SPG International Ltée v. R., [1998] 3 CTC 2046, 98 DTC 1706 (TCC)

Dussault T . C.J.:

This is an appeal from an assessment of the appellant, SPG International Ltée (“SPG”), for its 1991 taxation year. In the assessment, the Minister of National Revenue (“the Minister”) disallowed the appellant’s deduction of $99,287.31 in expenses on the basis of subsection 9(1) and paragraphs 18(l)(a) and (b) of the Income Tax Act (“the Act"). According to the Minister, the expenses, which were paid by the appellant and can be referred to as promotional expenses, were in fact incurred by its wholly owned American subsidiary, International Tool Boxes Corp. (“ITB”). The Minister’s position is that the necessary sums were simply advanced by the appellant to ITB and were therefore outlays of capital for the appellant.

At the start of the hearing, counsel for the appellant acknowledged that $2,462.20 in expenses were non deductible. The dispute therefore relates to the balance of $96,825.11.

In their written arguments, counsel for the parties set out the facts of this case in detail, the essential elements of which I will summarize here.

Since the 1960s, SPG has been carrying on business in Drummondville, Quebec, as a manufacturer of toolboxes and metal lockers for mechanics.

Its hundred or so products are sold primarily in the automotive aftermarket and the hardware market under the “International” trademark and the private trademarks of some of its clients. In the late 1980s, although the appellant was well placed in the Canadian market, its annual sales appeared to be levelling off at around $10,000,000.

In early 1990, Guy Guérette, the appellant’s sole shareholder, hired Maxime Poulin as the appellant’s chairman and chief executive officer and assigned him the specific task of doubling sales. Following certain initiatives and consultations, Mr. Poulin decided to focus his efforts on the United States, where the appellant had enjoyed little success, its very uneven sales having never exceeded $125,000.00 a year. Until that time, the sales manager for the American market lived in Canada and the appellant used a number of American manufacturer’s agents to sell its products. However, those individuals were also responsible for selling other types of products.

Once the difficulties of breaking into the American market and the need to present an American image by having staff and operations in the United States were understood, the first decision that was made was to incorporate a wholly owned subsidiary in the United States. ITB was therefore incorporated in Plattsburgh, New York, in June 1990. The initial capital invested by the appellant was about $1,000.00. Mr. Poulin was appointed as the president and René Lavigne as the secretary-treasurer. Mr. Lavigne was then the appellant’s vice-president of finance and internal comptroller.

In February 1991, an American, Brian Erickson, was hired as ITB’s sales manager in order to develop the American market. It is not entirely clear exactly what benefits, in the form of commissions, bonuses or profit- sharing, were granted to Mr. Erickson in addition to his salary. In any event, that has no direct bearing on the outcome of this case, since his total remuneration, his secretary’s salary, office expenses and certain commissions given to salespersons were paid directly by ITB out of funds provided to it by the appellant through periodic bank transfers. All of the funds thus transferred to ITB were treated as advances by the appellant to ITB and not as expenses for which the appellant could claim a deduction.

According to Mr. Poulin, Mr. Erickson already had some experience in this field, and one of his first tasks was to contact twenty or so target clients identified in the automotive after-market and the hardware market. Accordingly, in 1991 Mr. Erickson had to make two trips to the United States to meet these clients, present the products manufactured by the appellant and inquire about specific market needs.

Mr. Poulin also said that Mr. Erickson quickly realized that the Americans preferred high-end and low-end products, while the appellant specialized in manufacturing mid-range products. This meant that new products had to be developed in order to adapt to the American market as rapidly as possible.

When Mr. Erickson began contacting clients in the United States, he used the existing promotional materials in SPG’s name until SPG changed its catalogues, brochures and price list to include ITB’s name and the new products. This evidently occurred in the summer of 1991.

The expenses in issue in this case, which SPG would like to deduct, are expenses it incurred and paid itself to try to market its products in the United States. They include expenses incurred in 1990 to reserve space at 1991 trade fairs, including in Chicago, the cost of Mr. Erickson’s trips around the United States in 1991, which was paid using an American Express credit card issued in his name but held by the appellant, and expenses incurred to print catalogues, brochures and price lists ordered directly by the appellant but to be used by ITB.

Those expenses, which were paid in full by the appellant, were initially treated as advances in 1991 and entered in the books by the comptroller, René Lavigne, in the same account that showed bank transfers to ITB, namely the account for receivables from the subsidiary. It was not until after the year ended that, with a view to preparing the appellant’s financial statements and income tax return, it was decided, on the advice of external auditors from the firm of Verrier Paquin Hébert, to claim the expenses in question as expenses incurred by the appellant to try to break into the American market. It should also be noted that the appellant never billed ITB for the expenses.

In his testimony, Mr. Lavigne explained that the only reason the expenses were entered in a special account in the books as an amount owed by ITB to the appellant was to keep the expenses incurred to develop the American market separate from other expenses in order to have a precise idea of the cost of the project.

Mr. Poulin testified that he did not give Mr. Lavigne any specific instructions on how to record the expenses. According to him, it was clear that the appellant was incurring expenses to market its own products in the United States and that those expenses, including the cost of printing advertising brochures and catalogues, were of the same type as those incurred to promote its products to major distributors such as Home Hardware or Canadian Tire. As for ITB’s participation in trade fairs with the appellant, Mr. Poulin said that since the appellant had more or less required its subsidiary to participate, it seemed natural for it to absorb the related costs. As regards Mr. Erickson’s travel costs, Mr. Poulin testified that the matter had been discussed and that a budget of about $40,000.00 had been agreed on to cover those costs during the first year. According to Mr. Poulin, it had been planned from the outset that the appellant would assume all of these expenses for promoting or marketing its products in the United States during a start-up period of about one year, but that ITB would have to pay its own expenses thereafter to the extent that it increased its sales and became self-sustaining. Mr. Poulin said that he believed the change in how the expenses were treated occurred gradually in 1992 when it was noted that ITB’s sales were increasing rapidly. He said that he did not remember exactly when a consensus was reached in this regard, but that he thought it was when ITB’s sales reached $1 million to $1.5 million.

Guy Guérette, the appellant’s sole shareholder, also testified. As he saw it, all of the expenses in question had to be borne by the appellant to promote its products, since the ultimate purpose of venturing into the United States was to generate sales for the appellant.

Charles Hébert from the firm of Verrier Paquin Hébert, the appellant’s auditors, was called to testify on the application of generally accepted accounting principles. In his view, the principle of matching revenues and costs and what he called the substance-over-form principle justified the appellant in claiming a deduction for the expenses in question in 1991. He felt that for the appellant the expenses were promotional expenses incurred to launch its products in a new place through the newly formed ITB. Mr. Hebert also felt that the consistency principle had not been violated, since the situation in 1992 differed from that in 1991. In his view, when the period for launching the appellant’s products in a new territory ended and ITB became increasingly self-sustaining, it made sense for it to pay its own expenses. On cross-examination, Mr. Hébert even asserted, in reference to the matching principle, that the appellant could have deducted as its own expenses the salaries that ITB paid Mr. Erickson out of funds advanced by the appellant.

It should be noted at this point that ITB’s sales reached $393,445.00 U.S. in 1991 and $1,855,787.00 U.S. in 1992. [1] According to Mr. Poulin’s testimony, the appellant initially sold its products to ITB at its manufacturing cost plus 20 percent, but this was later reduced to 10 percent. In addition, ITB’s financial statements show that its rate of gross profit went from 1.33 percent in 1991 to 11.31 percent in 1992, an increase of 9.98 percent. [2]

Counsel for the appellant essentially argued that the expenses in question, all of which were incurred and paid by the appellant, can be deducted by it because they were incurred for the purpose of increasing income from its business. Since the expenses related to the promotion of its products in the United States, he argued that they were current expenses, as found, inter alia, in Minister of National Revenue v. Algoma Central Railway, 67 D.T.C. 5091 (Can. Ex. Ct.), and Canada Starch Co. Ltd. v. Minister of National Revenue, 68 D.T.C. 5320 (Can. Ex. Ct.).

According to counsel for the appellant, even if it is acknowledged that the expenses relate to ITB’s sales, the appellant can still deduct them since it can be considered that ITB was in fact merely the appellant’s agent. The decisions in Berman & Co. v. Minister of National Revenue, 61 D.T.C. 1150 (Can. Ex. Ct.), Aluminum Co. of Canada v. R., [1974] 1 F.C. 387 (Fed. T.D.), Pigott Investments Ltd. v. R., 73 D.T.C. 5507 (Fed. T.D.), and R. v. F.H. Jones Tobacco Sales Co., 73 D.T.C. 5577 (Fed. T.D.), were referred to in support of this argument.

Counsel for the appellant argued that the expenses in issue, unlike the transfers of funds, were not treated as loans or advances of funds by the appellant to ITB in their respective financial statements and that the Supreme Court of Canada’s decision in Stewart & Morrison Ltd. v. Minister of National Revenue, [1974] S.C.R. 477, 72 D.T.C. 6049 (S.C.C.), which found that advances made by a parent corporation to its subsidiary are an investment and are therefore non-deductible outlays of capital, is accordingly not applicable to this case.

Counsel for the respondent argued that the expenses in issue cannot be deducted by the appellant. He relied first of all on the principle that a parent corporation and its subsidiary are separate legal entities, as recognized, inter alia, in Canada Safeway Ltd. v. Minister of National Revenue, 57 D.T.C. 1239 (S.C.C.), Morflot Freightliners Ltd. v. R., 89 D.T.C. 5182 (Fed. T.D.), and MerBan Capital Corp. v. R., 89 D.T.C. 5404 (Fed. C.A.). In his view, a distinction must also be drawn between a corporation and its shareholder: R. v. Jennings, 94 D.T.C. 6507 (Fed. C.A.).

Since the salaries of ITB’s employees were paid by that corporation and the income from sales made in the American market was included in its financial statements as its own income, counsel for the respondent submitted that, despite its status as a subsidiary, ITB cannot be considered the appellant’s agent. In his view, the situation is therefore different from the one described in Livingston Wood Mfg. Ltd. v. Minister of National Revenue, 63 D.T.C. 535 (Can. Tax App. Bd.).

Counsel for the respondent also distinguished the facts of this case from those of Berman, supra, since in that case the corporation had taken back all of its subsidiary’s inventory property and paid the subsidiary’s debts to all of its suppliers, which were also the corporation’s own suppliers, in order to maintain its business relationship with them. As well, in that case the appellant’s president had guaranteed payment to the suppliers either orally or in writing. The payment of the subsidiary’s debts thus seemed natural, not only for business reasons but also because there was evidence to show that the subsidiary, despite being a separate legal entity, was considered merely a branch or agent of the appellant. Counsel for the respondent also distinguished the decisions in Pigott Investments Ltd., supra, and Aluminum Co. of Canada, supra, in which it was held that there was actually an agency or relationship between a subsidiary and a parent corporation.

All in all, counsel for the respondent’s argument on this point was that there is no evidence to show that such a relationship exists in this case. In his view, the amounts in question were first entered in the books of account as advances to the subsidiary and then, only after the end of the year, converted into the appellant’s expenses once the size of ITB’s loss for the year was known. He argued that this change was made merely “for retroactive tax planning and opportunistic reasons”. In addition, he pointed to the fact that the treatment of the expenses in question did not comply with the principle that they should be matched with ITB’s revenues from sales in the American market or with the consistency principle, since the subsidiary began to absorb this type of expense itself starting in 1992 without there being any notable change in the legal relationship between it and the appellant at that time.

Analysis

To begin with, I do not believe there is any evidence to show that ITB was merely the appellant’s agent. ITB was incorporated under the laws of a foreign jurisdiction as a legal entity separate from the appellant, although the appellant was its sole shareholder. Mr. Poulin and Mr. Lavigne were ITB’s directors and managers, just as they were for the appellant, and it is clear that they, like Mr. Guérette, the appellant’s sole shareholder, had to make a number of decisions concerning the relationship between the two corporations, among other things as regards the sharing of expenses and of the sale price of products manufactured by the appellant and sold in the United States. Mr. Erickson was hired by Mr. Poulin and Mr. Guérette as ITB’s general manager. While he may have had some freedom of action, it seems clear that he did not have carte blanche to do what he wanted and that decisions were made by the appellant’s managers. It is true that the evidence shows that discussions were held with Mr. Erickson to determine what level of expenses would be incurred to break into the American market. However, there is nothing to suggest that he was able to decide how those expenses were to be treated as between the two corporations. That decision was made by the appellant’s managers, since it was, in any event, the appellant that provided the necessary funds. Was the decision made at the outset, as events unfolded or simply once 1991 was over and the operating results known? It is difficult to answer this question with certainty. What is certain is that the appellant regularly provided ITB with funds through bank transfers to cover such expenses as salaries and office costs and that ITB paid the expenses in question directly. The sums thus trans- ferred by the appellant were treated as advances to ITB and the appellant did not claim a deduction for them.

With the expenses in issue in this case, on the other hand, a decision was made to proceed differently, since it was the appellant that incurred and paid them directly.

However, it is true that these expenses were also initially entered in the appellant’s books as advances to ITB. According to Mr. Lavigne, the purpose of this was simply to provide a separate indication of the expenses incurred to develop the American market. It is also known that after the year ended, with a view to preparing the appellant’s financial statements and filing its tax returns, Mr. Poulin and Mr. Lavigne decided, together with two representatives from the firm of Verrier Paquin Hébert who were serving as external auditors, to consider these expenses as the appellant’s own and to claim a deduction for them.

The question that arises is not whether the entries made in the books during the year represented reality, but rather whether the appellant can deduct the expenses in question in light of section 9 and paragraphs 18(1)(a) and (b) of the Act.

First of all, it is clear that the expenses in question, which all relate to the promotion of products manufactured by the appellant, are generally considered current expenses rather than outlays of capital. Only if the appellant can be considered to have paid the expenses on ITB’s behalf and if ITB can be considered to owe the appellant an equivalent amount can the amount be treated as an investment in a subsidiary and thus as an outlay of capital.

Based on the appellant’s position in relation to its subsidiary, ITB, and the transactions between the two corporations in 1991, significant distinctions can be drawn in respect of the facts described in the decisions to which the parties referred. I consider the decisions in which a subsidiary was treated more or less as its parent corporation’s agent inapplicable to this case, since no evidence was adduced to this effect. Nor is it appropriate to compare this situation to a situation in which a parent corporation seeks to deduct an expense that was incurred directly by a subsidiary, that only the subsidiary was obliged to pay and that was not incurred by the parent corporation for the purpose of gaining or producing income from its own business. MerBan Capital Corp., supra, provides an example of this type of situation. It is also inappropriate to refer to situations in which a parent corporation tries to deduct amounts in respect of bad debts, as in Flexi-Coil Ltd. v. R., 96 D.T.C. 6350 (Fed. C.A.).

Unlike the cases to which counsel for the parties referred, the appellant in this case is in a unique position vis-à-vis its subsidiary, in that it is also its exclusive supplier.

First of all, only the appellant manufactures the products it sells in Canada and around the world. The subsidiary, ITB, was incorporated in the United States in 1990 specifically to try to break into the American market. ITB did not manufacture anything in 1991. It sold only products purchased from the appellant, and nothing else. Each sale made by ITB also represented a sale for the appellant. According to the evidence, in 1991 the appellant sold its products to ITB for an amount that included its manufacturing cost plus 20 percent, which was later adjusted to 10 percent. As I have already noted, ITB’s financial statements show that its rate of gross profit went from 1.33 percent in 1991 to 11.31 percent in 1992, an increase of 9.98 percent. In such circumstances, it is rather difficult to conclude that the expenses incurred and paid by the appellant, which were never billed to ITB, were not expenses incurred by the appellant for the purpose of gaining or producing income from its own business, since their unquestionable result was not only to generate income for ITB but also to increase the appellant’s income significantly. In fact, in 1991 it was the appellant that took most of the gross profits.

All in all, the appellant decided to incur and pay the expenses in question itself in 1991 to launch its promotional campaign in the United States and, obviously, to increase its own income, even though its products were ultimately sold in the American market through ITB, which meant that income could also be generated for the subsidiary. The appellant decided that the circumstances were such that it should absorb these expenses itself and not make its subsidiary pay them during the initial promotional period. In my view, this was a perfectly legitimate business decision and there is no reason why the appellant cannot deduct such expenses, just as there is no reason why it cannot generally share expenses for advertising, marketing or promoting its products with its distributors. Neither section 9 nor paragraphs 18(1)(a) and (b) preclude the deduction of such expenses in these circumstances.

Further, paragraph 18(9)(Z>) authorizes the deduction in 1991 of expenses incurred in 1990 to participate in a 1991 trade fair.

The appeal is allowed and the assessment is referred back to the Minister for reconsideration and reassessment on the basis that the appellant is entitled to an additional deduction of $96,825.11 in operating expenses for its 1991 taxation year. The whole with costs to the appellant.

Appeal allowed.