22 April 1991 Internal T.I. 902339 F - Sale of Accounts Receivable, Inventory and Future Obligations - Transfer of Contingent Reserves

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

R.K. Khosla	Head Office
Chief of Audit	Rulings Directorate
Mississauga District Office	C.R. Bowen
4th Floor East	(613) 9567-2096
Attention: Michael E. Lee
Large File Program                198-1-3                       24(1)

We are writing in reply to your memorandum of August 31 and September 17, 1990, wherein you requested our comments on the income tax treatment of the

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You included with your memo 1) your letter to 24(1) dated April 20 1990, 2) the submission from the taxpayer's representatives dated July 4, 1990 (the "Taxpayer's Letter") and 3) a set of documents relevant to the sale transaction.  As per our telephone conversation (Bowen\Berdugo) of April 16, we have summarized below our understanding of the situation which includes only that information which is relevant to the technical interpretation requested.

Background

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Taxpayer's Position

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Your Opinion

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There are no ambiguities in the Act as it is structured to recognize the sale of a business as being on account of capital, unless the taxpayer sells businesses on a day-to-day basis.  More, specifically the sale of accounts receivable, inventory and future obligations are on account of capital unless an election is filed to treat any resulting loss on account of income.  The articles written by tax professionals indicate the practice of permitting a taxpayer selling his business to transfer a reserve claimed for income tax purposes to the vendor and receive a tax deduction, may be extended to contingent reserves.  RCT has not indicated support for this presumption.

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Your Questions

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Our Comments

Before answering specific concerns, we have provided general comments on some of the issues involved.

A)      General Comments

While there have been numerous approaches or principles of interpretation popular with the courts over the years, the current most widely held approach is the modern principle of statutory construction as summarized by E.A. Driedger in The Construction of Statutes (2nd edition), Butterworths, Toronto, 1983 at page 87:

To-day there is only one principle or approach, namely the words of an Act are to be read in their entire context in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act and the intention of Parliament.

This principle was accepted in the court case Stubart Investments Ltd., 84 DTC 6305, (SCC) at pages 6323-24 and repeated in several subsequent cases, e.g., Canterra Energy Ltd, 85 DTC 5245 (FCTD) and Lor-Wes Contracting Ltd., 85 DTC 5310 (FCA).

The basic method of construction using the modern rule summarized by Driedger at page 105 indicates, inter alia:

A.        If the words of an individual provision to be applied to a particular provision are clear and unambiguous and in harmony with the intent, object and scheme and with the general body of law, that is the end.

B.        If the words are apparently obscure or ambiguous, then the meaning that best accords the intention of Parliament, the object of the Act and the scheme of the Act, but one that the words are reasonably capable of bearing, is given to them.

In general, a business expenditure made by a taxpayer is deductible only if:

1)     prima facie it is incurred in accordance with ordinary principles of commercial trading and deductible in accordance with generally accepted accounting principles as applied to determine the profit under section 9 of the Act, and

2)     there is no overriding jurisprudence or statutory provision, for example paragraphs 18(1)(a), (b) and (e) of the Act, to the contrary.

This concept is supported in numerous court cases including Royal Trust Co., 57 DTC 1055 at page 1060 [Ex. Ct.]. In British Columbia Electric Railway Co. Ltd., 58 DTC 1022, at page 1027, the court's comment related to the predecessor to paragraph 18(1)(a) of the Act is as follows:

Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made for the "purpose of gaining or producing income" comes within the terms of section 12(1)(a) whether it may be classified as an income expense or as a capital outlay. Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or capital outlay.

General comments on interpreting the specific words in paragraph 18(1)(a) of the Act are outlined in IT-487.  However, in order for an expense to be deductible to a taxpayer, it must still meet all of the above tests.  It is not sufficient that only the criteria discussed in paragraph 2(d) of IT-487 is met.  The question of whether an expense has been "incurred" was discussed by Justice MacGuigan in, Edmonton Liquid Gas Ltd., in an unreported decision of the Federal Court of Appeal decided on September 28, 1984.  He quoted from the case Pickle Crow Gold Mines Ltd,, 55 DTC 1001 (Ex. Ct.] at 1003 that:

In my opinion, the words "expenses incurred by a taxpayer" have a natural and ordinary meaning of expenses either paid out by a taxpayer or which he has become liable to pay.

While the Act does not define the word "capital" in paragraph 18(1)(b) thereof, the Canadian courts have attempted to define that concept by using various judicial tests developed over time, such as the "enduring asset" test, and the "common sense" test, each of which has lead to variations such as the "enduring benefit", "businessman's approach", and "trading structure" tests.  Therefore, in order to determine whether an expenditure is prohibited by paragraph 18(1)(b) of the Act as a capital expenditure, it is necessary to determine whether it meets any of these tests.  In summary, the "enduring asset" test focuses on the nature of the asset acquired and whether the expenditure is a once and for all expenditure made with the view of bringing into existence an asset or advantage for the enduring benefit of a trade.  The "common sense" approach distinguishes between the structure of a business and the operation of a business and recognizes ordinary commercial principles.

In the court case Canada Starch Co. Ltd., 68 DTC 5320, [Ex. Ct.], the court considered whether expenditures made by the taxpayer were on account of capital or a current expenditure.  Comments on page 5323 of the case illustrate the concept of the "common sense" approach:

In other words, as I understand it, generally speaking, (a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure, or organization, for the earning of profit, or an addition to such an entity, structure or organization, is an expenditure on account of capital, and (b) on the other hand, an expenditure in the process of operation of a profit-making entity, structure, or organization is an expenditure on a revenue account.

In the Frankel case, the court addressed the issue of whether the gain which arose from the sale of inventory, sold in conjunction with the rest of the business assets of a particular operation of a taxpayer, was on account of capital or income.  The key issue examined by the court was whether or not there was  business sold by the taxpayer or a sale of assets of which inventory was one.  In order to determine if a separate business operation of the taxpayer had been sold, the court looked at a number of factors presented on page 1168 of the case.  These factors have been accepted by RCT and are reflected in paragraphs 2 and 3 of IT-206R Separate Businesses.  In the case, the sale of inventory was considered to be indivisible from the sale of other items such as machinery and equipment, accounts receivable, goodwill, etc.  As a result of purchasing this pool of assets, the vendor could immediately commence carrying on the business that the purchaser has sold.  The amount received by the vendor was not done so in the ordinary course of carrying on the business operations.  Although this case deals with whether the gain was on account of capital or ordinary income, it appears that the court used the "common sense" or "trading structure" test later articulated by the court in the Canada Starch case (as noted above).  The court cases Number 10 and Empire Manufacturing also distinguished between the regular business activities of the taxpayer and the sale of a business which included all of the assets.

In the court case Southam Business Publications Limited, 66 DTC 5215 (Ex. Ct.), the court examined the issue of whether an amount paid by the taxpayer for subscription lists purchased as part of a package of assets, was a deductible expense.  On page 5223 of the case, the court acknowledged that "..in the case of the purchase of a business as a going concern, ... the expenditure (if it is not clearly for the purchase of stock in trade) is always a capital expenditure...".  The court held that it was the nature of the entire transaction, i.e., the purchase of the entire business, that determined the nature of the payment and not the component parts of the purchase price.

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A cost is deductible only when a taxpayer has incurred an absolute and unconditional liability to pay the amount.  Numerous court case have dealt with the prohibition of paragraph 18(1)(e) of the Act which does not allow a deduction to a taxpayer for anticipated or future expenses and contingent liabilities.  These cases include Ross & Day, 76 DTC 6433 (FCA), Transport Direct Systems, 84 DTC 1773 (TCC), Burnco Industries Ltd., 84 DTC 6348 (FCA), Harlequin Enterprises Limited, 77 DTC 5164 (FCA), and Amesbury Distributors Limited, 85 DTC 5076 (FCTD).  Comments on the meaning of the words "contingent liability" are provided on page 1777 of the case Transport Direct Systems:

The third class is "contingent liabilities", which must mean sums, payment of which depends on a contingency, that is, sums which will only be payable if certain things happen, and which otherwise will never become payable.... Contingent liabilities must, therefore, be something different from future liabilities which are binding on the company, but are not payable until a future date.  I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence upon an event which may or may not happen.

Generally, RCT has accepted the criteria adopted by the courts in the application of paragraph 18(1)(e) of the Act and its position is reflected in paragraph 3 of IT-215 and in paragraph 12(e) of IT-109R.

We did not find any support in our research files for the positions taken by various authors quoted in the Taxpayer's Letter.  To the contrary, we found several letters in our research files which clearly took the opposite position and the contents of two of such letters are summarized below.

I)        In one situation, a vendor sold the business of providing services to its customers, had included fees received in advance from its customers in its income under paragraph 12(1)(a) of the Act and there was no election filed under subsection 20(24) of the Act.  Our comments on the resulting income tax consequences are:

a)   no deduction will be allowed to the vendor as no outlay of an expense nature has been incurred;

b)   the outlay made by the purchaser in connection with the service contracts was a capital outlay made in connection with the sale of a service business;

c)   the purchaser purchased a business and the service obligations assumed are part of the consideration paid for the business, so no amount can be brought into the purchaser's income under paragraph 12(1)(a) of the Act as the service obligations arose in connection with a capital transaction; and

d)   the purchaser will not be allowed to deduct any costs incurred to render the related services as the outlay is incurred in connection with a capital obligation acquired in the purchase transaction, that is, they are not expenses laid out to earn income.

II)       Another letter deals with the situation where a taxpayer acquired the assets of a business.  The business involves the manufacture and sale of products to dealers who in turn sell the product to retail customers.  There was a written warranty provided by the manufacturer to the customers at the time of the sale of the product.  Under this warranty, the manufacturer replaces the product if defective.  The manufacturer does not charge separately for the warranty and the warranty is not insured by an insurance company.  Although the vendor makes an accounting estimate for the estimated cost of replacing defective products, for income tax purposes only the actual costs of replacing the products are deducted from its income.  On the acquisition of the business assets, the purchaser assumed the outstanding warranty obligations of the transferor.  Our response indicated that:

a)   the warranty obligations represent liabilities of the transferor of the business and their assumption by the purchaser would be part of the consideration paid by the purchaser with respect to the acquisition of the business, i.e., had the purchaser not assumed these obligations the amount of cash or other consideration that it would have to pay would have been increased accordingly;

b)     the amount paid by the purchaser to honour the assumed warranty liabilities would not be a deductible expense as the expenditures are on account of capital; and

c)     the election under subsection 20(24) of the Act would not be available as there is no charge for the warranty and therefore, no amount has been included in the income of the transferor with respect to those warranties under paragraph 12(1)(a) of the Act.

d)     to the extent that the payments required to discharge the obligations assumed by the purchaser differ from the estimated amount of liability recorded, such a discrepancy would represent a capital gain or loss to the purchaser.

B)      Issues in Taxpayer's Letter

We have addressed the issues raised in the Taxpayer's Letter in the same order as they are indicated above.

1.     We agree with your position and it is supported by previous opinion letters issued by Rulings Directorate.

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2.     We agree with your comments and also add the following ones.

The court cases quoted in the Taxpayer's Letter which discuss choosing an interpretation of a statute which results in the smooth working of the tax system, deal with ambiguity of the words of a specific provision and appear to reflect in part the principles of the "golden rule" and the "mischief rule" of interpretation which are no longer popular or relevant principles of interpretation.  The golden rule allowed deviations from literal construction where such construction led to absurdity and the mischief rule assumed that legislation was enacted with the intention of producing fair and equitable results.  As noted above, the appropriate principle to be used in interpreting statutes should be the "modern rule" which requires provisions of the Act to be read in harmony with the scheme and object of the Act.

As supported by the Southam Business case, the nature of that transaction is determined by the nature of the entire package, i.e., the sale of a business and not the individual components therein.  The jurisprudence indicates that under the scheme of the Act, an expenditure for the acquisition of a business entity or structure is an expenditure on account of capital.  As previously indicated. 24(1) The positions taken by the authors quoted in the Taxpayer's Letter were all written prior to subsection 20(24) of the Act being introduced in the Technical Notes to Bill C-72 on September 9,1985.  The Explanatory Notes issued by the Department of Finance indicate the new subsection was intended to Include situations where a taxpayer, who previously included an amount in its income under paragraph 12(1)(a) of the Act, transfers his business to another taxpayer and pays the other taxpayer to take over his obligation for delivering future goods or services.  As the new subsection was made retroactive to 1982 and subsequent taxation year, it appears that the Department of Finance was willing to recognize that relief should be provided under certain circumstances.  However, we were unable to find any support in our research files to permit a deduction to a vendor for an amount paid to a purchaser to assume its contingent liabilities for which there are no reserves permitted for income tax purposes.  As noted above, we did find several letters which supported your position.

3.     The Herald case (as well as the other cases cited in, the Taxpayer's Letter i.e., re a Taxpayer-N.S.W. 1934 (No.2), 3 A.T.D. 79 (D.C.) and Imperial Oil Limited, 3 DTC 1090 (Ex. Ct)) does support the deductibility of current costs which arise as a result of normal income producing operations of the business, even when those costs arise subsequent to the time that the income is earned.  The amounts sought to be deducted in these cases represent a genuine liability of the taxpayer with an enforceable claim by the creditor for an ascertained amount which is unconditionally due and payable.  It is our opinion that these cases clearly support our existing assessing position that product warranty expenses are deductible at the time they are actually incurred, i.e. as a result of a legal liability arising from claims made by customers.   These cases do not address the issue of the deductibility of an amount not "incurred by a taxpayer" which arose as a result of a capital transaction.

The Taxpayer's Letter states that

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However, this argument fails to address the fact that other requirements must also be satisfied before an amount is a deductible expense, such as whether an expense was "incurred" for the purposes of paragraph 18(1)(a) of the Act or whether the deduction of the outlay is specifically prohibited by paragraph 18(1)(b) of the Act.  Accordingly, it is our opinion that there has been no change in RCT's administrative practice outlined in lT-487.  In addition, RCT has not published a position on the issue under consideration in any IC or IT.  Therefore, no public notice indicating a change in position, has there been one, would have required by RCT.

4.     We agree with your comments and add the following:

     As indicated above, jurisprudence over the years has developed several different tests in order to determine whether an amount is current or on account of capital.  We were unable to find any support for the position in the Taxpayer's Letter that the courts have attempted to establish different legal principles to be applied 1) to a purchaser of the assets of a business in order to determine whether the expenditure would be a current expense or an expenditure on account of capital as opposed 2) to the vendor of the assets of a business in order to determine whether the gain would capital or ordinary income.   As perviously mentioned it is our opinion that the judgement in the Frankel case (as well as the cases number 10 and Empire Manufacturing) is applicable to the current fact situation despite the fact that issue in the case was the determination of an gain as opposed to an expenditure

     We agree with the statement on page 17 of the Taxpayer's Letter that "The cases dealing with the characterization of an expenditure as being on income or capital account generally apply the `enduring benefit' or `trading structure` test to make the determination". While the comments quoted directly from various court cases in the Taxpayer's Letter are relevant in making this determination we do not agree that those comments can be extended.

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C)     Income Tax Treatment

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We trust these comments will be of assistance.

for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch