Reg Rad Tech Ltd. v. The Queen, 90 DTC 6350, [1990] 2 CTC 77 (FCTD), aff'd 91 D.T.C 5518 (FCA)

Collier, J.:—The plaintiff is a Saskatchewan corporation and carries on business in that province. It appeals reassessments, by the Minister of National Revenue, of its income for the 1982, 1983, 1984, and 1985 taxation years. In its returns for those years, the plaintiff had claimed:

(a) a manufacturing and processing tax credit pursuant to section 125.1 of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended.

(b) investment tax credits, pursuant to subsection 127(5) of the Act.

(c) capital cost allowance on assets categorized as Class 29 depreciable property—manufacturing and processing assets.

The Minister disallowed those claimed deductions. It was the Minister's view the plaintiff was not engaged in the manufacturing or processing of goods for sale; that the plaintiff was providing services to a partnership. The dispute will become clearer when the facts are developed.

At the material times, there were a number of radiologists practising together in partnership in Regina under the name Radiology Associates. The plaintiff company was originally incorporated in 1976, under the name Regrad Management Ltd. It was inactive until 1979. Prior to 1979, the partnership owned all the equipment used in the practice of radiology and employed all the employees. In 1979, the equipment was transferred from the partnership to the company, and the partnership's employees (technologists) became employees of the company. The company provided management and other services, and leased the radiological equipment back to the partnership. The company was owned indirectly by the five original partners and their holding companies. The 1979 arrangement (see Exhibits 1 and 2) was adopted to make admittance of new partners to the partnership easier; to cut down the initial capital contributions required under the previous arrangement.

In 1981 another change, described by plaintiff's counsel as “fundamental”, was made.

The company's name was changed to Reg Rad Tech Ltd. An agreement was entered into between the company and the partnership (Exhibit 4). The essential provisions of this contract are as follows:

WHEREAS Radiology Associates is a partnership of medical doctors carrying on the practice of radiology, and for the purpose of such practice, wish to enter into an Agreement with Tech for the supply of processed radiographic film;

AND WHEREAS Tech has the equipment and facilities necessary for the supply of such processed radiographic film as may be required by Radiology Associates from time to time;

NOW THEREFORE THIS AGREEMENT WITNESSETH that in consideration of the covenants and agreements hereinafter contained, the parties hereto hereby agree as follows:

1. Radiology Associates will purchase from Tech all of its processed radiographic film requirements at and for the purchase price of Six Dollars and Twenty Cents ($6.20) per processed film.

2. Tech will supply all of the processed radiographic film required by Radiology Associates for X-Ray purposes in their practice of diagnostic radiology during the term of this Agreement.

Prior to 1979, patients were referred by their own physicians to the partnership, Radiology Associates, for x-rays. The technical staff took the films, and developed them. The radiologists then "read" the films, or made diagnostic interpretations.

From 1981 on, the company bought the raw film, took x-rays or ultrasound, and then handed them to the partnership for diagnosis. The partnership's chartered accountant advisors, in 1981, felt the new agreement (Exhibit 4) was necessary to isolate the processing of the films in order to obtain tax credits under the Income Tax Act.

For the taxation years in question, the plaintiff has purchased raw film, taken x-rays or ultrasound films of patients referred to the partnership, developed the films, and sold them to the partnership. The films and the diagnostic reports are retained by the partnership for at least five years, and then destroyed.

The company also derived some income from the sale of silver. Silver was extracted in the x-ray development process. Rather than being thrown out, it was sold to a dealer.

It seems to appear from the financial papers that management services were provided to the plaintiff by a subsidiary company, Reg Rad Management Inc. (See pages 12 and 43 of Exhibit 10.) The only witness for the plaintiff, Mr. Heinz Ueberschar, a partner in Radiology Associates, said that under the new arrangement in 1981, all personnel involved in management came back to the partnership as employees there; there was no longer leasing of equipment by the plaintiff to the partnership. Exhibit 4 does not deal with any of these matters. I assume there are other agreements, not put in as exhibits at trial. I merely refer to the testimony given.

The plaintiff contends it was in the business of processing goods—x-ray and ultrasound film—for sale. It sold those goods to the partnership.

The defendant contends the business of the plaintiff was in reality, the provision of services to patients, and to the partnership.

Section 125.1 of the Income Tax Act permits a deduction from tax, by a Canadian corporation, calculated on its manufacturing and processing profits. Paragraph 125.1(3)(a) is as follows:

(a) “Canadian manufacturing and processing profits” of a corporation for a taxation year means such portion of the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada as is determined under rules prescribed for that purpose by regulation made on the recommendation of the Minister of Finance to be applicable to the manufacturing or processing in Canada of goods for sale or lease; and

[Emphasis added.]

The key issue is whether these films were the processing in Canada of goods for sale.

In respect of the investment tax credit which may be deducted pursuant to subsection 127(5), the same words I have emphasized appear in subparagraph 127(10) (c)(i).

Similarly, the same words appear in the capital cost allowance provisions of Class 29.

Both parties referred me to a number of decisions dealing with section 125.1 of the Income Tax Act. Many of the same cases were cited by counsel for each side. I do not propose to canvass them all. I shall refer at some length to only two.

I have concluded that the business carried on here by the plaintiff was not the processing of goods for sale.

I find the conclusion and reasoning of my colleague, McNair, J., in Dixie X-Ray Associates Ltd. v. The Queen, [1988] 1 C.T.C. 69; 88 D.T.C 6076 persua- sive. The facts were quite similar to those in this case. The issue was whether the taxpayer's business was that of processing and developing x-ray films for sale. There, the plaintiff company was incorporated by three radiologists. The company had the equipment and staff, as in this case, necessary for processing and developing the film. The films were then interpreted by a radiologist, and the report sent, in most cases, to the patient's referring physician. The plaintiff company retained the films. I quote from page 71 (D.T.C. 6077) of the report:

The defendant has admitted that the developing of x-ray film is “processing” and that the end product resulting from the processing, namely, the x-ray film or radiograph is "a good". That being so, the real issue from the defendant's standpoint is whether the plaintiff's business activity amounts to the processing in Canada of goods for sale. There is no question of any leasing of goods.

McNair, J. reviewed a number of cases and other authorities, all of which were cited, by one side or the other, to me. I am content to adopt as my own that review. At page 74 (D.T.C. 6079-80) my colleague went on:

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 Lumber Co. (1920), 51 D.L.R. 509 (Man. C.A.).

Fridman, The Sale of Goods in Canada (3rd ed.), agreeing that the better Canadian view was consonant with what the English Court of Appeal decided in Robinson v. Graves, states at page 22 as follows:

. . . if the primary object of the contract is the transference of property in something which was not originally the property of the “buyer”, the contract will be one of sale of goods, but if the primary purpose of the parties is the performance of certain work, or the provision of services, incidentally to which property in goods is to pass from one party to the other, the contract will not be one of sale of goods.

He referred to the evidence as to Dixie's normal procedure on patient referrals and set out his conclusions at pages 74-75 (D.T.C. 6080) :

On arrival at the plaintiff's premises, the referred patient is interviewed by the receptionist, who records the relevant patient information, including the OHIP number. The patient is taken to a changing room and required to disrobe to the extent necessary for taking the x-ray. The patient is then brought into the x-ray room where a qualified technologist takes the appropriate x-ray film and has the patient wait while the film is developed in a processor. The developed radiograph is then marked and identified and put into a manila envelope to await the interpretation and report of the radiologist which is required in the vast majority of cases. The evidence of Dr. Mergelas is quite explicit that the plaintiff at no time volunteers to the patient that the property in the radiograph is his for the taking and that it is only if the patient asks on his own initiative that he is told he may have it. The evidence is also clear that the billing terminology employed in all invoices of the plaintiff is that of "fees for services rendered".

Counsel for the plaintiff fairly and frankly admitted during the course of his argument that the patient is referred by his or her attending physician to Dr. Mergelas or one of his medical partners for a diagnostic report of the radiograph based on the attending physician's belief in the professional skill and competence of the radiologists rather than on the capability of Dixie X-Ray to properly process the x-ray film. Conceding the importance of the diagnostic report itself, he suggests that this is indicative of the fact that the referral is to the medical partners and that it is they who sub-contract the technical processing and development of the x-ray films to the plaintiff. I quite agree and indeed find that the evidence in its entirety points to no other logical conclusion than that all patient referrals in the first instance are to the medical partners by reason of their professional reputation in providing x-ray films of good quality and their skill and expertise in radiological diagnosis. This is what forms the basis of any contractual relationship vis-a-vis the patients and what happens thereafter as to the passing of any property in the radiograph itself is, in my view, of relatively secondary importance. In short, it is my opinion that the substance of the contract is the provision of services in which the passing of any property in the x-ray films is merely ancillary or incidental thereto, and that the contract is not one for the sale of goods per se. I am further of the opinion that the technological processing of the x-ray films by the plaintiff is but part of its overall function of providing service to the medical profession and their patients from which it follows that no essential differentiation can be made between the vast majority of cases where a diagnostic report is the end result of the whole process and those ten per cent of cases where the radiographs are delivered to others without any written report by a radiologist. Moreover, it is not without significance, in my view, that the definition of “qualified activities" in paragraph (b) of Regulation 5202 makes specific reference to activities performed in Canada "directly in connection with my manufacturing or processing . . . in Canada of goods for sale or lease”.

[Emphasis added.]

In the case before me, the evidence was not nearly as detailed as to the procedures when a patient was referred. But it was, in the basic essentials, the same as in Dixie. The patient was referred, for x-rays, to the radiologist partnership by his or her attending physician. A requisition was then issued to the plaintiff. Exhibit 5 in this case sets out routine views to be made in all cases.

As in Dixie, it is my view the substance of the plaintiff's business is providing services to the patient and to the partnership. The sale of the film to the partnership so diagnostic interpretation can be made is, to my mind, a minor step in the plaintiff's business of providing a service to the patients and the partnership. I come to the same conclusion as my colleague, McNair, J., did.

Counsel for the plaintiff here relied on the decision of my colleague Madam Justice Reed in Halliburton Services Ltd. v. The Queen, [1985] 2 C.T.C. 52; 85 D.T.C. 5336. I was also referred to Nowsco Well Services Ltd. v. The Queen, [1988] 2 C.T.C. 24; 88 D.T.C. 6300 (F.C.T.D.—Cullen, J.). The facts in those two cases were essentially the same. Both plaintiffs were oil well service companies. My two colleagues found theirs was a processing of goods for sale, and the deductions claimed should not have been disallowed by the Minister. Both cases went to appeal, and both decisions were affirmed. (Nowsco A-636-88 reasons dated April 10, 1990 [90 D.T.C. 6312] and Halliburton A-110-86, same date [90 D.T.C. 6320]).

At trial, in the Halliburton case, Reed, J. wrote at pages 55-56 (D.T.C. 5338):

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. The defendant cites in support of its argument Sterling Engine Works v Red Deer Lumber Co (1920), 51 DLR 509 (Man CA), and Scott Maritimes Pulp Ltd v B F Goodrich Canada Ltd et al (1977), 72 DLR (3d) 680 (NSSC App Div). It is argued that the test of relative importance set out at page 40 of Benjamin— Sale of Goods (1974) is applicable, and that in the present case the services provided by the taxpayer are a much more important component of its contract with its customers than are the products it produces. It is argued that the services and products are inseparable; that customers (except with respect to one specialized product) do not purchase the goods without the services. The way the industry is structured makes it impractical for customers to do so (as noted above some of the processing of the product must necessarily be done at the well site immediately before use). It is argued that what the customer contracts for is the placing of the cement in the well, the fracturing of the hydrocarbon bearing formation, or the cleaning of the well to free it from debris, blockage etc, not the products used to accomplish these results. Also in two cases (fracturing and cleaning) the product is consumed in the providing of the service.

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. I do not read paragraph 125.1(3)(b) as requiring that a taxpayer's profit has to arise out of a contract for a sale of goods as defined by the various Sales of Goods Acts. Paragraph 125.1 (3)(b) does not talk of a sale of goods. It talks of profit arising out of the processing of goods for sale. There is no doubt that the products in question are sold to the plaintiff's customers in the sense that the invoices list the cost of the various components which go into each product and the blending and processing charges are specifically detailed in the invoice.

Secondly, I do not find any requirement that the contract which gives rise to the taxpayer's profit must be of a particular nature, eg: 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 processing) 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 (eg: a chemical fertilizer) who also provided a service in connection therewith (eg: 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., for the Court of Appeal, both in Halliburton and Nowsco approved the above excerpt from the reasons of Reed, J. At page 11 (D.T.C. 6317) of Nowsco, he said:

I wholly subscribe to what the learned judge said in the foregoing passage and I do not think that I could improve on it by a prolonged analysis of it. Suffice it so say that to focus on the fact, as did counsel for the appellant in this case, relying on the Crown Tire Service case for support, that the work having been done to the property of the respondent's customers involving the use or affixing of materials thereto was the provision of a service to the customers, misconstrued the nature of the relationship between the parties. The factual situation in that case was not comparable to that in this case. A brief reference to the evidence indicates the reality of the relationship here.

At pages 3-4 (D.T.C. 6322) of the Halliburton appeal, Urie, J.A., stated:

In my reasons for judgment in the Nowsco case, I cited with approval the above passage and do so again. I also agree with Reed, J.'s analysis of the cases cited by counsel for the appellant and of the manner in which she distinguished the various cases cited to her and to us. For these reasons, and for the other reasons given in the Nowsco case, I am of the opinion that the respondent, being engaged, as its primary purpose, in the processing of goods for sale, was entitled to deduct from its tax otherwise payable, the manufacturing and processing tax credit provided by section 125.1 of the Act in the taxation years in issue.

To my mind, the facts in the two cases just referred to are distinguishable from the facts in the case before me. Here, as I see it, the plaintiff was not engaged, as its primary purpose, in the processing of goods for sale. It was, in my opinion, from a common sense, realistic and business-like appreciation of the evidence, providing services to the patients and the diagnosing radiologists of the partnership. In coming to that conclusion, I must not be taken as inadvertently transgressing the principles set out by Estey, J. in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536 at 575-76; [1984] C.T.C. 294; 84 D.T.C. 6305.

The appeal is therefore dismissed.

The defendant is entitled to the costs of this action.

Appeal dismissed.