Canadian Clyde Tube Forgings Ltd. v. The Queen, 82 DTC 6041, [1982] CTC 21 (FCA)

Urie, J:—This is an appeal from a judgment of the Trial Division dismissing the appellant’s appeal from a reassessment for income tax made by the Minister of National Revenue in respect of the appellant’s 1973 taxation year. The appellant’s appeal to the Tax Review Board had also been dismissed.

It is common ground that the sole issue in the appeal is the proper method of calculation of the manufacturing and processing tax deduction to which the appellant may be entitled by virtue of section 125.1 of the Income Tax Act, RSC 1952, c 48 as amended by SC 1970-71-72, c 63, s 1 (“the Act”). The appellant computed the deduction at $34,940. The reassessment reduced it to $5,497. Which calculation is correct must be determined by deciding whether payments made by the appellant to an independent contractor, Weram Limited, fall within the definition of “cost of labour” under section 5202 of the Income Tax Regulations (“the Regulations”).

The learned trial judge accurately described the appellant’s operations in the following fashion:

The Plaintiff is engaged in the manufacture and processing of special pipes and fittings for the refining industry. The entire operation is carried out in the Plaintiff’s plant into which it receives semi-finished fittings and flanges. The semi-finished items are delivered by the Plaintiff to the contractor for machining. They are then returned to the Plaintiff for finishing, such as painting, and are stocked there and shipped from there to customers. The contractor supplies the necessary machines and tools, employs the machinists and is paid at agreed piece rates. The machinery is all located in the Plaintiff’s plant and the contractor’s employees do all their work there. To any observer, the entire operation, from receiving to shipping, would appear to be a single, integrated process. There are no artificial physical barriers between the areas of the plant occupied by the Plaintiff and the contractor nor superfluous segregation [sic] of the employees of one from those of the other. This modus operandi was adopted when the plan was established in 1960 and continues today.

The relevant part of subsection 125.1(1) of the Act reads as follows:

(1) There may be deducted from the tax otherwise payable under this Part by a corporation for a taxation year an amount equal to the aggregate of

(a) 9% of the lesser of

(i) the amount, if any, by which the corporation’s manufacturing and processing profits for the year exceed the least of the amounts determined under paragraphs 125(1 )(a) to (d) in respect of the corporation for the year,

Section 5200 and the relevant definitions in section 5205 of the Regulations read as follows:

Basic Formula

5200. Subject to section 5201, for the purpose of paragraph 125.1 (3)(a) of the Act, “Canadian manufacturing and processing profits” of a corporation for a taxation year are hereby prescribed to be that proportion of the corporation’s adjusted business income for the year that

(a) the aggregate of its cost of manufacturing and processing capital for the

year and its costs of manufacturing and processing labour for the year

is of

(b) the aggregate of its cost of capital for the year and its cost of labour for the year.

Definitions

5202. In this Part, except as otherwise provided in Section 5203 or 5204,

“cost of labour” of a corporation for a taxation year means an amount equal to the aggregate of

(a) the salaries and wages paid or payable during the year to all employees

of the corporation for services performed during the year, and

(b) all other amounts each of which is an amount paid or payable during the year for the performance during the year, by any person other than an employee of the corporation, of functions relating to

(i) the management or administration of the corporation,

(ii) scientific research as defined in section 2900, or

(iii) a service or function that would normally be performed by an employee of the corporation.

but for the purposes of this definition, the salaries and wages referred to in paragraph (a) or other amounts referred to in paragraph (b) do not include that portion of those amounts that

(c) was included in the gross cost to the corporation of a property (other than a property that was manufactured by the corporation and leased during the year by the corporation to another person) that was included in computing the cost of capital of the corporation for the year, or

(d) was related to an active business carried on outside Canada by the corporation;

“cost of manufacturing and processing labour” of a corporation for a taxation year means 100/75 of that portion of the cost of labour of the corporation for that year that reflects the extent to which

(a) the salaries and wages included in the calculation thereof were paid or payable to persons for the portion of their time that they were directly engaged in qualified activities of the corporation during the year, and

(b) the other amounts included in the calculation thereof were paid or payable to persons for the performance of functions that would be directly related to qualified activities of the corporation during the year if those persons were employees of the corporation.

but the amount so calculated shall not exceed the cost of labour of the corporation for the year;

It will be seen that section 125.1 of the Act is a provision which permits a taxpayer to deduct from its tax otherwise payable an amount which would not otherwise be permitted as a deduction. The “Canadian manufacturing and processing profits” are computed by the application of a formula ascertained by means of section 5200 of the Regulations. The parties agreed that the formula is

MP = q = ML x Adjusted business income

for this purpose, the initials mean:

MP: Canadian Manufacturing and Processing Profits

ML: Cost of Manufacturing and Processing Labour

L: Cost of Labour

C: Cost of Capital

The parties agree on the amounts of all items to be used in the formula for purposes of this case except the “Cost of Labour” and “Cost of Manufacturing and Processing Labour”. The appellant computed the section 125.1 deduction for its 1973 tax return by including the labour costs paid to Weram Limited both in the numerator and the denominator of the formula while the Minister in his reassessment excluded that item from each. The exlusion was founded on his contention that the machining functions were not “normally” (that is to say as a “regular occurrence”) performed by employees of the appellant. The sole question is, then, which of the two computations, on applying the relevant definitions to the facts of this case, is the correct one.

The learned trial judge expressed his view on the question in a succinct fashion, as follows:

It is normal for a corporation carrying on such an operation to carry it on in its entirety and the service or function performed by the contractor for the Plaintiff is a service or function normally performed by employees of such corporation. It is not, however, a service or function normally performed by the Plaintiff’s employees. The Plaintiff normally engages the contractor, rather than its own employees, to perform that service or function. Indeed, its own employees have never, before, during or since its 1973 taxation year, performed that service or function.

Nothing in the related provisions of the Act or regulations leads me to conclude that the pertinent words of the definition of the “cost of labour” are to be interpreted otherwise than in their plain English sense. The adverb “normally” appears Clearly to relate to the modus operandi of the manufacturer and processor claiming inclusion of the particular outlay in its cost of labour. (Italics added.)

Despite the able and persuasive argument of counsel for the appellant expressing a contrary view, I agree with the conclusion of the learned trial judge and with his reasons for reaching that conclusion. Subparagraph (b)(iii) of the definition of cost of labour does not refer to a service or function that would normally be performed by an employee of a (ie any) corporation. It uses the definite article “the” before the word “corporation” thus pointing clearly to the corporation claiming the deduction from the tax otherwise payable as the relevant entity, namely, in this case, the appellant. Since normally it engages Weram Limited to do its machining, rather than using its own employees, it does not meet the requirements of the clause. It cannot, therefore, unfortunately for it, include the payment it makes to Weram Limited for its services as a cost of labour in the denominator of the fraction used in the calculation of its adjusted business income.

It follows, then, that since the definition of “cost of manufacturing and processing labour” in section 5202 of the Regulations refers to “that portion of the cost of labour of the corporation” as the latter term is defined in the same regulation, it cannot include the payment to Weram Limited as part of the cost of manufacturing and processing labour in the numerator of the formula for the calculation under section 5200.

The appeal should, accordingly, be dismissed with costs.