Executors of the Estate of the Late Eli Cowan v. Minister of National Revenue, [1981] CTC 2668, 81 DTC 596

Guy Tremblay:—This case was heard in Montreal, Quebec on May 30, 1980.

1. The Point at Issue

The issue is whether the executors (“the appellant”) are correct in claiming as business losses, on behalf of the late Eli Cowan, an engineer, the amounts of $44,599, $22,810, $13,381 and $12,000 for the 1972, 1973, 1974 and 1975 taxation years respectively. According to the appellant, the claimed business losses concern scientific research devoted to the development of a new process for the production of woodpulp and meet the definition of “adventure or concern in the nature of trade”. According to the respondent, the said expenses were of a capital nature.

2. The Burden of Proof

2.01 The burden is on the appellant to show that the respondent’s assessments are incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

2.02 According to that judgment, the assumptions of fact on which the Department of National Revenue bases the assessments are deemed to be correct unless they are contradicted by the appellant. In the present case, the assumptions of fact are described in paragraph 6 of the reply to the notice of appeal:

6. In assessing the late Eli Cowan for each of the taxation years 1972, 1973, 1974 and 1975 the Minister of National Revenue, respondent, proceeded, inter alia, on the following assumptions of facts:

(a) During the period material to this appeal, the late Eli Cowan was chairman of the Board of E & B Cowan Ltd., a pulp and paper engineering consultant firm, which paid him a salary;

(b) For each of the years in issue, the late Eli Cowan claimed the following business losses:

1972	$44,599
1973	$22,810
1974	$13,381
1975	$12,000

(c) The said so-called business losses represented expenditures incurred personally by the late Eli Cowan for the purpose of doing research into the possibility

of producing a pulping process which would be free of pollution;

(d) The late Eli Cowan never acquired rights, title or interest supported by patents or copyrights;

(e) The late Eli Cowan was not carrying on a business in Canada;

(f) The expenses incurred by the late Eli Cowan were of a capital nature;

3. The Facts

3.01 The late Eli Cowan, who was 76 years old when he died on November 12, 1976, had been involved in the pulp and paper field and his career had included employment within the industry itself. He was a member of the partnership of E & B Cowan, Consulting Engineers, founded in 1945. This is admitted by the respondent.

3.02 In filing his income tax returns for the 1972, 1973, 1974 and 1975 taxation years Mr Cowan claimed expenses, the quantum of which is admitted by the respondent, as follows:

During the same years, he received the salary of $60,000 per year (except in 1974, he received then $55,000) from E & B Cowan company.

3.03 These expenditures were incurred by the late Mr Cowan, for the purpose of doing research into the possibility of producing a pulping process which would be free of pollution. This is admitted by the respondent (paragraph 6c) in the reply to the notice of appeal quoted above).

3.04 This new pulping procès uses alcohol instead of inorganic chemicals to digest wood chips into pulp. It is non-pollutive and extensive wood resources (1,000 tons per day) are not required to make a mill using the new process economical. Instead, 150 tons per day mills are conceived as being economically viable.

3.05 The witness for the appellant was Mr Howard Palmquist, 68 years old. He is an engineer, having graduated from the University of British Columbia in forestry engineering. He has been involved in the pulp and paper industry since 1930.

3.06 He had known Eli Cowan since 1945 when the latter was in charge of the War Time Board for the pulp and paper industry. The witness then was

.. responsible for the Marathon Paper Mill of Canada — the building and construction and putting into operation of the pulp mill that was built from 1942 to 1945” (SN p 12).

It was located at Marathon in the district of Thunder Bay, Ontario.

3.07 In November or December 1945 “He came out to see us in Marathon and as a result within a week’s time he solved all of my major catastrophic problems and from that on I leaned on him very heavily to take care of the needs that we had in engineering and as a result of this he formed his engineering company known as E & M Cowan.” (SN p 13)

3.08 After that the witness knew Eli Cowan until his death:

A. Yes, I was associated with him while in 1948 I moved to the States and we continued to meet at intervals throughout that period of time until I returned in 1965 and became associated with the Chase Manhattan Bank in New York, and on various projects that I was involved in, I used the firm of E & M Cowan for the review of feasibility studies.

Q. Did this have anything to do with the pulp and paper industry?

A. It was totally involved with the pulp and paper industry.

Q. You continued to work in forestry products?

A. Yes, and use E & M Cowan, particularly Eli, Eli usually was the person responsible for the doing of these projects. And during this time, this period of time Eli and I kept talking about the need for changes in the industry and we got to a point of time where we met — we would kick these ideas around as to what should be done about an industry that was destroying some of our water, so much of our products, and so wasteful — wasteful in this way that half of the trees which make up our reserves are burnt or run into the river, pollute the rivers, so it was decided that we would set parameters in which we could change this problem — it was the first thing and that was to build a new process that would eliminate all air emissions and water pollution; two, that we would be able to use all species of wood, for example in the sulfite mill you can only use spruce and balsam — you could not use jack pine; three, that we should be able to use begas and straw, the straw that was in the fields and mills, after it is milled, it is left in the fields and serves no purpose at all and. (SN pp 14 and 15)

3.09 The witness worked for the Chase Manhattan Bank from 1964 to 1966. He lived in Neemo, Wisconsin. In February 1967, he moved to Montreal. From that time on he met Mr Cowan every day . . every morning at 8:30, I would pick him up and we went to work and we worked together until his death.” (SN Pages 15 and 16).

3.10 The witness worked with the appellant on different projects, “Ell Cowan was constantly — he had a very inquisitive mind and he was always searching to solve problems in the pulp and paper industry.” (SN p 16).

3.11 Mr Cowan solved many problems, “.. . worldwide, the name of Cowan is everywhere. You can’t go into a paper mill or a pulp mill without finding a Cowan screen, a Cowan decker, a Cowan brake press, etc.” These items are manufactured under licence in Germany, Britain, Finland and Sweden.

3.12 Mr Cowan, in fact, .. organized a company known to manufacturers

— to manufacture these machines at Sherbrooke, Quebec, known as the S W Hooper Company, and Mr Hooper ran this company, and is still running it, and I don’t know how many employees they have but I think they have around 200 employees in Canada, in the US, manufacturing basically the products of Eli and Ben’s inventions.”

3.13 The witness explained how Mr Cowan had an inquisitive mind:

He was constantly involved in the development of other processes, for example, he and the Holder Consultants of England, which he actually started into operation, he encouraged these young fellows to make a consulting firm in England to do work in the paper machine field because he felt that the paper machine was made a hundred years earlier at the time of Napoleon, when he awarded a prize to find a new means to manufacture paper instead of printing sheets so that he could print more paper money — the Forginier paper machine was developed, and he also felt that there had been much improvement in that, and these machines had been working for ten, fifteen years and with his experience he put in new developments and in this manner he found work for them so that they could along with his ideas to design a new type of paper machine and speed up the process. (SN p 19)

3.14 The research was being performed in Canada by Pulmac Research Laboratories of Vancouver:

Pulmac Research Laboratories was responsible for the operating, and the operating of the pulping research project, at Radi Pulp in Vancouver but that company has changed names — I don’t know just the state of that but that is somewhere in the period of that time it went to Econotec, which is now in existence in Vancouver. (SN p 24)

The bills issued by research companies (Pulmac Research Ltd., Radi Pulp Research, etc.), transport and telephone companies were produced in bundle as Exhibit A-1. Those bills constituted the expenses claimed by the appellant during the years of 1971 to 1976 inclusively. As said before, the quantum of the expenses claimed in the present case are not in dispute.

3.15 Negotiations were undertaken with different companies (Scott Paper Company, Canadian Paper Company, McLean, E B Eddy, Fraser Company, Abitibi Pulp and Paper Company Consolidated, St-Regis Paper, McMillan Bloedell, Domtar, etc):

Well, we were dealing with all of them — and we would have all day seminars with them because we were trying to gather information from them, from their research people who were working on this problem because pollution is a very important problem in the pulp and paper industry, because if you are going to put in pollution controls in these mills you are talking — and in the building of an ordinary mill you are talking of fifty to seventy-five million dollars — and we could build a mill of two hundred tons with this process for $30,000,000 and this is where their interests were, in this project.

Q. Alright, now you would have talked with the paper companies that you mentioned?

A. That’s right.

Q. In the period ’73 and following, would they not ask you what you were doing, what you intended to do?

A. Surely, and we told them what we intended to do.

Q. Well wouldn’t that be that when you were talking to them they might take your ideas?

A. Well, you don’t tell them everything you know, when you are in the research business of pulp and paper, you don’t tell them, give them descriptions that you do it this way and that way. You don’t tell them what pressure of water you are going to use, because in the pulp and paper industry you are talking of pressures of 145 pounds per square inch, and you have to have a big mill, it takes 8 hours to cook, 8 to 11 hours to cook the chips, and our process we are talking of from 5 to 15 minutes, so in other words you would be speaking of from 15 to 30 minutes, in other words you would not tell these companies how you would proceed, because otherwise they would not pay us royalties on every ton of pulp that they would produce, so there are some things that you would not tell them, we would give them the general outlines of the process that was developed and that was to be used. (SN pp 26 and 27)

3.16 The new process described in para. 3.04 was investigated by the Pulp and Paper Research Institute. Mr Cowan, the witness and a Mr Charley Wagner (partners on handshake, ie without a written contract) had worked on this process for 15 to 18 years. “I think that Eli Cowan started working on it as early as 1946” (SN p 28).

In 1971, the three handshake partners with a Mr Raphael Katzen formed a company called “C P Associates Limited” (CP = Cowan and Palmquist). The letters patent were filed as Exhibit A-2. The purpose of the company was “to provide management and marketing consultant services in the pulp and paper field”:

Q. Now, the company which was incorporated in 1971, at that time was it doing anything? Was it very active?

A. Yes, at this time we were working on the possibility of organizing a company with a US company, here in Canada, for the purpose of building the same process.

Q. And who were you working with by the way?

A. Kruger Paper Company and Holland Matheson — we did not succeed because the Canadian partners wanted to won 60% of the mill.

Q. In the years ‘70, ’71, 72, ‘73, ‘74, ‘75 did CP Associates Limited have any money?

A. No.

Q. Could it have paid any expenses?

A. No, we just organized it as a company to place all of our patents when they were received, and all of our know how in, so when if and when our process was accepted, we would have an incorporated company to be able to distribute our interests as they appeared. (SN p 31)

3.17 In Exhibit A-3, minutes of a meeting of the board of directors of C P Associates Limited, made on January 12, 1976, one can read among other things:

After discussion, it was moved, seconded and unanimously resolved that this Company does owe to Mr Eli Cowan, as of this date, the sum of $99,790 as part consideration for Mr Eli Cowan having assigned and transferred to the Company all his rights, title and interest in and to the process known as Alcohol Pulping Recovery Process and that the Company does hereby agree to issue to Mr Eli Cowan its demand non-interest promissory note for an amount of $99,790 which sum of money would be repaid to Mr Eli Cowan out of the first proceeds received by the Company in respect of royalties received by them from the licensing of the Alcohol Pulping Recovery Process.

In fact, this payment was never made to Mr Cowan (SN p 33). During the same meeting another resolution was passed to recognize a debt of $40,000 to Raphael Katzen Associates International, Inc for expenses and disbursements “on behalf of the company in the further development of the Alcohol Pulping Recovery Process”. It was also a non-interest bearing demand promissory note.

3.18 As Exhibit A-4, a memorandum of agreement in blank, between C P Associates Limited and Fraser Paper Company was produced. This agreement was never signed. Mr Palmquist explains the reason:

Q. Did C P Associates reach a stage where any of the parties in the paper industry where they got to the point of entering into an agreement?

A. Yes.

Q. Which one?

A. With Fraser Company with regard to the New Brunswick mill where we were going to buld the pulp mill, all the groundwork, all survey work, all engineering work was processed when Fraser Company was acquired by Noranda and No- randa, after meeting with them declared that they were in the mining and smelting business and not in the research of pulp and paper, and therefore declined to continue with the agreement, or sign the agreement to go ahead with this and as a consequence we were not able to bring our plans to fruition. (SN pp 33 and 34)

The agreement provided that the parties would form a new company and that “Fraser Paper Company and/or Noranda” would invest $1,000,000 “in the company to be formed, plus the experience of its personnel in the early investigation of alcohol, pulping and recovery process, including the expenses therein”.

It would be important to note that the first paragraph, above the numbered paragraphs, is written as follows:

WHEREAS, C P and Fraser are desirous of forming a corporation for the purposes of the developing, marketing and commercialisation of the alcohol, pulping and recovery process in respect to wood fiber, which process has been developed by CP.

3.19 The appellant filed as Exhibit A-5 (Notice of Allowance), a document issued by the patent office, Consumer and Corporate Affairs Canada. It is addressed to C P Associates Limited, concerning “Solvent Pulping Process”, and informing them that the application for patent had been allowed. The patent office claimed $300 as a final fee.

320. The appellant filed as Exhibit A-6, a release, published in February 1980, CEP (Chemical Engineering Progress) concerning “The Alcohol Pulping & Recovery Process”:

This is the release — it explains the process to somebody who would want to try to understand it but it does not tell you how this process works and we are quite satisfied that the patents that we have in hand and our ability now to be able to go ahead with this, and presently we are planning to go ahead. (SN p 38)

In March 1980, a USA magazine published an article entitled “New processing routes to paper”, subtitled “Pulping with aqueous ethanol is a promising alternative to kraft process”. It was filed as Exhibit A-7.

3.21 In October 1979, C P Associates Limited entered into an agreement with Foster Wheeler Energy Corporation for the exploitation of the process. The witness made this comment:

Yes, a firm of Foster, Wheeler & Company, which is an international company that builds all types of chemical plants, worldwide, they are presently doing a tremendous amount of work in the oil, tar sands operation and chemical plants, here in Canada as well as the United States, and worldwide, our agreement is an international agreement, and this is an ongoing agreement in which they have paid us $12,000.

That is the first time that I see that they pay you to be an agent — it’s the first time I have seen this but anyway, in consideration of the payment of $25,000, to wit on or before April 10, 1980, they give you an option to act as an exclusive agent for C P Associates licencing the APR procedure — did you get paid the $25,000?

A. Yes we have, we were paid that to act as agents, and we were told that they will pay us $500,000 in the next five years — a total of $500,000 if they exercise this option.

Q. Now the option is open until April 10, 1980?

A. It has been extended for another six months. (SN pp 39 and 40)

3.22 Mr Palmquist also explained that a typical expenditure involved in utilising the process in a new pulp and paper mill could add up to five million dollars:

We are speaking of something of the million to five million dollars — now may I mention something which I think is important that one of the parameters was to be able to build this mill in modules of 50 tons. (SN p 41)

3.23 Mr Palmquist also testified that the Canadian patent cost was $4,800 and the patent costs in other countries (USA, Germany, England, etc) would probably be around $100,000.

3.24 Later the presiding member read to the witness paragraph 6 of the notice of appeal, which is reproduced in paragraph 3.04 above. In response, the witness made the following comment:

That is correct. That is correct. You could go down to 50 tons and be economical, but we have used this because there are not any 50 ton pulp mills, you usually Start at 150 tons, that is why that term was used. That is a very important factor because we Call that the module design that makes this process so attractive to all of the small mills in the world, using modules, you don’t need locations where you have 3,000 acres of pulp but there are hundreds of locations where you could put a small mill, or where you could use say straw which would be left over from agricultural uses and process this. Now as you know it takes 3 tons of straw to make a ton of pulp — it takes 2 tons of wood to make a ton of pulp. But there are some disadvantages doing that, because with the straw you get a high carbohydron count, but less cellulose, you see it is about thirty per cent cellulose and about seventy per cent carbohydrons and you see with this process we try to extract the lignants and carbohydrates and water from the cellulose and after this separate the carbohydrates and lignants and that is what this process does, without having pollution, without having any impact on the environment, and being able to use, and this process can use silicone of wood, straw or begas, that is why we are excited.

I have found that this project has kept me young — I should have quit when I was 65 but I have found that working on this project has kept me young — it keeps me wanting to make sure that this happens and we are going to make it happen this year because we are working with a major company, a US company, this is the trouble up here you know we don’t think like they do down there, and we are going to build a demonstration plant in Alberta — a small mill — now the sulphite — the sulphite and sulphate — now sulphate is worse than sulphite, but the sulphite is something that you smell. (SN pp 54 and 55)

4. Law — Case Law — Analysis

4.01 Law

The provisions of the Income Tax Act involved in the present case are paragraphs 18(1)(a) and (b), 20(1 )(t) and subsection 37(1). They read 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;

(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;

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(t) such amount in respect of expenditures on scientific research as is permitted by section 37;

37. (1) There may be deducted in computing the income for a taxation year of a taxpayer who carried on a business in Canada and made expenditures in respect of scientific research in the year the amount by which the aggregate of

(a) such amounts as may be claimed by the taxpayer not exceeding all expenditures of a current nature made in Canada by the taxpayer in the year or in any previous taxation year ending after 1973

(i) on scientific research related to the business and directly undertaken by or on behalf of the taxpayer,

(ii) by payments to an approved association that undertakes scientific research related to the class of business of the taxpayer,

(iii) by payments to an approved university, college, research institute or other similar institution to be used for scientific research related to the class of business of the taxpayer,

(iv) by payments to a corporation resident in Canada and exempt from tax under paragraph 149(1 )(j), or

(v) by payments to a corporation resident in Canada for scientific research related to the business of the taxpayer;

(b) such amount as may be claimed by the taxpayer not exceeding the lesser of

(i) the expenditures of a capaital nature made in Canada (by acquiring property other than land) in the year and any previous year ending after 1958 on scientific research relating to the business and directly undertaken by or on behalf of the taxpayer, and

(ii) the undepreciated capital cost to the taxpayer of the property so acquired as of the end of the taxation year (before making any deduction under this paragraph in computing the income of the taxpayer for the taxation year), and

(c) such amounts as may be claimed by the taxpayer not exceeding all expenditures in the year or in any previous taxation year ending after 1973 by way of repayment of amounts paid to the taxpayer under an Appropriation Act and on terms and conditions approved by the Treasury Board in respect of scientific research expenditures incurred for the purpose of advancing or sustaining the technological capability of Canadian manufacturing or other industry,

exceeds

(d) the aggregate of all amounts paid to him in the year or in any previous taxation year ending after 1973 under an Appropriation Act and on terms and conditions described in paragraph (c),

to the extent that such expenditures were not deducted in computing his income for any previous taxation year.

4.02 Case Law

The judgments which the parties referred to the Board are the following:

1. Dominion Magnesium Limited v MNR, [1972] CTC 2148; 71 DTC 5332;

2. International Nickel Co. of Canada Ltd v MNR, [1971] CTC 604; 72 DTC 1138;

3. HMQ v The International Nickel Co. of Canada Ltd, [1975] CTC 620; 75 DTC 5460;

4. Rapistan Canada Limited v MNR, [1974] CTC 495; 74 DTC 6426;

5. Jan V Weinberger v MNR, [1964] CTC 103; 64 DTC 5060;

6. MNR v Henry J Freud, [1968] CTC 438; 68 DTC 5279;

7. Cormie Ranch Ltd v MNR, [1971] Tax ABC 671; 71 DTC 464;

8. David Tobias v HMQ, [1978] CTC 113; 78 DTC 6028;

9. Donald Preston McLaws v HMQ, [1976] CTC 15; 76 DTC 6005;

10. Vallambrosa Rubber Co Ltd v Farmer, 5 Tax Cases 529;

11. BSC Footwear Ltd v Ridgway, [1971] 2 All England Reports 534; 12. Commissioners of Inland Revenue v The Falkirk Iron Co Ltd, 17 Tax Cases 625;

13. Consolidated Textiles v MNR, [1947] CTC 63; 3 DTC 958;

14. E R Squibb & Sons Ltd v MNR, [1973] CTC 120; 73 DTC 5139;

15. Mrs Katie Esar and Reuben Esar v HMQ, [1974] CTC 34; 74 DTC 6062;

16. HMQ v Dorchester-Drummond Corporation Ltd, [1976] CTC 2109; 76 DTC 1088; [1979] CTC 219; 79 DTC 5163.

4.03 Analysis

4.03.1 It is obvious from the analysis of the evidence described above that the amounts claimed as expenses (see para 3.02) were made for scientific research.

This fact is admitted by the respondent not only in subparagraph (c) of paragraph 6 of the reply to the notice of appeal quoted above (see para 2.02), but also by the counsel for the respondent at the beginning of his verbal submission.

4.03.2 The appellant’s contention is to the effect that the expenses made for scientific research can be deducted first in paragraph 18(1 )(a) orsection 37.

The respondent’s contention is that it can be deducted neither in paragraph 18(1 )(a) nor section 37. It is mainly based on the affirmation made by Cattanach, J in International Nickel Co of Canada Ltd v MNR, (supra):

The obvious purpose of section 72 (the present section 37) is to permit the taxpayer to deduct from its income the amounts spent on scientific research within the meaning of section 72 which might not otherwise be deductible either because barred by section 12(1)(b) (the present section 18(1 )(b) ) as capital expenditures or because of the possibility the amount so expended might not be incurred directly in the income earning process within the meaning of section 12(1)(a) (the present section 18(1 )(a) ).

4.03.3 In this judgment Cattanach, J of the Federal Court of Canada continues after the quoted paragraph that: “It is common ground between the parties that the appellant’s expenditures on scientific research are deductible under section 72 . .(the present section 37).

In the present case, as it appears in the former paragraph, there is no common ground at all.

4.03.4 Section 37 only applies to the taxpayer “. . . who carried on a business in Canada . . The evidence does not show that Mr Eli Cowan carried on a business in Canada during the years involved. Mr Cowan received a salary from E & B Cowan company (para 3.02). The fact that he paid expenses for scientific research cannot be considered by itself a business under section 37.

The Board believes that if in the present case, there is an adventure of the nature of trade it cannot be envisaged within section 37, but only within paragraph 18(1 )(a).

4.03.5 Concerning paragraph 18(1 )(a), the respondent contends that the expenses for scientific research are only capital outlays; the respondent referred the Board to International Nickel Co of Canada Ltd v MNR, (supra) in which it refers to British Insulated and Helsby Cables, Limitd v Atherton, [1926] AC 205. The fundamental reason is because the expenditure is made only once and for all. It is made to acquire a patent from which it will receive royalties.

The evidence, however, does not show that the appellant acquired a patent.

The appellant transferred the right he had acquired in the new pulping process to C P Associates Limited in January 1976 (Exhibit A-3, para 3.17). The notice of allowance (Exhibit A-5) was issued only in October 1979, nearly three years after the death of the appellant (para 3.19).

Exhibit A-3 shows that even if the right to the new process had been legally transferred to C P Associates Limited in January 1976, the fact was that all these rights were to be transferred one day or the other.

In February 1975, indeed a memorandum of agreement (Exhibit A-4) was drafted to complete a verbal agreement between C P Associates Limited and Fraser Paper Company. This agreement clearly shows that C P Associates Limited practically already owned all the rights to the new process (para 3.18).

The fact that the agreement was not signed does not change the substance of the document and that it was Mr Cowan’s intention to transfer his rights to the said company.

There is no evidence that the original intention was to develop it personally. In fact, it was probably financially impossible, if we consider the memorandum of agreement which provided that Fraser Paper Company and/or Noranda would invest $1,000,000 in the new company to be formed to develop the new process.

In the Board’s opinion the preponderance of evidence is to the effect that the original intention of the appellant was to sell his rights.

The principles involved in the Freud case apply to the present case. Moreover, it is common ground that the earning of income in a year is not a prerequisite to deductibility.

The Board concludes that it was at the very least an adventure in the nature of trade and that the expenses are deductible within paragraph 18(1)(a).

5. Conclusion

The appeal is allowed and the matter referred back to the respondent for reassessment in accordance with the above reasons for judgment.

Appeal allowed.