Ben Matthews & Associates Limited v. Minister of National Revenue, [1988] 1 CTC 2372, 88 DTC 1262

Rip, T.C.J.:—The appellant, Ben Matthews & Associates Limited ("corporation"), appeals against income tax assessments for its 1979, 1980 and 1981 taxation years in which the Minister of National Revenue, the respondent, disallowed the deduction of certain legal expenses in computing the appellant's income for each of the respective years on the basis the expenses were not made or incurred for the purpose of earning income from a business or property within the meaning of paragraph 18(1)(a) of the Income Tax Act ("Act") [1] .

The facts leading to this appeal were set forth by counsel for the appellant and are not in issue. The evidence of Mr. Henry Muroff ("Muroff") was accepted by counsel for the respondent and the Court.

During its 1966 through 1971 taxation years, the appellant, whose corporate name was then Matthews Lumber Company Limited, carried on the business as retailers and wholesalers of lumber and building material in Windsor, Ontario. At all material times "Muroff" was a director, secretarytreasurer and general manager of the appellant. The chief executive officer and controlling shareholder of the appellant was Mr. Ben Matthews. At and under Mr. Matthews' direction, Muroff was, amongst other things, responsible for the valuation of the inventory of the appellant and for maintaining records of its inventory.

The appellant did not store its inventory, in particular, its lumber, in any semblance of order. When the appellant moved in 1964 to new premises lumber stock was piled at the rear of its yard and much of it was never sold. Large amounts of unsold lumber accumulated year by year and it was simply piled with the rest of the unsold stock at the rear of the yard. By 1971 the rear of the yard was full of unsold and aging lumber and a new area had to be used for storage. Later on lumber was stored in the parking lot.

At the beginning and at the end of each of the appellant's 1966 through 1971 taxation years, usually between Christmas and New Year's Day, its employees, under Muroff's direction, took a physical count of the inventory and initially valued such inventory at its cost to the appellant. Muroff then reviewed each item of inventory and, based on his experience and judgment, made reductions from cost to the value of inventory in respect of damage, staining or obsolescence of the goods. Such reductions ranged from 15 per cent to 50 per cent of the original cost of the inventory and the amounts of the reductions were indicated alongside the original valuation of those items. All such reductions and the initial inventory valuation were evident in the records of the appellant and all such records were at all material times kept in accordance with the provisions of the Act and were made available in accordance with the provisions of the Act to officials of the respondent.

In calculating the value of its inventory at the end of its 1971 taxation year, the appellant also reduced the value of its inventory in anticipation of future declines in the market value of its inventory. Subsequent to filing its income tax return for its 1971 taxation year, and on seeking legal advice, the appellant determined that this adjustment to the value of its inventory was not authorized under the Act, voluntarily refiled its 1971 income tax return with an appropriate increase in the value of its inventory and paid all tax arising from such adjustment to the value of its inventory.

The respondent issued reassessments in respect of the inventory valuation adjustments in respect of damage, staining and obsolescence described above in respect of the 1966 through 1971 taxation years. Such assessments were, after the appellant filed notices of objection, vacated by the respondent.

The appellant and Muroff, as its director, officer or agent, were jointly charged with making false and deceptive statements on the returns of income of the appellant for its 1966 through 1971 taxation years and with wilfully evading payment of taxes during those taxation years, contrary to subsection 239(1) of the Act. These offences were alleged in respect of the reductions of inventory valuation in respect of damage, stained and obsolete goods described above. The charges were tried before the Ontario Provincial Court Judge, His Honour Gordon Stewart, commencing in November 1978 and were dismissed November 19, 1979, on a motion for a nonsuit by counsel for the appellant and Muroff following a three-week trial.

The appellant retained McCarthy & McCarthy, a law firm in Toronto, to defend the charges, but on being advised that Mr. J.J. Robinette, Q.C., could not take the trial, retained another firm of lawyers, Greenspan & Moldaver. Thirty to sixty days before trial Mr. Robinette advised that he was able to appear and the appellant decided that Mr. Greenspan and Mr. Robinette should both appear because of the importance to the appellant of proving its innocence. At the trial the two counsel divided their roles, one nominally representing the appellant and the other Muroff. The appellant paid legal fees in respect of the defence of these charges in its 1979, 1980 and 1981 taxation years in the amounts of $29,997, $14,859 and $9,265 respectively which it deducted in computing income.

It is the deduction of these legal fees which the Minister of National Revenue disallowed. Ms. Julia Anna Lelik, CA, a partner in the chartered accounting firm of Peat, Marwick & Mitchell, testified as an expert witness on behalf of the appellant. Ms. Lelik has had audit responsibility at her firm and is presently in her firm’s Department of Professional Practice which is responsible for the firm's policies in auditing and accounting matters. In her opinion under generally accepted accounting principles in Canada, in computing income, costs incurred by a corporation in defending itself in respect of criminal charges, and its officers or employees in respect of charges arising out of their actions performed in the course of their duties, are expenses in the year incurred and are deductible in computing income.

I accept Ms. Lelik’s evidence that generally accepted accounting principles recognize that costs incurred by a corporation in defending itself against criminal charges, and its officers or employees in respect of charges arising out of their actions performed in the course of their duties are deductible in computing income in the year the expenses are incurred.

Legal fees, as any other expense, are deductible under paragraph 18(1)(a) only if the expense is made or incurred for the purpose of earning income from a business or property.

Counsel for the respondent submitted that based on the reasoning of the Supreme Court of Canada in The Queen v. Phyllis B. Bronfman Trust, [1987] 1 C.T.C. 117; 87 D.T.C. 5059, for an expense to be deductible under paragraph 18(1)(a) there must be a direct relationship between the money expended and the income earned. The legal expenses of the appellant were not made or incurred to earn income but for the purpose of defending criminal charges after income had been earned: the defence against criminal charges, he suggests, had nothing to do with the income earning process. Counsel relies on Spofforth and Prince v. Golder, 26 T.C. 310 (K.B.) and Worsley Brewery Co., Ltd. v. C.I.R., 17 T.C. 349 (C.A.) for his submission that legal costs incurred as a result of taxes or fines levied after the income was earned are not to be treated as deductible expenses made for the purpose of earning profit.

In the Spofforth and Prince case (supra), a firm of chartered accountants claimed in the computation of its profits the deduction of certain legal expenses paid in connection with the successful defence of one of the partners who had been charged with conspiracy to defraud the Revenue. Speaking for the King's Bench Division of the High Court of Justice, Wrot- tesley, J. disallowed the deduction of the legal expenses at issue on the basis that those disbursements had not been expended for the "wholly and exclusive" purpose of earning profits from the accounting business of the appellant's firm. At page 313, Wrottesley, J. wrote:

In order to succeed in this claim it must be shown that these costs were incurred by the Appellants’ firm, and were moneys wholly and exclusively laid out or expended for the purpose of the Appellants’ profession — accountancy.

At page 314, Wrottesley, J. went on to say:

The establishment of Mr. Spofforth's innocence, the saving of him from conviction and punishment, are matters which must have been the purpose of the expenditure, just as it would have been had the charge been one of fraud against Mr. Spofforth in his personal capacity. No doubt Mr. Spofforth was an important member of the firm, and his conviction, and still more his imprisonment, would have been a severe blow to it. That, however, is not the test. It is not every expenditure made by a firm which falls within the definition, however prudent it may be, even though it may tend to benefit the firm.

Finally at pages 314-15, the test applicable in the circumstances, laid down by Lord Davey in Strong & Co. of Romsey, Ltd. v. Woodifield, 5 T.C. 215 at page 220, was set out:

Is the disbursement one made not merely in the course of, or arising out of or connected with, or made out of the profits of the profession, but also for the purpose of earning the profits of the profession? It is difficult, if not impossible, to think of anything so nearly approaching the formula referred to by Lord Loreburn, L.C., as unattainable ( [1] ), as this last phrase. It covers the most multifarious kinds of expenditure, as has been shown in cases like Mitchell v. B.W. Noble, Ltd., 11 T.C. 372; G. Scammell & Nephew, Ltd. v. Rowles, 22 T.C. 479; Usher's Wiltshire Brewery, Ltd., v. Bruce, 6 T.C. 399. It is not by any means a harsh test to apply to a taxpayer. But it appears to me definitely not to cover anyhow the payment of the costs of defending Mr. Spofforth against the criminal charge preferred against him.

In 1948, paragraph 6(1)(a) of the Income War Tax Act was replaced by paragraph 12(1)(a) of the 1948 Income Tax Act, S.C. 1948, c. 52. Under this new provision the expression “wholly, exclusively and necessarily laid out" was missing.

The enactment of paragraph 12(1)(a) was not marked however by a radical departure from the earlier jurisprudence. For instance, in the case of No. 237 v. M.N.R., 12 Tax A.B.C. 230; 55 D.T.C. 135 (T.A.B.), a company was seeking to deduct legal expenses incurred in obtaining an amendment to import tariff creating a reduction in the cost of its import. At issue was, inter alia, what role generally accepted accounting principles play in distinguishing current expense from capital expense under paragraphs 12(1)(a) and (b) of the 1948 Income Tax Act. At page 236 (D.T.C. 137), Mr. Chairman Fabio Monet held that over and above how an expense is treated for accounting purposes, the test under the new language of the Income Tax Act remained a legal one.

The Exchequer Court confirmed this approach to paragraph 12(1)(a) in The Royal Trust Co. v. M.N.R., [1957] C.T.C. 32; 57 D.T.C. 1055. In that case the issue was whether social club dues and initiation fees paid by a company for its executives and senior personnel were deductible. Thorson, P. formulated the following two-tier test at page 42 (D.T.C. 1060):

. . . the first matter to be determined in deciding whether an outlay or expense is outside the prohibition of section 12(1)(a) of the Act is whether it was made or incurred by the taxpayer in accordance with the ordinary principles of commercial trading or well accepted principles of business practice. If it was not, that is the end of the matter. But if it was, then the outlay or expense is properly deductible unless it falls outside the expressed exception of section 12(1)(a) and, therefore, within its prohibition.

Having found that the payments in question were consistent with good business practice in the line of business of the appellant, Thorson, P. also found that the deduction of the club dues was not prohibited by paragraph 12(1)(a).

In Evans v. M.N.R., [1960] C.T.C. 69; 60 D.T.C. 1047, the taxpayer claimed legal fees she had paid while successfully defending a life interest to receive a yearly allowance from the estate of her father-in-law were deductible in computing her income for the year. Cartwright, J. of the Supreme Court expressed the view that the expenses were incurred not only for the purpose of earning income from property, but to protect the income-earning capacity of the taxpayer in future years as well. The taxpayer was successful in her appeal; the expense was properly incurred within paragraph 12(1)(a) for the purpose of gaining an income to which she was entitled.

Paragraph 12(1)(a) of the Act read as follows:

12 (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer;

The current provision of the Act, paragraph 18(1)(a), reads as follows:

18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

The reasoning in Evans (supra) was applied again by the Supreme Court in Premium Iron Ores Ltd. v. M.N.R., [1966] C.T.C. 391; 66 D.T.C. 5280. Legal expenses had been incurred by Premium Iron Ores Ltd. in successfully resisting payment of United States income and capital gains tax. The Exchequer Court ([1964] C.T.C. 202; 64 D.T.C. 5131), per Cattanach, J., disallowed the expenses. At page 206 (D.T.C. 5134), Mr. Justice Cattanach affirmed:

It is well settled that the legal costs incurred in disputing a claim for income tax may not be allowed as a deduction in computing business profits. In Smith's Potato Estates, Ltd. v. Bolland, [1948] 2 All E.R. 367, Lord Simonds said at page 374:

. . . neither the cost of ascertaining taxable profit nor the cost of disputing it with the revenue authorities is money spent to enable the trader to earn profit in his trade. What profit he has earned, he has earned before ever the voice of the taxgatherer is heard. He would have earned no more and no less if there was no such thing as income tax . . .

The appeal to the Supreme Court was allowed.

At page 420 (D.T.C. 5293), Mr. Justice Hall said:

In conclusion, as I see it, the expenditures here were ones which under sound accounting and commercial practice would be deducted in the Statement of Profit and Loss as expenditures for the year in determining the profit, if any, of the company for that year. Cattanach J. appears to have placed too much reliance on Lord Simond's words in Smith's Potato Estates case: "What profit he has earned, he has earned before ever the voice of the taxgatherer is heard." I think it proper to observe that in each of the years in question before ever the voice of the tax- gatherer was heard the expenditures in question had to be made to preserve the income and the working capital from the unwarranted claim of a foreign taxing authority otherwise the Canadian taxgatherer would have called in vain.

Mr. Justice Martland agreed with Mr. Justice Hall that the appellant was entitled to deduct the amounts paid for legal fees, although he reached his “conclusion on somewhat narrower grounds".

Martland, J. had difficulty in seeing how, in principle, an expense for legal services made for the purpose of protecting the appellant's income can be regarded as being different from that which was held to be perfectly deductible in the case of M.N.R. v. The Kellogg Company of Canada, Limited, [1943] S.C.R. 58; [1943] C.T.C. 1; 2 D.T.C. 601 and in the Evans case (supra) [3] . The disbursement made, said Martland, J. “was not an outlay or replacement of capital, nor a payment on account of capital, within section 12(1)(b)" [4] . The claim of the United States government, if established, would have created a liability in relation to its income. Mr. Justice Martland added:

It is true that the American government considered as taxable income items of profit which had not been so regarded in Canada, but the basis of the claim was in respect of income. It is also true that the disbursement was made to protect profits earned in years prior to the year in which the disbursement was made as well as the income of that and subsequent years. But in the light of the present wording of section 12(1)(a) and its application in the Evans case, this does not prevent this expense from being deductible. In both that case and the Kellogg case the expense involved was to establish a right to receive income, or for the protection of income in other years as well as that of the year in which the expenditure was made.

Mr. Justice Martland did not agree with Cattanach, J. that the matter of the deductibility of legal expenses was determined by the judgment of the House of Lords in Smith's Potato Estates Limited (supra). He stated on page 397 (D.T.C. 5283) that:

The relevant statutory provision in that case was materially different from section 12(1)(a) of our Act. The English statute only permitted deduction of:

money wholly and exclusively laid out and expended for purposes of the trade.

Reference to the words which I have italicized, as compared with the wording of our section 12(1)(a), indicates that the English provision was much narrower in its scope.

The Smith case was concerned with legal expenses made by an English company in England with a view to reducing its liability for tax in England. The effect of the decision is that an expenditure by a trader for legal fees incurred for the purpose of contesting an assessment of income tax cannot, as against the assessor of that tax, be claimed as money wholly and exclusively expended for the purpose of the trade. But that is not this case. The expense incurred here was for the purpose of resisting the demands of a foreign taxing authority, which, had it succeeded, would have substantially depleted the income of a Canadian company. In my opinion, a claim of that kind is a claim by a third party. The resistance of the claim is an attempt to protect Canadian income, and it matters not, so far as the Canadian taxing authority is concerned, that the nature of the claim is one for income tax. In so far as the Canadian taxing authority is concerned, I can see no difference, in principle, between an expenditure in the form of legal fees paid by a railway company to defend a damage claim by a passenger, and thus to protect the company's income, and the expenditure for legal fees paid by the appellant to resist a foreign tax claim and thus to protect its income. The former type of expense is admittedly properly deductible.

Counsel for the respondent submitted that Mr. Justice Martland's remarks were not directed so much to condemn the Smith's Potato Estates case (supra) as it was to distinguish it from circumstances where payment of legal fees is made to protect income against encroachment by a third party (e.g. the United States' taxing authority). In counsel's view, the defence of the appellant and Muroff was not, as in Premium Iron Ores (supra), a claim against a third party; consequently the rationale of the Smith's Potato Estates case (supra) should apply here and the amount of legal fees should not be allowed as a deduction.

It is quite obvious the carrying on of a business in today's commercial world requires the businessman to be keenly aware of the state of his financial affairs. The preparation and the making of financial statements, the maintaining of books of accounts and inventory records in respect of a business operation are necessary consequences of carrying on business. To carry on business the businessman must know what assets he has and the value of the assets; he must have knowledge of the extent of his liabilities as well as his profits and his losses. A lender of funds to a businessman to permit him to carry on the business will rely on the financial statements and records to determine, amongst other things, the amount of the loan he is prepared to make, the interest he will charge and the security he requires. Fees incurred in the making of the financial statements to ascertain profits are deductible in computing income: vide Strong v. Woodifield, (supra).

As Hall, J. stated in Premium Iron Ores Ltd. v. M.N.R., (supra), at page 404 (D.T.C. 5286):

A company such as the appellant exists to make a profit. All its operations are directed to that end. The operations must be viewed as one whole and not segregated into revenue producing as distinct from revenue retaining functions, otherwise a condition of chaos would obtain. For example, is the function of the Paymaster's Department to be considered as directly relating to the production of income, which it undoubtedly is, as distinct from the Audit Department which scrutinizes the disbursements made by the Paymaster? What of the sophisticated systems of internal and external audits adopted by commercial companies to assure that the income received by the company is properly retained? What of security arrangements to protect income already earned? What of claims against, say, a shopping centre for damages sustained by a customer or claimed to have been sustained and the legal costs of investigating and defending such claims? Counsel for the Minister freely admitted that these are routinely allowed as expenses incurred in earning "the income".

Legal expenses incurred by a taxpayer in defending itself from criminal charges arising out of its business operations, namely, to defend its business practices, have been found by the court to be deductible: M.N.R. v. L.D. Caulk Co. of Canada Ltd., [1952] C.T.C. 1; 52 D.T.C. 1034 (Ex. Ct.), affirmed by [1954] C.T.C. 28; 54 D.T.C. 1011 (S.C.C.) and Rolland Paper Co. Ltd. v. M.N.R., [1960] C.T.C. 158; 60 D.T.C. 1095 (Ex. Ct.).

In the reasons of the Exchequer Court, in the L.D. Caulk appeal Cameron, J. said, at page 12 (D.T.C. 1039):

It is true that the deduction permitted in that case [Mitchell (Inspector of Taxes) v. B.W. Noble Ltd. (1927) 1 K.K., 719] was not in respect of legal expenses, but as I have said above, the tests to be applied are the same for legal expenses as for other expenses. It seems to me that in many respects the opinions so expressed by the Master of the Rolls and Sargent, L.J. are applicable here. The payments were made in the usual course of business and were made with reference to a particular difficulty which arose in the course of the year, namely, the investigation by the Commissioner, the charge laid against the respondent and the unfavourable and damaging publicity which resulted therefrom, and which would have been greatly enhanced had the charge been sustained. The disbursements had nothing to do with the assets or capital of the company, but were made in an effort — which in the result turned out to be successful — to establish that its trading practices were not illegal, and to enable it to carry on as it had in the past, unimperilled by charges that such practices were illegal. They were wholly, exclusively and necessarily paid out for these purposes and were therefore, in my opinion, laid out for the purposes of its trade and for purposes of earning the income.

Mr. Justice Fournier stated the following in Rolland Paper Co. Ltd. (supra) at page 170 (D.T.C. 1101):

On the evidence adduced, I found that the legal fees and costs claimed as deductions had been properly entered in the profit and loss statement in computing the taxpayer's revenue; that according to sound accounting and commercial practice they were to be considered as business expenses; that in the carrying on of a fine paper business there would be no material difference in the accounting theory which would prevail in the make-up of financial statements of other industries.

Where a business carries out activities in the normal course of its operations, and the cost of those activities is deductible in computing the income of the business, any expense incurred to defend those activities is a direct result of the activities themselves and is permitted by paragraph 18(1)(a) to be deducted: vide The Queen v. Phyllis B. Bronfman Trust, (supra). The legal expenses in the case at bar were incurred to defend a prosecution against the appellant which arose directly from the practice of preparing financial statements in the normal course of business.

The expenses incurred in the defence of Muroff were similarly incurred in the normal course of business: they were expenses of an employee incurred as a result of actions executed by him within the scope of his employment and in the course of, and for the purposes of, the appellant's business. It is an implied term of Muroff's employment contract with the appellant that the appellant will bear the kind of costs necessarily incurred in a successful defence in respect of charges that an employee may have committed a criminal offence in the course of his employment. Vide Halsbury's Laws of England, 4th ed., Vol. 16 at paragraph 568. Such costs are the appellant's ordinary expenses of carrying on his business and are properly deductible by him pursuant to paragraph 18(1)(a) of the Act.

In the recent decision of the Federal Court of Canada in Border Chemical Company Limited v. The Queen, [1987] 2 C.T.C. 183; 87 D.T.C. 5391, the Court found that the activities of an officer of the appellant which led to the criminal charges against him were in respect of his own business activities, separate and apart from those of the appellant, and were of no concern to the appellant. Hence the legal fees paid by the appellant were not deductible in computing its income. In the case at bar the activities leading to the charges against Muroff and the appellant were part of the business operations of the appellant to earn income and the legal expenses incurred as a result thereof are deductible in computing income.

When Ms. Lelik was called to testify as an expert witness on behalf of the appellant, counsel for the respondent objected. His objection was based on the grounds that he had not been informed an expert witness would be called by the appellant and that he did not receive any information what her evidence would include.

Counsel for the appellant submitted that there is no rule of this Court setting out a procedure to be followed for the presentation of expert evidence, and that in any event, the appellant's notice of appeal states that "the legal fees in question were deducted by the company as business expenses according to generally accepted accounting principles and sound commercial practice". Thus, he stated, counsel for the respondent ought to have been aware that the appellant would call an expert witness to support this statement.

After receiving instructions from his client, counsel for the respondent withdrew his objection. However both counsel requested me to consider this problem in my reasons for judgment. The Rules of Practice and Procedure of the Court, including rules with respect to expert evidence, are now under review by the Court and amended Rules of Practice and Procedure are expected to be issued. Accordingly it would not be appropriate for me at this time to consider the procedure to be followed with respect to expert evidence.

The appeals of the appellant corporation are therefore allowed with costs.

Appeals allowed.