits describe publications totally destroyed. There was no sale of publications by the appellants to their suppliers in any realistic sense of that word. To my mind the true nature of the essential relationship between them was that the appellants purchased publications from the suppliers and the latter contracted to reimburse the appellants for the amounts paid in respect of publications distributed by them to retailers that were unsold. On the other hand the appellants covenanted to remove the unsold material from the market by destroying it. The return of covers and the affidavits were simply the procedure adopted by the parties in the execution of these mutual undertakings. The only inference that I can draw from the evidence is that on issuing credits to the appellants their suppliers had not the slightest interest in or expectation of a transfer to them of property in publications. Their assumption at that time was that the publications were no longer extant.

The fact that, for example, it is said in paragraph 7 of the Harlequin agreement that: By accepting and giving credit for returned covers, Harlequin is repurchasing from the customer the books in question" does not alter what has just been said. The same applies to paragraph 6 of the Warner agreement if it is intended to stipulate that Warner has title to unsold periodicals after the date of the issuance of credit to the appellants without anything more. I quote paragraph 6 again:

Title to all off-sale copies of periodicals distributed by Warner to Distributor shall vest in and remain with Warner as of the close of business on, and from and after the date of issuance of credit by Warner to distributor therefore, and any disposition thereafter of such copies by distributor or any third party other than as authorized by Warner is illegal.

I expect that paragraph 6 is in the agreement in anticipation of the situation where a distributor has obtained the issue of credit from Warner in respect of copies that have not been destroyed. Otherwise it is difficult to understand why the agreement would speak of "any disposition thereafter of such copies" respecting copies that no longer exist.

The course of action to be followed is to decide what on the evidence is the substance and reality of what took place between the appellants and their suppliers. In Purdy v. M.N.R., [1985] 1 C.T.C. 2294, 85 D.T.C. 254, this is said at pages 2295-96 (D.T.C. 256):

It must be borne in mind that in deciding questions pertaining to liability for income tax the manner in which parties to transactions choose to label them does not necessarily govern. What must be done is to determine what on the evidence is the substance or true character of the transaction and render judgment accordingly. In M.N.R. v. Saskatchewan Co-operative Wheat Producers Ltd. [1928-34] C.T.C. 47,1 D.T.C. 186, Lamont, J. in delivering the judgment of the Supreme Court of Canada said at page 54 (D.T.C. 189):

In revenue cases it is a well recognized principle that regard must be had to the substance of the transactions relied on to bring the subject within the charge to a duty and the form may be disregarded.” Pollock M.R. in Inland Revenue Commissioners v. Eccentric Club Ltd., [1924] 1 K.B. 390, at page 414.

Viscount Simon in delivering the judgment of the House of Lords in Commissioners of Inland Revenue v. Wesleyan and General Assurance Society (1948), 30 T.C. 11, said at page 25:

It may be well to repeat two propositions which are well established in the application of the law relating to income tax. First, the name given to a transaction by the parties concerned does not necessarily decide the nature of the transaction. To call a payment a loan if it is really an annuity does not assist the taxpayer, any more than to call an item a capital payment would prevent it from being regarded as an income payment if that is its true nature. The question always is what is the real character of the payment, not what the parties call it.

In Front & Simcoe Limited v. M.N.R., [1960] C.T.C. 123; 60 D.T.C. 1081, Cameron, J. said at page 132 (D.T.C. 1085):

In Simon's Income Tax, Second Edition, Volume 1, page 50, the author, after referring to a number of decisions, states:

The true principle, then is that the taxing Acts are to be applied in accordance with the legal rights of the parties to a transaction. It is those rights which determine what is the “substance” of the transaction in the correct usage of that term. Reading “substance” in that way, it is still true to say that the substance of a transaction prevails over mere nomenclature.

The foregoing was reiterated in M.N.R. v. Ouellette and Brett, [1971] C.T.C. 121, 71 D.T.C. 5094 by Walsh, J. at page 136 (D.T.C. 5103):

The jurisprudence is very clear that it is not what parties call a payment in a contract which determines the nature of it but the real character of the transaction.

See also /n re Ralli's Settlements, [1966] A.C. 483 per Lord Pearson at page 515, and Wenger's Ltd. v. M.N.R., [1992] 2 C.T.C. 2478, 92 D.T.C. 2132 per Rip, T.C.C.J. at pages 2486-87 (D.T.C. 2138-39).

The appellants are not entitled to inventory allowances respecting any of the years under review.

Turning now to the question of whether the income derived by MidWestern from its short-term investments in its 1981, 1982, 1983, 1984 taxation years is Canadian investment income as alleged by it. “Canadian investment income" of a corporation is defined under paragraph 129(4)(a) of the Act and for the purposes of this appeal what is said in that paragraph and in paragraph 129(4.1)(b) may be simplified as follows. Canadian investment income for a taxation year is the aggregate of:

1. taxable capital gains for the year less allowable capital losses for the year from dispositions of property to the extent that they may reasonably be considered to be income or losses, as the case may be, from sources in Canada; and

2. all amounts each of which is the corporation's income for the year from a source in Canada that is property net of all expenses; minus

3. the current years losses from a source in Canada that is property.

Paragraph 129(4.1)(b) states: "For the purposes of paragraph (4)(a) 'income' or loss' of a corporation for a year from a source in Canada that is incident to or pertains to an active business carried on by it.”

In McCutcheon Farms Ltd. v. The Queen, [1991] 1 C.T.C. 50, 91 D.T.C. 5047 (F.C.T.D.), Mr. Justice Strayer said at pages 53-54 (D.T.C. 5049):

In my respectful view, the paragraph [129(4.1)(b)] has been properly interpreted by Christie, A.C.J.T.C. in Atlas Industries Ltd. v. M.N.R., [1986] 2 C.T.C. 2392, 86 D.T.C. 1756. In that case a corporation carrying on a custom fabrication sheet metal business and a roofing business put surplus funds on hand in short-term deposits, the balance of its funds being retained in a non-interest bearing current account in amounts regarded as sufficient for operating purposes. In that case the taxpayer sought to establish that the interest earned on the short-term deposits was "Canadian investment income” whereas the Minister sought to establish that it was active business income within the meaning of paragraph 129(4.1)(b). Christie, A.C.J.T.C. allowed the appeal from the Minister's reassessment, holding that such interest income was not income from an active business. He gave the following interpretation of paragraph 129(4.1)(b) at page 2404 (D.T.C. 1764-65):

Giving the words “incident to or pertains to an active business” their grammatical and ordinary sense, and bearing in mind their context, there must I think be a financial relationship of dependence of some substance between the property and the active business before the exclusion in paragraph 129(4.1)(b) comes into play. The operation of the business ought to have some reliance on the property in the sense that recourse is had to it regularly or from time to time or that it exists as a back-up asset to be called on in support of those operations when the need arises. This I regard to be the basic approach to paragraph 129(4.1)(b). Whether income-producing property has crossed the dividing line into the paragraph will depend on the facts of each case. I am satisfied that the facts under consideration do not place the relevant property within it. The relationship between the debts created by the term deposits and the appellant’s businesses was tangential at best. The debts were never resorted to in aid of the appellant's businesses nor was there any real expectation that they would be. The fundamental purpose of these term deposits was unrelated to sustaining the appellant's businesses, but it was to direct the profits therefrom into the hands of the shareholders, primarily by way of bonuses.

See also Irving Garber Sales Canada Ltd. v. M.N.R., [1992] 2 C.T.C. 260, 92 D.T.C. 6498 (F.C.T.D.) per Joyal, J. at pages 270-71 (D.T.C. 6505); Newton Ready-Mix Ltd. v. M.N.R., [1989] 2 C.T.C. 2369, 89 D.T.C. 595 per Sarchuk, T.C.C.J. at pages 2374-75 (D.T.C. 598-99); Sanilit Ltd. v. M.N.R., [1987] 2 C.T.C. 2078, 87 D.T.C. 450 per Rip T.C.C.J. at page 2087 (D.T.C. 457).

The import of Mr. Shapiro's evidence about Canadian investment income is that a financial relationship of dependence did not exist between the funds to generate the interest in dispute and the active business carried on by MidWestern. That business did not rely on those funds in the sense described in Atlas Industries Ltd. This evidence prevails in the face of cross-examination. Consequently Mid-Western is entitled to succeed on this issue.

In summary the appeals of Regina News in respect of its 1981, 1982, 1983 taxation years are dismissed. The appeals of Mid-Western in respect of its 1981, 1982, 1983, 1984 taxation years are allowed and the matter is referred back to the respondent for reconsideration and reassessment on the basis that the interest in dispute in those years is Canadian investment income. Mid-Western is entitled to no other relief.

Appeals allowed in part.