Lily Cups Limited v. Minister of National Revenue, [1977] CTC 2164, 77 DTC 149

The Chairman:—This is the appeal of Lily Cups Limited from an income tax assessment in respect of the 1968 taxation year. The facts alleged in Paragraphs 6, 7, 8 and 9 of the appellant’s Notice of Appeal, which give rise to the issue of this appeal and which were admitted by the respondent, read as follows:

6. In or about August 1968, as a consequence of the action taken by the IRS, Lily Tulip charged the appellant for such management and technical assistance the following amounts:

(a) for services rendered during 1965, the sum of $70,700 including $8,547 interest;

(b) for services rendered during 1966, the sum of $70,651 including $5,684 interest; and

(c) for services rendered during 1968, the sum of $75,506;

for a total of $216,857.

7. In computing income for its 1968 taxation year, the Appellant deducted the said amount of $216,857 as an expense incurred for the purpose of gaining or producing income from its business.

8. The Minister allowed as a deduction in computing income for the said 1968 taxation year that portion of the total amount paid for such services rendered during the year 1968 and, by Notice of Re-Assessment dated March 7, 1972, the Minister disallowed the balance of $141,351. However, since the Appellant’s 1966 taxation year was still open for re-assessment, by Notice of Re-Assessment dated March 7, 1972, the Minister re-assessed the Appellant and allowed as a deduction in computing income for 1966 that portion of the total amount paid for services rendered during 1966 but not the interest charged thereon.

9. By Notice of Objection dated May 29, 1972, the Appellant objected to the Notice of Re-Assessment dated March 7, 1972 in respect of its 1968 taxation year and by Notification dated April 19, 1973, the Minister confirmed the said assessment stating as follows:

“as having been made in accordance with the provisions of the Act and in particular on the ground that the taxpayer’s income has been properly determined under sections 3 and 4 of the Act and subsection (1) of section 137 of the Act as the law was in force in the year under objection’’

The Issue

In his Notice of Appeal the appellant is seeking to deduct from his 1968 income an amount of $70,700, plus an amount of $8,547 interest, for services rendered during the 1965 taxation year, and $5,684 interest charged on the amount paid for services rendered in the 1966 taxation year.

There is a discrepancy between the figures used in Paragraph 6 of the Notice of Appeal and the figures referred to by the respondent in Paragraph 7 of his Reply. However, since the parties have agreed to settle on the figures, and the quantum is not really in issue, I have, for the sake of convenience, arbitrarily used the figures contained in the Notice of Appeal.

The appellant claims that these amounts were properly deducted in computing its 1968 income as expenses incurred for the purpose of gaining and producing income from its business pursuant to paragraph 12(1)(a) of the Income Tax Act, RSC 1952, c 148, as amended. Counsel for the respondent, on the other hand, claims that the amount of $70,700, paid for services received from the parent company in 1965, was not an outlay or expense for the purpose of gaining or producing income; that the appellant had no legal obligation to pay interest in the amounts of $8,547 and $5,684; and that the deduction of these amounts would unduly or artificially reduce the appellant’s income.

Finding of Facts

The pertinent and uncontradicted facts of this appeal, as stated under oath by Mr Kenneth F Page, Vice-President, Manufacturing and Assistant General Manager of the appellant company, can be summarized as follows:

Early in 1940 Lily Tulip Cup Corporation in the United States (hereinafter referred to as “Lily Tulip’’), purchased a small plant in Listowel, Ontario, known as Universal Paper Cup Company and renamed it Lily Cups Limited, the appellant company (hereinafter referred to as “Lily Cups’’). Over the years, both the parent company and its subsidiary expanded considerably. In 1950 the appellant company moved to Scarborough where a new plant was built and, after successive expansions, another plant was suosequently built. Lily Cups’ productive machinery grew from one or two paper cup-making machines to a series of specialized machinery which produced a great variety of cups and containers. Lily Tulip, the parent company, which experi- mented with such machinery and manufactured a considerable amount of its own machinery for production of its varied products, provided considerable technical assistance and advice to Lily Cups from the beginning of the latter’s operations. No charges were made by the parent company for these services, and Lily Cups paid nothing for services received. Mr Page explained that Lily Tulip was doing very well in the United States and was desirous of seeing Lily Cups grow and therefore did not change its Canadian subsidiary for the invaluable technical assistance it continually acquired. In this manner, Lily Cups whose sales were $1,000 in 1941, has now attained a sales figure exceeding 20 million dollars a year.

However, because of changes in the United States Internal Revenue Code, American corporations were required to charge their foreign subsidiaries for all technical advice and services rendered. Counsel for the respondent admits that in 1967 the Internal Revenue Service of the United States proposed assessing Lily Tulip on income deemed to have been received from Lily Cups for technical services rendered to the appellant by Lily Tulip.

In 1967, after negotiations with the Department of Internal Revenue in an attempt to reach an agreement, it was proposed that, instead of charging the appellant a 5% royalty on all sales of all products sold by the appellant company, Lily Tulip would charge its Canadian subsidiary 2% on the first $500,000 of sales of one product, viz. “Gem Cup’’, and 1% on the balance. Effectively, Lily Tulip charged Lily Cups, for services rendered in 1967, an amount so calculated, which was paid by the appellant. The appellant then deducted that amount in calculating its income for the 1967 taxation year and the respondent allowed that deduction in full.

In 1968 the agreement between Lily Tulip and the United States Internal Revenue Department was accepted and implemented. Lily Tulip, on the agreed basis, charged the appellant company for services rendered in 1968, the deduction of which was also allowed in full by the respondent. However, Lily Tulip included in its invoice, which was received by the appellant in 1968, charges for services it had rendered to the appellant in 1965 and 1966, as well as the interest thereon. The cost for services rendered in 1965 and 1966, including the interest charges, as well as the cost for services received in 1968, were paid by the appellant in 1968 and claimed as deductions for the 1968 taxation year.

The respondent re-opened the 1966 taxation year and allowed the amount of service costs claimed by the appellant as a deduction for that year. The respondent, in reassessing the appellant’s 1968 tax returns, while allowing the deduction of the cost of services received in 1968, disallowed the expenses claimed by the appellant for services received from Lily Tulip in 1965, and he also disallowed the interest paid by the appellant in 1968 on charges relating to services received from its parent company in 1965 and 1966, all of which constitutes the subject matter of this appeal.

Although it was not mentioned in the respondent’s pleadings, and not referred to in argument by counsel for the respondent, counsel for the appellant pointed out that the appellant’s 1965 taxation year was statute-barred pursuant to subsection 46(4) of the Income Tax Act, RSC 1952, c 148, as amended, since more than four years had elapsed since the day of mailing of the Minister’s notice of the appellant’s original assessment. This fact, as I see it, is not material to the issue, since the 1965 taxation year is not under appeal. What the Board has before it is an appeal from an assessment in respect of the appellant’s 1968 taxation year, by which the Minister disallowed an amount of $70,700, plus interest of $8,547, and an additional amount of interest of $5,684, which the appellant paid to its parent company in 1968, but which amounts were all related to services received by the appellant from its parent company in 1965 and 1966 respectively.

The legal points which the Board has to consider, as I see them, are the following:

1. Were the amounts paid by the appellant in 1968, for services received in 1965 and 1966, incurred for the purpose of gaining or producing income within the meaning of paragraph 12(1)(a) of the old Income Tax Act?

2. If these expenses were incurred to produce income in prior years, can they be deducted in the 1968 taxation year?

3. Was the appellant under a legal obligation to pay the interest charges claimed, as deductions in 1968?

4. Would the deduction of the amounts in issue unduly or artificially reduce the appellant’s income within the meaning of subsection 137(1) of the Income Tax Act, RSC 1952, c 148, as amended?

In dealing with the first point, the respondent’s position is set out in Paragraph 7(e) of his Reply, which reads:

7. In assessing the Appellant for the 1968 taxation year, the Respondent acted on the following assumptions:

(e) the expenditure in the amount of $62,210 was not an outlay or expense for the purpose of gaining income since at the time the services were being performed, it was the intention of the parent company that they would be performed gratuitously* [1] in the sense that no steps were to be taken to seek or secure payment for the services which its servants or agents were rendering on behalf of the Appellant;

Counsel for the respondent pointed out in argument that we are faced here with a non-arm’s length situation which “colours the nature and effect of the transactions’’, and submits that, at the time the services were rendered in 1965 and 1966, it was the intention of the parent company to perform the services to the appellant gratuitously. The respondent then concludes that the amounts paid by the appellant in 1968 were not expenses incurred for the purpose of gaining or pro- ducing income in 1965 and 1966 since these services had already been rendered and used up by 1968, and he suggests that the payments, which are the subject of this appeal, were some form of an accommodation payment to the parent company, which do not come within the purview of paragraph 12(1)(a) of the Act.

The only evidence before the Board is that the parent company had not, in the past, charged the appellant for its services, but there is nothing on record which might indicate that the parent company had made a binding executive decision or contracted with the appellant company never to charge for its services.

Whether Lily Tulip chose to exercise it or not, and whether or not a non-arm’s length situation existed between the appellant and Lily Tulip, as suggested by the respondent, Lily Tulip had the right to charge for its services at any time, and, in my opinion, Lily Cups not only had the legal obligation to pay for the said services, but it had, as pointed out by counsel for the appellant, a very practical business motivation to pay for the services if it expected to continue increasing its production and its income.

In my view, there can be no question that the nature of the services rendered had a direct bearing on the income-producing capability of the appellant company. Moreover, since the services rendered were admitted to have been in the form of technical information, advice and supervision in respect of the appellant’s current production, the charges for these services were not, in my opinion, an outlay or replacement of capital, nor a payment on account of capital, but were an outlay or expenses incurred by the appellant company for the purpose of gaining or producing income from the appellant’s business within the meaning of paragraph 12(1)(a) of the Income Tax Act.

For the purposes of this appeal, I do not consider it necessary to follow counsel for the respondent’s reasoning in making the time distinction that may exist between an expense and an expenditure. It seems to me that the requirements of paragraph 12(1)(a) of the Act are met if the expenses are incurred for the purpose of gaining income from a business, regardless of the time period in which the expenses were paid, or the consideration received.

As pointed out by counsel for the appellant, it would be difficult indeed to have a clearer confirmation of this opinion than Mr Justice Hall’s statement in the decision of the Supreme Court of Canada in Premium Iron Ores Limited v MNR, [1966] CTC 391, 66 DTC 5280, where Mr Justice Hall states, at page 417 [5292]:

To limit the expenditure, if it is to qualify as a deductible, to the income of the particular year in which it was made requires writing into section 12(1)(a) of the Income Tax Act words which Parliament did not put there. The only qualification which Parliament imposed was that the outlay or expense be “made or incurred by the taxpayer for the purpose of gaining or producing income from the property or business of the taxpayer’’. No limitation as to time can be found in the section in question.

Having reached the conclusion that the amount of $70,700 charged to the appellant company, and paid by it in 1968 for services received in 1965, was incurred for the purpose of gaining and producing income, and was deductible from the appellant’s 1968 income pursuant to paragraph 12(1)(a) of the old Income Tax Act, the question as to whether the appellant was under the obligation to pay, in 1968, interest on charges made for services rendered in 1965 and 1966, arises. Counsel for the respondent suggested, if I understand him correctly, that even though the principal amounts were incurred for the purpose of gaining and producing income, that it is conceivable that the amounts of interest paid could be considered as a payment on account of capital.

It seems to me that the nature of the interest payments should normally follow the nature of the principal payments, and since I have concluded that the principal payments were on current account, it follows that the interest payments should also be considered as part of the appellant’s normal business activities and therefore deductible.

Dealing with the last point, as to whether the deduction of $70,700 paid for services, and the interest payments, would unduly or artificially reduce the appellant’s income, pursuant to subsection 137(1) of the Income Tax Act, there is nothing in the evidence that would lead one to believe that the amount so paid was other than amounts paid in the normal course of business and for the purpose of gaining or producing income. I fail to see how deductions of those amounts could artificially or unduly reduce the appellant’s income.

Counsel for the respondent stated in Paragraph 7(d) of his Reply to Notice of Appeal:

7. In assessing the Appellant for the 1968 taxation year, the Respondent acted on the following assumptions:

(d) the Appellant, recognizing that these charges were identified with and directly related to the business activities of its 1965 taxation year and that these charges are not attributable to economic events occurring subsequent to the date of the financial statements for such period, charged the expense in respect of its 1965 business activities to the retained earnings, with a corresponding credit to cash in its financial statements for the year ended December 31, 1968;

A considerable amount of rather loose discussion took place at the hearing on the accounting principle of matching income and expenses, and as to whether or not the accepted accounting practices are binding on the courts.

As I see it, the Board need not make a finding on those two points in the circumstances of this appeal, because the principal issue is whether the amounts claimed as deductible by the appellant were incurred for the purpose of gaining or producing income, and, in my Opinion, the conditions of paragraph 12(1)(a) of the Income Tax Act have been met. On the basis of Mr Justice Hall’s decision in the Premium Iron Ores Limited case, there being no limit as to time in paragraph 12(1)(a), it is, in my opinion, immaterial for the purposes of taxation how the appellant in this appeal chose to record the transactions in his books.

I conclude therefore that the amounts claimed by the appellant related to services received in 1965 and 1966, and the interest charges thereon, were business expenses incurred for the purpose of gaining or producing income; that these expenses were paid in 1968 and were deductible from the appellant’s income in that year; and that the deduction of these amounts does not unduly or artificially reduce the appellant’s income within the meaning of subsection 137(1) of the Income Tax Act.

For these reasons, the appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment accordingly.

Appeal allowed.