A J Frost (orally: March 7, 1975):
1 I shall now give my decision in this appeal in respect of the appellant's 1970 and 1971 taxation years.
2 At the opening of the hearing, counsel for the respondent applied for an order quashing the appellant's notice of appeal with respect to the assessment of tax made for the appellant's 1970 taxation year on the ground that no appeal lies from a “nil” assessment of income tax. The unopposed application was granted.
3 An application by counsel for the appellant to bring forward the matter of legal and trustee fees originally claimed in respect of the 1970 taxation year to the 1971 taxation year was also granted. Counsel then advised the Board that the claim for a deduction of $5,428.82 in respect of Logstor Ror pipe insulation expenses was being withdrawn.
4 The appellant company is in the mechanical contracting business, which is a highly competitive field. At the relevant time, it had two wholly-owned subsidiaries, one of which was Hartwil Sheet Metal (1967) Limited, hereinafter referred to as “Hartwil”.
5 The appellant operated a contract division, a systems division, a jobbing division, a pollution control division and an electrical division. Normally 30% to 40% of a mechanical contractor's job costs are costs of sheet metal. To ensure a dependable supply of competitively-priced sheet-metal products, the appellant caused Hartwil to be incorporated in November 1967, and subsequently assisted in its financing by guaranteeing loans obtained by Hartwil from the Bank of Nova Scotia. In February 1970, due to an unfortunate internal development involving fraud on the part of a trusted employee, Hartwil went into bankruptcy.
6 Hartwil occupied premises in the same building as the appellant company, its parent. Purchases of sheet metal by the appellant from October 1, 1967, to August 31, 1969, were as follows:
Hartwil $ 454,606.00
From other sources for work contracted prior to
November 27/67 411,476.00
Special project too large for Hartwil to handle 149,000.00
Other purchases 26,634.00
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$1,041,716.007 Hartwil, while operating as a subsidiary, did have some outside sources of revenue. When it went bankrupt, the appellant company was called upon to pay the Bank of Nova Scotia the sum of $75,000 in respect of its guarantee. It also paid the following amounts in respect of the Hartwil bankruptcy:
legal fees $1,100.00
trustee fees 2,500.00
The Minister of National Revenue disallowed the above payments on the ground that they were capital outlays within the meaning of paragraph 12(1)(b) of the Income Tax Act, RSC 1952, c 148.8 Business expenditures are either capital outlays or business expenses, and fall within the general limitation of paragraph 12(1)(a) of the said Act which reads as follows:
12. (1) In computing income, no deduction shall be made in respect of
Once it is determined that an expenditure qualifies under paragraph 12(1)(a), it is then necessary to determine whether the item in question is of a capital or revenue nature. If the item is of a revenue nature, it is deductible from income as an expense in the year in which it is incurred, but if the item is a capital outlay, it can only be written off in accordance with paragraph 11(1)(a) of the Income Tax Act.9 The main question at issue in this appeal is in respect of whether the $75,000 payment to the Bank of Nova Scotia is in the nature of a deferred loan or a deferred expense.
10 Counsel for the respondent, in his argument, contended strongly that all payments in respect of guarantees were of a capital nature. He relied heavily on the appeal of MNR v George H Steer, [1967] S.C.R. 34, [1965] C.T.C. 181, 66 D.T.C. 5481; in which the Supreme Court of Canada characterized the transaction before it as a deferred loan and therefore of a capital nature. As I read this case, there is no question in my mind but that the payment in question in that case was capital because of the nature of the transactions which gave rise to the guarantee and was properly classified as a deferred loan payment. However, I do not conclude, from the facts of this case, that all payments under a guarantee are of a capital nature. Each case must be determined on its own underlying facts. A guarantee may well be capital in form but not necessarily so in substance. It is always necessary to consider the facts of each case before reaching a conclusion as to whether a particular guarantee payment is in the nature of a capital outlay or an ordinary business expense. The Steer case does not determine the law with respect to the appeal before the Board.
11 In the case at bar, it was adduced in evidence that the appellant's prices were “off the pace” prior to 1967 when Hartwil was acquired to give the appellant company a stronger competitive position. Mr H Griffiths testified that all sheet metal suppliers were tied in with major mechanical contractors, which caused him to lose many contracts by marginal amounts. He said the acquisition of Hartwil gave his company an “in-house” sheet metal division which became an operating arm of his company. He testified that the purpose of the bank loan guarantee was to provide working capital and give the parent company a continuous supply of sheet metal products. He further stated that the object of the acquisition of Hartwil was to improve the profit potential of the appellant company and that no consideration whatsoever was given to building up Hartwil's financial position to pay dividends. The purpose was to improve the appellant's profit picture, not Hartwil's.
12 For the above reasons, the Board concludes that the Hartwil operations were in substance part of the appellant's operations, and the financial support given by way of guarantees to the Bank of Nova Scotia was given for the purpose of gaining or producing income by ensuring a continued supply of sheet metal products at competitive prices. The fact that Hartwil was a separate legal entity enabled the parent to enjoy limited liability, although in substance Hartwil was merely a departmental operating division of its parent. The fact that a financial loss was incurred as a result of fraud does not change the nature of the $75,000 guarantee or the payment required to be made pursuant to that guarantee.
13 In my opinion, the guarantee was a source of income and profit for the appellant company and assisted it in carrying on its business activities and, accordingly, must be allowed as an operating business expense. Although the route of payment through a bank to a separate legal entity was indirect, this fact should not preclude the recognition that the payment was a business expense in the year the guarantee was paid.
14 With respect to the legal expenses and trustee fees, I take the view that these outlays were not only made on behalf of the appellant company but were also made for the purpose of preserving the rights of all Hartwil's creditors and other third parties, and cannot be recognized as an expense deductible from income. Accordingly, the appeal is allowed in respect of the $75,000 guarantee but dismissed in all other respects.
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