Neonex International Ltd. v. The Queen, 78 DTC 6339, [1978] CTC 485 (FCA)

Urie, J:—This is an appeal from a judgment of the Trial Division pronounced on August 26, 1977 wherein an appeal from an income tax assessment for the appellant’s 1969 taxation year was allowed and appeals from assessments for its 1970, 1971 and 1972 taxation years were dismissed.

Four separate issues were raised on appeal in response to reassessments for the 1969 through 1972 taxation years as follows:

(a) In computing its income for the 1971 taxation year the appellant asserted that a foreign exchange gain in the amount of $305,007.39 which was realized upon repayment of a loan earlier made by the appellant from a source in the United States of America was a non-taxable capital gain whereas the Minister of National Revenue viewed the gain as taxable income;

(b) In computing its income for the 1969 taxation year the appellant deducted the sum of $105,000 paid to the Prudential Insurance Company of America to retire its debt to that company whereas the Minister of National Revenue regarded the amount as an outlay on account of capital not deductible in computing income;

(c) In computing its income the appellant deducted legal expenses of $48,059.27, $98,046.52 and $113,117.94 incurred in the 1970, 1971 and 1972 taxation years, respectively, in connection with an abortive attempt to acquire the shares of Maple Leaf Mills Ltd whereas the Minister of National Revenue regarded the amounts so paid as outlays on account of capital; and

(d) In computing its income for the 1970, 1971 and 1972 taxation years the appellant deducted the costs incurred by its sign division in the course of producing custom electrical display signs and prior to their completion, delivery and installation, whereas the Minister of National Revenue regarded the expenses aggregating $176,561; $111,724 and $24,693 in the 1970, 1971 and 1972 taxation years, respectively, as the cost of inventory to be deducted in accordance with inventory principles of accounting at the time of delivery or installation of the signs.

The judgment of the Trial Division characterized the foreign exchange gain as income thus dismissing the appeal on this issue; allowed the appeal in respect of the deduction of the sum paid to the Prudential Insurance Company of America and dismissed the appeals in respect of the deduction of legal expenses and of the sign costs.

Neon Products of Canada Limited was incorporated under the federal Companies Act in 1929 and thereafter was engaged in the electric sign and outdoor advertising business. In 1968 control of the company was acquired by a new group headed by J A Pattison following which the company began to purchase small active companies engaged in a variety of businesses. In 1969, the name of the company was changed to that of the appellant, and the sign business became an operating division of the appellant. Insofar as the acquisitions were concerned the parent appellant provided for them management services and expertise as well as their capital and working capital requirements. Out of its own bank line of credit it made loans to the subsidiaries at interest rates of approximately 1 /2% above the rates it was itself, from time to time, charged. Its sources of income thus became (a) revenues from its sign division; (b) dividends from its subsidiaries; (c) management fees charged for services rendered its subsidiaries; and (d) interest on loans to its subsidiaries. By the end of 1972 it had acquired between 60 and 70 companies of which 30 to 40 were considered to be significant profit centres each embracing as they did, in some cases, more than one of the subsidiary companies.

With this general background in mind, for convenience sake, each of the issues will be dealt with seriatim.

1. Foreign Exchange Gain

In December, 1969, the appellant decided to attempt to wrest control of Maple Leaf Mills Ltd (hereinafter called Maple Leaf) in a complicated series of manoeuvres. Approximately 52% of Maple Leaf’s outstanding shares were, by written agreements, to have been acquired directly or indirectly through Norris Grain Company, Inc, an Illinois corporation. Leitch Transport Limited, an Ontario corporation and from the Leitch family interests. A further block of Maple Leaf shares, representing approximately 14% of its issued shares, were to be purchased in the open market.

The gross cost of the purchases was to be about $21,000,000 of which $7,000,000 was to be recovered from the sale, after the acquisi- tion, of shares of Dominion Foundries and Steel Company held as assets by a subsidiary of Norris Grain Company. A further $4,000,000 was to be generated from “internal sources” of the appellant and the balance of $10,000,000 was to be obtained by bank borrowing.

Early in 1969 the appellant had arranged for a bank line of credit with Canadian Imperial Bank of Commerce comprising operating loans of $8,000,000 and capital loans of $12,000,000 in accordance with the terms and conditions set forth in a letter from the appellant to the bank. At December 1969 approximately $10,000,000 to $10,500,000 remained available to the appellant. For reasons which are not really relevant to this issue, the appellant chose not to avail itself of this undrawn credit but chose rather to borrow the required money from Marine Midland Grace Trust Company of New York (hereinafter referred to as Marine Midland). On December 17, 1969 the sum of $10,000,000 (U.S.) was borrowed from Marine Midland and as security therefor the appellant delivered a three-months promissory note to the lender.

According to the evidence the $10,000,000 (US) was applied as follows:

The sum of $5,589,600 (US), representing $6,000,000 (Can), together with a further sum of $8,287 was lent by the appellant to Overwaitea Ltd, a subsidiary of the appellant which operates a chain of supermarkets, and the loan was secured by a promissory note or notes renewed from time to time at varying rates of interest in excess of that charged from time to time by Marine Midland to the appellant.

According to the evidence, for various reasons, Neonex had designated Overwaitea Ltd as its nominee to make the open market purchases of Maple Leaf shares. It had done so by making use of funds generated from its operations and it was to replace those funds that the $6,008,287 was lent to it. Overwaitea required the funds for store expansions, new store inventories and normal day to day operations.

It had been anticipated by Mr Pattison that the amount required to repay the Marine Midland loan would be drawn against the remaining line of credit with Canadian Imperial Bank of Commerce although, as pointed out by counsel for the respondent, that line of credit would have expired on January 31, 1970, well before the Marine Midland loan had to be repaid.

When the Canadian Imperial Bank of Commerce learned that the appellant had borrowed from Marine Midland without its prior consent. it froze the appellant’s borrowing at approximately $9,600,000 and instructed it to obtain alternative financing. This action resulted in the appellant being unable to repay Marine Midland on March 17, 1970 as scheduled and necessitated numerous extensions and renewals of its promissory notes. Eventually on August 23, 1971 Marine Midland was repaid the sum of $5.814.145.45 (US) which included the sum of $5.589.600 (US) previously converted to Canadian funds and lent by the appellant to Overwaitea Ltd. The foreign exchange gain in respect of the repayment of the $5.589.600 (US) was $305,007.39. It is this sum that the respondent assessed as income in the hands of the appellant which assessment was upheld by the learned trial judge. The appellant appeals from that decision.

It was the respondent’s contention both here and below, that the money was not borrowed for the appellant’s capital account but was borrowed for the purpose of lending it to one of its subsidiaries in financial operations that'were part of its business. While conceding that the appellant was not a “money lender’ in the sense that it would lend money to the public at large. counsel for the respondent contended that it acted as the central bank for the subsidiaries, supplying most of their capital needs. For that purpose it borrowed money and lent it to the subsidiaries at a rate 1 Vi % in excess of that which it paid. TRus one of the sources of the appellant’s earnings was. as earlier stated. income so generated. The transaction which gave rise to the foreign exchange gain was part of that financing business. There was nothing in this borrowing which, in counsel’s view. set it apart from other borrowings of the appellant in fulfilling its role as central banker for the various subsidiaries.

it was the appellants submission that the transaction could only be regarded as being one on. income account in. circumstances where the money borrowed constituted the stock in trade or inventory of the borrower. That was not the case here. The money borrowed here was to finance the acquisition of another company by purchasing sufficient shares to gain control of that company. As such it was money borrowed for capital purposes, and thus any gain which arose during the repayment of the money because of fluctuations in the foreign exchange rate between that which prevailed when the loan proceeds were acquired and when the loan was repaid, was a gain in respect of capital.

The learned trial judge agreed, in effect, with the respondent’s submissions when he said:

‘It i's a question of fact whether a business, in the sense of the Income Tax Act, iS carried out by a taxpayer (see for. instance The Queen v Rockmore [1976] CTC 291; 76 DTC 6156), and it seems to me that the facts revealed by the evidence here are to the effect that the plaintiff had been for some years actively, systematically and regularly engaged in the financing of its subsidiaries so as to make such financing part of its business. It is clearly established that the plaintiff did not borrow the money from Marine Midland to use it itself for a capital purpose like the buying of a capital asset; it borrowed the money so that it could carry on its financial operations and, more precisely, so that it could lend at a profit a large part of the proceeds of the loan to Overwaitea which required capital to satisfy its operating and other requirements.

This brings the matter within the line of reasoning of Tip Top Tailors Ltd v MNR [1957] SCR 703; [1957] CTC 309; 57 DTC 1232 applied in many recent cases (for instance Aluminium Union Limited v MNR [1960] Ex CR 363; [1960] CTC 206; 60 DTC 1138; DWS Corporation v MNR [1968] Ex CR 44; [1968] CTC 65; 68 DTC 5045). The foreign-exchange profit realized by the plaintiff here was generated by a transaction that was part of the business in which the company was engaged, namely that of financing its subsidiaries; it follows that such profit was not on capital account but on business account and was taxable.

Many cases have referred to the tests to be applied for the purpose of determining whether any transaction should be characterized as capital or income in nature. With reference to expenditures, Abbott, J in British Columbia Electric Railway Company Limited v MNR, [1958] SCR 133 at 137-138; [1958] CTC 21 at 31-32: 58 DTC 1022 at 1027-28 had this to say:

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 paragraph 12(1)(a) whether it be classified as an income expense or as a Capital outlay.

The general principles to be applied to determine whether an expenditure which would be allowable under paragraph 12(1)(a) is of a capital nature, are now fairly well established. As Kerwin J, as he then was, pointed out in Montreal Light Heat & Power Consolidated v MNR, [1942] CTC 1; 2 DTC 535, applying the principle enunciated by Viscount Cave in British Insulated and Helsby Cables, Limited v Atherton, the usual test of whether an expenditure is one made on account of capital is, was it made ‘‘with a view of bringing into existence an advantage for the enduring benefit of the appellant’s business’’.

The application of these tests to the facts of this case provide what I deem to be the correct characterization of the loan from Marine Midland to the appellant and thus the repayment of the monies used by Overwaitea Ltd to purchase shares in the open market. It must first be said that while it is true that a company may be engaged in the business of financing its subsidiaries in whole or in part, it does not, in my view, necessarily follow that all transactions between the parent and subsidiary are part of its financing business. A careful reading of the transcript of evidence and of the exhibits makes it crystal clear that the Marine Midland loan was made solely for the purpose of purchasing the controlling interest in Maple Leaf. The characterization of that loan must clearly be that it was capital in nature. The sole question to be answered then is whether that character changed as a result of the appellant using the proceeds of the loan, not to purchase the Maple Leaf shares in the open market therewith, but rather to replenish the cash resources of Overwaitea Ltd which had been depleted by the withdrawal from its accumulated revenue of sufficient funds to effect such purchases. While the actual purchases had been made by the appellant the shares were registered and had always intended to be registered, in the name of Overwaitea Ltd as the appellant’s nominee. The two reasons for handling the transaction in this way, as related by Mr Lewall, the assistant to the chief operating officer of the appellant, were:

I think there are probably two principal reasons, the first of which was to meet the existing income tax regulations it was necessary that we purchase these shares from cash generated from operations so that we would be able to make the interest tax deductible, and Overwaitea Ltd at that time generated roughly a million dollars a week in sales, so we set up: what was termed a cash dam out of their sales proceeds from their daily operations, and the second principal reason was that they were in the food business and Maple Meals Ltd, part of their operations was food. and it just seemed like a natural place to have it located within Overwaitea.

These provided, in my view, valid business reasons for having Overwaitea Ltd acquire the Maple Leaf Mills shares—reasons which did not have the effect of converting a loan made to acquire capital assets into one which was to provide funds for the financial business of the appellant (if in fact it was engaged in such a business) notwithstanding the fact that by making the loan to Overwaitea Ltd at a higher rate of interest than it paid, generated revenue for the appellant which would become part of its income for tax purposes. The character of the borrowing never changed. Nor did the machinery employed to effect the purchase make any change in the character of the transaction. Thus, with great respect, I am of the opinion that the learned trial judge erred in inferring that because the appellant loaned the borrowed money at a rate higher than it paid for the use of the money, the appellant in borrowing was engaged in its business. of financing its subsidiary, Overwaitea Ltd. To do so necessitated his ignoring the uncontradicted oral and documentary evidence in favour of drawing an inference that, in my view. is unsupported by that evidence. Since no issue of credibility was involved, we are in as favourable a position as the trial judge to draw inferences from the uncontradicted evidence. In my opinion, the only realistic inference to be drawn is that the borrowing from the Marine Midland was from beginning to end to finance a capital acquisition which in the event was abortive, and, therefore, the foreign exchange gain arose as an incident relating to the repayment of a loan made for a capital purpose and not one made as part of its subsidiary financing operations which may be of an income earning character. The appeal insofor as that gain is concerned should therefore, be allowed.* [1]

2. Loan Repayment Expenses:

The relevant facts relating to the repayment of the loan earlier obtained from the Prudential Insurance Company of America and resulting in the outlay of $105,000 disallowed as a deduction by the respondent, are set out in the partial agreed statement of facts, as follows:—

1. On December 1, 1966 the plaintiff borrowed $4,000,000 from The Prudential Insurance Company of America to be used for the purpose of gaining or producing income from a business or property, and as security for the loan executed and delivered to the lender, a promissory note due December 1, 1981 and bearing interest at 7 /s%.

2. The plaintiff was prohibited from prepaying the full amount of the loan referred to in paragraph 1 hereof at any time prior to December 1, 1971.

3. By agreement dated January 31, 1969 the plaintiff borrowed the sum of $15,000,000 (US) from Morgan Guaranty Trust Company of New York on the security of 5%4% convertible senior subordinate notes due 1984.

4. Section 5.6 of the loan agreement between the plaintiff and Morgan Guaranty Trust Company of New York provided as follows:

5.6 Prepayment of outstanding note. At or before the closing, the Company shall furnish you with evidence satisfactory to you and your special counsel that The Prudential Insurance Company of America has consented to the insurance and sale of the notes and the prepayment of the Company’s 7 /s% promissory note due December 1, 1981 out of the proceeds of the sale of the notes.

5. By letter in writing dated January 31, 1969, The Prudential Insurance Company of America agreed that the plaintiff might, out of the proceeds of the Morgan Guaranty Trust Company of New York loan, prepay in full the plaintiff’s 7 /s% note due 1981 at 103% of the principal amount plus accrued interest.

6. The amount, excluding interest, actually paid by the plaintiff to The Prudential Insurance Company of America out of the proceeds of the Morgan Guaranty Trust Company of New York loan proceeds, exceeded the principal amount then outstanding by the sum of $105,000.

7. In filing its 1969 tax return, the plaintiff claimed the said amount of $105,000 as a deduction in computing income.

In light of his conclusion on the foreign exchange gain problem, the trial judge had no difficulty in concluding that the Minister was wrong in disallowing the deduction and allowed the appeal on this issue.

The respondent, in cross appealing, conceded that if this court were to uphold the Trial Division on the question of the taxability of the foreign exchange gain, the trial judge correctly decided that the bonus would be deductible as an expense. Since, as has been seen, in my view, the trial division cannot be upheld on that issue, the question of deductibility must now be decided.

The appellant relies on paragraph 11 (1)(cb) of the Income Tax Act as it applied to the 1969 taxation year, for its contention that expenses incurred in the course of borrowing money is deductible in computing income notwithstanding that it would otherwise be regarded as being on capital account. That section reads as follows:—

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12*, [2] the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(cb) an expense incurred in the year,

(i) in the course of issuing or selling shares of the capital stock of the taxpayer, or

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property (other than money used by the taxpayer for the purpose of acquiring property the income from which would be exempt),

but not including any amount in respect of

(iii) a commission or bonus paid or payable to a person to whom the shares were issued or sold or from whom the money was borrowed, or for or on account of services rendered by a person as a salesman, agent or dealer in securities in the course of issuing or selling the shares or borrowing the money or,

(iv) an amount paid or payable as or on account of the principal amount of the indebtedness incurred in the course of borrowing the money or as or on account of interest;

The position taken by the appellant is that the prepayment “bonus” paid to Prudential Insurance Company of America was an expense incurred in the course of borrowing from Marine Midland and is thus deductible by virtue of subparagraph 11 (1 )(cb)(ii). Counsel relied on the decision of this Court in MNR v Yonge-Eglinton Ltd, [1974] FC 636; [1974] CTC 209; 74 DTC 6180 as indicating the reasoning to be applied in a circumstance such as the case at bar. In his view, the payment to the Prudential Insurance Company arose from or as a result of the decision to borrow additional funds. Discharge of the prior debt was a condition which had to be fulfilled before the borrowing from Marine Midland could have been made and thus was an expense incurred in the course of borrowing money to earn income.

On the other hand the Minister took the position that this» case is on all fours with the earlier decision of the Trial Division in Riviera Hotel Ltd v MNR, [1972] FC 645; [1972] CTC 157; 72 DTC 6142. He adopted the reasoning therein as wholly applicable to the case at bar. In counsel’s view, and contrary to that of appellant’s counsel, the Yonge-Eglinton decision does not call for a reconsideration of the Riviera Hotel decision since they are inconsistent.

In my opinion, counsel for the respondent is correct when he says that the decisions are not inconsistent. While each case involved the interpretation of paragraph 11(1)(cb), the nature of the expense claimed really turned in each case on the facts as found by the respective Courts. In the Riviera case, Cattanach, J found that the payment there in issue was not a payment for the use of the money obtained from the first lender of the money. The payment in issue amounting to six months bonus of interest was made to a first mortgage as an inducement for that lender to forego its right to hold its first mortgage to maturity. The payment was not made in the course of borrowing money from the first lender but it was made in the course of prepaying that money. That being so, it could not be said that the payment to the first lender could be construed as being an expense incurred by the appellant in the course of borrowing from a second lender who required as security for a loan, a new first mortgage, so that the expense could not fall within the provisions of clause 11(1) (cb)(ii).

In the Yonge-Eglinton case, however, the Minister had disallowed amounts claimed as expenses by a borrower of money which, under the terms of the contract with the lender, it was required to pay over and above its payments of interest on the money borrowed. Those amounts were calculated as one per cent of its gross rental income in each year in which it showed a net profit from the operation of a building, for a period of twenty-five years. Thurlow, J, as he then was, speaking for the majority of the court, found that the annual payments were not bonuses in the sense used in clause (iii) of paragraph 11 (1)(cb) but were simply a part of the consideration for a commitment to lend money on certain terms when and if called upon to do so. The payments were thus held to be deductible under clause 11(1)(cb)(ii).

It seems to me that the facts of this case more closely resemble the factual situation in the Riviera case than those in the Yonge- Eglinton case. The reasoning of Cattanach, J appears to me to be clearly right on the facts as he found them which facts are, as observed, closely similar to those in this case. In my view, the payment of $105,000 paid by the appellant, while in a sense necessary for the fulfillment of a condition imposed in respect of a second borrowing, is more properly characterized as a bonus paid to induce the first lender, Prudential Insurance Company of America, to forego its right to hold its first mortgage to maturity by permitting the mortgagor, the appellant herein, to prepay it. Thus, it cannot be construed as an expense incurred by the appellant in the course of borrowing money from Marine-Midland, the second lender. It was an expense incurred to rid itself of the first lender. Clearly, then, it does not fall within the exceptions to paragraph 12(1)(a), (b) or (h) of the Act provided by subparagraph 11 (1 )(cb)(ii) and the Minister’s cross-appeal must be allowed.

3. Deductibility of Legal Expenses:

The appellant claimed and the Minister disallowed certain legal expenses incurred by the appellant in the 1970, 1971 and 1972 taxation years.

Counsel for the appellant admitted in argument that the principles applicable for the deduction of legal expenses are no different than those applicable in determining the deductibility of any other expenses. lt must be ascertained whether the outlays were made in respect of matters capital in nature or income in nature. To enable him to avail himself of the deductibility of the expenses in question, counsel took the position that the business of the appellant, as stated in his memorandum of fact and law, involved

searching for, investigating and acquiring numerous profit or operating centres.

Those efforts, it was said, resulted in the appellant entering into contracts and arrangements with a view to accomplishing its objectives. The purpose was to acquire those profit or operating centres and thereafter to hold them for the purpose of earning income in the form of dividends and to a lessor extent, management fees. The appellant also derived interest for the reasons earlier stated, from loans made to subsidiaries. In his memorandum of fact and law counsel put his case on this issue as follows:

In the course of carrying out those business activities the appellant incurred expenses in respect of staff, travel and legal and accounting advice, all with a view to being able to earn income from its business and property. Throughout, as a conglomerate the appellant constantly entertained the necessary and incidential risk of having its pursuits fall apart either because the target companies which it investigated were unsuitable for its purposes, unavailable on terms acceptable to vendor and purchaser, or unavailable because the appellant and others involved in the transactions were unable, for whatever reason, to perform and carry out the arrangements agreed upon. A necessary and incidental risk, although an infrequent reality was the possibility of being engaged in legal disputes about rights and obligations assumed or acquired in the course of its business. Expenses incurred in those circumstances were necessary and incidental to the conduct of the Appellant’s business and are deductible in computing income under the provisions of paragraph 12(1)(a) of the Income Tax Act applicable to the 1970 and 1971 taxation years and paragraph 18(1)(a) applicable to the 1972 taxation year.

The appellant further submits that the legal expenses which it incurred as a result of the Maple Leaf Mills Ltd transaction whether in representations to the Canadian Imperial Bank of Commerce and other financial institutions or in pursuing or defending litigation in which it was involved, were not incurred to acquire a capital asset since no asset was acquired nor to defend title to a capital asset already owned since none had been acquired. Those cases which have decided that legal expenses are not deductible when incurred with respect to the acquisition of an asset when the acquisition is actually carried out, or when title to an asset owned is defended, have no applicability to the present Case.

A similar argument was made before the learned trial judge who found it difficult to accept that the buying of shares with a view to detaining them can itself be said to be a business. Rather, he held, the appellant was in the business of making and selling signs and, as well, in the business of supplying management expertise, services and funds to the companies, the control of which it had acquired by the purchase of shares. The acquisition of the shares was, in his view, not in itself a business but was, in each case, an investment made with a view to earning income, a fact that, as will be seen from the above quotation from the appellant’s memorandum of fact and law, was admitted by the appellant.

I wholly agree with this finding. I also agree with the trial judge that the legal expenses at issue herein—those incurred in an effort to complete the takeover and those incurred in seeking compensation in lieu of shares—were outlays associated with an investment transaction and thus were made on capital account. That being so the trial judge correctly held, in my opinion, that the expenses were not deductible in any of the taxation years 1970, 1971 or 1972. Moreover, the evidence adduced to support the division of the whole legal bilis between deductible and non-deductible portions, and in particular relating to the activities of the lawyers characterized as “protecting the credit’’ of the appellant, was so skimpy and unsatisfactory as to preclude both this court and the trial division from being satisfied that the division correctly and accurately reflected the actual apportionment of fees between the two types of expense. For these reasons, then, the appeal on this issue must be dismissed.

4, Deductibility of Sign Costs:

As previously noted, the appellant, as an operating division, in contradistinction to the services it renders its subsidiaries, is engaged in the production and subsequent sale or rental of electrical signs. Each sign is custom built to meet the requirements and specifications of each customer. No inventory of completed signs is kept on hand. However, the component raw materials for the signs are stocked. Most signs are sold under conditional sales contracts under which title does not pass until each sign is fully paid for. At year end, there is always a certain number of signs partially completed and in the course of construction. Until 1970 the appellant treated the uncompleted signs for both accounting and tax purposes as work in progress inventory. It continued to do so for accounting purposes thereafter but for the 1970, 1971 and 1972 taxation years the costs incurred to the end of the tax years in respect of partially completed signs were deducted, for the purpose of computing income for tax purposes, on the basis that they represented period expenses not required to be carried for income tax purposes as the cost of work in progress inventory. The amounts in issue in the respective years were $176,561, $111,724 and $24,963 which sums were disallowed as deductions by the Minister. The question simply put is was he right in so doing? The learned trial judge found that he was.

It is the Minister’s contention that in reporting income for tax purposes the calculation thereof must be made in accordance with generally accepted accounting principles unless the Income Tax Act expressly imposes or permits some other method. Counsel for the respondent called as an expert witness a highly qualified chartered accountant who testified that generally accepted accounting practice does not permit the deduction of costs associated with incomplete signs until those costs can be matched with the revenue with which they are associated. Since there can be no revenue until the completed signs have been delivered to the customers, the proper accounting treatment for incomplete signs, according to him, is. to carry them in the books of account as part of inventory until revenue is derived from their sales.

While agreeing that generally accepted accounting principles may favour the matching of costs with revenue, counsel for the appellant contended -that that practice need not be followed for income tax purposes because paragraph 12(1)(a)* [3] of the Act, as it related to the 1970 and 1971 taxation years and paragraph 18(1)(a)t [4] of the Act as it applied to the 1972 taxation year, permit the deduction of expenses incurred for the purpose of gaining or producing income. In his submission, there need not be a causal connection between the expenditure of money and the realization of revenue in the year in which the expense was incurred, or at all, in order for the outlay to be deductible for income tax purposes. Because it carries no stock in trade, because it operates and produces signs only after a contract has been entered into and because it cannot earn the income it has a contractual right to receive without incurring the expense in issue, it has, in the course of producing the signs, incurred expenses for the purpose of gaining or producing income within the meaning of the Income Tax Act and the expenses are therefore deductible when incurred. Put another way, the principle of matching revenue and expenses, in the circumstances of the appellant’s business, has no applicability for tax purposes.

The learned trial judge rejected the appellant’s submissions and, in my opinion, rightly did so. He held that:—

when a company, in submitting in a tax return a report of its expenditures and revenues during a taxation year with a view to establishing its profits or gains and tax base, purports to include as expenditures all the expenses incurred in realizing a manufactured article not yet finished but does not take into account the whole value of the article has for it at that time, it is not making an accurate report. True, in certain instances, costs which for accounting purposes are to be charged to inventory, may be deducted for income tax purposes (for example, expenses incurred in subdividing lots for sale or in bringing certain products to maturity, e.g. fruit orchard)-. But, in each instance, the “inaccuracy”, as a result of which tax is deferred, has been tolerated for very specific and exceptional reasons and not for the sole reason that the taxpayer suddenly found it more convenient so to do. I do not see any such reason in the fact that the work here was done in response to contracts already concluded.

There is no doubt that the proper treatment of revenue and expenses in the calculation of profits for income tax purposes with a view to obtaining an accurate reflection of the taxable income of a taxpayer, is not necessarily based on generally accepted accounting principles. Whether it is so based or not is a question of law for determination by the Court having regard to those principles (see: MNR v Anaconda American Brass Ltd, [1956] AC 85; [1955] CTC 311; 55 DTC 1220; see also: Associated Investors of Canada Ltd v MNR, [1967] Ex CR 96; [1967] CTC 138; 67 DTC 5096).

The uncontradicted evidence of the respondent’s expert witness, John C Bonnycastle, is succinctly summarized in the following excerpts from his statement:—

The matching principle requires that at the end of an accounting period an effort be made to identify those costs which have been incurred during the period but which have not yet been expended in the revenue earning process so that they may be recorded as assets and carried forward to the accounting period in which the revenue they aid in producing is recorded. At that point in time the costs will be matched with the related revenues by including both revenues and costs in the statement of income.

The objective that inventory accounting should give effect to the matching principle is implicit in the authoritative literature on the subject although difficulties in applying the principle in specific circumstances have given rise to differing conventions which will be discussed below. The Canadian Institute of Chartered Accountants (“CICA”) handbook states at paragraph 3030.09:

The method elected for determining cost should be. one which results in the fairest matching of costs against revenues regardless of whether or not the method corresponds to the physical flow of goods.

Accounting research bulletin No 43 of the American Institute of Certified Public Accountants (“AICPA”) statement 2 observes:

A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues

and again at paragraph 8 referring to the basis of valuing inventory:

Although the cost basis ordinarily achieves the objective of a proper matching of costs and revenues, under certain circumstances cost may not be the amount properly chargeable against revenues of future periods.

In summary, it appears clear that when the amounts involved would have a material effect upon the income of an enterprise, generally accepted practice would require some costs to be allocated to inventories which are associated with revenues which, at the end of the accounting period have not yet been included in income, even though there may be a number of acceptable alternatives for determining the amount of the costs to be so allocated.

In summary then, the matching principle requires costs to be recorded as expenses when the revenues with which they are associated are recorded in the income statement. I am assuming as fact that Neonex followed the “completed contract method” for recording its revenue from display and sign sales in that none of the revenue associated with a particular. sign would be recorded until the manufacture was completed and the item delivered to the customer. Thus it is my opinion, as stated previously, that costs associated with uncompleted signs should have been included in inventory as was done for financial statement purposes, and deferred until the related revenue was recorded.

This evidence I would accept, since it was not challenged, as establishing the accepted accounting treatment for partially completed signs being produced under contract by the appellant. The question then to be asked is whether the Income Tax Act requires or permits a different accounting treatment in the calcuiation of the appellant’s income for income tax purposes than that which is applicable for the purposes of accurately portraying the financial picture of the company for shareholders and creditors.

The court was not referred to any authorities which are precisely on all fours with the factual situation in this case. The appellant relied heavily on the case of Wilson and Wilson Ltd v MNR, [1960] Ex CR 205: [1960] CTC 1; 60 DTC 1018, but with respect, I am of the opinion that it has little application to the case at bar. In that case it was held by Cameron, J in respect of a construction contract, that the monies actually received by the taxpayer from time to time during the course of construction constituted income in the hands of the taxpayer in the year in which they were received. Thus the completed contract method used by the taxpayer in computing its income, which may have been in accordance with proper accounting practice, was contrary to the provisions of the Income Tax Act of 1948. He also held that the job costs were deductible in the year in which they were incurred, notwithstanding the fact that the engineer’s certificate in relation thereto might not yet have issue at the end of the taxaiton year. In addition, he held that the general principles as to the valuation of inventory which is applicable to manufacturers and others had no application to construction jobs of the kind there under consideration. It seems, then, that in point of fact the result in the Wilson case was that there was a matching of revenue and expense, thus lending stronger support to the respondent’s position than to the appellant’s.

In my opinion, the method used by the appellant in calculating its taxable income accorded neither with generally accepted accounting principles nor with the proper method of computing income for tax purposes under sections 3, 4 and paragraph 12(1)(a) of the Income Tax Act in the 1970 and 1971 taxation years and sections 3, 4 and paragraph 18(1 )(a) in respect of the 1972 taxation year. The expenses incurred in connection with the partially completed signs were laid out to bring in income in the next or some other taxation year, not in the year in which they were claimed. As a result, the income of the appellant would not be portrayed fairly nor accurately if it were permitted to adopt this method for tax purposes while for the purposes of its own creditors and shareholders it used the generally accepted accounting method presumably because that method fairly and accurately provides them with the profit or loss information to which they are entitled. For these reasons, I would dismiss the appeal on this issue.

To recapitulate, the appellant has succeeded on one branch of its appeal and been unsuccessful in three others. That being so, the respondent should be entitled to three-quarters of its taxed costs in this court.