Border Fertilizer (1972) LTD (Now Border Chemical Co Limited) v. Minister of National Revenue, [1985] 2 CTC 2229, 85 DTC 538

Taylor, TCJ: —This is an appeal heard in Winnipeg, Manitoba on June 19 and 20, 1985, against income tax assessment in which the Minister of National Revenue disallowed an amount of $21,068 claimed as legal fees expenses. The critical phrases in the amended notice of appeal read as follows:

— In order to protect its own interests and those of its directors and shareholders, and to ensure that further criminal charges were not brought against the corporation or any of its other directors, the Appellant retained legal counsel to defend Smerchanski. . . .

— The Appellant relies, inter alia, on paragraph 18(1)(a) of the Income Tax Act of Canada.

— The Appellant says that the legal expenses were incurred for the purpose of protecting and defending the business it carries on and more particularly, for the purpose of gaining or producing income from its business.

In the reply to notice of appeal, the Minister stated:

— . .. that the said legal fees claimed by the Appellant as a deduction are not outlays or expenses made or incurred by the Appellant for the purpose of gaining or producing income from a business or property within the meaning of subsection 18(1)(a) of the Income Tax Act with the consequence that these legal expenses cannot be deducted in computing the Appellant’s income for the 1980 taxation year.

— . . . that the said legal fees claimed by the Appellant as a deduction are payments on account of capital with the consequence that they cannot in accordance with section 18(1)(b) of the Income Tax Act be deducted in computing the Appellant’s income for its 1980 taxation year.

The “Smerchanski” noted above was Mr Mark Smerchanski, President of both “Border Fertilizer” and “Border Chemical”. Border Fertilizer during the time material, was a wholly owned subsidiary of Border Chemical, which was a publicly traded company. Mr Mark Smerchanski and his immediate family owned about 20 per cent of the issued shares of Border Chemical. Criminal charges were brought against Mr Smerchanski personally in 1979, and dismissed in 1980. The cost of defending Mr Smerchanski was paid for by the appellant, resulting in the issue in this appeal.

The bulk of the testimony and evidence by the appellant was directed toward establishing that the disputed expenditure was “‘for the purpose of gaining or producing income from its business”. A major part of the argument of counsel for the respondent was toward showing that at best the expenditure at issue was on capital, not on revenue account.

It is my view that an examination of the detailed and comprehensive case brought forward by counsel for the appellant could result in a decision that indeed the legal fees were a proper business expenditure for the appellant

— “made or incurred for the purpose of gaining or producing income from the business”. However, without finally deciding that issue, I am satisfied that even if that were true, the appellant could not overcome the second part of the Minister’s argument — that the expenditure incurred (even if acceptable under paragraph 18(1)(a) of the Act) was on capital account and excluded by virtue of paragraph 18(1 )(b) of the Act.

With regard to the argument under paragraph 18(1)(b) of the Act, counsel for the appellant produced the following list of case law, and summary which appear to me to put the matter into perspective:

Section 18(1 )(b) — The legal expenses were not a capital expenditure.

1. Hallstroms Proprietary Limited v The Federal Commissioner of Taxation (1946) 72 CLR 634 (HC) at pp 641 and 655.

The legal expenses are not capital since they were not made for the purpose of acquiring an asset or of adding to the capital structure of the business.

“Nor can it be said that the company, by making the expenditure, gained an enduring advantage. It gained nothing — it merely succeeded in maintaining an existing position. The prevention or avoidance of a loss is not a gain of anything. The prevention of subtraction is not the same thing as an addition.”

per: Mr Chief Justice Latham

2. Federal Commissioner of Taxation v Snowden & Willson Proprietary Limited 11 ATD 463 (HC) at p 473.

“It is one thing to say that unless a particular expenditure is out-laid the goodwill of a business will or may suffer and another to assert that this very circumstance alone will brand the expenditure, when made, as an expenditure of a capital nature for it is not only capital expenditure which is ultimately reflected in the value of the goodwill of a business since every step in the day to day operations of a business may tend to enhance, preserve, or destroy it. It may, I think, be said that the true character of the expenditure in question in this case is to be sought in a consideration of its immediate purpose ...”

per: Mr Justice Taylor

The court held that legal expenses to defend against allegations reflecting on the integrity of those conducting the taxpayer company’s business were currently deductible.

3. Canada Starch Company Limited v MNR 68 DTC 5320 (Ex Ct) at p 5324.

“Once goodwill is in existence, it can be brought, in a manner of speaking, and money paid for it would ordinarily be money paid on account of capital. Apart from that method of acquiring goodwill, however, as I conceive it, goodwill can only be acquired as a by-product of the process of operating a business. Money is not laid out to create goodwill. Goodwill is the result of the ordinary operations of a business that is so operated as to result in goodwill. The money that is laid out is laid out for the operation of the business and is therefore money laid out on revenue account.”

per: President Jackett

4. Kellogg Company of Canada Limited v MNR 2 DTC 548 (Ex Ct) and [1943] SCR 58.

Legal expenses paid to maintain the trading and profit making structure are currently deductible.

5. Minister of National Revenue v L D Caulk Company of Canada Limited and

Goldsmith Bros Smelting and Refining Co Limited 54 DTC 1011 (SCC).

Charges against company. Legal expenses in defending against charges deductible. Legal expenses paid to preserve the system that helped produce the taxpayer company’s income are currently deductible.

6. Premium Iron Ores Limited v MNR 66 DTC 5280 (SCC) at p 5283.

Legal expenses paid in an attempt to protect income are currently deductible.

It seems to me that the case most likely to serve this appellant’s purposes in establishing that the disputed payment of legal fees was on revenue, not capital account would be Canada Starch (supra) [[1968] CTC 466]. If that case does not fulfil that objective, I do not believe any of the other jurisprudence cited will do so, — they are all readily distinguishable as I read them.

I would quote directly from the headnote from the Dominion Tax Cases publication of Canada Starch (supra):

The $15,000 payment was deductible by the appellant company in computing its 1964 income — it was not a payment on account of capital. . . .

. . . A trade mark (or trade name) is merely of the goodwill of a business. Money paid out to acquire goodwill that is the creation of somebody else's business operations is money paid on account of capital. Apart from that method of acquiring it, goodwill can only be acquired as a by-product of the process of operating a business. Goodwill is the result of the ordinary operations of a business that is so operated as to create Goodwill. The money that is laid out is laid out for the operation of the business and is therefore money laid out on revenue account. [Emphasis mine.]

In this instant appeal, the appellant states that the expenditure for legal fees was on revenue account because it preserved (or even if it created) goodwill, since goodwill can only arise out of the “ordinary operations" (revenue account) of the business. (Canada Starch (supra)).

I would venture that the interpretation in the headnote of Canada Starch (supra) and the argument of counsel based thereon, finds its genesis in the following two comments from Canada Starch (supra) at 472 (DTC 5323) and 475 (DTC 5325) respectively:

(a) on the other hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition, to such an 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.

Putting my view another way, it is that, while a trade mark once it becomes a business or commercial reality is a capital asset of the business giving rise to it, just like goodwill, of which it is merely a concrete manifestation, a trade mark is not a capital asset that has been acquired by a payment made for its acquisition, but is a capital asset that arises out of, and can only arise out of, current operations of the business;

But it is critical to an understanding of that case that the last phrase in the same quotation on page 475 (DTC 5325) be noted:

and registration of a trade mark does not create a trade mark that is such a business or commercial reality, but is merely a statutory device for improving the legal protection for it.

As I read that final quotation, the learned judge, is not saying that the expenditure in question (“$15,000 — to obtain registration of its trade mark" —) at the time of payment fell into the category of preservation or enhancement of, or in addition to “goodwill". He is making a clear distinction between the purpose of the $15,000 payment, and goodwill in that company. The trade mark did not “create" a business, or commercial reality (ie a capital asset).

It seems to me fundamental to the position of counsel for the appellant in this matter (and I find no disagreement with it, nor do I believe did counsel for the respondent) that the item in dispute ($21,068 for legal fees) related to the maintenance, preservation or at least stability of the goodwill of Border Chemical, — if it had any business relationship at all to that company. If one is to use Canada Starch (supra) as support for the proposition then, (that this adjuncted or co-opted addition to or expenditure in the preservation of goodwill, is on revenue rather than capital account), the expenditure itself must fit under the narrowly defined confines of the judgment in that case.

In the instant case the legal fees were paid to preserve the image of the appellant as a good corporate citizen, and to preserve its good customer business relations, — essentially “goodwill”, if the assertion of the appellant is to be accepted at all — and that would nominally be on capital account. I have not found judicial support for the assertion that it should be anything but capital account. In reviewing the legislation and the case law I have been struck by the point that this rule seems to be very specific in its application to “intangible” assets such as goodwill. A novel thought which arises out of the hearing (more implicitly than explicitly), is that “goodwill” might deteriorate or become less productive and positive, just as can a “tangible” asset, such as a building, machinery, or equipment. With the latter group of assets — hard assets — the annual maintenance to keep the equipment in good condition, or repairs to damaged equipment, to ensure or retain its functioning potential may be treated as operating costs, and therefore deductible. This present situation might lend itself to similar consideration that the legal fees were only to restore the asset “goodwill” to its prior level of usefulness, taking into account any “damage” which might have resulted from the criminal charges. However, the thrust of the testimony and evidence at this trial was toward preventing such damage to “goodwill” (preserving its adequate condition) rather than renewing the asset itself, and I am unable to see how that line of thought is of value to the appellant.

In the end analysis, therefore, the appeal must fail. If made or incurred for the purpose of gaining or producing income from the business, the $21,068 at issue for legal fees, would fall victim to the exclusion contained in paragraph 18(1 )(b) of the Income Tax Act, as being on capital account — for the preservation of “goodwill”.

The appeal is dismissed.

Appeal dismissed.