Associated Investors of Canada Ltd. v. MNR, 67 DTC 5096, [1967] CTC 138 (Ex. Ct.)

JACKETT, P.:—This is an appeal from a decision of the Tax Appeal Board dismissing appeals by the appellant from assess- ments under the Income Tax Act, R.S.C. 1952, c. 148, as amended, for the 1960 and 1961 taxation years.

The facts established by the evidence in this Court are substantially the same as those that are set out in the judgment appealed from and it is therefore unnecessary for me to set them out at length. It is sufficient for the purpose of indicating the question that I have to decide to summarize the facts as follows:

1. During the relevant period—1954 to 1961—the appellant carried on a business that consisted of

(a) negotiating contracts with members of the public under which, in consideration of being paid a series of amounts over a period of time, it agreed to pay a specified amount at some time in the future; and

(b) investing the amounts received under such contracts.

2. To negotiate such contracts, the appellant employed a staff of salesmen who obtained applications from members of the publie and were paid for their services by way of commissions, the payment of which depended upon the receipt by the appellant of certain of the amounts payable to it under the contracts. Such salesmen were employed, organized and supervised, for the appellant, by managers who were similarly paid having regard to the results achieved by the salesmen working under them.

3. As there was, in the nature of the appellant’s business, a certain delay between the time when a sales employee expended his effort on the appellant’s behalf and the receipt by the employee of commissions for such services, it was a necessary feature of the appellant’s method of carrying on business that it make advances to each of its sales employees, which advances were ordinarily recovered by being set off against the commissions that became payable to the employee.

4. According to the way in which the appellant computed its annual profit from its business,

(a) advances so made during a year that were still regarded by the appellant at the end of the year as recoverable in the ordinary course of business were shown in the balance sheet as an asset of the business and were not treated in the profit and loss account as an expense of doing business;

(b) advances so made that were regarded by the appellant at the end of any year as having become, during that year, irrecoverable, were treated as an expense of doing business that year whether or not the advances were made that year or in a previous year.

5. While, in the ordinary course, an advance to a sales employee would have been relatively small, in the case of one Mitchell, who had been employed as a provincial manager by a special contract, under which he was to receive advances of $3,000 per month, in the expectation that he would be instrumental over a period of time in substantially increasing the appellant’s business, the excess of the advances over commissions earned in the period from 1954 to 1960 amounted to over $85,000.

6. At the end of 1960, the appellant, having concluded that the value of its claim against Mitchell for advances that had not been repaid was at least $25,000 less than the nominal amount thereof, treated the matter in a way in which it had never had occasion to treat advances made to other sales employees, namely, it wrote the asset value of the Mitchell advances down by $25,000 and included the amount of $25,000 as an expense of doing business for the 1960 year—doing so by including it in its profit and loss account as an expense of ‘‘Sales Promotion’’.

7. At the end of 1961, having concluded that the value of its claim against Mitchell was then at least $50,000 less than the nominal amount thereof, the appellant wrote its asset value down by another $25,000 and included the amount of $25,000 as an expense of its business for the 1961 year—again doing so by including it in its profit and loss account as an expense of “Sales Promotion’’.

In these circumstances the respondent disallowed as an expense of the appellant’s business for the 1960 taxation year, for purposes of the Income Tax Act, all of the sum of $25,000 deducted by the appellant for 1960 except the amount by which the advances to Mitchell in 1960 exceeded the commissions earned by Mitchell in 1960; and disallowed as an expense of the appellant’s business for the 1961 taxation year, for purposes of the Income Tax Act, all of the sum of $25,000 deducted by the appellant except the amount by which the advances to Mitchell in 1961 exceeded the commissions earned by Mitchell in 1961.

While the assessments appear to have been made on the basis that advances made by the appellant are deductible in computing the profits from its business for the year in which they were made to the extent that they have not been repaid in that year by offsetting commissions earned in the year, the position taken in this Court on behalf of the respondent was, in effect, as I understand it, that such advances can never be taken into account in the computation of profits from the appellant’s business.

The contention that such advances can never be taken into account was based, in the first place, upon a submission that the advances were not made in the carrying on of the appellant’s business. The alternative contention was that the deductions in dispute were, in effect, deductions for “bad debts’’, that no deduction for a ‘‘bad debt’’ may be made for purposes of the Income Tax Act, unless it is authorized by Section 11(1) (f) and that Section 11(1) (f) does not embrace such deductions.* [1]

Under the Income Tax Act, in determining the income tax payable by the appellant for a year, the first step is to determine the ‘‘income’’ from the appellant’s business for the year (Section 3). Subject to any special provision that may be applicable, the “income’ from a ‘‘business’’ for a year is the ‘‘profit’’ therefrom for the year (Section 4).

Profit from a business, subject to any special directors in the statute, must be determined in accordance with ordinary commercial principles.* [2] The question is ultimately ‘‘one of law for the court’’. It must be answered having regard to the facts of the particular case and the weight which must be given to a particular circumstance must depend upon practical considerations. As it is a question of law, the evidence of experts is not conclusive. [3] t

My first task is therefore to determine the proper treatment of the amounts in question in accordance with ordinary commercial principles. Having ascertained that, I must consider whether. any. different treatment is dictated by any special provision of the statute.

Ordinary commercial principles dictate, according to the decisions, that the annual profit from a business must be ascertained by setting against the revenues from the business for the year, the expenses incurred in earning such revenues.

is different in the case of “running expenses”. See Naval Colliery Co. Ltd. v. C.I.R., supra, per Rowlatt, J. at p. 1027 : . and expenditure incurred in repairs, the running expenses of a business and so on, cannot be allocated directly to corresponding items of receipts, and it cannot be restricted in its allowance in some way corresponding, or in an endeavour to make it correspond, to the actual receipts during the particular year. If running repairs are made, if lubricants are bought, of course no enquiry is instituted as to whether those repairs were partly owing to wear and tear that earned profits in the preceding year or whether they will not help to make profits in the following year and so on, The way it is looked at, and must be looked at, is this, that that sort of expenditure is expenditure incurred on the running of the business as a whole in each year, and the income is the income of the business as a whole for the year, without trying to trace items of expenditure as earning particular items of profit.” See also Riedle Brewery Ltd. v. M.N.R., [1939] S.C.R. 253; [1938-39] C.T.C. 312. With regard to the flexibility of method permitted under the Income Tax Act for computing profit, see Cameron, J. in the Ken Steeves case, supra, at pp. 113-4; 54-55.

In considering whether the results of any transaction can be considered in computing the profit of a business for a particular year, the first question is whether it was entered into for the purpose of gaining or producing income from the business.* [4] If it was not, such results cannot be taken into account in computing such profits. Even if the transaction was entered into for the purpose of the business, if it was a capital transaction, its results must also be omitted from the calculation of the profits from the business for any particular vear.t [5] There is no doubt that the appellant made advances to its sales employees as part of its effort to make a profit from its business. What is said, however, is, in effect, that they were capital transactions.

(It was not argued that a loss could not be taken into account in computing profit unless it arose from an operation or transaction calculated or intended to produce a profit. It is clear that such a contention could not succeed. A profit arising from an operation or transaction that is an integral part of the current profit-making activities must be included in the profits from the business. See M.N.R. v. Independence Founders Limited, [1953] S.C.R. 389; [1953] C.T.C. 310, and the foreign exchange cases such as Tip Top Tailors Limited v. M.N.R., [1957] S.C.R. 103; [1957] C.T.C. 809. If such a profit must be included in computing profits from a business, then a loss arising from any such source—that 1s, from an operation or transaction that is a part of the current profit-making activities of the business— must also be taken into account in computing the overall profit from the business.) J [6]

No simple principle has been enunciated that serves, in all circumstances, to solve a question as to whether a transaction is a capital transaction. The general concept is that a transaction whereby an enduring asset or advantage is acquired for the business is a capital transaction. [7] || This is not, however, a concept that is easy to apply in all circumstances. Clearly, the acquisition of property in which to carry on the business, or of plant or equipment to be used in carrying on the business, is a capital transaction. The acquisition of less tangible assets of an enduring nature has also been held to be a capital transaction. Transactions whereby a ‘‘trading structure’’* [8] is created are also capital transactions. The advances made by the appellant to its sales employees do not in my view fall in any of these categories. They were intended to provide the employees with an income during the periods while they were awaiting returns from their endeavours in the appellant’s service. They were by their very nature short term loans. They did not result in the acquisition of any asset or advantage of an enduring nature, nor did they create a ‘‘trading structure”? of a permanent character. In my opinion, they were an integral part of the appellant’s current business operations.

Having concluded that the making of the advances was an integral part of the appellant’s current business operations, the next task is to determine how the results of such transactions are to be taken into account in computing the profits from the appellant’s business.

In approaching this problem, it is important to have in mind the precise elements involved in one of these ‘‘advance’’ transactions. What happened was that

(a) the appellant made a payment to the employee,

(b) when the payment was made, there came into existence an indebtedness from the employee to the appellant in the amount of that payment,

(c) if and to the extent that the employee repaid the advance, the indebtedness disappeared.

The situation was therefore that, at the time that the advance was made, the appellant had exchanged its money for a “right” that was, from a businessman’s point of view, of equal value. It had substituted one asset in money for another of equal amount. As of that time, therefore, the making of the advance did not affect the overall value of the appellant’s assets. The advance cannot, therefore, as of that time, be regarded, from a businessman’s point of view, as having affected the appellant’s profit from his business.* [9] Similarly, if the advance was entirely repaid, there was again a substitution of one asset for another of equivalent value and there was no overall effect on the appellant’s asset position. When, however, the chose in action depreciated in value, there was an effect on the appellant’s asset position and accordingly, at that time, for the first time, the advance transaction resulted in the appellant having sustained a loss.t [10] As that loss arose out of a transaction in the course of the appellant’s current business operations, it must be taken into account in computing the profits from the appellant’s business or they will be overstated. In my view, it must be so taken into account in computing the profit from the business for the year in which the appellant, as a ‘‘businessman’’, recognized that the loss had occurred. It cannot properly be taken into account in computing the profit for a previous year. There is no sound basis for taking it into account in computing the profit for a subsequent year.* [11]

(It was not argued that the rule concerning when a “capital loss’’ is ‘‘sustained’’ that was established by M.N.R. v. Consolidated Glass Limited, [1957] S.C.R. 167; [1957] C.T.C. 78, has any application to determining when a profit or loss is to be regarded as having arisen in the course of current operations of a business. Presumably, having regard to Canadian General Electric Co. Ltd. v. M.N.R., [1962] S.C.R. 3; [1961] C.T.C. 512, it was recognized that that rule can have no application to prevent a businessman taking into account the revaluation of an asset or liability, the amount of which affects the annual profit or loss from the business. See Canadian General Electric case, per Martland, J. at pp. 14 and 520. Compare Owen v. Southern Railway of Peru, Ltd. (1956), 36 T.C. 602, per Lord Radcliffe at p. 642.)

For the above reasons,f [12] I am of opinion that the two deduc- tions in question were properly made unless their deduction is prohibited by some provision in the Income Tax Act. As indicated above, the provision relied upon by the respondent as constituting such a prohibition is Section 11(1) (£). This provision should be read as part of the scheme concerning bad ond doubtful debts, which is found in the following provisions:

6. (1) Without restricting the generality of section 3, there shall be included in computing the income of a taxpayer for a taxation year

(e) the amount deducted as a reserve for doubtful debts in computing the taxpayer’s income for the immediately preceding year;

(f) amounts received in the year on account of debts in respect of which a deduction for bad debts had been made in computing the taxpayer’s income for a previous year whether or not the taxpayer was carrying on the business in the taxation year;

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

(e) a reasonable amount as a reserve for

(i) doubtful debts that have been included in computing the income of the taxpayer for that year or a previous year, and

(ii) doubtful debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money;

(f) the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year, and

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for that year or. a previous year;

laying down “any universally applicable proposition to the effect that losses arising from such payments in advance can in no circumstances form a proper charge against a trading account”, in that case the advances to the managing director, that were recoverable by set-off against his commissions, played no part in, and were not conducive to, the making of profit in the company’s trade. On the contrary, he thought that the managing director had been using the company “as his banker”. In Marshall Richards Machine Co., Ltd. v. Jewitt (1956), 86 T.C. 511, where the question was whether advances made by a parent company to a subsidiary that performed services for it, were made on capital account, Upjohn, J. said that “the whole truth of the matter was this, that the parent company had to finance the subsidiary company”.

These provisions create a system whereby a businessman who computes his trading profit on an accrual basis under which he includes in his revenues, as “proceeds of sales’’, the prices at which he has sold his goods in the year in which he sold them, whether or not he has collected the amounts thereof from his customers, may in due course reflect in his profit computation in a year in which it occurs the amounts by which his claims against the customer for such prices depreciate in value.

Section 11(1) (f) does not, in terms, prohibit any deduction for ‘‘bad debts’’. It does, however, expressly authorize in qualified terms a deduction that could have been made, in accordance with ordinary business principles, in the computation of profit from a business. It might therefore have been thought, as the respondent contends, that a deduction for a “bad debt’’ that is excluded from Section 11(1) (f) by the qualifications expressed in it is impliedly prohibited. Such an interpretation would, however, have results that cannot, in my view, have been contemplated. For example, a bond dealer, who, in effect, buys and sells “debts”, would, on such an interpretation, be precluded from taking into account losses arising from bonds becoming valueless by reason of the issuing company becoming insolvent. If Section 11(1) (f) is not to be interpreted as impliedly prohibiting such an obvious and necessary deduction in arriving at the profits of a business, I am of opinion that it is not to be interpreted as impliedly excluding the deduction of the losses that are in question in this appeal, which, in my opinion, are just as obvious and necessary in computing the profits from the appellant’s business.* [13]

The appeal will be allowed, with costs, and the assessments will be referred back to the respondent for re-assessment on the basis that the two amounts of $25,000 were properly deductible in computing the profits from the appellant’s business for 1960 and 1961, respectively.