Dominion Magnesium Limited v. Minister of National Revenue, [1972] CTC 2148, 72 DTC 1138

W O Davis:—These are appeals from assessments to income tax in respect of the taxpayer’s 1962 and 1963 taxation years. In view of the fact that the same problem called for consideration in both years and that much of the evidence was applicable to both years, the two appeals were, with the consent of counsel, heard together at Toronto, Ontario, on March 12 and 13, 1969, at a sittings of the Tax Appeal Board as it was then constituted.

The question involved in these appeals is whether expenditures which the appellant made for scientific research in the years 1962 and 1963 must be deducted in determining the profit of the taxpayer in each of those years from all the “resources” operated by it as defined in Income Tax Regulation 1201. It is the appellant’s position herein that it is not required to deduct such expenditures in determining its base for computing the depletion to which it is entitled.

In his reply to the appellant’s 1962 Notice of Appeal the respondent, the Minister of National Revenue, has agreed with the allegations of fact as set out in the Notice of Appeal as follows:

A. The taxpayer was incorporated under The Corporations Act (Ontario) and has its head office in the City of Toronto. The principal business of the taxpayer is the mining and processing of dolomite ore to produce magnesium and is carried on at its mine and processing plant at Haley Station, Ontario.

B. The taxpayer filed with the District Taxation Office of the Department of National Revenue a corporation income tax return, Form T2, as required under the Income Tax Act, in respect of its fiscal year ending December 31, 1962.

C. In the assessment, the Minister allowed a deduction from income of $9,813.00 under the provisions of section 11(1)(b) of the Income Tax Act and paragraph (2) of Regulation 1201 of the Income Tax Regulations as an allowance (herein referred to as the “depletion allowance”) to a person who operates a resource.

D. In determining the amount of the said depletion allowance for 1962 the amounts deducted in computing the taxpayer’s profits for the taxation year reasonably attributable to the production of prime metal from the mine operated by the taxpayer included,

(i) the amount of $101,044.00, being the amount expended by the taxpayer in the year on scientific research relating to its mining activities and claimed by the taxpayer as a deduction in computing income under section 72 of the Income Tax Act and

(ii) the amount of $8,250, being that portion of the total deduction of $9,176 claimed by the taxpayer as a deduction in computing income under section 72A of the Income Tax Act that the expenditures incurred by the taxpayer on scientific research relating to its mining activities bore to the total expenditures incurred by the taxpayer in the year on scientific research.

E. If the amounts of $101,044 and $8,250 had not been deducted in computing the taxpayer’s profits for the taxation year reasonably attributable to the production of prime metal from the mine operated by the taxpayer, the depletion allowance to which the taxpayer would be entitled would be increased from $9,813 to $46,244 with the result that the taxpayer’s taxable income for the year would be $13,047 rather than $49,478.

Similarly, in his reply to the appellant’s 1963 Notice of Appeal the respondent agreed with the allegations of fact as set out in the Notice of Appeal as follows:

A. (same as for 1962)

B. (same as for 1962)

C. In the assessment, the Minister failed to allow a deduction under the provisions of section 11(1)(b) of the Income Tax Act and paragraph (2) of Regulation 1201 of the Income Tax Regulations as an allowance (herein referred to as the ‘‘depletion allowance’’) to a person who operates a resource.

D. The taxpayer calculates that the deduction which it is allowed under Regulation 1201 is 33-1/3% of $105,333 or $35,111. In computing the amount of $105,333, the taxpayer has made no deduction in respect of $123,930 and $14,949 deducted by it under sections 72 and 72A respectively of the Income Tax Act in computing its income for the year.

E. The taxpayer assumes that the Minister, in computing the profits of the taxpayer reasonably attributable to the production of prime metal, has deducted all or a portion of the amounts claimed by the taxpayer as deductions from income under sections 72 and 72A of the Income Tax Act with the result that, in his view, the taxpayer was not entitled to a deduction for depletion loss.

In his reply to the notice of appeal in respect of the 1962 taxation year the Minister says that in assessing the appellant as he did he acted on the following assumptions of fact:

(a) At all times material to this appeal the appellant carried on the business of producing magnesium through mining and processing dolomite ore and processing other metals and substances;

(b) In order to maintain its competitive position in the market as a producer of magnesium the appellant was compelled constantly to find new or improved methods of producing or extracting magnesium from dolomite ore;

(c) In order to carry into effect its plans of finding such improved production methods, the appellant employed part of its staff for the purpose of carrying out research designed to attain the said object;

(d) In the 1962 taxation year the appellant expended a total amount of $101,044 on the said research with respect to the production and processing of magnesium;

(e) The said amount of $101,044 consisted entirely of expenditures of a current nature, and did not include any expenditures of a capital nature, and was composed of such items as labour expenses, materials expenses, chemical analysis, labour and materials expenses, fixed overhead labour expenses and research overhead labour expenses and consultant’s fees and expenses, as is more particularly set out and described in Schedule A hereunto annexed and forming part of the Respondent’s reply to the appellant’s Notice of Appeal;

(f) In filing its income tax return for the 1962 taxation year and in computing its income for the said year, the appellant claimed the total amount of $112,- 384.49 as a deduction in respect of scientific research expenses pursuant to the provisions of section 72(1)(a) of the Income Tax Act, of which amount the said amount of $101,044 pertained to the said research with respect to the production and processing of magnesium, and claimed the additional amount of $9,176 as a deduction in respect of scientific research expenses pursuant to the provisions of section 72A of the Income Tax Act, of which amount the amount of $8,250 pertained to the said research with respect to the production and: processing of magnesium, and the respondent allowed all of the said amounts as deductions for the purpose of computing the appellant’s income for the said years;

(g) In computing its aggregate profits for the 1962 taxation year reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating its depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, the appellant deducted only the aforesaid amount of $101,044.00;

(h) In assessing the appellant for the 1962 taxation year the respondent also deducted the amount of $8,250 in computing the appellant’s aggregate profit reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating its depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, and computed the said aggregate profits at $29,439 and the said depletion allowance at $9,813.00;

(i) By filing its notice of objection, dated June 16th, 1966, for the 1962 taxation year, the appellant claimed that both the said amounts of $101,044 and $8,250 ought not to be deducted in computing the appellant’s aggregate profits reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the appellant’s resources operated by it for the purpose of calculating its depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, thus computing the said aggregate profits at $138,733 and the said depletion allowance at $46,244.00;

(j) By notification by the Minister under section 58 of the Income Tax Act, dated October 25th, 1967, the Minister confirmed the said assessment objected to as having properly been made in accordance with the provisions of the Income Tax Act.

The Minister submits that he was in error in deducting the said amount of $8,250 in computing the appellant’s aggregate profits reasonably attributable to the appellant’s operation of its “Resource” for the purpose of calculating its depletion allowances within the meaning of section 1201 of the Income Tax Regulations; but the respondent submits that in making the aforesaid calculations he has properly deducted the aforesaid amount of $101,044 because it was an outlay or expense which was made or incurred by the appellant for the purpose of gaining or producing income from the appellant’s business and was thus properly deductible for the purpose of computing the appellant’s income or profits from its business, within the meaning of sections 3 and 4 and paragraph 12(1)(a) of the Income Tax Act and its deductibility did not depend upon paragraph 11(1 )(j) and section 72 of the Act.

The respondent therefore asks that the appeal with respect to the 1962 taxation year be allowed in part in order to delete the said amount of $8,250 as a deduction in computing the appellant’s profits from its business for the purpose of calculating its depletion allowances within the meaning of section 1201 of the Income Tax Regulations, but that the appeal be dismissed in all other respects, that is, in respect of the deduction of $101,044.

In his reply to the notice of appeal in respect of the 1963 taxation year, the Minister says he acted on the following assumptions of fact:

(a), (b) and (c) (Same as for 1962)

(d) In the 1963 taxation year the appellant expended a total amount of $115,611 on the said research with respect to the production and processing of magnesium;

(e) The said amount of $115,611 consisted entirely of expenditures of a current nature, and did not include any expenditures of a capital nature, and was composed of such items as labour expenses, materials expenses, chemical analysis, labour and materials expenses, fixed overhead labour expenses and research overhead labour expenses and consultant’s fees and expenses, as is more particularly set out and described in Schedule A hereunto annexed and forming part of the respondent’s reply to the appellant’s notice of appeal;

(f) In filing its income tax return for the 1963 taxation year and in computing its income for the said year, the appellant claimed the total amount of $123,929.65 as a deduction in respect of scientific research expenses pursuant to the provisions of section 72(1 )(a) of the Income Tax Act, of which amount the said amount of $115,611 pertained to the said research with respect to the production and processing of magnesium, and claimed the additional amount of $14,949 as a deduction in respect of scientific research expenses pursuant to the provisions of section 72A of the Income Tax Act, of which amount the amount of $13,946 pertained to the said research with respect to the production and processing of magnesium, and the respondent allowed all of the said amounts as deductions for the purpose of computing the appellant’s income for the year;

(g) In computing its aggregate profits for the 1963 taxation year reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating its depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, the appellant did not deduct any amount on account of the aforesaid expenditures on research;

(h) In assessing the appellant for the 1963 taxation year, the respondent deducted the said amounts of $115,611 and $13,946 in computing the appellant’s aggregate profits reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating its depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, which resulted, instead of aggregate profits, in an aggregate loss in the amount of $24,224, so that the appellant was not entitled to any depletion allowance for its 1963 taxation year;

(i) By filing its notice of objection, dated June 16th, 1966, for the 1963 taxation year, the appellant claimed that the said amounts of $115,611 and $13,946 ought not be deducted in computing the appellant’s aggregate profits reasonably attributable to the production of oil, gas, prime meta! or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating depletion allowances, within the meaning of section 1201 of the Regulations made under the Income Tax Act, thus computing the said aggregate profits at $105,333 and the said depletion allowance at $35,111;

(j) By notification by the Minister under section 58 of the Income Tax Act, dated October 25th, 1967, the Minister confirmed the said assessment objected to as having properly been made in accordance with the provisions of the Income Tax Act, and in particular on the grounds that the amounts of $106,419 and $12,836 claimed by the appellant as deductions in respect of scientific research expenditures have been properly deducted from the appellant’s profits for the taxation year reasonably attributable to the production of prime metal, when calculating the taxpayer’s depletion allowance for the year, but the respondent now states that the said amounts mentioned in the said notification by the Minister were in error and should have been $115,611 and $13,946 respectively.

The Minister submits in his reply that he was in error in deducting the said amount of $12,836 (or, as stated in paragraph 3(j) hereof, the amount of $13,946) in computing the appellant’s aggregate profits reasonably attributable to the production of prime metal or industrial minerals, from all of the appellant’s resources operated by it for the purpose of calculating its depletion allowance within the meaning of section 1201 of the Regulations made under the Income Tax Act, but the respondent submits that, in making the aforesaid calculations, he has properly deducted the aforesaid amount of $115,611 because it was an outlay or expense which was made or incurred by the appellant for the purpose of gaining or producing income from the appellant’s business and was thus properly deductible for the purpose of computing the appellant’s income or profits from its business within the meaning of sections 3 and 4 and paragraph 12(1 )(a) of the Income Tax Act, and its deductibility did not depend on paragraph 11(1)(j) and section 72 of the Income Tax Act.

The respondent therefore prayed that the appellant’s appeal be dismissed as the deduction of the said amount of $115,611, rather than the deduction of that amount as well as the said amount of $13,946, when computing the appellant’s aggregate profits reasonably attributable to the production of prime metal or industrial minerals for the purpose of calculating its depletion allowances within the meaning of section 1201 of the Regulations made under the Income Tax Act, would still result in an aggregate loss in the amount of $10,278, rather than in aggregate profits, with the result that the appellant would still not be entitled to any depletion allowance for its 1963 taxation year.

The prime question presenting itself herein is with regard to how the depletion allowance, if any, to which the appellant is entitled is to be calculated.

The problem to be considered herein has its origin in paragraph 11 (1)(b) of the Act, which is 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:

(b) such amount as an allowance in respect of an oil or gas well, mine

or timber limit, if any, as is allowed to the taxpayer by regulation;

The regulation referred to is section 1201 of the Income Tax Regulations made under the Act, the relevant parts of which are as follows:

1201. (1) For the purpose of this Part,

(a) “resource” means

(iii) a base or precious metal mine, . . .

(2) Where a taxpayer operates one or more resources, the deduction allowed is 33 1/3% of

(a) the aggregate of his profits for the taxation year reasonably attributable to the production of oil, gas, prime metal or industrial minerals from all of the resources operated by him,

minus

(b) the aggregate amount of the deduction provided by subsection (4).

(4) For the purposes of subsections (2) and (3), there shall be deducted from the aggregate of the profits of a taxpayer for a taxation year reasonably attributable to the production of . .. prime metal or industrial minerals from all of the resources operated by him, the aggregate of —

[then follows a number of deductions, none of which is of application herein].

Thus the depletion allowance to which the appellant is entitled under subsection 1201(2) of the Regulations is 33 1/3% of its profits, minus certain deductions, which, in the present circumstances, must be established.

The starting point therefore for the calculation of the depletion allowance is the determination of the profits of the taxpayer. The greater its profits for the year, the greater its depletion and, because the depletion allowance is an allowance against income, the less its taxes will be.

The next question in these appeals is whether expenditures which the appellant made for scientific research in 1962 and 1963 must be deducted in determining the profits of the taxpayer for each of those years. It is the appellant’s position in these matters that it is not required to deduct expenditures which it made on scientific research in determining its base for depletion allowance. The Minister has taken the position that the taxpayer is required to deduct the expenditures on scientific research in establishing its base for the calculation of any depletion allowance.

The matter of scientific research is dealt with in paragraph 11 (1)(j) of the Act 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:

(j) such amount in respect of expenditures on scientific research as is permitted by section 72 or by section 72A;

In order to determine what research expenditures are permitted in computing the income of a taxpayer, it is necessary to refer, first, to section 72 of the Act, the relevant parts of which read:

72. (1) There may be deducted in computing the income for a taxation year of a taxpayer who carried on business in Canada and made expenditures in respect of scientific research in the year

(a) all expenditures of a current nature made in Canada in the year [then follow 5 classes which are not relevant]

(b) such amount as may be claimed by the taxpayer not exceeding the lesser of

(i) the expenditures of a capital nature made in Canada (by acquiring property other than land) in the year and any previous year ending after 1958 on scientific research relating to the business and directly undertaken by or on behalf of the taxpayer, or

(ii) the undepreciated capital cost to the taxpayer of the property so acquired as of the end of the taxation year (before making any deduction under this paragraph in computing the income of the taxpayer for the taxation year).

section 72A of the Act deals with additional deductions for scientific research as follows:

72A. (1) In addition to the deductions allowed for the year by section 72, a corporation, other than a corporation referred to in subsection (2) that carried on business in Canada and made expenditures in respect of scientific research in a taxation year, may deduct in computing its income for the year 50% of the amount by which . . .

The effect of this provision would appear to be that if, in a subsequent year, a taxpayer were to exceed the expenditures of the previous or base year he or it would be entitled to an additional 50% deduction. This provision would presumably have the effect of en- couraging taxpayers to increase their expenditures on scientific research.

In the assessments under appeal the Minister deducted, in determining the profits of the appellant, not only the amount of scientific research expenditures which fall within section 72, but also the amount which is deductible under section 72A. In paragraph 5 of the Minister’s reply for the 1962 taxation year he abandoned the deduction made in respect of section 72A and said:

The respondent submits that he was in error in deducting the said amount of $8,250 in computing the appellant’s aggregate profits reasonably attributable to the production of . . . prime metal or industrial minerals from all of the appellant’s resources operated by it, for the purpose of calculating its depletion allowances within the meaning of section 1201 of the Regulations made under the Income Tax Act. . .

The effect of this admission by the Minister is that in his assessment he should not have made any deduction (of $8,250) in respect of the incentive allowance provided for in section 72A of the Act. The same admission is made with respect to the appeal for the 1963 taxation year where the amount in question was referred to in error in his notification under section 58 of the Act as being $12,836 in place of the correct amount of $13,946.

Therefore, in any event the two appeals will be allowed in part and referred back to the Minister for reassessment by adding back to the base for determining depletion the amount of $8,250 deducted in respect of the 1962 year and the amount of $13,946 deducted in respect of the 1963 year.

With the above adjustment made, the issue narrows down to a consideration of scientific research expenditures falling within section 72, the question being whether these amounts are deductible in computing income. It is to be borne in mind that that section employs the words “There may be deducted” and the question remains as to whether such expenses must be deducted in computing profits.

The key word in section 72 is income whereas in subsection 1201(2) of the Regulations the key word is profits.

The appellant has taken the position that the scientific research expenditures with which this matter is concerned are of a capital nature and that capital expenditures are not deductions in the process of arriving at the profits of a business and, since subsection (4) of section 1201 of the Regulations does not require the deduction of such expenses in arriving at the profits of a business, the scientific expenses concerned herein need not be deducted in arriving at the base for depletion. This in substance appears to be the real issue in this matter as would appear from the Minister’s reply to the 1962 appeal wherein, after admitting error in the deduction of $8,250 already dealt with, he said:

but the Respondent submits that in making the aforesaid calculations he has properly deducted the aforesaid amount of $101,044 because it was an outlay or expense which was made or incurred by the appellant for the purpose of gaining or producing income from the appellant’s business and was thus properly deductible for the purpose of computing the appellant’s income or profits from the business, within the meaning of sections 3, 4 and 12(1)(a) of the Income Tax Act, and did not depend for its deductibility on sections 11(1)(j) and 72 of the Income Tax Act.

The Minister’s position was similarly defined in his reply to the 1963 appeal, the amount in question being referred to as $115,611.

Paragraph 12(1)(a), which is one of the sections relied on by the Minister, is a well-known provision of the Act but it may be useful to set it out once again, viz:

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.

Harold Beverly Clearihue, the secretary-treasurer of the appellant company and a chartered accountant by profession, was heard in evidence. Mr Clearihue’s association with the appellant began in 1941. He explained the composition of a schedule attached to the appellant’s income tax return for its fiscal year 1962 headed: ‘‘Calculation for Depletion December 31, 1962”. In this schedule under the heading of “Magnesium” there had been segregated in one column the sales and cost of producing the prime metal magnesium, which is sold in ingot or billet form; under another column headed “Others” were listed other operations of the company which are not subject to depletion allowance, such as manufacturing operations including the conversion of billets into rods and angles. In addition there was also included under the heading of “Others” the production of calcium, titanium, thorium, strontium and barium which are made from materials not mined in the appellant’s mine but purchased by the appellant from outside sources and therefore not subject to depletion. Having thus established the amount of the mining sales, deductions were then made of the cost of producing prime magnesium metal, such as selling and advertising, administration, research, depreciation, patent expenses, directors’ fees, and pension fund contributions.

On this basis of computation, for its 1962 year the company showed a profit of $172,928 on its magnesium operations and for 1963 a profit of $329,181.

The deduction under the heading “Research Expenses” for the year 1962 amounted to $101,044. Mr Clearihue said that, of a total amount of $112,384 spent on research in that year, $101,044 had to do with research on magnesium.

For the year 1963 no deduction was made by the appellant for research expenses related to the production of prime metal, but the amount of $123,930 was claimed as a deduction against “other” operations. The schedule setting out the calculation of depletion for the year 1963 was made some time after the filing of the 1963 return.

lt was made to appear by counsel for the appellant that, in calculating its depletion allowance for the 1962 year, the appellant deducted the said amount of $101,044, and, in assessing, the Minister did the same. The appellant is now taking the position in this appeal that the item of $101,044 should not have been deducted as an expense in the process of establishing its profits for the year and in the calculation of the depletion to which it was entitled under section 72 of the Act.

The appellant supported this position by saying that the issue here is not whether the appellant was right or wrong in making out its tax returns, but rather whether the assessments are right or wrong. Cat- tanach, J, put the situation as follows in Quemont Mining Corporation Ltd et al v MNR, [1967] 2 Ex CR 169 at 200; [1966] CTC 570 at 602:

. . . The issue is not whether Quemont prepared its return correctly but rather whether the Minister assessed the taxpayer in accordance with the Income Tax Act, and the Regulations thereunder as it is his duty to do.

For the purpose of clarity Mr Findlay, counsel for the appellant, referred to a schedule “A” attached to the Minister’s reply in respect of the 1962 appeal, showing total expenditures of $93,255.95 on Research and Development on Magnesium plus a consultant’s fee of $7,788.06 making an overall total of $101,044.01. These figures in Schedule “A”, Mr Clearihue said, were taken from a much more extended schedule which included research on metals other than magnesium, and had been prepared by the appellant’s plant office at his request to support the appellant’s claim for extra depletion allowance under section 72A of the Act. Not all the expenditures on Schedule “A” were said to relate to mining operations, one such exception being an item called surface finishing amounting to $3,679.24 which was related to surface finishing of extrusions, which are part of the appellant’s manufacturing operations. No capital cost allowance was taken into account in the schedules of cost of research as this was treated as a separate item on the undepreciated capital cost of the whole plant and did not go into costs.

A statement (Ex A-2) prepared by Mr Clearihue, which excluded items not related to mining operations, showed expenditures on Research and Development of Magnesium totalling $89,576.71 which, with the consultant’s fee of $7,788.06, made an overall total of $97,364.77 as contrasted with the Minister’s figure of $101,044.01.

Much the same circumstances relate to Schedule “A” to the Minister’s reply to the 1963 appeal, where he had listed expenses of $107,871.33 and a consultant’s fee of $7,740 making a total expenditure of $115,- 611.33 for research expenses in that year relating to development of prime metal.

In a statement (Ex A-3), prepared by Mr Clearihue in the same manner as he had prepared the one in respect of the 1962 year, expenditures relating exclusively to mining operations as opposed to other activities amounted to $100,077.53 and with a consultant’s fee of $7,740 made an overall total of $107,817.53 as contrasted with the Minister’s figure of $115,611.33.

At the conclusion of the evidence, counsel for the Minister placed on record the acceptance of the amended schedules which had been prepared by Mr Clearihue and which had the effect of amending Schedules “A” attached to the Minister’s replies. Thus the scientific research expenditures in issue for the 1962 year are taken to be $97,364.77 instead of $101,044.01. For the 1963 year the relevant scientific research expenditures are agreed to be $107,817.53 in place of $115,611.33.

The evidence was that, although the production of magnesium constituted its main activity the appellant nevertheless did have other activities in which it engaged, one of them being the processing of the prime metal produced by it into extruded shapes and forms, approximately 85% of the company’s revenue during its 1962 and 1963 fiscal periods being derived from the sale of prime metal, the remaining 15% coming from the sale of magnesium in extruded forms and other metals.

It was common ground that, while the appellant relies on mining for the production of magnesium, there are other processes by which magnesium can be produced, one being from sea water. Because of this the production of magnesium is a competitive business and calls for continuous research by the appellant in search of improved and efficient means of production if it is to maintain its competitive position in the production of magnesium.

In the profit and loss statement attached to, and forming a part of, the appellant’s return of income for its 1962 year, there appeared an item of $112,384 designated as ‘scientific research” which had been included in the deductions leading to the computation of profits of the taxpayer for that year.

This item, which had been charged as a Current expense, was said to include all scientific research expenditures for the year in respect of all types of scientific research, and these were not limited solely to the production of prime metal magnesium. The same is true in respect of the year 1963 where the item amounted to $123,930.

These profit and loss statements were said to have been prepared by the appellant’s accountants for the general purposes of the appellant company and in accordance with generally accepted accounting principles. There arises the question of why the statements should not be equally applicable for income tax purposes. The witness Clearihue testified that “the research expenditures in question were of a capital nature although they did not succeed in creating a capital asset like a building or a piece of equipment in its final form”. For this reason it was suggested that the appropriate treatment was to deal with them as Current expenses.

Harold George Warrington, a highly-trained metallurgist by profession and manager of sales and technical services of the appellant for some twenty years, gave evidence as to the particulars of the scientific research expenditures and the particular projects the appellant was attempting to deal with in its research program. It was recognized that the principal activity of the company was the extraction of magnesium from dolomite ore at its plant at Haleys, Ontario, in addition to which it manufactured certain extruded forms and shapes in magnesium and produced certain products from purchased materials. The company maintains a two-storey, fully equipped research building and an associated chemical laboratory adjacent to its main plant, employing, all told, three graduate metallurgists and a staff of 22 others.

Briefly stated, Mr Warrington said that the company’s research carried on in its 1962 and 1963 years in relation to the production of prime metal magnesium was for the purpose of developing and improv ing the equipment and the methods for the production of magnesium from dolomite. He said there were quite a number of problems related to the reduction furnaces, one being related to the retorts, which cost approximately $1,000 each with a life of less than one year, thereby occasioning an annual outlay of some $400,000 for new retorts.

Another problem concerned the capacity of the condenser to contain magnesium. It was observed by the witness that each retort is manually operated, manually filled and manually discharged and that, at that stage of the operations, the labour involved is extremely costly.

Proceeding further with his description of the refining process, the witness said the magnesium crystals had to be melted in melting pots and, in order to prevent oxydization, all fluxes and any impurities removed. The object of the research in this area was to avoid, in particular, losses of metal due to sludge.

In a memorandum prepared by the witness Warrington (Ex A-8) consisting of nine paragraphs and two schedules, there were set out the various research projects carried on in the 1962 and 1963 years and for which the research expenditures in question herein were incurred, all of which were directly related to the production of prime metal. These projects consisted of:

1. Development of new reduction furnace — not yet successfully completed. The biggest research project was to develop a new furnace to replace the reduction furnaces being used, and thus to eliminate the use of retorts. This project was extremely complicated and the objective has not yet been fully achieved and the project is continuing.

2. Development of improved retort condenser — one new method was devised and adopted. Research on improved insulation of retort cover was continued, as in any process using dolomite to produce magnesium a condenser is essential.

3. Development of new melting furnace — achieved in part but certain unresolved problems have precluded the immediate adoption of a furnace to replace melting pots.

4. Development of furnace in which to recover metal from sludge containing 20% to 25% metal — a furnace developed but so far it has not been economically feasible to put it into use but will be shortly.

5. Development of improved pumping equipment for transfer of metal from melting pots — research to develop a siphoning method of transfer and to improve pumps being used resulted in improvements in pumps.

6. Development of filter to eliminate flux — a satisfactory filter to remove flux from metal in sludge. A satisfactory filter was developed but improvements in fluxing rendered its use unnecessary.

7. Development of process of producing magnesium without melting — this project was to develop a process whereby the crystals from the condensers could be consolidated into ingot form without melting and casting. The research carried out involved the development of a method of producing purer crystals and extruding them under high pressures into ingots by specially-designed dies. The company adopted the method of producing purer magnesium, but has not adopted the method of extruding crystals which was developed.

8. Development of improved method of casting billets — this project was to develop a method of casting molten magnesium into billets which would eliminate the cracking which resulted from existing methods. Research was carried on to develop an improved method involving the use of a distributor plate and the new method was adopted in the company’s operations.

9. Development of alloy for use in die casting — this project was undertaken under an agreement with the Canadian Government whereby the company and the government bore the expense equally. The purpose of the research was to develop an alloy of magnesium which would be Suitable for use in die casting that could be used in the manufacture of lawn mowers, chain saws, etc. An alloy was developed which involved the addition to magnesium of small quantities of aluminum. The process developed to produce this alloy has been put into use by the company.

The position of the appellant is that the expenditures on scientific research should not be deducted in computing profits under Regulation 1201, nor is it directed by that regulation that such expenditures should be so deducted. It is the appellant’s contention that these expenditures are not laid out to earn Income, but are of a capital nature, and therefore have no bearing on the calculation of profits.

Some time after the hearing of this appeal, Cattanach, J, delivered judgment in the Trial Division of the Federal Court of Canada in The International Nickel Co of Canada, Ltd v MNR, [1971] CTC 604, where, as I understand it, among other matters, he was called upon to deal with the problem which arises in the instant matter. After a most thorough review of the jurisprudence involved, Mr Justice Cattanach reached the conclusion that the International Nickel Company’s expenditures on scientific research, which it claimed as deductions under sections 72, 72A and by virtue of paragraph 11(1)(j) of the Income Tax Act in computing its taxable income, were expenditures of a capital nature, as a consequence of which those expenditures were not to be deducted in determining the base for the calculation of depletion allowance for the purposes of Regulation 1201. It is my understanding that this decision has not been appealed.

After a most thorough and careful consideration of the evidence in the present appeal and of the judgment of Cattanach, J in the International Nickel case (supra), I have reached the conclusion that the appellant must succeed in its appeals.

The appeals in respect of the appellant’s 1962 and 1963 taxation years are therefore allowed in full, and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment accordingly.

Appeals allowed.