Supreme Court of Canada
Canning v. C.F.M. Fuels (Ontario), [1977] 2 S.C.R. 207
Date: 1976-12-20
Hugh James Canning and Basil Leo Canning (Plaintiffs) Appellants;
and
C.F.M. Fuels (Ontario) Limited (Defendant) Respondent.
1976: November 23; 1976: December 20.
Present: Martland, Judson, Spence, Pigeon and Dickson JJ.
ON APPEAL FROM THE COURT OF APPEAL FOR ONTARIO.
Contract—Sale of a business—Sale of shares—Warranty as to depreciation taken in valuation of assets—Interpretation—“Depreciation”—“Capital cost allowance under the Income Tax Act, R.S.C. 1952, c. 148.
Appellant brothers and a third brother were sole shareholders in a small company. In connection with the sale of fifty per cent of the shares of the company a warranty was given to the purchaser that “the company has claimed on its tax returns and has reserved on its books at least the depreciation referred to in a letter…” The letter noted “full depreciation in the accounts” for fiscal years 1967 and 1968, estimated depreciation as a charge against retained earnings prior to 31 May 1966, and full depreciation at capital cost allowance rates to 31 May, 1968. On a claim by respondent, successor to the purchaser, for breach of the warranty, the trial judge and the Court of Appeal maintained the claim.
Held: The appeal should be allowed.
On proper construction of the warranty clause “depreciation” cannot mean “full capital cost allowance.” The latter is a tax term signifying the writing off of the capital cost of an asset as allowed by the income tax regulations, whereas the former is an accounting term signifying the writing off of the cost of an asset over its useful life. The amount set aside for depreciation on the Company’s books amounted to full depreciation in that depreciation was taken on all vehicles for the period each was in service. This was done at capital cost allowance rates, i.e. amounts allowed by the tax regulations. The warranty did not specify for use of the capital cost allowance system, but only use of its rates in computing depreciation. Accordingly, there was no breach of warranty.
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APPEAL from a decision of the Court of Appeal for Ontario dismissing an appeal from a judgment of Donohue J. at trial. Appeal allowed.
J.Douglas Crane, Q.C., for the appellants.
S.G. Fisher, for the respondent.
The judgment of the Court was delivered by
DICKSON J.—The appellants are brothers. They, and a third brother, Edward Joseph Canning, were sole shareholders in a small company, Hygrade Fuels Limited, founded by their father. Hygrade Fuels was engaged in the sale at retail of fuel oil purchased from another company, Liquifuels Limited. Both companies were located in the City of Toronto. In 1968, negotiations were commenced between the appellants and Liquifuels which led to the signing of an agreement on December 4 of that year whereby liquifuels agreed to purchase all of the shareholdings of the appellants in Hygrade. The agreement gave Liquifuels a fifty per cent interest in Hygrade, the other fifty per cent remaining with Edward Joseph Canning. Following the sale, a dispute arose as to the construction of a warranty clause contained in the sale agreement and the present proceedings were instituted. The respondent, C.F.M. Fuels (Ontario) Limited, is successor to Liquifuels.
The price of shares, set out in the agreement, $371.89 per share, was based on the net book value of the shares as shown on the financial statement of Hygrade for the fiscal year, ended May 31, 1968, plus goodwill valued at $344,000, all subject to readjustment with respect to any undisclosed liabilities.
Provision was made in the agreement for a holdback of $50,000 as security for the performance of the vendors’ obligations under covenants contained in the agreement relating to accounts receivable and to furnace finance accounts. Some time after the closing the respondent paid the appellants the amount of the holdback, less adjustments. The respondent also retained out of the holdback the sum of $21,882 which it claimed by
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reason of alleged breach by appellants of a warranty contained in para. 3(g) of the agreement.
During argument, there was discussion as to the right of the respondent to retain the warranty claim out of the holdback. In its pleadings the respondent also claimed the sum by way of set‑off or counterclaim. In view of the conclusion I have reached on the main issue in the appeal, I do not think that we need consider further the niceties of pleading and the respective burdens of proof, other than to say that the appellants would appear to have assumed throughout the burden of proving their entitlement to the monies in dispute, whereas I should have thought that burden was properly that of the respondent.
The warranty clause in contention reads:
(g) The Company’s inventory has been valued for at least the last five (5) fiscal years at the lower of cost or market in accordance with sound accounting principles consistently applied, and the Company has claimed on its tax returns and has reserved on its books at least the depreciation on fixed assets referred to in a letter from the Company’s auditors to the Purchaser dated the 5th day of November, 1968. [Emphasis added.]
The letter to which reference is made reads:
5th November 1963.
Mr. J.M. McLean, Liquifuels Limited,
347 Bay Street,
Toronto 1, Ontario.
Dear Sir:
Re: Hygrade Fuels Limited
We understand that you have requested assurance from Mr. Hugh Canning that full depreciation has been provided to 31st May 1968 in the accounts of the subject company.
No depreciation had been provided in the accounts to 31st May 1966 which was prior to our engagement as auditors. We provided full depreciation in the accounts for the fiscal years 1967 and 1968. We provided in the 1967 statements as a charge against retained earnings our estimate of the depreciation which had not been provided for to 31st May 1966.
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To the best of our knowledge, full depreciation (using capital cost allowance rates) has been provided in the accounts to 31st May 1968.
Yours very truly,
SMITH, NIXON & CO.
per “J.H. Nixon”
“per FB”
JHN:fb
c.c. Mr. Hugh Canning
The circumstances giving rise to the letter and the warranty are these: During the negotiations, Mr. Hugh Canning, one of the vendors, received a telephone call from a Mr. McLean, who was the principal negotiator for Liquifuels, requesting certain financial information. Mr. Canning referred Mr. McLean to the auditor for Hygrade, Mr. J.H. Nixon. Mr. McLean advised Mr. Nixon that Mr. John Taylor, president of Liquifuels, was concerned that the income tax rate of depreciation, namely thirty per cent, had been taken on the Hygrade vehicles. Mr. McLean explained that Mr. Taylor had found from experience that some companies that had been purchased by Liquifuels had only depreciated their fleet at the rate of ten per cent or fifteen per cent per annum and this rate of depreciation did not reflect the true value of the fleet. Mr. Taylor considered that a thirty per cent rate of depreciation gave a reasonably good indication of fair market value of the assets. Mr. McLean asked Mr. Nixon to send a letter stating that full depreciation had been provided. The letter of November 5, 1968 was in response to that request. The question whether the depreciation shown on the financial statements of Hygrade was identical with the amount claimed as capital cost allowance on the income tax returns of that company was never discussed by Mr. McLean and Mr. Nixon. Yet it is that question which is central to this appeal.
Some time after closing it came to the attention of Liquifuels that, whereas the value of the fixed assets, less depreciation, of Hygrade according to the balance sheet as at May 31, 1968 amounted to $138,779 the capital cost allowance claimed in the Company’s income tax returns was such that unde-
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preciated capital cost of fixed assets amounted to $95,014, a difference of $43,765. The price of the common shares would have been reduced by $43,765 if, as the respondent contends, the undepreciated value of fixed assets should have been shown on the balance sheet as $95,014 and not $138,779.
The respondent, as purchaser of a fifty per cent interest in Hygrade, claims it overpaid fifty per cent of $43,765 or $21,882. The validity of this claim rests upon the construction of the warranty clause and letter.
Before examining in more detail the clause in question and Mr. Nixon’s letter, it might be well to mention that Mr. Nixon became auditor of Hygrade in 1967. His appointment was recommended by an officer of Liquifuels. At the time of appointment, the financial records of Hygrade were in a sorry state. Depreciation had not been provided for in the accounts to May, 1966. Mr. Nixon was instructed to put the books in proper order. He accordingly obtained particulars of the approximate cost of each vehicle in the Hygrade fleet and its date of acquisition. He then set up on the books of the Company a depreciation item for each vehicle, computed on a reducing balance basis at a rate of thirty per cent per annum, the maximum rate allowed for income tax purposes and for the period the vehicle was in service. This resulted in an increase on the books of an additional $115,000 in depreciation. Relying upon all of this, Mr. Nixon assured Mr. McLean that full depreciation had been provided in the accounts to May 31, 1968.
The capital cost allowance claimed on the income tax returns of Hygrade was computed on different basis. The Income Tax Act and regulations thereunder permit a taxpayer to claim capital cost allowance in respect of vehicles at a rate of thirty per cent on the reducing balance but the tax regulations are generous in the sense that they permit a claim for a full year’s capital cost allowance although the vehicle may have been purchased on the last day of the year. The significance of this becomes apparent by an example. Assume the purchase of a vehicle worth $10,000 on
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December 1 of any year. If a company wishes to depreciate the vehicle according to the time the vehicle is in service, directly matching cost to income, the depreciation taken at year end on December 31 would amount to $250 being thirty per cent of $10,000 for one twelfth of a year. On the other hand, for income tax purposes the company could claim $3,000, being thirty per cent of $10,000. For this and other reasons, the depreciation claimed on the books of any company and the capital cost allowance claimed on the income tax returns are often substantially different figures.
Turning now to the warranty clause, the trial judge, Donohue J., dismissed the plaintiffs action and allowed the counterclaim of C.F.M. Fuels. I refer to the judgment at trial because the Court of Appeal for Ontario in large measure merely adopted the views of the trial judge. The two following passages embody the gist of his judgment.
I believe that the clear implication of this wording in the warranty is that the depreciation shown in the income tax returns and that shown on the books of Hygrade which would include the financial statement for May 31st, 1968, is the same figure. Obviously it is not.
…
I find, therefore, that Mr. Hugh Canning and his co-plaintiff knew about the substantial difference between the two values mentioned above, yet they warranted, as I have found, that these values were the same. This is quite enough to conclude the case in favour of the defendant.
The difficulties which I have with this language are two-fold. First, C.F.M. Fuels did not contend at trial, or before this Court, that the vendors had warranted the depreciation on the Company books and the capital cost allowance on the tax returns to be the same figure: the contention was that the warranty assured that full depreciation would be taken on the Company books in accordance with the entire capital cost allowance “system” and that that had not been done. Mr. Taylor, through his counsel, denied it was the respondent’s position
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that the appellants had warranted identical figures:
Q. Then it is your allegation that the letter and the contract combined together to make the Plaintiffs warrant that the income tax depreciation and the depreciation on the books is identical?
A. No.
Secondly, at no time has C.F.M. Fuels taken the position that Mr. Hugh Canning and his co‑plaintiff knew about the substantial difference between the two values. They denied such knowledge, and counsel for C.F.M. Fuels conceded at trial that they did not know of the difference. Hugh Canning testified that it never crossed his mind that there was a difference between the depreciation on the Financial Statements and undepreciated capital cost, because he was not knowledgeable in accounting matters. Counsel for the respondent said during cross-examination of Mr. Canning that he did not suggest, for a moment, that Mr. Canning had been trying to deceive anybody. Counsel said repeatedly that his clients were not alleging misconduct on the part of anyone. For the respondent, no one ever inquired whether the depreciation on the books was identical with the capital cost allowance claimed on the tax returns and no one examined those returns prior to closing. Mr. Taylor was asked during discovery:
Q. 220 And if I can read, ‘At no time was Mr. Canning asked to confirm nor was it indicated that the depreciation shown on the balance sheet was the same as the capital cost allowance shown on the income tax return.’ Is that statement correct, Mr. Taylor?
He replied:
As far as I am concerned, it is. You see, it wouldn’t prove anything if it had been.
The case for C.F.M. Fuels does not rest upon misrepresentation, innocent or otherwise. Counsel simply says that on a proper construction, the warranty clause entitles the purchaser to claim that depreciation on the books of the Company should have been computed in the same manner as
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capital cost allowance for the purposes of the Income Tax Act. That is the issue.
The Court of Appeal for Ontario affirmed the judgment at trial, in these words:
The purchaser took the position that the company had warranted that the value of the fixed assets reserved on the books of the company would be determined after deducting from cost of full amount allowed for capital cost allowance, pursuant to the provisions of the Income Tax Act. In other words, the value of the fixed assets as set forth in the income tax returns would be the same as that reserved on the books of the company.
The learned trial Judge accepted that submission and found in favour of the purchaser, and we are all of the opinion that he was correct in so doing.
Reverting to the clause in question wherein it was warranted that the company had claimed on its tax returns and had reserved on its books at least the depreciation of fixed assets referred to in the auditor’s letter, it is clear, in our opinion, that what was warranted there was that the books of the company would reflect the same value for fixed assets as was provided for in the income tax returns. In the letter previously referred to, the words “full depreciation” are used throughout, accompanied by a reference to the use of capital cost allowance rates.
In seeking to interpret the warranty clause, one must first have regard to Mr. Nixon’s letter of November 5, 1968. The first point to note is that the word “depreciation” is used no less than five times; the words “capital cost allowance” are used once, in parenthesis, and in respect of rates only.
“Depreciation” is an accounting term. It signifies, according to the evidence, the writing-off of the cost of an asset over its useful life. Mr. P.H. Lyons, a chartered accountant, and an expert witness for the respondent, was asked: “Are we on common ground that the depreciation is an auditing word and not a tax word?” He replied: “Yes, it hasn’t been a tax word since 1948.” Capital cost allowance, on the other hand, is a tax term signifying the writing-off of the capital cost of an asset in an amount allowed by income tax regulations. There is no necessary connection between
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depreciation and capital cost allowance. It would appear from the evidence that it would be entirely fortuitous, or the result of a deliberate company policy, if the two were found to be identical. It seems to me that Mr. Nixon was quite in order in saying that the Company had taken full depreciation when it is understood that depreciation was taken on all vehicles for the period each was in service and at maximum rate of thirty per cent. He was also correct in saying that capital cost allowance rates had been used, that is to say, thirty per cent in respect of vehicles and at rates allowed by the tax regulations for other fixed assets. If, instead of the phrase “(using capital cost allowance rates)”, Mr. Nixon had spelled out the actual rates to which he was referring, so that the crucial paragraph of his letter read: “To the best of our knowledge, full depreciation (using thirty per cent on vehicles, twenty per cent on plant and equipment, ten per cent on buildings and coal yard) has been provided in the accounts to 31st May 1968”; the cornerstone of respondent’s case would be gone. The words in fact used, the words in brackets, refer only to “rates” and I can see no reason, in principle or otherwise, why they should be distorted to mean “(using the capital cost allowance system)”. Should Hygrade Fuel’s or Mr. Nixon be faulted for failing to take depreciation on vehicles for periods during which the vehicles were not owned by Hygrade? Surely the words “full depreciation” do not lead to such an extravagant result.
Passing then to para. 3(g), by which the vendors represent and warrant that the Company has claimed on its tax returns and has reserved on its books at least the depreciation on fixed assets referred to in the letter dated November 5, 1968. The words “at least” should not be overlooked. If it had been the intention of the draftsman of para. 3(g), that the books of the Company would reflect the same value for fixed assets as the income tax returns, one can only say that he chose strange wording to effect his purpose. Why would he not
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have stated merely that the Company had reserved on its books “full capital cost allowance,” or that the Company had depreciated fixed assets to the maximum allowed under the Income Tax Act? If the “depreciation” referred to in para. 3(g) means “full capital cost allowance,” what purpose then is served by “at least”? If, as I deem, the amount set aside for depreciation on the Company’s books amounted to full depreciation, then of course there had been no breach of the warranty, for that is the amount claimed on the books and “at least” that amount, indeed a greater amount, was claimed in the tax returns. One might perhaps wonder why a purchaser would want to be assured that “at least” a certain amount had been claimed on the tax returns when his interest lay in minimizing rather than maximizing the claim for capital cost allowance but the language is that of the purchaser, in the letter of intent and in the formal agreement, and the purchaser must be taken to have used the language advisedly.
A bulletin of the Institute of Chartered Accountants recognizes the difference between depreciation and capital cost allowance. Where the profit shown on the financial statement of a company is greater than that reported for income tax purposes, by reason of the company claiming a greater amount of capital cost allowance for tax purposes than claimed on the books for depreciation, a deferred income tax item must be shown on the financial statement. Such a notation is not required in respect of a company in a loss-carried-forward position, such as Hygrade as at May 31, 1968.
The appellants submitted that, even if there had been a breach of warranty, it was incumbent upon the respondent to prove damages and that on the undisputed facts the respondent did not suffer damage. At the time of the purchase, Hygrade had a tax loss of some $66,000, of which the respondent was unaware until after the closing, which served to offset later profits and reduce subsequent tax liability of Hygrade by an amount in excess of
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the $21,882 set off. It was also submitted that the true purpose of the warranty was to ensure that the value paid for the fleet of vehicles did not exceed fair market value; that appraisals showed the fair market value to be in excess of the net book value on the Financial Statements; therefore no damage. As the warranty was not breached, in my opinion, it is unnecessary to consider these further submissions.
I would allow the appeal, set aside the judgment of the Court of Appeal and substitute judgment in favour of the appellants for $21,882 plus, as agreed upon by the parties, interest at six and three-quarters per centum from December 4, 1968. The appellants are entitled to costs throughout. The respondent’s counterclaim should be dismissed without costs.
Appeal allowed with costs; counter claim dismissed without costs.
Solicitors for the appellants: Carrick, O’Connor, Coutts & Crane, Toronto.
Solicitors for the respondent: McMillan, Binch, Toronto.
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