Louben Sportswear Inc v. Minister of National Revenue, [1979] CTC 2526, 79 DTC 531

Delmer E Taylor:—This is an appeal heard in the City of Montreal, PQ, on April 9, 1979, against income tax assessments for the years 1974 and 1975, in which the Minister of National Revenue disallowed certain amounts for the purpose of computation of the “manufacturing and processing profits deduction”. The respondent relied, inter alia, upon the following section of the Income Tax Act: 125.1 and section 5202 of the Income Tax Regulations.

Facts

The taxpayer (hereinafter referred to as “Louben” or the “Company”) is a manufacturer of ladies sportswear and included in its computation of the “manufacturing and processing profits deduction” was an amount of $475,000 paid in 1975 and an amount of $347,920 paid in 1974 to outside contractors for labour performed on materials submitted by the taxpayer. The Minister of National Revenue disallowed the amounts paid to contractors in the computation of the “manufacturing and processing profits deduction” and thereby reduced the amount of the taxpayer’s claim for this deduction.

The Company has approximately one hundred employees of which 80 employees are engaged in manufacturing and 20 are engaged in office, selling and administrative functions. Out of the 80 manufacturing employees, approximately 45 employees are engaged as sewing machine operators. This is also the function performed by the contractors. The total payroll for the years 1974 and 1975, excluding payments to contractors, was $564,000 and $688,000 respectively, of which $464,000 and $568,000 respectively pertained to the manufacturing operations.

Contentions

The appellant contended that:

—the outside contractor performed functions normally performed by employees of the taxpayer and thereby the amount paid should be included in the computation of the “manufacturing and processing profits deduction”.

—The Company occupies manufacturing and office facilities at 5445 De Gaspe Street, Montreal, Quebec. The total area it occupied is approximately 25,000 sq ft of which 25% is used for offices, showrooms, reception and shipping, and 75% is used for styling, designing, cutting, sewing and pressing operations.

The position of the respondent was that:

— During the relevant period, the appellant had some sewing work done for its operations by outside enterprises;

—These “outside labour costs” were not normally performed by the appellant’s employees;

—These “outside labour costs’’ were incurred because of a lack of capacity of the appellant’s manufacturing process.

Evidence

Both the appellant and the respondent adduced evidence but the only additional point considered significant by the Board was that some of the payments involved had been made to incorporated businesses providing the serivce to the appellant, and some of the payments had been made to unincorporated businesses, such as partnerships, etc. There was no evidence that any of the amounts had been paid directly to individuals on their own account, for their own labour. The manufacturing functions had been performed by employees of other businesses—whether incorporated or unincorporated. Both parties made reference to section 5202 of the Income Tax Regulations, and a portion of it is herein quoted:

“cost of labour” of a corporation for a taxation year means an amount equal to the aggregate of

(a) the salaries and wages paid or payable during the year to all employees of the corporation for services performed during the year, and

(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

(i) the management or administration of the corporation,

(ii) scientific research as defined in section 2900, or

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

but for the purposes of this definition, the salaries and wages referred to in paragraph (a) or other amounts referred to in paragraph (b) do not include that portion of those amounts that

(c) was included in the gross cost to the corporation of a property (other than a property that was manufactured by the corporation and leased during the year by the corporation to another person) that was included in computing the cost of capital of the corporation for the year, or

(d) was related to an active business carried on outside Canada by the corporation;

“cost of manufacturing and processing capital” of a corporation for a taxation year means 100/85 of that portion of the cost of capital of the corporation for that year that reflects the extent to which each properly included in the calculation thereof was used directly in qualified activities of the corporation during the year, but the amount so calculated shall not exceed the cost of capital of the corporation for the year;

“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;

*(ltalics mine).

Further, a part of Interpretation Bulletin IT-145 related to the above was noted by counsel for the respondent:

Cost of labour

16. Interpretation of “Normally”. In addition to salaries and wages paid to a corporation’s employees, amounts paid to third parties for services which would normally be performed by the corporation’s own employees form part of the cost of labour. The term “normally” means “commonly”, “usually”, or “under normal or ordinary conditions”. It would apply in cases where a corporation usually performs certain services or functions itself but for some reason, such as lack of capacity, short-run economic conditions, labour problems, or machinery breakdowns, has sublet all or part of the work to third parties. Those corporations operating in more than one province will already have experience in calculating these amounts for purposes of allocating income to various provinces under Regulation 402(7).

Argument

The agent for the appellant rested his case on the proposition that the Company had paid “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” (from section 5202 in italics above, and the cost thereof should be allowed.

Counsel for the respondent relied heavily upon two points: (a) the view that the appellant had paid for “services”, not the performance of “functions” and (b) the interpretation given to the word “normally” in Bulletin IT-145.

Findings

The Board turns first to the arguments put forward by counsel for the respondent. The narrow argument that the activity of the subcontractors should be regarded as “services” rather than “functions”, and thereby the amount eliminated from the calculation is based on counsel’s view that the only operative word in section 5202 is “functions” under clause (b) of “Cost of Manufacturing and Processing Labour’’. In my view this is negated by the specific reference to “services” under (b)(iii) of the section of Regulation 5202 headed “Cost of Labour”, and also by the reference to “services” in the Interpretation Bulletin—“amounts paid to third parties for services”; and “where a corporation usually performs certain services or functions itself”.

Similarly, while an examination of Interpretation Bulletin IT-145 appears to support counsel’s argument that the activity under review in this appeal would not “normally” be conducted by the appellant, the thrust of the Bulletin itself must be questioned. That “normally” should mean “commonly”, “usually” or “under normal or ordinary conditions” seems proper to me but I fail to see legal or structural support for the attempt in the Bulletin to further restrict the application to “lack of capacity, short-run economic conditions, labour problems, or machinery breakdowns”. “Normally” means a function or service that one would expect to find carried on in the operation of the manufacturing or processing industry involved. In this case one would normally find sewing going on in the appellant’s plant, and it should be for the taxpayer to decide if all, some, or perhaps none of the sewing is to be carried on precisely on the premises, or is to be done by outsiders. The position of the Minister in this appeal finally comes down to opposing the use of subcontracted indirect labour rather than direct labour, and I find no basis for such opposition in the Act. It would seem more logical to conclude that the very purpose of this section of the Act providing for the deduction claimed, was to expand the manufacturing and processing sector of the economy by whichever means—direct or indirect labour.

Having reached this point, it is difficult to conclude that in themselves the reasons for the disallowance provided by the Minister in the reply to notice of appeal and at the hearing have been substantiated. While an argument may well be advanced (and often is in judgments of this Board and the Courts) that the Minister should be explicit in attempting to add an amount of income to that reported by a taxpayer, it must also be remembered that to claim a deduction, the responsibility for fitting squarely within the provisions rests directly with the taxpayer. From that perspective, the critical word in the relevant portion from section 5202 is “persons” in the phrase “paid or payable to persons”, and the Board earlier noted that the limited information provided by the appellant showed that the payments had been made to both an unincorporated business (eg, a partnership), and an incorporated business (a corporation), but not directly to individuals. It is clear, according to the definition provided in subsection 248(1) of the Act, that a corporation should be treated as a “person”:

“Person”.—“person”, or any word or expression descriptive of a person, includes any body corporate and politic, and the heirs, executors, administrators or other legal representatives of such person, according to the law of that part of Canada to which the context extends;

Under questioning by the Presiding Member, no argument was proposed by the agent for the appellant and that would permit the Board to consider a partnership as a “person”, for purposes of the Income Tax Act. Therefore, any payments made to such an unincorporated business (as part of the totals claimed) would not be allowable. At first glance it might appear that the payments which were made to corporations might be allowable even though such payments on a subcontract basis would seldom be just for wages—they would probably include overhead, administration, profit, etc. However, a further examination of part (b) of “cost of manufacturing and processing labour” in section 5202, which I take the liberty of quoting again, provides good reason to conclude that the legislators did not intend payments to corporations to be allowable:

(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, (Capitals and italics mine).

I am prepared to accept that the precise meaning of that paragraph is difficult to determine, but it is my opinion that this appellant, for the payments made to corporations (as persons) had met the stipulation for “functions that would be directly related to qualified activities”. However, I am not convinced that this appellant, in making the payments to corporations, has met the restriction placed upon the kind of “persons’ to whom such payments can be made. That restriction does not read—“persons. . . that would be directly related . . . if those persons were employees of the corporation”, nor does it read “persons . . . AS if they were employees of the corporation”. I can only interpret the restriction to mean that allowable payments can only be made to persons who could be employees of the payor corporation, and I am unaware of any provision which would permit the payee corporation to be an employee of the appellant. Indeed, while there is no specific definition of “employee” in the Income Tax Act, there is a definition of “employment” under subsection 248(1) which reads:

“Employment”.—“employment” means the position of an individual in the service of some other person (including Her Majesty or a foreign state or sovereign and “servant” or “employee’ means a person holding such a position;

I draw particular attention to the fact that while the employer may be a person, the employee, it appears, must be an individual.

Conclusion

The Board reaches the conclusion that, for purposes of a claim under section 125.1 and section 5202 of the Income Tax Regulations the “persons” to whom relevant payments are made must be “individuals”, and cannot be unincorporated or incorporated businesses.

Decision

The appeal is dismissed.

Appeal dismissed.