Bastion Management Limited v. Minister of National Revenue, [1988] 1 CTC 2344, 88 DTC 1245

Brulé, T.C.J.:—The appellant appeals in respect of the Minister of National Revenue's reassessment of its 1979 taxation year whereby the Minister disallowed the appellant's claim for an inventory allowance, pursuant to paragraph 20(1)(gg) of the Income Tax Act, (Act) in the amount of $196,072.

Facts

The appellant is a Canadian-controlled private corporation which is in the business of managing pools of funds for third parties and also is involved in the trading of securities or commodities for its own account. The company's fiscal year-end is July 31.

On July 26, 1978, the appellant purchased 15,000 ounces of gold bullion and 500,000 ounces of silver bullion for a cost of approximately $6,500,000. On the same day as these purchases the appellant sold 30-day futures contracts for equivalent amounts of gold and silver for delivery in August. The purpose of the futures contracts, as outlined in the notice of appeal, was to limit the downside risk of any potential loss in the value of the gold and silver. If the price of gold and silver were to rise, as anticipated by the appellant, the increased value of the bullion would more than offset a decline in value of the futures contracts. In this manner the appellant hoped to protect its investment from losses due to market swings.

On or about August 3, 1978, the appellant sold its holdings of gold and silver bullion and closed out the futures contracts, having taken advantage of the rise in the gold and silver cash markets.

For its 1979 taxation year the appellant claimed inventory allowance pursuant to paragraph 20(1)(gg) based on the inventory of gold and silver bullion held as of August 1, 1978, the commencement date of its 1979 fiscal year.

The Appellant's Position

The appellant maintains that the gold and silver bullion were inventory to its business at the commencement of its 1979 fiscal year within the meaning of paragraph 20(1)(gg) and therefore qualify for the inventory allowance permitted by that provision of the Act.

The Respondent's Position

The respondent submits that the rights to acquire the gold and silver bullion were purchased to satisfy the vendor's obligations under the August gold and silver futures contracts with the result that the gold and silver were not held for sale as of August 1, 1978. Accordingly, they are not inventory Within the meaning of paragraph 20(1)(gg).

The respondent also submits that deduction of the inventory allowance is unreasonable and would artificially reduce the appellant's income if allowed and consequently the deduction should be disallowed by virtue of section 67 and subsection 245(1) of the Act.

Analysis

Paragraph 20(1)(gg), which has been repealed, permitted a deduction from income of:

(gg) an amount in respect of any business carried on by the taxpayer in the year, equal to that port ion of 3% 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;

Albert D. Friedberg, president of Bastion, was the only witness called at trial. I found Mr. Friedberg to be candid and honest in his testimony and he provided the Court with very thorough evidence of the circumstances surrounding the transactions at issue in this appeal.

Mr. Friedberg was responsible for all the commodity trading at Bastion and testified that Bastion had speculated from time to time in approximately 27 different commodities. Although the company had dealt primarily with the futures market, it does not appear that dealings in the physical markets were outside of its normal course of business. Based on Mr. Friedberg's testimony I am satisfied that the transactions in question were within the ordinary business of the appellant. The appellant first learned of the inventory allowance permitted under paragraph 20(1)(gg) from his accountants in 1978. He was advised that this allowance only applied to the physical commodities market and that futures contracts would not qualify. He stated that he decided to utilize this tax arrangement for his benefit and in that respect decided on July 26, 1978, to buy physical commodities to take advantage of the inventory allowance.

On that date the appellant purchased 15,000 ounces of gold and 500,000 ounces of silver. At the same time the company sold futures contracts for similar quantities of gold and silver to reduce the risk of loss.

Counsel for the appellant produced in evidence documents which support the appellant’s position that the gold and silver purchased were tangible property of the appellant and not merely "choses in action". In particular, these documents identify 500,000 ounces of silver stored at First National Bank of Chicago and 14,960.6915 ounces of gold bullion stored at the Republic National Bank of New York. Attached to these documents were listings of the warehouse receipts and serial numbers for each bar of gold or silver.

Friedberg & Company Ltd., which is associated with the appellant company, acted as agent for Bastion in these transactions. Statements of the appellant's account with Friedberg & Company Ltd. indicate the dates on which these purchases took place and the corresponding dates of sale. In my opinion the evidence clearly shows that as of August 1, 1978, the commencement of the appellant's fiscal year, the appellant owned the gold and silver at issue in this appeal and the cost amount of such gold and silver was properly described in the appellant's inventory.

I cannot accept the respondent's submission that the rights to this gold and silver bullion were acquired to satisfy the vendor's obligations under the August gold and silver contracts. It is clear from the evidence that the latter were futures contracts and did not refer to specific identifiable bars of gold or silver. The August contracts could be fulfilled by means other than the sale of the specified bars and I have therefore concluded that at the commencement of its 1979 fiscal year the appellant held in inventory the quantities of gold and silver at issue in this appeal.

I wish to deal with the respondent's argument that the deduction claimed by the appellant is unreasonable and would, if allowed, unduly or artificially reduce the appellant's income. In this respect the respondent claims that the deduction should be disallowed pursuant to section 67 and subsection 245(1) of the Act.

In the present case, Mr. Friedberg readily admits that he was motivated for tax reasons to structure the transactions in issue in the manner outlined above. Were it not for the tax advantages it is possible that the dealings of the appellant would have been structured in some other manner. Bastion's accountant advised that the course of action followed could be a profitable one, as indeed it was.

Subsection 245(1) of the Act states:

In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

The issue arose at trial whether subsection 245(1) applies to deductions such as the inventory allowance created by paragraph 20(1)(gg) of the Act which do not involve an actual disbursement or expense. The Supreme Court considered the issue by way of obiter dictum in the case of Louis J. Harris v. M.N.R., [1966] C.T.C. 226; 66 D.T.C. 5189, and found subsection 245(1) applied to claims for depreciation or for capital cost allowance. The Supreme Court's comments were addressed by Addy, J. in the case of Gordon McKee v. The Queen, [1977] C.T.C. 491 at 493-94; 77 D.T.C. 5345 at 5346-47:

The case of Louis J. Harris v. M.N.R., [1966] C.T.C. 226; 66 D.T.C. 5189, a decision of the Supreme Court of Canada, contains the following passage at page 241 [5198] of the report:

If, contrary to the views I have expressed, we had accepted the appellant's submission that the transaction embodied in the lease was one to which section 18 applied and that on the true construction of the lease and the terms of that section the appellant was prima facie entitled to make the deduction of the capital cost allowance of $30,425.80 claimed by him, I would have had no hesitation in holding that it was a deduction in respect of an expense incurred in respect of a transaction that if allowed would artificially reduce the income of the appellant and that consequently its allowance was forbidden by the terms of subsection 137(1). The words in the sub-section "a disbursement or expense made or incurred" are, in my opinion, apt to include a claim for depreciation or for capital cost allowance, and if the lease were construed as above suggested the arrangement embodied in it would furnish an example of the very sort of ‘transaction or operation’ at which section 137(1) is aimed.

The case was decided on other grounds and the statement is, of course, obiter dicta and is therefore not strictly binding upon me. In view of its authorship however and of the fact that the judgment was concurred in by the remainder of the members of the Court who were sitting at that time, that particular interpretation of subsection 137(1) caused me some concern. The question, in my view, must be squarely faced in the case at bar.

at page 495 (D.T.C. 5347) the Court states:

I must therefore conclude that not only in their common ordinary meaning, but also in the technical language of accountancy and, more importantly, everywhere else in the Act itself wherever the words are employed, they are never used nor are they intended to be used as being synonymous to the word "allowance" but that, on the contrary, they are often directly used to indicate an expenditure which one may or may not be permitted to compensate for by an allowance according to the particular provisions of the Act.

In subsection 137(1) itself, the words "capital cost allowance” themselves describe an allowance to compensate for the cost or expense. Surely, this allowance itself cannot be the cost, expense or expenditure for which it is intended to provide some tax relief.

More recently the Federal Court of Appeal dealt with the question in the case of The Queen v. Nahum Gelber, [1983] C.T.C. 381; 83 D.T.C. 5385. At page 382 (D.T.C. 5387) of the report of Le Dain, J. states:

. . . The Trial Division allowed the appeal from the Minister's reassessment, holding that the capital cost of the respondent's share of the film was $38,333.33 and that capital cost allowance on the amount of $30,000 did not fall within subsection 245(1).

He goes on to state on the next page:

. . . In my opinion there is no basis in the conditions of the contract or in the evidence for treating the $30,000 in issue as resulting in an unduly large or artificial capital cost, and the section should not, therefore, be applied to disallow the capital cost allowance in respect of that amount.

Transposing the reasoning in the Gelber (supra) case to the facts before us, the issue to be determined in relation to subsection 245(1) is whether the appellant's operations or transactions can be said to have resulted in or created an unduly high or artificial inventory. The facts indicate this is not so. The value of the appellant's inventory reflected the true value of the bullion held by him for sale. There was nothing artificial or fictitious about the goods constituting the inventory, the appellant's ownership of the goods nor the fact that these were held out for sale. Subsection 245(1) will therefore not be applied to disallow the inventory allowance.

In cases such as the present one, not involving an incomplete transaction or a sham, a transaction may be set aside for tax purposes even though, in the words of Estey, J. in the case of Stubart Investments Limited v. The Queen, [1984] C.T.C. 294 (S.C.C.) at 317; 84 D.T.C. 6306 at 6324, the transaction "may not attain the heights of ‘artificiality’ in section 137”. The power of the Court to set aside such a transaction comes from the general pattern of the Act and not from a particular provision. In the words of the Supreme Court at page 316 (D.T.C. 6323) of the report:

The question comes back to a determination of the proper role of the court in construing the Income Tax Act in circumstances such as these where the Crown relies on the general pattern of the Act and not upon any specific taxing provision. The Act is to be construed, of course, as a whole, including section 137 but, for reasons already noted, without applying that section specifically to these assessments.

An otherwise valid transaction will not allow a taxpayer to claim a deduction or advantage created by the Act in the following cases, set out at page 317 (D.T.C. 6324) of the report if:

(a) the setting in the Act of the allowance, deduction or benefit sought to be gained clearly indicates a legislative intent to restrict such benefits to rights accrued prior to the establishment of the arrangement adopted by a taxpayer purely for tax purposes;

The case before us clearly does not fall within this description.

(b) the provisions of the Act necessarily relate to an identified business function. This idea has been expressed in articles on the subject in the United States.

Paragraph 20(1)(gg) may be said to “necessarily relate to an identified business function" in that the deduction created by the Act must relate to inventory held out for sale with respect to a business carried on by the taxpayer. The operations with respect to which the appellant seeks to claim the deduction satisfy this condition.

(c) "the object and spirit" of the allowance or benefit provision is defeated by the procedures blatantly adopted by the taxpayer to synthesize a loss, delay or other tax saving device, although these actions may not attain the heights of "artificiality" in section 137. This may be illustrated where the taxpayer, in order to qualify for an “allowance” or a “benefit”, takes steps which the terms of the allowance provisions of the Act may, when taken in isolation and read narrowly, be stretched to support. However, when the allowance provision is read in the context of the whole statute, and with the “object and spirit” and purpose of the allowance provision in mind, the accounting result produced by the taxpayer’s actions would not, by itself, avail him of the benefit of the allowance.

The "object and spirit” of paragraph 20(1)(gg) is to provide the taxpayer with relief against taxation of an amount which does not truly represent revenue from the sale of property but an increase in its sale value due to inflation. In the words of Hugessen, J. of the Federal Court of Appeal, in the case of Saskatchewan Wheat Pool v. The Queen, [1985] 1 C.T.C. 31 at 33; 85 D.T.C. 5034 at 5036:

The inventory allowance permitted by paragraph 20(1)(gg) was introduced into the Income Tax Act in 1977. Its obvious purpose was to allow some relief to businesses from the increased tax liability due to “false” profits created by the effect of high inflation on year-end inventories.

The operations by which the appellant purchased and sold the items held as inventory certainly do not defeat the purpose of the provision. The value of the bullion held as inventory was subject to inflation as was any other inventory and the taxpayer sought to utilize paragraph 20(1)(gg) to get precisely the relief it was created to provide.

The appeal is therefore allowed with costs on a party and party basis and the matter referred back to the Minister for reconsideration and reassessment.

Appeal allowed.