Paco Corp. v. The Queen, 80 DTC 6328, [1980] CTC 409 (FCTD)

Dubé, J [TRANSLATION]:—The question here is whether the losses of $282,852 for 1972 and $25,000 for 1974 incurred by plaintiff (“PACO”) are deductible as expenses incurred to earn income, as plaintiff contends, or constitute outlays on capital account, as the Minister held.

PACO is a Canadian company making and selling machinery and equipment used in the manufacture of concrete blocks. This company was created by two engineers and a businessman, all three from Montreal, for the purpose of marketing a new and more effective block production formula. This method of production, which is based on the “ROTOCLAVE” system, an invention patented by the engineer Pierre Laforêt, the president of the company, does not subject the blocks to blast furnace pressure, as required by the American “AUTOCLAVE” system. The “ROTOCLAVE” principle is based on a floating furnace, which is more automated, less energyconsuming and non-explosive: the blocks turn on a floating table and a benefit from ambient humidity.

PACO was soon able to sell its new equipment, first in Montreal and then in the eastern United States. Though quite expensive (in the $600,000 range), this machinery was not sold by catalogue but by demonstration. Possible customers were requested to visit an Ongoing manufacturing operation and see for themselves the benefits of the method. Canadian and American concrete block manufacturers are not secretive and are quite willing for other businessmen to visit their plants, since the plants operate several hundred miles apart and are not considered to be in competition with each other: the high cost of transportation of such blocks considerably limits the operating radius of producers.

The preceding facts and those that follow were provided to the Court by the three founding shareholders of PACO, the only witnesses at the hearing, and their testimony was not refuted in cross-examination. It appeared that towards the end of the sixties PACO decided to penetrate the European market. With its population at least equal to that of North America and a much less sophisticated block industry, Europe represented a very promising potential market.

After a few trips abroad the PACO directors quickly realized that it would be very difficult, if not impossible, for them to convince European businessmen of the merits of the rotating “ROTOCLAVE” system with the aid of documents or verbal explanations: it was obviously necessary to set up a demonstrator on the spot. As a result of inquiries in France PACO succeeded in interesting a small group of businessmen in joining with it to establish a block plant a few miles north of Paris. The French and Canadian partners founded “AFCOREX SA (France)”. PACO held 60% of the shares, the French residents 40%.

According to the testimony by the three PACO shareholders, which I accept without hesitation, PACO was not particularly interested in becoming a block manufacturer; its primary concern was to launch a local company which could later serve as a demonstrator and so enable ROTOCLAVE equipment sales to commence. Once the plant was in operation, PACO would sell its shares to the French shareholders, and reserve a right for potential customers to visit the plant.

This eventuality never arose, since the French operation went badly from the beginning. The two principal shareholders in the European group did not agree, the automated North American system did not correspond well with local customs and customer preferences, and there were other difficulties as well. To compensate for a lack of funds, PACO had to advance up to $100,000 in loans to refloat the nascent company. Finally, the business had to be sold, resulting in a loss for PACO of $288,852 in 1972 and another loss of $25,000 in 1974, while PACO only recovered $75,000 of the money loaned to AFCOREX.

Through his counsel the Minister alleged that the PACO investment by the purchase of AFCOREX shares constituted a capital outlay: the property acquired, whether shares or debts, was capital property within the meaning of the Act. In addition, even admitting the purpose of PACO’s actions, namely their intent to set up a demonstrator physically located in Europe, the monies allocated to the purpose were intended to secure a “permanent benefit of lasting value”. Subparagraph 54(b)(ii) defines ‘‘capital property” as “any property . . . any gain or loss from the disposition of which would . . . be a capital gain or a capital loss, as the case may be, of the taxpayer”. The funds advanced by PACO were clearly used in the AFCOREX business to purchase capital assets, namely plant, machinery, the building of roads and so on. At the time the AFCOREX shares were purchased by PACO there was no agreement, oral or written, that the shares would be resold by PACO to European shareholders when the enterprise became viable. Moreover, the size of the investment, some $400,000 for a company with assets of only $1,500,000, clearly showed, in the opinion of the Minister, that this was not merely an operating expense but in fact an investment of a lasting nature. Furthermore, in its initial tax returns PACO declared these losses as losses on capital account. Finally, PACO has never specialized in share purchases. It was even its first attempt at this kind of investment: accordingly, it was a transaction which resulted in a capital gain or loss.

It would appear at first glance that this is likely to be an investment of a lasting nature in view of the large sum involved, the fact that the transaction relates to the purchase of another company’s shares, and the initial tax return assigning these losses to capital outlays.

However, what is important is the substance of the transaction, the overriding intent of the taxpayer. In Algoma Central Railway v MNR, [1968] SCR 447; [1967] CTC 130; [1968] CTC 161; 67 DTC 5091; 68 DTC 5096, a decision of the Exchequer Court, affirmed by the Supreme Court of Canada, it was held that outlays made by this railway company to obtain geological surveys for the purpose of increasing traffic on its line were income-related expenses. What the company had “in mind” was obtaining information to place at the disposal of potential customers. If these expenditures were incurred for the purpose of producing income, they are “current expenses”.

In another decision by the same Court in the same year, 1967, Associated Investors of Canada Limited v MNR, [1967] CTC 138; 67 DTC 5096, Jackett, P also held that loans advanced to plaintiff’s employees had been so advanced for the purpose of earning income, and to enable the latter to have funds available during the period when they were waiting on their commissions. Such loans were therefore an integral part of the company’s current operations.

In Olympia Floor and Wall Tile (Quebec) Limited v MNR, [1970] CTC 99; 70 DTC 6085, the same judge held in 1970 that gifts to charitable organizations made largely, if not entirely, in order to increase sales were income-related expenses since they were really a form of promotional expense.

However, the Supreme Court of Canada held in Stewart & Morrison Ltd v MNR, [1972] CTC 73; 72 DTC 6049, that loans advanced by the Canadian company to its American subsidiary did not represent current expenses, but were expenses on capital account, and that the resulting losses were on capital account. However, it should be noted that the Canadian company held all the shares of its American branch and that the purpose of creating the American company was specifically in order to produce income.

In The Queen v Roméo Lavigueur, [1973] CTC 773; 73 DTC 5538, the taxpayer loaned money to his tenants to enable them to continue leasing his apartments. One of these loans was not repaid and in 1973 the Federal Court held that this loss was an outlay incurred for the purpose of earning income, and so deductible for that reason. The judge emphasized that the loans were “apparently an integral part of the profit-making activities of the business”.

In 1973 Noel, ACJ of the Federal Court observed, in The Queen v E H Jones Tobacco Sales Co Ltd, [1973] CTC 784; 73 DTC 5577, that the Court must consider the situation from a businessman’s point of view, and not dwell on technicalities. The loss of $115,000 from guaranteeing a loan for an important customer resulted from a transaction entered into for “commercial reasons”. He went on to say, at 790 [5581]:

For some years, however, our courts have been inclined to accept certain expenses or losses as deductible, considering not so much the legal aspect of the transaction, but rather the practical and commercial aspects.

In MNR v Henry J Freud, [1968] CTC 438; 68 DTC 5279, the Supreme Court of Canada held in 1968 that the amounts spent by the taxpayer on developing a prototype sports car to interest potential customers should be regarded as an income-related expenditure and not an expenditure on capital account. The project was intended from the outset as an investment for the purpose of producing income. Even if the expenditure was a loan, it was not necessarily an investment. It is clear that a loan made by someone who is not in the lending business is ordinarily regarded as an investment, but the circumstances may be “unusual and exceptional”.

It was clearly established by the uncontradicted testimony of the three PACO shareholders that the overriding intent of this company was not to establish a permanent foothold in Europe for the manufacture and sale of concrete blocks. Its primary purpose was to establish a demonstration project to assist it in penetrating the market.

PACO appears to have been invited several times, in both Canada and the United States, to join with North American shareholders in establishing block factories, but plaintiff always refused the invitation on the ground that it wished to devote itself exclusively to the sale of machinery and equipment. According to the three shareholders, it would have been clumsy and bad tactics from the standpoint of PACO’s customers for it to become their competitor. It is true that the expenses incurred in France were quite considerable, but plaintiff decided that the huge potential of the market made them worthwhile.

Although this transaction was not merely a loan, but also involved the purchase of another company’s shares, and so was a transaction which prima facie would appear to be an expenditure on capital account, it is important not to be misled by appearances. The Court must look at the substance of the transaction, and this is characterized above all by the overriding intent of the taxpayer at the time the money was invested, namely the intent to establish a demonstration project in Europe.

In the circumstances, the appeal is allowed and the income tax assessments of plaintiff for 1972 and 1974 are referred back to the Minister for reassessment in accordance with these reasons; plaintiff shall be entitled to cover its costs.