Scannar Industries Inc. (Receiver Of) v. R., [1996] 2 CTC 105, 96 DTC 6237

McKeown J.T.C.C.: — Scannar Industries Inc. (Scannar) appeals the assessment for tax made by the Minister of National Revenue (the Minister) under the Scientific Research Tax Credit (SRTC) provisions of the Income Tax Act, R.S.C. 1952, c. 148, as amended (the Act). The Minister alleges that Scannar did not make a payment of $25 million to a company, Proteus Bio-Research Corporation (Proteus) to do scientific research on its behalf notwithstanding the terms of a contract between Scannar and Proteus. The transactions in question do not fail to comply with the Act because they were “quick flip” transactions; such transactions were permitted under the Act as it then existed. The legitimacy of quick flip transactions, however, will not overcome the requirement that the contract between the parties must be one which is intended to be relied upon. In the case at bar, the agreement between Proteus and Scannar required that $25 million in scientific research be performed; notwithstanding the alleged payment of $17.7 million by Scannar to Proteus, no research was performed because, according to Proteus, an anticipated $7.3 million tax refund was never received.

The primary issue in this case is whether the $25 million payment was made by Scannar to Proteus. If I find that no payment of $17.7 million was made, and therefore, that the $25 million was not a real figure, then no deduction may be made under paragraph 37(1 )(a). If, however, I find that the payment was made, the Minister submits that that deduction is prohibited under subsections 245(1), 18(9) or section 67 of the Act. Both parties agree that no research was done.

Before proceeding to review the facts, it is useful to review the legislative facts surrounding the introduction of the SRTC and the subsequent moratorium on the issuance of so-called “quick flip” SRTC investments. I adopt the review set out in the Agreed Statement of Facts in Penner v. R. (sub nom. Penner v. Canada) [1994] 2 C.T.C. 253, 94 D.T.C. 6567 (F.C.T.D.) as follows at pages 255-57 (D.T.C. 6568-70):

A. Legislative Facts

1. Incentives for research and development have been provided for in the Income Tax Act for some time. Historically these tax incentives were only of value to companies that were currently paying tax. To assist research companies to attract external financing for their research and development programs in the April 19, 1983 Budget the Minister of Finance, the Honourable Marc Lalonde introduced a new financing mechanism for R&D companies. (Budget Speech - Tab 1; Research and Development Tax Policies Paper tabled with Speech - Tab 2; Comments of Minister of Finance on introducing amendments to the Income Tax Act - Tab 3)

2. The scientific research tax credit system provided a mechanism permitting corporations making expenditures on scientific research and development, but which were not in a position to otherwise utilize those expenditures as deductions under the Income Tax Act, to effectively renounce those expenditures in favour of investors who purchased certain qualifying securities of the corporation.

3. When first introduced effective October 1, 1983, scientific research and experimental development tax credits could be designated with respect to shares, debt or scientific research financing contracts.

4. Pursuant to subsection 194(4) of the Act, a taxable Canadian corporation was able to designate an amount up to the total of the consideration for which the SRTC Instrument was issued or granted. Upon such designation, the first registered holder of the SRTC Instrument, other than a broker or a dealer, became entitled to a scientific research tax credit under section 127.3 of the Act. In the case of the corporate taxpayers, the credit was 50 per cent of the amount designated by the “issuer corporation”. Individuals other than trust obtained a credit of 34 per cent of the amount designated. When provincial income tax was taken into account, the scientific research tax credit enjoyed by an individual approximated 50 per cent of the amount designated.

5. Upon making a designation in respect of an SRTC Instrument under subsection 194(4), the “issuer corporation” was required to pay a tax under Part VIII of the Act which was equal to 50 per cent of the amount designated. Pursuant to subsection 195(2), such tax was to be paid by the end of the month following the month in which the SRTC Instrument was issued or granted. However, it would be unnecessary for the “issuer corporation” to make such payment if it was confident that it would have a Part VIII tax refund for the year equal to its Part VIII tax liability.

6. An “issuer corporation” was able to earn a Part VIII refund for a taxation year up to a maximum of its refundable Part VIII tax on hand at the end of the year. Subject to this maximum, the Part VIII tax refund was made up of two components. The first component was the issuer corporation’s own scientific research credits, if any, to the extent that the issuer corporation had not used such credits under section 127.3 to reduce its tax otherwise payable. The second component of the Part VIII tax refund was 50 per cent of the issuer corporation’s qualifying scientific research expenditures for the year and the immediately preceding year, provided that those expenditures had not been previously applied to produce a Part VIII tax refund, had not been deducted by the issuer corporation under subsection 37(1) for Part I purposes and provided that no investment tax credit or additional allowance for scientific research and experimental development had been claimed by the issuer corporation.

7. If the Part VIII refund for the year equalled or exceeded a corporation’s Part VIII tax liability for the year, the requirement to make payments on account of Part VIII tax liability under subsection 195(2) for the year was effectively eliminated and no interest obligations under subsection 195(3) arose. If the Part VIII refund for the year was less than the Part VIII tax liability for the year, the shortfall was the total amount in respect of which interest was calculated.

8. On January 30, 1984, Revenue Canada issued a Press Release announcing that it would issue advance income tax rulings on “quick- flip” transactions if certain conditions were met. The Press Release also noted that the Department of Finance and Revenue Canada would be monitoring the effectiveness of these new scientific research tax credit provisions to ensure that the intent of the legislation was achieved and there were no abuses. Prior to this Press Release, many income tax advisers had been concerned that an intended temporary ownership of the SRTC instrument may be ineffective for the purposes of obtaining the scientific research tax credit. The Press Release seemingly relieved this concern and “quick-flip” transactions became widespread (Tab 3a).

9. In a typical “quick-flip” transaction:

(a) the research corporation would issue a negotiable debt instrument to the investor for say $1,000. Assume that the principal amount of the debt instrument is $600;

(b) the research corporation would designate the full amount of $1,000 consideration received by it for the debt instrument under section 194(4) of the Act;

(c) immediately after the issuance of the debt instrument, the research corporation would retire its indebtedness thereunder and pay $600 to the investor who would not retain any continuing interest in the corporation.

10. Effecting such a transaction would give rise to the following results:

(a) the investor would be entitled to a scientific research tax credit equal to $500 (i.e. 50 per cent of the amount designated by the research corporation under subsection 194(4) in respect of the debt instrument);

(b) the cost of the investor of the debt instrument otherwise determined under the Act (i.e. $1,000) would be reduced by $500 by virtue of subsection 127.3(6);

(c) upon redemption of the debt instrument for its principal amount of $600, the investor would realize a profit of $100 which would be subject to tax according to the principles ordinarily applicable under the Act;

(d) the research corporation would retain $400 for expenditures in its scientific research and development program and would lose $1,000 of deductions for expenditures and related investment tax credits which it may not have been able to currently utilize;

(e) the research corporation would have a Part VIII tax liability of $500; and in order to discharge such liability without the actual payment hereof, the research corporation would be required to incur $1,000 of qualifying expenditures. Since the research corporation would only retain $400 of the consideration received from the investor for the issuance of the debt instrument, the research corporation would be required to finance the balance of the required $1,000 expenditure requirement in another manner.

11. In the circumstances described above, Revenue Canada eventually became concerned that unless the research corporation had access to additional financing, the net proceeds from a “quick flip” would not be sufficient to finance the level of research and development necessary to eliminate all of the corporation’s Part VIII tax liability. Moreover, the federal Government also became aware that the SRTC program was costing it much more in lost tax revenues than ever expected and that the program was being abused.

12. On October 10, 1984, the Honourable Michael Wilson, Minister of Finance, announced a moratorium on the issuing of so-called “quick flip” Scientific Research Tax Credit investments. For the duration of the moratorium only common equity shares which complied with the criteria governing shares qualifying for the share purchase tax credit were to be entitled to the SRTC benefit. An exception was made for certain transactions which were “grandfathered” on the basis of agreements in writing or on the basis that they were substantially advanced.

13. The limitations which were imposed upon the availability of scientific research tax credit designations after October 10, 1984 by the requirement that no designation could be made unless the share was a “qualifying share” are found in subsection 192(6) of the Act.

15. The ability to make a scientific research and experimental development tax credit designation with respect to qualifying shares was eliminated in the Budget address of the Honourable Michael Wilson of May 23, 1985, effective immediately, unless the transaction met certain grandfathering provisions which included qualifying shares issued during the moratorium between October 10, 1984 and May 22, 1985 (Tab 6).

FACTS

The plaintiff, Scannar, appeals its assessment for tax made under Part VIII of the Act by the Minister in respect of Scannar’s 1985 taxation year. Scannar was involved in research and development in sonar and underwater research areas whereas Proteus was primarily involved in research in the medical field.

Scannar’s taxation year ended on November 30th of each year. In its 1985 taxation year, Scannar filed five designations pursuant to subsection 194(4) of the Act for amounts aggregating $30,101,000 in respect of shares or debt obligations issued to third party investors. As a result of the designations, Scannar became liable to pay a tax under subsection 194(4) of Part VIII of the Act. Scannar’s tax liability by virtue of subsection 194(4) of the Act was equal to 50 per cent of the amount designated in respect of share or debt obligations; Scannar’s Part VIII tax liability amounted to $15,050,500. The investors acquired SRTCs in an equivalent amount, proportionate to their investments. In February 1985, $8.7 million was remitted to the Receiver General on account of Scannar’s Part VIII tax liability which arose from the designations; this amount had been withheld by the investors on the closing of their acquisition of shares or debt obligations from Scannar. Scannar calculated the Part VIII refund for the year at $15,193,261 and the Minister calculated it as $1,945,183. In its 1985 taxation year, Scannar acquired an SRTC in the amount of $1.3 million in a separate transaction which was used to offset or reduce its Part VIII tax liability by means of the Part VIII refund mechanism. This SRTC is not in dispute. There are certain expenditures other than the $25 million paid with respect to the Proteus contract which were originally in contest between the Minister and Scannar and which are no longer in dispute.

On November 27, 1985, Scannar entered into an agreement (the Proteus contract) with Proteus for the conduct of research and development; Scannar was to prepay Proteus the sum of $25 million for such research. Its research was focussed in the area of monoclonal antibody technology with a view to developing in-vitro diagnostic products by subcontracting laboratory work to scientific laboratories at universities, hospitals, and provincial public health laboratories across Canada. In about the Summer of 1985, Mr. Appleton, Vice- President, Business Development at Scannar approached Mr. Tryon Williams, a principal of Proteus; they agreed to enter into a research and development agreement whereby Proteus would supervise the conduct of certain bio-medical research on behalf of Scannar. This research and development was intended to qualify as scientific research and experimental development under the Act. The research contracted for by Scannar was intended to be funded, at least in part, by Scannar’s expected refund of Part VIII tax. The first $1.4 million of the $8.7 million tax refund was, however, to be applied to Scannar’s other obligations and to provide it with necessary working capital. With Proteus’ assistance, Scannar prepared a business plan for medical products and systems management application research which described projects designed to make use of recent advances in bio-technology to develop advanced diagnostic products for which it anticipated significant demand.

Pursuant to the terms of the Proteus contract, Scannar engaged Proteus to conduct the research and development of four manually employed diagnostic kits to detect luteinizing hormone in urine samples, gardia lamblia in processed stool specimens, rubella antibodies in blood samples, and rotovirus in processed stool specimens (collectively, the kits). The Proteus contract stipulated that Proteus was to provide all materials and personnel for the conduct of the project and contemplated that Proteus could subcontract the work out to recognized universities and hospitals. Scannar was to be consulted periodically and provided with monthly reports as to the status of the project. Proteus was given the sole discretion to determine when further research and development was no longer necessary or when the research and development was ready to be reduced to practice. On execution of the Proteus contract, Scannar delivered to Proteus a cheque in the amount of $17.7 million and gave Proteus a demand promissory note in the amount of $7.3 million bearing interest at the rate of 8 per cent per annum. Pursuant to the Proteus contract, the cheque and the promissory note were expressly stated to constitute absolute payment of the research and development fee. Pursuant to the terms of a security agreement between Scannar and Interbio Export-Import, Clerical and Accounting Services Limited (Interbio), Scannar agreed to apply the anticipated $7.3 million Part VIII tax refund to satisfy its promissory note to Proteus.

On November 27, 1985, concurrently with the execution of the Proteus contract, Proteus entered into a supply agreement with Interbio, located in the Isle of Man. In this agreement, Interbio agreed to supply to Proteus a variety of reagents, including both monoclonal and polyclonal antibodies, and up to 200,000 experimental cartridges which were necessary for the development of the kits. Interbio subcontracted with Murex Ltd. (Murex) of Atlanta, Georgia for the supply of the test kits to be supplied to Proteus pursuant to the supply agreement. To facilitate this transaction, Murex formed a wholly owned subsidiary in the Isle of Man. Upon execution of the supply agreement, and in consideration for Interbio’s agreement to supply the test materials, Proteus was to pay $20,857,500 to Interbio; $17.7 million was paid by cheque and $3,157,500 was paid by demand promissory note bearing an 8 per cent interest rate. Interbio agreed to pay Proteus a royalty equal to 1/8 of all royalties received by it from the exploitation of the kits or the technology related thereto until Scannar had retired its loan, and thereafter, 1/4 of any such royalties.

Research to be conducted by Proteus was scheduled to commence on the date of execution of the contract, specifically, November 27, 1985. Pursuant to the supply agreement with Interbio, on July 7, 1986, but only after payment by a cheque of approximately $22,000 by Proteus to Interbio notwithstanding the earlier payment of $17.7 million by cheque, a number of test packs for the performance of the research were shipped to Dr. Wayne Bradbury, staff micro-biologist at the Toronto General Hospital and assistant professor at the University of Toronto; Dr. Bradbury conducted the initial research for Proteus in the Summer of 1986. Dr. Bradbury commenced preliminary trials of antibodies and screening of test materials and variables necessary before the clinical trials could be conducted. Dr. Bradbury’s preliminary testing continued until May 1987. The parties agreed that this did not constitute scientific research and I so find.

In order to fund its contract with Proteus, on November 27, 1985, Scannar borrowed $17.7 million from Interbio. The loan to Scannar was non-interest bearing and was due on November 30, 1988. However, Interbio was given an option in the loan agreement to make the loan bear interest at 8 per cent per annum subject to recourse being limited on the loan to the collateral described in the security agreement. The proceeds of the loan were paid to and received by Scannar by cheque on November 27, 1985. The loan was secured by a security agreement between Interbio and Scannar; a financing statement in respect of the security agreement was filed by Interbio pursuant to the Ontario Personal Property Security Act, R.S.O. 1980, c. 375. Under the security agreement, Interbio took security in Scannar’s intellectual property which related to the kits; Scannar’s book debts arising out of a licence agreement between Scannar and Murex, to be described later herein, any amounts payable to Scannar by Interbio pursuant to the loan agreement and the amounts owing to Scannar in respect of a tax refund under Part VIII of the Act (except for the first $1.4 million of such refund of tax which was to be applied by Scannar for its general business purposes); and, Scannar’s rights under the Proteus contract, the licence agreement with Murex and the kits. Pursuant to a term of the security agreement, Interbio agreed to allow Scannar to pay $7.3 million to Proteus in satisfaction of its promissory note upon receipt by Scannar of funds from the Receiver General in respect of its prepaid Part VIII tax.

Scannar entered into a licence agreement with Murex on November 27, 1985, through which Scannar granted Murex an exclusive licence to the technology relating to the kits. In consideration for the licence, Murex agreed to pay Scannar a royalty equal to 4 per cent of the net sale price of each item of each of the kits sold by Murex or any affiliate thereof, and 1/2 of the royalties received by Murex or its affiliates from the sales of any of the kits by a sublicensee. In the licence agreement, Scannar irrevocably authorized Murex to pay Interbio, on account of Scannar’s liability to repay the loan, 1/2 of all royalties payments that Scannar was entitled to receive.

In advance of the execution of the previously described transactions, Proteus obtained an opinion from Coopers & Lybrand to the effect that Scannar’s activities would entitle it to claim a scientific research expenditure of $25 million for the purposes of section 37 and clause 194(2)(a)(ii)(A) of the Act. The opinion provided by Coopers & Lybrand was based, in part, upon a November 20, 1985, opinion of Fritzsch Pambianchi and Associates Inc. (FPA), an independent consulting firm based in New Jersey which had experience in the commercialization of products using monoclonal antibodies and other immunologically based test systems; it was the opinion of FPA that the proposed project could not be completed for an amount significantly lower than that contemplated in the Proteus contract.

On December 2, 1985, Scannar filed its Part VIII tax return for the taxation year ending November 30, 1985. In its return, Scannar claimed a Part VIII refund in the amount of $8.7 million; this amount was previously remitted to the Receiver General on account of Scannar’s Part VIII liability. In January 1986, Scannar filed its income tax return under Part I of the Act for the taxation year ending November 30, 1985. In this return, Scannar specified the expenditure under the Proteus contract in accordance with clause 194(2)(a)(ii)(A) of the Act by indicating that such expenditure had been renounced. The Department of National Revenue (the Department) advised Scannar that it would not release the $8.7 million held on account of Scannar’s Part VIII liability and referred the file for in-depth investigation as a tax avoidance case.

Scannar became unable to meet its obligations to its banker, the Canadian Imperial Bank of Commerce (CIBC). On January 7, 1986, CIBC appointed Thorne, Riddell Inc. as receiver for Scannar. Scannar’s business has since ceased; its assets have been sold and its employees have been terminated.

By letter dated March 27, 1986, the Department indicated that as the expenditure under the Proteus contract constituted a “prepayment in 1985 fiscal year”, the Department would not give a favourable opinion with respect to that expenditure for the purposes of Part VIII of the Act. By a Notice of Assessment dated June 8, 1987, the Minister assessed Scannar in accordance with the provisions of Part VIII of the Act, disallowing scientific research expenditures totalling $26,579,015.63 in Scannar’s 1985 taxation year. The Minister allowed certain other expenditures on scien- tific research and experimental development. There were memoranda in the Department’s files suggesting that the proposed research was acceptable as scientific research and suggesting that only subsection 245(1) could upset the taxpayer’s planning.

On April 14, 1986, Proteus obtained default judgment against Scannar in the amount of $7.3 million. Although Proteus moved quickly to commence an action against Scannar, it took no action against Interbio for its failure to provide the test kits under the supply contract except to write one letter. Proteus obtained an Order of the Supreme Court of Ontario appointing Collins Barrow Limited as receiver for the purposes of collecting all money due and payable to Scannar from the Minister and the Receiver General of Canada in respect of the refund under Part VIII of the Act. Collins Barrow was later replaced, on consent, as receiver by Orenstein and Partners Inc. On September 1, 1987, in its capacity as receiver, Collins Barrow filed a Notice of Objection in respect of the Notice of Assessment of Scannar’s 1985 taxation year on the basis that the expenditures which the Minister had disallowed were valid and should be allowed. In a Notice of Confirmation by the Minister dated December 14, 1988, the Minister stated in part:

The Minister of National Revenue has considered the facts and reasons set forth in your Notice(s) of Objection and hereby confirms that the assessment(s) has (have) been made in accordance with the provisions of the Income Tax Act for the following reasons:

The Scientific Research and Experimental Development expenditures of $25,000,000.00 with respect to the Proteus Contract are not deductible in 1985 pursuant to subsection 18(9) of the Income Tax Act.

ANALYSIS

The SRTC was developed by the government to encourage scientific research. It was recognized that many companies could not take advantage of the tax credit. Accordingly, the Act was amended by this Part VIII mechanism to permit those expenditures which would ordinarily generate tax deductions or tax credits to the research performer to be renounced in favour of, or transferred to, investors in consideration for the investor putting up money to finance the research performer. At the time the tax credit was introduced, a supplementary budget information paper accompanied the Minister of Finance’s budget of April 1983. The document is

entitled Research and Development Tax Policies - A Paper for Consultation, dated April 1983 produced by the Department of Finance and the Minister of Finance. At page 26 it is stated:

... Thus, the corporation conducting the research would retain full control and rights to the R&D at all times in the process and investors can be limited in their liability. In turn, investors will be permitted tax incentives on funds they put up to finance the company. The financing will not have to be explicitly linked to particular R&D projects. This eliminates one of the major impediments to the use of SRICs, as now structured.

The allowable form of financing arrangement that will be eligible for the special treatment will be outlined in the Income Tax Act and Regulations in order to provide the maximum certainty in operation of the system for taxpayers.

After describing the way the mechanism works, the paper states at page 27:

The R&D performing company, at any time after raising capital, will be able to renounce its claim to R&D tax deductions and tax credits it otherwise could claim. The R&D performing corporation will be able to claim a rebate of its refundable tax at the rate of 50 per cent of the amount of R&D expenditures for which it renounces its claim to tax incentives. This credit and refundable tax mechanism ensures that investors will have more certainty about the tax benefits they will receive and provides flexibility to companies in arranging tax-assisted financing in advance of using the funds on R&D.

The Part VIII tax is a tax which, obviously, was not intended to be paid unless the research performer did not make the expenditures on the activity that was designed to be encouraged by this mechanism. If it made those expenditures and renounced them in favour of the amounts invested, the amount so renounced would completely offset the Part VIII tax liability which would otherwise arise under subsection 194(1) and the corporation would have no liability at all.

The relevant legislation in this case is clause 194(2)(a)(ii)(A) and paragraph 37(1 )(a) of the Act. Clause 194(2)(a)(ii)(A) reads as follows:

194.(2) “Part VIII refund” defined. - In this Act, the “Part VIII refund” of a corporation for a taxation year means an amount equal to the lesser of

(a) the aggregate of

(ii) such amount as the corporation may claim, not exceeding 50 per cent of the amount, if any, by which

(A) the aggregate of all expenditures made by it after April 19, 1983 and in the year or the immediately preceding taxation year each of which is an expenditure (other than an expenditure prescribed for the purposes of the definition “qualified expenditure” in subsection 127(9) claimed under paragraph 37(l)(a) or (b) to the extent that such expenditure is specified by the corporation in its return of income under Part I for the year

exceeds the aggregate of ...

Paragraph 37(1 )(a) reads as follows:

37(1) Scientific research and experimental development. - Where a taxpayer files with his return of income under this Part for a taxation year a prescribed form containing prescribed information, carried on a business in Canada and made expenditures in respect of scientific research and experimental develop- ment in the year, there may be deducted in computing his income for the year the amount, if any, by which the aggregate of

(a) such amounts as may be claimed by the taxpayer not exceeding all expenditures of a current nature made in Canada by the taxpayer in the year or in any previous taxation year ending after 1973

Section 37 provides a deduction to the taxpayer in computing his income for the purpose of determining his liability for tax under Part I of the Act where the taxpayer has performed or has spent money in relation to scientific research and experimental development.

As outlined above, Revenue Canada accepted the research proposed in the agreement between Scannar and Proteus as qualifying as scientific research within subsection 37(1) of the Act. In paragraphs 6, 7 and 8 of the Amended Statement of Claim Scannar stated as follows:

6. In its 1985 taxation year Scannar also incurred expenditures on “scientific research and experimental development” within the meaning of paragraph 37(7)(b) of the Act in the amount of $27,869,383, which expenditures were claimed under subsection 37(1) of the Act. Of these expenditures, $25,000,000 was paid pursuant to a contract (the “Proteus Contract”) between Scannar and Proteus Bio-Research Corporation (“Proteus”), a corporation incorporated under the laws of Canada.

7. In the Proteus Contract, Scannar agreed to pay, and in fact paid, a research and development fee in the amount of $25,000,000, which was payable as to $17,700,000 by cheque, and as to $7,300,000 by delivery of a promissory note, in consideration for Proteus’ agreeing to carry on scientific research and experimental development on behalf of Scannar in connection with certain laboratory rapid diagnostic products.

8. The aforementioned “scientific research and experimental development” tax credits and expenditures formed the basis for determining the amount, if any, of Scannar’s “Part VIII refund” within the meaning of subsection 194(2) of the Act. By virtue of that subsection, the amount, if any, of Scannar’s “Part VIII refund” is equal to the lesser of

(a) the aggregate of the amount of its “scientific research and experimental development tax credit” and 50 per cent of the amount of expenditures claimed by Scannar under subsection 37(1) of the Act, and

(b) the amount, if any, of Scannar’s “refundable Part VIII tax on hand” at the end of its 1985 taxation year with[in] the meaning of subsection 194(3) of the Act.

The amount, if any, of Scannar’s “Part VIII refund” is deemed to be an amount paid on account of its tax under Part VIII, for the year, by virtue of subsection 194(5) of the Act.

The defendant Minister denied the allegations in the Amended Statement of Claim when it stated at paragraph 13 of the Statement of Defence:

13. By Notice of Assessment dated June 8, 1987, the Minister did not accept that the amount allegedly paid to Proteus was an expenditure on scientific research and experimental development within the meaning of section 37 of the Act and accordingly did not include this amount in the calculation of Scannar’s Part VIII tax refund. The Minister assessed Scannar for tax owing pursuant to subsection 194(1) of the Act.

The defendant then stated at paragraph 14 of the Statement of Defence:

14. In so assessing Scannar, and in confirming the assessment, the Minister of National Revenue assumed, inter alia'.

(h) no research and development by Proteus on behalf of Scann[a]r was in fact carried out by Proteus in the 1985 taxation year of Scannar or at any time thereafter;

Thus, the Minister has put in issue that no expenditure was made by Scannar and, therefore, no amount could be claimed under paragraph 37(1 )(a) of the Act; Scannar is not entitled to include the claim in the amount of $25 million in calculating its refund. The Minister asserts that any memoranda to the contrary are not material. I agree. The issue before me is not whether the proposed research qualifies under the Act, but rather, whether there was a payment in the amount of $25 million to perform that research.

I agree with counsel for Scannar that the fact that the Part VIII tax liability arose in the first instance was the result of the “quick flip” investment into Scannar; the consequential designations made by Scannar are not germane to the issue in this appeal except that, of course, by making these designations Scannar was left with less funds than were required to be expended.

I accept the defendant’s submission that if the agreement with Proteus for $25 million is not bona fide then Scannar cannot succeed. Under the Proteus contract, Scannar gave Proteus a cheque for $17.7 million and a note for $7.3 million representing the anticipated $8.7 million refund less the $1.4 million owed to the bank and other creditors. In return, Proteus was supposed to do scientific research on Scannar’s behalf. There is also the supply agreement between Proteus and Interbio, whereby Proteus gave Interbio $17.7 million by cheque and over $3 million in the form of a promissory note. Mr. Gwynn Williams, the President of Interbio, made it very clear he was not going to provide any material unless he got paid cash. He did not consider the $17 million cheque as being cash in hand. For the very little material that Interbio sent to Proteus, Interbio insisted that Proteus pay $22,000 by cheque before it was prepared to release the material. It is clear that Interbio did not accept that there was any real prepayment in any amount; thus the $17.7 million figure becomes irrelevant; it could have been $47 million, it could have been $100 million. Mr. Gwynn Williams made it clear that unless he received some cash he was not going to supply any material although the agreement indicated he was to supply $20 million of material and he had received $17.7 million by cheque. The three witnesses from Interbio and Proteus all testified as to their belief that the research would produce great results in the market but none of them was prepared to do any research until such time as the amount of money that was allegedly owing to Scannar under Part VIII of the Act was received. The contract between Scannar and Proteus stated that the cheque in the amount $17.7 million and the promissory note in the amount of $7.3 million were an absolute payment and not a conditional payment. However, the contract provided that the research should be done and Mr. Tryon Williams testified that he would not proceed with the research until the Part VIII refund was received by Scannar. The inference I draw from that is that Proteus did not feel it was bound by the contract it had entered into. It would not recognize the validity of the contract to perform the research, until it received the $7.3 million from the $8.7 million tax refund. As stated earlier, the only legal action which resulted from the series of transactions involved in this case was that in 1986 Proteus brought an action on the promissory note and by April it had received default judgment. Proteus was not prepared to take action to ensure that Interbio supplied the material in accordance with the terms of the supply contract notwithstanding that it had paid Interbio $17.7 million by way of cheque. I can come to no other conclusion than that the cheque for $17.7 million which was exchanged between Scannar and Proteus was never intended to be acted upon; this is notwithstanding the fact that the receipt given by Proteus to Scannar purported to accept the cheque and the promissory note “as absolute payment to Proteus of a research and development fee”. The fact that a term of the Proteus contract stipulated that the delivery of the cheque and the promissory note constituted absolute payment only has the effect of determining the rights of the parties as between themselves. This term in the Proteus contract does not have the effect of preventing, for taxation purposes, an analysis of whether the contract itself is bona fide. The Court is entitled to see if there was any substance to the cheque, and in my view, there was not; accordingly, there was no substance or reality to the agreement. Since there was no substance to the $17.7 million cheque, Scannar is not entitled to claim that amount under paragraph 37(1 )(a) of the Act.

As a result of my determination that there was no real agreement for $25 million I do not have to consider the alternative arguments of the defendant. Since there was no recognition by the parties of the $17.7 million cheque, there was no $25 million contract. The action by Scannar is dismissed. If the parties are unable to agree on the costs, they may make written submissions to me.

Action dismissed.