Loewen v. The Queen, 94 DTC 6265, [1994] 2 CTC 75 (FCA)

Hugessen, J.A. (McDonald agreeing):—The question raised by this appeal is whether a transaction which is structured in such a way that it cannot possibly produce a trading profit may nonetheless be an adventure in the nature of trade. More particularly, the question is to know whether a notional profit resulting from such a transaction as a consequence of the law deeming the purchaser's cost of acquisition to be less than his proceeds of disposition is to be taxed as income or as a Capital gain.

The matter arises in this way. In July, 1984, the appellant purchased from a company called Dynaflex Industries Inc. a “scientific research tax credit" debenture for a price of $200,000 payable partly in cash and partly by promissory note, the balance of which was due no later than December 31, 1984. The issuer of the debenture, Dynaflex, undertook to "designate" the full amount of $200,000 pursuant to subsection 194(4) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). The debenture was redeemable by either party at a redemption price of $140,000 and was in fact redeemed on January 2, 1985 at appellant's request.

The whole purpose of the transaction, from the appellant’s point of view, was to allow him to benefit from a scientific research tax credit (SRTC) in his 1984 taxation year. The transaction, known in the vernacular of tax advisors as a "quick flip", achieved its purpose and the appellant obtained a credit against 1984 federal tax of $68,000. Since the reduction in the appellant’s federal tax payable also had the effect of reducing his provincial tax payable by $34,000, he obtained a total tax advantage of $102,000 from the transaction.

The relevant provisions of the Income Tax Act at the time were as follows:

127.3(1) There may be deducted from the tax otherwise payable under this Part by a taxpayer for a taxation year an amount not exceeding the aggregate of

(a) his scientific research tax credit for the year; and

(b) his unused scientific research tax credit for the taxation year immediately following the year.

(2)(a) “scientific research tax credit" of a taxpayer for a taxation year means the aggregate of all amounts each of which is an amount equal to

(i) where the taxpayer is a corporation, 50 per cent, or

(ii) where the taxpayer is an individual other than a trust, 34 per cent of an

amount designated by a corporation under subsection 194(4) in respect of

(iii) a share acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to be a registered holder thereof,

(iv) a bond, debenture, bill, note, mortgage, hypothec or similar obligation (in this section and in Part VIII referred to as a "debt obligation”) acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to be a registered holder thereof, or

(v) a right acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to have acquired that right,

less any amount required by subsection (5) to be deducted in computing the taxpayer's research tax credit for the year; and. . . .

127.3(6) For the purposes of this Act, where at any time in a taxation year a taxpayer has acquired a share, debt obligation or right and is the first registered holder of the share or debt obligation or the first person to have acquired the right, as the case may be, other than a broker or dealer in securities, and an amount is, at any time, designated by a corporation under subsection 194(4), in respect of the share, debt obligation or right, the following rules apply:

(a) he shall be deemed to have acquired the share, debt obligation or right at a cost to him equal to the amount by which

(i) its cost to him as otherwise determined exceeds

(ii) 50 per cent of the amount so designated in respect thereof; and

(b) where the amount determined under subparagraph (a)(ii) exceeds the amount determined under subparagraph (a)(i), the excess shall

(i) where the share, debt obligation or right, as the case may be, is a capital property to him, be deemed to be a a capital gain of the taxpayer for the year from the disposition of that property; and

(ii) in any other case, be included in computing the income of the taxpayer for the year,

and the cost to him of the share shall be deemed to be nil.

194(4) Every taxable Canadian corporation may, by filing a prescribed form with the Minister at any time on or before the last day of the month immediately following a month in which it issued a share or debt obligation or granted a right under a scientific research financing contract (other than a share or debt obligation issued or a right granted before October 1983, or a share in respect of which the corporation has, on or before that day, designated an amount under subsection 192(4) designate, for the purposes of this Part and Part I, an amount in respect of that share, debt obligation or right not exceeding the amount by which

(a) the amount of the consideration for which it was issued or granted, as the case may be,

exceeds

(b) in the case of a share, the amount of any assistance (other than an amount included in computing the scientific research tax credit of a taxpayer in respect of that share) provided, or to be provided by a government, municipality or any other public authority in respect of, or for the acquisition of, that share.

Briefly stated, the purpose of the statutory scheme (which was short-lived) was to encourage investment in companies doing scientific research. This was done by providing a federal tax credit of 34 per cent of any amount invested in such a company and "designated" by the latter. Since most provincial income tax is calculated as a function (about 50 per cent) of federal tax a reduction in the latter produced a corresponding reduction in the former for a total tax advantage to the investor of about 50 per cent of the amount invested. To offset some of the scheme's "tax cost" to the fisc the investor's cost of acquisition was deemed to be reduced by 50 per cent of the designated amount, or approximately the same amount as the tax credit he had received.

As previously indicated, the appellant did not require redemption of the debenture until January 1985. That redemption was for the stipulated price of $140,000. Since the appellant had paid $200,000 for the debenture, he suffered an actual loss on the redemption in the amount of $60,000. Furthermore, since the debenture was redeemable by either the company or the holder, it is inconceivable that it could ever have a value in excess of $140,000 and it was accordingly impossible that redemption could ever result in a profit to the holder.

In the unreal world of income tax, however, things are seldom what they seem and are frequently deemed to be quite different from what they are. By the terms of subsection 127.3(6), supra, the appellant was deemed to have acquired the debenture at a cost of only $100,000, being his actual cost ($200,000) reduced by 50 per cent of the designated amount, or, since the entire proceeds of the debenture had been designated, $100,000. That being so, the redemption price of $140,000 received by the appellant in 1985 was, for tax purposes, $40,000 greater than his cost of acquisition. It is that notional difference which is at the source of this litigation.

In his income tax return for the 1985 taxation year, the appellant showed this amount as a capital gain. The Minister reassessed on the basis that it was a profit from an adventure in the nature of trade and taxable as business income. The appellant appealed to the Tax Court of Canada which allowed the appeal and directed that the Minister reassess on the basis that the gain of $40,000 was a capital gain ([1990] 1 C.T.C. 2133, 90 D.T.C. 1009). The crux of the Tax Court judge's reasons appears from the following passage at pages 2138-39 (D.T.C. 1012-13):

In light of all the circumstances of this case, I am of the view that this transaction does not possess the characteristics of a trading operation. In my opinion, the evidence is clear that trading in securities was not in the ordinary course of the appellant's business. Moreover, the appellant did not trade in the subject debenture. He merely purchased it from its issuer for its inherent income tax attributes and redeemed it from its issuer at virtually no risk to him. He did not deal with the debenture in the same manner as a person whose ordinary business is the buying and selling of debentures and other securities. The acquisition of the debenture was not for the purpose of earning income therefrom as it would normally be understood by persons engaged in buying and selling debentures because the manner in which the present transaction was structured made this impossible right from the start. Indeed, the only way that the holder of the debenture could recover some of the original purchase price of the debenture was to call for its redemption for an amount less than the original purchase price. I agree with counsel for the appellant that no profit in a trading sense arose from the acquisition and disposition of the debenture. Indeed, if the benefits of the tax credit are disregarded, a loss according to ordinary commercial principles arose upon the redemption of the debenture because the acquisition cost to the appellant of the debenture ($200,000) exceeded the proceeds of its disposition ($140,000) on redemption by $60,000.

In brief general terms, the appellant did not deal with the property as an ordinary trader in property of that nature in order to realize a profit from its sale.

The Crown appealed from this decision to the Trial Division which allowed the appeal and restored the assessment. The trial judge said at page 218 (D.T.C. 5113):

However, he dealt with the SRTC debenture in the same way that a trader in property of the same kind would ordinarily, in the sense that he did not retain the debenture to earn interest income. In fact, as soon as the debenture was paid in full, he requested immediate redemption. A trader in such debentures would also quickly realize on them so as to free-up the funds invested.

The SRTC debenture in question was never designed to be held by the purchaser any longer than was required to enable him to obtain the tax credit. Immediate redemption was the incentive and long-time investment was never contemplated. Moreover, only a small portion of the funds paid by Loewen remained with Dynaflex. The final $152,000 payment was held in trust by Loewen's solicitor to ensure that the funds would be available to him for the redemption. Thus, the final payment which represented the bulk of the purchase price was never in the hands of Dynaflex and could not have been invested in its operations.

In considering which of these two approaches is to be preferred it seems to me that it is important to bear certain fundamentals in mind.

In the first place, it is clear that the basis on which the appellant has been assessed is not that he is a trader or engaged in a business, in a broad sense, but rather that the profits from this transaction are to be treated as business profits because the transaction itself is "an adventure in the nature of trade" within the meaning of section 248 of the Act. The profits from a trade or business are, of course, taxable on their own account and without recourse to any extended definition; the notion of an adventure in the nature of trade extends the reach of the charging sections to transactions which, although not carried out by a trader, are of the same kind as trading transactions. As was stated by Lord Radcliffe in Edwards v. Bairstow, [1956] A.C. 14, [1955] 3 AIl E.R. 48, at page 38 (A.C.):

The true question in such cases is whether the operations constitute an adventure of that kind, not whether they by themselves or they in conjunction with other operations, constitute the operator a person who carries on a trade.

The point is of importance in the present case because a trader may, in the course of his business, enter into transactions which cannot possibly generate a profit by themselves but whose purpose is to benefit the business as a whole. A simple example would be the purchase by a merchant of goods to be given away as premiums with the purchase of his regular merchandise. That is no doubt a trading transaction but it is difficult to see how the purchase of something for the purpose of giving it away could qualify as an adventure in the nature of trade if it were carried out by a non-trader.

Secondly, a distinction is sometimes drawn in the cases between transactions which are to be treated as "investments" and those which are to be considered as “speculations”. While that is frequently a useful way of looking at an income/ capital gains problem, it is not an infallible test since the concepts of investment and speculation are not exhaustive of the universe of transactions by which people acquire things and subsequently dispose of them. In particular, things may also be bought or sold for consumption or for use. Thus, while a positive Finding that a transaction was for speculation or for investment may be decisive as to whether it was or was not a trading transaction, an equivalent negative finding, i.e., that it was not one or the other of those things, cannot be so.

Clearly, in the present case, the appellant’s purchase and later redemption of the debenture were not of the character of an investment. He admits as much, in his memorandum of fact and law, at page 6:

The appellant’s purpose in purchasing the debenture was to acquire a scientific research tax credit worth $102,000. His only relationship with Dynaflex was the purchase of the debenture. He had no interest in Dynaflex’s operation other than receiving the tax credit. He did not know the nature of Dynaflex’s business, and did not determine whether it could actually carry out its business. He did not investigate Dynaflex’s solvency, he had no idea what sort of assets Dynaflex owned, and did not know what the floating charge contained in the debenture would attach to. The appellant never considered selling the debenture to anyone else. From the moment he purchased it, he intended to redeem it.

That, however, leaves open the question as to whether there was an adventure in the nature of trade.

Next, it is settled law that an intention to make a profit from a transaction is not a prerequisite to a finding that such transaction is an adventure in the nature of trade. In the leading case of M.N.R. v. Taylor, [1956] C.T.C. 189, 56 D.T.C. 1125 (Ex. Ct.), Thorson, P., after an exhaustive review of the cases, said at pages 211-12 (D.T.C. 1137-38):

And a transaction may be an adventure in the nature of trade although the person entering upon it did so without any intention to sell its subject matter at a profit. The intention to sell the purchased property at a profit is not of itself a test of whether the profit is subject to tax, for the intention to make a profit may be just as much the purpose of an investment transaction as of a trading one. Such intention may well be an important factor in determining that a transaction was an adventure in the nature of trade but its presence is not an essential prerequisite to such a determination and its absence does not negative the idea of an adventure in the nature of trade. The considerations prompting the transaction may be of such a business nature as to invest it with the character of an adventure in the nature of trade even without any intention of making a profit on the sale of the purchased commodity.

In the same case, Thorson, P. laid down a number of specific guidelines for determining when there is an adventure in the nature of trade. The first, and in my view the most important, was stated by him as follows at page 214 (D.T.C. 1139):

But there are some specific guides. One of these is that if the transaction is of the same kind and carried on in the same way as a transaction of an ordinary trader or dealer in property of the same kind as the subject matter of the transaction it may fairly be called an adventure in the nature of trade. Put more simply, it may be said that if a person deals with the commodity purchased by him in the same way as a dealer in it would ordinarily do such a dealing is a trading adventure.

This brings us back to the conflicting views expressed in the Tax Court and in the Trial Division in the present case and already uoted above. If I understand them correctly, the Tax Court judge was of the view that this could not be a trading transaction because, apart from its tax consequences, it could not generate a profit. The trial judge, on the other hand, came to the opposite conclusion because the appellant had disposed of the debenture, once it had served its tax credit purpose, as quickly as possible and in the same manner as would a trader.

In order to resolve the conflict, it is necessary, in my view, first to ask oneself whether tax considerations, and more particularly an anticipated tax advantage, can properly be determinative of whether or not any given transaction is a trading operation. In my view, they cannot. While the saving of taxes is clearly an important consideration in the conduct of any modern business, I do not think it can properly be said that a transaction whose sole purpose is to reduce the tax otherwise payable by a taxpayer is, for that reason alone, an adventure in the nature of trade. In the recent case of Moloney v. Canada, [1992] 2 C.T.C. 227, 92 D.T.C. 6570, this Court was faced with the opposite side of the income/capital gains coin, namely whether a taxpayer could deduct as business expenses the costs incurred in a scheme the whole purpose of which was to obtain refunds of tax. In dismissing the taxpayer's appeal, we said at pages 227-28 (D.T.C. 6570):

While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax. . .it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer's business for the purpose of the Income Tax Act. To put the matter another way, for an activity to qualify as a "business" the expenses of which are deductible under paragraph 18(1)(a), it must not only be one engaged in by the taxpayer with a reasonable expectation of profit, but that profit must be anticipated to flow from the activity itself rather than exclusively from the provisions of the taxing statute.

[Emphasis added.]

This conclusion is consistent with authority. In Bishop v. Finsbury Securities Ltd., [1966] 3 All E.R. 105, the House of Lords had to deal with a forward stripping operation, the success of which was dependent upon the taxpayer being ab e to treat as a trading loss the sale of shares the value of which had been reduced below their cost to the taxpayer by virtue of the latter having, in the interim, taken from the company, by way of dividend, its large accumulated surplus. While the question is not identical to the one facing us here, the following passage from the speech of Lord Morris at page 112 is instructive:

A consideration of the transactions now under review leads me to the opinion that they were in no way characteristic of, nor did they possess, the ordinary features of the trade of share dealing. The various shares which were acquired ought not to be regarded as having become part of the stock-in-trade of the company. They were not acquired for the purpose of dealing with them. In no ordinary sense were they current assets. For the purposes of carrying out the scheme which was devised the shares were to be and had to be retained. The arguments before your lordships depended mainly on the submission by the Crown that the shares were acquired for a period of five years as part of the capital structure of the company from which an income would be earned and, on the other hand, on the submission of the company that they were acquired as part of their stock- in-trade.

In my opinion neither argument is correct. For the reasons which I have already given this transaction on its particular facts was not, within the definition of s. 526, "an adventure or concern in the nature of trade" at all. It was a wholly artificial device remote from trade to secure a tax advantage.

[Emphasis added.]

The same judge in FA & AB v. Lupton (Inspector of Taxes), [1971] 3 All E.R. 948 (H.L.), a case involving a very similar transaction, said at page 952:

Deriving such help as a consideration of other cases may yield — the question for decision will be whether the particular transaction under review can and should be regarded as a trading transaction within the course of the trade of a dealer in shares.

This enquiry may or may not involve or necessitate a consideration of the profitability of a transaction or of the tax results of a transaction. One trading transaction may result in a profit. Another may result in a loss. If each of these, fairly judged, is undoubtedly a trading transaction its nature is not altered according to whether from a financial point of view it works out favourably or unfavourably. Nor is such a transaction altered in its nature according to how the revenue laws determine the tax position which results from the financial position.

[Emphasis added.]

This brings me back to the questions posed at the beginning of these reasons. In my view, and while, as indicated, an intention to make a profit is not essential in order for a transaction to be characterized as an adventure in the nature of trade, such transaction must be one from which it is possible to derive a profit in a commercial sense. Trade necessarily implies at least the possibility of profit. Not surprisingly perhaps, there are no cases dealing directly with the question since it is unusual, to say the least, to find an unprofitable transaction attracting tax as an adventure in the nature of trade. That it should do so in the present case results solely as a consequence of the reduction which subsection 127.3(6) deems to take place in the cost of acquisition of an SRTC instrument.

In all the reported cases that I have seen dealing with adventures in the nature of trade the taxpayer had actually made a profit on the transaction and it was that profit which had triggered the interest of the fisc. The nearest parallel to the present case is the decision in Moloney, supra, where there was no profit, but a purported expense incurred in connection with a tax avoidance scheme was disallowed.

In all the other cases on the point, however, the Court, in deciding whether a transaction is an adventure in the nature of trade, has clearly assumed that such transaction must be one which could produce a profit. Thus, by way of example, in the leading and often quoted case of Californian Copper Syndicate v. Harris (1904), 5 T.C. 159 (Ex. Ct. (Scot.)), the test was said to be “is it a gain made in an operation of business in carrying out a scheme for profit-making?” (page 166) [emphasis added]. Likewise, in the earlier case of Grainger & Sons v. Gough, [1896] A.C. 325, 3 T.C. 462 (H.L.), Lord Davey said at pages 345-46:

Trade in its largest sense is the business of selling, with a view to profit, goods which the trader has either manufactured or himself purchased.

[Emphasis added.]

Earlier still in Erichsen v. Last (1881), 8 Q.B.D. 414, 4 T.C. 422 (C.A.), Cotton, L.J., said at page 420 (T.C. 427):

. . .in my opinion, when a person habitually does and contracts to do a thing capable of producing profit, and for the purpose of producing profit, he carries on a trade or business.

[Emphasis added.]

The profit must also, in my view, be a commercial one. Or to put the matter another way, a purely notional profit cannot serve to turn an otherwise unprofitable transaction into an adventure in the nature of trade. The test being whether the transaction is of the same kind and carried on in the same way as one which a trader would normally enter into, it seems evident to me that no trader who expected to stay in business would enter into transactions which were capable of producing only fictitious profits.

Accordingly, while the appellant’s cost of acquisition of the debenture is deemed for tax purposes to be reduced to $100,000, that is a fiction: his real cost remains $200,000 and the fictionally reduced cost cannot be used to attribute to the transaction itself a profit-making capability which it does not have in reality.

The test for an adventure in the nature of trade is an objective one based upon the standard of the “ordinary trader or dealer". If the Income Tax Act is to deem a transaction to produce a notional profit, that profit must not be treated as real for the purposes of applying the test. In the context of the present case that means that the question to be asked must be whether such a purely notional profit would serve to induce a trader to enter into the transaction. In my view, it is clear that it would not. The real and only inducement here was the tax credit but that, as we have seen, cannot serve to turn the transaction into an adventure in the nature of trade.

I conclude, therefore, as did the Tax Court judge, that the appellant's purchase and subsequent redemption of the SRTC debenture was not an adventure in the nature of trade and that his deemed gain therefrom should be treated as a capital gain and not as income.

I would allow the appeal, set aside the decision of the Trial Division and restore the judgment of the Tax Court with costs throughout.

Pratte, J.A. (dissenting):—The facts which gave rise to this appeal as well as the relevant statutory provisions are set out in the reasons for judgment of my brother Hugessen.

In my view, the Trial Division was right in holding that the gain of $40,000 realized by the appellant on the redemption of the $140,000 debenture issued by Dynaflex Industries Inc. was income from an adventure in the nature of trade rather than a capital gain.

That gain of $40,000, of course, was not real. In fact, the appellant sustained a loss of $60,000 on the redemption of the debenture since he had paid $200,000 for it. However, pursuant to subsection 127.3(6) of the Income Tax Act, he was deemed to have acquired that debenture at a cost of $100,000. Hence, the $40,000 gain.

The appellant does not challenge that, for the purposes of the Income Tax Act, his acquisition and the subsequent redemption of the Dynaflex debenture resulted in a gain of $40,000. He agrees that the deeming provision of subsection 127.3(6) must be applied in order to determine whether the transaction resulted in a gain or a loss. However, his argument that the $40,000 was not a profit resulting from an adventure in the nature of trade is based on the assumption that subsection 127.3 has no role to play in the characterization of the transaction as an investment or an adventure in the nature of trade. In my view, that assumption is wrong.

As the deeming provision contained in subsection 127.3(6) was not enacted for special or limited purposes, it must be applied for all purposes relevant to the Income Tax Act including the characterization of a transaction as an investment or an adventure in the nature of trade. It follows that in determining the real nature of the transaction here in question one must assume that the appellant acquired the Dynaflex debenture for $100,000 and ignore the fact that he actually paid twice that amount for it.

As it is common ground that the appellant acquired the debenture with the intention that it be redeemed for $140,000 shortly afterwards, it also follows that he is in the same situation as if he had bought tor $100,000 a painting that he intended to sell a few days later for $140,000. His profit of $40,000 clearly results from an adventure in the nature of trade. If the appellant could make a persuasive argument to the contrary, it is only by referring to the fact that he actually paid $200,000 for the debenture (and could not, as a consequence, hope to make a profit on its redemption). But, as I have said, that fact must be ignored.

I would dismiss the appeal with costs.

Appeal allowed.

Canadian Reynolds Metals Company Limited — Société Canadienne de [Indexed as: Canadian Reynolds Metals Co. v. Canada]

Federal Court-Trial Division (Joyal, J.), April 28, 1994 (Court File Nos. T-4829-81, T-983/4-85), on appeal from assessments of the Minister of National Revenue.

Income tax—Federal—Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

The appellant was primarily engaged in the business of producing primary aluminium. The main earth-source raw material in the aluminium production process is mineral bauxite. The bauxite is ground, is digested in a caustic solution and eventually produces a substance called alumina. Alumina is aluminium oxide, being 53 per cent aluminium and 47 per cent oxygen. It takes about 190 tons of alumina to produce 100 tons of aluminium. Although alumina is the main ingredient in the production process, other substances are involved. The purpose for which these various substances are used is that through a process of electrolysis, the oxygen is reduced from the alumina to produce primary aluminium. The electrolysis process takes place in a large rectangular steel container called a cell or a pot. During the years under appeal, there were in excess of 800 pots at the appellant’s plant. Each pot is ined with refractory material to insulate the box and with carbon. Over time, substantial wear and tear to the cell becomes evident. As a consequence, a periodical clean out of all that each cell contains and a complete reconstruction of its contents are required. The cost associated with this relining operation is one of the issues in dispute. The appellant claimed that such expense was on account of capital to be depreciated in the course of the life expectancy of the lining. The Crown, knowing that in the past, the appellant consistently treated the cost as a recurring expense, saw no reason why the cost should now be capitalized.

The history of the appellant’s decision to change its accounting treatment is as follows. The cell has an average life of 20 years but originally, the useful or productive life of the lining was much shorter, somewhere around 20 months. Over the years, however, industrywide technological improvements, together with plant improvements, increased the lifespan of the lining. By 1978, the average life span had reached four years and by 1992 it had reached in excess of eight years. In 1982, the appellant’s auditors reexamined the whole accounting treatment given to the relining programme. By that time, the cost per replacement unit had reached about $60,000 and the current expense approach, which had been used up to that time, was creating significant distortions in the appellant’s balance sheet and profit and loss statements. The pots containing all the lining components had become significant capital assets. It was accordingly decided to treat each pot as two separate capital items, namely the steel cell itself and the cell’s lining. The first issue was whether the appellant could capitalize these recurring relining expenditures.

There was also a second issue and that related to whether some of the material which went into the production process was inventory of a kind to entitle the appellant to a three per cent inventory allowance under paragraph 20(1 )(gg). Although the basic material in the production process was alumina, the mix also contained quantities of cryolite, aluminium fluoride, sodium carbonate and anode carbon (coke, pitch and paste). The appellant took the view that these ingredients were eligible for the inventory allowance. The appellant's position, in terms of the chemical reactions taking place in the cell, was that all the products were the actual instruments in the process of producing aluminium. The ingenious combination of them, when subjected to electric current, resulted in a chemical transformation when positive and negative electrons in the respective products were exchanged and some of them became incorporated in the final product, aluminium. The Crown conceded that alumina, cryolite and aluminium fluoride were incorporated into the final product and were therefore eligible for the inventory allowance but it contested the eligibility of the other chemicals used in the production process.

HELD:

With respect to the capitalization issue, the appellant’s evidence on the technological progress made over the years to improve the life-span of the linings was pretty persuasive of now a particular cost may evolve from being one on current account to one of capital expense. The periodic relining was also effectively a replacement cost. In addition, the classifying of this expenditure as capital was in accordance with Generally Accepted Accounting Principles (GAAP) since from a purely accounting point of view, capitalizing the cost of that property provided a more accurate and more objective analysis of the appellant's balance sheet and of its profit and loss statement. Finally, even if everything were equal, there was left to a taxpayer in these circumstances a residual discretion which should be respected. In the result, the capitalization issue was resolved in favour of the appellant and it was entitled to capitalize the relining expenditure.

With respect to the second issue, the inventory allowance does not apply to all products which a taxpayer may have in inventory. It only applies to a product which is processed into property for sale, or fabricated into property for sale, or incorporated into property for sale, or attached or otherwise converted into property for sale. In this case, the closest the appellant’s argument could come to such “annexation” was that some electrons from the carbon anode were electrolytically liberated and found their way into the end product, aluminium. The flaw in that argument was that the product itself, namely carbon, did not find itself processed, or manufactured or incorporated into the product aluminium. Accordingly, it was concluded that the chemicals in issue, which included sodium carbonate and anode carbon (coke, pitch and paste), did not find their way into the products for sale and were not entitled to the inventory allowance. Appeal allowed in part.

Guy Du Pont and Basile Angelopoulos for the appellant.

Roger Leclaire and Josée Tremblay for the respondent.

Cases referred to:

Harry Ferguson (Motors) Ltd. v. 1.R.C., 33 T.C. 15, [1951] N.I. 115;

Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, [1985] 2 C.T.C. 111,

85 D.T.C. 5373;

Tucker v. Granada Motorway Services Ltd., [1979] 2 All E.R. 801, [1979] 1 W.L:R.

683;

Central Amusement Co. v. Canada, [1992] 1 C.T.C. 218, 92 D.T.C. 6225;

Canadian General Electric Co. v. M.N.R., [1962] S.C.R. 3, [1961] C.T.C. 512, 61

D.T.C. 1300;

The Queen v. Metropolitan Properties Co., [1985] 1 C.T.C. 169, 85 D.T.C. 5129;

Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd., [1964] A.C.

948, [1964] 2 W.L.R. 339;

Golden Horse Shoe (New) Ltd. v. Thurgood, [1934] 1 K.B. 548, 18 T.C. 280;

Glenco Investment Corp. v. M.N.R., [1967] C.T.C. 243, 67 D.T.C. 5169;

M.N.R. v. Vancouver Tugboat Co. Ltd., [1957] C.T.C. 178, 57 D.T.C. 1126;

Hinton (H.M. Inspector of Taxes) v. Maden & Ireland Ltd., 38 T.C. 391, [1959] 3 All

E.R. 356;

Tank Truck Transport Ltd. v. M.N.R. (1965), 38 Tax A.B.C. 332, 65 D.T.C. 405;

Halifax Cablevision Ltd. v. M.N.R., [1983] C.T.C. 2677, 83 D.T.C. 630;

Saskatchewan Wheat Pool v. The Queen, [1985] 1 C.T.C. 31, 85 D.T.C. 5034;

Burra rd Yarrows Corp. v. The Queen, [1986] 2 C.T.C. 313, 86 D.T.C. 6459;

Mattabi Mines Ltd. v. M.N.R., [1989] 2 C.T.C. 94, 89 D.T.C. 5357;

Consumers' Gas Co. v. D./M.N.R. (Customs and Excise), [1972] F.C. 1057, 72

D.T.C. 6431;

Code Brothers Ltd. v. Phillips, [1982] 2 All E.R. 247, [1982] S.T.C. 307;

O'Grady v. Bullcroft Main Collieries Ltd. (1932), 17 T.C. 93;

Thompson Construction (Chemong) Ltd. v. M.N.R., [1957] C.T.C. 155, 57 D.T.C.

1114;

Ted Davy Finance Co. v. M.N.R., [1964] C.T.C. 194, 64 D.T.C. 5124.

Joyal, J.:—These consolidated appeals by the appellant against a number of tax reassessments raise a number of factual and legal issues and, in the course of the trial and of later interventions, have caused counsel for the parties and their witnesses to marshal much evidence and considerable argument. After all this, however, the parties will concede that there is not much conflict on the facts and debate centres generally on the application of various income tax rules to these facts.

Background

The plaintiff is primarily engaged in the business of producing primary aluminium. Its production facilities are located in Baie Comeau. These facilities were originally built in 1955-57 when the operations were owned by the British Aluminium Co. In 1960, Reynolds Metals Co., of Richmond, Virginia, purchased a major interest in the Canadian company and in 1970, took over complete control and made the plaintiff its subsidiary.

The Baie Comeau plant’s annual capacity was originally 55,000 metric tons of aluminium. Since that time, a number of major plant expansions have taken place and today, its production is at the level of some 400,000 metric tons. The aluminium plant itself covers some 33 hectares and the whole plant property takes up some 700 hectares.

To produce an annual 400,000 tons of primary aluminium takes a lot of equipment and a large work force. Some 1,900 employees are located there and its financial statements contain figures usually in the seven to nine digit range.

In the course of the taxation years under appeal, two main issues are raised. One is the capitalization of certain recurring expenditures in production process equipment and the other is whether some of the material which goes into the production process is inventory of a kind to entitle the taxpayer to a three per cent inventory allowance under paragraph 20(1 )(gg) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). It is obvious that a determination of either issue calls for an inquiry into the type, nature and characteristics of the process involved in the production of aluminium. The process is far from simple, but the Court should nevertheless attempt to summarize its main features or its technology. In this regard, the Court has before it the evidence of Dr. N.E. Richards, Manager of the Manufacturing Technology Laboratory of the plaintiff's parent company in the United States, who provided the parties with a 28-page textbook or vade mecum on that subject. There is also the evidence of Dr. E.W. Dewing, a consultant in chemical metallurgy, who reports on the chemical reaction created by the electrolysis process ana provides additional scientific details.

Aluminium production process

The main earth-source raw material is mineral bauxite. In the case of the plaintiff, this is shipped to a plant in Texas where the bauxite is ground, is digested in a caustic solution and eventually produces a substance called alumina. Alumina is simply aluminium oxide (AI,O,). It is 53 per cent aluminium and 47 per cent oxygen. As indicated by Dr. Richards, some 190 tons of alumina are required for every 100 tons of aluminium produced.

Although alumina is the main ingredient in the process, other substances are also involved. These include cryolite (NA,AIF,), aluminium fluoride (AIF sodium carbonate (soda ash — NA,CO,) and calcium fluoride (fluorspar — CAF,).

Other materials required include coke which, when mixed with pitch, produces a paste which is called anode paste and is made in the form of briquettes. These briquettes may be called the carbon anode.

The purpose for which these various substances are used is that through a process of electrolysis, the oxygen will be reduced from the alumina (Al to produce primary aluminium (Al).

The electrolytic process takes place in a large rectangular steel container called a cell or a pot. These pots are arranged in five series called pot lines. At the relevant time, there were in excess of 800 pots or cells at Baie Comeau. Each pot is lined with refractory material to insulate the box and with carbon (coke, soft pitch and anthracite). In electrolytic terms, this is called the cathode.

Into this is fed a molten solution of the basic ingredients mentioned earlier, namely alumina, cryolite, aluminium fluoride and to which are added fluorspar and soda ash.

The electrolytic process takes place whereby, through a strong electric current, the substances I have described enter into a series of chemical reactions. Carbon electrons from the carbon anode become detached and oxygen ions are attached to form carbon dioxide. The detached electrons are then carried to the molten solution, releasing the oxygen and resulting in metal aluminium. This aluminium is then periodically vacuum-drawn into crucibles, transported to the cast house where it is poured into furnaces, subjected to purification treatment and finally cast into various semi-finished aluminium products.

Problems develop, some of which may be solved without removing the cell from the pot line. Over time, however, more substantial wear and tear to the cell becomes evident. Leaks appear, hard muck is formed, structural and chemical degradation takes place, erosion of the carbon layer allows the bath to overheat the steel shell, and the accumulation of electrically-resistive layers causes a cell voltage which is no longer economical. As a consequence, a periodical clean out of all that each cell contains and a complete reconstruction of its contents are required. It is the cost associated with this relining operation that is one of the issues in dispute. The plaintiff says that such expense is on account of capital to be depreciated in the course of the life expectancy of the lining. The defendant, knowing that in the past, the appellant consistently treated the cost as a recurring expense, sees no reason why it should now be capitalized. The relining operations themselves, as well as the costs charged to them, are not in dispute.

Cathode cell relining

The evidence tells us that where the rectangular steel cell or pot has an average life of some 20 years, the useful or productive life of the lining (or cathode) has historically been much shorter and in the earlier years, somewhere around 20 months. The practice of the plaintiff, at that time, was to charge the replacement cost to current expense. Over the years, however, industry-wide technological improvements, together with plant improvements in the control and monitoring of the electrolytic operations, have slowly but consistently increased the life-span of the cathode. In the relevant taxation years, the functional period had increased to some 45 to 60 months.

Particular attention in the 70s was paid to the tracking of data with respect to insulation or refractory bricks, carbon blocks, pitch paste, and other components of the process. All of this information was computerized. Through strong research and development programs conducted by the plaintiff's parent company, the quality of carbon was improved, energy consumption was reduced, lithium fluoride was added to the bath to allow operations at a lower temperature. The result was a constant improvement in the useful life of the cathode. By 1978, the average life span had reached some four years. By 1992, it had reached in excess of eight years. Tables and graphs filed in the record by the plaintiff provides a pretty clear picture of a constant improvement curve.

It was in 1982 that the plaintiff's auditors reexamined the whole accounting treatment given to the cathode-relining programme. By that time, the cost per replacement unit had reached something close to $60,000. Being in the process of adopting more contemporary methods categorized as the Sumitomo and Péchiney technologies, it was felt that the trend towards an increasing life-span would continue. In the meantime, the current expense approach was creating significant distortions to the plaintiff's balance sheet and profit and loss statements. The cells or pots containing all the cathode components had become significant capital assets. It was accordingly decided to treat each pot as two separate capital items, namely the steel cell itself and the cell’s lining.

The inventory issue

As explained earlier, the basic material in the production of aluminium is alumina (Al In the mix, however, is added quantities of cryolite, aluminium fluoride, sodium carbonate and anode carbon. Anode carbon itself comprises coke, pitch and paste. The plaintiff takes the view that these ingredients are inventory of a nature to which paragraph 20(1 )(gg) of the Income Tax Act applies, entitling the inventory to a three per cent inventory allowance.

The only way to understand the plaintiff’s rationale for this claim is to go into somewhat greater detail as to the process which takes place in the cells and how, through electrolysis, the chemical reactions involving these ingredients result in a metal becoming separated or released from its compounds and becoming the element aluminium (Al).

According to Dr. Richards, cryolite (NA,AIF.) is the basic electrolyte material into which alumina and the other chemicals are dissolved. Five tons or less are consumed for each 100 tons of metal produced. Then comes aluminium fluoride (AIF;) to maintain proper chemical balance in the cryolite bath. To this is added calcium fluoride or fluorspar (Can) and sodium carbonate or soda ash (NaZCO3).

The other substances are of course coke and pitch which are mixed to form the anode paste. As Dr. Richards puts it (P-22, page 15):

44. The cathode is comprised of the hearth or layer of prebaked carbon blocks underlying a pool of molten aluminium. This is called the metal pad and the surface in contact with the molten bath is the actual or active cathode. The bath or electrolyte forms a frozen layer of cryolite on the inside surfaces of the carbon sidewalls which protects and accounts for the long life of these sidewalls. The anode of a V.S.S. cell (A-25) is a single, rectangular block of self baking carbon. The extent of immersion and interelectrode distance is regulated by a mechanized jacking and suspension system. The electrodes are connected in a series by massive conductors known as "the bus work".

45. The anode consists of a single block molded from coke and pitch and baked so that it no longer contains volatile materials. The carbon in the anode is the source of the electrons which are moved around the electrical circuit and end up combined with the Al ions to form the metal aluminium. As electrons are so transferred, the remaining positively charged carbon ions combine with the oxygen-containing anions originating from the alumina (Al to form carbon dioxide (CO,). The carbon anode is thus consumed while contributing to the production of the metal aluminium.

46. The function of the carbon anode is to provide for the separation of the oxygen from the alumina (Al dissolved in the electrolyte. It provides tne electrons for the neutralization of positively charged aluminium ions at the cathode which, in turn, form liquid metal aluminium in the cell. The difference in voltage between cells moves these electrons from the anode of one cell to the cathode of the next.

Dr. Richards also explains (at page 19) the chemical reactions as they occur in the cell, namely the electrolyte, the anode and the cathode.

The electrolyte is the molten solution of cryolite, alumina and fluorspar, to which aluminium fluoride and soda ash are added to control and optimize the chemical composition of the bath. Cryolite, alumina and aluminium fluoride, he says, form part of the end product. During electrolysis, they dissociate with the net result that electrons are collected from the carbon anode and are transferred to the aluminium ions in the cathode, ultimately resulting in the liberation of the pure metal aluminium. Says Dr. Richards at page 20:

57, Thus, aluminium from these discrete sources, namely aluminium fluoride, cryolite and alumina, becomes the end product metal aluminium resulting from the electrochemical discharge of Al . . .from these sources. . . .

With respect to anode carbon, Dr. Richards suggests that its function in the electrolytic process is completely different from the function of “reagents” in ore beneficiation (of which more will be heard later in these reasons). According to Dr. Richards, carbon anodes are consumed, chemically changed and the electrons derived from them are essential to the production of metal aluminium. Indeed, he says, "It is those electrons which give to aluminium all of its characteristic metallic properties".

The plaintiff's position, in terms of the chemical reactions taking place in the cell, is that all the products which have been described are the actual instruments in the process of producing aluminium. The ingenious combination of them, when subjected to electric current, results in a chemical transformation when positive and negative electrons in the respect products are exchanged and some of them become incorporated in the product aluminium. There is therefore no reason, says the plaintiff, why the inventory of these materials should not enjoy the special allowance provided in paragraph 20(1 )(gg).

The law on the capitalization issue

It has often been repeated that the concepts of capital and income expenditures are not defined in the Income Tax Act. The general approach, of course, has reflected the principles of “lasting value” for one or recurring expenditure for the other. In most cases, the difference is readily apparent and no issue arises. In other cases, however, it happens that all of the historical criteria or principles relied upon to make a finding one way or the other are in a conflict situation, effectively resulting in a balance of considerations. In such cases, the final determination is not so easy.

The problem was expressed by Lord Chief Justice MacDermott back in 1951 in the case of Harry Ferguson (Motors) Ltd. v. I.R.C., 33 T.C. 15, [1951] N.I. 115 (N.I.C.A.) where ne said at page 42 (N.I. 139):

There is so far as we are aware no single infallible test for settling the vexed question whether a receipt is of an income or capital nature. Each case must depend upon its particular facts and what may have weight in one set of circumstances may have little weight in another. Thus the use of the words "income" and "capital" is not necessarily conclusive; what is paid out of profits may not always be income; and what is paid as consideration for a capital asset may on occasion be received as income. One has to look to all the relevant circumstances and reach a conclusion according to their general tenor and combined effect.

It follows from the foregoing that courts must take guidance from somewhere, if only to respect criteria which will assure some consistency in the doctrine and avoid too many conflicting decisions. That kind of guidance must come from case law. This is the view adopted by Estey, J. in Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, [1985] 2 C.T.C. 111, 85 D.T.C. 5373, where at page 70 (C.T.C. 125, D.T.C. 5383) he quotes the statement of Lord Wilberforce in Tucker v. Granada Motorway Services Ltd., [1979] 2 All E.R. 801, [1979] 1 W.L.R. 683 (H.L.) at page 804 (W.L.R. 686), as follows:

It is common in cases which raise the question whether a payment is to be treated as a revenue or as a capital payment for indicia to point different ways. In the end the courts can do little better than form an opinion which way the balance lies. There are a number of tests which have been cited in reported cases which it is useful to apply, but we have been warned more than once not to seek automatically to apply to one case words or formulae which have been found useful in another. . . . Nevertheless reported cases are the best tools that we have, even if they may sometimes be blunt instruments.

Further enlightenment on the issue was provided more recently by Rouleau, J. of this Court in Central Amusement Co. v. Canada, [1992] 1 C.T.C. 218, 92 D.T.C. 6225, at page 221 (D.T.C. 6228) where he said:

The determination as to what constitutes a capital expenditure as compared to a revenue expenditure is often an arduous task. There is no hard and fast rule as to when expenditures made on capital assets will, and when they will not, be considered to be capital expenditures within the meaning of paragraph 18(1)(b) of the Income Tax Act. Although general principles can be extracted from the jurisprudence, the issue of capital expenditure versus expenses, is largely a question of fact in each case and often a question of degree. The determination cannot be made by the application of any rigid test or definition. Rather, it is derived from an appreciation of the whole set of circumstances, some of which may point to the conclusion that the expenditure is capital in nature and others which indicate it is an expense. What is required is a common sense correlation of the legal principles as set out in the case law with the unique fact situation of any given case.

In a review of jurisprudence where courts had to come to terms with borderline cases, some insight may be gained, at least by analogy, in reviewing briefly the following cases.

In Canadian General Electric Co. v. M.N.R., [1962] S.C.R. 3, [1961] C.T.C. 512, 61 D.T.C. 1300, Martland, J. said at page 12 (C.T.C. 520, D.T.C. 1304):

Profits from a business subject to any special directives in a statute, must be determined in accordance with ordinary commercial practices.

In The Queen v. Metropolitan Properties Co., [1985] 1 C.T.C. 169, 85 D.T.C. 5129, Walsh, J. of this Court said at page 181 (D.T.C. 5137):

The fact that prior to the 1974 taxation year the Department of National Revenue had permitted defendant's predecessor corporations to deduct the type of expenses with which we are here concerned as revenue expenses does not of itself establish that this was normal commercial and business practice, nor does it estop plaintiff from adopting a different position for the 1974 taxation year.

In Johns-Manville Canada Inc., supra, the Supreme Court of Canada considered at length whether lands acquired by the taxpayer contiguous to its open-pit mining operations and necessary to maintain the appropriate wall slope and angle of repose of the overburden constituted a capital outlay or a running expense. Estey, J. reviewed at length the many expressions and comments made in other cases. He cited among others a Privy Council decision in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd., [1964] A.C. 948, [1964] 2 W.L.R. 339 at page 960 (W.L.R. 346), to the effect that when defining a capital structure established for an “enduring profit", "enduring" did not necessarily mean permanent nor did it mean perpetual. Estey, J. also cited Romer, L.J. in Golden Horse Shoe (New) Ltd. v. Thurgood, [1934] 1 K.B. 548, 18 T.C. 280 (C.A.) at page 563 (T.C. 300), to the effect that the issue ”. . .depends in no way upon what may be the nature of the asset in fact or in law. Land may in certain circumstances be circulating capital. A chattel or a chose in action may be fixed capital. The determining factor must be the nature of the trade in which the asset is employed". Finally, Estey, J at page 72 (C.T.C. 126, D.T.C. 5384) said that ”. . .where the taxing statute is not explicit, reasonable uncertainty or factual ambiguity resulting from lack of explicitness in the statute should be resolved in favour of the taxpayer".

In the Central Amusement case, supra, Rouleau, J. had to decide whether the amounts expended for conversion kits to replace the circuit boards on video games which, through recurring use by the public, had become obsolete, constituted a capital expenditure or a current expense. On the grounds that these circuit boards were changed on a continual and recurring basis, that the advantages gained were temporary (usually six to eight months) and that the costs involved were minor in relation to the value of the equipment, Rouleau, J. ruled the costs as being current in nature.

On the other hand, in Glenco Investment Corp. v. M.N.R., [1967] C.T.C. 243, 67 D.T.C. 5169 certain expenses in a building for special electrical wiring and washroom/toilet facilities to meet a lessee’s requirements were deemed as constituting an enduring benefit and ruled capital expense. [1]

In M.N.R. v. Vancouver Tugboat Co. Ltd., [1957] C.T.C. 178, 57 D.T.C. 1126, Thurlow, J. (as he then was) faced the issue of the cost of a new engine aboard one of the respondent's tugs which the plaintiff wanted to expense. His Lordship, in allowing the Crown's appeal and ruling that it constituted a capital outlay, said at page 188 (D.T.C. 1131):

While the expense of replacing engines is a recurring one in the sense that it recurs in respect to each tug once in five, eight, or ten years, I do not think the expenditure can be classed as one made to meet a continuous demand. There may be more or less continuous demand for repairs to the tug and to the engine in it, but there is no continuous demand for replacement of the engine any more than there is continuous demand for replacement of the hull as a whole. Moreover, in my opinion, the respondent's trade has gained an advantage by the expenditure, in that the expenditure has provided an engine which makes the tug more reliable, keeps it more constantly in service, and enables it to earn greater revenue and at the same time avoids the abnormal repairs formerly required. And such advantage is of an enduring nature in that the anticipated life of the new engine is ten years. No doubt there will be wear and tear each year beyond what is restored by repairs in the year and the advantage will ultimately be exhausted, but in my opinion that does not affect the nature of such advantage as capital. If any deduction from income is to be allowed in respect of such exhaustion, in my view, it must be by way of an allowance of the kind permitted under the exception to paragraph 12(1)(b).

In Hinton (H.M. Inspector of Taxes) v. Maden & Ireland Ltd., 38 T.C. 391, [1959] 3 AIT E.R. 356, a majority of the House of Lords ruled that the cost of knives and lasts purchased by the taxpayer for its shoemaking machines constituted a capital outlay. It would not have appeared to their Lordships that the low nominal value of the knives and lasts, nor their useful life of two or three years, made any difference to their determination.

The principle that a capital asset which might be regarded as only a part of a larger asset, as in the case of a tugboat engine, may still be treated separately for tax purposes was recognized in: Tank Truck Transport Ltd. v. M.N.R. (1965), 38 Tax A.B.C. 332, 65 D.T.C. 405, in regards to the replacement of steel tanks carried aboard tank trucks; and in Halifax Cablevision Ltd. v. M.N.R., [1983] C.T.C. 2677, 83 D.T.C. 630 (T.C.C.), with regards to drop lines connecting distribution cables to a subscriber's house.

As one may observe from all of the foregoing cases, the basic principles of “enduring asset” or “recurrin expenditure" have been applied fairly consistently. Where some of these cases, however, might be more than “blunt instruments", the rationale in the determination of each particular issue implies different perceptions, approaches, constructs and terms which are harmonious with the ultimate opinion expressed in the judgment call made. The logical conclusion, in effect, is that each hard case needs to be particularized.

The law on inventory allowance [paragraph 20(1 )(gg)]

The relevant statutory provision of the Income Tax Act reads as follows:

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(gg) Inventory allowance.— an amount in respect of any business carried on by the taxpayer in the year, equal to that portion of three per cent of the cost amount to the taxpayer, at the commencement of the year, of the tangible property (other than real property or an interest therein) that was

(i) described in the taxpayer's inventory in respect of the business, and

(ii) held by him for sale or for the purpose of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into or used in the packaging of, property for sale in the ordinary course of the business; This special allowance was put into the statute book in 1977. The Federal Court of Appeal noted in the case of Saskatchewan Wheat Pool v. The Queen, [1985] 1

C. T.C. 31, 85 D.T.C. 5034, at page 33 (D.T.C. 5036), that

. . .its obvious purpose was to allow some relief to businesses from the increased tax liability due to "false" profits created by the effect of high inflation on year-end inventories. [2]

In the case at bar, the materials which are in dispute consist of coke, pitch, anode paste, cryolite, aluminium fluoride and sodium carbonate. The material which does not appear to be in dispute consists of alumina, which, as noted before, is the basic raw material from which aluminium is produced. In argument, however, counsel for the defendant conceded that some aluminium (Al) is obtained from cryolite and aluminium fluoride.

It was said in Burrard Yarrows Corp. v. The Queen, [1986] 2 C.T.C. 313, 86 D. T.C. 6459 (F.C.T.D.), at page 316 (D.T.C. 6461), that four preconditions must be met before a taxpayer may benefit from a paragraph 20(1)(gg) allowance. The first condition is that the allowance must be claimed on the cost amount of the property at the beginning of the year. The second condition is that the property must be tangible property other than real estate or an interest therein. The third condition is that the property be described in the inventory in respect of the taxpayer's business. There is no dispute with respect to these conditions.

The fourth condition is the one in issue, namely whether the impugned products are

. . .[being] processed, [fabricated], manufactured, incorporated into, attached to, or otherwise converted into property for sale in the ordinary course of that business.

The Court is not aware whether or not an electrolytic process of the nature described was in the minds of the legislators when that particular statutory provision was adopted. The chemical reaction whereby, through electrolysis, electrons released from carbon run to aluminium compounds and in turn release the oxygen therein is a pretty arcane or esoteric process. The parties agree, however, that the matter has not been previously subjected to judicial test and that very little case law exists to guide the Court.

Nevertheless, a similar but not identical process was scrutinized by Teitelbaum, J. in Mattabi Mines Ltd. v. M.N.R., [1989] 2 C.T.C. 94, 89 D.T.C. 5357, whose learned and considered judgment was later confirmed by the Federal Court of Appeal. In that case, the mining company had a process to form copper, zinc and lead concentrates from the raw ore extracted from an open pit operation. The raw ore was put through various crushers until pulverized into a granular form or coarse powder.

To produce the concentrates, a flotation process was used. This is described at page 96 (D.T.C. 5359) as follows:

Flotation is a physico-chemical method of concentrating finely ground ores. The process involves chemical treatment of an ore pulp to create conditions favourable for the attachment of certain mineral particles to air bubbles. The air bubbles carry the selected minerals to the sources of the pulp and form a stabilized froth which is skimmed off while the other minerals remain submerged in the pulp.

The chemical treatment involved consists of flotation reagents categorized as conditioners, modifiers, activators, depressants, frothers and collectors. Different categories of reagents are used for different purposes and different amounts are added to the pulp depending on what mineral is involved. When air bubbles are fed into the pulp, the reagents cause one or more of the minerals to cling to the bubbles and rise to the surface. There, the minerals are skimmed off and the residue is slag. The operation is several times repeated to achieve the required level of concentration.

The company claimed that these reagents were inventory and entitled to the three per cent inventory allowance. Establishing that treating the reagents as inventory was a good and well-accepted accounting practice, the company argued that the reagents were fully covered by subparagraph 20(1 )(gg)(ii) in that they were held for the purposes of being processed, fabricated, manufactured, incorporated into, attached to or otherwise converted for sale of the concentrates.

The company also relied on Interpretation Bulletin IT-435R issued June 23, 1982, which at paragraph 17 states as follows:

17. With regard to the requirements in 14(b) above, the Department's position is that the inventory must be physically used or be an actual ingredient in the finished product, but it is not necessary that the inventory be identifiable in the finished product. An example of a raw material which is an essential ingredient of the finished product is a chemical used to make a product, where the chemical is not identifiable in the end product. Examples of materials which are not physically used or an actual ingredient in the finished product are supplies and spare parts used to maintain and repair machinery essential to production or a combustible material, such as coal, used to generate the energy necessary to operate the equipment.

In his decision, Teitelbaum, J. carefully analyzed the function and the purpose of the reagents and how they are used. He found that they create conditions favourable to the adherence of the minerals to the air bubbles, resulting in the required separation. He found that the bulk of the reagents remain in the tailings and only minute particles are present in the saleable concentrate. They in fact disappear altogether in the final refining process.

Teitelbaum, J. then concluded that the reagents were not property that could be said to be ''processed into" or "incorporated into" property for sale and therefore were not entitled to an inventory allowance.

Another case cited is Consumers' Gas Co. v. D./M.N.R. (Customs and Excise), [1972] F.C. 1057, 72 D.T.C. 6431, where the issue was whether regulators to vary gas pressure in the delivery of gas to consumers were, under the Excise Tax Act, exempt from tax as being "machinery and apparatus sold to or imported by manufacturers or producers for use by them directly in the manufacture or production of goods”.

In confirming the earlier Tariff Board decision that the regulators did not qualify for an exemption, the Federal Court of Appeal said at page 6440 (F.C. 1073):

. . .it was still open to the board on the material before it to regard as it did the gas itself as the “goods” referred to in the statute and to find, as it also did, that the pressure regulators had not changed the commercial qualities or characteristics of that gas to such an extent as to amount to “manufacture or production” of gas in the common meaning or sense of that expression.

In my opinion, it was also open to the board to find, as it did, as a concomitant to this conclusion that the change in pressure was but a change in pressure at which the gas was delivered, for to my mind it appears from the evidence that the successive steps in reducing the pressure of the gas to move it safely and economically through the appellant’s distribution system and the pressure maintained at the several stages of movement of the gas through that system could be regarded as features or characteristics of that system and as dictated by its needs and the need to deliver the gas to consumers at a sufficiently high range of pressure to enable the final regulator to maintain the supply at a low but constant pressure.

One may observe from the foregoing cases that the conditions for an inventory allowance nave certainly not been interpreted in a fashion that would bring all property in inventory within the terms of the benefit. In other words, when interpreting such terms as "processed into” or “incorporated into” or "manufactured into" or "attached to", the courts so far have resisted a reductio approach and have shied away from adopting the doctrine of analogous grounds too readily. Findings

The Capitalization Issue

There is no penury of evidence in respect of the electrolyte or cathode as property and as to its identity in the process of producing metal aluminium. That evidence from the plaintiff's witnesses seems to be in sync on both the nature and the characteristics of that property and on its periodic replacement costs as constituting a capital outlay.

The story told from the earlier years of the Baie Comeau operations up to the taxation years in question and beyond is pretty conclusive in explaining why the plaintiff should have decided that the replacement costs, hitherto expended annually, should later be capitalized.

I must find that in terms of definable property, in terms of its function in the production process, in terms of its increasing life-span, it certainly fits into the various categories of capital assets which case law has long established and recognized. Whether one is dealing with an engine in a tugboat, washroom facilities in a building, knives and lasts in the fabrication of shoes, or a steel tank aboard a tank truck, the same principle of “lasting asset" or "enduring benefit" applies.

The evidence of the plaintiff on the technological progress made over the years to improve the life-span of the cathodes — from 20 months to 45-60 months and currently running at some eight or nine years — is pretty persuasive of how a particular cost may evolve from being one on current account to one of capital expense.

I am also satisfied that on the evidence, the periodic relining of the cathode is effectively a replacement cost. The steel cell, after removal from the pot-line, is literally scoured of all its contents before the relining operation takes place. This involves the installation of insulation material, refractory bricks, coke, pitch and paste, briquettes and steel rods to carry the electric current. In the relevant period, the operation required some 28 man days to complete and the cost ran from $46,000 to $60,000. This might not be a big item in a big plant when each cathode is examined individually. It will be recalled, however, that the plaintiff runs five pot-lines with a total in excess of 800 cells, which one can measure as requiring annually some 150 relinings. Currently, the plant has in excess of 1,000 cells and relining costs have now reached something close to $100,000 each.

The evidence is also clear that classifying this expenditure as a capital outlay is in accordance with Generally Accepted Accounting Principles (GAAP). Mr. D. Filion, a chartered accountant, is quite satisfied that the cathode is readily identifiable as tangible property and although its earlier life-span might not have made of it property of lasting value, the longer life later experienced invited another look. From a purely accounting point of view, capitalizing the cost of that property provides a more accurate and more objective analysis of the plaintiff's balance sheet and of its profit and loss statements. Mr. Filion also suggested that if the relining costs had remained constant, the distortion under the earlier scheme might have been minimal, but the cost escalation over a period of time made the issue more substantial.

The evidence of Mr. lan Hume, also a chartered accountant, confirms that of Mr. Filion in declaring without hesitation that the capitalization of the cathode costs is very much in accordance with GAAP. In this regard, Mr. Hume considered a number of sources dealing with the subject of current expenditures and capital costs, including the Canadian Institute of Chartered Accountants’ "Handbook", Mr. R.M. Skinner's “Accounting Principles” (CICA 1972), and other authorities as well.

The witness quotes from R.M. Skinner’s book, which states at page 88 that:

In theory, any tangible asset acquired for use and not for resale and having a usefulness extending beyond one yearly accounting period is a capital asset.

It might be argued that such a theoretical approach does not always meet the realities of a situation, but in my view, its application creates no problem in the case at bar.

Mr. Hume also cites authority in respect of the dissociation of certain component parts of an asset if such parts were to have a useful life different from the asset as a whole. In this respect, he cites as examples an aircraft and its engine, a building and its roof and its plumbing, which might be separately accounted and depreciated accordingly.

The defendant, however, invites the Court to step back from the cathodic process and take a much broader view of aluminium production as a whole. Included in the assets of the plant are harbour facilities, discharging equipment, storage silos, huge suction elevators, cells, forms and crucibles. These, says defendant's counsel, are obviously capital assets. Not so, however, for the production process where the cathodes, being an integral part of that process, are simply consumable stores applied against the revenue-producing process.

I will concede that such an approach to the subject matter is arguable and in other circumstances might even be conclusive. In my respectful view, however, the cathodes involved are identifiable and separable as are indeed the steel cells themselves. The situation in that respect is no different from that recognized by courts in some of the cases I have cited and in many others as well, namely: Code Brothers Ltd. v. Phillips, [1982] 2 All E.R. 247, [1982] S.T.C. 307 (H.L.) ; O'Grady v. Bullcroft Main Collieries Ltd. (1932), 17 T.C. 93; Thompson Construction (Chemong) Ltd. v. M.N.R., [1957] C.T.C. 155, 57 D.T.C. 1114.

The Court has no evidence before it as to what is the current industry practice with respect to similar methods of production and to what extent a breakdown of several components in a total production process has been established for expense purposes. Nor has the Court any rebuttal evidence to vary or alter the plaintiff's position on the facts it has presented. I can only observe that even if everything were equal, if no statutory bar were to intervene, and if the position were in accordance with accounting principles, there is left to a taxpayer in those circumstances a residual discretion which, in my view, should be respected.

The Inventory Allowance

This issue between the parties is somewhat more vexing. The electrolytic process in aluminium production is not an assembly job. Nor is it one where a slab of steel is added to asbestos or other refractory substances to create a firewall. It is a process of electrical energy, where indigenous substances are submitted to a chemical chain-reaction. The substances in suit are cryolite, aluminium fluoride, coke, pitch and anode paste. Of these, the defendant’s counsel has pretty much conceded that as the aluminium in cryolite and in aluminium fluoride becomes part of or is added to the volume of the final product, it might very well appear to come within the kind of property described in paragraph 20(1 )(gg) of the Income Tax Act. There is therefore left to consider the other substances, namely coke, pitch and anode paste.

The position taken by the plaintiff is that all of these substances, together with alumina, aluminium fluoride and cryolite are all chemically transformed by electrolysis and become components of the end product aluminium.

The process, says counsel, requires that the positively charged aluminium ions (Al ) which have been discharged from all of the aluminium compounds be neutralized by negative ions which are discharged from coke, pitch and anode paste (collectively the anode carbon) in the form of electrons. These electrons from the carbon anode unite with the aluminium ions found in the aluminium compounds.

As I understand counsel’s argument, it is these electrons which are incorporated into the product aluminium and as such fall into the provisions of paragraph 20(1 )(gg) of the Act. On that basis, counsel argues that:

1. The metal aluminium would not exist without these electrons, and these electrons are a recognizable, beneficial and integral part of the end product.

2. The electrons are contributed by the carbon anode and the oxygen which is liberated from the oxides unites with carbon to change its composition from carbon to carbon dioxide.

3. The chemical changes involved are neither accidental, nor incidental, nor residual in producing tne end product; they are for the very purpose intended, i.e., the liberation of pure aluminium.

Plaintiff's counsel goes to some length in distinguishing these substances from the reagents used in the flotation process described in the Mattabi case, supra, where it was ruled that such reagents did not qualify as inventory for inventory allowance purposes. As to these reagents, counsel suggests that:

1. The flotation process is more a physical beneficiation of the ore involved.

2. The separation process is through differing physical properties in the ore itself, whereby through magnetic or electrostatic forces, metallic elements adhere to bubbles and float to the surface.

3. The reagents do not react with or interchange any particle of their composition with the ore product.

4. The residual reagents left in the concentrate have not changed their nature or characteristics, nor have they absorbed any component elements in the concentrate; in fact, they remain as distinct impurities in the concentrate and are eliminated when further refining of the product takes place.

The foregoing exposé might appear to be pretty persuasive, but before analyzing it further, it might be wise to recapitulate the process which takes place in the cell. It appears to me that the basic chemical transformation which takes place is that the carbon anode releases electrons to the alumina and the oxygen ions in the alumina are transmitted to the carbon to form carbon dioxide. This transformation or decomposition is literally at the atomic level of change and according to the evidence, the electrons themselves become incorporated into the aluminium product.

This is all very well, but it must be kept in mind that the cell itself is lined not only with refractory bricks, but also with carbon made up of coke, soft pitch and anthracite. This lining forms the cathode and the surface in contact with the molten bath, consisting of alumina, cryolite and aluminium fluoride (and other conducive agents as well), constitutes the actual or active cathode.

Yet, the evidence discloses that all the different materials in the cathode cell are also transformed by the chemical process. This transformation has been called structural and chemical degradation, creating among other things an erosion of the carbon blocks on the cell base and sidewalls, allowing the cell to overheat, and an accumulation of electrically resistive layers where the voltage required is no longer economical.

I would therefore observe that if the carbon blocks and paste in the cell’s lining are also chemically transformed over time, an anomaly might be created in treating the carbon blocks and the carbon anode differently. Having found that the carbon blocks constitute part of the capital outlay, they can no longer be part of the inventory.

As stated by Gibson, J. in Ted Davy Finance Co. v. M.N.R., [1964] C.T.C. 194, 64 D.T.C. 5124 at page 197 (D.T.C. 5126):

. . . inventory in my view should not be given the broadest meaning that could be attached to it, but instead, the whole Act should be looked at to give it a reasonable and practical meaning, especially when, for example, there are sections of the Act which in themselves constitute a complete code.

And later:

Depreciable assets fit the description of “inventory” in the Act, but cannot be such because if classified as inventory, then paragraph 1102(1 )(b) of the Regulations precludes a capital cost allowance deduction.

Of course, I need not resolve that seeming anomaly for purposes of this case, but I nevertheless should point out that if both carbon blocks and carbon anode are to be treated separately, the total cost of their common ingredients would have to be segregated.

In any event, it appears to me that the only product which is left in issue in this inventory business is the anode carbon, consisting of coke, pitch and paste formed into briquettes. These briquettes in turn are dipped into the electrolyte bath. As we have seen, the anode carbon provides electrons for the reduction of alumina and provides the end product aluminium. The evidence before the Court is that the typically shiny appearance of the metal reflects the optical properties of these electrons that give it such high electrical and thermal conductivity.

All this might be true, in a sense. The question may be asked, however, whether it is in that sense that the legislators perceived an inventory allowance when paragraph 20(1 )(gg) was enacted.

First of all, the inventory allowance does not apply to all products which a taxpayer may have in inventory. It only applies to a product which is processed into property for sale, or fabricated into property for sale, or incorporated into property for sale, or attached or otherwise converted into property for sale. What meaning may be ascribed to this family of words?

The Concise Oxford Dictionary, 7th Edition, at page 820, defines "process" as a course of action; a series of operations in manufacture; natural or involuntary operation; series of changes.

At page 345, “fabricate” is defined as "construct"; manufacture (especially product in final shape from semi-finished metal stock).

At page 507, "incorporate" is said to mean unite (in one body, with another thing); combine (ingredients) into one substance.

On the face of it, the product involved would include, as the statute defines it, a multiple of tangible assets. In my view, however, it is the product which somehow or other must be processed, manufactured, incorporated into, attached to or converted into the product for sale. Heaven knows how many such assets are part of a taxpayer's inventory, but the statute makes no mention of assets or products which are used to make a product, or employed, consumed, applied or exploited for that purpose.

The closest that plaintiff's argument can come to is that some electrons from the carbon anode are electrolytical I y liberated and find their way in the end product aluminium. The flaw in that argument is that the product itself, namely carbon, does not find itself processed, or manufactured or incorporated into the product aluminium. In my view, it is only when the product goes into the product for sale can it be classified as inventory enjoying special treatment.

In any event, if it can be said that the total electrolytic process creates chemical reactions and transformations in the cell as well as in the bath, one might wonder why all of the coke, pitch and paste used in the process should not similarly be treated. In other words, the reduction process which is evident in the plaintiff's argument might have to run parallel with the reduction process in the cell itself, a position which, in the light of the capitalization issue, it would be difficult for the plaintiff to take.

I have earlier observed that it was an open question as to whether the kind of chemical process involved in the production of aluminium or of any other product was in the minds of the legislators when the statute, as drafted, was enacted. The relevant case law I have cited has evidently recognized the limitations as to the kind of inventory products which obviously do not enjoy preferential treatment. I interpret the reasoning of Teitelbaum, J in the Mattabi case, supra, as imposing on the scheme a condition that the product must find its way into the product for sale and that in the absence of that product in the product for sale, the inventory allowance does not apply to it. Teitelbaum, J. fully explored the interpretative arguments advanced by the taxpayer to the effect that the reagents added to the ore are essential raw material for the production of metal concentrates and that the process cannot be commercially viable without these reagents. He concedes that the taxpayer's reasoning on this was correct. Nonetheless, he concludes that the reagents did not find their way into the products for sale, namely the concentrates.

On the facts before me, I should arrive at the same conclusion. A contrary finding would, in my view, give an extended meaning to the text of paragraph 20(1)(gg), a meaning which, on my analysis, it will not bear. If the carbon anode is said to be consumed, it is not consumed in the aluminium product, an element which contains no carbon. It is consumed, as the evidence discloses, into carbon dioxide.

Included in the inventory which does not benefit from the inventory allowance are the other products, namely fluorspar and soda ash. These products are not in dispute. There is left, of course, the other ingredients which fall into paragraph 20(1)(gg), namely alumina (Al cryolite (NA,AIF,) and aluminium fluoride (AIF

Conclusion

These reasons dispose of both the capitalization and the inventory allowance issues. In the reassessments for the relevant tax years, however, a number of other contentious matters were raised. Subsequent to the trial and through the able collaboration and mutual understanding of both counsel, these other concerns were settled and simply require the Court's endorsement. They are as follows:

1. Plaintiff's 1977 Taxation Year

(a) The plaintiff's appeal with respect to the amount of $4,723,535, representing the plaintiff's accrued net gain at the end of its 1977 taxation year in respect of its sales made in United States dollars to affiliated companies, is dismissed.

(b) Legal expenses in the amount of $14,314, incurred by the plaintiff to earn income from a Canadian resource company, are deductible as a Canadian exploration expense in accordance with subsection 66.1(3) of the Income Tax Act.

(c) Canadian exploration expenses in the amount of $26,341.59, incurred by the plaintiff as a participant in a joint venture, are deductible as a Canadian exploration expense in accordance with subsection 66.1(3) of the Income Tax Act.

(d) The amounts of $14,314 and $26,341.59, described in subparagraphs 1(b) and (c) above, are to be included in the plaintiff's earned depletion base and the deduction permitted pursuant to subsection 65(1) of the Income Tax Act should be calculated in accordance thereof.

2. Plaintiff's 1979 Taxation Year

(a) Legal expenses in the amount of $3,270, incurred by the plaintiff to earn income from a Canadian resource company, are deductible as a Canadian exploration expense in accordance with subsection 66.1(3) of the Income Tax Act.

(b) The amount of $3,270, described in subparagraph 2(a) above, is to be included in the plaintiff’s earned depletion base and the deduction permitted pursuant to subsection 65(2) of the Income Tax Act should be calculated in accordance thereof.

(c) An additional amount of $85,462.73 will be included in the plaintiff's earned depletion base and the deduction permitted pursuant to subsection 65(1) of the Income Tax Act should be calculated in accordance thereof.

3. Plaintiff's 1980 Taxation Year

(a) The amount of $1,330,620, representing the price of aluminium in respect of which title did not pass to the plaintiff's parent and customer during the 1980 taxation year, should not be included in its income for the year.

The Court is aware that other tax consequences flow from the determination made with respect to what has been referred to as the capitalization issue and the inventory allowance issue. These consequences might include appropriate adjustments on capital cost allowance, on investment tax credits and on the earned depletion base, and perhaps include other adjustments as well. Such adjustments, in my view, flow logically and necessarily from the disposition of the plaintiff's claim to capitalize the relining costs of its cathode cells. Other adjustments might also flow from the disposition of the plaintiff's claim to an inventory allowance and which might fall into the same category of logic and necessity.

Where I would normally issue a formal judgment dealing with all substantive issues, including all appropriate adjustments for the relevant taxation years, it might be more prudent to request counsel for the parties to prepare and agree on the appropriate draft judgment and submit it to me for endorsement. In this way, there will be more assurance that all items in dispute will have been covered and that no outstanding issues are left.

Costs, including the costs of expert witnesses, are awarded to the plaintiff. These are limited to the costs of the trial, the parties having agreed that they are to absorb their own costs relative to the issues settled on consent.

I may of course be spoken to if counsel cannot reach full agreement on the terms of the draft judgment. In the meantime, of course, I remain seized of the case.

Appeal allowed in part.