The Elias Rogers Company Limited v. Minister of National Revenue, [1972] CTC 233, 72 DTC 6199

Kerr, J:—This is an appeal against reassessments of income tax under the Income Tax Act on the appellant company for its 1966 and 1967 taxation years.

The company sells fuel oil to consumers and also sells and installs furnaces and heating equipment. It leases oil-fired water heaters to certain of its fuel oil customers and installs the heaters in the customers’ premises. During its 1966 and 1967 taxation years it made outlays of $14,450 and $27,200 respectively on account of various costs relating to installations of such leased heaters and in computing its income for those years deducted the said amounts. The respondent disallowed the deductions.

The company says that the amounts were current outlays or expenses made or incurred for the purpose of gaining or producing income for its business and accordingly were deductible. The respondent says that the amounts constituted an outlay or payment on account of capital within the meaning of paragraph 12(1)(b) of the Income Tax Act and accordingly were not deductible as expenses; and that they formed part of the capital cost to the company of property within the meaning of paragraph 11(1 )(a) of the Act in respect of which capital cost allowance may be claimed.

There is no dispute that the water heaters themselves are capital assets. The issue relates to the costs of their installation.

Four witnesses were called on behalf of the company, namely, Mr Leo J Hanley, vice-president of the company and manager of Fuel Oil Sales of Texaco Canada, of which the appellant company is a subsidiary; Mr Calvin Wattie, general manager of sales of Texaco Canada: Mr H David Spielman, general manager of the Oil Heating Association of Canada; and Mr David Tarr, a chartered accountant with Arthur Andersen & Company, the auditors of Texaco Canada and its subsidiaries.

Mr Hanley and Mr Wattie testified to the effect that the appellant company operates in the Toronto area, its business being wholesale and retail distribution of fuel oil and heating equipment. It sells fuel oil to householders, commercial users and jobbers; and also sells furnaces and heating equipment and installs them, and leases and installs the water heaters whose installation costs are here in issue. It has a fleet of trucks and a service department. In the 1960’s the company found itself faced with severe competition from natural gas and among plans conceived by it to retard the encroachments of such gas was a plan to lease water heaters to householders. The heaters are for domestic use and consist of a hot water tank and a heating unit powered by fuel oil instead of by gas or electricity. An initial plan involved sale, rather than rental, of the heaters, but it was not successful and leasing was resorted to. The intention was to retain the company’s customers, increase the number of its residential accounts, and sell about 300 additional gallons of fuel oil yearly to each customer having a leased heater. A brochure, Exhibit A-2, picturing the heater and setting forth its advantages vis-a-vis gas or electric water heaters, was published.

The number of heaters installed in 1966 and 1967 was 175 and 268, respectively, of which 101 and 197 still remained as at December 31, 1971, as shown in Exhibit A-8. In 1969 and 1970 the company had 578 and 693 accounts with water heaters, as compared with 40,412 and 39,334 without heaters, and the cancellations of accounts with heaters were 1.7% and 2.2%, as compared with 6.49% and 6.28% for accounts without heaters, as shown in Exhibit A-1. I gathered from the testimony of the company’s officers that they considered that the program helped to keep the company in business and that the revenue derived was worth the effort, although looked at by itself the leasing of the heaters was not profitable.

Exhibit A-5 shows a typical heater installation, which involves, inter alia, plumbing, electrical work, venting of a flue pipe, and connecting the heater to the oil tank. The average installation costs per heater were $85 in 1966, and $100 in 1967. Details are shown in Exhibits A-6 and A-7. The costs were borne by the company, not charged to the customer. The costs to the company of a water heater, with its controls, not installed, was $197. The selling price of fuel oil in 1966-67 was about 20 cents per gallon. The expected additional 300 gallons sold to a customer using a water heater would yield about $60 gross to the company. There was also a monthly rental charge for some or all of the term as set forth next. When heaters are removed they go through reconditioning processes and some are used again. The costs of removal are written off.* [1] When heaters are removed, some of the installed parts, including the flue pipe and water line, are left in the premises, as the cost of their removal and transportation would exceed their value to the company.

Exhibits A-3 and A-4 are typical lease agreements for the company’s water heaters. The lease is for a minimum term of two years, thereafter from year to year terminable by prior written notice of two months. In cases where the customer moved from the premises or otherwise terminated the lease, the company did not in fact collect any penalty and it absorbed the installation expenses. The rent, payable monthly, is $2.50, plus provincial sales tax. In the A-3 lease, which was the form used in 1966, there was a provision that no rental charge was payable during the first six months. The company retains ownership of the heater and maintains it while leased. The customer agrees to purchase exclusively from the company during the term of the lease all furnace fuel oil required to heat the residence and to operate the heater. There is a separate fuel oil contract, such as Exhibit A-9.

As I recall the evidence, the average length of time during which fuel oil customers were holding their oil contracts with the company in the 1960’s was about 6.8 years, and the average for those having water heaters was somewhat longer; and the heaters had a useful life of about eight years.

The company’s officers, Mr Hanley and Mr Wattie, said that the installations costs were charged to current expenditures. They were considered to be expenses incurred in the company’s efforts to meet and attack the competition from natural gas and to promote sales of fuel oil, and the company felt that it was proper to charge them to current account in the same way as advertising expenses would be so charged. Mr Tarr, the auditor, also treated the costs as promotional expenses, based on considerations that there was uncertainty as to how long the customer would retain the heater and purchase the necessary fuel for its operation and uncertainty as to whether the expenses of installation would be recovered, for the expenses were sunk and would be lost if the contract were not continued for a sufficient period; the company gambled that it would retain the customer. long enough to cover the expenses; and the expenses were related to the company’s promotional program to retain customers, combat the competition of natural gas and increase the number of its fuel oil accounts and sale of oil. Mr Tarr agreed, as I understood his testimony, that the installation expenses were incurred with the hope of earning revenue over a period of years, that the heaters themselves were fixed capital assets, and that their installation in the customer’s premises was a condition precedent to their use and capacity to earn income; but he considered that in the case of the appellant it was right to charge the installation costs as current expenses in the year in which they were incurred, and inappropriate to charge them to capital, and this was the view of his firm, Arthur Andersen & Company. He agreed with a statement on page 431 of Principles of Accounting, 4th edition, 1951, by Finney and Miller, that “the cost of machinery includes the purchase price, freight, duty and installation costs”, but he seemed not to regard the heaters as being “machinery”.

Mr Spielman, general manager of the Oil Heating Association of Canada, spoke of the competition between natural gas, electricity and fuel oil, and to competition between members within the industry. He said that all major oil companies have programs for supplying water heaters to their customers, and that the majority of such companies, more than 70% of them, charge the installation expenses to current account, while some charge them to capital account.

In argument counsel for the appellant made a general submission that the answer to the question whether an outlay is a capital or business expenditure has to be derived from many aspects of a whole set of circumstances and a common sense appreciation of all the guiding

features* [2] and that it depends on.:_;what the expenditure is calculated to effect from a practical and business point of view rather than the juristic classification of the legal rights, if any, secured, employed or exhausted in the process;t [3] that from a “common sense” appreciation of the facts in this case the expenditures on account of installation of the heaters were part of the total costs relating to the marketing of fuel oil and “from a practical and business point of view” these costs were incurred to create (a) an increase in the volume of fuel oil sold by the appellant and (b) protection against a reduction of its business caused by a loss of a portion of the heating market to competitors, and as such the installation costs were “an expenditure in the process of operation of a profit-making entity” and properly deductible as expenses in the year in which they were incurred.^: [4]

As to the facts in the present case counsel submitted that the appellant’s business was selling fuel oil; due to competition from natural gas its sales were suffering and it conceived a program initially of selling and later of leasing water heaters to increase its volume of oil sales and to retain its customers; the rental program was profitable not per se but only when considered with the result of the increased volume of oil sales; the duration of the term of leases was uncertain: the recovery of the installation costs was also uncertain and they were not in fact recovered in the cases of early cancellations; the costs were promotional, like advertising costs; the company knows best how to run its business, and its officers and auditors thought it proper to charge the installation costs to current account rather than to capital in the face of drastic and continuing competition and a constant need to compete and to promote sales of fuel oil; the company was forced by circumstances to engage in the leasing program in order to hold customers and stay in business; the great majority of other fuel oil companies treat similar installation costs as current expenses in their business practice; and the appellant’s auditor and Arthur Andersen & Company thought that it was in accordance with generally accepted business and accounting principles to charge the costs to current expenses rather than to capital account.

Counsel for the respondent contended that the installation costs were outlays on account of capital. He submitted that the heaters can earn income only after they are installed, that the cost of readying a fixed capital asset for use has been generally held to be on capital account, and that in the present case the installation costs were part of the cost of providing fixed capital assets for the purpose of earning income over a period of years, the intention being to retain customers as long as possible; the appellant is seeking to offset the costs against rental revenue and profits from additional fuel oil sales in years subsequent to the year in which the heaters were installed; the heaters were expected to stay in place on the average for a number of years and had a useful life expectancy of some years, which is not controverted by the fact that a relatively small percentage were removed within two years (8.6% of those installed in 1966 and 4.9% of those installed in 1967 as per Exhibit A-8); the installed heater is a new income earning capital asset that earns income as from its installation, and it is different from a crated heater that has no capacity in that condition to earn income; installation and its costs are not recurrent each year in the case of the individual customer: installation of a fixed asset is what results from the outlay, it is intended to be and normally is of enduring benefit over a period of years; the principal, immediate and direct result is rental revenue and additional oil sales, plus perhaps some goodwill, and any promotional element is secondary; the rental revenue and profit from additional oil sales appear to be sufficiently large to lead to an inference that the leasing of heaters is not per se unprofitable; also that the practice of the appellant and of numerous others, but not all, oil companies of charging heater installation costs to current account is not conclusive as to the propriety of so doing, the appellant did not cite any accounting book as authority for that practice, and the company’s auditor agreed that in the case of the appellant the crux was the uncertainty as to the outcome of the expenditures in view of the uncertainty as to how long heaters would be retained by customers.

Counsel for the respondent cited the following cases: BC Electric Railway Co Ltd v MNR, [1958] SCR 133; [1958] CTC 21: 58 DTC 1022: Thomson Construction (Chemong) Ltd v MNR, [1957] Ex CR 97 at 104- 06; [1957] CTC 155; 57 DTC 1114; Law Shipping Company Ltd v CIR, 12 TC 621; Glenco Investments Corporation v MNR, [1968] Ex CR 98; [1967] CTC 243; 67 DTC 5169; MNR v Lumor Interests Ltd, [1960] Ex CR 161; [1959] CTC 520; 60 DTC 1001; MNR v Vancouver Tugboat Company Limited, [1957] Ex CR 160; [1957] CTC 178: 57 DTC 1126; MNR v Haddon Hall Realty Inc, [1962] SCR 109; [1961] CTC 509; 62 DTC 1001; CIR v Granite City Steamship Company Ltd (1927), 13 TC 1; Sherritt Gordon Mines Limited v MNR, [1968] Ex CR 459; [1968] CTC 262; 68 DTC 5180; British Insulated and Helsby Cables Limited v Atherton, [1926] AC 205; Vallambrosa Rubber Company Ltd v Farmer, 5 TC 529; Montship Lines Limited v MNR, [1954] Ex CR 376; [1954] CTC 295; 54 DTC 1151; Regent Oil Company Ltd v Strick, [1965] 3 WLR 636.

Paragraphs 11(1)(a) and 12(1)(a) and (b) of the Income Tax Act in the taxation years concerned read as follows:

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation;

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,

It is sometimes difficult to determine whether an outlay can be set against income or must be regarded as a capital outlay. Several criteria have been used in the cases cited in argument. In the Regent Oil Co v Strick case (supra) Lord Reid said at pages 645-46:

Whether a particular outlay by a trader can be set against income or must be regarded as a capital outlay has proved to be a difficult question.

One must, I think, always keep in mind the essential nature of the question. The Income Tax Act requires the balance of profits and gains to be found. So a profit and loss account must be prepared setting on one side income receipts and on the other expenses properly chargeable against them. In so far as the Act prohibits a particular kind of deduction it must receive effect. But beyond that no one has to my knowledge questioned the opinion of Lord President Clyde in Whimster & Co v Inland Revenue Commissioners, [1926] SC 20; 12 TC 813, where, after stating that profit is the difference between receipts and expenditure, he said: ‘the account of profit and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting so far as applicable .. .” So it is not surprising that no one test or principle or rule of thumb is paramount. The question is ultimately a question of law for the court, but it is a question which must be answered in light of all the circumstances which it is reasonable to take into account, and the weight which must be given to a particular circumstance in a particular case must depend rather on common sense than on a strict application of any single legal principle.

In the Bowater Power Company v MNR case (supra) Noël, ACJ of this Court said at pages 836-37, 838 [ 5480, 5481 I:

The law with regard to the deduction of what might be called border-line expenses or “nothings” has moved considerably ahead in the last few years, as can be seen from the above decisions. The Chief Justice of the Supreme Court, in dismissing the appeal from the decision of the President in MNR v. Algoma Central Railway (supra) at page 162, referred with approval to the following statement of Lord Pearce in BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia, [1966] AC 224, at page 264:

“The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the. whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation. of all the guiding features which must provide the ultimate answer/’

The solution, therefore, “depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process” (Hallstroms Pty Ltd v Federal Commissioner of Taxation, 8 ATD 190 at 196). The question of deductibility of the expenses must therefore be considered from the standpoint of the company, or its operations, as a practical matter.

In distinguishing between a capital payment and a payment on current account, regard must always be had to the business and commercial realities of the matter.

The heaters, when installed, are fixed capital assets. Thereafter, but not before, they are revenue earning assets. The expenses of installing them are preliminary and necessary to the revenue earning use of the heaters and the expenses are incurred in order to bring them into such use. I think that if the appellant had purchased from some sup- lier heaters which at the time of purchase were installed and ready to be used, the capital cost of the heaters to the appellant as so installed would be the price paid to the supplier, including installation charges. If that be so, why should the installation expenses be classified differently when the appellant installs the heaters? The respondent takes the position that the installation expenses are part of the capital cost to the appellant of the heaters, as and when installed, in respect of which capital cost allowances may be claimed.

The lease agreement for the heaters provides for a minimum term of two years and thereafter from year to year, terminable at the expiry of the two-year term or of any subsequent year by prior written notice of two months. There is always the possibility that a customer may terminate the lease at any time, and some have done so within the two years, but heaters are installed in the expectation on the company’s part that by and large the heaters will be retained for a period of years, and the company’s experience is that the majority of the leases continue for at least several years and that the heaters have an average useful revenue earning life of upwards of eight years. The installation expenditures are made once and for all with a view to bringing into use a Capital asset for the enduring benefit of the company’s business, at least in the sense that the objective of the company when it enters into a lease of a heater is that the benefit will endure for some years and that the heater will earn revenue throughout that period. The company would hardly be in the business of leasing heaters without having that objective, having regard to the cost of the heater plus the cost of installation vis-a-vis the resulting net revenue. The outlay for installation is an initial expenditure, substantial relative to the cost of the heater itself, and while the expense recurs when a heater reaches the end of its useful life and has to be replaced, or when a lease is cancelled and the heater is removed and installed elsewhere, I do not think that the expenditure involved can be classed as made to meet a continuous demand or as a recurrent expenditure that may be deducted as a current expense from the income of the year in which the outlay is made. The heaters meet, it is true, a continuous demand for fuel oil and they serve the general purposes and general interests of the company’s business, but so do storage tanks and other fixed assets of the company that unquestionably are capital assets.

As to the practice of the major oil companies in their treatment of the expenses of installing water heaters, there is not unanimity among them. The majority charge the expenses to current account, while some charge them to capital. The appellant is among those who choose to charge them to income of the year of the installation. They may find it more convenient to charge the expenses once and for all in the year in which they are incurred, rather than to add them to the price paid for the heaters and claim capital cost allowances on the total cost of the installed capital asset. The appellant company’s auditor supported that treatment, based mainly on the uncertainty as to how long customers would retain the heaters, and on uncertainty as to whether the installation expenses would be recovered, because customers might cancel their contract before the expenses are recovered. The practice of the oil companies, differing as it does between the companies, is a consideration to be taken into account, but I do not think that the practice followed by the majority of them is a paramount factor. I also think that the uncertainty above referred to is hardly a valid basis upon which to found a decision as to the category in which the expenses naturally fall.

The auditor also regarded the expenses as promotional expenses incurred to increase sales of fuel oil and to meet the competition of natural gas. I am satisfied that the expenses were incurred with the objective of increasing oil sales and meeting competition. But ! find it difficult to put them in a promotional category or to treat them, as advertising expenses are treated, as current expenses deductible in the year in which they were expended. To me, they have little resemblance to promotional or advertising expenses.

As previously indicated, Finney and Millar’s Principles of Accounting, chapter 19 deals with “Tangible Fixed Assets” and states at page 431:

The cost of machinery includes the purchase price, freight, duty, and installation costs. If machinery has to be operated for a time for the purpose of breaking it in and testing it, the costs of such necessary preliminary operation may be capitalized.

The appellant’s auditor did not dispute that the statement was correct in respect of machinery, but he was unwilling to agree that it applied to the oil heaters here concerned. I do not think that I should treat it as applying to the heaters, even although they are tangible fixed assets, as it is possible that the authors would not have treated heaters the same as they treated machinery.

On my appreciation of the facts and the guiding features, which I hope is a commonsense appreciation made with proper regard for the business and commercial realities of the matter, I find that the expenses of $14,450 and $27,200 incurred by the appellant during its 1966 and 1967 taxation years on account of various costs relating to the installation of water heaters constituted an outlay or payment on account of capital within the meaning of paragraph 12(1)(b) of the Income Tax Act and, accordingly, were not deductible from income. The appeal will, therefore, be dismissed. The respondent is entitled to his costs.