Central Amusement Company Limited v. Minister of National Revenue, [1990] 1 CTC 2299, 90 DTC 1208

Christie, A.C.J.T.C.:—This appeal relates to the appellant's 1983 taxation year. The issue is whether, in computing its income for that year, the appellant is entitled to deduct expenditures that it made of $175,026 as currently deductible expenses. In reassessing the app< llant's liability to tax for that year the respondent assumed that the expendik -es were outlays on account of capital and consequently are to be added to the undepreciated capital cost of the appellant's depreciable assets. Although this is a commonly litigated issue, the facts of this appeal are perhaps somewhat unique.

The principal witness at trial, Mr. Robert J. Charlton, C.A., is employed by the appellant as its Comptroller. The head office of the appellant is at New Glasgow, Nova Scotia. It has a number of branch offices throughout the Maritime provinces. It has been in the business of dealing in coin-operated amusement machines since 1947. At the time relevant to this appeal they included pool tables, jukeboxes, pinball machines and video games. They are described generically in the evidence as basically any amusement machine that can be operated with a quarter. The appellant's amusement machines were located in about 200 places throughout the Maritimes. Eighty per cent of its business flowed from machines in premises other than the appellant’s, such as bowling alleys, clubs, shopping centres, pool rooms, ferries, corner stores, etc. Fifty per cent of the revenue produced went to these other individuals or corporations and the appellant retained the balance. Its employees would generally empty the machines once a week, although this would be more frequent in the high volume locations. The proceeds would be divided on these occasions. It operated three arcades in premises leased by it in enclosed malls. All of the revenue from these locations was retained by the appellant and, of course, it incurred expenses there for rent and other things that it would not be responsible for in the other locations.

This appeal is concerned with video games. They are played by operators who, having inserted $.25 in the video's coin door, endeavour to electronically control or manipulate images on screens. Their basic components are a cabinet built largely of wood and solid in construction to which is attached a plastic marquee, decals, a control panel that includes a steering wheel or a joystick with or without buttons, a monitor that is also referred to as a T.V. screen, a circuit board and wiring. The circuit board is key for it is the source of the game that is played. In 1983 the appellant had about 475 video games in service. They outnumbered the other amusement machines.

The video game business is very competitive and it is essential that the interest of those who play them be secured and maintained. Initial interest will depend on a game's appeal to that segment of the public that is partial to them. Their revenue-producing capacity decreases with overexposure to customers which induces declining interest and repetitious playing makes customers so skilled that they can keep the game in play for inordinate periods of time for one fee. Here the reward is not free games, but primarily the length a game lasts for the $.25 paid.

There are two minimizers employed to deal with these consequences. First, the games are rotated among the locations which vary in commercial value along these lines: arcades in busy shopping plazas in large centres rank first followed by ferries; bowling alleys and pool rooms; taverns and clubs; and corner stores. Second, new games are acquired either by purchasing entirely new videos, i.e. a cabinet plus all the components just mentioned and conversion kits. An entirely new video is referred to in the evidence as a "dedicated game" which presumably is language of the trade. The kits consist of a new circuit board which is the most important feature plus another marquee, new decals and likely material for adjustments to the control panel. When the components of the conversion kit are installed and wired in a dedicated game or a dedicated game that was previously converted, the customer is presented with an entirely new game, e.g. "Major Havoc" might be replaced by "Heavy Barrel”. The circuit board that is replaced by a conversion is discarded. Details of the manner in which the rotation is done, the acquisition of dedicated games and conversion kits is a matter of business judgment. Actual revenue produced by individual games has significant weight in respect of rotation, and important regarding acquisitions is what is made available and in what quantities by manufacturers.

The cost of the kits and the cost of their installation is what this appeal is about. The disputed deduction of $175,026 consists of: “Repairs and Supplies Expense $161,904 and Wage Expenses $13,122”. The appellant acknowledges that dedicated video games are capital assets and treats them as such in its returns of income. In evidence the cost of a dedicated game and a conversion kit is given as in the order of $5,000 and $1,000 respectively. Some of each cost more and some less, but those figures are sufficiently accurate for these reasons.

Pac Man is portrayed as the first totally modern video game in colour and it is credited with starting the video boom. Charlton gave it this terse description: "The object of Pac Man is to use your joystick to control your man and eat all the dots on the screen before the bad guys eat you.” Pac Man came on the market in 1981 and it was followed about a year later by Ms Pac Man, which was also a great success.

The appellant commenced using conversion kits in 1983. In that year it had 475 video games in service of which 134 or 28 per cent were converted. The analogous figures for subsequent years are: 1984 - 600, 121 or 20 per cent; 1985 - 600, 187 or 31 per cent; 1986 - 740, 163 or 22 per cent and 1987 - 800, 118 or 15 per cent. During these years conversions averaged 23 per cent. There is also in evidence the earning history of seven different video games: Contra, Gondo- mania, Solar Wars, etc. involving 24 games, i.e. 5 Contras, 2 Gondomania, 3 Solar Wars and so on, over a period of two years. It depicts the declining returns of these games. On average the weekly income of each game in the first six months was $93. For the next three six-month periods it was $64, $45 and $29 respectively. During the two-year period these games were in the rotation procedure and they were not converted.

In his examination-in-chief Charlton said that the economic life of a dedicated game is six to eight months and if converted that life is extended another eight or nine months. In cross-examination he repeated the first part of that statement and added that some games are better than others. He said that on conversion economic life as a general rule was six to eight months, which is a change from his evidence-in-chief. He added that dedicated games would be "more on the eight month side of it” and "conversion kits would probably be more on the six month side of it." This can at best be an overall estimate because the economic life of a game will be subject to variables the most important of which is, I expect, its popularity. What is meant by economic life is the optimum revenue-producing period of a dedicated or converted game and not the period during which the game is an income-producing asset for the appellant. This was made clear in argument. Also it could not be the latter. That would be inconsistent with the evidence regarding the rate of conversions during 1983 to 1987 and that of the earning history of the seven games previously referred to. Further the appellant placed in evidence two photographs taken in February 1989. Both show video games being played by members of the public. One of the video games in the first photograph is Ms Pac Man and the video game in the other photograph is Pole Position. Pole Position was then in one of the appellant's prime locations. Ms Pac Man was acquired in 1982 and there were four or five in service at the time of the trial. Pole Position was purchased in 1983. Another video game, Star Wars, was in service from 1983 to 1987. These are examples only.

Expert opinion evidence by Mr. Frank J. Kelly, F.C.A., that to treat the $175,026 as a current expense would be "appropriate" under generally accepted accounting principles was offered at trial by the appellant. Counsel for the respondent objected to its being received and after having had the benefit of briefly perusing a summary of the opinion, I said I was very dubious about it. Nevertheless, I agreed to hear it and decide later what weight, if any, it deserved. There is a very substantial body of jurisprudence on current versus capital expenditures and I find that the opinion evidence does not assist me in drawing the necessary inferences from the facts proved at trial to decide this appeal. In the circumstances I am not assigning any weight to it. On this point see Irwin v. M.N.R., [1989] 2 C.T.C. 2115; 89 D.T.C. 386 at page 2120 (D.T.C. 390).

These observations by Jackett, P., later Chief Justice of the Federal Court, in Canada Steamship Lines Limited v. M.N.R., [1966] Ex. C.R. 972; [1966] C.T.C. 255; 66 D.T.C. 5205, strike me as especially apposite to the facts of this appeal. He said at page 5207-8 258 (D.T.C.):

Things used in a business to earn the income—land, buildings, plant, machinery, motor vehicles, ships—are capital assets. Money laid out to acquire such assets constitutes an outlay of capital. By the same token, money laid out to upgrade such an asset—to make it something different in kind from what it was —is an outlay of capital. On the other hand, an expenditure for the purpose of repairing the physical effects of use of such an asset in the business—whether resulting from wear and tear or accident—is not an outlay of capital. It is a current expense.

Dedicated video games are amusement machinery used in the appellant's business to earn income. A conversion is simply an upgrading of a dedicated game or dedicated game that has previously been converted to make it different in kind from what it was. The existing game is replaced by a new and different game. The conversion of video games is not repairing them.

In my opinion, if a taxpayer is in the business of earning income by giving others exclusive temporary use of chattels for a price, whether by lease or otherwise, the expenditures made to acquire those chattels and to improve or upgrade them are outlays on capital account. On the other hand, expenditures incurred in making them available to customers, such as, rent for premises and repairs, are on revenue account.

In argument counsel for the appellant drew this analogy which he submitted carried the case for his client a long way. In a situation where a typewriter is properly regarded as a capital asset, the cost of replacing a worn ribbon is nevertheless deductible as a current expense in computing income. I agree that in those circumstances the cost of the ribbon could be so regarded because what is done is to repair the typewriter by replacing one expendable component of it that has become worn by the physical effects of its use. When the worn ribbon is replaced what is there after replacement is the same thing that existed before, namely, the typewriter in working condition. That is not, however, the result of using conversion kits in relation to video games.

The $175,026 in dispute were payments made on account of capital, the deduction of which in computing the appellant's income for its 1983 taxation year is prohibited under paragraph 18(1)(b) of the Income Tax Act’. [1]

The appeal is dismissed.

Appeal dismissed.