Satin Finish Hardwood Flooring (Ontario) Ltd. v. R. I, 97 DTC 287, [1997] 2 CTC 2915 (TCC)

Bell T.CJ .:

Issue:

The issue is whether the Appellant was, throughout its 1990 taxation year, “a corporation whose principal business was the leasing, rental, development or sale, or any combination thereof of real property owned by it”, within the meaning of subsection 1100(12) of the Income Tax Regulations.

If its principal business is not as above described, the Appellant will be prevented from using capital cost allowance to produce a loss from rental property which could be applied to reduce other taxable income. [1]

The Minister of National Revenue (“Minister”) reassessed the Appellant for its 1990 taxation year disallowing the deduction of capital cost allowance in the sum of $482,722 on the assumption that the Appellant was not a principal business corporation as above described. It is from that reassessment that this appeal has been commenced.

Facts:

The Appellant, incorporated in September, 1971, manufactured unfinished parquet flooring. In its 1990 taxation year it reported earnings from operations before tax in the sum of $319,603. Mr. Manji (“Manji”), Appellant’s comptroller, testified that the Appellant, at the end of the 1990 calendar year, transferred this floor manufacturing business to a related corporation [2] which manufactured linear flooring. Manji said that the transfer was made because there was no sense in the Appellant having a manufacturing business in decline with no potential for growth. He said that the Appellant had 120 employees, all of whom worked in the manufacturing business, he being the only one who dealt with real estate.

Manji also testified that the Appellant had been acquiring real estate interests since 1977, mostly in Florida. He testified that the Florida properties were managed by Florida resident partners, their decisions involving regular conference calls with officials in Toronto. A schedule of those properties showed three buildings totalling 164,320 square feet which had been sold at a substantial profit and 18 buildings comprising 874,794 square feet owned, as to a 50% interest, by the Appellant. All of these properties were industrial warehouses. The Appellant also, through a nominee, Suburb Investments Limited, owned a 34% interest in a 324 unit apartment building in Mississauga, acquired in 1977. Manji testified that management regarded its realty as the most important part of its operations and had discussed the potential of closing down the floor manufacturing business.

The 18 industrial warehouses were described as Canam Associates Venture No. 4 (“Canam”). Manji, referring to the financial statements, said that Canam, to the end of its 1989 fiscal year, had claimed total depreciation of $5,394,365 for accounting purposes and that applying that sum to Partners’ deficiency of $4,245,845 there was a resulting net equity of $1,148,520. He stated that the Appellant had, over eight years, earned approximately $300,000 from its 50% interest in what was described as the Tenure property (Tenure Investments being a nominee corporation), that it had been sold and that the Appellant had a mortgage receivable of approximately $832,000 in its 1990 taxation year.

Mr. Colin Hunter Loudon, Chartered Accountant, (“Loudon”) was qualified as an expert witness respecting the relative fair market values of the Appellant’s real estate business and manufacturing business in the 1990 taxation year. He filed a report which estimated the fair market value of the manufacturing operation on a going concern basis using the capitalized earnings before interest and taxes (“EBIT”). He also estimated the fair market value of the real estate operations on the basis of an adjusted net asset value approach whereby the value was determined based on the estimated market value of the properties in the company’s operations. His summary of value follows:

In so doing, for the manufacturing operation, he showed management fees and salaries of $705,792 in 1988 with earnings from operations before tax of $396,802, management fees and salaries of $568,692 in 1989 with earnings from operations before tax of $287,033 and management fees and salaries of $296,345 in 1990 with earnings of $319,603. He stated that management fees and salaries were discretionary in a private company and that the reduction in those amounts reflected a drop in profits of the floor manufacturing business in a real economic sense. Loudon’s evidence, related to his detailed report including computations and explanations therefor, was unchallenged by Respondent’s counsel.

Analysis and Conclusion:

Appellant’s counsel referred to Interpretation Bulletin Number IT-371 and Interpretation Bulletin IT-290. The latter bulletin states that “principal” is not defined in the Act but considers that the words “chief’ and “main” are synonymous to it. It goes on to provide that:

Although none of the following criteria may be sufficient in or by themselves, they should be considered in determining which of the corporation’s businesses is its principal business...

(a) the profits realized by each one of a corporation’s businesses;

(b) the volume and the value of the gross sales or transactions of each business;

(c) the value of the assets of each business;

(d) the capital employed in each business; and

(e) the time, attention and efforts expended by the employees, agents or officers of the corporation in each business.

Counsel referred to Thomas Co. (Niagara) v. Minister of National Revenue. (1984), 84 D.T.C. 1641 (T.C.C.), at 164 where Christie, C.J.T.C. said, at 1643 in respect of subsection 1100(12):

..In order to correctly determine that question, a number of criteria should be examined in relation to each of the corporation’s businesses providing, of course, that evidence relating to them is introduced at the hearing. These criteria have been suggested, although they do not purport to be an exhaustive enumeration: profits, volume and value of gross sales of transactions, assets, capital employed and the time, attention and effort expended by the employees, agents or officers of the corporation.

Appellant’s counsel continued with the thesis that the value of the Appellant’s real estate so dwarfed the value of its manufacturing business that the real estate business was, if not far more important, at least slightly more important in the 1990 taxation year than the manufacturing business thus qualifying it as the principal business. He then stated that the evidence demonstrated that, based on value, the real estate business was significantly more important than the floor manufacturing business. He referred to the comments of Bowman, J. in Hover v. Minister of National Revenue. (1992), 93 D.T.C. 98 (T.C.C.), at 10 in quoting Lord Pearce of the Privy Council in B.P. Australia Ltd. v. Commissioner of Taxation of Australia. (1965), [1966] A.C. 224 (Australia P.C.) at page 264:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.

Appellant’s counsel stated that the evidence showed that in 1990 the sales of floor products was declining, that profits were declining, that there was a drop in demand for flooring products generally due to fewer housing starts and a lesser demand for parquet flooring in particular. He testified that the business was discontinued in the 1990 calendar year, after the termination of the 1990 taxation year. He reviewed Mr. Manji’s evidence about the sensible combination of the floor manufacturing business with that of an affiliated company.

Respondent’s counsel placed great emphasis on the earnings test. He quoted Cameron, J. in American Metal Co. of Canada v. Minister of National Revenue, (1952), 52 D.T.C. 1180 (Can. Ex. Ct.), at 118 as follows:

‘Chief business’ is not defined in either of the Acts and the phrase, so far as I am aware, has not been the subject of judicial interpretation. In my view it is a question of fact to be determined by an examination and comparison of all the facts concerning each of the various types of business in which the company is engaged. ...A business is carried on for the purpose of making a profit and from that point of view at least the more profitable operations of one branch of a business makes that branch more important than other branches which are less profitable, at least to the corporation.

The learned Justice stated with regard to the Appellant’s exploration business that it was at all times conducting exploring operations of a relatively minor nature. This was said in the context of the Appellant having purchased and sold minerals valued at well over $40,000,000 and having made substantial profits therefrom. He concluded that mining and exploring for minerals was not the company’s chief business.

Counsel then emphasized that one must look at the profits shown on financial statements, after depreciation, and that Courts should not be considering a company’s cash flow from a different business. Counsel also referred to Combined Appraisers & Consultants Co. v. Minister of National Revenue, (1983), 83 D.T.C. 543 (T.C.C.) where Taylor, J. of this Court determined that the Appellant’s principal business was not the real estate rental operation which produced a net loss but was the appraisal operation which produced a net return to the company, both in income and cash. He relied on the words of Taylor, J. found at page 548, namely:

The real estate rental in this appeal need not produce income in order to remain the source of income — even the source of business income. However, except in the most unusual or temporary circumstances, a source which produces a negative impact on the total income should not represent the “principal business” of the taxpayer, or the essential ingredient in the combination in the “principal business” when another “business” conducted in the same corporation shows a positive impact on the total income, ... Where the range of businesses being conducted ... include those related to real property listed in Regulation 1100(12)(a), and one or more not so specified, the task of showing that the specified businesses represent the “principal business” is formidable indeed when the result of those specified businesses is a “loss” rather than “income”, while the non-speci- fied businesses show a profit.

Respondent’s counsel then submitted that little weight should be given to the ratio of capital employed in each business, and that the Canam arm of the realty operation was managed, day by day, by the Florida personnel. He emphasized that the number of employees weighed in favour of the floor manufacturing business being the principal business. He sought to draw a distinction between “cash flow” and earnings. He also criticized Loudon’s valuation report but in so doing, attempted to draw conclusions on his own analysis, questions in that regard not having been put by him to Loudon. Indeed, he stated that in sum total, Loudon’s opinion should not be given much weight. Finally, he submitted that no importance attached to the fact that the Department of National Revenue did not reassess the Appellant for the years 1984 to 1989 inclusive disallowing the claim of principal business in the real estate operations.

I have concluded that the Appellant’s principal business was the leasing, rental, development or sale, or any combination thereof, of real property owned by it in its 1990 taxation year. The net asset value of the real estate operations was almost triple that of the manufacturing operations. Although the real estate operation did not show a profit for accounting purposes, its cash flow in that year exceeded the net profit of the floor manufacturing operation. The fact that that business had 120 employees whereas a relatively small number of people conducted the real estate operation is not only not determinative but rather irrelevant given the relative nature of the operations. Although the evidence of Manji with respect to the choice of business to be continued by the company could be construed as self-serving, the discontinuance of the floor manufacturing business at the end of 1990 lends weight to that statement.

The question to be determined is which business was more important and, having regard to the foregoing factors, I have no difficulty in concluding that it was the real estate operation. I heartily agree with the words of Urie, J.A., in Nowsco Well Service Ltd. v. Canada, (1990), 90 D.T.C. 6312 (Fed. C.A.), at 631, where after referring to Lord Pearce’s words quoted above, spoke of the importance of “a common-sense, realistic and businesslike appreciation of” all factors. The real estate assets had been accumulated over a long period of time, they were valued at $24,319,000 and carried mortgage debt of $15,197,000. Their value was a multiple of the value of the manufacturing operation assets. It appears that the accounting deficit had little if any effect on mortgage lenders who were looking to the value of the asset used in the real estate operation. The realty operation cash flow before depreciation was substantial. I am not persuaded that the Respon- dent’s view that only the 1990 taxation year can be examined for the purpose of this determination has value. The assets were not acquired simply in 1990 but reflected the intense activity of the Appellant, having been assembled over a period of time. The actions of the Appellant in late 1990 (after the Appellant’s 1990 taxation year end) made it clear that real estate was its principal business because it became its only business. Although not determinative of the issue, I give some weight to the fact that the Minister chose not to reassess the Appellant for the 1984 to 1989 years inclusive by disallowing the claim of principal business status.

Accordingly, the appeal is allowed, with costs.

Appeal allowed.