Lomex Inc. v. MNR, 92 DTC 2253, [1992] 2 CTC 2678, [1992] 1 CTC 2731, [1992] DTC 2246 (TCC)

Garon, T.C.CJ.:—This case involves appeals from reassessments dated January 22, 1988 for the appellant's 1982, 1983, 1984 and 1985 taxation years. By these assessments, the respondent, in determining the amount of the manufacturing and processing profits tax credit to which the appellant was entitled for each of the four years in issue, excluded the assets relating to the transport of raw materials from the computation of the cost of manufacturing and processing capital, and excluded the cost of labour relating to transporting raw materials and maintaining its fleet of trucks from the cost of manufacturing and processing labour.

The facts overall were not contested.

The appellant has its head office and its plant in Montreal, with depots in Navan, near Ottawa, and in St-Hyacinthe, Quebec. In its field of activities, the appellant serves about half of the province of Quebec. The appellant has for several years operated a business picking up and treating animal by-products and waste by a dehydration process. As paragraph 5 of the notice of appeal states:

The basic raw material for production consists in animal residues (fat, bones, trimmings, meat scraps, feathers, blood, offal, animal carcasses); these materials come from about 1,500 pick-up points within a 250 km radius of Montreal, including butcher shops, restaurants, supermarkets, farms, abattoirs and so on.

[Translation.]

The finished goods resulting from this dehydration treatment process consist in meat, bone, feather ana blood protein meal and lard for animal feed. These goods are used by soap manufacturers and in the oleochemical industry. The same goods are then sold by the appellant on the domestic and international markets.

In order to provide the necessary control over the program and the quality of the production, and compliance with government regulations designed to protect public health, the appellant maintains its own fleet of 102 vehicles for picking up raw materials, consisting in, inter alia, dump trucks, trailers and some tanker trucks. As well, the appellant had other vehicles, as noted in paragraph 7(i) of the reply to the notice of appeal, as follows:

The appellants fleet, which is used in transporting raw materials, was also composed of two small trucks used for maintaining the trucks on the road, two trailers, two garbage trucks, a vacuum truck, a truck used to pick up buckets of oil, a sweeper truck used to clean the lot at the plant and trucks with cabs only which are used to transport the trailers.

[Translation.]

To manage this large number of vehicles, the following is noted in paragraph 9 of the notice of appeal:

The collection fleet is operated by 56 individuals, including the fleet operations manager, 44 operators, four mechanics, five garage employees, a foreman and a supervisor for maintaining and washing the equipment.

[Translation.]

The evidence established that the allegation in paragraph 8 of the notice of appeal was correct:

.. .certain pieces of collection equipment are used, for example, to sort raw materials, drain them during transport or keep them at a proper temperature so that they do not congeal.

[Translation.]

The following description of some of the tasks of the operators of certain vehicles is given in paragraph 10 of the notice of appeal:

In addition to their normal responsibilities, the operators perform the following duties in relation to receiving raw materials:

(a) weighing raw materials;

(b) classifying materials according to the fat and bone content;

(c) visual inspection of materials to ensure that they meet the quality standards required and that they contain no undesirable residue;

(d) finalizing a shipping label attesting to the receipt of the materials;

(e) handling and emptying the suppliers’ containers or other receptacles.

[Translation.]

André Couture, the president of the Sanimal group, of which the appellant is a member, provided some supplementary information concerning his business. Mr. Couture stated, inter alia, that the raw material is purchased under price agreements with the suppliers. He noted that the containers in the abattoirs belong to the appellant. The trailers contain drainage equipment which ensures that they do not fill up with water during the day. These trailers are equipped with a double floor or a double lining on the sides. Mr. Couture also dealt with the various categories of material collected, including blood, which is picked up using specially-built tanker trucks. Some material is collected using a dump truck. A special process has to be followed in operating the tanker trucks and dump trucks. Mr. Couture also noted that in some cases the raw material must be processed within 24 hours. The quality of the raw material is of great importance in this processing. The trucks are filled and serve as a sort of storage place until the plant can accept the raw material at the loading chutes. Mr. Couture provided additional information on these lines of products:

(a) Frying oil is filtered, separated from water and sterilized.

(b) Feathers are put under pressure and dried, then turned into powder.

(c) Blood is drained out of the tank and stored inside a reservoir. This blood goes into a centrifuge system to separate the proteins. There is then a processing stage to take out the water, and a drying stage. The final product becomes blood meal.

(d) The processing method for meat is the most complex, and involves 75 per cent of the volume of the raw material.

There are certain characteristics in respect of the duties of the operators and the various types of vehicles which are used by them in this business. They may be summarized as follows:

(a) The semi-trailer drivers do a little sorting when they pick up blood;

(b) The dump trucks may hold up to 12 tons of by-products and the drivers may visit between 20 and 40 customers per day. They have to put in some time waiting before being able to do the pick-up. These dump trucks are used for picking up material from butcher shops and small abattoirs.

(c) The drivers play an important role in terms of controlling the quantity and quality of the product.

(d) The appellant does not hire transporters or subcontractors and does not pick up dead animals.

(e) The containers may weigh between 50 and 200 kilos.

(f) Some dump trucks are equipped with front end loaders.

(g) Some trucks are equipped with screens and levers for separating different materials.

(h) The trailers are made out of aluminum or stainless steel because there is some acidity in the by-products.

(i) The raw material is often weighed in the customers’ establishments and the weight of the material is estimated by the drivers of the appellants’ vehicles.

(j) The processing cycle takes about two hours.

(k) Grease is picked up from restaurants using containers supplied by the appellant and these containers are transported using quarter-ton panel vans.

The Court also learned that the most important market for the appellants products is local. These products are sold to mills. The second market involves the export abroad of products which are stored and delivered to the port of Montreal. The testimony of Jean Gauthier, who was employed by the appellant from 1965 to 1988 as a loader, a truck driver and, ultimately, starting in 1971, as officer in charge of by-product purchasing, provided some additional information which should be noted:

(a) The truck drivers visited 3 or 4 abattoirs per day and took between 30 and 60 minutes per customer to do the pick-ups. The time they spent on the road was estimated to be 30 per cent of their working time;

(b) The chicken trailers were different, in terms of their interior structure, while the beef trailers have a drainage system only. Another type of trailer was used for crushing bones only.

(c) The blood tanks were used in the evening and the tank operators might visit 8 to 10 customers per day, spending 20 to 45 minutes at each customer's to complete the pick-up operations. The drivers spent about 35 per cent of their working time driving their vehicles.

(d) The drivers of the panel vans picked up grease mainly from restaurants and had to pick up and empty out containers weighing about 500 pounds into 45 gallon barrels kept inside the trucks. They spent 5 to 30 minutes per customer and might visit 30 customers per day. The drivers had to unload their trucks themselves when they arrived at the plant.

(e) The bins in the various butcher shops were supplied by the appellant.

(f) The appellant employed 11 workers in the garage who looked after maintaining and repairing the vehicles and equipment.

(g) In terms of shipping equipment, the appellant had 2 grease trailers, 2 tanks, 1 tractor and 1 trailer for the meal.

(h) The appellant had about 2,500 suppliers with whom its employees met at least once a week. On any given route, the appellant’s employees might visit 25 to 40 customers per day.

(i) The dump truck drivers always did the same work. They had to weigh the product or estimate it by the naked eye. The only sorting to be done was in taking out garbage, metal and plastic. The driver was the one who decided whether the merchandise should be rejected. On any given route, a driver took the same time, both summer and winter, except that there might be fewer customers during the cold season. Ideally, there was one driver per dump truck. On the other hand, one person might have to drive both a dump truck and a tractor-trailer.

Jacques Boulet, an inspector employed in the non-edible meats section of the Ministère de l'Agriculture du Québec, was called to testify on behalf of the respondent. It was this government department which had issued a permit to the appellant in 1986 for the use of 41 dump trucks, 46 trailers and 9 tanks, some of which were used in shipping the finished goods. Mr. Boulets testimony, overall, did not contradict the evidence given by André Couture and Jean Gauthier. He provided some additional details, stating that in general all products are mixed together on board the vehicles but that some trailers are compartmentalized, for example, for hair and feathers. He stated that the feathers and viscera are sorted at the abattoir, and that the appellant's truck driver does not take part in that operation. Mr. Boulet also indicated that there were about three to five grease trucks. A driver of this sort of truck fills out a receipt at the supplier's after doing an estimate of the water by the naked eye or using a stick. The final measurement of the merchandise is done at the plant where the final measurement data are compared with the data given by the drivers.

We should now examine the arguments of the parties in light of this evidence.

The appellant's position is set out in paragraph 17 of the notice of appeal, as follows:

More particularly, the appellant alleges:

(a) that picking up the raw material constitutes receiving and storing of raw

materials within the meaning of subparagraph 5202(a)(ii) of the Regulations;

(b) in the context of an integrated operation such as the appellant's, the sorting and examining of materials by the operators, and the operations which may be done during transport, such as separating materials and water and keeping some materials at a pre-determined temperature, constitute producing, assembling or handling within the meaning of subparagraph 5202(a)(ii) [SIC] of the Regulations;

(c) the activities referred to above are activities performed in Canada directly in connection with manufacturing or processing by the appellant, within the meaning of paragraph 5202(b) of the Regulations, since the operation carried out by the appellant is continuous and integrated.

[Translation.]

The respondent set out his arguments in support of the assessments generally in paragraphs 9 and 10 of the reply to the notice of appeal. Perhaps the respondent's position is best described in paragraph 7(o), which states that in assessing the appellant for the years in issue the respondent relied, inter alia, on the fact that in the respondent's view "the transport of raw materials, and everything involved therein, did not constitute manufacturing or processing activities by the appellant during the taxation years in issue” [translation].

Analysis

Section 125.1 of the Income Tax Act allows a deduction from tax otherwise payable in respect of a corporation's Canadian manufacturing and processing profits for a taxation year. The legislator defined the terms "manufacturing or processing" in paragraph 125.1(3)(b) to make this tax credit inapplicable to ten categories of businesses. The meaning of the expression "Canadian manufacturing and processing profits” is also defined, in paragraph 125.1(3)(a), as".. . such portion of the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada as is determined under rules prescribed for that purpose by regulation made on the recommendation of the Minister of Finance to be applicable to the manufacturing or processing in Canada of goods for sale or lease;". These rules, which determine the income of a corporation from an active business carried on in Canada, have been established by sections 5200 to 5204 of the Income Tax Regulations. The issue in these appeals are specifically on the application of sections 5200 and 5202 of the Income Tax Regulations, which read as follows:

5200. Subject to section 5201, for the purposes of paragraph 125.1 (3)(a) of the Act, “Canadian manufacturing and processing profits” of a corporation for a taxation year are hereby prescribed to be that proportion of the corporation's adjusted business income for the year that

(a) the aggregate of its cost of manufacturing and processing capital for the year and its cost of manufacturing and processing labour for the year,

is of

(b) the aggregate of its cost of capital for the year and its cost of labour for the year.

5202. In this Part, except as otherwise provided in section 5203 or 5204,

“ qualified activities" means

(a) any of the following activities, when they are performed in Canada in connection with manufacturing or processing (not including the activities listed in subparagraphs 125.1(3)(b)(i) to (ix) of the Act) in Canada of goods for sale or lease:

(i) engineering design of products and production facilities,

(ii) receiving and storing of raw materials,

(iii) producing, assembling and handling of goods in process,

(iv) inspecting and packaging of finished goods,

(v) line supervision,

(vi) production support activities including security, cleaning, heating and factory maintenance,

(vii) quality and production control,

(viii) repair of production facilities, and

(ix) pollution control,

(b) all other activities that are performed in Canada directly in connection with manufacturing or processing (not including the activities listed in subparagraphs 125.1 (3)(b)(i) to (ix) of the Act) in Canada of goods for sale or lease, and

(c) scientific research as defined in section 2900,

but does not include any of

(d) storing, shipping, selling and leasing of finished goods,

(e) purchasing of raw materials,

(f) administration, including clerical and personnel activities,

(g) purchase and resale operations,

(h) data processing, and

(i) providing facilities for employees, including cafeterias, clinics and recreational facilities

At the very beginning of the hearing, counsel for the parties indicated that in applying the formula provided in section 5202, the issue involved two items in the numerator of the fraction set out below. As was noted earlier, these two items deal with the cost of manufacturing and processing capital and the cost of manufacturing and processing labour. The fraction in question was described as follows:

CMPC = Cost of manufacturing and processing capital

CC Cost of capital

CMPL = Cost of manufacturing and processing labour

CL	= Cost of labour
ABI	Adjusted business income
MPP	Manufacturing and processing profits

Calculation:

CMPC = 100/85 x 10% of the cost of manufacturing and processing capital

In undertaking our study of the definition of qualified activities" in section 5202 of the Income Tax Regulations, we find that in the list of qualified activities set out in paragraph (a) of that definition the first four subparagraphs describe four categories of operations in the chronological order of the manufacturing or processing process. First, there is the “ engineering design of products and production facilities”. This is obviously a stage which occurs at the very beginning of the process, at the point when the plans on the technical side of the material to be processed or manufactured, depending on the case, and the facilities which must be set up so that production can be carried out, are being developed. From there, we go on to the necessarily later stage of "receiving and storing raw materials’. This second stage is followed by the production stage, properly speaking, which operation includes “ assembling and handling of goods in process". Finally, the fourth stage is "inspecting and packaging of finished goods". The other five categories covered by subparagraphs (v) to (ix) of paragraph (a) of this definition of“ qualified activities" are not in themselves distinct stages in the manufacturing or processing process, although they are all activities immediately, or in some cases relatively immediately, related to the manufacturing of particular goods. Reference is made to "line supervision"—I think this means the supervision of workers engaged in production operations, “ production support activities including security, cleaning, heating and factory maintenance", ” quality and production control", repair of production facilities” and "pollution control". From this list of activities, it will be seen that neither the purchase of raw materials at the beginning of the production cycle nor the stage involving shipping or selling finished products at the end of the cycle is covered. It may be inferred from this list of categories of activities covered by paragraph (a) that qualified activities involve operations both before and after the production stage itself which are sufficiently closely connected to the production stage, but do not include operations which occur at the two extreme ends of the chain of production taken in a very general sense, apart, of course, from the case of" engineering design of products and production facilities”.

In defining “ qualified activities" the regulatory authority did not stop at the nine categories of operations in paragraph (a) which are commented on above, but indicated in paragraph (b) of the definition of that expression that it also included

(b) all other activities that are performed in Canada directly in connection with manufacturing or processing (not including the activities listed in subparagraphs 125.1 (3)(b)(i) to (ix) of the Act) in Canada of goods for sale or lease. . . .

The regulatory authority also included, in paragraph (c) of the definition of the expression "qualified activities", “ scientific research as defined in section 2900” of the Income Tax Regulations.

It seems clear that the aim of paragraph (b) of the definition of “ qualified activities’, quoted above, is to add other operations to those covered b paragraph (a) of that definition. This is spelled out by the use of the words ll other activities". Second, the regulatory authority had in mind additional activities "that are performed in Canada directly in connection with manufacturing or processing in Canada". The words “directly” and “in connection with” must be noted and studied. In my view, these expressions mean activities which, first, are connected with manufacturing and processing operations in Canada but are not an integral part of the actual manufacturing and processing process. If this were not the case, the expression “dans le cadre des opérations de fabrication ou de transformation”, or in the English version, the prepositional phrase “in connection with”, would not have been used. In addition, these activities, which occur on the periphery of manufacturing or processing, must be concerned directly. These operations, which are ancillary to manufacturing or processing in Canada, are therefore an integral part of the qualified activities, on the condition that they are themselves the subject of such activities. If we restrict the scope of this part of paragraph (b) further, we end up with nonsense, since no effect could be given to that paragraph. In my opinion, we must interpret paragraph (b) in a large and liberal manner, so that it may include activities other than those already covered by paragraph (a) of the definition. In addition, the word "directly", which appears in paragraph (b), requires that there be a direct relationship between the ancillary or connected activities and the manufacturing or processing. Since the possibility of applying either of the exceptions — referred to in paragraph (b) of the definition of qualified activities" — found in subparagraphs 125.1(3)(b) (i) to (ix) of the Income Tax Act was not raised at the hearing of these appeals, we need not comment on these exceptions.

I now come to the exceptions which are in issue in paragraphs (d) to (i) of the definition of the expression “ qualified activities". First, it is clear from the structure of this definition that the six activities described in those paragraphs are exceptions to the overall set of activities contemplated by paragraphs (a),

(b) and (c) of the definition of the words "qualified activities’. These six categories of activities described in paragraphs (d) to (i) help us to cover more precisely the extent or the parameters of paragraphs (a) and (b) of that defini- tion. Thus at the one extreme end of the process,“ purchasing raw materials” is excluded from the process, and at the other extreme, “storing, shipping, selling and leasing of finished oods” are eliminated. This definition also does not include certain activities relating to facilities provided for employees, such as "cafeterias, clinics and recreational facilities’, or certain activities relating to the general aspects of the administration of a business, such as “data processing" and “clerical and personnel activities”. It should be noted that the categories of operations relating to data processing and particularly to the administration of these general aspects are quite far removed from activities relating to production or processing in Canada. Moreover, by excluding "purchase and resale operations" it is made clear that these activities are not eligible since they involve another entirely distinct operation, that of the purchase and immediate resale of some product without it being in any way modified or processed.

From this study of the various paragraphs dealing with the definition of “ qualified activities", I conclude that the appellants activities involving picking up raw materials and transporting them to the plant are included in qualified activities within the meaning given to that expression in section 5202 of the Income Tax Regulations.

First, I believe that the appellant's activity of picking up the raw materials right on the suppliers' premises using its own vehicles, which were specially equipped for their functions, comprises the stage of receiving raw materials within the meaning of subparagraph 5202(a)(ii) of the Regulations. I am of the opinion that receiving raw materials occurs when the business in question, which is involved in manufacturing or processing in Canada, takes possession of the raw materials and thereafter has control of them. It is not important whether possession is taken of the raw materials in the suppliers’ establishments or on the premises of the business in question or elsewhere. The raw materials are in fact received" when the suppliers deliver them or transfer them to the employees of the manufacturing or processing business who accept them on behalf of that business. The materials are, from that moment on, the property of the appellant and are at the risk of the appellant. It does not seem to me to be logical to argue, as did the respondent, that the materials are received only at the plant when processing of the material has begun. That restriction seems to me not to be justified on the words of subparagraph 5202(a)(ii), and not to take into account the special method of operation of the appellant's business.

Furthermore, if, contrary to what I believe, picking up and transporting the raw materials to the plant are not covered by paragraph (a) of the definition of "qualified activities”, it seems to me to be indisputable that these operations are included in "other activities" as set out in paragraph (b) of that definition because these operations are sufficiently closely related to manufacturing or processing in Canada. Picking up these raw materials is, it goes without saying, an essential operation in carrying on manufacturing or processing in Canada. Moreover, picking up and transporting these raw materials to the plant is in no way similar to the exceptions set out in paragraphs (d), (f), (h) and (i), which relate to finished goods or to the general aspects of the administration of a business. Nor are the operations involved in picking up and transporting the raw materials to the plant, which are by nature physical, covered by the activities described in paragraphs (e) and (g) of the definition of the expression "qualified activities”. The activities described in paragraphs (e) and (g) relate rather to negotiating and signing contracts and to the financial, legal and other terms of such contracts.

The approach I have taken in interpreting the various paragraphs of the definition of the expression “ qualified activities" seems to me to be consistent with the interpretation adopted by Mr. Justice Walsh of the Federal Court of Canada-Trial Division, in the case The St. Catharines Standard Ltd. v. The Queen, [1978] C.T.C. 258, 78 D.T.C. 6168, although the nature of the business in question in that case was totally different from the business with which we are concerned here. Among the decisions cited by counsel for the appellant, I also considered the decision of the Supreme Court of Canada in Irving Oil Ltd., Foster Wheeler Ltd. and Canaport Ltd. v. The Provincial Secretary for the Province of New Brunswick, [1980] 1 S.C.R. 787, 109 D.L.R. (3d) 57 and the decision of the Federal Court of Appeal in D/M.N.R. for Customs and Excise v. Amoco Canada Petroleum Company Ltd., [1986] 1 C.T.C. 124, 86 D.T.C. 6008, and I concluded that these decisions were not very useful for the purposes of this case: these two decisions dealt with the interpretation of legislative provisions which were quite different from those which concern us in this case. The issues were also dissimilar to those before us here.

Nor do I believe that the decisions to which counsel for the respondent drew my attention are directly applicable to the present case. The decision of the Federal Court of Appeal in the case Nova Scotia Sand and Gravel Ltd. v. The Queen, [1980] C.T.C. 378, 80 D.T.C. 6298, did in fact deal with the application of section 125.1 in respect of the manufacturing and processing profits tax credit, but the issue in that case was whether the company in question was involved in producing industrial minerals within the meaning of subparagraph 125.1(3)(b)(vii). That subparagraph is one of several categories of businesses to which the manufacturing or processing profits tax credit does not apply. In the case Hopkins Construction (Lacombe) Ltd. v. M.N.R., [1984] C.T.C. 2172, 84 D.T.C. 1150, Judge Sarchuk of this Court decided that the section 125.1 tax credit did not apply on the ground, inter alia, that the taxpayer's activities did not relate to manufacturing or processing in Canada of goods for sale or lease. According to Judge Sarchuk, there was rather a business contract for the performance of certain services. The issue was therefore whether or not paragraph 125.1(3)(a) of the Income Tax Act should be applied.

In studying the abundant case law referred to by counsel for the parties, I believe that it is important to keep in mind the point that the present case did not relate directly to the issue of whether the appellant was involved in manufacturing or processing in Canada: it was in fact admitted by both parties that the appellant was operating a business manufacturing or processing the materials in issue in this case. The business which concerns us is not excluded by paragraph 125.1(3)(b) of the Act. Rather, the issue is whether the activities which gave rise to this case are qualified activities within the meaning of the definition of that expression set out in section 5202 of the Income Tax Regulations which, as I have attempted to show, includes certain activities that obviously are not manufacturing or processing.

I am therefore of the opinion that the appeals should be allowed with costs. The assessments are therefore referred back to the respondent for reconsideration and reassessment on the basis that, in computing the manufacturing and processing profits tax credit, the assets used in picking up and transporting raw materials are, for the purposes of section 5200 of the Income Tax Regulations, part of the cost of manufacturing and processing capital, and the cost of the labour involved in transporting theraw materials and maintaining the vehicles in question is part of the cost of manufacturing and processing labour.

Appeal allowed.