Ref Automation Limited v. Minister of National Revenue, [1987] 1 CTC 2425, 87 DTC 292

Taylor, T.C.J.:—This is an appeal against an income tax assessment, for the year 1981, heard on February 3, 1987, in Toronto, Ontario, in which the Minister of National Revenue disallowed amounts of $144,000 and $1,285 claimed as expenses against income. The framework of the appeal may best be seen by excerpts from the pleadings of the appellant and the respondent as set out below.

From the notice of appeal:

Statement of Facts

— In December 1981 the Appellant entered into a settlement agreement to obtain the termination of an agreement to manufacture electrical parts in the United States of America. In order to be released from this agreement the Appellant agreed to pay $144,000.00 to the other party to the contract.

— The Appellant incurred legal expenses of $1,285.00 in relation to the settlement of the manufacturing contract referred to in paragraph 1.

— The Appellant contends that the settlement paid to obtain a release from the agreement to manufacture electrical parts was a payment incidental to, and a risk normally inherent in, the Appellant's business operation. It was required to take this step because it had the opportunity to obtain an exclusive manufacturing agreement in the United States which would be, and has been, more profitable. (Emphasis mine.)

— The Appellant contends that the settlement represented a payment made solely for the purpose of gaining or producing income and that the payment should therefore be properly deducted from the Appellant's income.

— The Appellant alleges that the expenditure was not an outlay of capital so as to constitute an eligible capital expenditure. The Appellant further alleges that the expenditure was made solely for the purpose of gaining or producing income.

— The Appellant disputes the Minister's application of Section 14(5)(b) of the Income Tax Act, Canada to the payment in question and alleges that the payment is properly deductible under Section 18(1)(a) of the Income Tax Act, Canada.

— The legal fees incurred were fees incurred to settle an agreement that was incidental to, and a risk normally inherent in, the Appellant's business operation.

— The Appellant repeats the reasons set out in paragraph 3 in support of the appeal against the reassessment referred to in paragraph 2.

From the reply to notice of appeal:

— The Appellant by agreement dated June 2, 1978, agreed with 4 other parties to establish a new corporation to carry on the business in the United States of America of manufacturing electrical connectors, lugs, neutral bars and associated products.

— Under the agreement the Appellant was to receive 50% of the shares of the new corporation for which the Appellant agreed to transfer certain specialized machinery useful to the manufacture of electrical products to the new corporation.

— The cost of the specialized machinery to be transferred by the Appellant to the new corporation was not less than the value of the shares to be received by the Appellant from the new corporation. The Appellant was transferring the specialized machinery to the new corporation to capitalize the new corporation and not as a sale to earn a profit. [Emphasis mine.]

— The Appellant and the other parties to the June 2, 1978 Agreement, agreed to provide such services, functions and duties as may reasonably be required by the new corporation.

— The Appellant agreed that in the event it wished to sell the specialized machinery in the United States, it would appoint the new corporation its sole agent for the purpose of effecting such sales.

— The Appellant decided not to honour its obligations under the agreement dated June 2, 1978 and did not deliver the specialized machinery to the new corporation. [Emphasis mine.]

— The other parties to the June 2, 1978 agreement threatened legal action against the Appellant with the result that the Appellant in its 1981 taxation year agreed to pay the other parties the amount of $144,000.00 in return for a release by the other parties of all their rights arising under the June 2, 1978 agreement.

— In negotiating the settlement referred to in paragraph 8 herein, the Appellant incurred legal fees in the amount of $1,285.00 in its 1981 taxation year.

— the Appellant was not in the business of investing in or creating other corporations

— the Appellant, as a participant in a venture to establish a new corporation to carry on business in the United States was engaged in a capital transaction

— the Appellant, by obtaining a release from its obligations under the June 2, 1978 sic] obtained an asset or advantage for the enduring benefit of its business.

The Respondent relied, inter alia, upon paragraph 18(1)(b) of the Income Tax Act R.S.C. 1952 c. 148 as amended (the Act).

It was agreed by the parties that there was no separate issue with respect to the legal fees of $1,285. Whatever disposition arose with regard to the $144,000 amount would apply equally to the $1,285. The agreement to settle the matter was based on U.S. funds ($120,000) which was translated for purposes of the deductions claimed and for this hearing into the above noted $144,000 Canadian. There was no issue with regard to that calculation between the parties. I would also comment that, while the Minister's reply to notice of appeal (supra) dealt with paragraph 18(1)(b), the confirmation of the assessment by the Minister, after an earlier notice of objection had been filed contained the following remark:

The amounts of $144,000 and $1,285.00 claimed as deductions from income in 1981 were capital outlays within the meaning of paragraph 18(1)(b) of the Act and were eligible capital expenditures within the meaning of paragraph 14(5)(b) of the Act.

The Minister's reliance on paragraph 14(5)(b) of the Act, may or may not be agreeable to the appellant, but it was not the basis for this particular dispute as brought to Court. This decision will deal only with whether the assessment, which disallowed the deduction because it was prohibited by the provisions of paragraph 18(1)(b), should be upheld.

Before proceeding to an examination of the issue, I would note also that several documents were filed by the parties, from which I have selected the following excerpts which I considered particularly critical, (in all cases the emphasis is mine):

Full and Final Release

IN CONSIDERATION of the payment or of the promise of payment to us of TWENTY THOUSAND DOLLARS — ($20,000.00) - upon the signing of this release and upon the payment of ONE HUNDRED THOUSAND DOLLARS — ($100,000.00)

— evidenced by a Promissory Note attached hereto and made a part hereof, we hereby release and forever discharge REF Automation Limited and the Estate of Rudenz Ernst Flubacher and the Flubacher family and the legal representatives of all three from any and all actions, causes of action, claims and demands, for damages, loss or injury, howsoever arising, which heretofore may have been or may hereafter be sustained by us in consequence of alleged failure of REF Automation Limited to deliver production machinery as covenanted in a certain contract between ourselves and the releasees dated June 2, 1978, which machinery was essential to establish a proposed corporation (North American Connector Corporation) as a U.S.-based highly automated manufacturing concern, and which failure to deliver forced the aforesaid corporation to cancel orders thereby causing it irreparable damage not only to its goodwill but also to its credibility. This full and final release shall include all claims for damages, loss and injury not now known or anticipated but which may arise in the future and all effects and consequences thereof as a result of the alleged breach of the said contract of June 2, 1978 by REF Automation Limited or by any of the other releasees.

AND FOR THE SAID CONSIDERATION we further agree not to make any claim or take any proceedings against any other person or corporation who might claim contribution or indemnity under the provisions of any common law or statute law from the Estate, the Flubacher family, REF Automation Limited or the legal representatives of all three being the releasees discharged by this release.

IT IS UNDERSTOOD AND AGREED that the said payment or promise of payment is deemed to be no admission whatsoever of liability on the part of the said REF Automation Limited or of the said Estate of Rudenz Ernst Flubacher or of the Flubacher family or of the legal representatives of all three.

IT IS AGREED that this release shall be construed as a complete termination of the contract as of June 2, 1978 and shall be governed by the laws of the State of New Jersey.

All dollar amounts stated herein are stated in United States dollars.

This release constitutes the entire release and accord agreement amongst the parties. There are not and shall not be any verbal statements, representations, warranties, undertakings or agreement between or amongst the parties thereto.

IN WITNESS WHEREOF we have hereunto set our hands and seals this 1 day of December 1981.

(Signatures)

WHEREAS, the parties to said agreement of June 2, 1978 agreed to terminate the agreement and release each other from obligations thereunder, pursuant to certain understandings, among which REF has agreed to supply to NORTH AMERICAN on a continuing basis connector bodies at the same price as charged by REF to its largest customer for comparable products;

1. REF agrees to supply to NORTH AMERICAN on a continuing basis connector bodies at the same price as charged by REF to its largest customers for comparable products and at the same terms (including quality and delivery) as applied and supplied to by REF to its largest customer. This agreement shall continue in effect so long as NORTH AMERICAN places in each calendar year a minimum of $25,000.00 Canadian worth of orders with REF or any of its subsidiaries. In the event that NORTH AMERICAN fails to meet the minimum requirements as provided for herein in any calendar year then REF may, upon written notice to NORTH AMERICAN, terminate its supply to NORTH AMERICAN as provided for herein.

AGREEMENT made this 2nd day of June, 1978.

AND WHEREAS each of the Parties hereto desires to cause electrical connectors, lugs and neutral bars and associated products to be manufactured in one of the United States of America;

AND WHEREAS each of the Parties hereto is in a position and is willing to supply such capital, industrial property, technical skills and know-how as are required for their common purpose

AND WHEREAS each of the Parties desires to form a corporation to effect their common purposes;

The Parties set out hereunder subscribe to such capital stock of the Corporation in the percentages set out opposite their respective names:

(a) Grandis — 10%

(b) Volta	- 40%
(c) REF	— 50%

5. In payment for the Shares of the Corporation to be acquired by Grandis, he shall, at the time of the incorporation of the Corporation or at a date thereafter as agreed upon in writing between Norden and Flubacher, transfer to the corporation the sum of $25,000.00 (U.S.). Forthwith upon issue of Shares of the Corporation to Grandis pursuant to section 4 hereof, Grandis shall execute an irrevocable proxy in favour of Norden for the Share of the Corporation so issued entitling Norden to vote such Shares during the lifetime of Norden.

6. In payment for the Shares of the Corporation to be acquired by Volta, it shall, at the time of the incorporation of the Corporation or at a date thereafter as agreed upon in writing between Norden and Flubacher, transfer to the Corporation the sum of $100,000.00 (U.S.).

12. It is understood and agreed between the Parties hereto that the base selling price will be $40,000.00 (U.S.) per machine based on 1978 costs to REF and that the selling price of such machines in the years succeeding 1978 shall be the said $40,000.00 (U.S.) increased by the additional amount calculated by taking the percentage increases in costs to REF to produce such machines in the year of sale over the costs to REF to produce like machines in the 1978 was base year time the said $40,000.00 (U.S.). The selling price per machine as calculated above is for a minimum order of 5 machines of a type manufactured by REF to the date of this Agreement. The selling price of machines otherwise ordered by the Corporation from REF shall be as agreed upon by REF and the Corporation. Payment terms for machines ordered by the Corporation from REF shall be as agreed upon by REF and the Corporation.

16. REF hereby agrees that in the event that REF wishes to sell automatic drilling, tapping and cut-off machines in the United States of America that it will appoint the Corporation its sole agent for the purpose of effecting sales of such machines, the details of such agency agreement to be the subject of further agreement between REF and the Corporation.

There was considerable testimony and evidence provided by the appellant designed to indicate that the ''transfer" or “sale” of the five machines from REF to the Corporation was in the nature of an ordinary sale of such equipment by the appellant. While there had been a period of time, earlier in the 1970s when REF had indeed sold the machinery it produced to make the "electrical connectors", rather than producing the "electrical connectors" for sale, in my view during the times material (1978 through 1981) this was not the business of REF. During these latter years, REF had found it more profitable to produce and sell the “electrical connectors", rather than producing and selling the machines to make the electrical connectors. The evidence does not support a conclusion that the Agreement of 1978 (supra) was a normal “sale” of machinery, as opposed to a process for setting up a new "Corporation". I would add that the testimony also established that there were no "patents" or "copyrights" on the machinery which was used to manufacture the “electrical components". That is extremely important, in my view, because it was the capability of REF (in actual fact its originator—Mr. A. Flubacher—who was a brilliant “tool and die" maker, according to the testimony) to design and develop this complex machinery which was the main asset of REF at the times material. In fact, it is clear that it was a "policy" decision of REF not to patent or copyright the procedures for the production of the machinery used. I accept that it would have been possible for REF to "re-enter" the machinery sales market—but that would have flown directly in the face of the policy of the company during the years involved,—to produce (either as manufacturer or sub-contractor) the “electrical components" themselves, rather than producing and selling the machinery for such use.

The Court could not have the benefit of the direct testimony of Mr. Flubacher the Founder of REF — he died in October, 1980. Accordingly we do not know precisely what may have been in his mind when he signed the Agreement of 1978 Agreement (supra). The current president of REF, Mr. Richard I.R. Winter, quite properly noted for the Court that he had not been involved with the signing of the 1978 Agreement (supra), be he did provide to the Court from his own experience and knowledge of REF, the background of the Agreement as he viewed it, as did a Mr. Edward Albert Hawes, who had been the accountant for REF—but again, subsequent to 1978. It was Mr. Hawes' view, that the $40,000 (U.S.) “selling” price for the machines (see Agreement (supra) ) was a fair one according to the production records he had been able to examine. In this connection I would point out that it might be argued that on that basis ($40,000 per machine) REF would be contributing $200,000 (U.S.) to the Corporation, whereas Grandis and Volta together were only contributing $125,000 (U.S.), but were receiving 50 per cent of the Corporation. I make no attempt to reconcile that apparent discrepancy, in fact, I may not completely understand the Agreement (supra). But my point is that I do not think the alleged “value” of the machinery has any bearing on this decision to be made on the specific issue before the Court. That issue it seems to me, is—what was the nature of the Agreement of 1978, under which REF took on certain obligations? While the settlement in 1981 ($144,000 Canadian at issue here) may help to focus on some aspects of that 1978 Agreement, it seems to me that it is quite clear that REF simply breached the 1978 Agreement and paid to get out of it—whatever that payment may be called in the settlement, or however it may be described or coloured, it seems equally clear, from the Agreement above, that after signing that Agreement Mr. Flubacher did not want to pursue it, or fulfil it. He had not done so by the time of his death in 1980, and the current president, Mr. Winter, agreed in his testimony that he did not believe it was in the best interests of REF to fulfil the Agreement in 1981 —preferring instead to breach it and pay for that action. Mr. Winter also noted that the best estimate he could get with respect to possible costs to defend the legal action instituted by Volta was about $150,000 (U.S.), even if REF was successful. That, among other considerations, made him opt for the settlement at issue in this appeal.

But for the Court, I do not think that either the reasons for not fulfilling the Agreement of 1978, or those for making the settlement in 1981 are critical. It is simply clear that some aspects of the 1978 Agreement were an anathema to REF. A particularly odious clause (supra) to REF might have been:

16. REF hereby agrees that in the event that REF wishes to sell automatic drilling, tapping and cut-off machines in the United States of America that it will appoint the Corporation its sole agent for the purpose of effecting sales of such machines, the details of such agency agreement to be the subject of further agreement between REF and the Corporation.

But that would only be speculation. Further, the testimony disclosed that no manufacturing of the "electrical components" was carried on in the U.S. by the corporation with which REF finally did make an Agreement after 1981. REF — in Canada — now acts as “sub-contractor” for its "partner" in the U.S.

— (referred to at the hearing as "C.M.C") performing certain mechanical operations (with its own machines in Canada) on partially completed products made by and always belonging to C.M.C. REF is not obligated in any way to sell machines to C.M.C., and that clearly preserves its policy of retaining control of the production of the machines involved, and it would appear retaining such controls in Canada. (There was some evidence regarding a wholly-owned subsidiary of REF, now operating in the U.S., but that did not seem to enter into the determination of this issue.)

In summary, therefore, as I see it, in 1978, REF entered into an agreement to sell or to transfer to a new U.S. corporation in which it would nave a 50 per cent stock ownership, certain machines which would then be used by the new corporation for the production of electrical components for sale in the U.S. That "sale" — if it was to be a sale, was not for the prime purpose of making a profit on the sale transaction itself — although it is possible it would have done so. That “sale” was for the purpose of acquiring a proprietary interest in a new enterprise. I cannot think of a basis upon which it could be described as anything other than a capital transaction. I am quite sure that at the outset — in reality the 1978 Agreement — Mr. Flubacher expected that REF could obtain dividend income from the share ownership

— but I am not aware that the mere possibility — even the prospect — of dividend receipt in itself is sufficient to characterize the transaction as on "income" rather than “capital” account — and no jurisprudence was proffered by the appellant which could support that proposition.

Equally, I am satisfied that the subsequent Agreement with C.M.C. (supra) was in the view of REF, a better and more positive one — indeed that it might produce more income to REF. But that is beside the point — the payment at issue was not made for the purpose of signing the new Agreement with C.M.C. — at best it was made to terminate an obligation under the 1978 Agreement, and obtain the "right" to sign an Agreement with C.M.C. That strengthens my view that the amount at issue must be characterized as on "capital", not "income" account.

I would note that counsel for the respondent presented certain jurisprudence, and I would cite in particular:

B.C. Electric Railway Co. Ltd. v. M.N.R., [1958] C.T.C. 21; 58 D.T.C. 1022 (S.C.C.) and Sunshine Mining Company v. M.N.R., [1975] C.T.C. 223; D.T.C. 5126 (F.C.T.D.). And I would add as support for the conclusion in this decision, 289018 Ontario Limited v. M.N.R., [1987] 1 C.T.C. 2095; 87 D.T.C. 38.

The appeal is dismissed.

Appeal dismissed.