L. Berman & Co. Ltd. v. Minister of National Revenue, [1961] CTC 237, 61 DTC 1150

THORSON, P.:—This is an appeal against the appellant’s income tax assessment for 1956.

In re-assessing the appellant for that year, as appears from the notice of re-assessment, dated April 14, 1958, the Minister disallowed certain deductions made by it on its income tax return and added back to the amount of taxable income certified by it the sum of $15,042.13. The appellant objected to the assessment but the Minister confirmed it and the appellant then brought its appeal against it to this Court.

In its Income tax return for 1956 the appellant included in its statement of expenses the following item :

“Bad debts:

This amount included payments made by it, under the circumstances described later, amounting to $15,042.13.

The issue in the appeal is a narrow one, namely, whether the Minister was right in disallowing these payments as deductions from what would otherwise have been the appellant’s taxable income for 1956 and, conversely, whether the appellant in computing its income for that year was entitled to deduct their amounts or any of them.

The appellant was incorporated by Manitoba Letters Patent, dated November 8, 1944, under the name of Rex Novelty Company Limited for the following purposes and objects :

“(a) To carry on business as wholesale or retail merchants

and importers, dealing in all classes of merchandise usually carried in stock by jewellers, silversmiths, watchmakers, clockmakers, novelty dealers, as well as dealers in all materials, tools, machinery, supplies, furniture, fixtures and equipment of and incidental to the said occupations.

(b) To act as agents for other dealers or manufacturers im any of the above mentioned merchandise.”

and by supplementary letters patent, dated September 13, 1947, its former name was changed to its present one.

Only six shares of the appellant’s capital stock have been issued, three to Mr. Leonard Berman, its president, one to his wife, one to his brother and one to his father who is now deceased.

The facts from which the issue in the appeal arose were stated by Mr. Berman and by Mrs. Margaret Langevin, the appellant’s bookkeeper, and a great many exhibits were filed.

I set out the substance of Mr. Berman’s evidence. Early in 1955 he gave instructions which resulted in the incorporation of United Glass & China Imports Ltd. by Manitoba Letters Patent, dated March 22, 1955, with the following objects:

“To enter upon and undertake the importing and exporting of goods, wares and merchandise of every kind, character and description, to buy and sell such goods, and to do a general import and export business ;

To carry on a general mercantile business as importers and dealers in all kinds of goods, wares and merchandise, whether wholesale or retail, and by means of stores, warehouses, shops or agencies in all such places as the company may deem to be profitable and advantageous ;

To act as commission or commercial agents in respect of all kinds of natural imported or manufactured products of every nature and description, and to buy and sell all such products upon a commission, salary or other lawful consideration ;

To act as agents, commission agents, commission merchants, brokers or representatives in Canada and any foreign country or countries for Canadian or foreign commercial houses and for other persons, firms or corporation.”’

The new company will be referred to as United. It was never organized for business in the usual way. Its shareholders were the three applicants for incorporation, who were members of a Winnipeg law firm that acted as solicitors for the appellant. One share was allotted to each of them by the letters patent which made them the provisional directors of the corporation and they were never replaced.

The appellant started operating United as its agency in Toronto soon after its incorporation and installed Mr. Michael O’Neil as its. manager. He made arrangements for leasing a sample room and a warehouse and hiring salesmen. United had no money of its own and the appellant supplied it with funds as they were required. This was arranged by the appellant as a loan through the Royal Bank of Canada by a transfer from its Main and Logan branch at Winnipeg with which the appellant dealt to a branch of the Bank at Toronto with which an account was opened for United.

After United had got started in Toronto the appellant sent samples of its wares from Winnipeg to it and its salesmen sold various accounts in Eastern Canada based on them. Then the appellant sent the merchandise from its warehouse in Winnipeg to these customers. The goods were invoiced to United by the appellant at a jobber’s discount plus charges for transportation if they were to be prepaid and United invoiced the goods to its customers at the first price, the discount to be its profit. The customers paid United for the goods and the moneys so received by it were deposited with the branch of the Royal Bank at Toronto at which its account was kept.

About April or May, 1955, the appellant found that this method of doing business was impractical. There was a long lag between the time the customer gave his order to United’s salesman and the time he got his goods from Winnipeg, and its prices were not competitive with those of eastern suppliers.

The appellant then decided that its suppliers of merchandise should also supply United direct and that he and Mr. O’Neil should go to trade fairs where the appellant’s suppliers were showing their wares. In July, 1955, they went to a trade fair at Atlantic City and saw Mr. Stoloraff, the president of the United China and Glass Company, an American company, with its headquarters at New Orleans. It was the appellant’s supplier of Japanese merchandise. The appellant placed an order with Mr. Stoloraff with instructions to divide it with part to go to the appellant at Winnipeg and part to United at Toronto.

Mr. Berman and Mr. O’Neil also went to a trade fair at New York. There they saw Mr. Rosenstack of Crystal Imports Corporation, an American company with headquarters at New York. It was an importer of crystal products from Poland, Czechoslovakia and Germany. The appellant placed an order with it to be divided in the same way as that which had been arranged with Mr. Stoloraff.

At New York Mr. Berman and Mr. O’Neil also saw Mr. Gustave Lap who represented the Schramberger Company, a German firm that manufactured china, and the appellant made an arrangement with him similar to that which he had made with the others.

When Mr. O’Neil arrived back in Toronto he felt that it would be advantageous to obtain some controlled patterns of china in exclusive lines and found that in order to get an exclusive line the amount of merchandise that was ordered had to be in large volume. He got in touch with Steiner-Parsons Limited, a Toronto firm that represented some English firms that handled fine bone china, and selected certain lines that he felt would be good for the eastern and western trade. Through Steiner-Parsons Limited he placed orders two two English companies, Thos. C. Wild & Sons Ltd. and Shore & Coggins Ltd., to send the selected patterns to be divided in the same way as in the case of the orders placed at Atlantic City and New York. This was done with Mr. Berman’s consent. Mr. O’Neil felt that he could sell a greater volume than the appellant was accustomed to buying and the appellant relied on his judgment and went along with his decision.

Mr. Berman outlined the procedure that was followed after these arrangements had been made. The appellant’s salesmen sold goods against advance samples and when the goods arrived they were delivered to the customers whether at Winnipeg or at Toronto. There were several months of delay in getting the merchandise and even then only partial shipments were made. When a shipment was divided the appellant paid for the goods and invoiced United for the part that was drop-shipped to it at Toronto with a charge of 5 per cent for handling. When United received a total shipment it informed the appellant that the goods had arrived and the appellant supplied the funds required to meet the draft drawn on it. There was no set rule and on occasion the draft was presented to the appellant at Winnipeg and paid by it. If the merchandise was at Toronto and the appellant required part of it United billed the appellant for it at the proportionate landed cost and added 5 per cent for handling.

The appellant’s Toronto venture was not a success. Shipments from the suppliers were delayed and when they came they were only partial so that the customers to whom United had sold goods had to be kept waiting. Moreover, the summer months were poor selling months and very little business was done. In September, 1955, Mr. O’Neil made a trip to Montreal to show the appellant’s goods at a trade fair there. He sold a considerable amount of goods but not enough to offset the amount that had been ordered. About this time the merchandise that had been ordered earlier was starting to come in and large amounts of funds were required for their clearance which the appellant supplied.

About this time the appellant instructed United to send its complete set of books to Winnipeg and thereafter all its bookkeeping was done in the appellant’s office at Winnipeg. It then found that the expenditures of United were out of line with its sales but decided to continue its operations until the end of December, 1955, in order to get as much of the year end business as it could and so reduce the amount of the loss. In December it decided that it could not continue the operation and informed Mr. O’Neil that the Toronto office would be closed. Arrangements were made to have all the goods that were in the warehouse at Toronto sent to Winnipeg and this was accomplished by the end of March, 1956. There were still accounts to be paid. The appellant felt that as it had been doing business with the suppliers and was going to continue to do business with them all the debts of United had to be paid and it paid them.

The appellant gave a written guarantee to United China and Glass Company, the New Orleans American company, in a letter dated July 27, 1955, in which Mr. Berman made it clear that United was actually its branch. It guaranteed payment of its account. The arrangements with the other suppliers were made by word of mouth, the appellant having guaranteed payment verbally. All merchandise was sold by letter of credit or sight draft with bill of lading attached and if United could not pay the amount the appellant supplied it with the necessary funds.

After the merchandise of United had been sent back to the appellant at Winnipeg, United closed up and ceased functioning. There was no formal winding up. All that happened was that the appellant took over its merchandise and paid its unpaid bills: That was the end of United.

This brings me to the deductions claimed by the appellant in its income tax return for 1956. The particulars appear on so-called memo invoices of the appellant, filed as Exhibits 5a to 5e inclusive, all addressed to United and each carrying the notation that the amount referred to was paid by the appellant. The particulars are as follows: February 30, 1956, to United China & Glass—New Orleans, $3,675.03; February 30, 1956, to Thomas C. Wild—England, $1,570.09 ; March 31, 1956, to Crystal Import, $3,467.42, plus S. & S. duty September 10, 1957, $1,600.00, making a total of $5,067.42; March 31, 1956, to United China & Glass, $2,620.35, plus Canada S.S. Lines $219.23, plus Samson & Shaen, $1,302.61, making a total of $4,142.19; and June 6, 1956, to Shore & Coggins, $998.75. These amounts come to $15,453.48 but each of the memo invoices carried an addition of 5%, or a total of $772.66, which made up the total of $16,226.14 which the appellant sought to write off as bad debts. This total represented merchandise that had been ordered by United from various suppliers and paid for by the appellant and charged back in the books to United.

But, of course, the appellant did not pay any of the 5% amounts included in these memo invoices. It is important to set out the payments actually made by it and the dates on which it made them. The particulars are as follows: On September 1, 1955, to Crystal Imports, $3,467.42; on September 10, to Gebr. Hirdes, $1,600.00 for duty; on December 5, 1955, to Canada Steamship Lines, $219.23 for freight; on December 8, 1955, to Samson & Shaen, $1,302.61 for duty; on December 15, 1955, to United China & Glass Company—New Orleans, $2,620.35 ; on January 31, 1956, to United China & Glass Company—New Orleans, $3,675.03, in respect of which there was a credit to United of $411.35; on February 2, 1956, to Thos. C. Wild, $1,570.09; and on July 6, 1956, to Shore & Coggins, $998.75. These payments came to a total of $15,042.13 which was the amount that the Minister disallowed.

Mr. Berman was cross-examined by counsel for the Minister for almost two days in the course of which he was taken over the various books of account and records of the appellant as well as those of United. This was done with a view to casting doubt on his credibility by showing that the manner in which the books were kept did not support his evidence. During the hearing I made the statement that the effort to discredit Mr. Berman had made no impression on me. In my opinion, there is no reason for doubting his evidence. It may well be that the manner in which the accounts between the appellant and United were set up is subject to criticism but I am satisfied that Mr. Berman’s evidence was substantially correct. It is not a matter for surprise that he was not able to explain all the items in the books of account and suggested that Mrs. Langevin could give the necessary information. She did so in a competent manner and showed a remarkably accurate memory of the transactions that had been recorded in the books.

I can see no object in going into the books of account except as to the payments in question. Indeed, the question before the Court is not how the transactions between the appellant and United were recorded but what the true nature of the payments in question was and what purpose they served in the appellant’s business including its Toronto venture.

I now come to the determination of the issue in the appeal. I reject out of hand the appellant’s contention that when it made the payments in question it did so on behalf of United and United thereby became indebted to it in their amounts and that since United did not pay such amounts they became bad debts and the appellant was entitled to write them off as such. The evidence does not warrant any such contention. The appellant did not make the payments at the request of United or on its behalf or for its benefit. Consequently, when it purported to charge their amounts back to United by the memo invoices, filed as Exhibits 5a to 5e, as if they had been advances or loans or sales to United it had no right to do so. The evidence of Mr. Berman is quite clear that its purpose in making the payments was Otherwise. It paid the amounts because it had been doing business with the suppliers and was going to continue to do business with them. The payments were made by it for its own purposes and their amounts never became debts of United to the appellant. They could not, therefore, ever become bad debts and, consequently, the appellant was not entitled to write them off as such as it claimed to do in its income tax return.

But that is not the end of its rights. As I view the evidence as a whole my opinion is that the appellant made the payments as an item of expenditure in its unsuccessful venture into the eastern field by its operation of United as its Toronto branch or agent. It is conceded, of course, that United was a separate legal entity and, consequently, for income tax purposes, it was a separate taxpayer, but that did not prevent it from being a branch of the appellant in the sense of being its agent in such a way as to make the appellant responsible for it. Certainly, Mr. Berman considered United as the appellant’s branch or agency and in Mrs. Langevin’s mind there was no doubt at all that the office of United at Toronto was the appellant’s branch office. She frequently spoke of it as such.

Indeed, Mr. Berman stated that the reason for the incorporation of United was to extend the appellant’s china and glass import business in Eastern Canada. One of the reasons for having the United China & Glass Company of New Orleans and Crystal Imports Corporation supply both the appellant and United was that both of these companies controlled lines of merchandise that were very desirable for the appellant’s trade and it was to its advantage to have them as its suppliers for each did a very large volume of business in the United States and the appellant felt that the acceptance of their products in the American market helped the appellant in the Canadian market. And the appellant made its arrangement with Mr. Lap of the Schramberger Company because its line was much sought after. It had only four accounts in Canada in which each had a controlled pattern. The appellant had one of these areas and felt that if it could get another area in Ontario it could increase its volume of business and take merchandise billed to Winnipeg and United and drop-ship some or all of it to United at Toronto. The appellant had been dealing with the three companies that Mr. Berman and Mr. O’Neil contacted when they went to Atlantic City and New York before the appellant set up its agency at Toronto. Moreover, Mr. Berman stated that the appellant gained new accounts from the selling efforts made by United and made a profit from them. Certainly, he expected that the establishment of United as its agent would be a profitable venture for it gave the appellant the advantages of new accounts and the handling of exclusive lines.

In my opinion, the payments in question come within the meaning of the exception of Section 12(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148, which provides as follows:

“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,”

This section replaced Section 6(a) of the Income War Tax Act, R.S.C. 1927, ce. 97, which read as follows:

“6. In computing the amount of the profits or gains to be assessed, a deduction shall not be allowed in respect of

(a) disbursements or expenses not wholly, exclusively and necessarily laid out or expended for the purpose of earning the income;’’

I had occasion in two cases to consider what should be the primary approach to the question whether a disbursement or expense was deductible for income tax purposes under Section 6(a) of the Income War Tax Act. In Imperial Oil Limited v. M.N.R., [1947] Ex. C.R. 527 at page 531; [1947] C.T.C. 353 at page 399, I expressed the following opinion :

“The section ought not, in my opinion, to be read with a view to trying to bring a particular disbursement or expense within the scope of its excluding provisions. If it is not within the express terms of the exclusions its deduction ought to be allowed if such deduction would otherwise be in accordance with the ordinary principles of commercial trading or well accepted principles of business and accounting practice.”

I also stated that the principles for the computation of the profits or gains to be assessed under the Income War Tax Act were not defined in the Act but were stated in judicial decisions such as Gresham Life Assurance Society v. Styles, [1892] A.C. 309, where Lord Halsbury said, at page 316:

‘ Profits and gains must be ascertained on ordinary principles of commercial trading,’’

and Usher’s Wiltshire Brewery, Limited v. Bruce, [1915] A.C. 433, where Earl Loreburn, at page 444, approved the statement that

“profits and gains must be estimated on ordinary principles of commercial trading by setting against the income earned the cost of earning it,”

In Daley v. M.N.R., [1950] Ex. C.R. 516; [1950] C.T.C. 254, I carried the analysis a step further and expressed the opinion that it was not correct to look at Section 6(a) as the authority for permitting the deduction of a disbursement or expense but that the correct view was that the deductibility of the disbursements and expenses that might properly be deducted in) computing the amount of the profits or gains to be assessed was inherent in the concept of ‘‘annual net profit or gain’’ in the definition of taxable income contained in Section 3. This concept, as I have stated, was defined in judicial decisions such as those cited. There are several other decisions to the same effect.

In Royal Trust Company v. MN.R., [1957] C.T.C. 32, I expressed a similar view with respect to Section 12(1) (a) of the Income Tax Act, Statutes of Canada, 1948, c. 52, which was in the same terms as Section 12(1) (a) of the present Act. In that case, after reviewing the decisions in the Imperial Oil Limited case (supra) and the Daley case (supra), I expressed the opinion that instead of saying that the range of deductibility of an outlay or expense under Section 12(1) (a) of the Income Tax Act of 1948 was greater than that of a disbursement or expense under Section 6(a) of the Income War Tax Act it would be more accurate to say that the extent of the prohibition of the deduction of an outlay or expense was less under Section 12(1) (a) of the Income Tax Act of 1948 than that of a disbursement or expense under the Income War Tax Act, and that it was plainly intended that it should be so, with the result that the gap between the kind of an outlay or expense that was deductible according to ordinary principles of commercial trading and business practice and that which was deductible for income tax purposes was narrower than it had been under the former Act. Then, at page 42, I stated:

■‘ Thus, it may be stated categorically that in a case under ‘the Income Tax Act the first matter to be determined in deciding whether an outlay or expense is outside the prohibition tion of Section 12(1) (a) of the Act is whether it was made -or ineurred by the taxpayer in accordance with the ordinary v; principles of commercial trading or well accepted principles -of business practice. If it is not, that is the end of the matter. But if it was, then the outlay or expense is properly deductible -unless it falls outside the expressed exception of Section ; 12(1)(a) and, therefore, within its prohibition.’’

There is no doubt in my mind that the appellant made the payments in question as a business person intending to continue in business would reasonably do and that, consequently, they were made in accordance with the ordinary principles of commercial trading or well accepted principles of business practice and I am unable to find any ground in Section 12(1) (a) for their exclusion.

Even if the appellant had not been legally bound to make the payments that did not prevent them from having been made in accordance with the ordinary principles of commercial trading. There is strong authority for this statement in Usher’s Wiltshire Brewery, Limited v. Bruce, [1915] A.C. 433. In that case the tenants of the appellants’ tied houses were by agreement bound to repair their houses and pay certain rates and taxes. They failed to do so. The appellants, though in no way legally or morally bound to do so, paid for these repairs and paid these rates and taxes. They did so, not as a matter of charity, but of commercial expediency, in order to avoid the loss of their tenants, and, consequently, the loss of the market for their beer, which they had acquired these houses for the purpose of affording. It was held that, although they were not legally or morally bound to make these payments, yet they were, in estimating the balance of the profits and gains of their business for the purposes of assessment of income tax, entitled to deduct all the sums so paid by them as expenses necessarily incurred for the purposes of their business.

And in British Insulated and Helsby Cables v. Atherton, [1926] A.C. 205, Viscount Cave, L.C., said, at page 211 :

“It was made clear in the above cited cases of Usher s Wiltshire Brewery v. Bruce, [1915] A.C. 4838, and Smith v. Incorporated Council of Law Reporting, [1914] 3 K.B. 674, that a sum of money expended, not of necessity and with a view to a direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency, and in order indirectly to facilitate the carrying on of the business, may yet be expended wholly and exclusively for the purposes of the trade;”

There was an illustration of this principle in Cooke v. Quick Shoe Repair Service (1949), 30 T.C. 460. In that case the agreement by which the respondent firm purchased a shoe repair business provided that the vendor should discharge all liabilities of the business outstanding at the date of sale. The vendor failed to do so, and the respondent, in order to preserve the good will and to ensure continuity of supplies of material, etc., paid certain sums in discharge of the vendor’s liabilities. It was held by Croom-Johnson, J., confirming the Commissioners for the General Purposes of the Income Tax, that the sums so paid by the respondent were wholly and exclusively laid out for the purposes of its business.

In the present case the appellant’s position is stronger for it made the payments in pursuance of its promises to the suppliers to do so. Thus they were made in the course of the appellant’s business as ‘‘part of the process of profit making’’. In my opinion, they meet the test of deductibility laid down by the Lord President (Clyde) of the Scottish Court of Sessions in Robert Addie & Sons Collieries, Limited v. C.I.R., [1924] 8.C. 231-235, when he was considering a provision of the United Kingdom Act corresponding to Section 6(a) of the Income War Tax Act. At page 355, he said:

“What is ‘money wholly and exclusively laid out for the purpose of the trade’ is a question which must be determined upon the principles of ordinary commercial trading. It is necessary, accordingly, to attend to the true nature of the expenditure, and to ask oneself the question, Is it part of the Company’s working expenses; is it expenditure laid out as part of the process of profit earning?’’

This test was approved by the Judicial Committee of the Privy Council in Tata Hydro Electric Agencies, Bombay v. Income Tax Commissioner, Bombay Presidency and Aden, [1937] A.C. 685 at page 696, and adopted as applicable to Section 6(a) of the Income War Tax Act by the Supreme Court of Canada in M.N.R. v. Dominion Natural Gas Co. Ltd., [1941] S.C.R. 19; [1940-41] C.T.C. 155. In my opinion, the said test is just as applicable in the case of Section 12(1) (a) of the Income Tax Act.

I have, therefore, come to the conclusion that when the appellant made the payments in question it did so for the purpose of earning or producing income from its business within the meaning of the exception in Section 12(1) (a) of the Act.

The fact that no income resulted from the expenditures in 1956 does not affect the matter: vide Vallambrose Rubber Company, Limited v. C.I.R. (1910), 47 Se. L.R. 488. Nor would it matter if no profit resulted at all : vide C.I.R. v. The Falkirk Iron Co., Ltd. (1933), 17 T.C. 625.

But the appellant is not entitled to deduct from what would otherwise have been its taxable income for 1956 all the payments made by it. The payments made in September and December, 1955, are not deductible. I had occasion to consider a similar question in Consolidated Textiles Limited v. M.N.R., [1947] Ex. C.R. 77; [1947] C.T.C. 63. In that case the appellant, a manufacturer of lingerie fabrics, in making its income tax return for the year 1939, sought to deduct from its 1939 receipts certain operating expenses incurred in 1938. The deduction was disallowed by the Minister and the appellant appealed. I agreed with the Minister and held that Section 6(a) of the Income War Tax Act excluded the deduction of disbursements or expenses that were not laid out or expended in or during the taxation year in respect of which the assessment was made. Consequently, I hold that the appellant was not entitled to deduct from its 1956 receipts any of the payments made by it in 1955. My reasons for doing so are the same as those set out in the case to which I refer and I include them, mut at is mutandis, in these reasons.

These amounts come to a total of $9,209.51. But the payments made by the appellant in 1956, amounting to $5,832.52, were deductible and the Minister was wrong in disallowing them.

It follows from what I have said that the appeal herein must be allowed in part as indicated and the assessment referred back to the Minister for amendment accordingly. The appellant is entitled to costs to be taxed in the usual way.

Judgment accordingly.