Porta-Test Systems Ltd. v. The Queen, 80 DTC 6046, [1980] CTC 71 (FCTD)

Primrose, J:—This is an appeal by the plaintiff from a decision of the Tax Review Board, Exhibit 1. The circumstances are fully set out in the judgment. Liability for tax, if any, turns on a licensing agreement, Exhibit 2 effective August 1,1970 pursuant to which Porta-Test Manufacturing Ltd, the predecessor to the present plaintiff granted a license to SPP Group Ltd a body corporate in the United Kingdom giving it the exclusive right to manufacture, use and sell Porta-Test inventions in the United Kingdom and certain other areas and that portion of the North Sea outside the three mile limits of the bordering countries etc. I will quote in extenso some of the provisions of the licensing agreement which are important to the ultimate decision as to liability for tax. The plaintiff says the licensing agreement constitutes a disposition by the plaintiff of property which was capital to its enterprise. Section 5.01 of the agreement says:

For the rights and privileges granted under the licenses, SPP shall pay to Porta- Test throughout the term of the agreement a royalty of five percent (5%) of the net proceeds realized by SPP and/or its sub-licensees on the manufacture, use or sale of any Porta-Test separator.

Section 5.04 provides a guaranteed minimum royalty and provides:

SPP shall guarantee to Porta-Test a minimum royalty of $150,000 Canadian for the period commencing on the date of this agreement and ending on the third anniversary thereof. In this regard, SPP shall pay to Porta-Test with its report for the third year such sum in addition to the royalty payments for such year as may be required to make the total payments to Porta-Test for the said three years equal to the sum of $150,000 Canadian.

Section 5.05 provides for a royalty to be paid in subsequent years after the expiration of the third year. Section 13.03 provides:

In the event of termination of this agreement all licenses granted hereunder, except the license under Paragraph 7.01, will be terminated with the further exception that SPP and its sub-licensees shall have three months from termination within which to sell or dispose of any Porta-Test separator on hand or in process at the time of termination and shall pay Porta-Test royalties as provided in Article V on all such Porta-Test separators.

The president of the plaintiff company gave evidence outlining that the plaintiff had various patents for recycling, and separating liquid from gas for further refinement, which patents were for ten countries including Canada, the United States, United Kingdom, Japan and others. During the years 1968 to 1970 the efforts of the company were in Canada and the company began to develop markets in the United States.

With discoveries of oil in the North Sea the plaintiff tried to develop markets in the United Kingdom commencing about 1968 and 1969 through the British Gas Council and decided that it would develop ie manufacture in the United Kingdom in order to be competitive with British manufacturers. However, it did not have the financial backing to proceed with manufacturing there and thought it would be preferable if the development went to concerns in the United Kingdom, and the company therefore entered into the licensing agreement mentioned above. On the evidence of its patent solicitor in Edmonton the plaintiff asked the British interests for a royalty of 5%. The plaintiff thought that since the product was new and the oil/gas was only in the exploration stage in the United Kingdom in the North Sea, the market would be relatively small. The plaintiff produced schedules of its sales in Canada which were filed as Exhibits for the years 1968 to 1977 (Exhibit 3) and in the United States for the years 1971 to 1977 (Exhibit 4) and produced a schedule of sales in the United Kingdom converted to Canadian dollars for the years 1971 to 1977, which confirmed this assessment of the market.

The president of the plaintiff company Mr Swann, pointed out that it would have required three million dollars in sales in the United Kingdom to generate $150,000 being the amount called for in the agreement Exhibit 2 over a period of three years and in his view there was, having regard to sales in Canada and in the United States in the early years, he felt there was no possibility the sales in the United Kingdom would reach a figure of three million dollars although the agreement itself calls for a payment of $150,000 over the three year period. He testified this sum did not bear any relation to the sales estimated by the company. It did represent, he said, recovery of some of the costs of the patents for the plaintiff. He also said: “we thought we were selling an asset of the company to the SPP group”—the amount of $150,000 was arrived at because the plaintiff did not wish the SPP group to retain a license to manufacture and not put forth the maximum effort in doing so, and he reiterated that $150,000 was far in excess of the royalties expected in the first three years. On cross-examination before the Tax Review Board at page 24 he gave different evidence, which I am satisfied was due to his misunderstanding of the question that he was asked on cross-examination at that time. He testified that he thought they were selling an asset of the company. He said that the company might have spent as much as 100 to $200,000 in developing the patent, and that the company sold the license in question for a royalty and a capital sum. This is the next question to be determined in this trial de novo.

In its income tax return dated June 30, 1974 the plaintiff showed Exhibit 1, page 22 an item “gain on license agreement $75,040” under its statement of income. Under its T-2S1 Exhibit 1, page 14 it also shows gain on license agreement $75,040. The tax return was re-assessed and the whole amount treated as income. The taxpayer appealed to the Tax Review Board, and the learned Tax Review Board member confirmed the re-assessment as income, under paragraph 12(1 )(g) of the Income Tax Act.

There was another issue raised in the amended statement of claim in paragraph 10, that if the item of $75,040 was not capital then it became a receivable by the plaintiff in another taxation year, but counsel for plaintiff intimated at the trial that it would abandon any claim under this paragraph of the statement of claim so the only issue is as to the liability for tax on the item of $75,040.

The plaintiff referred in argument to the form and substance rule and cited Duke of Westminister v CIR, 19 Tax cases 490 and the judgment of Lord Russell at 524 and also The Horse Co-Operative Marketing Association Ltd v MNR, [1956] CTC 115; 56 DTC 1064, a decision of the learned president of the Exchequer Court. At 135 [1074] discussing the interpretation of an agreement under which the appellant association in that case had been taxed on the basis of taxable income, where it contended that it was a Co- operative, acting only as agent for its members, the appeal was allowed and the learned president said at 135 [1074]:

The document must be read as a whole and also looked at in the light of the surrounding circumstances. It is the substance and reality of the transaction that should be considered, rather than the form in which it was expressed.

The licensing agreement here is inconsistent in its terms, in that it describes royalty in section 5.04 ‘‘a minimum royalty of $150,000 for the period commencing on the date of this agreement and ending on the third anniversary thereof.” And then in the next sentence says: “In this regard SPP shall pay to Porta-Test with its report for the third year such sum in addition to the royalty payments for such year as may be required to make the total payments to Porta-Test for the said three years equal to the sum of $150,000.” The latter sentence supports the evidence on the president, who knew that the anticipated sales in the United Kingdom could not amount to $150,000 royalty in three years to the plaintiff company and who says that sum was computed as partly for the cost incurred by theplaintiff in developing the patents. In other words the plaintiff says that $150,000 had two aspects ie the $150,000 comprised something more than royalty, or to put it in the words of the plaintiff’s counsel $150,000 mentioned in the agreement was to be abated by royalty payments, which would reduce it and did, and in that result the plaintiff says approximately $75,000 was for royalty and the other item $75,040 was separable and to be treated as the gain on the license agreement, which was shown in the income tax return for 1974 accordingly.

The defendant relies on paragraph 12(1 )(g) of the Income Tax Act which reads as follows:

Payments based on production or use.—any amount received by the taxpayer in the year that was dependent upon the use of or production from property whether or not that amount was an instalment of the sale price of the property (except that an instalment of the sale price of agricultural land is not included by virtue of this paragraph;

We are not, of course, concerned with the sale price of agricultural land. Defendant’s counsel reviewed this section in the Act, which was equivalent to paragraph 6(1)(j) of the Act of 1952, which is broader now than formerly.

The defendant referred to George E Lackie v Her Majesty the Queen, [1979] CTC 389; 79 DTC 5309 where the Federal Court of Appeal discussed at length the difference between income from a business and income from a property and quoted paragraph 12(1)(g) of the Income Tax Act. At p 5311 the Court quoted part of the decision of the trial judge in the following excerpt:

Several useful guidelines emerge from the decisions above referred to.

Several useful guidelines emerge from the decisions above referred to. Where property is sold for a set sum to be paid in fixed instalments, those payments are not income. If it is sold for a share of the profits, the payments then bear the character of income, and so would annuities and royalties. If property is sold for a sum certain, plus annual sums dependent on the volume of business, those annual sums would be income.

The report goes on further to say:

It is common ground that if the sums received are regarded as income from a business the attribution rules under section 74(1) of the new Act and section 21(1) under the old Act do not apply. Thus the problem falls squarely on the interpretation to be given to the phrase in section 12(1 )(g) “any amount received by the tax- payer in the year that was dependent upon the use of or production from property. . . Was the removal of the gravel from the property in question dependent on the use of or production from production property or rather was Mr Lackie in the business of deriving income from the business of selling gravel?

In Vauban Productions v Her Majesty the Queen, [1975] CTC 511; 75 DTC 5371 at 513 [5372] Addy, J defined royalties in the following way:

The term “royalties” normally refers to a share in the profits or a share or percentage of a profit based on user or on the number of units, copies or articles sold, rented or used. When referring to a right, the amount of the royalty is related in some way to the degree of use of that right. This is evident from the various dictionary definitions of the word “Royalty” when used in connection with a sum payable. Royalties, which are akin to rental payments, have invariably been considered as income since they are either based on the degree of use of the right or on the duration of the use, while a lump sum payment for the absolute transfer of a right, without regard to the use to be made of it, is of its nature considered a capital payment, although it may of course be taxable as income in the hands of the recipient if it is part of that taxpayer’s regular business. This concept of the basic difference between “royalties” and “lump sum payments” for the transfer of rights has been recognized in the following cases: CIR v Rustproof Metal Window Co Ltd, 29 TC 243 at 254 and 255:

In my view paragraph 12(1 )(g) of the Act and the numerous decisions that have decided its meaning, does not proclude in a proper case, the differentiation between capital and income. It seems that if the amount expressed as the consideration had been expressed in dollars, independent of royalties for user, it would then be treated as capital.

I hold part of the consideration for the licensing agreement represented something over and above royalties for user, which is supported by Mr Swann’s evidence, and the terms of the agreement, although it does lack something in drafting. Nevertheless the court must look at all the surrounding facts and circumstances in deciding whether the sum in question is taxable as income. The plaintiff says if it is calculated in relation to user it is income but if not, it is a capital receipt. After careful consideration I am prepared to agree with this submission which I think does not contravene the principle outlined in Lackie or conflict with it, as it can be distinguished in the special circumstances in this case finding as I do that it was the sale of an asset, with the price calculated partly as royalties.

I therefore hold that the sum of $75,040 referred to in the income tax return for 1974 taxation year was a non-taxable capital receipt, divisible from the royalty aspect of the licensing agreement. Judgment accordingly with costs.