Levi Strauss of Canada, Inc v. Her Majesty the Queen, [1980] CTC 480, 80 DTC 6345

Grant, DJ:—This is an appeal by the plaintiff from reassessments of its income tax returns for the years 1974 and 1975 made by the Minister and dated June 6,1978. It was incorporated under the laws of Ontario on April 4, 1972 and is a wholly owned subsidiary of Levi Strauss International, a US Corporation which is a wholly owned subsidiary of Levi Strauss & Co, a publicly owned US corporation. Under Levi Strauss International the plaintiff’s affiliates manufacture and distribute similar products throughout the world.

The plaintiff first commenced business in Canada in 1972 by distributing here items of clothing which it imported from its related companies or foreign contractors. This consisted mostly of jeans, corduroys, stretch trousers and a variety of co-ordinated tops including shirts, jackets and accessories but its greatest sale was in blue jeans and to a lesser extent tops. It first commenced manufacturing any of its products in Canada in 1973. It purchased machinery and equipment in the nature of sewing machines which it used to train employees in the manufacture and assembly of its product. It constructed a plant in Cornwall to be used in manufacturing as well as a distributing centre. In that year about 96% of its sales were derived from imported wares and 4% from its own manufacture. In that year the plaintiff’s sales and the number of its employees greatly increased from 70 in 1972 to 369 and by the year 1977 amounted to 849.

In 1974 the Company’s plant in Cornwall was operating at full capacity and its sales increased from $18,027,438 in 1973 to $41,503,696. Its sales have continued to grow in each subsequent year. It also became involved in designing its products and controlling the method and different steps involved in the making of those garments produced by its affiliates or contractors. By 1974 the plaintiff had the physical facilities and employees to do all but the actual “cut, make and trim” of all its pants products. It purchased all the necessary fabric from producing mills. In order to have sufficient wares to meet the public demand in Canada for its products in the years 1974 and 1975 the plaintiff purchased from its affiliates outside Canada the “bottoms” and arranged for Canadian contractors to do the most of the ‘“‘cut, make and trim” with respect to the tops. The services that such contractors performed in so completing the tops were identical with the type of work the plaintiff’s own employees would employ in making the tops. In 1975 about 60% of the plaintiff’s sales were not of its own make.

The extent of the growth of the plaintiff’s business in Canada is indicated by the fact that it secured the following plants. Namely, in 1975 it leased a factory in Hamilton, in 1979 it acquired 2 plants in Brantford, and is now erecting 2 plants in Quebec. Each plant will specialize in the manufacture of a particular garment. The management of the plaintiff company anticipate it will not be necessary to engage any contractors in Canada to produce garments after 1981 but that it will still utilize the help of its foreign affiliates.

Exhibit 3 is a breakdown of the units produced in the years 1974 and 1975 and shows the source thereof. In 1974 the plaintiff only processed pants in its own factory in the amount of $1,002,000 or 21 % of its sales. Its Canadian contractors produced no pants but did make 351,000 tops and other garments or 30% thereof. In 1975 the plaintiff made 1,670,000 pants or 33% of its sales thereof while its Canadian contractors made no pants but did make 521,000 tops and other garments or 48% thereof. American contractors or the plaintiff’s affiliates made the balance of the company’s merchandise. As of today the plaintiff only manufactures the Levi pants.

The plaintiff’s merchandising department would issue an order to the company supplying the fabric to deliver it direct to the contractor.

The contractor supplies a finished product for which he is paid on a unit basis.

The total amount paid by the plaintiff to contractors was $1,570,946 in 1974 and $2,197,887 in 1975. Of those said amounts $733,200 in 1974 and $1,806,291 in 1975 were paid to Canadian contractors. The Canadian contractors, the type of product on which the contractors worked and the amount paid to the contractors in 1974 and 1975 are set out below:

For the years in question section 125.1 of the Income Tax Act provides for a reduced tax rate on “Canadian manufacturing and processing profits”. This provision, if applicable, would reduce the plaintiff’s federal tax on such income to 40%.

The term “Canadian manufacturing and processing profits” is defined in paragraph 125.1(3)(a) of the Act in the following manner:

Canadian manufacturing and processing profits of a corporation for a taxation year means such portion of the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada as is determined under rules prescribed for that purpose by regulation made on the recommendation of the Minister of Finance to be applicable to the manufacturing and processing in Canada of goods for sale or lease.

The term “manufacturing or processing’’ as used in section 125.1 of the Act is not defined. Paragraph 125.1(3)(b) of the Act excludes from the phrase certain activities not engaged in by the plaintiff.

Under the authority of subsection 125.1(3) of the Act as set out above, the rules prescribed by regulation for the purpose of determining “Canadian manufacturing and processing profits’’ are set forth in Part Lil of the Income Tax Regulations (the “Regulations”).

The basic formula for the computation of the “Canadian manufacturing and processing profits” is contained in section 5200 of the Regulations:

MP = MC + ML x ADJLJB

C + L

Where: MP = Canadian manufacturing and processing profits

C = cost of capital

MC = cost of manufacturing and processing capital

L = cost of labour

ML = cost of manufacturing and processing labour

ADJUBI = adjusted business income

The various terms as used in the proceding paragraph are defined in section 5202 of the Income Tax Regulations. Therein the “cost of manufactuing and processing labour” is defined in the following manner:

“cost of manufacturing and processing labour” of a corporation for a taxation year means 100/75 of that portion of the cost of labour of the corporation for that year that reflects the extent to which

(a) the salaries and wages included in the calculation thereof were paid or payable to persons for the portion of their time that they were directly engaged in qualified activities of the corporation during the year, and

(b) the other amounts included in the calculation thereof were paid or payable to persons for the performance of functions that would be directly related to qualified activities of the corporation during the year if those persons were employees of the corporation,

but the amount so calculated shall not exceed the cost of labour of the corporation for the year.

The term “cost of labour” is also defined in section 5202 of the Regulations. Included in the “cost of labour” are:

(b) all other amounts, each of which is an amount paid or payable during the year for the performance during the year by any person other than an employee of the corporation, of functions relating to

(iii) a service or function that would normally be performed by an employee of the corporation . . .

In computing its “cost of manufacturing and processing labour” the plaintiff included the amounts paid to Canadian contractors in 1974 and 1975 of $733,200 and $1,806,291 respectively for the purpose of getting the deduction provided thereby.

The Minister takes the position that such amounts paid to the Canadian contractors should not be so included as they were not payments for the performance of a function relating to a service or function that would normally be employed by an employee of the corporation and so do not fall within the definition of “costs of labour’’ above set out. In support of this he points out that the plaintiff in those or any other years made only pants. Its employees never engaged in the “cut, make or trim’’ of shirts or other products of the plaintiff's manufacture and so the Canadian contractor was engaged in an operation making a product entirely different from that which the plaintiff’s employees made.

To come within the section and definition above quoted the functions and services performed by the contractor must be those normal to the duties of the plaintiff’s employees. The plaintiff had established a practice of contracting out all of the work in connection with its manufacture of shirts. The plaintiff’s witness, Gregory Swyers who was production manager at the Cornwall plant stated in evidence that the company had never manufactured its shirts but rather contracted them out.

It is a well established rule that the exempting provisions of a taxing act must be construed strictly.

Wylie v City of Montreal (1885), 12 Can SCR 384 at 386.

Lumbers v MNR, [1943] Ex CR 202 Aff’d [1944] SCR 167; [1943] CTC 281; [1944] CTC 67; 2 DTC 631; 2 DTC 652.

The case of Canadian Clyde Tube Forgings Limited v Her Majesty the Queen, [1980] CTC 41; 80 DTC 6008 is very similar to the facts herein. Therein Mahoney, J stated at 42 [6009]:

Nothing in the related provisions of the Act or regulations leads me to conclude that the pertinent words of the definition of the “cost of labour” are to be interpreted otherwise than in their plain English sense. The adverb “normally” appears clearly to relate to the modus operandi of the manufacturer and processor claiming inclusion of the particular outlay in its costs of labour. Put briefly, it is subjective not objective normalcy that is determinative or whether the amount paid or payable is property a “cost of labour”.

I agree with the defendant’s submissions. The appeal should be dismissed with costs.