Rolls Royce (Canada) Ltd. v. Her Majesty the Queen, [1993] 1 CTC 272, [1993] DTC 5031

MacGuigan, J.A.:— This is an appeal from a judgment of Martin, J. of October 11,1991, dismissing the appellant's appeal from income-tax reassessments for its 1977 to 1981 taxation years.

The issue before this Court is whether the appellant's activities in overhauling airplane engines during those taxation years constituted manufacturing or processing of goods for sale such that the appellant would be entitled to: (1) deductions for inventory allowance pursuant to 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 S.C. 1970-71-72, c. 63) (the “ Act”) as it then was — the provision was repealed by S.C. 1986, c. 55, subsection 5(1); (2) deductions of manufacturing and processing tax credits from tax otherwise payable, pursuant to s. 125.1 (1) of the Act; and (3) deductions of capital cost allowance on property included in Class 29 of Schedule Il of the Income Tax Regulations.

Since all of these provisions have as a common element that the taxpayer be engaged in manufacturing or processing goods for sale, for present purposes it will be sufficient to reproduce the definition in paragraph 125.1(3)(a), which clearly sets out the legislative phrase to be interpreted, and the limitation in subparagraph 125.1(3)(b)(x):

(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.

(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 10 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.

[Emphasis added.]

No distinction was made by the parties in this case between manufacturing and processing, and in the argument the two were normally coupled together. These concepts were, however, explored by Linden, J.A. in Tenneco Canada Inc. v. The Queen, [1991] 1 C.T.C. 323, 91 D.T.C. 5207 (F.C.A.).

It was common ground that the periodic rebuilding of airplane engines is required by national aviation authorities, that, when rebuilt, the engines are returned to their original owner with the substitution of a considerable number of parts, and that over a number of overhauls (probably three) all the parts of an engine would be replaced. Nevertheless, the trial judge found as a fact (Rolls Royce (Canada) v. Canada, [1991] 2 C.T.C. 252, 91 D.T.C. 5579, at page 254 (D.T.C. 5580-81)) that:

Each such engine delivered for overhauling has a serial number by which it is identified throughout its life. Each such engine also has a log book which identifies it and its component parts throughout its life. After overhauling the engine is not sold to the customer or certified as a new engine but instead is returned to the customer complete with its record of time use on parts requiring time-use information.

It is true that on receipt of the engine for overhauling it is broken down into its component parts for inspection, cleaning, testing, metal work, processing and assembly, but the parts for each engine are not intermingled with the parts of other similar engines. Instead they are kept segregated so that the engine itself never loses its unique identity as the particular engine owned by a particular customer.

It was also common ground that the replacement parts came from four sources (the appellants own manufacture, its parent company, authorized subcontractors, or parts generally available on the market), [1] that the appellants invoices included charges for materials (including a markup of some 18 per cent) which ran to about 70 per cent of the total amount charged to the customer, and that overhauling engines is manufacturing or processing (though it was not of course, conceded by the respondent that it was manufacturing or processing for sale).

The trial judge analyzed the facts and stated the issue as follows at pages 254-55 (D.T.C. 5581-82):

I suppose an argument could be made that if every component part of an engine were replaced the so-called overhauling process should be classified as a manufacturing one for sale. That however was not the evidence led at the trial. Invoices were introduced at the trial which simply indicated that overhauling an engine was an expensive process. The two invoices tendered identified overhauling costs in excess of $300,000 for each engine which, in the case of the overhauled airplane engine,represented about one third of the sale value of a new engine. The evidence, if I recall correctly, did not allow one to conclude what percentage of the component parts had been replaced in the overhaul but the lack of that evidence would lead me to believe that the replacement of component parts would be well below the 50 per cent level.

There was also introduced in evidence several sample contracts. These contracts did not speak of remanufacturing of the airplane engines or of the manufacturing or processing for sale of airplane engines. The contracts spoke in terms of the "Complete Engine”, the "Basic Engine”, the customer's particularly identified engine, the "Overhaul of the Basic Engine”, the “ Repair of the Basic Engine”, the “Component Repairs” and "Accessory Repairs”, none of which terms tend to indicate sale but rather service, material, repair and overhaul operations.

As I understand the issues in this matter they all centre around the question of whether the plaintiff, in overhauling the airplane engines, manufactures or processes goods in Canada for sale or lease in the relevant taxation years so as to entitle it to the tax benefits claimed.

In taxation cases of this sort there are two lines of authority. One line. . .which appear to favour the plaintiff's case, and the other line of cases. . .which appear to favour the defendant's case.

The trial judge followed 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 distinguishing between a contract for the sale of goods and one for labour and materials in which property in the materials passes by accession and not by contract of sale. He also distinguished the decision 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.), upheld [1990] 1 C.T.C. 4267, 90 D.T.C. 6320 (F.C.A.), and that of this Court in The Queen v. Nowsco Well Service Ltd., [1990] 1 C.T.C. 416, 90 D.T.C. 6312, where Reed, J.'s reasoning in Halliburton was strongly endorsed.

The trial judge went on to conclude at Rolls Royce, supra, page 259 (D.T.C. 5584):

In this case the plaintiff. . .was not engaged, as its primary purpose, in the processing of goods for sale. It was, from a common sense and business-like appreciation of the evidence, engaged in the overhauling and repairing of airplane engines which, throughout the process, remained the property of the customers to which the labour and materials which were added became a part of the overhauled or repaired engine by accession and not by sale.

It seems to me that the two lines of authority referred to by the trial judge are, as he thought, reconcilable. In Crown Tire the taxpayer corporation was engaged in a tire retreading business in which the old tread would be stripped off, leaving a "casing," and new rubber strips would be applied and secured, and the tire would then be returned to the customer. On these facts Strayer, J. held at page 414-15 (D.T.C. 5428-29):

With respect to the retreading of tires owned by customers, it appears to me that the customers retain ownership throughout the process. In an order from admitted as Exhibit P-1, the customer asked Crown Tire Service to retread a particular tire" if economical". Testimony from the company’s officers given before me indicated that this meant that if, upon closer inspection, Crown Tire concluded that the tire was not worth retreading, it would so advise the customer and request further directions as to whether the customer wanted the tire returned to him or discarded. Where a tire was retreaded, it would be returned to the same customer who supplied it. This suggests to me that the casing was seen throughout as being the property of the customer and the work and material provided by Crown Tire were applied to that casing. This involved essentially a contract for repairs. Once the rubber material was affixed to the casing it would become the property of the owner of the casing by accession. That materials could therefore not be the subject of a contract of sale since it merged with the customer's property at the time of adhesion to it. . . .

The most important factor in establishing that Crown Tire's contracts for retreading customer's tires were contracts for work and material is, in my view, the fact that the work was done to a tire casing which the customer owned throughout. I think this distinguishes the present situation from those involved in many of the decided cases where the customer had never previously owned any part of the end product.

Although there was evidence that in some cases the taxpayer itself owned the casings and that after retreading, the tire would be sold to random purchasers, the taxpayer was unable to say how much of its business was of this kind, and so was unable to rebut the Minister's assumption that this accounted for less than the 10 per cent of gross revenue required by paragraph 125.1 (3)(b)(x) to qualify for the tax deduction.

The facts in Halliburton were quite different, as was pointed out by Reed, J. at page 58 (D.T.C. 5340):

It should first of all be noted that while Mr. Justice Strayer relied on the distinction between contracts for the sale of goods and contracts for work, labour and materials as described in Benjamin's Sale of Goods, he expressly noted that the application of that principle was “always a matter for interpretation in each case". Secondly the processing with which he was concerned did not involve the creation of a good antecedent to its use in the provision of a service. Thirdly, thesignificant factor in that case was the fact that "the work was done to a tire casing which the customer owned throughout". Accordingly, while the distinction between contracts for the sale of goods and contracts for work, labour and materials may have been significant in the Crown Tire Service case, I do not think it is applicable in the present one.

In Halliburton the taxpayer corporation was involved in cementing activities in oil and gas wells in which the cement for each cementing operation was custom made by the taxpayer, following discussions with the customer as to the particular needs of the well in question. Reed, J. wrote in relation to these facts at page 55-56 (D.T.C. 5338):

The defendant does not dispute the facts 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 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. . . .

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 services.

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 Act. 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 plaintiff's 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 processing) that is important for the purpose of paragraph 125.1(3)(b), not the nature of the taxpayer's contractwith 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 his customers he would be allowed the deduction.

The crucial distinction between Crown Tire and Halliburton seems to me to be the second difference noted by Reed, J., viz., that the processing in Crown Tire "did not involve the creation of a good antecedent to its use in the provision of a service." (In my view it might also have been "contemporaneous with” its use in the provision of a service). The rubber strip in Crown Tire was not on the evidence manufactured or processed by the taxpayer, whereas the cement in Halliburton was made by the taxpayer, indeed was custom- made according to very exact specifications. [2]

A similar distinction is also evident in Nowsco, though in that case the taxpayer, which was also in the business of providing services to oil and gas wells, did not so much manufacture its cement as modify the cement with its own additives, thus selling its blended cements in conjunction with placement service at the well sites. In addition, the taxpayer provided stimulation services designed to stimulate the flow of oil and gas into the well bar, though fracturing and acidizing both of which required the preparation of special fluids. It was conceded that what the taxpayer was doing was either manufacturing or processing, probably the latter. On these facts Urie, J.A. wrote at pages 424-25 (D.T.C. 6318):

I am of the opinion that a commonsense realistic and business-like appreciation of all of the foregoing indicates that the respondent does not enter into pure service contracts, but rather processes goods to the operator/customer's specification which it utilizes to perform the specified services required of it by its customer. It does so by means of what the Trial Judge described as a "mobile factory” which utilizes the various materials, mixtures and blends produced for delivery to the well bore for the purposes required by the customer. 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.

Once again, as in Halliburton, there are goods produced for sale by the taxpayer, viz., the cement blends and the fluids specifically prepared for the conditions of the well hole. In other words there was ''manufacturing or processing in Canada of goods for sale.”

conditions of the well hole. In other words there was “manufacturing or processing in Canada of goods for sale.”

In the case at bar, the appellant's problem is that there is nothing so produced. True, the overhauling of the airplane engines is manufacturing or processing, but not for sale, since the engines are owned throughout by the customers. There is a sale of replacement parts, but the majority of these parts are not manufactured or processed by the taxpayer — or at least the taxpayer here, somewhat like the taxpayer in Crown Tire, which could not identify the percentage of its ownership of the tire casings, is unable to say what proportion of parts sold it manufactures itself.

The essence of the appellant's case, as argued, was that it provided goods for sale (all the replacement parts, whatever their source) in the course of an engine rebuilding operation that the respondent conceded was manufacturing. But this is not enough to fulfil the requirements of the statute. The elements must match. The taxpayer must manufacture or process goods for sale, i.e., it must manufacture or process the same goods it sells. All that the taxpayer manufactures is the whole engine, which is not for sale by the taxpayer. It does not manufacture most of the parts, which is all it puts on sale.

In fact, the appellant did not even attempt in oral argument to put its case in terms of the Act itself, but only in relation to how it claimed Halliburton and Nonsco interpreted the statute. However, I can find no warrant in those cases for the appellant's interpretation.

There is nothing in the recent decisions in Tenneco or in Hawboldt Hydraulics Inc. v. The Queen, [1992] 2 C.T.C. 361, 92 D.T.C. 6452 to support the appellant's contention. In the latter case (which we were informed was under appeal) the taxpayer, which was involved in the repair and remanufacturing of hydraulic components for equipment, was found to manufacture the parts it used to effect the repair of the hydraulic components, and so was held to qualify. [3]

The appeal must therefore be dismissed with costs.

Appeal dismissed.