Germac Enterprises Ltd. v. Her Majesty the Queen, [1993] 2 CTC 3061

Sobier, T.C.C.J.:—The appellant appeals from the assessments for its 1981, 1982,1983 and 1984 taxation years, whereby the Minister of National Revenue (the “ Minister”):

(a) reclassified property acquisitions claimed by the appellant as being assets of the category of Class 29 of Schedule II of the Income Tax Act Regulations (the “ Regulations”), used directly or indirectly by the appellant principally in the manufacture or processing of goods for sale or lease into assets of the category of Class 8 of Schedule Il of the Regulations;

(b) limited inventory allowances claimed by the appellant under paragraph 20(1)(gg) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in the following amounts in the following years:

1981	$9,715
1982	$13,609
1983	$10,905
1984	$6,452

instead of the amounts claimed by the appellant in those years; and

(c) denied that the appellant had manufacturing and processing profits for the years 1981, 1982, 1983 and 1984 within the meaning of paragraph 125.1 (3)(a) of the Act, thereby disentitling the appellant to deduct from taxes otherwise payable by it, the manufacturing and processing credit provided by section 125.1 of the Act.

The following is a summary of the amounts in dispute:

The issues raised are twofold. First is the substantive issue dealing with the assessments themselves. Second is a procedural issue dealing with whether, in 1987, the Minister dealt with the objection filed by the appellant under subsection 165(3) of the Act. It is the contention of the appellant that a letter dated December 1, 1987, from B. Sachvie, on behalf of the Chief of Appeals of the Winnipeg District office of Revenue Canada Taxation, set out a decision by the Minister under subsection 165(3) and that although conditional, it was the Minister's action, as required under that subsection, with the result that the objection of the appellant had been dealt with and his appeal, at that stage, was in fact allowed by the Minister, provided that the appellant in the case mentioned in the letter, was successful.

The provisions of subsection 165(3) read as follows:

Upon receipt of a notice of objection under this section, the Minister shall,

(a) with all due dispatch reconsider the assessment and vacate, confirm or vary the assessment or reassess, or

(b) where the taxpayer indicates in the notice of objection that the taxpayer wishes to appeal immediately to the Tax Court of Canada and that the taxpayer waives reconsideration of the assessment and the Minister consents, file a copy of the notice of objection with the Registrar of that Court,

and he shall thereupon notify the taxpayer of his action by registered mail.

I will deal with this procedural argument first.

Was the letter of December 1, of 1987, notification by the Minister of his action?

As can be seen, the action which shall be taken by the Minister is to vacate, confirm or confirm the assessment or to reassess. The respondent maintains that the letter was one which put the process in abeyance until the case of Nowsco Well Services Ltd. v. Canada, [1988] 2 C.T.C. 24, 88 D.T.C. 6300 (F.C.T.D.); aff'd [1990] 1 C.T.C. 416, 90 D.T.C. 6312 (F.C.A.) had been decided by the Federal Court-Trial Division.

I cannot agree with the appellant's position. The letter in no way vacated, confirmed or varied the assessment, nor did it purport to reassess the appellant. At best, the letter stated that if the taxpayer agreed to have his objection held in abeyance pending the decision, he could do so by agreeing in writing.

Although a decision by the Minister need not be in any specific form, it must at least indicate what the Minister’s decision is, and no such decision to vacate, confirm or vary or to reassess can be gleaned from this letter.

Therefore, the appellant fails on the procedural argument. I will now deal with the substantive issues raised in this appeal.

The appellant carried on business under two divisions. The first, known as Midwest Drilling ("Midwest"), was engaged in providing diamond drilling services to customers, primarily in drilling core samples for the mining indus- try. The second division, known as Delro Industries ("Delro"), manufactured and/or processed some drilling equipment, including drilling rods, casings, core barrels, diamond bits and casing shoes, (individually a "product" or collectively "products"). Delro supplied Midwest with products and did not deal with Midwest customers, only with Midwest.

Evidence was adduced as how core drilling operations were carried out, as well as how the products were either purchased or manufactured or processed. Some products were designed for use by customers based on information provided by the customer to Midwest. Drill bits were designed to drill particular rock formations and overburden. However, some standard bits were produced and kept by Midwest in inventory for use on jobs, since many of the jobs did not require custom made bits. Midwest gave Delro a forecast of its future jobs and products were either purchased, manufactured or taken from existing inventory to carry out the various jobs. Products were taken by Midwest to job sites and stockpiled.

As well, some sales of products were made to third parties. However, these did not amount to a significant part of Delro's sales—perhaps five to ten per cent.

The accounting for the two divisions was separate. Purchases by Midwest were initiated by purchase orders addressed to Delro. Delro would fill the order and invoice Midwest, after which Midwest would pay Delro by cheque or bank transfer. It was not apparent from the evidence whether Delro sold to Midwest at a profit, since sometimes Delro sold at cost. Of course this may be of some interest internally for the appellant, however, it did not affect its overall financial position.

Contracts were entered into between Midwest and its clients. On some occasions, a Midwest form of contract was used and on others, the client's form was used.

An examination of the various contracts, such as those with Noranda Exploration Co., Teck Exploration Ltd., Falconbridge Ltd., Esso Minerals Canada, a Division of Esso Resources Canada Ltd., and Cominco Ltd., shows that Midwest was providing drilling services and that with a few exceptions the charges to the client by Midwest were for these services. There were some instances where charges were based on a cost plus or field cost basis, but for the most part, the client was charged on a cost per meter drilled. The cost per meter is arrived at by factoring in all of the costs including consumed products and a profit margin. Generally, there were no direct charges for consumed products. Also, there was no charge for wear and tear of products, since this cost was also built into the cost per meter charges.

The relevant provisions of the Act and the Regulations applicable to this appeal are reproduced below:

CAPITAL COST ALLOWANCE

Class 8

Property not included in Class 2, 7, 9, 11 or 30 that is

(i) a tangible capital property that is not included in another class in this Schedule except

[the exceptions are not applicable].

Class 29

Property that would otherwise be included in another class in this Schedule

(a) that is property manufactured by the taxpayer, the manufacture of which was completed by him after May 8,1972, or other property acquired by the taxpayer after May 8, 1972,

(i) to be used directly or indirectly by him in Canada primarily in the manufacturing or processing of goods for sale or lease . . . .

MANUFACTURING AND PROCESSING TAX CREDIT

125.1(1) There may be deducted from the tax otherwise payable under this Part by a corporation for a taxation year an amount equal to the aggregate of

(a) nine per cent of the lesser of

(i) the amount, if any, by which the corporation's Canadian manufacturing and processing profits for the year exceed the least of the amounts determined under paragraphs 125(1)(a) to (d) in respect of the corporation for the year, and

(ii) the amount, if any, by which the corporation’s taxable income for the year exceeds the aggregate of

(A) [Repealed.]

(B) the least of the amounts determined under paragraphs 125(1)(a) to (d) in respect of the corporation for the year,

(C) two times the aggregate of amounts deducted under subsection 126(2) from the tax for the year otherwise payable under this Part by the corporation, and

(D) the amount, if any, by which the aggregate of the corporation's Canadian investment income for the year and its foreign investment income for the year (within the meanings assigned by subsection 129(4)) exceeds the amount, if any, deductible under paragraph 111(1)(b) from the corporation’s income for the year; and

125:1(3)(a) “ Canadian manufacturing and processing profits" of a corporation for a taxation year means such portion of the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada as is determined under rules prescribed for that purpose by regulation made on the recommendation of the Minister of Finance to be applicable to the manufacturing or processing in Canada of goods for sale or lease; and

(b) manufacturing or processing" does not include

(x) any manufacturing or processing of goods for sale or lease, if, for any taxation year of a corporation in respect of which the expression is being applied, less than ten per cent of its gross revenue from all active businesses carried on in Canada was from

(A) the selling or leasing of goods manufactured or processed in Canada by it, and

(B) the manufacturing or processing in Canada of goods for sale or lease, other than goods for sale or lease by it.

INVENTORY ALLOWANCE

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(gg) an amount in respect of any business carried on by the taxpayer in the year, equal to that portion of three per cent of the cost amount to the taxpayer, at the commencement of the year, of the tangible property (other than real property or an interest therein and currency that is held for other than its numismatic value) that was

(i) described in the taxpayer's inventory in respect of the business, and

(ii) held by him for sale or for the purposes of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into or used in the packaging of, property for sale in the ordinary course of the business

that the number of days in the year is of 365;

The issue in this appeal is not whether the appellant manufactured or processed goods, but whether it manufactured or processed goods for sale or lease. It was conceded by both parties that the appellant did manufacture or process the products, but they disagree on whether it was held for sale. The appellant, of course, maintains that the products were manufactured or processed for sale, and the respondent takes the opposite view.

Counsel for the appellant puts forward his position as follows:

Insofar as the three provisions of the legislation are concerned, and I think my learned friend agrees, at least thus far, that is with respect to all of the provisions it comes down to whether the product manufactured, the drills rods, the diamond bits, casing, reaming shells, casing shoes, et cetera, were manufactured and processed products for sale.

The wording is marginally different in each of the sections and in class 29, as Your Honour pointed out yesterday, it’s a question of whether the equipment was used primarily in the manufacturing or processing of goods for sale. I think my learned friend agrees that if this product was manufactured for sale, that the equipment was not used for any other purpose. Mr. John Gale's division used that equipment to produce this product.

And secondly, we would make it clear that our position is that all of the product produced falls within the parameters of the provisions.

There was evidence yesterday from Mr. Gordon Cyr that certain of the product, under some of the contracts, were charged out specifically at cost plus 15 per cent. In other words, there were particularized items that were charged, I believe he said in the cases where the abnormal hole condition came in or in cases where the depth of the overburden was not known and in those cases the field cost issue came in and that’s where there was particular product charted out at cost plus 15 per cent.

We are not coming to the Court to say that—to try to distinguish that product from the product that was used in all of the work and that was consumed on a job to job basis.

And secondly, I wanted to point out that in the summary of the amounts that was provided yesterday, in the manufacturing and processing tax credit Revenue permitted nothing, in capital cost they permitted nothing and in the inventory allowance there were some amounts permitted, much smaller amounts than claimed by Germac.

The amounts permitted by Revenue in the inventory allowance were with respect to the portion of the inventory identified that was sold directly to outside parties. I just wanted to explain that Revenue has not prejudiced itself by allowing some of the inventory, because there was a clear reason that that was allowed.

And furthermore, by way of introduction and arguing on behalf of Germac, we acknowledge, we are not trying to pull the wool over Revenue Canada's eyes, we acknowledge that different from most of the other cases, in this case the product, the bulk of the product was not invoiced item by item to the customer.

As Mr. Cyr indicated, it was not practicable in this industry to sit on a job and say, "Yes, on this job this drill rod expired, this diamond bit went down the tube and here is your bill". It was not pragmatic and the industry does not operate that way and we do not close our eyes to that.

And secondly, we do not close our eyes to the fact that the product had a certain lifespan and that much of the product was such that it would go from one job, perhaps to a second job and maybe some little to a third job or whatever, but we have got the statistics which I will be referring to in terms of the lifespan. So we do not close our eyes to the fact that the product, as it were, was not used up entirely in an identifiable way on a particular job. And again, we acknowledge that that is different from most of the other case law.

And we acknowledge that in much of the other case law, particularly the old case law, there was a fairly consistent reference to sales of goods ideas where because these provisions speak of goods for sale, the older cases particularly talk very much in the sense of looking at a transfer of title of property. And we acknowledge again, in the Germac case, that you are not going to find a nice neat sale of goods contract or agreement where we can Say at this point title passed, because this is not that kind of industry.

On the other hand, we would and we will be arguing that the case law has come a long way from the old, what I will call sale of goods type tax cases, in that there has been a pragmatism introduced into the interpretation of these sorts of tax credits and allowances and that the policy behind this sort of legislation must be given some weight in that the recent cases, several coming out of the Federal Court of Appeal, has done just that and that it is within those parameters that we say Germac falls within the scope of these provisions. [1]

In support of his position, counsel relied on the Court of Appeal decision in Nowsco, supra. In doing so, he begins by distinguishing Nowsco from an earlier decision of Strayer, J. in Crown Tire Service Ltd. v. The Queen, [1983] C.T.C. 412, 83 D.T.C. 5426 (F.C.T.D.).

In the latter case, it was determined that there was no sale, since the appellant was retreading tires owned by its customers and, therefore, there was no manufacturing or processing of goods for sale. The learned judge found that the contracts involved were for work and material, and not for the sale of goods. This type of reasoning is characterized by counsel for the appellant as the Benjamin's Sale of Goods" theory.

On the other hand, in Nowsco, supra, the Court went further than the “Benjamin’s Sale of Goods" theory in its analysis of" goods for sale or lease”. In Nowsco, the Court of Appeal took up the position of Reed, J. in Halliburton Services Ltd. v. The Queen, [1985] 2 C.T.C. 52, 85 D.T.C. 5336 (F.C.T.D.); aff'd [1990] 1 C.T.C. 427, 90 D.T.C. 6320 (F.C.A.).

At pages 421-23 of Nowsco (D.T.C. 6316-17), Urie, J.A. states as follows:

I have no difficulty in concluding that the trial judge correctly held on the evidence that what was being processed by the respondent were "goods" within either the ordinary meaning or the technical meaning of that term, if any. The difficult question is were they "goods for sale"? In the view of counsel for the appellant they were not because the respondent was not engaged in the business of "processing of goods for sale” but rather was in the business of providing a service to oil and gas well operators which involved incidentally the processing and supplying of materials necessary to carry out that service. On that basis, it was counsel's contention that the trial judge erred in declining to apply the common law distinction between a contract for the sale of goods and a contract for work, labour and materials. The application of that distinction, it was said, was consistent with the apparent scheme and intent of the Act which was to enable Canadian manufacturers and processors to maintain their competitive positions as against other industrialized nations and to protect Canadian jobs. That protection does not and was not intended to extend, counsel argued, to service industries such as that of the respondent. In drawing this distinction counsel relied on a passage from Benjamin - Sale of Goods, a line of cases from the Trial Division of this Court, the Tax Court of Canada and one from the Court of Appeal. Among those cited were Canadian Wirevision Ltd. v. The Queen, [1979] C.T.C. 122, 79 D.T.C. 5101 (F.C.A.), Crown Tire Services Ltd., supra, M.N.R. v. Nova Construction Co., [1979] C.T.C. 2048, 79 D.T.C. 77 (T.R.B.); var'd [1983] C.T.C. 58, 83 D.T.C. 5105 (F.C.T.D.), rev'd [1986] 1 C.T.C. 68, 85 D.T.C. 5594 (F.C.A.), and Tenneco Canada Inc. v. The Queen, [1987] 2 C.T.C. 231, 87 D.T.C. 5434 (F.C.T.D.).

I have reviewed each of those authorities as well as others cited by counsel but find them to be each quite distinguishable on their facts. I prefer the reasoning of Reed, J. in the Trial Division in the case of Halliburton Services Ltd., supra, the appeal from which was heard immediately following the conclusion of argument in this case. Halliburton was engaged in the same type of business as Nowsco in this case. In fact, they were competitors. As will be seen from the excerpt from the reasons for judgment at pages 53-54 (D.T.C. 5337), the work in which Halliburton was engaged and the position which it took as to the nature of its services is identical to that of the appellant here:

The activities in issue are all ones in which the plaintiff produces a specialized product for its customers as well as providing certain services connected therewith. These activities are: (1) oil and gas well cementing activities;

(2) a fracturing process which involves the pumping of a specialized fluid into an oil or gas well, and (3) an acidizing process which involves the pumping of a specially prepared acid blend into a well. The plaintiff's position is that with respect to all three activities, while a service may be provided, it is also involved in the manufacture or processing of goods for sale as that concept is used in paragraph 125.1(3)(b) of the Income Tax Act.

While, in the following excerpt from her reasons, Reed, J. specifically was dealing with the phrase "manufacturing or processing” as it appears in paragraph 125.1(3)(b) it is equally applicable to that phrase as it appears in paragraph 125.1 (3)(a) to which argument was directed in this case. She stated, at pages 55-56 (D.T.C. 5338):

The defendant does not dispute the fact that in all three activities there is processing carried out. Nor does she dispute the fact that "goods" are produced. What is disputed, however, is that there is a "sale of a good". It is argued that the plaintiff’s main activity is the provision of services and that the production of "goods" in connection therewith is only incidental to the service being provided. Therefore, it is argued there can be no "manufacturing or processing of goods for sale” as that concept is used in paragraph 125.1(3)(b) of the Income Tax Act.

This argument is based on the well known distinction between contracts for the sale of goods and contracts for work, labour and materials, developed with respect to sales of goods legislation. The defendant cites in support of its argument Sterling Engine Works Ltd. v. Red Deer Lumber Co., [1920] 2 W.W.R. 194, 51 D.L.R. 509 (Man. CA.), and Scott Maritimes Pulp Ltd. v. B.F. Goodrich Canada Ltd. (1977), 19 N.S.R. (2d) 181, 72 D.L. R. (3d) 680. It is argued that the test of relative importance set out at page 40 of Benjamin' Sale of Goods (1974) is applicable, and that in the present case the services provided by the taxpayer are a much more important component of its contract with its customers than are the products it produces. It is argued that the services and products are inseparable; that customers (except with respect to one specialized product) do not purchase the goods without the services. The way the industry is structured makes it impractical for customers to do so (as noted above some of the processing of the product must necessarily be done at the well site immediately before use). It is argued that what the customer contracts for is the placing of the cement in the well, the fracturing of the hydrocarbon bearing formation, or the cleaning of the well to free it from debris, blockage etc., not the products used to accomplish these results. Also, in two cases (fracturing and cleaning) the product is consumed in the providing of the service.

I have considerable difficulty with this line of argument. In the first place, it is based on distinctions developed for purposes of the sale of goods legislation, not with respect to paragraph 125.1(3)(b) of the Income Tax Act. I do not read paragraph 125.1(3)(b) as requiring that a taxpayer's profit has to arise out of a contract for a sale of goods as defined by the various Sales of Goods Acts. Paragraph 125.1 (3) (b) does not talk of a sale of goods. It talks of profit arising out of the processing of goods for sale. There is no doubt that the products in question are sold to the plaintiffs customers in the sense that the invoices list the cost of the various components which go into each product and the blending and processing charges are specifically detailed in the invoice.

Secondly, I do not find any requirement that the contract which gives rise to the taxpayer's profit must be of a particular nature, eg: one for the sale of goods and not one of a more extensive nature involving work and labour as well as the goods or material supplied. In my view it is the source of the profit, (arising out of process) that is important for the purposes of paragraph 125.1(3)(b), not the nature of the taxpayer's contract with its customers.

In the third place, to adopt the distinction for which the defendant argues would be to create an illogical result. As counsel for the plaintiff pointed out, under such a regime, a manufacturer or processor of a product (eg: a chemical fertilizer) who also provided a service in connection therewith (eg: spreading the fertilizer for his customers) would be denied the processing tax deduction. If he merely sold the product to this customers he would be allowed the deduction.

I wholly subscribe to what the learned judge said in the foregoing passage and I do not think that I could improve on it by a prolonged analysis of it.

While I wholeheartedly concur with the reasons of Madam Justice Reed in Halliburton, I cannot agree that it is applicable to this appeal. In Nowsco and Halliburton, while services were provided to clients, they also purchased products which were manufactured or processed by the taxpayer and sold to its customer.

An analysis of the facts here shows that there were goods manufactured or processed, but they were never sold to the customers. The customers never received possession of any of the products. They were consumed in the drilling process or were returned to the appellant for future use or recycling. In my opinion the Court is being invited to go beyond Nowsco and say that by including the cost of a product in the contract price, one is selling the product. This is even more so, according to the appellant, because of the fact that the products are fundamental to the performance of the contract. With this, I cannot agree.

In Nowsco, the customer comes away from the contract with tangible goods manufactured by the taxpayer, and it pays for such goods. In the case at bar, the customer comes away only with core samples and products abandoned or left in the hole. Even taking the businesslike common sense approach, one cannot stretch the point any further. The customer purchased and received core samples as a result of its contract with Midwest. That is all it received. That is all it bargained for. The customer was not purchasing products. It cannot be said that the customer were even intended to acquire the products according to contracts. Products were used or consumed by Midwest in providing a service of producing core samples to its clients. Examination of other cases referred to by counsel also makes it clear that, although there was servicing involved, there was also goods sold to the customer (see Coopers and Lybrand Ltd. (Trustee) v. The Queen, [1992] 2 C.T.C. 361, 92 D.T.C. 6452 (F.C.T.D.) and Stowe-Wood ward Inc. v. Canada, [1992] 1 C.T.C. 209, 92 D.T.C. 6149 (F.C.T.D.)).

As Judge Tremblay of this Court said in Ashworth Bros. Canada Inc. v. M.N.R., [1991] 2 C.T.C. 2458, 91 D.T.C. 1218, at page 2466 (D.T.C. 1223):

In the present case, there might be one question to ask to determine the substance of the contract. What is the customer’s fundamental reason for entering into a contract with the appellant? Is it simply to obtain the clothing or card or is it also and principally to obtain the work and service performed by the appellant? If the answer is the latter then it makes sense to say that the appellant does not sell a good but a service.

From Rolls-Royce (Canada) Ltd. v. Canada, [1991] 2 C.T.C. 252, 91 D.T.C. 5579 (F.C.T.D.), it is clear that Nowsco, supra, did not overrule Crown Tire, supra.

Counsel for the appellant further contends that no conveyance is necessary in order to effect the sale. Yet the Court of Appeal in Nowsco, supra, could not completely ignore the question of conveyance or passing of title when Urie, J.A. said at page 424-25 (D.T.C. 6318-19):

Contrary to the argument of counsel for the respondent, I believe that determining the particular time at which and where title to the goods passes, is of little importance, on the facts of this case, in the determination of the relationship between the parties. However, what is of some significance, I think, is that since the products furnished are produced to the particular specifications of the operator/customer and must be paid for by it whether completely used or not (subject to some limited contractual exceptions), it may well be that title passes when the mixing and blending is effected. At whatever point the transfer is effected, adopting the modern principle of statutory interpretations that “the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, and the intention of Parliament", I am of the opinion that the processing activities of the respondent fall within the meaning of processing of goods for sale in paragraph 125.1(3)(a) of the Act.

Although Urie, J.A. maintains that the timing of passing of title is of little importance, it is clear that title must pass at some time. Here, neither possession nor title was passed.

Appellant's counsel argued that in the industry, it was not practical to bill for expired products or drill bits that "went down the tube”. The answer of course is that this practice is consistent with the fact that these items have already been factored into the price per meter cost.

Even taking into account that "the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, and the intention of Parliament’, I cannot extend the meaning of the words in question to cover the case at bar. Some meaning must be given to the words "goods for sale” and especially "for sale”. To ignore them is tantamount to creating mischief.

The appellant has not convinced the Court that it is entitled to relief under any of the three headings above enumerated. Therefore, the appeals are dismissed with costs.

Appeals dismissed.