NRB Inc. v. The Queen, 93 DTC 295, [1993] 1 CTC 2435 (TCC)

Hamlyn, T.C.C.J.:—

Facts

The appellant, NRB Inc., appeals reassessments dated May 16, 1990, in respect of its 1986, 1987 and 1988 taxation years.

The appellant filed notices of objection which were confirmed by notices of confirmation dated February 28, 1991.

The Minister of National Revenue (the"Minister") reassessed on the basis that the appellant was not entitled to the claimed manufacturing and processing profits deduction as calculated pursuant to section 125.1 and Regulations 5200 and 5202 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

These provisions allow certain manufacturing and processing corporations carrying on active business in Canada to deduct specified manufacturing and processing profits from tax otherwise payable for a taxation year. This deduction is determined by a prescribed formula. The formula, amongst other things, requires the determination of the cost of manufacturing and processing labour. Specifically, the cost of labour includes all amounts paid to subcontractors in the production process relating to a service or function that would normally be performed by an employee of the corporation.

The Minister denied the deduction as calculated on the basis that payments made by appellant to subcontractors ought not to have been included in the calculation of the cost of labour and the cost of manufacturing labour.

At the outset the parties filed an agreed statement of facts. The relevant portions are hereinafter reproduced:

1. The appellant is a Canadian controlled private corporation within the meaning of paragraph 125(7)(b) of the Income Tax Act.

2. The appellant manufactures, builds and erects modular buildings (“the units”). The appellant performs this work in its plant and adjoining yards in Grimsby, Ontario. The appellants drivers deliver the units to the customers’ premises. On a very small number of contracts the appellant has built and erected the units at its customers' premises. The appellant custom makes all units.

3. In the taxation years 1986, 1987 and 1988 the appellant claimed the manufacturing and processing profits deduction ("the MPPD”) pursuant to section 125.1 and Regulation 5202 of the Act.

5. The sole issue to be determined on this appeal is whether the appellant's payments to independent contractors, other than electricians and plumbers, are to be included in the calculation of CMPL (cost of manufacturing and processing labour) and CL (cost of labour) in each of the three taxation years under appeal, namely 1986,1987 and 1988 ("the three taxation years").

7. In the three taxation years the appellant used employees and subcontractors, who were not employees, to make the units.

8. In each of the three taxation years approximately 80 per cent of the appellant's annual manufacture of portable classrooms occurred in the four month period starting on or about May 1st and ending on or before Labour Day because of school boards' orders of portable classrooms for delivery before the beginning of the school year. In the four month periods in the three taxation years the appellant increased the number of subcontractors and employees hired so as to meet the demand created by school boards.

9. In the three taxation years the appellant made the following numbers of units:

Year	Portable Classrooms	Other Modular Buildings	Total
1986	350	116	466
1987	514	171	685
1988	551	297	848

10. In the three taxation years the appellant employed full-time employees and employees who did not work the full year to make the units. The proportions were as follows:

	Full-time	Less than the
Year	employees	full-year employees	Total employees
1986	19	64	83
1987	10	93	103
1988	10	85	95

During this period the appellant made the following payments to subcontractors (other than to plumbers and electricians):

It is also agreed, as per the agreed statements of facts, that:

16. In the three taxation years the appellant's foremen and supervisors were full- time employees.

17. The subcontractors’ activities included framing, carpentry, installation of doors, windows, insulation, flooring, ceilings and drywall, roofing, plumbing and electrical works.

18. Except for the electrical and plumbing work, the appellant’s employees were capable of performing the same type of work as the subcontractors, although not the same volume of units. The appellant also alleges that its employees did in fact perform the same type of work as the subcontractors, namely, framing, carpentry, installation of doors, windows, insulation, flooring, ceilings and drywall and roofing.

The appellant called one witness, Mr. Robert McNeil Junior. For the 1986, 1987 and 1988 taxation years he was the vice-president of the corporation in charge of production; his evidence was precise, extensive and exact in relation to the activities of the corporation for these years.

He stated the work of the subcontractors was the same work performed by the employees of the appellant save and except the work of the subcontracted plumbers and electricians.

The work of the subcontractors was not specifically segregated nor separated from that of the regular employees performing the same functions, that is, the work of the subcontractors and the appellant's employees was the same work and was integrated into the production line of the corporation.

As indicated, for the particular years in question, the appellant had a high volume period and a low volume period. The high volume period was May, June, July and August; during this period the manufacture of portable school rooms grew to an” unbelievable" level of production. The demand for portable modular school rooms for the years in question was also" unpredictable”. The appellant could not meet the demand solely with hourly rated employees. Specifically, the gross sales doubled and the production tripled because of the various school board clients'"dire need" for the product. In order to meet the demand, the appellant had to hire many subcontractors as its employment roster could not meet the need.

The evidence further established that, during the taxation years, approximately 92 per cent of the labour cost in question related to subcontractors.

Legislation

Former paragraph 125.1 (1)(a) of the Act (now repealed) provided in part:

125.1(1) There may be deducted from the tax otherwise payable under this Part by a corporation for a taxation year an amount equal to the aggregate of

(a) 7 per cent of the lesser of

(i) the amount, if any, by which the corporation's Canadian manufacturing and processing profits for the year exceed the least of the amounts determined under paragraphs 125(1)(a) to (c)in respect of the corporation for the year, and

(ii) the amount, if any, by which the corporation's taxable income for the year exceeds the aggregate of

(A) [Repealed by 1976-77, c. 4, subsection 50(1).]

(B) the least of the amounts determined under paragraphs 125(1)(a) to (c) in respect of the corporation for the year,

(C) 2 times the aggregate of amounts deducted under subsection 126(2) from the tax for the year otherwise payable under this Part by the corporation, and

(D) the amount, if any, by which the aggregate of the corporation’s Canadian investment income for the year and its foreign investment income for the year (within the meanings assigned by subsection 129(4) exceeds the amount, if any, deducted under paragraph 111(1)(b) from the corporation's income for the year; and

(b) five per cent of the lesser of

(i) the corporation’s Canadian manufacturing and processing profits for the year, and

(ii) the least of the amounts determined under paragraphs 125(1)(a) to (c) in respect of the corporation for the year.

Paragraph 125.1(3)(a) provides that:

“Canadian manufacturing and processing profits" of a corporation for a taxation year means 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.

Regulation 5200 provides that:

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 ear 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.

Regulation 5202 provides that:

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

"cost of labour” of a corporation for a taxation year means an amount equal to the aggregate of

(a) the salaries and wages paid or payable during the year to all employees of the corporation for services performed during the year, and

(b) all other amounts each of which is an amount paid or payable during the year for the performance during the year, by any person other than an employee of the corporation, of functions relating to

(i) the management or administration of the corporation,

(iii) a service or function that would normally be performed by an employee of the corporation.

[Emphasis added.]

Jurisprudence

Two decisions of the Federal Court of Appeal are of particular assistance in this matter (Canadian Clyde Tube Forgings Ltd. v. The Queen, [1980] C.T.C. 41, 80 D.T.C. 6008 (F.C.T.D.), aff'd [1982] C.T.C. 21, 82 D.T.C. 6041 (F.C.A.), and Levi Strauss of Canada Inc. v. The Queen, [1980] C.T.C. 480, 80 D.T.C. 6345 (F.C.T.D.), aff'd [1982] C.T.C. 65, 82 D.T.C. 6070 (FCA)). The conclusion to be drawn is that the application of the test in 5202(b)(iii) is subjective and quantitative in the sense that the appellant has employees performing functions which the subcontractors were engaged to perform.

It is important to bear in mind that in Levi Strauss of Canada Inc., supra, and Canadian Clyde Tube Forgings Ltd., supra, none of the functions performed by the subcontractors were performed by the employees.

Analysis

The modus operandi of the production line of the corporation was to use its own employees (both full year and part year employees) augmented and supported by subcontractors. The subcontractors did nothing more than the regular employees although the volume of the production in terms of cost was on account of the subcontractors (over 90 per cent).

The subcontractors’ services were the same services performed by the employees of the corporation, that is, they were together and integrated within the production line of the corporation. The input of the employees was real and carried on throughout the production process. To calculate the cost of labour within Regulation 5202 necessitates the determination of whether the amount paid to the subcontractors for the functions related to the services performed by the subcontractors that would “normally” be performed by an employee of the corporation.

The production demand increase resulted from “ unpredictable” market demands for portable school rooms from consumer school boards in the months of May, June, July and August. In the same period, the appellant corporation for the years in question experienced unbelievable” production increases in this same period. As such the market demands for production as experienced by the appellant for those functions that would have normally been performed by the employees of the corporation was beyond the capacity of the corporation. This resulted in a substantive increase of subcontractors performing the same integrated tasks of employees in the production process. As a consequence, subcontractors performing the same services of employees allowed the corporation to meet its increased market demands.

Regulation 5200 does not limit the number or portion of employees to subcontractors. I, therefore conclude that the performance of functions by the subcontractors related to the service normally performed by employees of the corporation.

Decision

The appeals are allowed and referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the amounts paid to subcontractors, other than the amounts paid to plumbers and electricians, are to be included in the calculation of the cost of manufacturing and processing labour and the cost of labour in the 1986, 1987 and 1988 taxation years in accordance with sections 5200 and 5202 of the Income Tax Regulations and section 125.1 of the Act.

The appellant is awarded its costs.

At the outset of this hearing counsel for both parties placed before the Court their consent to a secondary issue found in the pleadings (the allocation of management and office salary expense in the calculation of the cost of manufacturing and processing labour) and asked this Court to pronounce judgement in accordance with that consent.

On this particular issue the appeals are allowed and referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the allocation of management and office salary expense in the calculation of the cost of manufacturing and processing labour shall include $113,484 for the 1987 taxation year and $145,927 for the 1988 taxation year.

Appeal allowed.