Ethicon Sutures LTD v. Minister of National Revenue, [1983] CTC 2758, 83 DTC 674

Rip, TCJ:—This is an appeal by Ethicon Sutures Ltd against a notice of reassessment by the Minister of National Revenue, the respondent, in respect of the Appellant’s 1978 taxation year. The question in appeal is whether certain gains in the amount of $119,030 made by the appellant in respect of foreign exchange were on account of capital or income.

It is the appellant’s contention that moneys invested in term deposits in United States currency (“US term deposits”) were for the purpose of paying dividends and for capital expenditures and therefore the US term deposits were capital property to the appellant and any foreign exchange gain or loss in respect of these deposits is on account of capital.

The respondent’s position is that the US term deposits were properties used and held by the appellant in the course of carrying on its normal business activities, and any foreign exchange gain or loss in respect of the deposit is on revenue account.

The appeal was filed with the Tax Review Board and heard on February 12, 1982, by the late Assistant Chairman of the Board, Mr Frank Dubrule, QC, who reserved decision. Unfortunately, prior to disposing of the appeal Mr Dubrule died. The parties agreed that the appeal be considered on the record and transcript of the evidence and argument by another member. Effective July 18, 1983, the Tax Review Board was continued under the name of this Court pursuant to section 3 of the Tax Court of Canada Act.

I have had the opportunity to review Mr Dubrule’s notes which, wherever practical, I have included in these reasons.

The appeal proceeded on the basis of an agreement as to facts. Oral evidence was given for the appellant by a Mr Robert lan Bradley and a Mr Peter J Simpson. In the course of the proceedings reference was made to a Mr Klassen. These three gentlemen held the position of secretary-treasurer of the appellant at various times. Mr Simpson held that position in 1978 and was succeeded by Mr Klassen after 1978. Mr Bradley succeeded Mr Klassen in late 1981. Mr Klassen is no longer associated with the appellant or any of its afffiliated companies. Each of these gentlemen, during his term as secretary-treasurer, was responsible for all local financial matters of the appellant. While Mr Bradley was not the chief financial officer of the appellant in 1978, he reviewed the books of the appellant in preparation for this hearing. He became a chartered accountant in 1973 and worked for an accounting firm before joining the appellant in late 1980.

The appellant was incorporated in 1963 as a wholly-owned subsidiary of Johnson & Johnson of the United States of America and carries on the business of manufacturing and distributing surgical sutures and instruments in Canada out of its head office in Peterborough, Ontario. Johnson & Johnson and its subsidiary companies in Canada and elsewhere are in some phase of the health care business. The appellant sells its products throughout Canada and all sales are in Canadian currency. About 80 per cent of the appellant’s purchases were made from Ethicon, Inc and Codman & Shurtleff, two United States subsidiaries of Johnson & Johnson; other purchases were made from Johnson & Johnson subsidiaries in Italy and to a lesser extent in the United Kingdom and Germany. The practice among the Johnson & Johnson group of companies was that if the invoice to a company in the group was in a foreign currency the payment would be paid in that currency. The appellant would draw money from its Canadian dollar bank account and convert it to US (or other) funds or make payment from its US dollar bank account directly to the vendor. The appellant paid all its payables on a current basis. Total inventory acquisitions by the appellant in 1978 were $3,744,429. In addition, the appellant made payments for royalties and head office expenses to Johnson & Johnson in US currency; the appellant would convert its Canadian funds to US currencies for such payments.

The appellant’s taxation year is a 52 week year, basically being a calendar year; the 1978 taxation year under appeal commenced on January 2, 1978 and terminated on December 31, 1978.

All financial control of the appellant was with the comptrollers of Johnson & Johnson in the United States. Each autumn the appellant (as well as other subsidiaries of Johnson & Johnson) prepared a budget of expectation as to the success of the operations of the appellant in the next ensuing fiscal year. A forecast was made and one of the important features was the prospective payments of dividends. The appellant had a history of profits and Johnson & Johnson required it to pay a percentage of its net income after taxes as dividends. This percentage was usually fixed at the time of the forecast and ranged from 65 per cent to 90 per cent of the net income. These dividends were declared at the first annual meeting of the board of directors, normally in February, and were payable usually on a quarterly basis: mid-March, June, September and December. From the beginning of its fiscal year the appellant commenced to accumulate funds so that it would have sufficient money on hand to pay the dividends on the dates payable. Notwithstanding the dates the dividends were declared payable by the directors of the appellant, the dividends were not to be paid until Johnson & Johnson asked for it; however, the money could not be invested without Johnson & Johnson’s consent. Money had to be available at all times for payment of the dividend since Johnson & Johnson may call for the dividend at any time. Johnson & Johnson would normally telephone the appellant asking for the dividend; the telephone call would be followed by a telex and a written letter. Johnson & Johnson naturally wanted its subsidiaries to earn as high a return as possible on the moneys it was holding effectively for Johnson & Johnson, but at the same time required the investment to be secure. Therefore, the appellant was instructed to invest the money in shortterm deposit notes of major Canadian banks.

Until 1977 it was thought most prudent to make such deposits in Canadian dollars. In 1977 Johnson & Johnson’s policy changed and the appellant and other subsidiaries of Johnson & Johnson were directed to make such deposits in US dollars. In other words, the Canadian dollars of the appellant were converted into US funds, and term deposits were made with the same Canadian banks, but in US currency. Mr Bradley testified that this change may have come about because Johnson & Johnson in the United States adopted accounting policy changes proposed by the Financial Accounting Standards Board in the United States which required foreign currency transaction gains or losses to be taken into income in the current year of individual corporations. Johnson & Johnson would prepare a consolidated financial statement of it and all of its subsidiaries in United States dollars. If a subsidiary had funds in other than US dollars it would have to be converted to US dollars for the purposes of the consolidated statement. This may result in a gain or loss to a particular subsidiary and reflect on the financial statement of Johnson & Johnson on a consolidated basis.

Mr Bradley suggested that normally a Canadian company would not want to retain its excess funds in foreign currency because of the risk factor in foreign exchange fluctuations. He said he was against such policy.

Mr Simpson testified the appellant had cash surplus in 1977 which it was retaining in term deposits in Canadian funds. Sometime in late 1977 he received a telephone call from Johnson & Johnson officials in the United States instructing him “to consider our short term deposits in US funds as an effort to reduce our net asset exposure”; Mr Simpson interpreted “net asset exposure” to mean the exposure of currency to the vagaries of fluctuation. Since Johnson & Johnson reported its financial results on a consolidated basis not only revenue and income statements were consolidated but so were assets and liabilities and therefore, since gains and losses on consolidation of assets now had to be recognized, “the theory was that if we could reduce the types of assets that were subject to re-evaluation because of fluctuation in the US and other currencies, we would in effect be controlling more effectively that type of gain or loss”.

Mr Simpson testified that Johnson & Johnson’s financial policies were ultra-conservative. “They believed it was necessary to conduct business in such a way, in the case of short-term deposits or any deposits, that they be, and could be made available literally at a phone call with a minimal penalty”. Mr Simpson also acknowledged that money from the notes went towards the purchase or the acquisition of inventory. However, he stated that while inventory was not a predictable amount that one could foresee to be paid down the line during the course of the year, the dividend payments and the payments for capital purchases were predictable and that the moneys were put into term deposits to meet these predictable liabilities as and when they came due.

It should be noted that in respect of trade accounts from other affiliates of Johnson & Johnson Mr Bradley testified the appellant would “translate” the foreign currency amounts due from an affiliate company into Canadian dollars at the year end rate prevailing. The cost of any purchases of inventory from affiliates would be recorded in Canadian dollars at the rate in effect on the date the appellant pays for the particular inventory so that the revenues “flow through to the statement of profit and loss during the year”. Any gains or losses incurred during the year are not deferred until a subsequent accounting period but are picked up immediately in the year. Mr Bradley stated that any exchange gains or losses in respect of accounts payable or accounts receivable are included in the appellant’s “cost of sales, selling, general and administrative expenses” on its statement of earnings and retained earnings, and are separate and distinct from any gains or losses on the term deposits in issue in this appeal.

While Johnson & Johnson instructed the appellant to keep all of its excess funds in US currency, this appears not to have been the case. For example, the appellant’s annual management report for the 52 week period ended January 1, 1978 (Exhibit A-3) showed:

As a result of a policy change, the majority of our term deposits at year end were in US dollars, ie, $1,806,000.00 in US dollars are invested at interest rates ranging from 5.0625% to 7.25%, while $550,000.00 Canadian dollars are invested at rates from 7.25% to 7.5%.

For the 52 week period ended December 31, 1978, the bulk of the US term deposits were for between 30 to 90 days, but some were for as short as three days or as much as 179 days. In all there were some 48 term deposits in US and Canadian dollars that were purchased during 1977 and 1978 which matured in 1978; 11 were in Canadian dollars and the balance were in US dollars. Some of the deposits in Canadian funds were for short periods of time, according to Mr Bradley, probably because US dollar term deposits may not have been available for three to four days; but at least one deposit in Canadian dollars was for a term of 124 days.

In his examination in chief Mr Bradley testified that when the appellant acquired the term deposits there were several considerations determining the term. One of the determinations, according to Mr Bradley, was the availability of cash to meet current requirements such as the payments of salaries to employees, payments to suppliers, purchases of inventory, and “the ordinary cash needs of the corporation as it goes about its day-to-day business”. The other two considerations included interest rates and the date dividends would be anticipated to be paid up to Johnson & Johnson. It was the intention, also, of the appellant if a term deposit had to be called, the penalty for calling same before the term matured would be kept at a minimum. Although Mr Bradley was not certain, he suggested that the reason for the very short terms (eg, three and four days) was to cover the long weekends. On some occasions, when a term note came due, there was a rollover in whole or in part into a new note depending on how much of the money of the first deposit was then needed.

Dividends were paid in 1977. There was no dividend paid in the first and second quarter of 1978. It is to be noted that the anti-inflation legislation was in force in the period October 14, 1975, to October 13, 1978, and the amount of dividends was limited until the latter date. A total of $1,526,000 of dividends, however, was paid in 1978.

The appellant claims that the moneys invested in US term deposits were to be used for payments of dividends in US funds to its parent, and also to pay US suppliers for capital property purchased in the United States. In the taxation year 1978, on September 20, a gross dividend of $570,000 (Canadian) was payable to Johnson & Johnson; after withholding tax was deducted from the dividend Johnson & Johnson was to receive $484,500 (Canadian). The $484,500 was converted to US funds and the appellant issued a cheque in the amount of US $413,466 to Johnson & Johnson. On September 20 a US term deposit of $400,000 has matured and the proceeds were used for the dividend.

In the fourth quarter of 1978 the appellant met a dividend of $956,000 (Canadian) in two instalments; after withholding tax the total dividend to be paid to Johnson & Johnson was $812,600 (Canadian). The first instalment was paid on November 15 in the amount of $400,000 (Canadian) and the second instalment was paid on December 15 in the amount of $350,195.21 (US). Mr Bradley could only guess as to why the dividend was paid in a mix of Canadian and US funds. Also, on December 15 US term deposits of $945,000 matured which were not renewed.

In 1978 the appellant expended $1,428,000 for acquisition of capital property, of which $128,000 was paid out in the first quarter of the fiscal year, $814,000 in the second quarter, $309,000 in the third quarter and $177,000 in the fourth quarter. These expenditures were used to purchase, and to erect a building for the installation of, a Cobalt Radiation Sterilizer. (The building cost the appellant approximately $250,000; an additional $85,000 was paid to the Atomic Energy Corporation of Canada for the actual cobalt). The equipment placed in the building cost approximately $650,000. Also, the appellant acquired a fibre extrusion facility in 1978 to produce a yarn. The equipment came primarily from a US supplier and the funds to pay for the equipment came from the funds the operations produced. The moneys were paid to US suppliers in US funds.

The appellant’s 1978 opening balance of US term deposits was $1,650,000. The closing balance for its first quarter for 1978 was also $1,650,000, although in February the balance had reached $1,700,000. During the first quarter no dividends were paid and $128,000 was spent on capital expenditures. The second quarter closing balance of US term deposits was $1,245,000; in the second quarter no dividends were paid and $814,000 was incurred for capital expenditures. During the second quarter the appellant purchased a total of $1,495,000 in term deposits, while $2,000,000 of term deposits matured. There was no evidence that the difference between the opening and closing balances namely, $405,000 was utilized for capital expenditures.

In 1978 the appellant earned $128,000 on its term deposit investments. The appellant had no other investments other than deposits in Canadian and US funds.

It appears clear not all the moneys in US term deposits were being used for the payments of dividends or for acquisition of capital assets.

The determining factor in a case such as this, as in most cases which one is required to distinguish as to whether the transaction is on account of income or capital, is the intention with which the foreign currency is originally bought; if it is to carry out an intended commercial transaction in the normal course of the business then any profit, however arising, made on disposal of the foreign currency is of a revenue nature and taxable (Hannan and Farnsworth, The Principles of Income Tax, p 46; vide Imperial Tobacco Co (of Great Britain and Ireland) Ltd v Kelly, [1943] 2 All ER 119, 431).

The appellant relies on the decision of the King’s Bench Division (UK) of McKinlay v Jenkins (HT) & Son, Ltd (1926) 10 Tax Cas 372, per Rowilatt, J at 403 to 405. In that case the respondent taxpayer received an advanced payment of £20,000 from a purchaser of Italian marble and used the £20,000 to purchase lire at 103 to the £. The lire rose in value as against the sterling and when the taxpayer respondent sold the litre it made a profit. The taxpayer then purchased lire to buy marble for delivery under contract. The Court of Sessions held that the original purchase of lire was a “speculator” and thus the profit on its sale was on capital account. The correctness of this decision has been doubted by the Court of Appeal of the United Kingdom (vide Landes Bros v Simpson, (1943) 19 Tax Cas 62 and Lord Green, MR in Imperial Tobacco Co v Kelly, op cit, 122).

In the case at bar it is clear that the appellant had surplus funds for which it had no immediate use. The appellant put these funds in term deposits for various terms. But the surplus funds were not specifically earmarked for dividends or capital expenditure, or, in other words, became capital property, any more than they were specifically earmarked for inventory purchases or payments of salaries to employees. It appears to me that the appellant had surplus funds it did not require at a particular moment in time and decided to put the funds in term deposits for a number of days at which time it hoped it would be in a position to better decide the use of the funds. The term deposits were available for the appellant in the carrying on of its business and therefore any profit earned on the term deposits was earned in the course of that business.

The appeal must therefore be dismissed.

Appeal dismissed.