D. Morgan Firestone v. Her Majesty the Queen, [1986] 2 CTC 251, 86 DTC 6405

McNair J.:—This is an appeal by the plaintiff from the Minister's reassessments of tax for the 1969, 1970, 1971 and 1972 taxation years whereby certain claimed expenses were disallowed and added back into income. The expenses in question can be broadly categorized under the headings of investigation of opportunities and supervision of companies in the sums of $77,590 and $101,640 respectively. The facts are relatively undisputed and are set out in an agreed statement of facts, with accompanying schedules. These schedules set out the parties’ agreement as to the correct treatment of all the expenses which were the subject of the reassessments. Counsel for the parties agreed at trial that the professional services expense of $15,213 found in Schedule “‘B” to the agreed statement is no longer in issue. It is conceded by paragraphs 15 and 16 of the agreed statement that the four per cent surtax on investment income was properly imposed and that the Minister properly disallowed a foreign tax credit claimed by the plaintiff.

The issue in this appeal, as I see it, is whether these investigation and supervision expenses were properly deductible in computing the taxpayer's income for the years in question.

The plaintiff describes himself as a venture capitalist. He is the grandson of the founder of the U.S. corporation, Firestone Tire and Rubber Company. Following university graduation and a tour of duty with the United States Army in Korea, he went to work for the U.S. corporation and rose through the sales and managerial ranks. In 1966, he was posted to Canada to become the vice president of the wholly-owned Canadian subsidiary, Firestone Tire and Rubber Company of Canada. He eventually became president of the Canadian company. The plaintiff saw Canada as a land of unique opportunity from his standpoint and he decided to remain here. In 1968, he resigned his office with Firestone Tire and Rubber Company of Canada with the view of pursuing his own business objective, which was that of assembling a diversified conglomerate of companies whose shares would later come to be traded publicly.

To achieve his goal, the plaintiff leased office space and hired full and part-time employees to assist him in investigating various business opportunities. The key employees on whom he largely depended were Albert Jemison and Arne Erickson.

Between 1969 and 1972, the plaintiff and his advisers investigated and evaluated a wide range of business opportunities, approximating 50 in number. The plaintiff was only interested in companies in which he could acquire full control and the prime targets were those which appeared to have potential but were in financial straits. In 1970, the plaintiff acquired all the issued shares and the capital stock of Professional Bowling Services Limited, Quality Plastics Limited and Kevco Industries Limtied. The plaintiff incorporated and took all the issued shares of Firan International Limited (“Firan”) in March of 1971. Firan acquired all the shares and the capital stock of Graphico Precision Works Limited in August of 1971. In April of 1972 the plaintiff transferred to Firan all his shares of stock in Professional Bowling, Quality Plastics and Kevco. Firan became the holding company for the shares of these operating companies. The conglomerate was in place.

During this period, the plaintiff and his key employees supervised the Operation of and provided management services to the companies which he had acquired. The plaintiff and his staff deliberately chose not to become involved in the day-to-day operations of these companies. Instead, their chosen role was to monitor the fiscal policy and business operations of the companies and give general direction and guidance with a view to making them more profitable. The plaintiffs employees were paid by him rather than by the companies which he had acquired. He did this to assure their loyalty to him. After the transfer of shares of the operating companies to Firan in 1972, the latter assumed the responsibility for paying these salaries.

Over the same period 1969 to 1972, the plaintiff did not charge the acquired companies a management fee. His policy was to leave the profits in the companies in order to build them up, rather than milk them of cash through management fees.

In 1975 the plaintiff acquired control of a public company, Glendale Corporation, whose shares were traded on the Toronto Stock Exchange. In December 1978, Firan and Glendale Corporation were amalgamated to form Firan-Glendale Corporation, the name of which was changed to Firan Corporation in 1982. The plaintiff owns the majority of the issued shares of Firan Corporation. It is a public company whose shares are traded on the Toronto Stock Exchange. The venture goal was realised and the prospect of monetary return became a reality.

During the years 1979 to 1984 the holding company paid annual dividends to the plaintiff totalling $860,000. Prior to that, the plaintiff received no income from his corporate conglomerate. His income came from his own private resources and was duly reported in his income tax returns. No separate financial statements were prepared for the venture capital business itself. The expenses now sought to be deducted on revenue account were arrived at by an after-the-fact allocation based on time spent on investigation of opportunities and supervision of companies that yielded the respective amounts of $77,590 and $101,640 aforesaid.

For the 1969, 1970, and 1971 taxation years, the statutory provisions more particularly applicable to the plaintiffs case were sections 3 and 4, paragraphs 12(1)(a) and (b) and subsection 203(1) of the Income Tax Act, R.S.C. 1970, c. 1-5. On December 23, 1971, the Income Tax Act was substantially amended by the enactment of an amending Act, S.C. 1970-71-72, c. 63. The former statutory provisions were revised and renumbered to read:

3. The income of a taxpayer for a taxation year for the purposes of this Part is his income for the year determined by the following rules:

(a) determine the aggregate of amounts each of which is the taxpayer's income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, his income for the year from each office, employment, business and property;

9.(1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

(2) Subject to section 31, a taxpayer's loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis.

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; [or]

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

248.(1) In this Act,

“business” includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, includes an adventure or concern in the nature of trade but does not include an office or employment;

“property" means property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes

(a) a right of any kind whatever, a share or a chose in action,

For the sake of brevity and convenience, I will refer to the relevant statutory provisions according to the numbering sequence of the 1971 amendments. They are essentially the same as the predecessor sections of the former Act.

In order for an expense to be deductible in computing a taxpayer's income, two preconditions must be met. The expense must have been made or incurred for the purpose of gaining or producing income from the business or property of the taxpayer within the ambit of paragraph 18(1)(a) of the Income Tax Act. Once it is found that a particular expenditure is one made for the purpose of gaining or producing income then it must still be determined whether or not such expenditure is a payment on account of capital within the prohibition of paragraph 18(1)(b): see B.C. Electric Railway Co. Ltd. v. M.N.R., [1958] S.C.R. 133; [1958] C.T.C. 21; 58 D.T.C. 1022. It is the position of the defendant that neither of these preconditions have been met with respect to the expenses in question.

It is common ground that the plaintiff's ultimate goal was to earn profits from the businesses which he acquired. The evidence leaves little doubt that the activity in which he was engaged occupied much of his time, attention and energy. Counsel for the defendant strongly urged that the purchase of shares with a view to profit by holding them as an investment is not a business. It was pointed out that the plaintiff charged no management fees to the conglomerate companies. Emphasis was laid on the fact that there was no business of providing management services. Hence, there was no source of income nor a reasonable expectation of profit from an activity that could be classified strictly as -a business. There was at best only the expectation of ultimately benefiting as an investor. Counsel for the defendant argued therefore that the outlays incurred in the investigation of corporate opportunities and the supervision of companies acquired as a result thereof were not deductible on revenue account.

Revenue derived from the ownership of corporate shares is generally regarded as income from property that does not normally require the exertion of much activity or energy on the part of the owner in order to produce the anticipated return: Hollinger v. M.N.R., [1972] C.T.C. 592; 73 D.T.C. 5003 (F.C.T.D.).

The companies acquired by the plaintiff were ailing or stagnant businesses which were targeted because of their unrealised profit potential. Much time, care and energy was exerted in the initial acquisitions and thereafter. The evidence goes to show that these acquisitions would not have been likely to produce gainful income without the active and extensive businesslike intervention of the plaintiff and his key employees. The crux of the matter, as it seems to me, is whether the expenditures in question were paid on revenue account as running expenses incurred in the process of operation of the plaintiff’s venture capital business or whether they were capital expenditures paid as part of a plan for the assembly or putting together of the very business structure itself, that is, the corporate conglomerate.

This feature has been the subject of many cases over the years. Suffice it to mention a few.

Canada Starch Co. Ltd. v. M.N.R., [1969] 1 Ex. C.R. 96; [1968] C.T.C. 466; 68 D.T.C. 5320 held that $15,000 paid to a third party to procure the registration of a trademark was not a payment on account of capital within the prohibition of paragraph 12(1 )(b) but rather was money laid out on revenue account. Jackett, P., made an analysis of the distinction between revenue and capital payments at 101 (C.T.C. 471; D.T.C. 5323), which has been quoted time and again:

. . . I find it helpful to refer to the comment on the “distinction between expenditure and outgoings on revenue account and on capital account” made by Dixon J. in Sun Newspapers Ltd. et al v. The Federal Commissioner of Taxation (1938), 61 C.L.R. 337 at page 359, where he said:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay returns representing profit or loss.

In other words, as I understand it, generally speaking,

(a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure, or organization, is an expenditure on account of capital,

and

(b) on the other hand, an expenditure in the process of operation of a profitmaking entity, structure or organization is an expenditure on revenue account.

Bowater Power Co. Ltd. v. M.N.R., [1971] F.C. 421; [1971] C.T.C. 818; 71 D.T.C. 5469 (F.C.T.D.) held that the cost of engineering studies in connection with a proposed hydroelectric development were properly deductible as an ordinary business expense on the ground that the expenditure was laid out as part of the operation and cost of the business. The fact that the expenditure would eventually bring into existence a capital asset did not necessarily make it a capital expenditure.

M.N.R. v. Algoma Central Railway, [1968] S.C.R. 447; [1968] C.T.C. 161; 68 D.T.C. 5096 held that the costs of a geological survey paid by a railway company with a view to enhancing the development of the area over which its line of track extended and increasing the volume of traffic was not a capital outlay within the meaning of paragraph 12(1)(b) of the Income Tax Act. The court pointed out that no single test was determinative and that it was the facts of the particular case and a commonsense appreciation of all its guiding features which must provide the ultimate answer.

Oxford Shopping Centres Limited v. The Queen, [1980] C.T.C. 7; 79 D.T.C. 5458 (F.C.T.D.) held that an expenditure of $490,050 paid by the owner of a shopping centre to a municipality in lieu of local improvement rates and taxes was from a practical and business point of view a running expense of the business as a whole and deductible as a revenue expense in the year in which it was paid. Thurlow, A.C.J., made this significant statement at 14 (D.T.C. 5463):

... it is the nature of the advantage to be gained which more than any other feature of the particular situation will point to the proper characterization of the expenditure as one of capital or of revenue expense.

The most recent case of high authority is the Supreme Court of Canada decision in Johns-Manville Canada Inc. v. The Queen, [1985] 2 C.T.C. 111; 85 D.T.C. 5373. Here the court was squarely confronted with the question of the proper application of the former paragraphs 12(1 )(a) and 12(1 )(b) in distinguishing between an income and capital expenditure. It was held that the cost of land purchases at the periphery of an open pit asbestos mine to accommodate the taxpayer’s mining operations were expenditures incurred bona fide in a day-to-day business operation and were therefore properly allocated to revenue account and not to capital.

The rationale underlying the decision is thus stated by Estey, J., at 126 (D.T.C. 5384):

. . . Common sense dictated that these expenditures be made, otherwise the taxpayer's operations would, of necessity, be closed down. These expenditures were not part of a plan for the assembly of assets. Nor did they have any semblance of a once and for all acquisition. These expenditure were in no way connected with the assembly of an ore body or a mining property which could itself be developed independently of any ore body . . . [Emphasis added.]

Counsel for the defendant places much reliance on the decisions in Neo- nex International Ltd. v. The Queen, [1977] C.T.C. 472; 77 D.T.C. 5321; (F.C.T.D.); affd. [1978] C.T.C. 485; 78 D.T.C. 6339 (F.C.A.). Here the taxpayer corporation, in addition to being engaged in an electric sign and outdoor advertising business, was the parent company of a conglomerate of over 50 subsidiary or affiliated companies engaged in various unrelated types of businesses. Neonex borrowed money to loan to its subsidiaries at interest rates of approximately one and one-half per cent above the rate it was charged for the loan funds. In addition to this income, it collected fees for management services rendered to its subsidiaries. Other sources of income were dividends and revenues derived from the sign and advertising business. In 1969, Neonex decided to add another company to its conglomerate group through a takeover bid for shares. To realise the takeover, Neonex went through a complicated series of transactions. A dispute arose and the takeover transaction finally failed. Heavy legal expenses were incurred which Neonex sought to deduct from income. There were several issues before the court but the deductibility of these legal expenses is the one most apposite to the case at bar. Both the Trial Division and the Court of Appeal held that the legal expenses were not deductible on the ground that they were capital outlays associated with an investment transaction. In reaching this result, Mr. Jusice Marceau, of the Trial Division, made the following finding of fact at 479 (D.T.C. 5325):

. . . I don’t see how buying shares, not in order to sell at a profit, but with the view to holding and owning same, can be said to be a business within the meaning of the word in the Income Tax Act. As Martland, J. said in Irrigation Industries Ltd. v. M.N.R., [1962] C.T.C. 215 at 221; 62 D.T.C. 1131 at 1133: shares “constitute something the purchase of which is, in itself, an investment”. The Plaintiff was in the business of making and selling signs, and it was also in the business of supplying funds and management services to its subsidiaries. But the acquisition itself of the shares of those subsidiaries which were to keep carrying on their own businesses, can only be regarded as a pure investment. [Emphasis added.]

The learned judge immediately went on to conclude:

The conclusion to be drawn is unavoidable: the legal expenses here in question — those incurred in an effort to complete the take-over as well as those incurred in seeking to get compensation in lieu of shares — were outlays associated with an “investment transaction", they were made in connection with the acquisition of a capital asset. They were, therefore, expenditures on capital account.

Mr. Justice Urie, of the Federal Court of Appeal, agreed with the finding of the learned trial judge, stating at 497 (D.T.C. 6346):

I wholly agree with this finding. I also agree with the trial judge that the legal expenses at issue herein — those incurred in an effort to complete the takeover and those incurred in seeking compensation in lieu of shares — were outlays associated with an investment transaction and thus were made on capital account.

Counsel for the defendant took the point that the plaintiff had no source of income other than his own private resources, at least until the ultimate profits began to flow upward through the dividend conduit. It is well established that it is never necessary to show a causal connection between an expenditure and a receipt. Expenditures that are part of a taxpayer's working expenses and that are laid out as part of the process of profit earning are deductible in the year in which they are made, even though no profit results therefrom. Nor is there any limitation as to time in paragraph 18(1)(a) to prevent the deduction of such expenses against income in other years than that in which the expenditure was made: see Consolidated Textiles Ltd. v. M.N.R., [1947] Ex. C.R. 77; [1947] C.T.C. 63; 3 D.T.C. 958 (Ex. Ct.); and Premium Iron Ores Limited v. M.N.R., [1966] C.T.C. 391; 66 D.T.C. 5280 (S.C.C.). In my opinion the point thus raised is of little or no significance.

Counsel for the plaintiff strenuously contends that his case is readily distinguishable from Neonex on several grounds. Foremost is the fact that the legal expenses in Neonex were incurred in a single abortive takeover transaction aimed directly at acquiring the shares of a single company. It was this “acquisition itself” feature which vested the transaction with the character of a pure investment. Moreover, it was conceded by the taxpayer in Neonex that the legal expenses in question would have formed part of the cost of the shares had the takeover been completed. These factors, it is said, swayed the court in deciding in favour of capital outlay over revenue expense. Additional distinguishing features of lesser degree were the noninvolvement in the day-to-day business operations of the operating companies, the provision of management services free of charge, and the fact that the plaintiff earned no income per se from these companies. As I read the decisions in Neonex, none of these so-called distinguishing features played any significant part in the actual result. If anything, the situation would seem just the converse. The argument put forward in Neonex was that the taxpayer was in the business of seeking out, investigating and acquiring numerous profit or operating centres and managing them profitably with a view to earning income therefrom, whereby the legal expenses incurred as part of the cost of the profit-making undertaking for the acquisition of subsidiaries were deductible on revenue account. Mr. Justice Urie, of the Court of Appeal, summarized the whole thrust of the argument at 496 (D.T.C. 6346):

. . . The purpose was to acquire those profit or operating centres and thereafter to hold them for the purpose of earning income in the form of dividends and to a lesser extent, management fees.

Accordingly, I am of the view that the Neonex decision is indistinguishable from the case at bar in all essential aspects.

There is, however, no single overriding principle applicable to all sets of facts or circumstances. Each case must be decided on its own merits, so to speak. In any event, there would seem to be little doubt that the plaintiffs expenditures were made or incurred “for the purpose of gaining or producing income”, whether it be from property or a business. The plaintiffs contention is, of course, that the expenditures were running expenses laid out as part of the profit earning process of his business. This is the crux of the case and the remaining question, as I see it, is whether the expenditures were on revenue account or were capital outlays within the prohibition of paragraph 18(1)(b).

I find on the evidence that the plaintiff was a skilled and determined entrepreneur who embarked on the venture of acquiring ailing business enterprises having recognizable profit potential with a view to turning them to profitable account. The acquisitions were accomplished in each case through the purchase of shares and only after careful deliberation and evaluation. Much attention and expertise were devoted to enhancing the profitability of the acquired companies. A concomitant purpose, once the desired level of profitability had been attained, was to superimpose a holding company whose shares would trade publicly. The long range objective was to reap the profit reward by dividends funnelled through the holding company.

Essentially, this was the entrepreneurial design of the plaintiffs plan. I must now ask myself this question — is it any different from the taxpayer's plan in Neonex? In my opinion, it is not. Given the fact that the plaintiff may have looked at a number of business prospects before finally deciding, the business itself really came into being with the acquisition of the operating companies. This saw the establishment of the basic business entity or structure. The creation of the holding company was the finishing touch. I cannot regard the organization of the corporate conglomerate as anything other than an investment transaction. It must logically follow that the ex- penditures are not running expenses laid out as part of the profit earning process of the business. Rather, they were laid out as part of a plan for the assembly of business entities or structures. It is my opinion therefore that these expenditures were capital outlays within the prohibition of paragraph 18(1 )(b) of the Income Tax Act.

For the foregoing reasons, the plaintiff's appeal is disallowed, with costs.

Appeal dismissed.