Mackenzie & Fiemann Limited v. Minister of National Revenue, [1989] 2 CTC 2133, 89 DTC 407

Taylor, T.C.J.:—This is an appeal heard in Vancouver, British Columbia, on May 2, 1989, against an income tax assessment for the year 1984 in which the Minister of National Revenue disallowed a deduction of $212,049, which represented advances made by the appellant to Sumas Industries Ltd. (Sumas).

From the notice of appeal:

— The Appellant's business is the chemical distribution business, which business is the main source of its income.

— In the course of its chemical distribution business, the Appellant obtains distributorship rights to distribute various products from which it earns its income.

— The Appellant desired to have a source of caustic soda to add to its list of chemicals which it was distributing.

— Sumas Industries Ltd. is a company which was incorporated to investigate new methods of drying caustic soda.

— The Appellant desired to sell caustic soda to its various clients, and accordingly, negotiated an agreement with Sumas Industries Ltd. wherein the Appellant would acquire supplies of caustic soda which it intended to sell to its customers at a profit.

— In conjunction with the business relationship with Sumas Industries Ltd., the Appellant advanced funds to Sumas Industries Ltd.

— Sumas Industries Ltd.'s process for drying the caustic soda ultimately did not prove successful and, by the end of the Appellant's 1984 taxation year, the Appellant's advances to Sumas Industries Ltd. had become bad debts and were worthless.

— The sole motivating factor to the taxpayer making the advances of $212,409 to Sumas Industries Ltd. was to earn income from its distribution business . . .

From the reply to notice of appeal:

— The Appellant purchased 3,000 shares of Sumas Industries Ltd. for $3,000.00 and advanced money in the amount of $209,408.60.

— The respondent submits that the Appellant's outlays to the extent of $212,409.00 were outlays or expenses incurred on account of capital and are not deductible from income in 1984.

— The Respondent further submits that the Appellant's advances to Sumas Industries Ltd. were neither bad debts nor uncollectable until 1985.

— The respondent has allowed the Appellant an allowable capital loss in 1985 in respect of its purchase of shares and an allowable business investment loss in 1985 in respect of its advances to Sumas Industries Ltd.

Evidence

The main witness was Mr. William Koral, President of the Appellant corporation (M. & F.), who also became President of Sumas. He described the general operating procedure of M. & F., including the range and variety of purchases and resales of chemical products. Caustic soda, which was the product expected from Sumas, represented about '/2 of 1 per cent of the sales of M. & F. — about $120,000 out of some $24M total sales in 1981.

M. & F. worked on a type of "discount" with each different supplier of chemical products, and for caustic soda, its major supplier was in the United States and gave about a 5 per cent discount. Mr. Koral had anticipated that the 5 per cent discount would reach perhaps 10 per cent from Sumas, thereby ensuring potential profit for M. & F. M. & F. calculated that there was a potential of 1,000 tons per year of local sales as contrasted with current sales volume in 1981, of about 300 tons. The soda sold at about $400 per ton. There were three particular documents introduced by the parties referenced as:

Exhibit A-5 — Letter Agreement between M. & F. and Sumas, dated April

16, 1981.

Exhibit A-6 — Form letter from M. & F. to its major customers dated

September 7, 1984 stating that operation of Sumas had ceased.

Exhibit A-7 — A letter of agreement from Sumas Chemical Corporation

to Sumas Industries Limited (in this appeal "Sumas") dated February 8, 1985 representing the purchase by Sumas Chemical Corporation of the remaining plant and assets of Sumas. (There was no indication at the hearing that the emergence of Sumas Chemical Corporation, whatever it represented had any direct bearing on the point at issue in this appeal).

The Court will be referring to these documents later in the reasons for judgment. Exhibit A-5 deals with the question of basic deductibility, while Exhibit A-6 and Exhibit A-7 point more towards the question of the appropriate year. I would quote the entire Exhibit A-5 at this point:

. . . Gentlemen:

We wish to confirm the verbal understanding between Sumas Industries Ltd. and Mackenzie & Feimann Limited concerning the distribution agreement between the two companies.

This agreement made and entered into by Sumas Industries Ltd., a corporation organized and existing under the laws of British Columbia with principal offices in North Vancouver, British Columbia and of Mackenzie & Feimann Limited, a corporation organized and existing under the laws of British Columbia with principal offices in North Vancouver, British Columbia.

Sumas Industries Ltd. hereby appoint Mackenzie & Feimann Limited as the sole and exclusive distributor of all the products produced by Sumas Industries Ltd. The territory will include Canada and any export markets from Canada.

This will be an "evergreen" agreement running year to year and commencing February 1, 1981.

This agreement can be terminated for reasons of non-performance by Sumas Industries Ltd. 90 days before the annual agreement date. Mackenzie & Feimann Limited will carry out to the best of its ability a merchandising policy designed to promote and sell the products from Sumas Industries Ltd. and will do so in a manner consistent with the highest standards of fair trade and business ethics.

Mackenzie & Feimann will not disclose to any third parties information concerning manufacturing and production techniques.

It is understood that the quality of any products manufactured by Sumas Industries Ltd. and distributed by Mackenzie & Feimann Limited will meet the proper and normal commercial specifications for such products and that it can return for full credit any merchandise that does not meet the generally recognized standard quality for commercial production of like products in North America.

It is understood that the purchase price by Mackenzie & Feimann Limited from Sumas Industries Ltd. for Caustic Soda or Sodium Hydroxide in the dry form will be the lowest delivered competitive price for container lots or carload lots to all Western Canadian points where competitive material sells less a discount of ten percent. A discount of ten percent will also apply to sales by Mackenzie & Feimann Limited in other marketing areas. The commission rate can be negotiated if market conditions are such that the netback to Sumas Industries Ltd. is diminished to the point where it is not economically feasible to sell the merchandise but where both parties feel a competitive situation should be met.

This agreement can be terminated by Sumas Industries Ltd. upon failure of Mackenzie & Feimann Limited to pay the invoices rendered by Sumas Industries Ltd. It is understood, however, that should the product purchased be defective, the goods can be returned to Sumas Industries Ltd. for full credit including any freight costs incurred.

This agreement constitutes the entire agreement between the parties with respect to the subject matter hereto and supercedes all prior agreements between the parties whether written or oral relating to the same subject matter.

On the major point I would quote from the argument of counsel for the appellant:

. . . I suggest that the amounts advanced to Sumas Industries were made by Mackenzie and Feimann as part of its process of profit-making. They were made to acquire the distribution rights, and that was their business operation. That was what they were in business for, to distribute chemicals. And this was an amount paid to acquire the distribution rights .. .

. . . I suggest, Your Honour, that had Mackenzie & Feimann spent money advertising or hired new people to secure new operations, that would have been — such an expense would have been deductible in the same manner, I suggest, that expenses incurred to acquire distribution rights should also be deductible.

. . . Now, the next case under Tab 5 [1] is where I suggest Canada started to really become involved in a whole new approach to the interpretation of, as it used to be, 12(1)(b) and now 18(1)(b). And this, I suggest, is the Algoma case. It’s one of the leading cases in our country, in our courts, in determining capital outlays.

And in that case President Jackett of the Exchequer Court was considering the deductibility of the cost of geological surveys by this railway company in the hopes of attracting new customers. Revenue had taken the position that such amounts were on account of capital.

. . . the intention of the Appellant company was to obtain commissions from distributing the chemicals. It was not the intention of acquiring income by way of dividends or capital gains on the sale.

. . . We have an amount spent to acquire distribution rights, although there was involved some shares, that was not the main reason that the money was spent. To use the reference in Algoma, it was not the advantage to be gained; or to use the reference that Justice Estey said in Johns-Manville [2] we must look at the real reason for getting involved in this.

And in the Johns-Manville case Estey said this was part of the income earning process; to acquire that land that Johns-Manville did meant that they could continue to operate their mine by enlarging the pit.

I suggest, Your Honour, that if Johns-Manville had been heard 20 years ago, 30 years ago, without this development of the lot, that expense would clearly be on account of capital.

. . . as we have in this case, but the amount was paid by the Appellant company to acquire distribution rights and it would sell the caustic soda and make commission.

That is our position. The company would be taxable on the commissions and it spent money to earn the commission, therefore it should be entitled to deduct the advances. That is a very simple essence of what we are trying to say, Your Honour. That's the Appellant's primary issue, that money was spent to earn commission income, and it didn't work. It was a great idea but it didn't work, and nevertheless the expenses should still be allowed.

Analysis

Both counsel dealt with a range of case law, but much of the effort was concentrated on Algoma, supra. In this decision I have also chosen to review that judgment primarily.

I would agree with counsel for the appellant that there were two expectations that M. & F. might find in the agreement with Sumas — a greater commission income (ten per cent instead of five per cent, on a larger volume), and the “distribution rights". The increased commission and volume were related directly to the "Western Canadian” business already held by M. & F. The "distribution rights’ applied to a larger area — all of Canada

— and indeed export markets (see Exhibit A-5).

Both parties in this trial have used the term "distribution rights” as noted above, but I would suggest that the evidence available to the Court indicates strongly that an equally appropriate term might be "the provision of a stable source of supply for caustic soda", as the prime motivation for the efforts at establishing Sumas. But whichever term is used, it is this aspect of it, the exclusive availability of caustic soda from Sumas, permitting sales to increase from the existing 300 tons up to the total projected Sumas production of some 3,000 tons which was the main attraction for M. & F. As I see it, therefore, the decision by M. & F. to enter into an agreement with the other parties to build and operate the Sumas caustic soda plant was based on a reasonable expectation by M. & F. that additional immediate commission income could be earned (up to the projected Western Canada 1,000 tons); and that a good prospect existed for wider market penetration (up to 3,000 tons) from a stable supply base.

I read the "two stage” analysis by the learned President in Algoma, supra, to mean that the use to which Algoma hoped to or intended to put the information obtained, was crucial in distinguishing between the direct (current) and indirect (capital) expenditures. In Algoma, supra, the advantage to the company arose only by virtue of the utilization by other parties of the information obtained, and not directly from the expenditure at issue. Therefore, the President was able to view that expenditure as not providing a capital asset to Algoma. In effect, since the President did not see in the expenditure itself an enduring benefit, thereby characterizing it as falling under the exclusion in paragraph 12(1)(b), (now paragraph 18(1)(b), of the Income Tax Act (the Act)) the amount was determined to be covered by the provisions of paragraph 12(1)(a) now paragraph 18(1)(a). It might well be argued that the distribution by Algoma of the information and its use by other parties assisted in stabilizing or improving the operating base of Algoma — a result closely aligned to preserving or increasing the capital structure of Algoma. However, the Court in that instance decided that the amount at issue ($267,167) was not expended directly for the distribution or use of the information, and allowed the deduction. I fully recognize that it could be said Algoma might not have been interested in acquiring the information, had not the larger objective of its use been its ultimate goal, but the learned President therein did not look through the primary consideration to this greater purpose in that matter. This particular disassociation, which forms the basis of the judgment in Algoma, supra, favourable to the appellant, was noted in Befega Inc. v. M.N.R., [1972] C.T.C. 197 at 205; 72 D.T.C. 6170 at 6175:

. . . The judgment in the Exchequer Court had made a distinction between the information gathered as a direct result of the expenditure, which was not of itself an advantage for the enduring benefit of the taxpayer’s business, and the subsequent exploitation of that knowledge.

Considering the above in connection with the facts of the instant case we have:

1. the claim for $212,409 consisted of $3,000 for the purchase of capital stock in Sumas; and $209,409 for construction, development, operation etc. of the Sumas plant. I make the point here that, whether significant or not, no breakdown of this amount of $209,409 was provided to the Court;

2. there was no intention to build a plant, get it to a producing level, and sell the plant; [3]

3. the original objective was to bring the plant to full production as quickly as possible — a matter of months — and expand the existing market for caustic soda from about 300 tons to about 1,000 tons per year;

4. a longer range objective was to use the excess products from point 3 above up to a total of about 3,000 tons per year for other Canadian and even export markets;

5. at an original estimated cost of some $325,000, the above programme for

M. & F. seemed economically feasible;

6. at an investment of about $800,000, the prospect for profit no longer remained, and the appellant cut its losses and left the venture.

In the case at bar, the amount of $209,409 (leaving aside for this purpose the other $3,000), was spent to build the plant, develop the process and set up the manufacturing system.

In Algoma, supra, the “immediate and direct result” of the expenditure was the acquisition of the information desired — that was the primary purpose according to the learned President. The objective in the instant case was not simply to build and develop a caustic soda plant as something potentially useful to other parties and from which somehow might flow additional business for M. & F. The plant, when in production, was to provide caustic soda to M. & F. which would be sold at a profit by M. & F. and hopefully, also a profit for Sumas. The objective in this expenditure under review was to expand the base of the appellant's operation by providing it with a stable economic supply of caustic soda for the purpose of additional business. I do not see that even the very delicate contrast between objectives which arises out of Algoma, supra, can be applied in this matter.

That leaves me facing the second proposition examined in Algoma, supra — the question of whether an increase in business in itself is an "advantage" (see page 134 (D.T.C. 5094)). The President addressed this question (see page 136 (D.T.C. 5095)) but, in my view, he did not see it necessary to do so on an explicit or deliberate basis. As he did, I also "have great difficulty in distinguishing" certain expenditures as to whether they are capital or income and the learned President gave certain examples in his case. While advertising as one of these examples may well be "designed to create a dramatic increase in the volume of a business”, and “is designed to benefit the business in an enduring way”, I would hesitate to place an advertising campaign in the same category as the construction of a manufacturing plant, or perhaps even

— in all instances — the acquisition of certain information or knowledge. While any or all of these could be directed toward gaining income, an item such as advertising is directly consumed in that process, and usually in a very current period of time. I cannot easily visualize an advertising campaign which leaves behind it a tangible, perhaps clear and comprehensible base for future operations, even though it might well produce an increase in volume, even add to the goodwill or reputation of a corporation. I can conceive of an information base accumulated and codified which might arguably be of some long-term benefit, a "capital" expense, possibly dependent on the usage. But I have no difficulty thinking of physical assets and manufacturing processes as having more than current “value”, perhaps not in all cases, but certainly in many of them.

It is apparent to me from Algoma, supra, that when the learned President reached the conclusion that the expenditure in that case was on current account, which decision was upheld on appeal, ([1968] C.T.C. 161; 68 D.T.C. 5096), there was little if any reason for answering the alternate question he saw. But I do not take his use of advertising as an example, to mean that when I have reached a conclusion on these facts, that the basic reasoning in Algoma, supra, should not apply here, that serious consideration should still be given by to this appellant's alternate proposition — that the provision of a physical and mechanical structure for the purpose of increasing the volume of a taxpayer's business, is an expenditure on current account. I would also add that I have been unsuccessful in my review of the case law attempting to find references which might further provide enlightenment or guidance on the comments regarding “advertising” made by the President.

In the end analysis regarding the capital-income question, I would quote from The Queen v. Marchand, [1978] C.T.C. 763; 78 D.T.C. 6507 at page 767 (D.T.C. 6509):

One of the principal characteristics of receipts or outlays on capital account is that, generally speaking, they are of a more or less permanent nature, whereas income accounts represent receipts and disbursements of a more or less transitory and periodic nature. Capital receipts and outlays on the other hand, generally speaking, all possess an existence, an effect or a scope that, if not permanent, is at least of long duration. Income accounts, on the other hand, represent receipts and outlays with an existence, effect or scope that is more or less transitory and periodic. It is not necessary that the capital asset be capable of either depreciating nor increasing in value, nor is it essential that one be able to dispose of it for value, despite the fact that one or other of these characteristics is usually found in a capital asset.

And from the recent judgment of the Federal Court-Trial Division in Morflot Freightliners Ltd. v. Canada, [1989] 1 C.T.C. 413; 89 D.T.C. 5182 [page 416 (D.T.C. 5185)]:

The plaintiff contends here, however, that it advanced money to Morflot Freightliners Inc., not with a view to getting a return on its investment through dividends but instead to try to ensure the success of its own business as agent for Far Eastern Shipping. It had concluded that it could not carry out its agency responsibilities in U.S. ports without having a U.S subsidiary.

It has frequently been said in cases of this nature that one must try to characterize a situation from a practical business point of view to determine the intent with which the money was provided. I have endeavoured to do that, and have concluded that the advances were provided by the plaintiff with a long-term objective in mind, namely to preserve for the indefinite future its U.S. subsidiary as a viable contracting party through which its agency responsibilities to Far Eastern Shipping could be carried out in the United States. I believe the critical distinction here is as between the preservation of an enduring asset on the one hand and the expenditure of money for direct and more immediate gaining of profit through sales, or, as in this case, the earning of commissions.

The portion of the appeal dealing with the basic deductibility of the amount as on current account will be dismissed. The amount at issue is on capital account.

Turning finally, to the question of the appropriate year for consideration of the availability of the amount lost, I would suggest that the issue rests on two Exhibits, A-6 and A-7 noted above. Exhibit A-6 is simply a form letter sent out by Sumas to its major customers indicating that the company had ceased operations. Exhibit A-7, however, deals with the terms of settlement of the agreement between Sumas and M. & F., so that M. & F. had no further involvement with that company. The details of that Exhibit are not directly relevant in my view, but I do conclude from it that it would not have been possible before that date to determine with any reasonable degree of accuracy the amount of involvement in Sumas which M. & F. eventually would be required to absorb. I am quite satisfied that M. & F. realized the seriousness of the situation in 1984 when the plant was closed down, but that is not the same as meeting the requirement under subsection 50(1) of the Act — in specific mathematical terms — “a debt owing to a taxpayer . . . is established by him to have become a bad debt in the year . . .". In my view, there exists more reason to uphold the Minister’s determination that the appropriate year for any deduction is the year 1985, than to consider the appellant's submission that the loss eventually incurred had become a "bad debt" in the year 1984.

The appeal is dismissed.

Appeal dismissed.