Neonex International LTD v. Her Majesty the Queen, [1977] CTC 472, 77 DTC 5321

Marceau, J:—The plaintiff, a public corporation, was assessed income tax for its 1969, 1970, 1971 and 1972 taxation years by notices of assessment, each of which was dated April 15, 1975.* [1] The assessments were objected to in due course, but those for the three first mentioned years were confirmed by the Minister of National Revenue, on May 25, 1976, and a reassessment was issued for the year 1972, notice of which was also dated May 25, 1976. This is an appeal directly to this Court against the four assessments.

The appeal was heard in Vancouver. Along with the documents transmitted by the Minister of National Revenue in pursuance of subsection (2) of section 176 of the Income Tax Act, two exhibit books, one prepared by the plaintiff, the other by the defendant, were put into evidence with the permission of the Court. Furthermore, a “partial agreed statement of facts’’ was executed by the parties and filed at the outset of the hearing. The trial was thus somewhat simplified. Two witnesses testified on behalf of the plaintiff: its president and chief executive officer and the assistant to its president during the relevant years. The defendant for her part called only one expert witness. Actually, the facts are not really in dispute: it is the proper inferences to be drawn therefrom with regard to various provisions of the Income Tax Act (the former Act, RSC 1952, c 148 as amended, with respect to the 1969, 1970 and 1971 taxation years, and the Act as it now reads, SC 1970-71- 72, c 63 as amended, with respect to the taxation year 1972) which raise difficulties.

Four issues arise in the appeal and they ought to be considered successively. Before doing so, however, as the special nature of the plaintiff's enterprise is put into question in all four issues, it will be proper to say something about it immediately.

The plaintiff carries on business in the Province of British Columbia and elsewhere in Canada. It was incorporated under the federal law of Canada in 1929 and was engaged for many years exclusively in the electric sign and outdoor advertising business under the name of Neon Products of Canada Limited. The company assumed its present name in 1969. The year before, under the direction of a new group of owners headed by the actual president, the company began to acquire, for some of its common shares and cash, the shares of a variety of other existing companies and businesses. It soon became the parent company of over fifty subsidiary or affiliated companies engaged in various unrelated types of business. The group became a so-called “conglomerate” organization, that is, a group formed by a company which acquires other companies with a view to directly becoming involved in their day-to-day operation, policy decisions and course of development. From then on, the relations between the plaintiff and its wholly-owned subsidiaries were set on a Clear pattern: the plaintiff company operated as a corporate office and provided to its subsidiaries all the capital the latter needed for their operations as well as management advice and services. Out of its own bank line of credit, it made loans to its subsidiaries for interest payment rates of approximately 1 /2% above the interest rate it was itself charged and it collected fees for the management services it rendered. Thus the plaintiff’s sources of income became dividends, management fees and interest on loans, in addition to the revenues derived from its sign and advertising business which, after 1968, had become in practice only one of its operating divisions.

I turn now to the four issues raised by the action.

1. The first one involves a foreign exchange profit of some $306,007.38 that the plaintiff realized in 1971, due to fluctuations in the Canada-United States exchange rate, when it repaid a loan which was redeemable in American funds.

The essential facts pertaining to this issue are well stated in paragraphs 9 to 17 of the parties’ partial agreed statement of facts:

9. On December 17, 1969 the Plaintiff borrowed $10,000,000 (US) from Marine Midland Grace Trust Company of New York and as security therefor, delivered its promissory note to the lender.

10. On December 23, 1969, $6,000,000 of the loan proceeds were transferred to the Plaintiff’s account in Vancouver.

11. On or before December 30, 1969 the Plaintiff lent the sum of $6,008,287 which included the $6,000,000 referred to in paragraph 10 hereof) to Overwaitea Limited, a company controlled by the Plaintiff, and the said loan was secured by a promissory note or notes renewed from time to time at varying rates of interest in excess of that charged from time to time by Marine Midland Grace Trust Company of New York to the Plaintiff.

12. The loan from the Plaintiff to Overwaitea Limited remained outstanding until December 31, 1973.

13. The promissory note or notes aggregating $10,000,000 (US) referred to in paragraph 9 hereof were renewed on March 17, 1970 and April 17, 1970 in amounts aggregating $10,000,000 (US).

14. On May 18, 1970 the said notes were renewed for a period of nine months to mature February 18, 1971.

15. On February 18, 1971 the Plaintiff delivered a promissory note to Marine Midland Bank—New York in the principal amount of $7,204,600 (US) being the unpaid balance of the loan of $10,000,000 (US) referred to in paragraph 9 hereof. The said promissory note was renewed on March 18, 1971 and April 19, 1971. The principal amount secured by the promissory note included the $6,000,000 referred to in paragraph 10 hereof.

16. On April 22, 1971 the Plaintiff concluded a loan agreement with Marine Midland Bank—New York with respect to the principal amount of $7,300,000

(US) then outstanding, which included the $6,000,000 referred to in paragraph 10 hereof.

17. On August 23, 1971 the Plaintiff repaid the outstanding principal amount of $5,814,145.45 (US) in respect of the said April 22, 1971 loan agreement. The foreign exchange gain relating to the $6,000,000 of loan proceeds referred to in paragraph 10 hereof and occurring upon the repayment of the said sum of $5,814,145.45 (US) was $305,007.39.

For the Minister, this gain has to be treated as taxable income. His contention is that, at all material times, the plaintiff was carrying on the business of financing its subsidiary corporations in consideration for which it received interest. The loan transaction in question being part of that business, the foreign exchange profit it generated was income from a business within the meaning of paragraph 11(1)(c) of the Income Tax Act as it applied to the 1971 year.

The plaintiff, for its part, contends that the profit was a non-taxable capital gain since the borrowing from Marine Midland was done for the purpose of permanently augmenting the company’s financial capital and enabling it to expand its operations. The plaintiff admits that, as a result of corporate policy established by it with a view to minimizing the cost of putting independent lines of credit in place, as well as obtaining more favourable rates of interest and making maximum use of minimum credit, it was supplying to its subsidiaries, regardless of their nature or extent, the capital they required to finance their obligations. But, says the plaintiff, at no time has it been engaged in business as a moneylender, nor was the money borrowed, in the circumstances described, inventory of a business. It is true that it charged to the subsidiaries a rate of interest slightly in excess of that it had itself to pay to its own creditors, but that was not for the revenue it could derive from the transactions, which revenue was in any event proportionately only a small part of its overall income; the charging of a slightly higher interest rate was only to ensure that interest payable by it on its commitments could be deductible.

I have difficulty in understanding the real meaning of this last statement but, in any case, the fact remains that the lending of money by the plaintiff was profit-yielding. It is clear that the plaintiff was not engaged in the general business of moneylending, that it was not a “moneylender” in the sense that it was willing to lend to all and sundry (which, incidentally, is the only admission made by the defendant in its statement of defence, contrary to what counsel for the plaintiff pleaded). But it seems to me that, since 1968, as the parent company of the group, it had assumed, as part of its business, the financing of the subsidiary companies and it had derived profit therefrom. As I understand it, a “conglomerate” usually operates this way.

It is a question of fact whether a business, in the sense of the Income Tax Act, is carried out by a taxpayer (see for instance The Queen v Rockmore Investments Ltd, [1976] CTC 291: 76 DTC 6156), and it seems to me that the facts revealed by the evidence here are to the effect that the plaintiff had been for some years actively, systematically and regularly engaged in the financing of its subsidiaries so as to make such financing part of its business. It is clearly established that the plaintiff did not borrow the money from Marine Midland to use it itself for a capital purpose like the buying of a capital asset; it borrowed the money so that it could carry on its financial operations and, more precisely, so that it could lend at a profit a large part of the proceeds of the loan to Overwaitea which required capital to satisfy its operating and other requirements.

This brings the matter within the line of reasoning of Tip Top Tailors, Ltd v MNR, [1957] SCR 703; [1957] CTC 309; 57 DTC 1232, applied in many recent cases (for instance Aluminum Union Limited v MNR, [1960] Ex CR 363; [1960] CTC 206; 60 DTC 1138; DWS Corporation v MNR, [1968] 2 Ex CR 44; [1968] CTC 65; 68 DTC 5045). The foreign exchange profit realized by the plaintiff here was generated by a transaction that was part of the business in which the company was engaged, namely that of financing its subsidiaries; it follows that such profit was not on capital account but on business account and was taxable.

On this first issue, I am therefore of the view that the Minister was right and the appeal must be dismissed.

2. In view of the conclusions I reached on the first issue, the second issue raised by this appeal becomes devoid of substance and need only be very briefly stated.

In assessing the plaintiff for its 1969 taxation year, the Minister disallowed the deduction of a sum of $105,000, which sum the plaintiff had been forced to pay to get out of a loan agreement so that it could obtain a new loan for a greater amount from a second lender. The Minister denied that the sum was deductible for the reason that, contrary to the plaintiff’s contention, it was not an expense incurred in the course of borrowing money used by the company for the purpose of earning income from a business or property within the meaning of subparagraph 11 (1 )(cb)(ii) of the Income Tax Act, RSC 1952, c 148, as it then was.

If the plaintiff was in the business of financing its subsidiaries since 1968, as I found it was, then it follows—and at the hearing counsel for the Minister readily agreed to the conclusion—that the sum the plaintiff paid to the first lender, so that it could obtain a new loan and carry on its financial operations, was deductible as a bonus expense under section 4 and paragraph 12(1)(a) of the Act. Section 11 had not to be resorted to and did not come into play.

The Minister here was wrong in disallowing the deduction, and the appeal on this issue succeeds.

3. The third issue raises the question whether some legal expenses incurred by the plaintiff during the years 1970, 1971 and 1972 were deductible for computing its income. The facts that must be known can be summarized as follows.

In 1969 the plaintiff decided to add to its group a company called Maple Leaf Mills Limited. To realize the take-over, it went into a complicated series of transactions among which were three option agreements, executed in December 1969. Two of these option agreements, the subject matter of which were common shares of Maple Leaf Mills Limited, were between the plaintiff and one Norris Grain Company, a United States corporation, and the third one between the plaintiff and one Leitch Transport Ltd. Unfortunately, before the closing date, a dispute arose between the parties, the agreements were not acted upon and the transaction finally failed. The legal expenses here in question were incurred in connection with that transaction. They amounted to $48,059.27, $98,046.52 and $113,117.94 in the 1970, 1971 and 1972 taxation years respectively. In 1970 they were incurred mainly in connection with the preparation of closing documentation and the taking of other means in an effort to assert the plaintiff’s rights and, in spite of the dispute, complete the take-over; whereas in 1971 and 1972 they were practically all incurred at first in attempting to reconstruct the deals and finally in conducting the legal proceedings taken by or against the plaintiff after it had become clear that the transaction would not go through. I say “mainly” and “practically all” to take into account a suggestion made by the plaintiff that all those legal fees disallowed by the Minister were not spent solely in connection with the Maple Leaf take-over; some would have been incurred in:protection of the credit position of the company with its bank. Such a suggestion, however, can have no bearing, since the evidence adduced did not support it or, at least, did not demonstrate where the distinction could be drawn.

For the Minister, these legal expenditures were made in connection with the acquisition, the defending or the substitution of a capital asset; they were payments on account of capital or expenses incurred in connection with property the income from which would be exempt. Therefore, they were not deductible by virtue of paragraphs 12(1)(b) and 12(1 )(c) of the former Act with respect to the 1970 and 1971 taxation years and of paragraph 18(1)(b) of the new Act with respect to the 1972 taxation year.

The plaintiff agrees that the principles by which the deductibility of legal expenses is to be determined are the same as for other expenses, and the test to be applied is whether they were an outlay attributable to capital or revenue. But each case must turn on its own peculiar facts, says it, and the facts here do not support the Minister’s contention.

“The Plaintiff submits [and I am here quoting from its memorandum, p 20] that its business was the seeking out and investigation of profit or operating centres, the acquisition of contracts and arrangements with a view to acquiring numerous ventures through manoeuvres and arrangements of considerable complexity. The purpose of all of its activities in this regard was to acquire those profit or operating centres and thereafter to hold them with a view to using the Plaintiff’s management and expertise to operate those centres at a profit with a view to earning income in the form of dividends and to a considerably lesser extent, management fees and interest.” It follows, continues the plaintiff, that the company’s business was that of acquiring subsidiaries. As a result, the expenses incurred in respect of proposed acquisitions which did not proceed to completion were deductible as part of the cost of carrying on the company’s profit-making undertaking, even though such expenses would have formed part of the cost of the shares had the purchases been completed.

Such a line of reasoning seems to me to be unacceptable. I don’t see how buying shares, not in order to sell at a profit but with the view to holding and owning same, can be said to be a business within the meaning of that word in the Income Tax Act. As Martland, J said in Irrigation Industries Ltd v MNR, [1962] CTC 215 at 221; 62 DTC 1131 at 1133, shares “constitute something the purchase of which is, in itself, an investment’’. The plaintiff was in the business of making and selling signs, and it was also in the business of supplying funds and management services to its subsidiaries. But the acquisition itself of the shares of those subsidiaries which were to keep carrying on their own businesses, can only be regarded as a pure investment.

The conclusion to be drawn is unavoidable: the legal expenses here in question—those incurred in an effort to complete the take-over as well as those incurred in seeking to get compensation in lieu of shares

—were outlays associated with an “investment transaction’’, they were made in connection with the acquisition of a capital asset. They were, therefore, expenditures on capital account. For the taxation years 1970 and 1971 they were not deductible in computing the plaintiff’s income for income tax purposes by virtue of paragraph 12(1 )(b) of the former Act, and for the taxation year 1972 they were not deductible by virtue of paragraph 18(1 )(b) of the new Act and could be allowed only as an eligible capital expenditure (paragraph 14(5)(b)). (See Canada Safeway Ltd v MNR, [1957] SCR 717; [1957] CTC 335; 57 DTC 1239; British Columbia Power Corp, Ltd v MNR, [1968] SCR 17; [1967] CTC 406; 67 DTC 5258; Farmers Mutual Petroleums Ltd v MNR, [1968] SCR 59: [1967] CTC 396; 67 DTC 5277.)

4. The fourth issue is quite different from the first three as it has nothing to do with the nature of the plaintiff’s enterprise as the parent company of a group or “conglomerate’’. It concerns the sign and advertising business in which Neon Products of Canada Ltd was engaged prior to 1968 and which had become, when the plaintiff assumed its present name, one of its operating divisions.

This business of the sign division of the plaintiff was that of fabrication and selling of electrical signs and displays. The plaintiff stocked the component raw materials of the signs and displays but it did not carry an inventory of signs for sale. The production occurred when a contract was received, so that each sign produced could be tailored to the individual requirements of a customer and built in accordance with specific drawings. When completed, the signs were sold in most cases pursuant to conditional sale agreements under which title was retained by the company until the purchaser paid the full and complete purchase price.

Inevitably, at the end of a year, a certain number of signs and displays were in the process of being produced. Until 1970 taxation year, the plaintiff included all of its costs, including the job costs, relating to those uncompleted displays and signs in its work in process inventory as at the end of the year. It kept doing so afterwards for accounting purposes, but in its 1970, 1971 and 1972 taxation years, for income tax purposes, the plaintiff deducted the job costs associated with its uncompleted displays and signs, in the amounts of $176,561, $111,724 and $24,963 for the three years respectively, as outlays or expenses incurred for the purpose of gaining or producing income from its business. Were these deductions properly made? That is the question that has to be decided.

The defendant’s submissions in support of the Minister’s disallowance can be summarized as follows. The uncompleted advertising signs and displays as at December 31, 1970, December 31, 1971 and December 31, 1972 were “inventory” of the plaintiff as defined by paragraph 139(1)(w) of the Income Tax Act, RSC 1952, c 148 as amended, and by subsection 248(1) of the Income Tax Act, SC 1970-71-72, c 63 as amended. Now, subsection 14(2) of the Income Tax Act as it applied to the 1970 and 1971 taxation years and subsection 10(1) of the Income Tax Act as it applied to the 1972 taxation year, required the plaintiff, for those taxation years, to value its “inventory” at the lower of cost or fair market value. By purporting to deduct these job costs, the plaintiff improperly reduced profit from its business of manufacturing and selling advertising displays and signs in that these costs were part of the values of inventory according to generally accepted accounting principles. And, indeed, at the hearing an expert accountant, called as a witness, gave evidence that it is not in accordance with principles of generally accepted accounting to deduct the costs associated with incomplete display signs until they can be matched with the revenue with which they are associated.

The plaintiff agrees that generally accepted accounting principles must guide the determination of income for tax purposes, and it did not try to contradict the evidence of the defendant’s expert with regard to the principle of matching revenue and expense for accounting purposes. What the plaintiff submits is that the booking of costs as inventory, until the article concerned becomes the subject of a contract of sale, exists because, normally, the purchase or production of the article cannot be related to any specific revenue-earning. Its case is different. Because it carries no stock in trade for sale but operates and produces only in response to contracts, and because it cannot earn the income it has a contractual right to receive without incurring the expenses in issue, it is not bound to carry these costs on its books until delivery and installation has occurred. The principle of matching revenue and expenses, in those circumstances, has no applicability for tax purposes. No provision of the Income Tax Act requires the matching principle to be applied in such circumstances.

Here again, I am unable to accept the plaintiff's submissions. I do not think it necessary to enter into a lengthy discussion about accounting. Suffice it to say that, in my view, accounting must not only be useful, it must above all be accurate, and of course no special legislative enactment is needed for such a basic principle to be accepted. As I see it, when a company, in submitting in a tax return a report of its expenditures and revenues during a taxation year with a view to establishing its profits or gains and tax base, purports to include as expenditures all the expenses incurred in realizing a manufactured article not yet finished but does not take into account the whole value the article has for it at that time. it is not making an accurate report. True, in certain instances costs, which for accounting purposes are to be charged to inventory, may be deducted for income tax purposes (for example, expenses incurred in subdividing lots for sale or in bringing certain products to maturity, eg fruit orchard). But. in each instance, the “inaccuracy”, as a result of which tax is deferred, has been tolerated for very specific and exceptional reasons and not for the sole reason that the taxpayer suddenly found it more convenient so to do. I do not see any such reason in the fact that the work here was done in response to contracts already concluded.

In my view, the Minister was right in disallowing the deduction of the value of the work in process in the amounts of $176,561, $111,724 and $24,963 for the taxation years 1970, 1971 and 1972 respectively. The appeal, on this issue, must also be dismissed.

In the result, therefore, I have found in favour of the defendant on three of the four issues raised by the action while the fourth one was decided as an inevitable consequence. As the defendant was for the most part successful, she will be entitled to the general costs of the action except any items pertaining exclusively to the issue on which she has failed. The plaintiff may tax and set off against the costs so awarded to the defendant any taxable costs it may have incurred pertaining to the issue on which it has succeeded.