Stowe-Woodward Inc. v. The Queen, 92 DTC 6149, [1992] 1 CTC 209 (FCTD)

Dubé, J.:—The issue to be resolved in these three actions heard together is whether or not the plaintiff was manufacturing or processing goods for sale under section 127 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") during the taxation years 1984, 1985 and 1986.

The plaintiff is a British Columbia company with head office at Surrey, B.C. and plants located at Surrey, B.C., North Bay, Ontario and Sherbrooke, Quebec. Its operations consist mainly of the application of rubber covers to roll cores, mostly from mills in the pulp and paper industry. The defendant admits that the plaintiff does manufacture or process but denies that it manufactures or processes goods for sale.

At the request of the parties, the Court agreed to visit the plant at Surrey accompanied by the solicitors for both parties, the president of the plaintiff who also is the manager at Surrey, Mr. Stuart Harrowing, and the court registrar, for the purpose of inspecting the operations carried out on the premises. In the course of the hearing the plaintiff also showed a video of these operations.

At the plant, the storage room contains the material and all the ingredients necessary for the preparation of rubber covers. The basic material consists of raw rubber imported from Malaysia and synthetic rubber from the United States. There are various other materials and chemicals, mostly originating from the United States, which are stored in crates, barrels, bags and bales on metal pallets. A highly trained operator selects the proper chemicals in accordance with rigid specifications. The chemicals are weighed carefully on electronic scales and placed into bags, then assembled in a mixing tub. Different liquids are added to the mix. The tub is then moved under a mixer called the Schold Mixer, the lid is closed, and the batch of prepared formula is mixed and brought to the open mill.

The open mill consists of two steel rollers which counter-rotate to break down the chunks of raw rubber put in it to form what is known as a“ pig” of rubber. Through mastification from the rollers, the rubber is turned into a smooth, plastic, pliable band of material around the faster rotating roller. The mixed chemicals are then poured onto the rubber in the open mill according to strict production specifications. The chemicals physically blend with the rubber.

The rubber is then removed from the mixer with a mill knife and stored overnight on "cooling racks". At that point a sample is taken from the material as a quality control measure. The material produced at that stage is called "green material”. It is usually in a slab form. This green material, if not used the next day in the preparation of the rubber cover, is placed in storage and may last some four to six months.

However, since the rubber covers are made as a result of specific orders from customers and the green material is made to specifications for that order, there is no inventory of green material, except for very few occasions where an order has been cancelled. The sole instance of cancellation described by Mr. Harrowing happened when MacMillan Bloedel cancelled an order but paid for the material and labour involved up to that stage. As it turned out, not long after, MacMillan Bloedel placed another order for the same type of cover and the plaintiff was able to use that particular slab of green material. From time to time customers also request green material, or "repair kits", from the plaintiff so as to repair tears in their roll covers themselves.

As we saw at the plant and on the video, the slabs of rubber or green material are then placed on another open mill where rotating cutting knives are lowered against the slab so as to produce strips of rubber four inches wide and three-eighths of an inch thick. The strips are bathed into a dip tank containing an anti-stick agent. The strip is taken out of the tank onto a perforated conveyor where air jets remove any excess agent and dry the surface.

These strips are then festooned into a basket and wheeled to a machine called an extruder. The strips travel down the length of the barrel of the extruder through various areas of temperature. They are pushed through a die and come out in the form of a very smooth plastic strip. The strip follows a series of dancing rollers and is applied to the roll core of the customer. The roll core is rotated on a lathe while the material is applied to it. Once the rubber coating has been applied to the roll it is wheeled into a vulcanizer.

The vulcanizing period may last up to 24 hours. Thereafter the roll is cooled to room temperature. After vulcanizing the enrobed roll is machined off through a process known as rough grind". A crown may also be ground onto the roll where that type of covering has been ordered instead of a flat surface. A covered roll may also go through a drilling machine, when requested, to permit the vacuuming out of the water at the customer's mill.

The roll is then wrapped in a protective paper, crated and placed on board a carrier for transportation back to the customer's plant.

At the outset, the normal procedure after the plaintiff has received an order from a customer is to discuss the specifications of the roll and the type of cover requested. There are several cover options carrying trade names, each with its own specifications. The trademarks are the property of the plaintiffs parent company in the United States, S.W. Industries Inc., and the plaintiff operates under a licence agreement dated January 1, 1972. After the proper selection of cover is made, the plaintiff quotes the price and delivery date. The price varies between $50,000 and $120,000 per cover according to the size of the roll and the quality of the cover requested. The price is obtained from a fixed price list and the invoices rendered by the plaintiff show that 67 per cent of the total price relates to material and 33 per cent to labour. This is done to satisfy certain exemption requirements set out in the Excise Tax Act.

The roll core sent by the customer to the plaintiff may be entirely new or be a used core with some used rubber still in place. In the latter case, the old cover is stripped off the roll by the plaintiff. The roll core is then grit blasted with a material called zirconium aluminate to bring the core to the appropriate surface profile so as to ensure proper chemical or mechanical bonding. The roll core is then moved to a lathe at right angles to the extruder described above, and special adhesives are applied to it before the strip of rubber emanating from the extruder is wrapped around it.

According to the evidence of Mr. Harrowing, who was the sole witness for the plaintiff, an average operation lasts about 11 hours. It takes about five hours for an employee to perform the functions up to the extrusion stage, that is, up to the creation of the green material; one hour for extrusion, and five hours after the extrusion stage to the completion of the operation.

It should be noted that the plaintiff is licensed as a manufacturer or producer of goods for sale for purposes of the Excise Tax Act. The plaintiff purchases goods on a tax-exempt basis and charges customers no federal sales tax if an exemption is available. Such exemptions are quite common. The invoices of the plaintiff to the customer then reflect that no federal sales tax is payable.

It should also be noted that Revenue Canada audits carried out in 1984 relating to the 1979-1982 taxation years of the plaintiff accepted the entitlement of the plaintiff to the tax incentives in issue in the instant action. Yet, the plaintiff was carrying on the same processes in its operations at that time as it did for the 1984-1986 taxation years. For the taxation years now in question the Minister came to the opposite conclusion.

The amounts involved for each of the three taxation years in question are agreed to. The sole issue to be determined is whether or not the taxpayer was manufacturing or processing goods for sale.

I now turn to the jurisprudence in the matter. In the most recent decision in such a manufacturing and processing case, Rolls-Royce (Canada) Ltd. v. Canada, [1991] 2 C.T.C. 252, 91 D.T.C. 5579, my former colleague Martin, J. dealt with the case of a taxpayer who overhauled and re-certified aircraft engines. He found that there are two lines of authority in these taxation cases at page 255 (D.T.C. 5581):

In taxation cases of this sort there are two lines of authority. One line, Halliburton Services Ltd. v. The Queen, [1985] 2 C.T.C. 52, 85 D.T.C. 5336 (F.C.T.D.); [1990] 1 C.T.C. 427, 90 D.T.C. 6320 (F.C.A.) and Nowsco Well Service Ltd. v. The Queen, [1988] 2 C.T.C. 24, 88 D.T.C. 6300 (F.C.T.D.); [1990] 1 C.T.C. 416, 90 D.T.C. 6312 (F.C.A.) which appear to favour the plaintiff’s case, and the other line of cases represented by Crown Tire Service Ltd. v. The Queen, [1983] C.T.C. 412, 83 D.T.C. 5426 (F.C.T.D.), Tenneco Canada Inc. v. The Queen, [1987] 2 C.T.C. 231, 87 D.T.C. 5434 (F.C.T.D.) and Reg Rad Tech Ltd. v. Canada, [1990] 2 C.T.C. 77, 90 D.T.C. 6350 (F.C.T.D.); [1991] 2 C.T.C. 201, 91 D.T.C. 5518 which appear to favour the defendant's case.

He extracted the guiding principles from each line of authority and applied them to the facts of the case before him. That is precisely what I propose to do in this instance.

In Crown Tire, the taxpayer was engaged in the tire re-treading business. The old tread of the tire would be stripped off, leaving a casing; a new tread would be applied and secured and the tire would then be returned to the customer. Strayer, J. found that the taxpayer was notengaged in the manufacturing or processing of goods for sale. The contracts were for work and materials and since the taxpayer did not establish that the retreading of casings of its own tires amounted to more than ten per cent of its business, the Minister's assessment was upheld. The learned judge referred to Benjamin's Sale of Goods to distinguish between a contract of sale of goods and a contract for work and material: where work is done on the chattel of another involving the use of affixing materials, the contract will ordinarily be one for work and materials, the property passing from one to the other "by accession and not under any contract of sale".

The Tenneco decision was a decision of mine released in 1987. Tenneco was in the business of installing mufflers on automobiles. I held that it did not manufacture goods for sale; it merely installed on cars goods already manufactured elsewhere. I referred to Crown Tire and to Halliburton as well but felt that Crown Tire better applied to the facts of the case then before me.

On March 21, 1991, the Federal Court of Appeal confirmed my decision in Tenneco [at [1991] 1 C.T.C. 323, 91 D.T.C. 5207]. Linden, J.A. referred to the Federal Court of Appeal's decision in Halliburton but did not state that Crown Tire was bad law. On the contrary, it confirmed mine which relied largely on it. In Reg Rad Tech my colleague Collier, J. held that the substance of the taxpayer's business was providing services to patients in processing x-ray films for medical partnerships. The sale of developed films was only a minor step in this process. My colleague relied heavily on a previous decision of McNair, J. of this Court in Dixie X-Ray Associates Ltd. v. The Queen, [1988] 1 C.T.C. 69, 88 D.T.C. 6076, and reported this key paragraph of his decision at page 74 (D.T.C. 6079):

The test for determining whether a contract is one for the sale of goods or for the supply of services is to ask the question: What is the substance of the contract? If the substance of the contract is the production of something to be sold and the transference of property therein to a buyer then the contract is a sale of goods. But if the real substance of the contract is the skill and labour of the supplier in the performance of work for another then that is a contract for work and labour, notwithstanding that property in some materials may pass under the contract as accessory thereto. See Atiyah, The Sale of Goods, 7th ed., pp. 23-24; Robinson v. Graves, [1935] 1 K.B. 579 (C.A.) per Greer, L.J., at page 587; and Sterling Engine Works v. Red Deer Ltd. (1920), 51 D.L.R. 509 (Man. C.A.).

Judge Collier's decision was confirmed by the Federal Court of Appeal on September 4, 1991. Marceau, J., speaking for the Court, said that the case was "quite unlike the situations in Halliburton and Nowsco Well Service where the production and eventual sale of the product was found to be the dominant feature of company activity."

As to the other line of cases, also known as the "oil well cases", the Federal Court of Appeal decisions in Nowsco and Halliburton were both released on April 10, 1990 and were written by Urie, J.A. The two decisions favoured the taxpayer. The facts are similar in both cases and the substantial judgment was rendered in Nowsco. The learned judge reviewed the cases I have already mentioned as well as others and found each to be quite distinguishable on its facts.

Urie, J. preferred the reasoning of Reed, J. of the Trial Division in Halliburton and quoted her extensively. The taxpayer in Halliburton was engaged in the business of oil well servicing and its activities included the preparation and pumping into well sites of special mixtures of cement. These materials were used to facilitate the extraction of oil. Reed, J. found it inappropriate to adopt a fragmented view that, when the blending has been completed there is a finished good, and that pumping constitutes the delivery of a finished good which would not be manufacturing or processing. Cullen, J. found in Nowsco that the taxpayer's activities constituted a continuous process, and all aspects of it, including the blending, mixing, pressurizing and pumping, were one and the same process. In confirming Nowsco Urie, J.A. reproduced several paragraphs from Reed, J.'s decision in Halliburton at pages 421-22 (D.T.C. 6316-17) which may be of assistance in the instant case.

The activities in issue are all ones in which the plaintiff produces a specialized product for its customers as well as providing certain services connected therewith. These activities are (1) oil and gas well cementing activities; (2) a fracturing process which involves the pumping of a specialized fluid into an oil or gas well, and (3) an acidizing process which involves the pumping of a specially prepared acid blend into a well. The plaintiff's position is that with respect to all three activities, while a service may be provided, it is also involved in the manufacture or processing of goods for sale as that concept is used in paragraph 125.1 (3)(b) of the Income Tax Act.

The defendant does not dispute the fact that in all three activities there is processing carried out. Nor does she dispute the fact that"goods" are produced. What is disputed, however, is that there is a“ sale of a good". It is argued that the plaintiff's main activity is the provision of services and that the production of "goods" in connection therewith is only incidental to the service being provided. Therefore, it is argued there can be no“ manufacturing or processing of goods for sale” as that concept is used in paragraph 125.1(3)(b) of the Income Tax Act.

This argument is based on the well known distinction between contracts for the sale of goods and contracts for work, labour and materials, developed with respect to sales of goods legislation.

I have considerable difficulty with this line of argument. In the first place, it is based on distinctions developed for purposes of the sale of goods legislation, not with respect to paragraph 125.1 (3)(b) of the Income Tax Act.

Secondly, I do not find any requirement that the contract which gives rise to the taxpayer's profit must be of a particular nature, e.g.: one for the sale of goods and not one of a more extensive nature involving work and labour as well as the goods or material supplied. In my view it is the source of the profit, (arising out of process) that is important for the purposes of paragraph 125.1(3)(b), not the nature of the taxpayer's contract with its customers.

In the third place, to adopt the distinction for which the defendant argues would be to create an illogical result. As counsel for the plaintiff pointed out, under such a regime, a manufacturer or processor of a product (e.g., a chemical fertilizer) who also provided a service in connection therewith (e.g., spreading the fertilizer for his customers) would be denied the processing tax deduction. If he merely sold the product to his customers he would be allowed the deduction.

Urie, J.A. wholly subscribed to the arguments of Reed, J. and added his own analysis as follows at pages 423-24 (D.T.C. 6317-18):

First, as earlier noted, the respondent, in consultation with the operator, its customer, prepares a treatment proposal. According to the evidence, it is the operator who is familiar with the formation through which the drill hole is bored as well as that from which he hopes to extract the oil or gas. Consequently, he must decide on the type of cement slurry required and the stimulation most likely to assist in the extraction, relying on the advice of the respondent in each case as to the proper products to be used to achieve the best results, the equipment to be used and the pressures and rates utilized for the best results. In all cases it is the customer who must ultimately make the decisions on each branch of the proposal.

Secondly, as I understand the evidence, after the proposal as amended is accepted, the respondent proceeds to the well site with its equipment to carry out its proposal which involves, on a carefully orchestrated and integrated basis, the mixing, blending, pressuring and pumping of the various materials, additives, acids, proppants and gases required in cementing and well stimulation.

Thirdly, the form of invoice rendered clearly indicates that the customer is billed for both the materials which it provides in accordance with the customer's specifications and the services it performs in utilizing those materials to achieve the stimulation or cementing results required by the customer. Even a rather cursory inspection of the various invoices in the record, apparently selected and entered in evidence on a random basis, indicates that in dollar amounts the division between materials and services is roughly fifty-fifty.

Fourthly, while the evidence is somewhat sparse there is on the record evidence of an element of profit to the respondent in the sale of its material which on a gross profit basis, (which is the only basis disclosed) is roughly equivalent to the gross profit derived from it by the supply and rental of its equipment.

Consequently, I must be guided by the criteria emanating from the two lines of jurisdiction and apply them to the facts of the instant case. In Tenneco, there was no manufacturing or processing as the mufflers were merely purchased by the taxpayer and attached to the automobiles at the premises of the taxpayer. Obviously, there is manufacturing and processing in the instant case, as admitted by the defendant. In Crown Tire Strayer, J. found that there was processing and manufacturing at the taxpayer's plant but held that the taxpayer did not produce goods for sale. He relied largely on Benjamin's Sale of Goods to the effect that affixing of materials to the purchaser's property means that "the contract will ordinarily be one for work and materials". My two colleagues in the Trial Division in Nowsco and Halliburton came to a different decision on the facts of the cases before them. Their decisions were confirmed by the Federal Court of Appeal. One must bear in mind that Benjamin said that contracts for affixing of materials to customer's property will "ordinarily" be contracts for work and materials, implying there are exceptions to that general rule.

In the Rolls-Royce decision, Martin, J. found that a contract for overhauling aircraft engines did not fall within the exception. That contract was mostly for repairs, not unlike the facts in Crown Tire, which he followed. The Rolls-Royce contract did not involve the creation of a product or of any goods antecedent to their injection into the airplane engines.

In my view, the plaintiff in the instant case is not in the repair business and does not provide repair services. The plaintiff does not repair, but replaces covers. In a 1991 decision of the Supreme Court of Newfoundland, Corner Brook Pulp v. Newfoundland (yet unpublished, released April 3, 1991) Soper, J. had to deal with" roll recovering" in a pulp and paper mill with reference to the provincial Retail Sales Tax Act. The following two paragraphs (at page 3) under the heading “ Roll Recovering Expenses" bear reproduction.

One stage of the paper making process uses large, steel roll [sic] which are covered with material. That material is subject to and may be replaced. In the replacement process the material removed [sic], the roll is cleaned and made ready to be covered again. The work which is done on the steel rolls is done simply to remove all traces of the old material. In other words, the material is replaced, not repaired. That is critical to the outcome if we consider the roll and the covering as being distinct from each other but they cannot be. They are two parts of one unit and must be considered from that point of view. Can the replacement of the covering be regarded as repair of the unit? The Oxford English Dictionary has one definition of "repair" which may be considered:

To restore to good condition by renewal or replacement of decayed or damaged parts.

There is no doubt that the covering of the steel rolls is replaced but the recovering has to be replaced because it is worn, not because it is "decayed" or “ damaged”.

[Emphasis added.]

As Cullen, J. said in Nowsco at page 39 (D.T.C. 6311), the Court must adopt a “business-like common sense approach to the determination of the question rather than a theoretical one.” He indicated that the mixing and blending aspects of the taxpayer's activities were not separate and distinct from the pressurizing and pumping aspect into the well. His remarks, in my view, are even more appropriate in the instant case where all the operations constitute a continuum and are completed on the taxpayer's premises. There is, of course, an element of service in the sense that the new cover is placed on the roll by the manufacturer, but the bulk of the activities and the substance of the manufacturing and processing take place before the cover is applied to the roll core.

As well as in the oil well cases, this taxpayer has created a product, namely the green material, before any services are rendered to the customer. There can be no doubt that the green material has been manufactured and processed in a continuous operation to the point where it is applied to the roll core of the customer through the extruder. That material is as much a good for sale as the cement slurry in the oil well cases.

In Nowsco, as mentioned earlier, Urie, J.A. adopted a common sense approach to come to the conclusion that the taxpayer does not enter into a pure service contract", but rather processes goods to the customer's specifications. He believed "that determining the particular time at which and where title to the goods passes is of little importance". However, he found it to be of some significance that "the products furnished are produced to the particular specifications of the operator-customer and must be paid for by it whether completely used or not" (Nowsco at page 424 (D.T.C. 6318)).

In reality, what must be determined is the substance of the contract. Most manufacturing and processing contracts involve equipment and labour. Where these elements are brought together to produce "something", and that something is sold, the contract is in the nature of a contract of sale of goods. However, where the taxpayer is hired mostly for his skills in operating or repairing his customer's property, then the contract may be one for services. Obviously, in the case at bar, the taxpayer does more than rent his services. It manufactures a specialized product with its expensive and highly sophisticated machinery, then delivers that good by applying it to the customer's roll. This taxpayer is the licensee of various roll cover trademarks and is the sole manufacturer in Canada authorized to produce those goods. True, it does service the goods, but its customers may buy the green material if they wish, and they do so, albeit only for repairs.

The primary object of the contracts between the plaintiff and its customers is for the transfer of property in something. The customers send in purchase orders requesting roll covers of a certain type and quality, roll covers designed to their specifications. In return, they receive roll covers for which they pay according to a flat list price. Customers are not billed for the provision of services. The taxpayer does not even maintain a record of the labour involved on each cover sold. Again, the roll covers are not repaired at the plaintiff's plant, they are replaced.

Summing up, the activities of the plaintiff do not differ materially from those undertaken by the taxpayers in Halliburton and Nowsco. In the oil well cases, the taxpayer produced a cement lurry” as its "good". The slurry is a mixture of water, dry cement and various additives. The mixing is done in a portable mixer at a well site. The plaintiff, in this case, produces a very sophisticated good which it alone may produce in Canada, the“ green material", and does so at its own factory. In both operations, the mixing and blending require complex and precise specifications. In one instance, the good is delivered at the well, whereas in the instant case, the rubber cover is wrapped directly on the customer's roll at the plaintiff's premises.

Consequently, I find that the plaintiff is involved in the manufacturing and processing of goods for sale, and is therefore entitled to a trilogy of tax incentives, that is the manufacturing and processing tax credit under section 125.1; the investment tax credit under subsection 127(5); and capital cost allowance under paragraph 20(1)(a) of the Income Tax Act. There is no dispute as to the amounts resulting from these three incentives.

Judgment in favour of the plaintiff, with costs.

Appeal allowed.