McNair, .: —This is an appeal by the plaintiff from the Minister of National Revenue's reassessment of income for the 1980 taxation year. The first issue is whether the Minister was correct in treating as inventory the cost of spare parts at the plaintiff's Nanticoke and Sarnia facilities in the amounts of $1,358,567 and $119,011 respectively, rather than as depreciable property within Class 29 of Schedule II to the Regulations under the Income Tax Act, R.S.C. 1970-71-72, c. 63, as amended, thus making them eligible for capital cost allowance and investment tax credits, as the plaintiff contends they should be. The second issue is whether the Minister correctly reclassified as Class 3 assets two shelters at the plaintiff's Sarnia facility having a cost value of $615,042, which the plaintiff listed as depreciable Class 29 property in its 1980 tax return.
The facts are relatively undisputed. They were presented by plaintiff's counsel both in the form of a comprehensive opening statement and through the extensive testimony of four witnesses employed in various capacities by the plaintiff.
The plaintiff is a wholly-owned subsidiary of Air Products and Chemicals, Inc. ("Air Products"), a corporation incorporated in the United States. In its 1980 taxation year, the plaintiff operated an air separation facility at Nanticoke, Ontario (the “Nanticoke facility”), and was engaged in the construction of a cryogenic facility to produce liquid hydrogen at Sarnia, Ontario (the “Sarnia facility”).
Spare Parts
A. The Nanticoke Facility
The Nanticoke facility was constructed by the plaintiff pursuant to the terms of a contract with The Steel Company of Canada Limited ("Stelco") dated September 9, 1975 (the "Stelco contract"), and was completed in 1980. The facility produces gaseous oxygen and gaseous nitrogen through an air separation process. Under the Stelco contract, the plaintiff is required to deliver a continuous supply of gaseous oxygen and nitrogen, within specified minimum and maximum hourly production rates, to Stelco's Lake Erie Works adjacent to the Nanticoke facility. The contract included further provisions for the production, storage and subsequent vaporization of liquid oxygen and nitrogen at specified rates for Stelco's use in the event of cessation of production from the air separation facility under normal operating conditions. Finally, the Stelco contract permitted the plaintiff to construct its facility with additional production and storage capacity, thus enabling it to manufacture liquid oxygen, liquid nitrogen and liquid argon for resale to other customers.
The production process at the Nanticoke facility involves a large number of specially-designed and interconnected machines and pieces of equipment, consisting of numerous parts. Part failure or breakdown in a piece of machinery or equipment generally causes it to cease operating, leading to a shut-down of all or a significant portion of the facility. Many of the parts installed in the facility are custom-manufactured and not readily available from suppliers, and lead times for replacements can vary from between 2 to 48 weeks. For a number of reasons, including insurance requirements as well as the contractual stipulation requiring the maintenance of a stock of specified spare parts either at Nanticoke or at the plaintiff's spare parts depot at Leetsdale, Pennsylvania, the plaintiff made a "business decision” to purchase and keep on hand at the Nanticoke facility the spare parts in issue in this appeal.
For accounting purposes, the plaintiff treated any spare part initially stocked with an estimated useful life of more than one year as depreciable property to be capitalized over the life of the facility, and referred to it as a “capital spare part". This practice was in accordance with the internal accounting policy generally followed by Air Products' subsidiaries. If additional parts were acquired for storage subsequent to the initial stocking and capitalization, the costs thereof were capitalized for accounting purposes provided the parts had both an estimated useful life in excess of one year and a cost of $500 or more. In the event a “capital spare part" was required for repair purposes, it was the plaintiff's practice to immediately acquire a “replacement spare part", either by repairing the original spare part or ordering a replacement therefor. The costs of these so-called replacement spare parts were expensed for accounting purposes. The only capital spare parts in issue in this appeal are those which the plaintiff initially stocked or subsequently acquired for storage purposes. According to the plaintiff's experts, many of these parts will not be used before the expiration of the useful life of the Nanticoke facility, at which time they are likely to have only nominal value by reason of having become technically obsolete and generally unmarketable.
In its 1980 tax return, the plaintiff treated the $1,358,567 cost of spare parts at Nanticoke as a capital expenditure, classified the “capital spare parts" as property in Class 29 of Schedule II to the Income Tax Regulations and claimed capital cost allowance and investment tax credits in respect thereof.
B. The Sarnia Facility
Pursuant to a contract dated May 23, 1979 between the plaintiff and Dow Chemical of Canada, Limited ("Dow"), the plaintiff agreed to construct a cryogenic facility adjacent to Dow's plant at Sarnia to produce liquid hydrogen. Construction of the facility was completed in 1982. Under the terms of the contract, the plaintiff purchased the gaseous hydrogen by-product of Dow's production process, which it then proceeded to purify, liquify and sell. Like the production process at Nanticoke, production at Sarnia is achieved through an interconnected process employing a large number of machines and pieces of equipment, any one of which will generally cease operating on the breakdown of an essential part. Again, the consequences of such a breakdown could be the shut-down of the entire facility or a reduced production capacity. The evidence showed that the Sarnia production process relied not so much on centrifugal equipment as at Nanticoke, but rather on reciprocating equipment whose parts suffered more wear and tear and were thus more likely to fail.
As with the Nanticoke facility, the plaintiff purchased spare parts to be kept on hand at Sarnia for use in the event of failure of a corresponding part in any given machine or piece of equipment. For accounting purposes, the plaintiff capitalized the cost of the spare parts in issue in Sarnia as part of construction in progress, the Sarnia facility not being scheduled for completion until 1982, and no depreciation was claimed in respect thereof. The reason for this was simply that most of these parts were regarded as being likely to have become technically obsolete at the expiration of the useful life of the Sarnia facility, based on the business experience acquired from the operation of other liquid hydrogen plants by the plaintiff. Moreover, the spare parts in issue were not seen as being generally interchangeable with kindred parts in other such plants. However, in its 1980 tax return, the plaintiff included the cost of the "capital spare parts" at Sarnia in Class 29 of Schedule II to the Regulations and claimed the corresponding capital cost allowance and investment tax credits in respect thereof.
Shelters
There were two shelters located at the Sarnia facility enclosing, among other items of machinery and equipment, a nitrogen compressor and two hydrogen compressors. The plaintiff's project manager at the Sarnia facility, Mr. Holley, testified that the compressors generate a considerable amount of noise and vibration in the course of operation. The shelters were constructed to enclose the machinery and equipment and reduce the resultant noise level in order to comply with a local noise control by-law. Each shelter was constructed of corrugated sheet metal siding with approximately six inches of insulation in the walls and ceilings. Because hydrogen is a flammable gas and nitrogen an asphyxiant, the plaintiff installed blowers at grade level and ridge vents in the ceiling to afford adequate ventilation, and included the cost of these items in the cost of the shelters. The walls of the hydrogen shelter were specially designed to blow out in the event of an explosion, thereby releasing the explosive energy sideways and minimizing its impact on the roof and structural supports. According to Mr. Holley, the compressors and other equipment could operate without the shelters and
would not be affected by cold temperatures. Indeed, the witness stated that at a comparable facility operated by the plaintiff in New Orleans, which was located in an industrial park and thus not subject to local noise regulations, the shelters consisted merely of a roof and walls extending down therefrom for approximately ten feet.
-The S'arma shelters were under construction in 1980 and were substantially completed in 1981. In filing its 1980 tax return, the plaintiff included the $615,042 cost of the shelters incurred in 1980 in Class 29 of Schedule II to the Regulations and claimed the applicable capital cost allowance and investment tax credits in respect thereof.
The Issue Relating to Spare Parts
As pleaded in the statement of defence, the Minister of National Revenue, in reassessing the plaintiff for its 1980 taxation year, relied upon the assumption that the spare parts kept on hand by the plaintiff at all material times constituted inventory and did not constitute capital or depreciable property of the plaintiff. While the definition of "inventory" is too broadly worded to be of use here, paragraph 10(5)(a) of the Act is more relevant:
10. (5) Without restricting the generality of this section,
(a) property (other than capital property) of a taxpayer that is advertising or packaging material, parts or supplies is, for greater certainty, inventory of the taxpayer.
Counsel were agreed that the term "parts" in that definition could include "spare parts". Therefore, the first question for determination is whether the plaintiff's spare parts constituted capital property and were thus excepted from the definition of "inventory" contained in paragraph 10(5)(a) of the Act.
The sole direct reference to income tax treatment of spare parts contained in the Income Tax Act relates to aircraft spare parts, which are specifically mentioned in Classes 9 and 16 of Schedule Il to the Regulations as capital property in respect of which capital cost allowance may be taken. There is no other provision of the Act which dictates either capital or inventory treatment for spare parts in a general sense. In the absence of statutory direction, it becomes necessary to look to other sources to determine what might be considered an appropriate tax treatment in the present case.
A. Accounting Principles
The extent to which generally accepted accounting principles may be considered for income tax purposes is well defined by the jurisprudence. In Dominion Taxicab Assn. v. M.N.R., [1954] S.C.R. 82; [1954] C.T.C. 34; 54 D.T.C. 1020 (S.C.C.), at page 37 (D.T.C. 1021), Cartwright J., referring to the expression "profit", stated as follows:
It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.
Several years later Thorson, P., of the Exchequer Court, in M.N.R. v. Publishers Guild of Canada Ltd., [1957] C.T.C. 1; 57 D.T.C. 1017 (Ex. Ct.), reviewed the role of accountancy experts at length, concluding at page 1026:
Thus the prime consideration, where there is a dispute about a system of accounting, is, in the first place, whether it is appropriate to the business to which it is applied and tells the truth about the taxpayer's income position and, if that condition is satisfied, whether there is any prohibition in the governing income tax law against its use. If the law does not prohibit the use of a particular system of accounting then the opinion of accountancy experts that it is an accepted system and is appropriate to the taxpayer's business and most nearly accurately reflects his income position should prevail with the Court if the reasons for the opinion commend themselves to it.
See also: Neonex International Ltd v. The Queen, [1978] C.T.C. 485; 78 D.T.C. 6339 (F.C.A), at page 6348; and The Queen v. Metropolitan Properties Co. Limited, [1985] 1 C.T.C. 169; 85 D.T.C. 5128 (F.C.T.D.).
Certainly, there was much dispute in the present case regarding the appropriate system of accounting for the plaintiff's spare parts. Mr. Carl Frensky, manager of corporate accounting, gave evidence as to the plaintiff's accounting policy. He testified that it is the practice of all of Air Products’ subsidiaries, with the exception of a facility in Brazil, to treat spare parts as part of the operating facility and to record them in conjunction with the capitalization of the plant. At the Nanticoke facility, the spare parts were shown on the balance sheet as “Gas generating facility, machinery and equipment" under the heading "PROPERTY, PLANT AND EQUIPMENT”. Parts at the Sarnia facility were shown in the plaintiff's 1980 financial statements as "Construction in progress" because the plant was not complete. However, the Sarnia parts were subsequently accorded the same treatment as the parts at Nanticoke. According to Mr. Frensky, the purpose of the plaintiff's accounting policy was to report accurately on the economic effect of maintaining the spare parts by relating their cost to the revenue stream from the facility. In short, spare parts are kept on hand to ensure a revenue stream from the plants, and are recorded accordingly in conjunction with the latter's capitalization.
Mr. John Long, a partner of Arthur Andersen & Company and an expert accounting witness on behalf of the plaintiff, testified that the plaintiff's accounting practice was in accordance with generally accepted accounting prin- ciples. In his opinion, the spare parts kept on hand by the plaintiff represented a permanent investment in components to support the production process at the Nanticoke and Sarnia facilities with the result that it was entirely appropriate to allocate their cost over the estimated useful life of the facilities. He based his view on several postulates. One was the definition of "property, plant and equipment" contained in the exposure draft of the Canadian Institute of Chartered Accountants of May, 1989. The other was a statement in the explanatory section of International Accounting Standard 16 dealing with accounting for property, plant and equipment, to the effect that major spare parts and stand-by equipment were normally capitalized. According to him, the parts in issue were major parts coming within that definition, thereby justifying their depreciation over the life of the facilities. Essentially, Mr. Long was of the view that the plaintiff's accounting treatment of spare parts was preferable to treating them as inventory because it resulted in a better matching of the plants' cost to the revenue stream generated therefrom.
The other accounting expert on the plaintiff's behalf was Mr. Morley Car- scallen, a partner of Coopers & Lybrand, who gave as his opinion that the accounting practices followed by the plaintiff in 1980 were in accordance with generally accepted accounting principles in Canada, and more appropriate in the circumstances than the practice of carrying spare parts as inventory and charging them out to income when the parts were used or had become obsolete because of changes in production equipment. In his view, the fundamental production unit was the equipment plus the spare parts, whereby it was entirely appropriate to treat them as fixed assets and depreciate them through charges to income over the same useful life period as that used to calculate depreciation for the related piece of production equipment. Considering the economic necessity of ensuring the continuous operation of the facility, Mr. Carscallen concluded that the spare parts, which were in essence part of that facility, were being used on a continuous basis even while sitting on the shelf.
It was brought out during Mr. Carscallen's testimony that neither the CICA Handbook nor the American Standards addressed the question of capitalization of certain spare parts. In arriving at his conclusions, Mr. Carscallen considered the results of a search made of published financial statements of commercial enterprises in Canada and the United States. According to those results, only one Canadian and seven United States companies followed accounting practices for spare parts similar in principle to those utilized by the plaintiff, while the greater number of corporations treated spare parts as inventory. In the witness' view, these results were not determinative, given that some enterprises would not employ capital spare parts and that any capitalization of the same by others might not be reflected on the financial statements. Mr. Carscallen was unaware of any Canadian publications dealing specifically with the capitalization of spare parts. However, he did refer to an accountants’ handbook published in the United States as well as to the CICA Handbook and the International Accounting Standard above mentioned, and concluded that these reference works supported his opinion that the plaintiff's practice was in accordance with generally accepted accounting principles.
The final accounting expert called to testify was Mr. John E. Goodwin on behalf of the defendant. Mr. Goodwin took the position that spare parts could never be regarded as fixed assets. He explained it this way. The cost of fixed assets comprises the total expenditures incurred to acquire and prepare the fixed asset for its intended use and, since it was possible to operate the plaintiff's facilities without the spare parts, the cost of acquisition of those parts was not part of the cost of the fixed assets themselves. When asked on cross- examination whether the spare parts could be considered a capital asset, he responded as follows:
In this particular case, and in similar cases where they must buy a stock of spare parts, to call them a capital asset is, I think a difficult question. I think I'd want to study that to some extent. I think it’s an accumulation of expense. In a way, it fits the definition of a prepaid expense.
You are trying to get me to describe these as a capital asset, and I'm not really sure what they are. They are a prepaid expense. They are certainly not fixed assets. They are really a prepaid expense or a deferred charge. We are playing with words that have a lot of different meanings.
It was Mr. Goodwin's view that the plaintiff's practice of capitalizing the spare parts in issue was not in accordance with generally accepted accounting principles. If I apprehend his evidence correctly, the appropriate accounting treatment would be to describe the parts in issue as an “inventory of spare parts”, the cost of which, in order to reflect what he termed the business costs associated with "the intangible value of the comfort to management in having these parts there", should be amortized over an appropriate period which would not be the useful life of the plant.
B. Case Law
Counsel for both parties went to some pains to point out that the present case is a novel one inasmuch as the issue of the capitalization of spare parts at the time of purchase has never before been litigated in the courts of this country. They cited an extensive number of cases dealing with the categorization of capital as opposed to income expenditure as well as with the proper accounting treatment of expenditures incurred in the replacement of worn or damaged parts. The only Canadian authority dealing with a situation akin to the present one appears to be the decision of the Tax Review Board in Wallaceburg-Singer Ltd. v. M.N.R., [1972] C.T.C. 2109; 72 D.T.C. 1087, which held that the Minister was justified in refusing to permit the write-off of the cost of the entire inventory of supplies and parts on hand as a yearly operating expense. The case seems to have turned essentially on the taxpayer's inconsistent accounting practice of treating the supplies and parts as inventory in previous tax years.
Counsel for the plaintiff relied strongly on the Australian case of Guinea Airways Ltd. v. Federal Commissioner of Taxation (1949-1950), 83 C.L.R. 584 (H.C. of A.), urging that this affords jurisprudential support for treating spare parts as capital. In this case, the Australian High Court had to consider the appropriate income tax classification for a loss of stocks of spare parts and stores for use in business. Guinea Airways Ltd. was an air transport company with a base in New Guinea which, due to the remoteness of the territory in which it operated, maintained a stock of spare parts for maintenance and repair of its airplanes as well as a stock of general stores required to carry on its business. The spare parts were destroyed when Japan invaded New Guinea in 1942. The loss entitled the company to compensation under the National Security (War Damage to Property) Regulations. The company contended that the loss of £5,983 pounds was an allowable deduction under subsection 51(1) of the Australian Income Tax Assessment Act 1936-1942, which read as follows:
All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.
The Commissioner of Taxation considered the loss as one of a capital nature, and disallowed both the company's claim and its subsequent objection to the Commissioner's assessment—The company appealed to the High Court of Australia.
Dixon, J. dismissed the appeal on the ground that the loss incurred was one of capital or of a capital nature. His reasoning was as follows (at page 586-87):
The company had formed or built up a reservoir of spares for aircraft and of stores of considerable size and value and maintained it as part of its permanent establishment. It does not appear whether it had been built up gradually or formed initially, but it is immaterial which way it was done. To maintain an available stock of spares and stores at a proper level the requisite amount of capital must be committed to the purpose. The ingredients in the stocks might change. Spares would be drawn and new spares taken into store in the ordinary course of business. But the stock of spares remained. The existence of the stock of spares was a feature of the permanent organization of the enterprise. It formed part of the general equipment. When spare parts were issued and taken into use, it was right no doubt to debit the cost to running expenses, though whether for purposes of income tax the ten per cent could be added is another matter. But it by no means follows that the spare parts constituting the reservoir represented anything but capital. . . . the permanent stock of spare parts and stores forms part of the profit yielding subject, as Lord Blackburn called it in United Collieries v. I.R.C.
[Emphasis added.]
The judgment of Dixon, J. was unanimously upheld by the five judges of the Full Court. Chief Justice Latham, at page 590, wrote as follows:
... the cost of maintaining a large stock which, though it probably represents a wise policy, is beyond any requirements for prospectively immediate use cannot, in my opinion, be regarded as an expenditure properly chargeable to income account. It represents, in my opinion, an expenditure of the capital of the company in procuring an asset to be used in the future in carrying on the incomeearning enterprise of the company.
Similarly, Kitto, J. hypothesized at page 592 as follows:
If a new propeller blade had been affixed to one of the company's aircraft by way of replacement immediately before the Japanese attack, the destruction of the new blade together with the aircraft would clearly have meant a loss of a capital nature. The position cannot be different because the blade was destroyed while still among the company's stock of spare parts.
The truth appears to me to be that the spare parts and stores represented an investment of capital moneys.
[Emphasis added]
Determination or Finding
In my opinion, the statements of Dixon, J. and the judges of the Full Court in Guinea Airways, supra, are apposite to the facts of the present case and I have no hesitancy in adopting their reasoning, given the apparent want of Canadian jurisprudence on the subject matter at issue. Moreover, I am satisfied on the evidence of Messrs. Long and Carscallen that the plaintiff's accounting practice with respect to the spare parts was in accordance with generally accepted accounting principles.
True, neither of these witnesses could cite any Canadian texts supporting their positions and were able to refer only to one American and one international publication, the latter of which dealt specifically with the mining industry. It is also the fact that both the CICA Exposure Draft on property, plant and equipment and International Accounting Standard 16 were published subsequently to the plaintiff's 1980 taxation year. It is also the fact that the computer search of financial statements indicated a total of only eight commercial enterprises in Canada and the United States which followed accounting practices for spare parts similar to those adopted by the plaintiff. As noted previously, it was Mr. Carscallen’s view that the results of his computer search were not conclusive. As for those corporations shown in the search to have accounted for spare parts as inventory, he was of the opinion, based on his experience with corporations over the years, that most either had no spare parts similar to those capitalized by the plaintiff or did not have a sufficient stock of parts to warrant establishing a separate accounting system for them. Finally, Mr. Carscallen saw no reason to ignore the CICA Exposure Draft and the International Accounting Standard simply from the mere fact of their being published after the end of the 1980 taxation year. As he perceived it, these works were meant to describe standard accounting practice as at the date of publication and, in his view, there had been no change of practice with respect to the subject area of fixed assets for a number of years.
In cross-examining this expert witness, counsel for the defendant suggested that it would be almost impossible to logically maintain his opinion that the plaintiff's practice of accounting for spare parts was in accordance with generally accepted accounting principles in Canada, given that virtually no Canadian companies seem to follow it and the dearth of any Canadian texts on the subject. Mr. Carscallen responded that he had no difficulty in maintaining his position, which he explained more fully during the course of reexamination as follows:
It has always been necessary to determine what constitutes generally accepted accounting principles in Canada. It has never been possible not to arrive at a determination, so the fact that the most relevant literature is published in the United States, although frequently referred to in Canada, or that there is a reference in an international accounting standard, doesn't mean that we ignore them.
The weight to give to various things has always been an area of judgment, and will always have to be, because nowhere does it — except in a recommendation does it say, “This is GAAP and that's all you need consider”. Even there, there's a statement in the Handbook that you still have to use judgment and apply it to the particular circumstances.
Essentially, we have always taken this sort of thing into account. It’s the normal practice in Canada in establishing generally accepted accounting principles. For that reason I have no problem with the opinion I have given, based on the matters that have been brought forward.
Defendant's counsel referred to a number of spare parts initially stocked at Nanticoke and Sarnia which were classified as "working spares" by the plaintiff and capitalized, even though the individual costs thereof ranged downward from less than $500 to less than $1. The total cost amounts of these working spares stored at Nanticoke and Sarnia were $234,204 and $50,983 respectively. Both Messrs. Long and Carscallen were of the opinion that capitalization of these working spares was appropriate. According to Mr. Long, the spares fit his definition of “a major part" in that they had a useful life of more than one year, were critical to the process and, perhaps not individually but certainly as a group, had a significant cost characteristic. Mr. Carscallen considered the low cost of some of the so-called working spares as being entirely irrelevant. It was his opinion, with which I agree, that any part capable of causing a lengthy termination of production could be called a major part so that the working spares in essence merely represented unitemized “capital spare parts".
Considering the evidence in its entirety, I am satisfied that the plaintiff's accounting treatment of the capital spare parts in issue was in accordance with generally accepted accounting principles as they existed in Canada at the material time. Applying the principle of Guinea Airways Ltd. v. Federal Commissioner of Taxation, I find that the plaintiff has proven on balance of probability that the capital spare parts were in fact capital property, and that the Minister erred in classifying them as inventory within the meaning of subsection 10(5) of the Income Tax Act.
Whether Used Primarily in the Manufacturing or Processing of Goods for Sale
The next question that arises is whether the spare parts constituted depreciable property of the plaintiff. "Depreciable property" is defined in paragraph 13(21)(b) of the Income Tax Act as follows:
13. (21) In this section, section 20 and any regulations made under paragraph 20(1)(a),
(b) "depreciable property" of a taxpayer as of any time in a taxation year means property acquired by the taxpayer in respect of which he has been allowed, or, if he owned the property at the end of the year, would be entitled to, a deduction under regulations made under paragraph 20(1)(a) in computing income for that year or a previous taxation year.
Paragraph 20(1)(a) of the Act permits a taxpayer to deduct capital cost allowance at prescribed rates for properties included in any one of the 35 classes of depreciable properties described in Schedule II to the 1980 Regulations. It should be noted that the plaintiff's spare parts do not constitute property specifically excluded from the capital cost allowance regime by virtue of subsection 1102(1) of the Income Tax Regulations. The crucial issue for determination is simply this: within which of the classes of depreciable property do the plaintiff's spare parts properly fall?
Since determination of the appropriate class for the spare parts will dictate not only the claimable capital cost allowance but also the plaintiff's eligibility for an investment tax credit, it might be useful at this juncture to outline briefly the relevant statutory framework pertaining thereto. The somewhat tortuous maze prescribed by the Act and Regulations may be summarized as follows:
1. Subsection 127(5) of the Act permits the deduction of an investment tax credit from tax otherwise payable not exceeding the lesser of the amounts prescribed therein.
2. Subsection 127(9) of the Act defines investment tax credit in more detail. 3. The term “qualified property" is defined by paragraph 127(10)(b) of the Act to include "prescribed machinery and equipment acquired by the taxpayer after June 23, 1975”, that is to be used by the taxpayer in Canada primarily for the purpose of "manufacturing or processing of goods for sale” [subparagraph 127(10)(c)(i)].
4. Subsection 4600(2) of the Income Tax Regulations provides that property qualifies as "prescribed machinery and equipment" for purposes of paragraph 127(10)(b) of the Act if it is depreciable property of the taxpayer that is property included in Class 8 of Schedule ll [paragraph 4600(2)(c)] or property included, inter alia, in Class 29 of Schedule II [paragraph 4600(2)(k)].
5. Class 8 property is defined in Schedule II of the Regulations to include, among other things, “a tangible capital asset that is not included in another class in this Schedule . . .
6. Class 29 is defined in Schedule II as property acquired by the taxpayer "to be used directly or indirectly by him in Canada primarily in the manufacturing or processing of goods for sale" and that is "property that, but for this class, would be included in Class 8”.
The plaintiff contends that the spare parts were properly classified as Class 29 property for the purpose of claiming capital cost allowance and that, by reason thereof, the plaintiff is also entitled to the appropriate investment tax credit in respect of expenditures incurred by the plaintiff in purchasing the spare parts. I have no doubt that the spare parts, which I have found to be capital property, do indeed constitute tangible capital assets within the definition contained in Class 8 of Schedule II. The question is whether they also fall within the definition of Class 29 assets, thus permitting the plaintiff to claim a larger capital cost allowance and investment tax credit.
Were the plaintiff's spare parts acquired to be used primarily for the purpose of manufacturing or processing of goods for sale? Counsel for the plaintiff cited the recent Tax Court of Canada cases of Dragon Construction Ltd. v. M.N.R., [1989] 2 C.T.C. 2047; 89 D.T.C. 464 and Setrakov Construction Ltd. v. M.N.R., [1989] 2 C.T.C. 2147; 89 D.T.C. 396 for the proposition that it is the taxpayer's intention at the time of purchase of the machinery and equipment and not the use to which they may be put subsequently, which is the determinative factor for resolving this question. He pointed out that the spare parts in the present case were acquired for use in the event of machine or equipment failure, noting that the "existence of the stock of spares was a feature of the permanent organization of the enterprise", as in the Guinea Airways case. He pointed to the opinions of Messrs. Long and Carscallen which, from the business and accounting perspective, were clearly to the effect that the spare parts were used when they were acquired because they were economically necessary for the continued operation of the facility and the supply of product to customers. In his submission, this was the case even though the parts remained physically on the shelves until called upon to remedy a mechanical breakdown. Finally, plaintiff's counsel relied strongly on the Federal Court of Appeal decision in Lor-Wes Contracting Ltd. v. The Queen, [1985] 2 C.T.C. 79; 85 D.T.C. 5310, and urged that the same broad approach to the interpretation of the investment tax credit provisions be adopted in the present case.
Counsel for the defendant took the position that the "use" of property in respect of any entitlement to investment tax credit, must be a mechanical use. In his submission, the mere intangible assurance that production would not be interrupted at either of the plaintiff's facilities was not such a use for the purpose of manufacturing or processing as would constitute the spare parts qualified property within the meaning of subsection 127(10) of the Income Tax Act. Defendant's counsel further submitted that even if it could be assumed that the spare parts were used both as an assurance and as repair back-up, it was the primary use which was determinative, citing in support the case of Mother's Pizza Parlour (London) Ltd. et al. v. The Queen, [1988] 2 C.T.C. 197; 88 D.T.C. 6397 (F.C.A.). It follows therefore, in his submission, that the investment tax credit must be denied.
The whole question, as it seems to me, is whether parts can be said to be used “within the meaning ascribed by subparagraph 127(10)(c)(i) of the Income Tax Act, while such parts are sitting passively on shelves and are not actually installed in the machines which they are intended to serve as replacements in the event of breakdown. On Mr. Carscallen's theory, they are because they provide the assurance that the production process will continue uninterrupted.
While not directly on point, the wide import of the word "use" featured prominently in Qualico Developments Ltd v. The Queen (No. 1), [1984] C.T.C. 122; 84 D.T.C. 6119 (F.C.A.), a case where a real estate developer sought to deduct the landscaping costs of houses held in inventory for ultimate sale, pursuant to paragraph 20(1)(aa) of the Income Tax Act. The Minister had taken the position that the landscaping costs were deductible only in the year of sale. The sole question for determination involved the proper interpretation of paragraph 20(1)(aa) and its context within the scheme of the Act, especially in reference to the controlling words “used by him primarily for the purpose of gaining or producing income therefrom or from a business”. The Court dismissed the taxpayer's appeal on the ground that the deduction afforded by paragraph 20(1)(aa) did not apply to landscaping costs incurred in respect of property included in inventory, which were deductible only in the year of sale.
Hugessen, J. concluded at pages 130 (D.T.C. 6125-26):
In my view, the "use" of a building in the context of paragraph 20(1)(aa) of the Income Tax Act requires something more than the passive holding of it, waiting for it to be sold.
See also: Re Hollinger Cons. Gold Mines Ltd., [1931] 4 D.L.R. 239 (Ont. A.D.); affirmed [1933] S.C.R. 321; 3 D.L.R. 15 at pages 241-42; Canvil Ltd. v. M.N.R., [1985] 2 C.T.C. 2451; 85 D.T.C. 699 (T.C.C.); Versatile Machine & Tool Manufacturing Co. Ltd. v. M.N.R., [1986] 2 C.T.C. 2387; 86 D.T.C. 1785 (T.C.C.); and Bunge of Canada Ltd. v. The Queen, [1984] C.T.C. 284; 84 D.T.C. 6276 (F.C.A.).
The controlling words of subparagraph 127(10)(c)(i) are "to be used by him in Canada primarily for the purpose of manufacturing or processing of goods for sale” (my emphasis). Paragraph (a)(i) in Class 29 of Schedule II to the Regulations introduces the words “directly or indirectly” immediately following the words "to be used", but otherwise the wording is identical to the controlling words set out in subparagraph 127(10)(c)(i) of the Act. I propose to completely ignore the words “directly or indirectly" contained in Class 29 and follow the wording of subparagraph 127(10)(c)(i) of the Act because, in my view, the “intent of the statute transcends and governs the intent of the regulation": Driedger, Construction of Statutes, 2nd ed., page 247.
In my opinion, the words in subparagraph 127(10)(c)(i) "to be used" connote an actual physical or functional use of the prescribed machinery and equipment and spare parts stocked on shelves as an assurance against possible mechanical breakdown do not come within that concept of use, regardless of the soundness of the underlying business policy in stocking them. Given that functional meaning, there is no way of determining in the present circumstances the exact number or quantity of the stock of spares that might have to be installed as replacements in the machines they were intended to serve during the life of the facility. The fact remains that a substantial portion of them might never be used in that sense. Consequently, I find that the spare parts in issue are not Class 29 assets, but rather constitute tangible capital assets within Class 8 of Schedule II to the Regulations. In the result, the capital spare parts are capital property and an integral part of the plaintiff's two facilities, as I have found, but they are not being actively used in any functional way in the manufacturing or processing of goods for sale within the meaning of subparagraph 127(10)(c)(i) of the Income Tax Act.
The Shelters
The final matter in issue is whether the two compressor shelters at the plaintiff's Sarnia facility were properly treated as Class 3 assets in accordance with the Minister's basis of reassessment, rather than being treated as Class 29 assets, as the plaintiff contends they ought to have been. Class 3 assets include the following:
Class 3 (5 per cent)
Property not included in any other class that is
(a) a building or other structure, including component parts such as electric wiring, plumbing, sprinkler systems, air-conditioning equipment, heating equipment, lighting fixtures, elevators and escalators. . . .
The statutory provisions relating to Class 29 assets have already been generally covered. It is apparent from the statutory regime of Class 29 of Schedule Il to the Regulations and, more particularly, by virtue of the wording of subparagraph (b)(i) thereof, that the shelters must fall within the categories of properties prescribed by Class 8 before they can qualify for Class 29 treatment. The relevant Class 8 requirements for purposes of the present case read as follows:
Class 8 (20 per cent)
Property not included in Class 2, 7, 9 or 10 that is
(a) a structure that is manufacturing or processing machinery or equipment; . . .
In the course of his argument at trial, counsel for the defendant indicated a willingness to concede that the shelters were used by the plaintiff in Canada indirectly in the manufacturing or processing of goods for sale within the meaning of the prescribed definition for Class 29 property. Classes 2, 7, 9 and 30 are not in issue. Thus, the sole question for determination is whether the Sarnia shelters constitute structures that are "manufacturing or processing machinery or equipment" within the meaning of Class 8.
Both counsel referred to the decision of the Ontario Court of Appeal in Metals & Alloys Co. v. Reg’l Assessment Com'r (1985), 49 O.R. (2d) 289; 15 D.L.R. (4th) 250, a case involving facts and issues similar to those of the present case. In the Metals & Alloys case, the plaintiff company operated a secondary aluminum smelter and purchased a metal shredder to shred scrap aluminum into minute particles to facilitate the extraction of iron. The shredder presented environmental problems with respect to noise and the possible discharge of dust-like particles into the atmosphere. The Ministry of Environment made suggestions for controlling atmospheric pollution, but could offer no suggestions regarding the noise problem. Consequently, the plaintiff elected to construct a heavily insulated building around the shredder, which effectively muffled the noise of its operations. The plaintiff brought an action for a declaration that the enclosure item was exempt from taxation under the relevant provisions of the Assessment Act as "machinery and equipment used for manufacturing. . .purposes". The trial judge found for the plaintiff on the ground that the enclosure was an appurtenance necessary for the operation of the shredder. The assessment commissioner appealed on the ground that the enclosure was real property liable to assessment and taxation as a “building or structure" as defined in section 1(k)(iv) of the Act. Arnup, J.A, after extensively reviewing the authorities, concluded that the appeal should be allowed on the ground that the enclosure item in question must constitute either a “building” or "machinery" by virtue of the appropriate legislative provisions. Referring to a statement of Ritchie J. in Minister of Municipal Affairs of Province of New Brunswick et al. v. Canaport Ltd., [1976] 2 S.C.R. 599, Arnup, J.A. observed at page 305 :
In short, I agree that once it has been decided that in all the circumstances the item is a “building”, it cannot then be held to be "machinery" because it is used in conjunction with a manufacturing process.
The rationale for the conclusion that the item in question was indeed a building liable to taxation and not machinery is contained in the following statement from the learned judge's reasons at page 306:
“Building”, however, is an ordinary English word, and in this statute should be given the meaning an ordinary person would attribute to it. What we have in this case looks like a building. It is almost identical to its neighbouring structure, which is admittedly a building. It is built like a building. It is used like a building. Nothing takes place in it or on it of a mechanical or chemical nature independently of and distinct from the various machines that it encloses. The only reasonable conclusion, in my view, is that it is a building.
Plaintiff's counsel submitted that the Metals & Alloys case, as well as the later decision of the same court in Nabisco Brands v. Ontario (Reg'I Assessment Com'r) (1988), 64 O.R. (2d) 135, are distinguishable from the present case. In particular, he stressed the point that under the Ontario Assessment Act "buildings and structures" and "machinery and equipment” are mutually exclusive categories of property, whereas paragraph (a) in Class 8 of Schedule I! to the Regulations refers to "a structure that is manufacturing or processing machinery or equipment". In his submission, a finding that the plaintiff's shelters are structures is merely a precondition to the consideration of whether they are in fact machinery or equipment, rather than an end to the inquiry.
Defendant's counsel, if I apprehend his submission correctly, would have me adopt the reasoning of Arnup, J.A. in the Metals & Alloys case and find that the two subject shelters are built and used like buildings, look like buildings and thus are buildings. He also argued that the classification of these shelters as Class 3 assets would better reflect the intention of Parliament in creating the various classes of depreciable property than would a forced or strained characterization as Class 8 assets.
I agree that the Metals & Alloys and Nabisco Brands cases are distinguishable, to some extent at least, by the fact that the words "buildings and structures" and “machinery and equipment" are employed in the Ontario statute in a contradistinctive sense. However, these authorities are still useful for their careful and reasoned exposition of what constitutes a “building or structure", as opposed to “machinery or equipment". The words “building or other structure" are employed frequently in reference to various categories of property described in Schedule II to the Regulations, including, without limitation, paragraph (a) in Class 3 and paragraphs (d) and (e) in Class 8. By the same token, paragraph (c) in Class 8 refers to "a building that is a kiln, tank or vat”, whereas the subject paragraph (a) refers to “a structure that is manufacturing or processing machinery or equipment". Whether or not the word "structure" in paragraph (a) in Class 8 impliedly encompasses “a building" becomes something of a moot point. In B.C. Ice and Cold Storage Ltd v. M.N.R., [1981] C.T.C. 2563; 81 D.T.C. 508 (T.R.B.), the Chairman, Mr. Cardin, felt compelled to observe that he could not imagine "anyone who would claim that a building is not a structure". He went on to conclude that the freezing plant in that case was a structure within the meaning of Class 8. To pick up on the words of Denning L.J. in Cardiff Rating Authority v. Guest Keen Baldwin's Iron & Steel Co. Ltd., [1949] 1 K.B. 385 at 396; 1 All E.R. 27, one could perhaps venture to suggest that a building is undoubtedly a structure, but not every structure is a building. On the other hand, one could just as readily argue that the omission of any reference to a building in paragraph (a) in Class 8 simply manifested the deliberate intent of the legislative draftsman.
Fortunately, I am spared the necessity of delving into the niceties of statutory ambiguity by the very wording of paragraph (a) in Class 8, which poses explicitly the question of whether the subject shelters are in fact structures constituting "manufacturing or processing machinery or equipment". Plaintiff's counsel alluded to the case of The Trimont Corporation Ltd. v. Deputy M.N.R. (1961), 1 T.B.R. 244, wherein the Tariff Board held that a concrete placer and components were not "machinery within Tariff Item 427(a)" and, more particularly, the Board's adoption of the popular meaning of the word "machinery" at page 247:
. . . A machine is comprised of a more or less complex combination of moving and stationary parts and does work through the production, modification or transmission of force and motion.
On the facts of the present case, I cannot see that the plaintiff's shelters come within the Trimont definition.
The shelters were constructed of specially insulated walls and ceilings and were affixed to a concrete base. The only moving parts were the blowers at grade level and the ridge vents in the ceiling, which were installed to afford adequate ventilation and prevent the build-up of hydrogen and nitrogen gases. While Mr. Holley testified that the movement of air within the shelters was the result of "work" being done, it is apparent that this work is not work directly related to the manufacturing or processing of gas, which is the plaintiff's business. The shelters were built solely for the purpose of noise abatement. Mr. Holley further testified that the compressors and other equipment could operate without the shelters and would not be affected by cold temperatures. But for the noise abatement purpose, the shelters, including the blowers and ridge vents, would have been totally unnecessary. In my view, the evidence precludes any finding that the shelters constituted "a structure that is manufacturing or processing machinery or equipment", according to the plain and ordinary meaning of those words in context with the statutory scheme, and the contrary interpretation sought by the plaintiff would require the straining of these words to an unnatural and illogical degree. I find therefore that the plaintiff's shelters, whether they be buildings or structures, are properly classified as Class 3 assets. In my opinion, the plaintiff has failed to prove on balance of probability that the Minister’s basis of reassessment with respect to these properties was erroneous, with the result that the reassessment must stand.
For the foregoing reasons, the plaintiff's appeal is allowed only to the extent that the capital spare parts kept on hand at the Nanticoke and Sarnia facilities are capital property and not inventory within the meaning of subsection 10(5) of the Income Tax Act, as determined by the Minister. Coincidentally, there is the further concomitant finding that such capital spare parts are tangible capital assets within the meaning of paragraph (i) in Class 8 of Schedule Il to the Regulations, thus qualifying for the prescribed 20 per cent capital cost allowance. The plaintiff's appeal on the other points is dismissed. Hence, the matter is referred back to the Minister for reconsideration and reassessment in accordance with these reasons for judgment. The plaintiff being only partially successful on its appeal, there will be no order as to costs.
Appeal allowed in part.
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