Majestic Tool & Mold Limited v. Her Majesty the Queen (Informal Procedure), [1993] 2 CTC 2813

Kempo, T.C.CJ. (orally):—These informal procedure appeals concern the appellant's taxation years ending October 31, 1989 and October 31, 1990. They arise from reassessments by the Minister of National Revenue (the"Minister") as particularized in the reply to the notice of appeal:

2. In computing income for the 1989 and 1990 taxation years, the appellant classified its entire interest and investment income of $30,192 and $25,644 (the"interest income"), respectively, as active business income for the purpose of calculating its claims for the small business deduction amounting to $18,206 and $8,705 on total active business income of $113,788 and $54,407 in the 1989 and 1990 taxation years, respectively.

3. In reassessing the appellant for the 1989 and 1990 taxation years, the Minister of National Revenue (the "Minister") reclassified the interest income as Canadian investment income and reduced the amount of active business income qualifying for the small business deduction by $19,516.30 and $14,969.76, respectively, thereby reducing the appellant's claims for the small business deduction by $3,122 in the 1989 taxation year and by $2,395 in the 1990 taxation year.

4. In so reassessing the appellant, the Minister made the following assumptions of fact:

(a) the appellant was, at all material times, actively engaged in the business of making and selling plastic molds;

(b) since 1987, the appellant held $150,000 in term deposits (the "term deposits") which were never used in the active business;

(c) in addition, the appellant had lent $106,000 on a long-term basis to an associated company, known as T. J. M. Investments Ltd.;

(d) the term deposits were not required in the active business carried on by the appellant and the interest earned thereon was separate from its normal business activity;

(e) interest income of $19,516.30 and $14,969.76, stemming from the appellant's investment in term deposits in the 1989 and 1990 taxation years, respectively, was derived from an activity that was separate from the appellant’s normal business activity;

(f) at all material times, the appellant's ratio of current assets to current liabilities reflected good financial stability and its long-term liabilities were minimal.

(g) at no time were the term deposits put in a position of risk or used as collateral;

(h) the interest income of $19,516.30 in 1989 and $14,969.76 in 1990 is not income from property that is incident to, or pertains to, an active business carried on by the appellant, or from property used or held principally for the purpose of gaining or producing income from an active business carried on by the appellant.

5. The issue is whether interest income from the term deposits is active business income qualifying for the small business deduction.

6. He relies on subsections 125(1), 129(4), 129(4.1) and paragraph 125(7)(a) of the Income Tax Act [R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63)] (the "Act") as amended for the 1989 and 1990 taxation years.

Succinctly put, if the interest earned by the appellant in each of the subject years from its term deposits arising out or surplus funds on hand from time to time may be found to be either income "from any property that is incident to or pertains to an active business carried on by it” or "from any property used or held principally for the purposes of gaining or producing income from an active business carried on by it" pursuant to subparagraphs 129(4.1)(b) or (c) of the Act, such interest would be active business income as contended by the appellant and not investment income pursuant to subsection 129(4) as assessed by the Minister.

The properties generating the interest in question were 30- to 60 or 90-day term deposits in varying amounts held with the Toronto-Dominion Bank in Windsor, Ontario. According to the appellant's president, Mr. John Tomac, the funds so held arose out of its business operations and were considered by him, at all times material, to be surplus funds fundamentally tied to the integrity, maintenance and growth of the business.

Mr. Tomac is the appellant's sole shareholder. He has 32 years' experience in the tool and mold making business. The appellant's business began in 1977 and has survived to this date within an acutely competitive industry not only through adverse economic conditions but also through periods of rapidly changing technologies.

Mr. Tomac said that to survive the appellant was at all times called upon to prove skill, good performance, integrity, stability and above all customer trust in this exceedingly competitive environment. He knew of many tool and mold businesses that had come and gone under over the years. He said the appellant's growth was steady, was financially stable, and remained small in comparison with over 400 similar and but larger ones located in the Windsor area. Apparently Windsor enjoys the largest number of tool and mold making industries in North America and therefore many non-Canadian customers were common, and actively sought after by everyone in this business.

Mr. Tomac testified that potential customers had checked out the appellant's financial stability with Dun & Bradstreet and that some also were made directly to the appellant's bank at his suggestion, and that he was always aware this was a very common practice in the industry. He was unable to confirm whether any of these inquiries were specifically targeted to the subject term deposits then on hand. He knew the bank would be conveying a positive financial report. He could not recall whether, during the years under appeal, the bank had required the term deposits as a specific condition of any of its operating loans. According to the appellant’s other witness, Mr. Boggs, it was satisfied with collateral on the appellant’s machinery and equipment.

With respect to the 1989 and 1990 fiscal years, Mr. Tomac said these represented recessionary times during which good contracts with paying customers were very hard to get. Customers were exceedingly wary. They had to know that their own investment in granting out contract work was safe from that supplier's bankruptcy. As an example, Mr. Tomac said the confidence of and business obtained from Pulsar Plastics was directly related to their financial inquiries, including direct contact with a knowledgeable individual at the Toronto-Dominion Bank, and that therefore they must have known of the term deposits. While recognizing this represents double hearsay, the Court accepts this testimony as being beyond mere self-serving statements because of Mr. Tomac's intimate knowledge of the appellant's business affairs on a long-term basis, and particularly because this customer was acquired during the recessionary period 1989 to 1991. Mr. Tomac's manner, demeanour and candour were refreshing. He did not present himself as a well-rehearsed witness operating from hindsight in a self-serving manner. Long-standing experience, with astute judgment skills, had taught him that financial stability permitting timely delivery of the molds contracted for was the primary concern of all customers at the time.

Evidence was given by the appellant's long-term accounting and business adviser, Mr. Gordon Boggs, respecting financial matters and the business decisions which were discussed. Mr. Tomac agreed with all of Mr. Boggs' testimony and that during 1988, 1989 and 1990 the appellant's machinery and equipment was reflected at a fixed asset value of over one-half a million dollars but added that any sale thereof, especially during recessionary times, would be by section and would draw significantly less than the values shown on the financial statements. He also stressed that while the term deposit fund could have been withdrawn in favour of the shareholder at any time, the business plan was always to leave surplus funds in the company account to satisfy ongoing customer demands of financial comfort. It was he who decided how much should go or remain in the term deposits and for what period of time. He conceded however, when pressed, that a $150,000 figure had not been decided upon by him as a firm bottom line amount. When further pressed he opined that, only possibly and with obvious discomfort, it could have been around $100,000. His evidence was not concise or clear, nor was it specifically directed to, whether some, or none, of the term deposit amounts had been made up of customers' deposit moneys on a short-term basis before being expended for materials and labour for their particular jobs. The appellant's customers were required to pay a deposit of one-third of the contract price, the balance being payable after shipping the finished product. Obviously two- thirds of the job required the appellant's financing. Given the paucity of evidence on this subject, the Court is unable to conclude with any degree of certainty that any of the term deposits had been temporarily composed of customer deposit amounts.

Mr. Tomac was unable to recall any specific particulars of term deposit activity for 1987 or for any of the previous years. He opined however that without the term deposits the appellant's business would have been "slim" at best and that, without them it was “ possible” it would not have survived.

During the 1991 fiscal year, which was not under appeal; new machinery and equipment was acquired to the extent of $170,000 of which $70,000 was derived from the term-deposit source, the balance being financed. This was done at that time in response to a predicted economic upturn. For that year a net loss of $45,299 was recorded taking into account interest income of $23,254 from all sources. The previous year, 1990, recorded a modest profit of $5,000 with total interest income of $25,644. For 1989 the profit was $77,412 with total interest income of $30,192. For 1988 the amounts were $18,152 as profit with $6,637 for interest income.

Mr. Tomac explained that the 1989 sales figure of $802,740 was extraordinary in that it encompassed a very large project not repeated due to the recession having begun with that customer being unable to sell the product. The appellant's sales were, rounded out, $456,000 for 1988, $802,700 for 1989, $528,000 for 1990 and $480,000 for 1991.

Mr. Boggs is a certified general accountant and has been the appellant's business adviser and accounting consultant since 1977. His home is very close to Mr. Tomac's home with the result that they had met and talked business very frequently over the last 16 years. Mr. Boggs said he was and is very well versed in and attuned to Windsor's tool and mold making industry and as such has always been competently able to advise Mr. Tomac as to appropriate business decisions on a timely basis. During mid-1989 he had predicted and warned Mr. Tomac of the industry's pending recession with advice to keep capital intact and expenditures down. He later predicted and advised of economic recovery in the industry. It was in response to the latter that the appellant had purchased new and updated equipment at still depressed prices in order to maintain its competitive edge within a rapidly changing technology.

Mr. Boggs authored the financial statements for the appellant's 1988, 1989, 1990 and 1991 fiscal years as. found in the book of documents, Exhibit A-1. This book also contains combined financial statements of the appellant and of its associated corporation, T.J. & M. Investments Ltd. which owns the land and building within which the appellant's operations are carried on and which, apparently, is its sole asset. This property was originally owned by the appellant but was rolled into its sister company in order to separate its business operations from its real estate holdings and also to take fiscal advantage which existed at the time respecting the interest payments on the debt. It was conceded the acquisition debt of $106,764 [see the reply to the notice of appeal, supra, paragraph 4(c)] could and would not be repaid.

In any event, and since the Minister's audit had also indicated T.J. & M. Investments Ltd., Mr. Boggs prepared unaudited combined statements for fiscal year endings of October 31, 1989 and 1990. Even with earnings combined, tool and mold making was the principal source of income.

Mr. Boggs calculated a working capital ratio (hereafter sometimes called the "WCR"), being the relationship of current assets to current liabilities. He also calculated the percentage of term-deposit interest income as related to sales for the period 1989 to 1991 inclusive. They may be summarized as follows:

It was Mr. Boggs’ view that a working capital ratio of 2:1 represented financial health and stability portraying an ability to meet work in progress demands and that a ratio nearing 1:1 would be alarming as it would reflect on the appellant's ability to pay its bills. For example, he said the working capital ratio of 1.18/1 without the term deposits in 1990, and the 1.19/1 with and the 0.85/1 without term deposits for 1991, would each have triggered alarm and doubt by customers looking for reliability which in turn would have resulted in a decidedly destabilizing effect on this appellant’s business throughout that time.

On the basis of these working capital ratios, Mr. Boggs had advised Mr. Tomac throughout the periods 1988 to 1991 inclusive to retain the established term deposit amounts within the company for its use in the business for purposes of retaining its customers during the recession, of gaining new ones in spite of the fierce competition and of obtaining new equipment on a timely basis in response to rapidly changing technology to meet customer needs. It was his view the appellant would have been less prosperous without the subject term deposits and that their absence could possibly have impacted on its very survival.

Mr. Boggs confirmed the term deposit amounts at year end were $150,000 for 1987, $160,000 for 1988, $150,000 for each of 1989 and 1990 and $80,000 for 1991. New equipment purchases were (rounded out) $25,000 for 1988, $19,200 for 1989, $41,500 for 1990 and $174,400 for 1991. Financial statements were forwarded to Dun & Bradstreet by him which included mention of the term deposits as assets. He also supplied financial information to the Toronto- Dominion Bank which had expressed pleasure with the term deposits being in the company account. Neither Mr. Tomac nor Mr. Boggs was able to confirm how the bank would have reacted if the term deposit moneys had been withdrawn from the company.

On cross-examination, Mr. Boggs conceded that of the appellant's total assets, two-thirds thereof represented long-term assets for 1988, and more than one-half were long-term for each of 1989 and 1990. While agreeing that loans may be obtained against half a million dollars of machinery and equipment on hand during these years, he said its realizable or liquid value would be significantly less because of its age, type, obsolescence and market downturn.

Mr. Boggs confirmed that his own business included many of the kind of clientèle being sought after by the appellant who asked the same kind of financial questions respecting working capital ratios, and that the normal independent informational sources were annual financial statements and updated information supplied to Dunn & Bradstreet as well as to the banks.

Analysis

The resolution of the issue turns on the facts of the case. In my view, the common sense and reasonable business acumen of the witnesses ought to be assigned appropriate weight and ought to be applied in approaching this matter unless there appear some appropriate reasons not to. I do not agree with respondent-counsel's submission that significant parts of the evidence tendered was merely self-serving and therefore of limited probative value. Both witnesses had long-term, hands-on experience and involvement in the tool and mold making industry which was so heavily centred in the Windsor area. Collectively, their evidence fits and is integrated; Mr. Tomac being the mold and business decision maker and Mr. Boggs being his trusted, frequent and very competent business and accounting adviser.

While agreeing that the short-term deposit amounts during 1989 (Exhibit A-2) rangea from a high of $260,000 to a low of $150,000, and that term deposits of $100,000 could possibly have been enough, the Court is not prepared to hold, given all of the circumstances of this case, that the $150,000 for each of 1989 and 1990 was either excessive or not necessary to preserve, maintain or enhance the appellant's business operations. During the recessionary years of 1989 and 1990 neither its inventory, receivables, nor its machinery and equipment, alone or collectively, represented the kind of financial liquidity and stability actively sought for by customers. In my view the appellant has established on the balance of probabilities for its 1989 and 1990 years that the subject term deposits were used to fulfil a requirement that had to be met in order to do business (see: Ensite Ltd. v. The Queen, [1986] 2 S.C.R. 509, [1986] 2 C.T.C. 459, 86 D.T.C. 6521 at page 520 (C.T.C. 465, D.T.C. 6525-26)), that there existed a financial relationship of substantive dependence and reliance between the $150,000 in term deposits and the appellant's active business, that they existed as a decided and reasonable back-up asset of liquidity as demanded in the industry, and that their fundamental purpose was to sustain the business operations during those difficult times (see: Atlas Industries Ltd. v. M.N.R., [1986] 1 C.T.C. 2392, 86 D.T.C. 1756 (T.C.C.) at page 2404 (D.T.C. 1764)).

The facts of the case at bar in their totality can be contrasted with those of McCutcheon Farms Ltd. v. M.N.R., [1991] 1 C.T.C. 50, 91 D.T.C. 5047 (F.C.T.D.) and Irving Garber Sales Canada Ltd. v. M.N.R., [1992] 2 C.T.C. 261, 92 D.T.C. 6498 (F.C.T.D.). McCutcheon Farms involved a grain farming operation. It earned income from grain sales as well as from the production and sale of seed, plus sales of fertilizer and chemicals, and interest from surplus fund investments in the range of 15 to 20 per cent of gross income. Here, the appellant's interest income represented less than three per cent of the gross. Irving Garber Sales was a furrier, its principal asset being large amounts of surplus cash which was determined to be markedly excessive to cover the normal risks associated with that taxpayer's business and therefore a lesser and more reasonable amount was allowed to meet that industry's demand for liquidity.

Again, and returning to all of the circumstances of the appellant's business, and especially as it found itself throughout 1989 and 1990, the removal of the subject term deposits, whether in part or in whole, would have had a decidedly destabilizing and significant effect on its business operations as testified to. I see no reasons supportive of any reduced amount because the particular circumstances of this appellant do not warrant such an exercise without entering into the realm of possibility, probability and ultimately mere conjecture. The amounts were not excessive, nor did they portray overly generous or excessive working capital ratios calling for reduction.

For the reasons given, the appeals are allowed, with costs, on a party-to- party basis.

Appeal allowed.