Wacky Wheatley's TV & Stereo Ltd. v. MNR, 87 DTC 576, [1987] 2 CTC 2311 (TCC)

Brulé, T.C.J.:—These appeals, which were heard on common evidence, concern the deductibility of travel expenses incurred as a result of a trip to Australia in January of 1982. The issue in these appeals is whether the travel expenses were deductible as current expenses of the businesses or whether they were capital in nature.

The appellant, Wacky Wheatley's TV and Stereo Ltd. ("Wacky Wheatley's") appeals with respect to amounts claimed as travel expenditures in the 1982 and 1984 taxation years. The claim for deduction in 1984 in the amount of $11,683.08, resulted from expenses incurred during the 1982 trip to Australia but due to an accounting error the expense was not recognized until 1984. If it is determined that the expenses were income in nature it will be necessary to determine whether the Income Tax Act permits a delayed deduction of expenses under such circumstances.

The appellant, 90861 Canada Ltd., appeals with respect to its 1981 taxation year. In 1982 the appellant claimed travel expenses of $4,581 in connection with the Australia trip which were disallowed by the Minister on reassessment. A loss in respect of its 1983 taxation year had been carried back to its 1981 and 1982 taxation years. As a result of the 1982 reassessment the loss carry back to 1981 was reduced by $4,581. The success of the 1981 appeal therefore depends on the determination of the validity of the travel expenses deducted in 1982.

The appellant, 95093 Canada Inc., appeals solely in relation to its claim for a deduction in 1982 for travel expenses incurred in connection with the trip to Australia.

Facts

The basic facts of this case were not in dispute at the hearing.

The three appellant companies are all in the business of retail marketing of televisions, stereos and related electronic consumer products and work in association with each other.

In 1981 the appellants identified a potential opportunity for expansion into the Australian market in the area of television, stereo and video cassette recorder sales. Preliminary market research indicated that expansion was viable but further information was required. Lack of market entry information necessitated a trip to Australia and in January, 1982, Michael Wheatley, Robert Wheatley, Douglas Wheatley, Murray Wheatley and Bernard Caspick travelled to Australia to examine the feasibility and profitability of a stereo, video and television business in Australia.

Prior to the trip, it was decided that if the opportunity was profitable, Mr. Robert Wheatley would emigrate to Australia and operate the Australian business in partnership with Wacky Wheatley's. Although immigration applications had been obtained from the Australian Consulate, they were not processed and Mr. Douglas Wheatley testified that there was no absolute intention to emigrate to Australia. Mr. Robert Wheatley testified that there had been no discussion regarding the form of organization in Australia as the venture was merely in an investigatory stage.

During the trip to Australia, the appellants' officers met with various government officials and businessmen in several urban centres to determine the viability of an Australian operation. As a result of the meetings and discussions conducted during the trip, it was determined that the opportunity in the Australian market was apparently not as profitable as that in the Canadian market and the Australian opportunity was not pursued any further.

Testimony with respect to Wacky Wheatley's 1984 claim for expenses, incurred as a result of the 1982 Australia trip, was given by Cheryl Inmen, a chartered accountant and vice-president of finance of Wacky Wheatley's. She was not employed by the appellant at the time of the Australia trip. Following her employment she discovered that as a result of a bookkeeping error by an employee in 1982, the travel expenses relating to the Australia trip had been understated in 1982. Ms. Inmen corrected this error by claiming the expense in 1984. She testified that this method of correcting an error is in accordance with Generally Accepted Accounting Principles (GAAP) where the amount is not material. It was her opinion that the amount of $11,683.08 was not material to an operation the size of Wacky Wheatley's which in 1982 and 1984 had sales of $3,135,933 and $4,349,083 respectively.

The Appellants' Position

The appellants submit that the travelling expenses incurred by the respective companies, in connection with this trip, are clearly relevant to the businesses of the companies and they should be able to deduct any reasonable disbursements incurred for this purpose, which was to investigate the possibility of expansion. They further submit that the expenditures were not capital in nature and should be fully deductible as current expenses of the businesses.

The appellant, Wacky Wheatley's, also maintains that the deduction of travel expenses in 1984 was in accordance with the provisions of subsection 9(1) of the Act and was properly deducted according to accepted accounting practice.

The Minister's Position

The Minister submits that the travel expenditures claimed are not deductible as they were not made or incurred for the purpose of gaining or producing income from business or property within the meaning of section 18(1)(a) of the Act. In addition, counsel for the Minister argued that the travel expenditure claimed by Wacky Wheatley's in the 1984 taxation year was not an expenditure made or incurred in that year within the meaning of section 9 of the Act and is therefore not deductible.

Counsel for the Minister also argued that the travel expenditures claimed by the appellants were payments on account of capital within the meaning of paragraph 18(1)(b) of the Income Tax Act and therefore not deductible as current expenses of the businesses.

Analysis

With respect to the Minister's submission that the travel expenses in question were not incurred for the purpose of gaining or producing income from business within the meaning of paragraph 18(1)(a) of the Act, I find that the evidence given at the hearing does not support such a conclusion. Subsection 18(1) provides, in part, as follows:

18 (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) (General limitation.) — 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;

(b) (Capital outlay or loss.) — an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part.

The testimony offered on behalf of the appellants clearly indicated that the trip to Australia was made for the express purpose of exploring the potential of expanding current operations into the Australian market. I have no difficulty concluding that these expenses were incurred for the purpose of producing income. The fact that no income was forthcoming as a result of these expenses does not affect their deductibility.

Having concluded that the expenditures were incurred for the purpose of producing income, it must then be determined whether they were on account of capital or income. Paragraph 18(1)(b) of the Act precludes the deduction of any payment on account of capital except as expressly permitted by the Act. In support of her submission that these payments were on account of capital, counsel for the respondent provided the Court with a number of cases which I will now review.

In Canada Starch Company Limited v. M.N.R., [1968] C.T.C. 466; 68 D.T.C. 5320, Jackett, P. distinguished capital from income expenditures as follows at page 472 (D.T.C. 5323):

In other words, as I understand it, generally speaking,

(a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition to such an entity, structure or organization, is an expenditure on account of capital, and

(b) on the other hand, an expenditure in the process of operation of a profitmaking entity, structure or organization is an expenditure on revenue account.

The respondent argued that in the present case the amounts under appeal were expended for the purpose of creating a business structure or organization and therefore, in accordance with the Canada Starch case, were expenditures on account of capital. In further support of this argument she placed particular reliance on the Federal Court of Appeal's recent decision in D. Morgan Firestone v. The Queen, [1987] 2 C.T.C. 1; 87 D.T.C. 5237. There are important distinctions between the Firestone case and the present appeal and for that reason I will discuss it at some length.

In the Firestone (supra) case the appellant resigned from his employment with the intention of starting his own “venture-capital” business by acquiring a number of small to medium-sized manufacturing concerns. He was seeking financially distressed companies with unrealized potential for profits. His goal was to put together a "mini-conglomerate" and eventually trade the shares publicly.

To achieve his goal the appellant leased office space and hired several employees to assist him in investigating opportunities and in supervising the operation of acquisitions once made. Between 1969 and 1972 the appellant investigated approximately 50 business opportunities. In 1970 he acquired three companies. The appellant and his employees continued to investigate new opportunities following these acquisitions. In 1971 the appellant incorporated a company which became the holding company for the acquisitions. Following the incorporation, the appellant personally continued to employ individuals to carry on the investigation of further business opportunities. Mr. Firestone appealed from the Minister’s disallowance of his claim for a deduction of expenses categorized as “investigation of opportunities."

The finding of both the trial judge ([1986] 2 C.T.C. 251; 86 D.T.C. 6405) and the Court of Appeal was that the expenses were incurred in connection with the acquisition of a capital asset and were therefore expenditures on capital account. At trial, it was concluded at page 258 (D.T.C. 6410):

Given the fact that the plaintiff may have looked at a number of business prospects before finally deciding, the business itself really came into being with the acquisition of the operating companies. This saw the establishment of the basic business entity or structure. The creation of the holding company was the finishing touch. I cannot regard the organization of the corporate conglomerate as anything other than an investment transaction. It must logically follow that the expenditures are not running expenses laid out as part of the profit earning process of the business. Rather, they were laid out as part of a plan for the assembly of business entities or structures. It is my opinion therefore that these expenditures were capital outlays within the prohibition of s. 18(1)(b) of the Income Tax Act.

Before the Federal Court of Appeal, Mr. Firestone's counsel acknowledged that the costs of investigation of opportunities in relation to those companies actually acquired were on account of capital, but argued that the investigation costs of those opportunities which did not lead to acquisition should be regarded as expenditures of an operating nature. The Court rejected this submission and stated, at page 7 (D.T.C. 5241):

I find it impossible to accept this contention. It seems to me that all of the expenditures relating to the investigation of opportunities must be considered on the same footing. They were the same kinds of expenses, and they were made for the same purpose. They were, in effect, all part of the same venture-capital business which, the appellant strenuously urged, existed from 1969 on. It makes no sense to separate off the few which led to acquisitions from the many that did not. All were equally part of the appellant's plan of assembly of business assets. It was only to be expected, and indeed was the premise of the appellant's investigative method, that some possibilities would on examination turn out to be good risks, others too poor to be proceeded with. In my view, the very common-sense approach for which the appellant contended vitiates his attempted distinction.

Central to both Courts' decisions was the finding that the expenses were incurred as part of the appellant's plan for the creation of a business structure. The important distinction between the Firestone case and the case before this Court is that in the present case the appellants expended the funds in order to ascertain the feasibility of extending presently existing operations into the Australian market. Unlike Firestone, the appellants were carrying on a business and had no plan to acquire or create a new business structure.

A potential opportunity for business expansion had been identified and lack of market information through local sources necessitated travel to Australia to further examine the potential of the Australian market. Robert Wheatley testified that Wacky Wheatley's was "expansion minded" and opportunities in various markets in the United States and Canada had previously been explored, and at times acted upon. During its ten years of operation, Wacky Wheatley's had grown to include eight retail stores and further expansion was anticipated.

If the Australian opportunity had proved viable and actual plans for entry into the Australian market had been made by the appellants, any expenditures incurred to facilitate the actual expansion would arguably be on capital account. The expenditures in question were not, however, of such a nature. These expenses were anterior to any business decision to enter the Australian market and it is my opinion that they were clearly incurred as part of the current expenses of the appellants’ operations.

Clear support for this conclusion is found in the case of Bowater Power Co. Ltd. v. M.N.R., [1971] C.T.C. 818; 71 D.T.C. 5469, in which the issue was the deductibility of outlays made by the appellant for engineering studies to determine the feasibility of installing thermal power. The Court held at pages 837-38 (D.T.C. 5481):

I do not indeed feel that merely because the expenditure was made for the purpose of determining whether to bring into existence a capital asset, it should always be considered as a capital expenditure and, therefore, not deductible. In distinguishing between a capital payment and a payment on current account, regard must always be had to the business and commercial realities of the matter. While the hydroelectric development, once it becomes a business or commercial reality is a capital asset of the business giving rise to it, whatever reasonable means were taken to find out whether it should be created or not may still result from the current operations of the business as part of the every day concern of its officers in conducting the operations of the company in a business-like way. I can, indeed, see no difference in principle between all of these cases.

In the present case, the evidence shows that expansion into new markets was an on-going concern of the appellants. It is my opinion that the expenditures in question resulted from the current operations of each of the appellants "as part of the every day concern of its officers in conducting the operations of the company in a business-like way."

A major expenditure of many businesses today is moneys expended to maintain or increase market share under increasingly competitive conditions. To this purpose, many corporations spend significant amounts each year in advertising, promotions and market surveys. The expenditures in issue in these appeals, in my view, related to such an endeavour. They were moneys spent to determine the profit potential of the Australian market and were current expenses of the appellants. This characterization reflects the “business and commercial realities of the matter".

Having determined that the expenses were current and therefore deductible, I must next determine the validity of Wacky Wheatley's claim for deduction of expenses in 1984. Specifically, the issue is whether the Income Tax Act permits a taxpayer to claim expenses of another year in situations where there has been an accounting error or whether it requires the taxpayer to adjust its former returns. This determination depends on the Operation of subsection 9(1) of the Income Tax Act which provides as follows:

Sec. 9(1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

The term "profit" as used in subsection 9(1) is not defined within the Act. Its meaning has been the subject of numerous cases including the recent case of The Queen v. Nomad Sand & Gravel Ltd., [1987] 2 C.T.C. 112; 87 D.T.C. 5343 decided by the Federal Court, Trial Division on July 16, 1987. In his reasons for judgment, Rouleau, J. stated at page 116 (D.T.C. 5347):

The Income Tax Act does not define the term "profit" as that word is used in subsection 9(1) of the Act. However, a judicial statement as to the proper approach for determining net profit is set out in Daley v. M.N.R., [1950] C.T.C. 254; 50 D.T.C. 877 where Thorson, P. stated at 260 (D.T.C. 880):

. . . The correct view, in my opinion, that is the deductibility of the disbursements and expenses that may properly be deducted “in computing the amount of the profits or gains to be assessed" is inherent in the concept of “annual net profit or gain” in the definition of taxable income contained in Section 3. The deductibility from the receipts of a taxation year of the appropriate disbursements or expenses stems, therefore, from Section 3 of the Act, if it stems from any section, and not at all, even inferentially, from paragraph (a) of Section 6.

That being so, it follows that in some cases the first enquiry whether a particular disbursement or expense is deductible should not be whether it is excluded from deduction by Section 6(a) or Section 6(b) but rather whether its deduction is permissible by the ordinary principles of commercial trading or accepted business and accounting practice . . .

Section 3 was the forerunner to the present subsection 9(1) and paragraph 6(a) was the forerunner to the present paragraph 18(1)(a).

Therefore, in accordance with this principle, an expenditure properly deducted according to accounting standards would be deductible for tax purposes unless prohibited by some provision of the Act. [Emphasis added.]

A similar statement regarding the use of Generally Accepted Accounting Principles (GAAP) was followed by Jerome, A.C.J., in Edmonton Plaza Hotel (1980) Limited v. The Queen, [1987] 2 C.T.C. 153; 87 D.T.C. 5371. Relying on the case of The Queen v. Metropolitan Properties Co. Ltd., [1985] 1 C.T.C. 169; 85 D.T.C. 5128, Jerome, A.C.J., made the following comments at page 159 (D.T.C. 5375) of his decision:

. . . For financial statement purposes, the taxpayer reported the cost of these services as additions to the cost of its land inventory, in accordance with GAAP. Walsh, J. found that GAAP should normally be applied for taxation purposes, as representing the true picture of a corporation's loss or profit for a given year. They should not be departed from unless the Income Tax Act requires it.

In the present case, Ms. Inmen testified that in her opinion the amount in question, $11,683.03, was not material to a company with operations the size of Wacky Wheatley's. She further testified that she had acted in accordance with GAAP when she discovered the accounting error in 1984 and deducted the expenses in that year although they in fact related to the 1982 taxation year. The Minister did not challenge Ms. Inmen's testimony.

In the years 1982 to 1984, Wacky Wheatley's financial statements recorded the following:

Having reviewed all of the evidence, I find nothing to indicate that the actions taken by the appellant, Wacky Wheatley's, were not in accordance with GAAP. Further, I find nothing in the Income Tax Act which would preclude the appellant from taking such a course of action where an error is identified and I was not referred by the Minister to any such provision. In light of the case law referred to above, I must therefore conclude that the deductions sought by Wacky Wheatley's in 1984 were in accordance with the provisions of the Income Tax Act.

The appeals with respect to the three corporate appellants are therefore allowed and the assessments are referred back to the Minister for reconsideration and reassessment.

The appellants are entitled to one set of costs on a party and party basis with respect to their appeals.

Appeals allowed.