Edifice Continental Inc v. Minister of National Revenue, [1977] CTC 2072, 77 DTC 55

Guy Tremblay:—This case was heard at Sherbrooke, Quebec, on November 2, 1976.

1. Summary

It must be determined whether certain expenses incurred in an office building are "business” expenses or "capital” expenses. These expenses were incurred to obtain plans and estimates and for levelling a cement floor, demolishing fixed walls, installing movable partitions, erecting a hung ceiling and adapting existing electrical and air- conditioning systems to the aforementioned alterations.

2. Burden of Proof

The appellant has the burden of showing that the respondent’s assessment was not justified. This burden of proof is based not on a particular section of the Income Tax Act but on several judicial decisions, among them a decision of the Supreme Court of Canada rendered in P W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. Facts

3.1. In its tax return for 1970, the appellant, which owns an office building on King Street in Sherbrooke, claimed the sum of $36,929 as expenses for building maintenance and repairs.

3.2. The respondent allowed the sum of $17,658.49 for customary expenses for maintenance and repairs as a direct deduction in computing income, since these are "business” expenses. The balance, that is, the sum of $19,270.51, was disallowed as a direct deduction but allowed as an indirect deduction in the form of depreciation after capitalization of the expenses for alterations, refitting and improvements, since all of these are "capital” expenses.

3.3. It was agreed between the parties that an initial amount of $20,554.80 should be divided as follows:

3.4. It was also agreed that, from another point of view, these expenses should be divided, in accordance with Exhibit A-2, as follows:

According to the respondent, moreover, the sum of $1,500 had been provided by a tenant for alterations to the second floor. Since the "capital” part of this amount was fixed at $1,284.29, according to a rule of three as shown in Exhibit A-2, the total capital expenditure would thus amount to $19,270.51.

3.5. The principal witness for the appellant was Mr Jean Gaudreau, CA, who from 1958 to 1975 inclusive was a shareholder, director and general manager of the company. In the last capacity, he was personally familiar with the alterations carried out, even though he maintains in his testimony that his duties consisted of renting out the building and receiving the rent, whereas the bookkeeping, repairs and maintenance were the responsibility of another person, Dr Paul Chevalier.

3.6. The work was carried out in 1970 in order to meet the requirements of three major tenants (a law firm on the second floor, a firm of stockbrokers on the fourth floor and an insurance company on the fifth floor) and to obtain their signatures on long-term leases. According to the witness, the contract with the law firm was signed for eight years with an option to renew for ten years.

3.7. According to Mr Gaudreau, the plans and estimates were necessary, not only to reduce the cost of the alterations, but also to ensure that the contracts were signed.

3.8. The work involved in the hung ceiling was also necessary for three reasons:

(a) to make it possible to install the movable partitions, which could not be used because the existing ceiling was too high; construction of the hung ceiling thus reduced the height of the ceiling;

(b) to make it easier to install electrical wiring and the pipes for the air-conditioning system;

(c) to reduce the cost of the work.

3.9. The installation of prefabricated, movable partitions made it unnecessary to reconstruct the masonry walls, which would reduce current costs and made it easier to move these partitions at minimal cost to meet tenants’ future requirements. The partitions were made of gypsum and were secured by screws and attached to the ceiling.

3.10. The expenses for plumbing work arose from the need to relocate the air-conditioning system. This was made necessary by the moving of the partitions to meet the tenants’ requirements. The same was true of the expenses for electrical work.

3.11. It is quite clear, according to Mr Gaudreau, that these plumbing and electrical expenses did not lead to any enlargement or improvement of the air-conditioning and electrical systems. This work was done only to adapt the existing systems to the relocated partitions and other work demanded by the tenants.

3.12. The work on the floor consisted of levelling the cement floor after the walls were moved. The floors, which were constructed in 1948, were only finished after the walls had been built and this led to unevenness from one room to another, which became evident when the walls were demolished and a movable partition was erected in a different place from where the old wall had stood.

3.13. The work described above was done on the second, fourth and fifth floors at the proportional costs described in paragraph 3.4.

3.14. The occupancy rate of the building for the period from 1958 to 1975, according to the witness, was greater than 90%. The clientele fluctuated very little and some tenants have been there since 1958.

3.15. The average length of the leases was five years.

3.16. Following the work which was carried out in 1970, the rents were increased over the previous cost per square foot occupied.

3.17. The expenses incurred in 1970 were necessary to meet the competition. In fact, according to Mr Gaudreau, the law firm which, inter alia, had been a tenant for ten years, and which had signed a lease covering 2,800 square feet on the second floor, was prepared to move to another building if its conditions were not met.

3.18. When the work described above was completed, the lessor did not have to make any further improvements for the duration of the lease. Any possible improvements were the responsibility of the tenants.

3.19. According to Mr Gaudreau, alterations of the type made in 1970 had not been made previously.

3.20. This last statement of Mr Gaudreau was, however, contradicted by a second witness for the appellant, Mr David Crockett, who had been a tenant in the building in question since 1950 and was the appellant’s accountant. Mr Crockett alleged that on three occasions before 1970, namely, in 1958, 1963 and 1966, masonry dividing walls had been demolished and reconstructed elsewhere in order to alter the premises. These expenses had been allowed as a direct deduction in computing income.

The respondent, however, objected to Mr Crockett’s testimony on this point. He also objected to the Board’s taking these facts into account. In effect, they contradict the testimony of the principal witness. According to the strict rules of evidence, it would have been necessary for this witness to be declared hostile beforehand. The Board understands the respondent’s point of view, but believes, however, that it must accept the established facts on the basis of subsection 9(2) of the Tax Review Board Act, SC 1972, c 11:

9. (2) Notwithstanding the provisions of the Act under which an appeal is made, the Board is not bound by any legal or technical rules of evidence in conducting a hearing for the purposes of that Act, and all appeals shall be dealt with by the Board as informally and expeditiously as the circumstances and considerations of fairness will permit.

If the Board had to dismiss the appeal on the basis of this one point, it might be possible for the appellant to prove it subsequently before a higher court. It is clear to the Board that the principal witness could have forgotten something which occurred more than ten years ago, while another witness remembered it. The Board will assess below the relevance and the evidentiary value of the facts stated by Mr Crockett. The Board believes that it was within its rights in taking cognizance of them during the hearing.

3.21. In its tax return for 1970, in which it claimed expenses of $36,929, the appellant arrived at an operating loss of $11,822. In 1971 the appellant applied its loss of the previous year against its operating income of $26,148, which left net income of $14,685. The respondent, by disallowing expenses of $19,270 in 1970, caused the loss to disappear and established a net income of $7,807.51. Application of the loss of $11,822 against its 1972 income, which was established at $26,148, was disallowed by the respondent. The assessments were issued on July 23, 1974.

3.22. The appellant objected on October 19, 1974 and the respondent notified it on April 30, 1975 that the assessment was upheld.

3.23. The appellant appealed to the Board on July 25, 1975.

4. Problem

Must the disbursements of $19,270 which were made in 1970 to obtain plans and estimates, demolish fixed walls, erect movable partitions, install a hung ceiling and adapt the electrical and air-conditioning system to the improvements made, be considered business expenses and allowed directly in computing income, or must they be regarded as Capital expenses and allowed as a deduction only through depreciation?

5. The Act and Comments

Paragraphs 12(1)(a) and (b) of the Income Tax Act, RSC 1952, c 148 as amended, provide the basis for solving this problem:

12. (1) In computing income, 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 property or a business of the taxpayer,

(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,

A long line of authorities was cited by the counsel and representatives of the parties, especially by counsel for the respondent: Bar Realty Corporation v MNR, 31 Tax ABC 183; 63 DTC 220; Boyd Building Limited v MNR, 10 Tax ABC 422; 54 DTC 271; Twin Port Developments Limited v MNR, 24 Tax ABC 410; 60 DTC 402; Yorkton Motors Limited v MNR, 2 Tax ABC 144; 4 DTC 276; Graham and Vick Limited v MNR, 1 Tax ABC 343; 4 DTC 143; Better Plumbing Company Limited v MNR, 6 Tax ABC 177; 52 DTC 146; Glenco Investment Corporation v MNR, [1967] CTC 243; 67 DTC 5169; Thompson Construction (Chemong) Ltd v MNR, 15 Tax ABC 62; 56 DTC 204; [1957] CTC 155; 57 DTC 1114; MNR v Vancouver Tugboat Company Limited, [1957] CTC 178; 57 DTC 1126; M NR v Lu mor Interests Limited, [1959] CTC 520; 60 DTC 1001; MNR v Haddon Hall Realty Inc, [1961] CTC 509; 62 DTC 1001; British Columbia Electric Railway Company Limited v MNR, [1958] CTC 21; 58 DTC 1022; Montreal Light, Heat & Power Consolidated and Montreal Coke and Manufacturing Company v MNR, [1942] CTC 1 ; 2 DTC 535; Vallambrosa Rubber Co Ltd v Farmer (Surveyor of Taxes), 5 TC 529; Commissioners of Inland Revenue v Granite City Steamship Company, Limited, 13 TC 1; [1927] SC 705; British Insulated and Helsby Cables, Limited v Atherton, [1926] AC 205.

The authors of the various decisions cited above have emphasized on several occasions that it is not always easy to make a distinction between current operating expenses and expenses of a capital nature. The concepts of these two types of expenses are not made up of strict unchanging elements which make it possible to provide a precise and exhaustive definition that is easy to apply. It is very often a simple question of degree which is not always easy to resolve.

Based on the extensive experience contained in the cases considered by the courts on the subject of expenses incurred by businessmen or owners of rentable property, general principles have been stated to make it easier to apply the legal provision cited above. These general principles, which complement each other, may be summarized as follows:

1. Recurring expenses which provide benefits that are limited in time are regarded as current operating expenses, and must be deducted directly in computing income. On the other hand, expenses incurred once and for all, such as to start up a business or company, to expand it or to substantially replace the bulk of its assets, equipment and so on, or to provide permanent advantage, that is, over an extended period, are on the whole regarded as expenses of capital nature, and can be allowed as deductions in computing income only through depreciation.

2. Alterations which add nothing substantial to the value of the property or do not prolong its life in any appreciable way should be regarded as current operating expenses. However, alterations which are in the nature of replacements, and which prolong the life of the property substantially and prevent deterioration, should be classified as expenses of a capital nature.

In the case before it the first conclusion reached by the Board, after studying the various facts listed above, was that the expenses were incurred to make the building more functional, that is, more suitable, for the needs not only of the present tenants but also of future tenants. The installation of movable partitions and of the hung ceiling will, in fact, make future alterations much easier and less costly.

If a building is thus rendered more functional by means of the alterations that were made, does this produce a limited or a long-term benefit? Does it add something substantial to the value of the property, or does it add nothing? Does it prolong the life of the property appreciably or not?

The Board does not believe that the alterations described can be said to prolong the physical life of the property. It does believe, however, that the alterations as a whole will prolong the commercial usefulness of the property. It does not consider that anything substantial has been added to the physical value of the property, although it does consider that something substantial has been added to the commercial value of the property.

In other words, these alterations will enable the premises to be rented with much greater flexibility, since they can be adapted to a more varied clientele and this will make it possible to maintain the present high occupancy rate of 90%, thus prolonging the business activity carried on in the property. These distinctions between the physical and commercial life and between the physical and commercial value of the property enable us to evaluate the facts of this case. They demonstrate once again the flexibility of these concepts of operating and capital expenses. Not only do the various facets of these two concepts change in the contexts of different subject matter, but change under different aspects of the same subject matter as well. These are not, moreover, the only concepts of a fiscal nature possessing this characteristic of very great flexibility which complicates their application. It is sufficient to recall, inter alia, the concept of residence.

Finally, the Board considers that the alterations made produce benefits which can be classed as permanent in comparison with altera- tions of benefit to the present tenants only. As an example, the Board feels that the cost of moving the movable partitions to satisfy future tenants could be allowed as a current expense, since there would in that case be only a limited and temporary benefit. In the cost of the work involving the movable partitions, the hung ceiling and the alterations to the plumbing and electrical systems, what part applies only to the present tenants and will not benefit future tenants? The appellant’s evidence has not established this. In reality, it is quite probable that this cost is minimal: and, independently of the burden of proof, there are grounds to rely here on the old principle de minimis non curat praetor.

The facts stated by Mr Crockett to the effect that in the past expenses incurred for demolishing masonry walls and reconstructing them in masonry at a different place were regarded as current expenses, cannot change the Board’s conclusion. On the contrary, they confirm it. These expenditures, which were liable to change with each new tenant, were in fact only temporary. Since the wall had to be demolished, nothing remained of the previous expenditure. In the case at bar the whole value of the movable partition, of the hung ceiling, of levelling the floors and of installing air-conditioning and electrical systems, remains for future tenants.

The Board therefore considers these expenditures on alterations to be capital expenses. It does not feel, however, that the above conclusions apply to the expense of $851.25 for plans and estimates. This expenditure was in fact made, inter alia, to satisfy the future tenant in advance and to persuade him to sign the rental contract, as was made clear in the evidence. According to the general practice in rentals of this nature, an expenditure of the same kind will have to be made again for future tenants for the purpose of erecting subdivisions of the space and persuading them to sign, and so on. This expenditure, in the opinion of the Board, is thus of limited benefits and can be classified as an operating or business expense.

6. Conclusion

The Board allows the appeal in part, that is, for the expenditure on plans and estimates in the amount of $851.25, and upholds the rest of the assessment.

Appeal allowed in part.