Integrated Wood Research Inc. v. R., 98 DTC 1258, [1998] 1 CTC 2681 (TCC)

Bonner T.C.J.:

This is an appeal from assessments under Part VIII of the Income Tax Act for the 1988, 1989 and 1990 taxation years. The issue relates to the inclusion of interest costs in the computation of Part VIII refunds. The position of the Appellant is that the Minister of National Revenue was wrong in refusing to include in the computation of such refunds certain interest costs which were accrued but unpaid. Those costs were, according to the Appellant, “... expenditure^] made ...” by it within the meaning of paragraph 37(1 )(tz) and Clause 194(2)(^)(ii)A of the Act.

The position of the Respondent rested on the view that the interest in question had merely been accrued by the Appellant in its financial records in circumstances which suggest that the likelihood of payment was very slight indeed. According to the Respondent the interest was not in respect of “genuine continuing liabilities of the Appellant” and therefore could not be regarded as an expenditure made with the meaning of the statutory language. The Respondent argued as well that, whether the liabilities were genuine or not, the accrual of interest not accompanied by payment did not satisfy the statutory requirement. It was said that where all that happened was accrual no expenditure was “made” within the meaning of sections 194 and 37.

It was alleged by the Appellant and admitted by the Respondent that the Appellant “... carries on the sole business of conducting scientific research and experimental development”. [1] The Appellant was engaged in the development of a computer-integrated manufacturing system for the secondary processing of lumber. Work on the design of the device extended over several years during which the Appellant earned no income.

All of the Appellant’s activity was dependent on borrowed money. Its paid up capital consisted of the sum of $100. Late in 1985 it raised part of the money required to conduct research by issuing $4,000,000 in bonds to Domglas Inc., a corporation with which it dealt at arm’s length. There was designated by the Appellant under subsection 194(4) of the Act in respect of the debt obligation the full $4,000,000 consideration for which the obligation was issued. As a result, Domglas, the purchaser of the bonds, became entitled under section 127.3 of the Act to a scientific research tax credit equal to 50 per cent of the amount designated. As a further result the Appellant became liable under subsection 194(1) of the Act to pay $2,000,000 in tax and to make a payment on account as required by subsection 195(2). The bonds were promptly redeemed for $2,280,000. The arrangement between the Appellant and Domglas required the Appellant to deposit with an escrow agent the sum of $2,000,000 to be held by the agent and released to the Appellant only on receipt of proof that expenditures on scientific research qualifying under the Act had been or would be made within 30 days. In order to meet the terms of that agreement the Appellant borrowed $280,000 from Bovi Holdings Limited (“Bovi”) a corporation with which it did not deal at arm’s length. [2]

The Appellant was eligible under subsection 194(2) of the Act to earn a refund of Part VIII tax to the extent of 50% of expenditures made by it on scientific research claimed under subparagraph 37(l)(a)(i) of the Act. Practically speaking, the net result of the Domglas bond transaction with its accompanying designation was that the Appellant was left with an empty treasury and an obligation to either pay tax under subsection 194(1) or spend $4,000,000 on scientific research with the expectation of recovering under the escrow arrangement $1 for every $2 spent. [3]

The Appellant entered into a second non-arm’s length borrowing transaction, this time with John Ziner Lumber Ltd. (“Ziner”). This transaction served to supply the monies required for all subsequent corporate activities of the Appellant whether scientific research or not. The Ziner loan agreement dated December 29, 1985 reads in part:

...this letter confirms our agreement that John Ziner Lumber will pay bills on behalf of IWR Inc. IWR will repay 50% or as much as possible to Ziner Lumber as moneis become available to it from its escrow releases or other sources.

Interest will accrue to Ziner Lumber on amounts outstanding to it on the following basis:

the amount outstanding at the end of each calendar quarter will earn interest at the rate of prime plus 6% or 16% in total whichever is lower.

Total outstanding will be paid to Ziner Lumber as soon as a financing deal is put in place which addresses the SRTC Part 8 (sic) account.

Plainly, barring fresh sources of funds, neither the advances from Bovi and Ziner nor interest thereon could be repaid save to the extent that funds might become available by release from escrow consequent upon expenditures for scientific research.

Extensive efforts were made by the Appellant to secure additional financing by government grant, by the infusion of equity and by borrowing. The efforts were largely unsuccessful. Thus the debts giving rise to the interest costs now in question continued to grow. By the end of 1991 advances and interest net of repayments amounted to more than $1,900,000.

In computing its Part VIII refunds for the years in issue the Appellant claimed:

a) for 1988, $26,400 in respect of interest on money borrowed from Bovi;

b) for 1989, $59,400 and $33,597 in respect of interest on money borrowed from Bovi and Ziner respectively; and

c) for 1990, $62,208 and $225,672 in respect of interest on money borrowed from Bovi and Ziner respectively.

I will deal first with the Respondent’s argument that the Appellant was not subject to any “genuine” liability to pay interest either to Bovi or Ziner. The argument seems to rest on the close relationship between the Appellant and the two creditors, the high risk nature of the loans, the fact that only part of the interest due was paid, the fact that by 1988 the prospect of the Appellant meeting its obligations to pay interest had virtually disappeared, the absence of any attempt by the creditors to take legal action to enforce payment and finally actions of the creditors which recognized that receivables from the Appellant were without value.

No doubt the relationship between the Appellant, Bovi and Ziner was very close. The president and sole shareholder of the Appellant was Robert Czinner. Bovi is a corporation the shares of which were held by a trust for Robert Czinner and his sister. The trustees were Robert Czinner’s parents, Rose Ziner and John Ziner. Ziner was a wholly-owned subsidiary of a holding company which in turn was controlled by John and Rose Ziner. Rose Ziner appears to have been instrumental in Bovi’s decision to make the loans. John Ziner made the arrangement for the advances by Ziner to the Appellant.

Without doubt the loans were extremely risky. At the time when Bovi advanced the funds and when Ziner agreed to pay the Appellant’s bills it was far from certain that the Appellant would be able to borrow money, sell technology or otherwise raise the money needed to repay the debts. No doubt counsel for the Respondent was right in asserting that it is unlikely that an arm’s length lender would have agreed to lend the money on the terms of the Bovi and Ziner loans. Rose Ziner indicated that one of the reasons the loans were made was that her son Robert was president of the Appellant. She described the loans as business transactions but she is quite evidently a very intelligent person and I have no doubt that she recognized the extent of the risk and that the loans were made primarily on the basis of the relationship with Robert Czinner.

On April 30, 1988 Bovi’s accountants wrote off the company’s receivable from the Appellant and ceased to accrue interest income thereafter on the basis that it was futile to accrue interest and then write it off. The accountant explained that, at that time, the loan was into its third year of non-performance. In 1989 Ziner assigned to Bovi approximately $761,000 of its receivable from the Appellant and wrote off the balance.

The circumstances which I have summarized form the basis for the Respondent’s assertion that the amounts claimed by the Appellant were not in respect of “genuine continuing liabilities”. I do not agree with that assertion. In essence the Respondent argues that either:

a) the advances by Bovi and Ziner were, when made, gifts, or

b) at some later time Bovi and Ziner released the Appellant from its obligation to pay more interest than had in fact been paid.

Either way, the argument has no foundation in evidence or in law. Firstly a transaction may be a loan even though lender and borrower do not deal with each other at arm’s length. Secondly neither the presence of a high risk of default nor an actual default will convert a transaction which begins as a loan into something else or free the borrower from the obligation to pay interest under the loan agreement. Thirdly the recognition by a lender in its books of account that a receivable has become worthless does not free the debtor from its obligations under the loan agreement. Nothing in the evidence supports a conclusion that the advances were gifts or that the obligation to pay interest was forgiven. Although counsel for the Respondent did not directly suggest that the obligation to pay interest was agreed to be contingent upon the availability of the money required to effect payment I will note that the evidence cannot support any such argument. Recognition by a lender that a borrower might be unable to pay does not automatically result in an obligation to pay which is contingent on ability to do so.

I turn next to the question whether, when interest was accrued by the Appellant, expenditures were made within the meaning of sections 194 and 37 of the Act. The term Part VIII refund is defined in subsection 194(2) of the Act. Paragraph 194(2)(a) reads:

(2) In this Act, the “Part VIII refund” of a corporation for a taxation year means an amount equal to the lesser of

(a) the aggregate of

(i) the amount, if any, by which the scientific research and experimental development tax credit of the corporation for the year exceeds the amount, if any, deducted by it under subsection 127.3(1) from its tax otherwise payable under Part I for the year, and

(ii) such amount as the corporation may claim, not exceeding 50% of the amount, if any, by which

(A) the aggregate of all expenditures made by it after April 19, 1983 and in the year of the immediately preceding taxation year each of which is an expenditure (other than an expenditure prescribed for the purposes of the definition “qualified expenditure” in subsection 127(9)) claimed under paragraph 37(1 )(a) or (b) to the extent that such expenditure is specified by the corporation in its return of income under Part I for the year

exceeds the aggregate of...

The interest in issue was claimed under subparagraph 37(1)(a)(i) which reads:

(1) Where a taxpayer carried on a business in Canada in a taxation year and files with his return of income under this Part for the year a prescribed form containing prescribed information, there may be deducted in computing his income from the business for the year such amount as he may claim not exceeding the amount, if any, by which the aggregate of

(a) the aggregate of all amounts each of which is an expenditure of a current nature made by the taxpayer in the year or in a preceding taxation year ending after 1973

(i) on scientific research and experimental development carried on in Canada, directly undertaken by or on behalf of the taxpayer, and related to a business of the taxpayer, or...

Paragraph 37(7)(c) limits subsection 37(1) as follows:

(7) In this section,

c) references to expenditures on or in respect of scientific research and experimental development...

(ii) where the references occur other than in subsection (2), include only

(A) expenditures each of which was an expenditure incurred for and all or substantially all of which was attributable to the prosecution, or to the provision of premises, facilities or equipment for the prosecution, of scientific research and experimental development in Canada, and

(B) expenditures of a current nature that were directly attributable, as determined by regulation, to the prosecution, or to the provision of premises,

facilities or equipment for the prosecution, of scientific research and experimental development in Canada; ...

There were three elements to the Respondent’s submission that the words “expenditure made” require payment. Firstly counsel discussed in a general way several recent decisions on statutory interpretation. The decisions included Québec (Communauté urbaine) c. Notre-Dame de Bonsecours (Corp.) [1994] 3 S.C.R. 3 (S.C.C.) in which Gonthier J. stated at page 17:

...there is no longer any doubt that the interpretation of tax legislation should be subject to the ordinary rules of construction. At page 87 of his text Construction of Statutes (2nd ed. 1983), Driedger fittingly summarizes the basic principles: “... the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament”. The first consideration should therefore be to determine the purpose of the legislation, whether as a whole or as expressed in a particular provision. The following passage from Vivien Morgan’s article “Stubart: What the Courts Did Next” (1987), 35 Can. Tax J. 155, at pp. 169-70, adequately summarizes my conclusion:

There has been one distinct change [after Stubart], however, in the resolution of ambiguities. In the past, resort was often made to the maxims that an ambiguity in a taxing provision is resolved in the taxpayer’s favour and that an ambiguity in an exempting provision is resolved in the Crown’s favour. Now an ambiguity is usually resolved openly by reference to legislative intent. [Emphasis added.]

Oddly enough, counsel failed to discuss the relationship between the purpose of the provisions in question and a reading of sections 194 and 37 which confines the words expenditures made to cases where there has been a payment of cash or property. I can find nothing in the legislation which suggests an intention to encourage expenditure on scientific research for which immediate payment has been made but not to encourage expenditure for the same purpose which is made on credit. Such a limitation would be irrational and not in harmony with the statutory scheme.

Secondly, the Respondent relied on what counsel asserted was the plain meaning of the words expenditure made. In my view an expenditure is just as clearly made when a buyer commits his credit as when he pays cash.

Finally, counsel referred to the presumption of consistent usage. He noted that in paragraph 18(1)(a) the legislation prohibits deduction in respect of “... an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property: ..” and stated that in paragraph 18(1 )(a) the words “outlay made” signify an actual disbursement and “expense incurred” signify a liability incurred but not yet paid. Similarly, it was said, the word “made” in sections 194 and 37 restricts those provisions to cases of actual payment. In my view the presumption on which counsel relies is of limited assistance. In a 1959 decision of the Supreme Court of Canada I Sommers v. R.], Fauteux J., speaking for the Court, said:

This rule of interpretation is only tantamount to a presumption, and furthermore, a presumption which is not of much weight.^ [4]

It is also difficult to reconcile the Respondent’s submission with the use of the word “incurred” in clause 37(7)(c)(ii)A.

Counsel for the Respondent did not argue that the interest in question, if an expenditure made, was not an expenditure of a “current” nature. I will therefore observe only that in my view statutory context makes it clear that the words “of a current nature” in clause 37(7)(c)(ii)B are not used to distinguish between expenditures that are on account of capital and those that are not. Thus, for example, clause B, which contemplates that an expenditure of a current nature may include one which is directly attributable to the provision of premises and facilities for the prosecution of research, is not limited to provision by way of rental as opposed to purchase.

Finally I note that the Respondent declined to argue that the interest in question, if an expenditure made, was not an expenditure made by the Appellant “on scientific research”. While I have no doubt that at least some if not all of the borrowed money was spent on scientific research, I must emphasize that I am not called on to decide whether the interest in issue or, indeed, the compound interest component thereof, was an expenditure on scientific research. The issue before this Court was whether the interest accrued was an “expenditure made” by the Appellant and nothing more. On that issue the Appellant is entitled to succeed.

For the foregoing reasons, the appeals will be allowed with costs and the assessments will be referred back to the Minister of National Revenue for reconsideration and reassessment consistent with these reasons.

Appeal allowed.