Rolls-Royce (Canada) Ltd. v. The Queen, 91 DTC 5579, [1991] 2 CTC 252 (FCTD), aff'd 93 (DTC) 5031 (FCA)

Martin, J.:—The plaintiff, Rolls-Royce (Canada) Limited, is the corporation resulting from the merger of Rolls-Royce (Canada) Limited and Bristol Aero Industries (Mtl) Limited on June 16, 1979.

At issue in this matter is whether the plaintiff, by overhauling airplane engines and, to a lesser extent, other engines, during its 1977 to 1981 taxation years, manufactured or processed in Canada goods for sale or lease that would have entitled it to:

a) deductions for inventory allowances pursuant to paragraph 20(1)(gg) of the Income Tax Act (the "Act");

b) deductions from tax otherwise payable the Canadian manufacturing and processing tax credit pursuant to subsection 125.1(1) of the Act;

c) deductions of capital cost allowance on property in Class 29 of Schedule B (now Schedule II) of the Income Tax Regulations (the "Regulations").

During the relevant taxation years the plaintiff was engaged in the overhauling of aircraft engines in Canada for various air carriers. It was also engaged, as already noted, in overhauling some other types of engines but to a lesser extent. As the same principles apply to the reasoning in this matter to both types of engines I will restrict my comments to the airplane engines alone with the understanding that those comments apply equally to the other types of engines as well.

The regulatory authorities of most countries provide that an airplane engine, depending on the engine and the authority, can only be operated for a specified number of hours after which it must be removed from the aircraft and either replaced by a new engine, an acceptably certified overhauled engine, or be itself overhauled for replacement by a company certified by the appropriate authority to perform such overhauling work.

The tax considerations in this action arise only out of the operation in which the customer's engine is removed from the aircraft, overhauled and then replaced in the same customer's aircraft. This action does not concern itself with the sale, exchange or replacement of airplane engines but only with the delivery by the customer to the plaintiff of a specific engine, the overhaul of that specific engine and the return of the same engine to the same customer by whom it was originally delivered.

The plaintiff is a company certified by regulatory authorities of several countries to overhaul airplane engines. Because a given delivered engine is without certification on arrival at the plaintiff's premises, and thus unable to be used in flight, the plaintiff has, in its pleadings, characterized the engine so received as "scrap" which, in order tn be used and useful again, must be remanufactured as a new engine.

In support of this contention. the plaintiff's witnesses say that airplane engines, unlike automobile or other engines, have no single part such as the engine block of an automobile engine to which one can point as being the essential or core piece or the "engine" to which is attached other relatively minor or incidental parts which complete rather than create the engine.

Rather the airplane engine was described as a more complicated arrangement of somewhere between 5,000 and 25,000 parts which, although not all of equal significance, no one part stood out identifiably as the "engine".

The purpose of this line of evidence was, I presume, to illustrate that the piece of useless scrap representing the customer's engine, which came into the plaintiff's facility for overhauling, could not be considered to be the same engine which was returned after being overhauled or, as the plaintiff's witnesses put it, after being remanufactured. That being so it was submitted by the plaintiff that its overhauling operations amounted in fact to the manufacturing or the processing of goods for sale in Canada.

I was not much impressed by this argument. In my view there is no question that an airplane engine delivered to the plaintiff's facility retains its identity as the engine of a particular customer throughout the overhauling process and that the same engine which is delivered for overhauling is the self same engine which is returned after being overhauled.

Each such engine delivered for overhauling has a serial number by which it is identified throughout its life. Each such engine also has a log book which identifies it and its component parts throughout its life. After overhauling the engine is not sold to the customer or certified as a new engine but instead is returned to the customer complete with its record of time use on parts requiring time-use information.

It is true that on receipt of the engine for overhauling it is broken down into its component parts for inspection, cleaning, testing, metal work, processing and assembly, but the parts for each engine are not intermingled with the parts of other similar engines. Instead they are kept segregated so that the engine itself never loses its unique identity as the particular engine owned by a particular customer.

I suppose an argument could be made that if every component part of an engine were replaced the so-called overhauling process should be classified as a manufacturing one for sale. That however was not the evidence led at the trial. Invoices were introduced at the trial which simply indicated that overhauling an engine was an expensive process. The two invoices tendered identified overhauling costs in excess of $300,000 for each engine which, in the case of the overhauled airplane engine, represented about one third of the sale value of a new engine. The evidence, if I recall correctly, did not allow one to conclude what percentage of the component parts had been replaced in the overhaul but the lack of that evidence would lead me to believe that the replacement of component parts would be well below the 50 per cent level.

There was also introduced in evidence several sample contracts. These contracts did not speak of remanufacturing of the airplane engines or of the manufacturing or processing for sale of airplane engines. The contracts spoke in terms of the "Complete Engine”, the “Basic Engine", the customer's particularly identified engine, the "Overhaul of the Basic Engine", the "Repair of the Basic Engine", the "Component Repairs" and "Accessory Repairs”, none of which terms tend to indicate sale but rather service, material, repair and overhaul operations.

As I understand the issues in this matter they all centre around the question of whether the plaintiff, in overhauling the airplane engines, manufactures or processes goods in Canada for sale or lease in the relevant taxation years so as to entitle it to the tax benefits claimed.

In taxation cases of this sort there are two lines of authority. One line, Halliburton Services Ltd. v. The Queen, [1985] 2 C.T.C. 52; 85 D.T.C. 5336 (F.C.T.D.); [1990] 1 C.T.C. 427; 90 D.T.C. 6320 (F.C.A.) and Nowsco Well Service Ltd. v. The Queen, [1988] 2 C.T.C. 24; 88 D.T.C. 6300 (F.C.T.D.); [1990] 1 C.T.C. 416; 90 D.T.C. 6312 (F.C.A.) which appear to favour the plaintiff's case, and the other line of cases represented by Crown Tire Service Ltd. v. The Queen, [1983] C.T.C. 412; 83 D.T.C. 5426 (F.C.T.D.), Tenneco Canada Inc. v. The Queen, [1987] 2 C.T.C. 231; 87 D.T.C. 5434 (F.C.T.D.) and Reg Rad Tech Ltd. v. Canada, [1990] 2 C.T.C. 77; 90 D.T.C. 6350 (F.C.T.D.); [1991] 2 C.T.C. 201; 91 D.T.C. 5518 which appear to favour the defendant's case.

In my view the principles set out by Strayer, J. in the Crown Tire case apply to the factual position in this case. I have come to this conclusion notwithstanding the fact that the two cases appearing to favour the plaintiff's case went to appeal and that in those cases the Crown Tire case was distinguished by the Appeal Court and the taxpayers in each case claiming relief similar to that claimed by the taxpayer in this matter were found to be entitled to it.

In Crown Tire the taxpayer was engaged in the retreading of tires or tire casings, an operation or activity which, although not as complicated as the overhauling of an airplane engine, is, in my view, essentially the same. Strayer, J. found that while the activity constituted manufacturing or processing, which the overhauling of airplane engines must also be considered to be, he also found that the manufacturing or processing was not with respect to goods for sale or lease. Strayer, J. referred to Benjamin's Sale of Goods (London, 1974) to distinguish between a contract for the sale of goods and a contract for labour and materials in the following quote from page 29 of that work:

Where work is to be done on the land of the employer or on a chattel belonging to him, which involves the use of affixing of materials belonging to the person employed, the contract will ordinarily be one for work and materials, the property in the latter passing to the employer by accession and not under any contract of sale.

Strayer, J. then went on to observe at page 414 (D.T.C. 5428-29):

This I believe states the general principle applicable to the situation, although its application is of course always a matter for interpretation in each case.

I believe that the situation here fits within the general principle as stated in Benjamin. With respect to the retreading of tires owned by customers, it appears to me that the customers retain ownership throughout the process. In an order form admitted as Exhibit P-1, the customer asked Crown Tire Service to retread a particular tire “if economical”. Testimony from the company's officers given before me indicated that this meant that if, upon closer inspection, Crown Tire concluded that the tire was not worth retreading, it would so advise the customer and request further directions as to whether the customer wanted the tire returned to him or discarded. Where a tire was retreaded, it would be returned to the same customer who supplied it. This suggests to me that the casing was seen throughout as being the property of the customer and the work and materials provided by Crown Tire were applied to that casing. This involved essentially a contract for repairs. Once the rubber material was affixed to the casing it would become the property of the owner of the casing by accession. That material could therefore not be the subject of a contract of sale since it merged with the customer's property at the time of adhesion to it.

He concluded his remarks in this respect, at page 415 (D.T.C. 5429), in the following terms:

The most important factor in establishing that Crown Tire's contracts for retreading customers’ tires were contracts for work and material is, in my view, the fact that the work was done to a tire casing which the customer owned throughout. I think this distinguishes the present situation from those involved in many of the decided cases where the customer had never previously owned any part of the end product.

While the distinctions employed here may seem somewhat technical and remote from revenue law, one must assume that Parliament in speaking of “goods for sale or lease" had reference to the general law of sale or lease to give greater precision to this phrase in particular cases.

The major considerations which caused Strayer, J. to conclude as he did were:

(i) the property or chattel upon which the work was done and the new material attached remained the property of the customer throughout the process;

(ii) the contract was essentially a contract of repair so that the new materials or items added to the customer's chattel became the property of the owner or customer by accession;

(iii) since the new material or items added to the customer's chattel merged with the customer's chattel at the time of adhesion to it the material or items so attached could not therefore be the subject of a contract of sale.

As already indicated Strayer, J. concluded that the most important of the above considerations was the fact that the work was done to a chattel which the customer owned throughout and this, he noted, distinguished the Crown Tire case from those involved in many of the decided cases where the customer had never previously owned any part of the end product.

In the Halliburton and Nowsco cases, decided at trial by Reed, J. and Cullen, J. respectively, and on appeal by Urie, J.A. with Heald and Stone, JJ.A. concurring, the Federal Court of Appeal found that the tax benefits claimed by the taxpayers in those cases, which were similar to the benefits claimed by the taxpayer in this case, should be allowed.

The preferred decision by the Appeal Division was that of Reed, J. in the Halliburton case. In this respect both Reed, J. and Urie, J.A. distinguished but did not overrule the decision of Strayer, J. in the Crown Tire case. At trial Reed, J. had this to say about the Crown Tire decision:

It should first of all be noted that while Mr. Justice Strayer relied on the distinction between contracts for the sale of goods and contracts for work, labour and materials as described in Benjamin's Sale of Goods, he expressly noted that the application of that principle was "always a matter for interpretation in each case". Secondly the processing with which he was concerned did not involve the creation of a good antecedent to its use in the provision of a service. Thirdly, the significant factor in that case was the fact that “the work was done to a tire casing which the customer owned throughout”. Accordingly, while the distinction between contracts for the sale of goods and contracts for work, labour and materials may have been significant in the Crown Tire Retreaders case, I do not think it is applicable in the present one.

I agree with the distinctions made by Reed, J. Firstly, I have concluded that the contracts for overhaul or repair of the customer's engines were essentially ones for work, labour and materials and not contracts for the sale of goods. Secondly, I agree that the Halliburton and Nowsco cases involved the creation by the taxpayer of a good or product, cement, prior to its use in the provision of the service. This was done by the taxpayer in those cases in what one of the trial judges described as mobile factories owned by the taxpayers and brought to the oil-well site for the purpose of producing or manufacturing the product which was then sold to the customer.

Finally, Reed, J. acknowledged that the significant factor in the Crown Tire case was the fact that the chattel, upon which the work was done, was a chattel which the customer owned throughout and that that factor was not applicable in the Halliburton case which was then under her consideration.

In my view the distinctions made by Reed, J. between the Halliburton case, which she decided, and the Crown Tire one, decided by Strayer, J., apply equally to the present case.

Counsel for the plaintiff urged me to find that the Federal Court of Appeal's decisions in the Halliburton and Nowsco cases had, in effect, overruled the Crown Tire case and that by virtue of the principle of stare decisis I was bound to give effect to the decisions of the Appeal Division and find in his client's favour in this matter. I do not see the decision of Urie, J.A. in that light at all.

Urie, J.A., who gave the Appeal Division's decision in both the Halliburton and Nowsco cases, said, with respect to the Crown Tire decision, that he had reviewed it and had found it distinguishable on its facts which, of course, was precisely what Reed, J. had decided as well.

In the Nowsco decision, at page 423 (D.T.C. 6317), Urie, J. said, with respect to the Crown Tire case and the Halliburton case, that the factual situations were not at all comparable and that counsel for the appellant in the Halliburton case had, presumably unlike counsel for the taxpayer in the Crown Tire case, misconstrued the nature of the relationship between the parties:

Suffice it to say that to focus on the fact, as did counsel for the appellant in this case, relying on the Crown Tire Service [supra, pages 414-15 (D.T.C. 5428-29)], case for support, that the work having been done to the property of the respondent's customers involving the use or affixing of materials thereto was the provision of a service to the customers, misconstrued the nature of the relationship between the parties. The factual situation in that case was not comparable to that in this case. A orief reference to the evidence indicates the reality of the relationship here.

Urie, J.A. went on to describe what he considered the differences between the customer-taxpayer relationship in the two cases in the following terms:

1. in the oil well cases it is the taxpayer who prepares a proposal but it is the customer who must make the decision on each branch of the proposal;

2. after the proposal is accepted by the customer the taxpayer proceeds to the well site with his “mobile factory" to create the specialized cement;

3. the product is created by the taxpayer at the well site and delivered to the customer who at all times remains in complete charge and control of the equipment for receiving delivery of the newly created product;

4. the taxpayer guarantees no results;

5. the taxpayer bills the customer for both materials which it provides and the services which it renders;

6. Urie, J.A. acknowledged the difficulty in determining whether the cement was processed for sale within the meaning of the Act and, in this respect, observed at page 424 (D.T.C. 6318):

. . . I believe that determining the particular time at which and where title to the goods passes, is of little importance, on the facts of this case, in the determination of the relationship between the parties. However, what is of some significance, I think, is that since the products furnished are produced to the particular specifications of the operator/customer and must be paid for by it whether completely used or not (subject to some limited contractual exceptions), it may well be that title passes when the mixing and blending is effected.

Of the six times which Urie J.A. noted to indicate the reality of the relationship between the customer and the taxpayer, and how the facts in the case he was considering were not comparable to those in the Crown Tire case, only one of the items appears to be similar to the facts in the present matter and that is item 5 whereby the taxpayer bills the customer for both materials and services.

However even this apparent similarity is not really comparable for in the case being considered by Urie, J.A. the billing of materials are for those provided in accordance with the customer's specifications while in the present case the billing of materials is simply an itemization of the materials which the taxpayer has decided are necessary in order to complete its contract for overhauling the engine.

I agree with the observations made by Urie, J.A. that the Crown Tire case and the oil well cases are not comparable and I find that the present case bears far more similarity to the Crown Tire case than to the oil well cases. In this case the customer relies completely upon the taxpayer's judgment for the work and materials to be supplied. No new goods are created which are sold to the customer prior to their being incorporated into the customer's engine. It is the taxpayer and not the customer who remains in control of the entire operation. It is the taxpayer who guarantees the work. Finally, title to the materials used passes from the taxpayer to the customer not by sale as found by Urie, J.A. in the oil well cases but by accession at the time they are attached to and become a part of the engine being overhauled similarly to the position in the Crown Tire case.

Furthermore it is a fact and, according to Reed, J., a significant factor differentiating the cases that in the Crown Tire case the customer owned the chattel throughout. Urie, J.A. did not suggest that this was not a significant factor in the Crown Tire case or that it was a factor to be ignored in other cases. He simply pointed out that in his view counsel’s over emphasis on this factor in the oil well cases had the effect of misconstruing the nature of the relationship between the parties. I am unable to accept those observations as being tantamount to overruling the Crown Tire case or the reasoning upon which it was based.

Counsel also addressed me on the matter of the law of Quebec which they submit is applicable to the interpretation of the contracts for the overhaul of the airplane engines. In this respect I have little experience. However from listening to counsel and upon considering the authorities and authors cited by them I am satisfied that the position under Quebec law is the same as I have found it to be under the common law cases cited to me.

Mignault, in his 1906 treatise on Le droit civil canadien, at page 402 refers to the work of a tailor on a customer's bolt of cloth to be made into a suit becoming attached to it by accession rather than by a sale. Again, at page 405 of the same work, Mignault refers to the same principle which would govern in the case of things such as buttons, threads and linings which are added to the customer's cloth becoming the property of the customer as and when those accessories are attached to the material owned by the customer.

There is also the quote from Faribault's 1951 Traité de droit civil du Québec (translated by counsel for my benefit) at page 424 at which the learned author discusses Article 1685 of the Quebec Civil Code using the same sort of example cited by Mignault and notes that:

Such accessories become my property as and when they are attached to the material which I own.

The rule established by this section is general, and applies to all contracts of enterprise, whether in respect of moveable or immoveable property.

Like Collier, J. in Reg Rad Tech Ltd. v. Canada, supra, I find that the oil well cases are distinguishable. In this case the plaintiff, likewise, was not engaged, as its primary purpose, in the processing of goods for sale. It was, from a common sense and business-like appreciation of the evidence, engaged in the overhauling and repairing of airplane engines which, throughout the process, remained the property of the customers to which the labour and materials which were added became a part of the overhauled or repaired engine by accession and not by sale.

It follows from what I have said that the plaintiff's appeal is dismissed. The defendant will have Her costs of this action.

Appeal dismissed.