McCutcheon Farms Limited v. Her Majesty The Queen, 91 DTC 5047, [1991] 1 CTC 50 (FCTD)

Strayer, J.:—

Relief Requested

The plaintiff appeals, in respect of taxation years 1981, 1982, 1983 the reassessments of the Minister of National Revenue in which he reassessed certain interest income of the plaintiff as Canadian investment income. The plaintiff seeks a judgment of this Court referring such reassessments back to the Minister with the direction that the amounts in question be reassessed as active business income of the plaintiff.

Facts

To understand the significance of the facts it is important first to set out the relevant statutory provisions. Section 125 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") provides for a “small business deduction” in the rate of taxation from the "active business income” of such a corporation. Paragraph 125(6)(d) defines “active business” and it is not disputed in this case that the plaintiff, in respect of its actual farming and "agribusiness" (the sale and cleaning of seed grain, and the sale of farm chemicals) is engaged in an active business. Paragraph 125(6)(e) defines "income . . . from an active business” as follows:

125. (6)(e) “income of the corporation for the year from an active business” means the income of the corporation from an active business carried on by it, including any income pertaining to or incident to that business and amounts deemed by subsection 129(6) to be income from an active business, but does not include income for the year from a source in Canada that is a property (within the meaning assigned by subsection 129(4.1)) ;

[Emphasis added.)

It will be noted that income from certain property as referred to in subsection 129(4.1), which provides a partial definition of "Canadian investment income”, is not to be treated as income from an active business. Subsection 129(4.1) provides as follows:

129. (4.1) For the purposes of paragraph (4)(a) and subsection (6), "income" or "loss'* of a corporation for a year from a source in Canada that is a property includes the income or loss from a specified investment business carried on by it in Canada other than income or loss from a source outside Canada but does not include income or loss

(a) from any other business,

(b) from any property that is incident to or pertains to an active business or a non-qualifying business carried on by it, or

(c) from any property used or held principally for the purpose of gaining or producing income from an active business or a non-qualitying business carried on by it.

[Emphasis added.)

Paragraphs 129(4.1)(b) and (c) thus describe certain exceptions to the general principle that income from property is investment income. Thus if one can ring the income in question here within the general definition of income from an active business in paragraph 125(6)(e) “including any income pertaining to or incident to that business . . .” and within either of paragraphs 129(4.1)(b) or (c) then such income will be treated as income from an active business and not “Canadian investment income”. The significance of this distinction for the plaintiff is set out in the brief of its counsel as follows and is not disputed by the defendant.

The context of the specific issue in the present case is the interrelationship of Sections 125 and 129 of the Act, the former permitting a deduction from tax otherwise payable on income from an active business carried on by a Canadian- controlled private corporation to a specific amount of income and income over that specific amount being taxed at the full rate (i.e. $150,000.00 until 1982 and $200,000.00 thereafter) and the latter enabling a private company that has paid income tax at the full corporate rate on Canadian investment income to recover a portion of that tax by virtue of the payment of taxable dividends to its shareholders. The structure of Sections 125 and 129 requires a distinction to be drawn between two general sources of income—income from an active business and income from property.

The reassessments in question have already been unsuccessfully appealed to the Tax Court of Canada, the appeal having been dismissed in a judgment of Sarchuk, T.C.J. of February 22, 1988 [[1988] 1 C.T.C. 2349; 88 D.T.C. 1208]. The evidence before me was generally consistent with his findings of fact and I shall not dwell on the facts in detail. The president of the plaintiff, and its guiding mind, is Orville Allan McCutcheon. He has been farming since 1940 and in 1976 he, with his family, incorporated the farm. He turned over certain assets to the corporation as a shareholder's loan. The corporation owns no land, renting part of it from Mr. McCutcheon and part from others. It is obvious that the farm has been very successful. Apart from growing and selling grain in the usual manner, the corporation carries on various associated forms of business. It produces and sells certified seed; does "custom" cleaning of seed for farmers; and sells fertilizers and chemicals, most of these being supplied by the Cargill Company and by Cominco.

The interest income in question during the relevant taxation years arose out of three sources. The plaintiff kept on demand deposit with the Cargill Company substantial sums of money, starting with $117,000 provided by Mr. McCutcheon at the time of incorporation. By 1982 this had grown to some $245,000 and Cargill declined to keep such large sums. It paid to the plaintiff all amounts over $100,000 which the plaintiff then deposited with the Saskatchewan Wheat Pool in a similar demand deposit. The interest earned from each of these deposit accounts was automatically redeposited with these respective companies and in turn earned more interest. The evidence is that neither of these accounts, nor the interest therefrom, have ever actually been drawn from for the farm or business operations. The other source of the contested interest income was, during the years in question, term deposits with the Canadian Imperial Bank of Commerce in Saskatoon. These have been generally short-term deposits, most of them for 60 days or less and only one for as long as 180 days. The interest earned from these term deposits was paid into the plaintiff corporation's current account at the bank from which operating expenses were paid. It is also true that certain amounts surplus to current needs have been drawn from the current account from time to time and put into further term deposits. On only one occasion has any principal amount been withdrawn from the term deposits to meet farming and business expenses and that was the sum of $20,000, drawn out in 1977 well before the taxation years in question. The evidence indicated that only $14,000 of this was spent on operating expenses.

The general magnitude of these capital sums can be seen in the following table which also shows the interest income in each of the years in question as compared to the gross income from the farm and business and the relationship which the interest income bore to the gross income. As I understand it, the “ Cash Holdings” item includes the amounts held in the demand deposits at Cargill and the Saskatchewan Wheat Pool, as well as the current operating account at the Canadian Imperial Bank of Commerce.

The evidence indicates that interest rates earned generally followed money market changes.

It appears to me that if this interest income can be brought within paragraph 129(4.1)(b) as being from property ” that is incident to or pertains to an active business” then it would also meet the general definition of income from an active business set out in paragraph 125(6)(e) as "income pertaining to or incident to that business . . .”. There have been several decisions of the Tax Court of Canada in respect of the meaning of paragraph 129(4.1)(b) since its adoption in 1979 (S.C. 1979, c. 5). I am advised by counsel that several such decisions are on appeal to this Court but no such appeals have yet been decided. In my respectful view, the paragraph 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 incomeproducing 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.

Counsel have not relied on recent jurisprudence with respect to the meaning of paragraph 129(4.1)(c) also added in 1979. It appears to be common ground, however, that the approach to this paragraph should be similar to that employed in interpreting former paragraph 129(4)(a) where there was excluded, from "Canadian investment income”, income from a property used or held by the corporation in the year in the course of carrying on a business". In the decision of the Federal Court of Appeal in The Queen v. Marsh & McLennan, Ltd., [1983] C.T.C. 231; 83 D.T.C. 5180 at 243 (D.T.C. 5190) Le Dain, J., in referring to a fund of an insurance broker into which there were paid premiums received from insured parties and out of which the broker paid the company, the broker earning interest in the meantime on surplus amounts in the fund not yet due to the insurer, applied the following as the proper test under subparagraph 129(4) (a) (ii): ”. . _. was the fund employed and risked in the business?” [Emphasis added.] He held that it was because an amount equivalent to the fund “was committed to the carrying on of the business in order to meet the company's obligations to the insurers". This test was approved by Wilson, J. writing for the majority of the Supreme Court of Canada in Ensite Ltd. v. The Queen, [1986] 2 C.T.C. 459; 86 D.T.C. 6521. In elaborating on the test of" risk" and on this test generally, she said (at page 464-65 (D.T.C. 6525-26)):

But” risked” means more than a remote risk. A business purpose for the use of the property is not enough. The threshold of the test is met when the withdrawal of the property would “have a decidedly destabilizing effect on the corporate operations themselves”: March Shipping Ltd. v. M.N.R., supra, at 2531 (D.T.C. 374). This would distinguish the investment of profits from trade in order to achieve some collateral purpose such as the replacement of a capital asset in the long term (see, for example, Bank Line Ltd. v. Commissioner of Inland Revenue (1974), 49 T.C. 307 (Scot. Ct. of Session) from an investment made in order to fulfil a mandatory condition precedent to trade (see, for example, Liverpool and London and Globe Insurance Co. v. Bennett, [1913] A.C. 610 (H.L.) and Owen v. Sassoon (1951), 32 T.C. 101 (Eng. H.C.J.). Only in the latter case would the withdrawal of the property from that use significantly affect the operation of the business. The same can be said for a condition that is not mandatory but is nevertheless vitally associated with that trade such as the need to meet certain recurring claims from that trade: see, for example, The Queen v. Marsh & McLennan, Ltd., supra, and The Queen v. Brown Boveri Howden Inc., [1983] C.T.C. 301; 83 D.T.C. 5319 (F.C.A.).

It is true that in this case the taxpayer could have done business and fulfilled the Philippine requirement that foreign currency be brought into the country by a means not involving the use of property. It could have borrowed the U.S. currency abroad and brought it into the Philippines. But this consideration is irrelevant to our inquiry. The test is not whether the taxpayer was forced to use a particular property to do business; the test is whether the property was used to fulfil a requirement which had to be met in order to do business. Such property is then truly employed and risked in the business.

With these tests in mind I shall deal briefly with the various claims of the plaintiff that the income in question was from property that is incident to or pertains to an active business" or is" used or held principally for the purpose of gaining or producing income from an active business”.

It was contended that these large capital sums are required by the plaintiff in case of emergencies or crop failures—failures which would not only drastically reduce or eliminate farm income but would badly affect sales of seed grain, fertilizer, and chemicals. But the evidence indicates that these capital sums were not drawn on for such purposes, not just in the years in question but never since the incorporation of the farm in 1976. While both the evidence and common knowledge indicate that there are many risks in farming, the risk that sums in the amount of the principal sums in question here would be required must, in the absence of more precise evidence, be regarded as "remote" and this, according to the Ensite decision, is not sufficient. One can readily understand, and admire, the position taken by Mr. McCutcheon, the president of the plaintiff company, that he would not want to farm without cash reserves, having seen many farm failures in the past by those who had inadequate reserves. But there is a basic problem in that the plaintiff has not shown clearly what would be a reasonable reserve nor does the evidence indicate any rational relationship between the principal sums accumulated and the reserves required. Mr. McCutcheon spoke of wanting the equivalent of two years' expenses available in cash reserves. But the principal sums in question here have simply been allowed to grow by reinvestment of interest and by transfers from the current account without any indication of a rational plan or any evidence that such a plan was being followed. (See, e.g., Newton Ready-Mix Ltd. v. M.N.R., [1989] 2 C.T.C. 2369; 89 D.T.C. 595 at 2375 (D.T.C. 599) (T.C.C.).)

It was argued that the plaintiff carried no insurance of any kind during the years in question either on buildings, crops, or equipment and therefore required these large capital sums as a form of "self-insurance". But the day-to- day operations of the business would not be dependent on the existence of such a fund nor, indeed, would the corporation necessarily draw on the fund in case of loss. There is no evidence, not only in respect of the three years in question, but over the whole period since the plaintiff was incorporated in 1976, that these principal amounts have ever been drawn on to pay for any loss by hail, or even theft, for example. The prospect of a widespread disaster to a value represented by these capital amounts again must be regarded as remote. The investment of surplus funds in these interest-bearing deposits is no different from any other investment the corporation might make in order to ensure that it was solvent enough, in the face of some disaster, to either resume this business or undertake some other business.

It was suggested that such capital sums were required to establish a proper credit rating with Cargill and Cominco, wholesale suppliers of chemicals and fertilizers to the plaintiff. But there was little evidence to indicate what the credit requirements of these companies are and certainly nothing to suggest that they required liquidity in the order of several hundred thousand dollars. The evidence indicated that the plaintiff's credit limit with Cargill was $30,000, an amount which has obviously allowed the plaintiff to carry on its fertilizer and chemical business without difficulty. Assuming Cargill would want to be assured of liquid assets held by the plaintiff in this amount, this has no relationship to the principal sums actually held.

Again it was argued that this interest income was important to the overall profitability of the company. It will be noted in the table quoted above that interest income ranged from 15.92 per cent to 20.10 per cent of the gross income of the company and over 50 per cent of the net income before its taxes. But the more critical question is, was this income somehow necessary to the farming and agribusiness? It is clear that they would have been profitable without the income. It is also true that, with the exception of the interest income from term deposits which was paid into the company's current account, the money was not employed in the business in any way. If the interest from the term deposits had simply been automatically accumulated in more term deposits the company could still have met its expenses and produced a profit. Further, there is evidence that from time to time surplus funds were drawn from the current account to augment the term deposits. As was pointed out in the case of Ben Barbary Co. v. M.N.R., [1989] 1 C.T.C. 2364; 89 D.T.C. 242 (T.C.C.) such income and the asset from which it is earned is no different from any other investment which the taxpayer might make even if it chose to use the income from such investment to help support its business. This does not make the capital asset" incident to or pertain to” the business. Nor in my view does it make it properly “used . . . principally for the purpose of . . . producing income from an active business".

It was suggested that the capital sums might have to be used from time to time to pay expenses. As noted earlier, there is only one instance of this having happened, and that was in 1977 when $20,000 was withdrawn from term deposits of which $14,000 was actually used for expenses. In fact, the only formal arrangement with the bank, in case of overdrafts on the current account from which operating expenses were paid, was that the bank could automatically have recourse to Mr. McCutcheon's personal account. There might well be some justification for having liquid assets such as a portion of the term deposits available to cover short-term cash shortages. But it is difficult to see that in these particular facts there was a relationship of financial dependence on them "of some substance" as referred to in the Atlas Industries Ltd. case, supra. As was said in that case, the relationship between the term deposits and the appellant's businesses "was tangential at best". Or in the language of Ensite, supra, the risk of such sums being needed was "remote". If some reasonable amount of reserves was in fact required, this amount was not demonstrated by the evidence.

It was argued that such liquid sums were required to provide for replacement of what is undoubtedly very expensive farm machinery. Yet again there is no evidence that any of these capital sums were ever resorted to for such purpose. In the Ensite case Wilson, J. said that a" business purpose for the use of property" is not enough and regarded profits held by a business ”. . . in order to achieve some collateral purpose such as the replacement of a capital asset in the long term . . .” as not being "employed or risked in the business" and therefore not“ "properly used or held . . . in the course of carrying on a business”.

Finally, it was argued that these large capital sums were required in order for the plaintiff to be in a position to purchase land and pay all or substantial amounts of the purchase price in cash. First, it should be observed that since 1976 down to the present the corporation has never bought any additional land and although it has made a few offers none of these have been accepted. Secondly, I do not accept that money accumulated to expand a business, if that was really in contemplation here, creates any“ financial relationship of dependence" (Atlas Industries, page 2404 (D.T.C. 1764-65)) between that sum and the existing business or that it involves money "employed" or "risked" (Ensite, pages 464-65 (D.T.C. 6525-26)) in the existing business.

Looking at all of these putative purposes of the liquid capital sums involved, I cannot find a “financial relationship of dependence of some substance” between those sums and the ongoing existing business. The money was generated by the business but it was not, in the years in question, employed in the business except in a limited way through the use of term deposit earnings for current expenses. As noted, this was not a one-way street, as surplus funds from the current account were also used to purchase term deposits from time to time. The possibilities of these funds being drawn upon to sustain the business in any important way was remote and in fact did not happen during the years in question. I therefore do not think that these capital sums can be seen as "property that is incident to or pertains to an active business” within the meaning of paragraph 129(4.1)(b). Using the tests employed respectively in analogous provisions under consideration in cases such as Ensite, I am unable to conclude that these sums amounted to "property used or held principally for the purpose of gaining or producing income" from the business, as referred to in paragraph 129(4.1)(c). These sums were not truly " employed and risked" in the business. One test referred to in the Ensite case was to consider whether the withdrawal of the property would have a "decidedly destabilizing effect" on the business (pages 464-65 (D.T.C. 6525-26)). Looking at all the facts, I am unable to conclude that such withdrawal would have that effect.

Counsel for the plaintiff invited me to consider in the alternative, if I was not prepared to direct that all of this income be regarded as coming from property which is incident to the business or held principally for the purpose of the business, to conclude that certain of the funds in question were of this nature and others were not. From what I have said, it is clear that I am unable to make such a distinction because I do not find that any of the capital sums were truly committed to the business and necessary to its good operation. It should also be noted that the burden is always on the taxpayer to show that the assessment is wrong and it would have been open to the taxpayer to produce much more precise evidence as to the extent of liquid capital reserves which the business could reasonably be said to require and upon which the business was financially dependent. That has not been done.

I am therefore dismissing the appeal with costs.

Appeal dismissed.