Harvey C. Smith Drugs Ltd. v. The Queen, 92 DTC 6349, [1992] 1 CTC 325 (FCTD), aff'd 95 DTC 5026 (FCA)

Reed, J.:—The plaintiff corporation appeals (by way of trial de novo) a decision of the Tax Court dated March 12, 1986, and reported at [1986] 1 C.T.C. 2339, 86 D.T.C. 1243, which held that the dispensing of prescription drugs in tablet and capsule form does not constitute'"processing" for the purposes of the manufacturing and processing deduction under section 125.1 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), as amended.

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

(a) 9% of the lesser of

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

(b) 5% of the lesser of

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

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

except that in applying this section for a taxation year after the 1973 taxation year, the reference in paragraph (a) to"9%" shall be read as a reference to"8%" for the 1974 taxation year, "7%" for the 1975 taxation year, and “6%” for the 1976 and subsequent taxation years.

Facts

The plaintiff owns and operates a retail drug store in the city of Brantford. Part of that business involves the dispensing of prescription drugs. Such drugs can be liquids, ointments or creams, reconstituted drugs (i.e., made from powders by mixing with distilled water or other solvent), compound prescriptions, tablets or capsules. With respect to the dispensing of all of these except tablets and capsules the plaintiff is accorded the section 125.1 processing deduction (except when the drug is merely relabelled in the manufacturer's container). I understand, for example, that the deduction is allowed if a small quantity of a liquid drug is taken by the pharmacist from a larger bulk quantity, inspected, placed in an appropriately sized, and if required coloured, bottle and labelled. In the case of ointments and creams, the processing deduction is allowed when these are scooped from a bulk quantity, perhaps smoothed by a mortar and pestle, and placed in an appropriately sized smaller container. I understand, too, that the taking of non-prescription tablets and capsules from a bulk quantity, placing them in colourful containers, sealing the containers and placing them on drugstore shelves for selection by customers is also considered to be processing. The dispensing of prescriptions drugs in tablet or capsule form, however, is not treated as processing by the defendant.

The dispensing of drugs in tablet or capsule form is the most significant part of the plaintiff's dispensing business. Without this being included for section 125.1 purposes, the plaintiff cannot meet the ten per cent of gross revenues required by subparagraph 125.1(3)(b)(x) of the Income Tax Act (the “de minimis rule”).

The dispensing of drugs in capsule or tablet form requires the pharmacist to read the prescription, verify its authenticity, determine what is required to fill the prescription, select the appropriate tablets or capsules which have been purchased in bulk form (that is in containers of 100, 500, 1,000, 2,500 or 5,000), dump the tablets into a tray and using a spatula remove any that are discoloured, broken, chipped or cracked, count the tablets and place them in the appropriate container. Two different trays are used, one for penicillin products and one for non-penicillin products. The pharmacist may select as between a brand name drug and a generic unless the doctor directs otherwise. If cold storage prevents deterioration of the drug, the drug will have been kept refrigerated by the pharmacist. The pharmacist is required by legislation [1] to put the capsules into a container with a child-proof safety cap. (Patients who are arthritic can request a snap cap.) The container is a vial which is either clear or amber. Amber vials are used to preserve certain drugs from the effect of light which deteriorates the strength of the medication. The size and colour of the vial is determined by the prescription. The pharmacist does not seal the vial. Lastly, the pharmacist is required by provincial law to label the container with a prescription number, the patient's name, full directions for use, the doctor's name, the quantity of the medication and the date dispensed.

Legislative history

Section 125.1 provides for a deduction from the tax otherwise payable by a corporation. The amount is calculated by reference to the corporation's "manufacturing and processing profits for the year". Paragraph 125.1(3)(a) defines Canadian manufacturing and processing profits:

“Canadian manufacturing and processing profits” of a corporation for a taxation year means such portion of the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada as is determined under rules prescribed for that purpose by regulation made on the recommendation of the Minister of Finance to be application to the manufacturing or processing in Canada of goods for sale or lease; . . .

[Emphasis added.]

Section 125.1 was added to the Act in 1973. The text of the budget speech of the Minister of Finance [2] when introducing the relevant amendment states:

As a major step in the development of a new industrial policy, I am bringing forward measures of a fundamental nature to revitalize the manufacturing and processing industries. These measures will help this sector improve its competitive position in the world and will thus protect existing jobs and provide well paying new jobs for Canadians in and near the urban centres where they want to work. Moreover, these proposals will further reinforce growth throughout the economy by stimulating an early expansion in capital investment.

First, I propose that the cost of all machinery and equipment purchased after tonight by a taxpayer to be used for the purpose of manufacturing or processing goods for sale or lease in Canada may be written off in two years. A new capital cost allowance class will be established and a taxpayer will be entitled to claim as depreciation up to 50 per cent of the cost of the asset in the year in which it is acquired and the unclaimed balance in any subsequent year.

Second, commencing January 1, 1973, the top rate of corporate tax applicable to manufacturing and processing profits earned in Canada will be reduced to 40 per cent. Similarly, the effective rate of corporate tax applicable to manufacturing and processing profits earned in Canada eligible for the small business deduction will be reduced from 25 per cent to 20 per cent. In order to give effect to these rate reductions, it will be necessary to provide rules to enable a corporation to distinguish its manufacturing and processing income from other kinds of income, such as investment income, wholesaling and retailing income and natural resource income. Specific rules for this purpose will be included in the bill and in the regulations.

The tax treatment of companies engaged in manufacturing and processing will now compare very favourably with that in other nations, particularly the United States and the enlarged Common Market countries. Accordingly, it is to be expected that these measures will provide a substantial incentive for the establishment in Canada of new manufacturing enterprises and the expansion of existing enterprises by increasing the return that can ultimately be realized on capital investment.

The increase in the flow of funds available to these industries will strengthen their ability to compete with foreign manufacturers in a variety of ways. They may make use of these expanded resources to finance new research and development, to finance an expansion of productive capacity, to introduce new product lines and to finance the development of new cost-reducing methods.

Prior to the 1973 amendment, a related provision had existed in the taxation years 1962 and 1963. During those years subsection 40A of the Income Tax Act provided:

(1) There may be deducted from the tax otherwise payable for a taxation year by a manufacturing and processing corporation an amount determined by the following rules:

(2) In this section,

(a) "manufacturing and processing corporation" means a corporation that had net sales for the taxation year in respect of which the expression is being applied from the sale of goods processed or manufactured in Canada by the corporation the amount of which was at least 50% of its gross revenue for the year, but does not include a corporation whose principal business for the year was

(i) operating a gas or oil well,

(ii) logging,

(3) For the purpose of paragraph (a) of subsection (2)

(a) goods processed or manufactured shall be deemed not to include goods that have been packaged only; . . . .

[Emphasis added.]

Several cases were cited which dealt with the interpretation of the admonition in subsection 40A(3) that packaging was deemed not to be manufacturing or processing. In Federal Farms Ltd. v. M.N.R., [1966] C.T.C. 62, 66 D.T.C. 5068 (Exch. Ct.) aff’d 67 D.T.C. 5311 (S.C.C.), it was held that washing, brushing, spraying, drying, sizing, culling, grading and packaging carrots and potatoes was a process or a series of processes which prepared the product for the retail market. This activity was held to fall within the ordinary meaning of the word “processing”. (The vegetables travelled along conveyor belts, went through washing machines, etc.) That decision referred to various dictionary definitions of the word process" at page 67 (D.T.C. 5071-72) :

In Webster's Third New International Dictionary published in 1964 the word "process" is defined as follows, "to subject to a particular method, system or technique of preparation, handling or other treatment designed to effect a particular result: put through a special process as (1) to prepare for market, manufacture or other commercial use by subjecting to some process (- ing cattle by slaughtering them) (- ed milk by pasteurizing it) (-ing grain by milling) (- ing cotton by spinning):

In Webster's Second New International Dictionary published in 1959 the following definition of the word process” appears, "To subject (especially raw material) to a process of manufacturing, development, preparation for market, etc.; to convert into marketable form as live stock by slaughtering, grain by milling, cotton by spinning, milk by pasteurizing, fruits and vegetables by sorting and repacking."

Other standard works consulted define "process" as “to treat, prepare, or handle by some special method."

Mr. Justice Cattanach summed up his decision in the Federal Farms Ltd. case by saying at page 67 (D.T.C. 5072):

Although the product sold remains a vegetable, nevertheless it is not a vegetable as it came from the ground but rather one that has been cleaned, with improved keeping qualities [as a result of the spraying] and thereby rendered more attractive and convenient to the consumer. . . . I do not consider that the operations of the appellant constitute packaging only.

In Admiral Steel Products Ltd. v. M.N.R., 40 Tax A.B.C. 322, 66 D.T.C. 174 (T.A.B.), the slitting, flattening, shearing and edging of coils of strip steel in order to adapt them to the needs of the taxpayer's customers was held to be processing. The taxpayer changed the form of the steel coils to render them more useable and marketable. The Tax Appeal Board noted that the form in which the steel coils were received from the foundry was not usable by the ultimate customer until their form had been changed. This change of form required the use of extensive machinery.

In W.G. Thompson & Sons Ltd. v. M.N.R., 41 Tax A.B.C. 1, 66 D.T.C. 291 (T.A.B.), the taxpayer purchased white beans directly from growers. The beans were then put through eleven operations which involved the use of elaborate equipment. They were for example, to be cleaned, sorted, dried, treated with chemicals to prevent bacterial infection and packaged. The Tax Appeal Board held that this did not constitute "packaging only” (at page 296):

. . . In interpreting section 40A(2)(a), quoted above, there only seems to be the one statutory guide-post, namely, section 40A(3)(a) which states that "goods processed or manufactured shall be deemed not to include goods that have been packaged only". So, it is clear from that guide-post that, while section 40A remained in effect (the section was made applicable to any taxation year ending after March 31, 1962 and repealed in 1963 cutting off the deduction to the 1964 and subsequent taxation years), Parliament had no intention of providing a production incentive to a processing corporation where the operation carried on by it was nothing more nor less than one of packaging.

It should be observed that Parliament does not say in section 40A(3)(a) that there is no such thing as a packaging process. Indeed, that section which is quoted above suggests to me that Parliament accepts the proposition that packaging can be regarded as a process. If the word manufactured” in section 40A(3)(a) happens to apply to the goods in question then it is, obviously, unnecessary to decide whether the word "processed" is also applicable to the said goods, but if the word "manufactured" is not applicable to the said goods, then the alternative word "processed", assuming it is possible to interpret section 40A(3(a) [sic], must be applicable to the goods in question. On that basis, it would appear to be reasonable to regard packaging as a process for the purposes of section 40A of the Act. Accordingly, all that remains to be decided now is whether the appellant's processing operation of white beans, involving the steps Nos. 1-11 outlined earlier, constitutes something more than the routine or perfunctory operation of packaging. When it is realized that only step No. 10, of the 11 above-mentioned steps, constituted packaging then it begins to look as if the appellant was entitled to the production incentive provided in section 40A in its 1962 taxation year. When it is further realized: that steps Nos. 1, 2, 3, 4, 5, 6, 7, 8, 9 and 11 involved modern, mechanical, chemical, electrical, and electronic equipment; that such equipment had to be operated and maintained by trained technical personnel; that some of the technicians had to be licensed to handle . . .

The taxpayer was thus entitled to the processing tax credit.

After the 1973 amendment which added the present section 125.1 to the Act, the Interpretation Bulletin issued by the Department of National Revenue (IT-145 dated February 5,1974) with respect to the manufacturing and processing deduction, stated in paragraph 6:

6. The Department views packaging and wrapping activities as processing provided that they are carried on in conjunction with other manufacturing or processing activities. As well, the activities of breaking bulk and repackaging are generally considered to be processing.

In 1981, the relevant Interpretation Bulletin (IT-145R dated June 19, 1981) was changed somewhat. In paragraph 41 it states:

41. The mixing of various liquids or compounds when preparing a drug prescription is considered to constitute manufacturing and processing. However, the filling of prescriptions by placing labels on products already in their own container or by the placing of pills, capsules or liquids purchased in bulk into small containers and labelling them is not considered to qualify as manufacturing and processing. Where a corporation has considered activities referred to in the previous sentence as qualified activities when computing their manufacturing and processing deduction in previous years, this will be accepted by the Department for taxation years ending prior to January 1, 1979 [but not thereafter].

Statutory interpretation

Much of counsel's argument centred upon the relevant principles of statutory interpretation. It is accepted that Mr. Justice Estey in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, [1974] C.T.C. 294, 84 D.T.C. 6305 swept away the artificially restrictive rules of interpretation respecting taxing statutes which seem to have prevailed prior to that time. It is no longer acceptable to parse the language of a taxing statute rigidly. It is no longer appropriate to decide that if a taxpayer does not fall squarely within the four corners of a charging section that that section cannot be applied to the taxpayer. It is no longer acceptable to require a taxpayer to demonstrate that he or she falls precisely and exactly, without any doubt, within the literal wording of a deduction or exemption section in order to benefit from it.

Taxing statutes, like other statutes, are to be interpreted in accordance with their object and purpose. But the question remains where does one find that purpose? There is no doubt that other sections of the Act, the context of the Act generally and other statutes in pari materia are sources of purpose and intent. Although there was a general principle that legislative debates and other similar material were not referred to as a source in interpreting legislation, that principle is no longer rigorously applied. Explanations given, particularly by departmental officials, in Senate or House of Commons Committee proceedings may shed light on ambiguous statutory provisions. These must be used with care however, since it is known that such proceedings take on an advocacy flavour; those supporting the proposed legislation wish to put it in the best light.

Although one would not want to discount entirely statements by Ministers in the House of Commons these often will be even less reliable. In my view, the reliance on the Minister of Finance's budget papers in this case is a good example. As counsel for the plaintiff argues the Minister's statement may be absolutely true, that is he explained the object of the section 125.1 deduction as being designed to encourage processing in Canada (to give a deduction to Canadian firms which were in direct competition with foreign competitors). The provision as drafted may very well accomplish that object. But the deduction is more broadly drafted than necessary to meet only that objective. For example, the treatment of prescription drugs which are liquids and ointments and which treatment the defendant admits constitutes processing does not fall within the object of the legislation as enunciated by the Minister. A reference to the object of the legislation as enunciated by the Minister in the budget papers cannot be used to graft onto the statutory provisions of the Act terms and conditions which are simply not there. In the present case, I cannot give much weight to the statements of the Minister of Finance in interpreting section 125.1.

With respect to the statements in Wally Fries v. The Queen, [1990] 2 S.C.R. 1322, [1990] 2 C.T.C. 439, 90 D.T.C. 6662 (S.C.C.) and Johns-Manville Canada Inc. v. The Queen, [1985] 2 C.T.C. 111, 85 D.T.C. 5373 (S.C.C.) which indicate that in cases of uncertainty the taxpayer must be given the benefit of the doubt, I do not interpret those comments as in any way resiling from the principle set out in Stubart. In my view, those cases merely indicate that if after one has read the relevant statutory provisions of an Act and read them in the light of the purpose and object of the statute, there is still doubt as to which alternative interpretation was intended, then, that doubt should be resolved in favour of the taxpayer, regardless of whether the provision in question is a charging section or an exemption or deduction provision.

Recent jurisprudence

A number of decisions which have been rendered with respect to section 125.1 of the Income Tax Act were cited. The most important of these for present purposes is Tenneco Canada Inc. v. The Queen, [1991] 1 C.T.C. 323, 91 D.T.C. 5207 (F.C.A.). In that case, the Court dealt with whether or not the assembling and replacing of mufflers on cars was a“ manufacturing” or "processing" activity. In deciding that it was not, the Federal Court of Appeal relied on the Federal Farms case, supra. The Court went on to state (at page 5209):

Processing occurs when raw or natural materials are transformed into saleable items. Such raw or natural materials are unsaleable, or would sell for a lesser price, in their unprocessed state. Thus, gravel treated by washing, drying and crushing becomes more valuable (Nova Scotia Sand and Gravel Ltd. v. The Queen, [1980] C.T.C. 378, 80 D.T.C. 6298 (F.C.A.)), as do vegetables prepared by washing, brushing, spraying and packing (Federal Farms v. M.N.R., supra). Both of these opera- tions are processing. Furthermore, processing implies uniformity; the same process, or a highly similar one, is usually applied to each item treated (Vibroplant v. Holland, [1982] 1 All E.R. 792 (C.A.)).

The operations of the appellant did not come within these definitions. There was no real change in the form, appearance or characteristics of the pipes and other parts being used in the exhaust systems. There were minor alterations of them, when needed, in order to enable them to fit together and to function as a system. If the alterations and adjustments were not made, the customer would not receive a repaired, operating exhaust system.. . .

The Court added:

This case is not like Admiral Steel Products Ltd. v. M.N.R. (1966), 40 Tax A.B.C. 322, 66 D.T.C. 174, where steel products were substantially changed in form so as to be more usable and marketable. Nor is it like the Federal Farms and Nova Scotia Sand and Gravel cases where the products were processed in order to make them saleable. What was done here resembles more what was done in Harvey C. Smith Drugs Ltd. v. M.N.R., [1986] 1 C.T.C. 2339, 86 D.T.C. 1243 (counting pills) and Kime! Ltd. v. M.N.R., [1982] C.T.C. 2076, 82 D.T.C. 1086 (cutting cloth). Suppose someone purchased a ready-made suit of clothes, which required some alterations, at a retail clothing store. To do those alterations on a ready-made suit would not, I think, be considered manufacturing or processing. To order a suit made to measure, however, would be manufacturing by the maker of the suit

Counsel for the plaintiff recognizes that the reference to the Tax Court decision in the present case [3] is a difficulty he must address. He argues that the Federal Court of Appeal referred to the Tax Court decision without having viewed the evidence in this case and particularly without being aware that the pharmacist does more than merely count the tablets and capsules. He notes in addition that the reference to alterations by a tailor appears to conflict with paragraph 48 of IT-145R.

Considerations and conclusion

As I read the cases that have been cited to me, I conclude that in order to characterize an activity as processing within the meaning of section 125.1 there must at the least be a change in form or appearance of the product being processed. In all of the cases, there has been a physical change in the product being processed. The physical change may be chemical or electrical and thus not immediately visible to the eye but there has been a physical change to the product. In Federal Farms, the carrots and potatoes were washed and sprayed with a growth retardant to prevent deterioration. In Admiral Steel Products, the steel was flattened, sheared, split; it was changed into a different shape and size so as to become useable by the ultimate consumer. In the Thompson case, the beans were washed and treated with chemicals to prevent bacterial infection. In Woods Harbour Lobster Company Ltd. v. M.N.R., [1989] 2 C.T.C. 2032, 89 D.T.C. 303 (T.C.C.) at page 2034 (D.T.C. 306), the lobsters were cleaned, their claws were pegged.

Moreover, I agree with the analysis in M. Kimel Ltd. v. M.N.R., [1982] C.T.C. 2076, 82 D.T.C. 1086 (T.A.B.) where processing was defined in light of its association with “ manufacturing” it was held that taking a large bolt of cloth from the manufacturer, unrolling it, measuring it into smaller lengths, smoothing it out, cutting it and rerolling onto spindles (cardboard tubes) was not processing for section 125.1 purposes at page 2078 (D.T.C. 1088):

The word "process" is one of very broad import . . . . It is not, however, in my opinion, an apt word to use in collectively describing the various operations which were carried on in the appellants’ stores. This is particularly apparent when it is remembered that it is, in the Act, used in conjunction with the word "manufacturing".

Counsel for the plaintiff argues that the interpretation principle captured by the Latin phrase noscitur a sociis should not be employed in this case. (That is, that the meaning of processing" should not be influenced by its association with "manufacturing".) It is argued that Mr. Justice MacGuigan's comments in British Columbia Telephone Company Ltd. v. Her Majesty the Queen, [1992] 1 C.T.C. 26, 92 D.T.C. 6129 (F.C.A.) at page 32 (D.T.C. 6133), should be adopted. Mr. Justice MacGuigan quoted Maxwell on the Interpretation of Statutes, 12 ed. by P. St. J. Langan at page 289 and Attorney-General for British Columbia v. The King (1922), 63 S.C.R. 622 at page 638, for the proposition that the noscitur a sociis rule should not be applied lightly. Counsel for the plaintiff argues that in this case when the words manufacturing or processing" are used, they are being used disjunctively and one should be careful to give each its separate meaning.

While I accept that admonition, in the present case the whole context of the Act makes it clear that the concepts "manufacturing" and "processing" are related. The concept "processing" as was noted in the Kimel case, is very broad. The ordinary dictionary definition of that word encompasses a very wide variety of activity. For the purposes of section 125.1, it is necessary to narrow that broad scope in order for the term to be meaningful. One factor which is useful in such interpretation is the import and meaning of the associated word "manufacturing". This to me imports a requirement that the product being processed undergo a physical change in form or appearance and not merely be packaged.

In the present case, the pharmacist does not change the form or appearance of the tablets and capsules. They remain in the form in which they were received from the manufacturer. While the pharmacist may cull broken or discoloured units from the whole, I am not prepared to categorize this as processing. I agree with Brulé, J. in the Tax Court that the pharmacists' dispensing activities cannot be classified as processing because there is no change in the form or appearance or other characteristic of the tablets and capsules which are actually sold.

I place little reliance on the fact that sale of the drugs, in counsel for the respondent's words, is effected when the doctor writes a prescription. I have some difficulty with the idea that a processing activity loses its character as such, if it occurs after an order is made rather than before. This argument seems to flow from the assumption that processing for section 125.1 purposes is synonymous with any activity which makes the product more marketable". I do not read the jurisprudence as establishing this criterion as an independent test. Such a test would be very broad indeed. An activity which makes the product more marketable in my view, can encompass much that would not fall under the concept processing. I have no doubt that the activity engaged in by the pharmacist renders the prescription drugs more marketable. Indeed, they cannot be sold to the ultimate consumer without the dispensing activity.

If rendering the product more marketable is an independent test, then, the activity of a pharmacist in dispensing prescription drugs qualifies. If I am wrong and the two tests (change in form or appearance and increase in marketability) are separate and alternative tests then I must conclude that the plaintiff's activity falls into section 125.1. The drugs cannot be sold without the activity undertaken by the druggist. The fact that this is required by law rather than being merely a personal requirement of the customer is not significant.

This raises for consideration counsel for the plaintiff's argument that regardless of the lack of any change to the form or appearance of the actual tablets and capsules, packaging itself is a process. He argues that this follows from the text of the earlier section 40A of the Act which deemed packaging not to be such. It is also implicitly accepted by the judgment of the Tax Court in the present case (pages 1249-50):

Naturally, the sale of non-prescription pills is different. If, for example, a drug store were to purchase non-prescription pills in bulk and package them in eyecatching containers under their own brand name in perhaps quantities not normally available then this would, it seems to me, increase the marketability of the pills. This, I believe, was the intention of the original Interpretation Bulletin.

I have considerable difficulty classifying packaging alone as a processing operation as contemplated by section 125.1. The earlier, analogous provision in section 40A may have deemed "packaging only" not to be processing but I do not conclude that the absence of such an admonition leads to a conclusion that packaging must be considered a process under section 125.1. The "deeming" clause in section 40A can be interpreted as intending only to ensure that what did not naturally fall within the concept of processing for section 40A purposes would not in fact do so. One can envisage that many production processes involve as an end step the packaging of the product being processed. This may very well legitimately be considered to be part of a processing of the product. But, I am not convinced that packaging alone, apart from such integrated activity, which involves change in the form or appearance of the product itself, can be classified as processing for section 125.1 purposes.

For the reasons given the plaintiff's action will be dismissed.

Appeal dismissed.

M. Donald Easton and Harold Freeman v. Her Majesty The Queen

[Indexed as: Easton (M.D.) v. Canada]

Federal Court-Trial Division (Dubé, J.), February 6, 1992 (Court File Nos. T-2314-87 and T-2403-87) on appeal from a reassessment of the Minister of National Revenue.

Income tax—Federal—Loan guarantees—Whether losses on guarantees on loans

The plaintiffs were involved through their private corporations in a joint venture financed by bank loans which they had personally guaranteed. The venture collapsed and they were called on the guarantees. The banks settled with Easton for $300,000 and with Freeman for $350,000. In addition, Easton was a shareholder in another corporation which advised developers. Its bankers also demanded his personal guarantee which was also called. On this he paid $133,334. All these amounts were claimed as non-capital losses but only allowed by the Minister as capital losses. The questions before the Court were whether the losses were allowable to the plaintiffs or their corporations and, if the former, whether they could be claimed as capital or noncapital losses.

HELD:

Cases of this kind turn on their own facts. The key factor in deciding whether a gain or a loss is on capital or income account is the intent of the taxpayer. If the intention was to derive a stream of income the loss is capital, whereas if the intention was to dispose of an asset at a profit, the loss is a business loss. The joint venture of the two plaintiffs was intended to create an enduring benefit. The guarantees were an investment in it and the losses on the guarantee were capital losses just as an eventual gain would have been a capital gain. When money is obtained by a bank loan with a taxpayer's guarantee, that guarantee is a deferred loan by the taxpayer to the corporation and if he is called on it the loss is his. The business of the corporation is not that of the guaranteeing taxpayer. The guarantees in the joint venture were deferred loans by the taxpayers to their corporations and the losses were capital losses to them. The same conclusions were applied to the guarantee by Easton of the loan to his consulting corporation. Appeals dismissed.

David A. Freeman for the plaintiffs.

William Mah for the defendants.

Cases referred to:

Panda Realty Ltd. v. M.N.R., [1986] 1 C.T.C. 2417, 86 D.T.C. 1266;

M.N.R. v. Henry J. Freud, [1969] S.C.R. 75, [1968] C.T.C. 438, 68 D.T.C. 5279;

Cull v. The Queen, [1987] 2 C.T.C. 63, 87 D.T.C. 5322;

O. Mandryk v. Canada, [1989] 1 C.T.C. 162, 89 D.T.C. 5062;

Vine v. The Queen, [1990] 1 C.T.C. 18, 89 D.T.C. 5528;

Associated Investors of Canada Ltd. v. M.N.R., [1967] C.T.C. 138, 67 D.T.C.

5096;

Commonwealth Construction Company Ltd. v. The Queen, [1984] C.T.C. 338,

84 D.T.C. 6420;

M.N.R. v. George H. Steer, [1967] S.C.R. 34, [1966] C.T.C. 731, 66 D.T.C. 5481;

Stewart & Morrison Ltd. v. M.N.R., [1972] C.T.C. 73, 72 D.T.C. 6049;

Donald Preston McLaws v. M.N.R., [1972] C.T.C. 165, 72 D.T.C. 6149;

The Queen v. H. Griffiths Company Ltd., [1976] C.T.C. 454, 76 D.T.C. 6261;

The Queen v. MerBan Capital Corporation Ltd., [1989] 2 C.T.C. 246, 89 D.T.C.

5404;

Eugene Kalthoff v. The Queen, [1990] 1 C.T.C. 336, 90 D.T.C. 6378;

K.J. Beamish Construction Co. Ltd. v. M.N.R., [1990] 2 C.T.C. 2199, 90 D.T.C.

1584;

Alberta Gas Ethylene Company Ltd. v. The Queen, [1990] 2 C.T.C. 171, 90

D.T.C. 6419;

Roger Lachapelle v. M.N.R., [1990] 2 C.T.C. 2396, 90 D.T.C. 1876;

Tor-Guelph Holdings and 309901 Ontario Ltd. v. M.N.R., [1991] 1 C.T.C. 2252,

91 D.T.C. 355;

Hamnett P. Hill v. M.N.R., [1991] 2 C.T.C. 2356, 91 D.T.C. 1094;

Salomon v. A. Salomon and Company Ltd., [1897] A.C. 22.

Dubé, J.:—This appeal is from the reassessment of the plaintiff's 1981, 1982 and 1983 taxation years. The appeal was heard at the same time as the companion action of Harold Freeman (1-2403-87) and the same reasons for judgment will apply mutatis mutandis to both cases.

At the outset of the hearing, the parties filed a joint agreed statement of facts and definition of issues in each case. No witnesses were called. The facts are somewhat complex but the basic issue is whether or not the losses sustained by the plaintiff in each case constitute a non-capital loss as claimed by the plaintiff, or a capital loss as assessed by the Minister of National Revenue.

For the purposes of this judgment the essential facts may be reduced as follows. Both plaintiffs, Easton" and “Freeman”, are lawyers who are also involved in several businesses, at times jointly and at other times separately, including the promotion of a pulp mill, the establishment of marinas, the development of residential properties, the operations of a chain of short order restaurants, and other activities.

In early 1975, both plaintiffs conceived the idea to develop certain property located at Secret Cove, B.C. Their joint intention was to acquire lands adjacent to the Secret Cove Marina, already established by them to subdivide the land, develop and ready it for construction and to build houses thereon. On June 4, 1975, both men obtained an option to purchase a lot for the price of $150,000 which they exercised in June 1976. The title to the property was transferred jointly to their names. They deposited the certificate of title in escrow upon the approval of the subdivision plan. The funds for the purchase of the property were provided by Freeman and Easton and borrowed by them in part from the Bank of Nova Scotia and the Toronto-Dominion Bank.

On June 17, 1976, both men entered into an agreement with one Aaron Kagna and his wife Toby Kagna ("the Kagnas") whereby they provided the Kagnas an undivided one-third interest in the property. Easton was already the sole shareholder, officer and director of the British Columbia Corporation, incorporated in 1972, named Rayfield Holdings Ltd. ("Rayfield") which at that time had no assets or function save as a holding company for Easton. On June 23, 1976, Easton entered into an agreement for the sale and transfer by him to Rayfield of his one-third interest in the property for the price of $50,000 payable; $6,000 cash and the balance by Rayfield's assumption of the plaintiff's liability to the vendors of the property arising from the exercise of the option.

On June 23, 1976, Freeman entered into a similar agreement with Fairlyn Holdings Ltd. ("Fairlyn") with respect to his undivided one-third interest in the property. The Kagnas, at the same time, entered into a similar agreement with Bairdmore Enterprises Ltd. ("Bairdmore"). The next day a joint venture agreement was entered into between Fairlyn, Rayfield and Bairdmore ("the corporate co-venturers") so as to set out the responsibility of the parties, the obtaining of a land use contract from the local authorities, the development of the land, and the construction of dwellings under the name Secret Cove Developments (the “ joint venture"). On September 29, 1977, the property was subdivided and the land use contract was granted providing for 29 residences to be constructed.

To finance the development and construction costs of the joint venture, each of the co-venturers, Freeman, Easton and the Kagnas, contributed $46,696 in the Secret Cove Development venture through their respective companies. Further financing was obtained by the corporate co-venturers. Together they ultimately borrowed approximately $4,100,000 from the Bank of Montreal (the "bank"). Thereupon the bank required debenture security for the moneys advanced and to be advanced. Each corporate co-venturer was required to execute and deliver joint and several debentures on his prospective assets to the bank.

In addition, the individual co-venturers were severally required to guarantee their liabilities to the bank of their respective company to the extent of the principal sum, totalling $300,000 each. This was accomplished in each case by two separate documents of guarantee of $150,000 each. In consideration of the granting of the loan, Freeman and Easton executed two such documents of guarantee in favour of the bank for the liability of their companies in the principal sum of $150,000, on October 3, 1979 and September 30, 1980 respectively.

During the course of construction the bank advanced funds in excess of $3,900,000 and amounts totalling $4,100,000 were secured by debentures executed jointly by the corporate co-venturers in the years 1979, 1980 and 1981. In April of 1981, the project began to look marginal because of escalating construction costs, the down-turn in the economy and the cancellations of property sales. The bank requested additional guarantees from the individual coventurers. In the latter part of 1980, the contractor Chartwell Development Corp. defaulted in the course of the performance of the construction contract and subsequently went into bankruptcy. As a consequence, the plaintiff and Freeman took over the construction project on a daily basis and became directly involved.

During the summer of 1980, a few of the residences were marketed, although not completed for occupancy and on October 31, 1980, a company agreed to purchase all of the residences not already sold at a fixed purchase price of $98,100 per unit. In the fall of 1981, the real estate in British Columbia collapsed and so did the joint venture, thus completely eliminating any equity in the joint venture.

The bank declared the loans to be in default. The corporate co-venturers were placed in receivership by the bank under the terms of the debentures in October 1981. On October 20, 1981, the bank made demand on both plaintiffs for payment under the guarantees. In 1982, the bank determined that its losses were substantially in excess of $1,000,000 and formerly required both plaintiffs to make payment under the guarantees. The plaintiffs admitted to owing the bank $300,000 but refused to pay any amount in excess thereof.

The total claim of the bank against Easton was for an amount of $400,000 and against Freeman for $523,727.73. The bank commenced an action against both plaintiffs. On March 14, 1986, Easton made a cash payment of $300,000 to the bank in settlement and on May 1984 Freeman made a cash payment of $350,000 in settlement. This agreed statement of facts applies to both plaintiffs save where otherwise described. The further agreed statement of facts which I now abridge applies only to the plaintiff Easton.

In 1972, Easton became a 33 /s per cent shareholder in Crescentview Enterprises Ltd. (” Crescentview"), a Canadian-controlled private corporation which was engaged in the business of providing bridge financing for real estate development projects by third parties. Easton reviewed all loan applications made to Crescentview and approved or disapproved the same and determined the terms of loan including security, interest rates and repayment schedule.

Crescentview obtained a line of credit from its bankers, the Bank of British Columbia in the amount of $3,000,000 and the bank required Easton and two other shareholders to execute unlimited guarantees in favour of the bank. On February 5, 1980, Easton signed a memorandum of agreement with Crescentview wherein he and two other shareholders contracted to guarantee debts owed by Crescentview to the Bank of British Columbia for an annual fee of one per cent of the average indebtedness of the company to the bank. Crescentview carried on a successful financial business until 1981 when the Bank of British Columbia refused to continue providing a line of credit and Crescentview defaulted in its repayment to the Bank of British Columbia, ceased operations and became bankrupt in 1982.

In July 1983, the Bank of British Columbia demanded that Easton honour its guarantee. In November 1983, the Bank of British Columbia agreed to settle its claim for the sum of $133,334. The plaintiff paid the amount by borrowing that sum from the same bank on a personal loan which said loan has been repaid at the rate of $18,000 per year, plus interest since 1984.

The issue to be resolved in the case of the plaintiff Easton, as agreed to by the parties, are as follows:

(a) whether the non-capital loss of $300,000 was a loss of Rayfield or a loss of the plaintiff;

(b) whether the Minister properly disallowed the $300,000 non-capital loss claimed by the plaintiff in his T1 Income Tax Return for the 1982 taxation year on the basis that the plaintiff's claimed loss was non-capital; and

(c) whether the non-capital loss of $133,334 was a loss of Crescentview or a loss of the plaintiff;

(d) whether the Minister properly disallowed the $133,334 non-capital loss claimed by the plaintiff in his T1 Income Tax Return for the 1983 taxation year on the basis that the plaintiff's claimed loss was non-capital; and

(e) whether the non-capital loss of $133,334 was correctly allowed in the plaintiff's 1983 taxation year as an allowable business investment loss in the amount of $66,667.

The issues to be decided with reference to the plaintiff Freeman are as follows:

(a) whether the non-capital loss of $300,000 was a loss of Fairlyn or a loss of the plaintiff;

(b) whether the Minister properly disallowed the $300,000 non-capital loss claimed by the plaintiff in his T1 Income Tax Return for the 1982 taxation year on the basis that the plaintiff's claimed loss was non-capital; and,

(c) whether the non-capital loss of $300,000 was correctly allowed in the plaintiff's 1984 taxation year as an allowable business investment loss, on the basis that the Bank guarantees were paid by the plaintiff in that year.

The plaintiff's counsel referred to seven judicial decisions in the matter favouring the taxpayer [1] and the defendant referred to eleven cases wherein the courts held otherwise. [2] Obviously, each case will turn on its own factual situation. However, there are basic criteria which emanate from the jurisprudence that can be of assistance in resolving the issues.

The Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") does not define the terms“ capital loss" or "business loss". The Minister of National Revenue and the taxpayers have had to turn to the courts for guidelines to characterize losses and gains as either capital or business.

The courts have been unable to enunciate a simple principle that serves, in all circumstances, to solve the question as to whether a particular transaction is capital in nature. The general concept, however, is that a transaction whereby an enduring asset or advantage is acquired for the business is a capital transaction. On the other hand, if the transaction is an integral part of the taxpayer's current business operations, then the transaction is a business transaction (Associated Investors of Canada Ltd. v. M.N.R., supra, note 1).

It is now well-settled that even a single operation may be considered as a business although it is an isolated venture entirely unconnected with the taxpayer's profession or occupation. Generally, a loan made by a person who is not in the business of lending money is to be considered as an investment. It is only under quite exceptional or unusual circumstances that such an operation should be considered as a speculation (M.N.R. v. Henry J. Freud, supra, note 1).

The key factor in characterizing the nature of any particular gain or loss is the intent of the taxpayer at the time the expenditure was incurred or the asset acquired. In order to determine the taxpayer's intent, all the facts must be considered in the context of the taxpayer's entire course of conduct. The determining factor is how the taxpayer intended to profit. Therefore, if a taxpayer acquires an asset with the intention of deriving a stream of income therefrom, the subsequent loss is a capital loss. If the asset was acquired with the intention of disposing of it, the taxpayer may claim a business loss if the venture proves unsuccessful (Roger Lachapelle v. M.N.R., supra, note 2).

In order to determine the proper characterization of a loss sustained upon disposition of an asset, the courts have approached the matter by asking whether the asset was acquired as an investment, thus a capital loss, or for the purpose of trade, resulting in a business loss (Roger Lachapelle v. M.N.R., supra, note 2).

In the situation of a taxpayer who has sustained a loss on a loan or guarantee, the courts have considered the practical and commercial aspects of the situation to determine the proper characterization of a particular transaction. The "usual test" whether such a payment is one made on account of capital is whether the loan or guarantee was made with a view of bringing into existence an advantage for the enduring benefit of the taxpayer's business (The Queen v. H. Griffiths Company Ltd., supra, note 2).

In a situation where the money required by a company was needed for a particular purpose and that a convenient way for the company to obtain this money was through a bank loan with the taxpayer's guarantee, then the guarantee is considered a deferred loan by the taxpayer to the company and thus a capital outlay by the taxpayer (M.N.R. v. George H. Steer, supra, note 2). In the event that the taxpayer is required to make payment on the guarantee, then the taxpayer's loss is a capital loss. In these situations, the limited liability feature of the incorporation may prove to be a very valuable shield protecting the taxpayer against the company's creditors, thus compensating to some degree for the lack of deductibility afforded by the guarantee, for the business of the company is not that of the taxpayer (The Queen v. H. Griffiths Company Ltd., supra, note 2).

Ever since the English Court of Appeal decision in Salomon v. A. Salomon and Company Ltd., [1897] A.C. 22, referred to in Beamish (K.J. Beamish Construction Co. Ltd, v. M.N.R., supra, note 2 at page 180 (D.T.C. 1592)), it has been accepted that although the shares of a corporation may be owned by the same person who also manages the corporation, the business of the corporation is nevertheless that of a distinct entity: the corporation has its own rights and obligations.

In my view, the plaintiffs have sustained a capital loss. Although they are both lawyers, they are also involved in several businesses. Some of these businesses might be or have been adventures in the nature of trade. The real estate development they launched at Secret Cove, B.C., was for the purpose of creating an enduring asset. Had they eventually sold the whole project at a profit, it would undoubtedly have been considered to be a capital gain. However, due to unfortunate economic circumstances, the joint venture collapsed and produced a capital loss.

So as to finance the development and construction costs of the joint venture, certain arrangements had to be made with the Bank of Montreal including the personal guarantees of the two plaintiffs. When the two companies were placed in receivership by the bank, the latter made demand on both plaintiffs. The guarantees are to be considered as deferred loans by the plaintiffs to the two companies. When they were called upon to repay, their loss must be considered a capital loss.

The limited liability feature of the incorporation of the two companies did prove to be a very valuable shield to them as they could not be called upon to make good for the companies' other obligations. However, the plaintiffs cannot have it both ways. In order to obtain the loans from the bank they had to provide their personal guarantees for which they remained personally responsible.

As mentioned earlier, generally a loan made by a person who is not in the business of lending money, is considered to be a capital investment, as is clearly the case in this instance. Both plaintiffs were not speculating. They were investing with a view of bringing into existence an advantage for their own enduring benefit. They acquired an asset with the intention of deriving a stream of income therefrom, thus their subsequent loss is a capital loss.

Where a taxpayer has sustained a loss on a guarantee for a loan, the courts must look at the practical and commercial aspects of the transaction. In the instant case, I view the guarantees by the plaintiffs as investments on their part in a joint venture which they felt was to be for their enduring benefit. Unfortunately, and through no fault of their own, the project became a victim of the economic down-turn of the early 19805. Consequently, their loss is of a capital nature.

The particular situation of the plaintiff Easton in his dealings with Crescentview, wherein Easton contracted to guarantee debts owed by Crescentview to the Bank of British Columbia, calls for the same conclusions. When Crescentview defaulted and became bankrupt, the plaintiff Easton had to make good on his guarantee. He and the bank settled for the sum of $133,334 which must be considered to be a capital loss, for the same reasons.

I must also find that the defendant correctly allowed the losses for the years in question, that is, on the basis that the bank guarantees were paid by the plaintiff during those years (Hamnett P. Hill v. M.N.R., supra, note 2).

Consequently, in answer to the issues raised in both cases, I must reply as follows: in the case of both plaintiffs, (a) the loss was the loss of the plaintiffs and not that of their companies; (b) the Minister properly disallowed the $300,000 non-capital loss claimed by the plaintiffs and properly allowed the capital loss for the years in question when the loans were repaid.

In the case of the plaintiff Easton, (c) the capital loss of $133,334 was the loss of the plaintiff; (d) the Minister properly disallowed the $133,334 as a noncapital loss; and (e) the Minister correctly allowed, in the plaintiff's 1983 taxation year, the amount of $66,667 as an allowable business investment loss.

Both plaintiffs' actions are therefore dismissed with costs.

Appeals dismissed.