Leo E Raessler v. Minister of National Revenue, [1984] CTC 2575, 84 DTC 1516

Christie, CJTC:—The issue is the amount the appellant is entitled to deduct from his total income in his 1975 taxation year by way of capital cost allowance claimed by a limited partnership in which he was a limited partner.

The limited partnership was formed on July 29, 1975, when the required certificate was filed and recorded in the Central Registry in accordance with section 51 of the Partnership Act, RS A 1970, c 271. The firm name of the partnership is Decoder Systems Development (“DSD”). There are a number of limited partners, but only one general partner, Codavision Development Ltd which was incorporated under the laws of Alberta. The capital of the partnership is restricted to $3,610,000 divided into 100 units worth $36,100 each. The distribution of profits and losses among the general and limited partners is in proportion to the number of units subscribed for. One vote is assigned to each unit purchased. The certificate describes the character of the business to be “generally” the promotion, financing, operation and licencing of pay subscription television systems. A number of detailed purposes follow, but specific reference need be made only to:

(a) obtaining from Pay Television Corporation, a Delaware corporation having its head office in New York City (“PTV”), 82 Canadian patents and five applications for Canadian patents, all of which are particularly identified;

(b) to provide pre-production design and engineering required to produce a marketable in-home decoder for use as a component of pay subscription television; and

(c) to agree with PTV for payment by it of royalties to DSD in respect of manufacturing decoders.

The fundamentals of the system with which DSD was concerned involved attaching a device known as an encoder to the broadcasting equipment which “scrambles” the emitted signals and the recipient of those scrambled signals requires a decoder to unscramble them in order that there may be normal viewing of the pictorial presentation. The decoder includes the ability to record the use made of the system by the consumer for billing purposes.

On July 30, 1975, an agreement was entered into between the general partner and the limited partners (“the Partnership Agreement”). It is repetitious of what is said in the certificate filed pursuant to section 51 regarding the character of the business of the firm and goes on to deal with admission to the partnership, etc. Pursuant to the terms of the Partnership Agreement, the appellant purchased four units at $36,100 each for a total of $144,400. Of the $144,400, $6,920 was paid in cash. In addition, a promissory note signed by the appellant was delivered to DSD for $38,400 payable at $1,600 per month, with the full amount due not later than March 31, 1977. A second promissory note in the sum of $99,080 was signed by the appellant payable to DSD. This second note is payable on demand subject to these provisos. First, the demand could only be made after March 31, 1977, and second, only for the purpose of meeting payments for the patents and patent applications to PTV. In this regard bear in mind in what follows that there was a period between March 31, 197, and December 31, 1977, during which payments were required to be made by DSD to PTV for the patent applications, but no minimum royalties were payable by PTV to DSD. The payment of minimum royalties was not scheduled to commence until January 1978.

On August 28, 1975, PTV and DSD entered into a rather elaborate agreement consisting of a preamble and four parts (“the 1975 PTV-DSD agreement”). For the purposes of this appeal it may be attenuated as follows. Part I provides that PTV shall sell 82 patents and 5 patent applications to DSD for $3,045,000. The breakdown is 82 patents at $36,585.37 each ($3,000,000) and 5 applications at $9,000 each ($45,000). Terms for payment of the $3,045,000 were, $232,000 in cash before July 31, 1975, and the balance in accordance with Exhibit “C” to the agreement. This exhibit provides for additional payments to be made to PTV at specified times during the period August 31, 1975, to December 31, 1977 in the amount of $453,000. The total amount to be paid for the patents and patent applications by December 31, 1977, was therefore $685,000. With respect to payment of the balance of $2,360,000 owing after December 31, 1977, on the $3,045,000 Exhibit “C” provides (the figures are in thousands):

♦Payments to be made in four equal quarterly payments at the end of each quarter. However, PTV will receive 33 percent of the gross income of DSD if it is higher than the scheduled payments until the total purchase is paid.

On closing, the patents were to be placed in escrow with a bank. They are there to this day.

Clause 13 of Part I states, among other things, that by purchasing the Canadian patents and applications, DSD is entitled to “put into use the inventions set forth or claimed in the patents and patent applications hereby purchased, either directly or indirectly, through agents; and to sell, lend, lease, franchise or otherwise transfer for use by others, in Canada, components for pay subscription television systems”.

Clause 1 of Part II includes an undertaking by DSD to allocate out of its capital the sum of $565,000 “to be used for its administrative expenses and research and development, development of production designs, engineering and the manufacturing of working models of the subscription pay television system which is the subject of this agreement, which said sums shall be expanded between the date hereof and the last day of March 1977”. Clause 2 of Part II states that, if the $565,000 is insufficient, DSD shall add to the $565,000 any amounts received by it from any government agency by way of non-repayable grants. If the $565,000 and the grants together “are insufficient to produce a commercially viable and marketable system, all other expenses in research and development shall be borne totally by PTV”. PTV was entitled to the results of the research and development by DSD and the former, in turn, agreed to pay DSD royalties for each decoder manufactured by or on behalf of PTV. The royalty was set at 10 per cent of the total price to the manufacturer of decoders subject to some qualifications which need not be recited here. Payment of the royalties. at the rate of 10 per cent was to continue until DSD had received $7,500,000, where upon the rate of the royalties was reduced to three per cent. It is also provided that the provisions of the agreement respecting royalties “shall commence upon the execution hereof, and be concluded 25 years from the date hereof, or such later date when DSD has been paid $9,750,000 in royalties”. Clause 6 of Part II (“clause 6”) which is of considerable signficance reads:

6. PTV undertakes and agrees that the minimum royalties for decoder units that shall be payable to DSD for Eight (8) years beginning January 2, 1978, shall be based on the following minimum schedule of royalties:

1978	$ 536,000
1979	758,000
1980	1,091,000
1981	1,091,000
1982	1,091,000
flncludes the $685,000

1983	1,091,000
1984	1,091,000
1985	751,000

In the event that in any year during the currency hereof, said minimum royalty is not met solely (after using its best efforts) because an insufficient no of said decoder units are sold, and PTV shall fail to pay the dollar amount of royalties represented by the unmet portion of the minimum, DSD’s sole remedy shall be to defer payment on any moneys owing to PTV in excess of 33 per cent of its gross income, arising out of the purchase of the said Canadian patents, from time to time, until such minimum royalty payments arrears have been met and made good.

So long as the said minimum royalties are met by PTV, or the failure to meet such minimum results solely (after using its best efforts) from the inability to sell sufficient decoder units, the rights to the DSD know-how shall be exclusive to PTV, provided that should PTV be declared bankrupt, or make a voluntary assignment for the benefit of its creditors, or otherwise cease to carry on its business, the said exclusive rights shall be extinguished.” [Emphasis added]

Clause 11 of Part II (“clause IT’) reads in part:

11. In the event that in any year during the currency hereof, the aforesaid minimum royalties are not paid, through lack of manufacturing of the said decoders, and PTV defaults in its requirements to pay to DSD the cash payment in lieu of the said royalties, DSD shall only be entitled, to withhold payment of any moneys in excess of 33 per cent of its gross income then or thereafter to become due and payable by DSD to PTV in respect of the purchase of the aforesaid Canadian patents by DSD from PTV. [Emphasis added]

Part 111 provides that, upon the Canadian Radio-Television Commission authorizing subscription pay television systems to be introduced in Canada, DSD shall be entitled to an exclusive franchise to operate the PTV system in Canada. PTV agreed “to enter into an appropriate franchise agreement with DSD” in this regard. Part IV deals with general matters such as the giving of notices under the agreement and arbitration.

Counsel for the appellant submitted two additional agreements in evidence. The consensus at the hearing appeared to be that neither can have much, if any, bearing on the result but I will relate briefly what they are about to round out the narrative. On January 1, 1978, the 1975 PTV-DSD agreement was supplemented and amended to provide for the payment of $75,489.15 by PTV to DSD. This was the amount in excess of the previously mentioned $645,000 expended by DSD on research and development. It was also agreed to increase the balance owing for the patents and applications from $2,360,000 to $2,477,000, which is $117,000 and:

The method of payment of the patent payment as provided for in Exhibit C to the original Agreement is hereby deleted and the said remaining balance of Two Million, Four Hundred and Seventy-Seven Thousand ($2,477,000) Dollars is to be paid as follows:

Payment —

Greater of (a) 33 per cent of the gross income of

DSD for the calendar year ended on the

immediately preceding December 31, of (b) the following amounts, until a total of

Year	$2,477,000 has been paid
1979	$	0
1980	117,000
1981	250,000
1982	360,000
1983	360,000
1984	360,000

1985	360,000
1986	360,000
1987	310,000

Each such payment shall be made on the first business day of each year.

The first subparagraph of clause 6 was deleted and the payment of these royalties was rescheduled in the same amounts during the years 1980 to 1987 inclusive. Payment to be made on the first business day of each year. The existence of the second and third subparagraphs of clause 6 are expressly preserved. The other additional agreement is between C W Murchison, Jr of Dallas, Texas, and DSD. The latter was anxious to have one of its nominees on the board of directors of PTV. Murchison owned a large number of shares of PTV and held proxies for others and he agreed to exercise their voting authority to the attainment of this objective.

No payments for the patents or applications for patents have been made beyond December 31, 1977. Accordingly the total paid in this regard to date is $685,000 leaving, during the taxation years under review, the previously mentioned unpaid balance of $2,360,000. Furthermore no “minimum royalties” were paid at any time.

The fiscal year of DSD is the calendar year and in its financial statements for the year ending December 31, 1975, items said to be deductible for income tax purposes totalled $979,918. The appellant claimed four per cent of this (representing his four units in the partnership), namely, $39,196.72 to be deductible from his total income for 1975. A number of items are included in the $979,918 but in reassessing, the respondent only challenged two. One was for $11,400 which can be quickly disposed of. The partnership agreement provided that if, at the time of applying for partnership in DSD, a limited partner paid a specified minimum amount in cash towards the full price of a partnership unit, he was entitled to a rebate of $600 for each unit purchased. The rebates paid by DSD in this regard in 1975 totalled $11,400. These discounts on capital contributions are not deductible from the income of the partnership. This was conceded by counsel for the appellant during the course of the hearing. The second item challenged by the respondent is $660,013 which DSD claimed as a deductible capital cost allowance. It pertains to the purchase of the 82 Canadian patents and the five applications for Canadian patents. In computing the capital cost allowance, DSD used as its base figure the entire purchase price of $3,045,000. The respondent used $647,877 as his base figure in calculating the capital cost allowance. The $674,877 represents the total payments made by DSD for the patents up to December 31, 1977. The figure is arrived at by subtracting $10,123 from $685,000. The amount of $10,123 represents expenditures for applications for patents and bears the same ratio to $685,000 that $45,000 bears to $3,045,000.

It is the contention of the respondent that while the appellant correctly treated the expenditure for the patent applications as capital in nature, these applications, unlike the patents, are not within the class of property for which a capital cost allowance may be deducted. Paragraph 18( l)(b) of the Income Tax Act, RSC 1952, c 148 (“the Act”) provides that in computing the income of a taxpayer from a business or property, no deduction shall be made in respect of payment on account of capital except as expressly permitted by Part I of the Act. Paragraph 20(l)(a) of the Act which is also included in Part I states that in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such amount in respect of capital cost to the taxpayer of property as is allowed by regulation. Part IX of the Income Tax Regulations deals with allowances in respect of capital cost. Paragraph 1100( l)(c) which appears in Part XI and Class 14 of Schedule B to the Regulations provide for allowances in respect of patents, but are silent regarding applications for patents. I am in agreement with the respondent on this point.

To the litigants however the question whether the cost of the applications for patents should be included in computing the capital cost allowance is of relatively minor importance. As the figures dictate, the principal economic issue with which they are concerned relates to the $3,000,000 for the patents.

The position of the respondent is that the meaning of clause 6 and clause 11 is that, if no minimum royalties were paid the scheduled payments in Exhibit C in respect of the $2,360,000 were not payable. From this premise stems the respondent’s submission that liability regarding the $2,360,000 was contingent, which is not the kind of liability in respect of which capital cost allowance may properly be claimed. The position of the appellant is that the scheduled payments referred to were payable regardless of whether the minimum royalties were paid and consequently they were not contingent liabilities. The words 33 per cent of gross income are used in the agreement on three occasions: first, in Exhibit C, then in clause 6 and clause 11. In Exhibit C they clearly mean 33 per cent of gross income from any source in excess of the scheduled payments referred to therein, ie 33 per cent in excess of $250,000 in 1978, 33 per cent in excess of $360,000 from 1979 to 1983 inclusive and 33 per cent of $310,000 in 1984. Notwithstanding that the reference to 33 per cent of gross income originates in Exhibit C, it will be noted that in clause 6 and clause 11, unlike Exhibit C, the reference to 33 per cent of gross income is restricted to the kind of income to which it relates. The restrictive words in clause 6 are “arising out of the purchase of the said Canadian Patents, from time to time’’ and in clause 11 are “then or thereafter to become due and payable by DSD to PTV in respect of the purchase of the aforesaid Canadian patents by DSD from PTV’’. [Emphasis added] Counsel for the respondent contends that gross income in clause 6 and clause 11 is confined to income from royalties. Counsel for the appellant says that gross income in those clauses goes beyond that. When asked to exemplify, he referred to clause 13 of Part II, (supra), of the 1975 PTV-DSD agreement. While it is possible to make an argument having some plausibility that the meaning of gross income in clause 6 could include anticipated income from sources such as those described in clause 13, that is not possible in relation to clause 11. Furthermore, when the 1975 PTV-DSD agreement is regarded in its entirety there is no discernible rationale for attributing a different meaning to “gross income’’ in clause 6 which deals with the situation where some decoders are manufactured and sold and clause 11 which contemplates the condition where none are manufactured. Nor was any such rationale advanced during the course of hearing. I agree with the respondent that gross income in clause 6 and clause 11 is limited to income from royalties.

I note in passing that the use of the phrase “minimum royalties’’ in the context is a misnomer. If some royalties were paid on manufactured decoders then the difference between that amount and the “minimum royalties’’ would be a cash payment in lieu of royalties. If no royalties were paid then the entire “minimum royalties’’ would be a cash payment in lieu of royalties. Nevertheless as the expression “minimum royalties’’ is used in the agreement I have used it in these reasons for judgment as including income from royalties and cash payments in lieu of royalties.

If the basic issue had to be decided on the basis of the documentation alone I would dubitatively conclude that the interpretation advanced by counsel for the respondent is correct and that in the absence of payment of minimum royalties, DSD was not under a legal obligation to make the scheduled payments listed in Exhibit C. It strikes me that the construction advanced by the appellant leads to the conclusion that DSD entered into an unrealistic agreement respecting payment to it of royalties. While it is quite possible to enter into binding agreements which may be regarded as commercially unrealistic or improvident that construction is not to be adopted in the face of uncertainty in the language of the contract. In these circumstances recourse should be had to the rules applicable to the interpretation of ambiguous contractual provisions. One such rule is to have recourse to extrinsic evidence.

I believe that there is sufficient ambiguity on the face of the documentation to allow extrinsic evidence to be taken into consideration if it is explanatory of the intention of the parties in relation to the words they have used which give rise to the uncertainty. Generally disputes about the meaning of contractual obligations arise between or among the parties to the contract. Here, however, we have a dispute about the meaning of a contract regarding which one of the disputants, the respondent, had no relationship to the contractors in respect of its formation. If, in these circumstances, evidence is forthcoming by a witness called by the appellant which is supportive of the construction contended for by the respondent that, in my opinion, seals the debate in favour of the respondent. The appellant did not testify. The only witness called on his behalf was Mr Daniel R Sutherland. He is a consulting engineer and a businessman. He was one of, if not the principal promoter of what transpired between PTV and DSD. While being examined in chief, Sutherland said:

And we certainly weren’t going to pay out the full amount of the patents unless Pay Television Corporation did its share of the bargain, and its share of the bargain was to get somewhere in the world, pay television implemented. We felt that if they didn’t that there should be a penalty for their not having achieved that particular part of the function, and the penalty was that we didn’t pay them for the patents if they didn’t pay us for the royalties. So that that way they had an incentive that made them get out and try and get pay television operating.

In the course of being cross-examined he said:

Q. My question is this: if there were no royalties coming in, was DSD nevertheless to pay that balance of $2.3 million in any event?

A. Say that again.

Q. If no royalties came in, none whatsoever —

A. Yes.

Q. — was DSD to pay the $2.3 million, whatever the balance was?

A. Under several, three conditions which I pointed out on pages 11 and 17, yes they were.

QO. No, no. But if you received no royalties, if Pay TV wasn’t selling, then you would not receive royalties, right?

A. We did not — no, let’s put it another way around.

Q. Well, maybe you could answer my question first.

A. We would make payments to them — its kind of the chicken and the egg. What we were saying is that if we didn’t get any royalties, then we’re not going to make any further payments to them because they haven’t performed. There is a penalty, and it was the only leverage DSD had on Pay Television Corporation, to withhold paying that.

Q. Don’t you agree that the agreement itself says if there are no royalties then your remedy is to defer payment? Isn’t that what the agreement says?

A. That’s correct.

Q. Okay. Isn’t it fair to say that deferral will be forever if there are no royalties?

A. No, on that I disagree with you.

Q. Okay. Now, sir, where does the deferral stop?

A. The deferral stops when they start to pay royalties.

QO. Now, we’re really chicken and egg. We have circled.

In the result, my determination is that the payments scheduled in Exhibit C in respect of the balance of $2,360,000 were payable only if the minimum royalties were paid. Payment of the minimum royalties consituted a condition precedent to the existence of a legal obligation on the part of DSD to make the scheduled payments. Fulfilment of that condition precedent was not at all certain to occur. Liability on the part of DSD was, therefore, contingent and the $2,325,123* [2] could not properly be included in calculating the deduction which DSD could make in 1975 for capital cost allowance respecting the purchase of the patents: Mandel v The Queen, [1978] CTC 780; 78 DTC 6518, a judgment of the Federal Court of Appeal which was unsuccessfully appealed to the Supreme Court of Canada. See [1980] CTC 130; 80 DTC 6148. The position of DSD respecting its claim for capital cost allowance must, of course, be applied to the appellant’s claim in this regard.

The final point in controversy concerns the correct procedure for amortizing the purchase price of the 82 patents. Both parties agree that it is not possible to assign a reliable dollar value to each patent. The manner of determining the value of this depreciable property adopted by DSD was to divide the total cost of the patents, $3,000,000, by 82 and acknowledge the $36,585.36 quotient to be the value of each patent. The straight-line method was then applied to the remaining life of the patents. This can be illustrated by reference to the 31 patents having the briefest residual esixtence. Each patent was for 17 years.

This method, when applied to all 82 patents, produces $657,366.15 as DSD’s amortization of patent costs for 1975. This excludes the applications for patents. Assuming for the moment that this is the correct method, the $3,000,000 would have to be adjusted down to $674,877 in the light of my conclusion regarding contingent liability.

The only witness called at the hearing by the respondent was Mr. William Blahun, a certified general accountant employed by Revenue Canada. He testified in favour of the formula applied by the respondent. The respondent’s starting point is that $674,877 was the total amount in respect of which DSD could claim capital cost allowance in 1975. The respondent then established a direct relationship between the $674,877 and the remaining life of each patent. To do this a factor of “Patent years” was created by adding all of the remaining years of the 82 patents. This totalled 468 patent years. A value of $1,442.04 was then assigned to each patent year by dividing $674,877 by 468. The straight-line method was then applied. To illustrate again by reference to the 31 patents having the shortest span of duration.

This method, when applied to the 82 patents, produces $118,246 as DSD’s amortization of patent costs for 1975.

Sutherland said that the method adopted by DSD was on the advice of a firm of chartered accountants. No one was called as a witness from the firm although it has a substantial office in Edmonton, where this appeal was heard. He also said that a patent with a briefer residual existence than another might well be the more valuable. I do not disagree with the validity of that as a general proposition, but it strikes me that when faced with a situation where, as here, there are a number of patents of varying remaining terms which cannot be individually priced and two formulas for appraisal are put forward, the one which places the greater emphasis on longevity is to be preferred. After all the essential nature of a patent of invention is to exclude others from using the patented technology without the permission of the holder of the patent for a specified period of time. I regard the respondent’s patent years approach preferable to that chosen by DSD and advocated by the appellant.

The appeal is dismissed.

Appeal dismissed.