Skidmore v. R., [1998] 1 CTC 2619, 98 DTC 1135

Sarchuk T.C.J.:

These are appeals by Russell Skidmore and Jean Skidmore (the Appellants) from assessments of tax with respect to their 1989 taxation year by which the Minister of National Revenue (the Minister) disallowed certain capital gains exemptions claimed by each Appellant on the sale of shares of Birchill Nurseries Inc. (Birchill). The basis for the assessments was that Birchill was not a small business corporation as defined by subsection 248(1) of the Income Tax Act (the Act).

Background

For a number of years, the Ontario Ministry of Natural Resources (the Ministry) operated a program to maximize the production of Black Spruce seedlings for the purposes of reforestation. The program had achieved mixed results and by the early 1980s, a decision was taken to turn the project over to privately-owned nurseries in Northern Ontario. As an incentive, the Ministry offered matching grants amounting to 50% of the start-up costs to individuals who were prepared to establish seedling nurseries. The Appellants submitted a proposal to establish such a nursery near Cochrane, Ontario, which was accepted. Birchill was incorporated for that purpose and on May 27, 1982 entered into an agreement with the Crown to erect greenhouses on its premises and to grow seedlings. The Crown, for its part, allocated a $215,000 grant to Birchill. [1]

The Crown Contract: Pursuant to subparagraph 8(1) of the original Agreement, the Crown and Birchill undertook to annually extend the arrangement and on July 7, 1983 executed a further Agreement for that purpose (the Crown contract). [2] Pursuant to this contract, the Crown was required to purchase Birchill’s entire crop up to an agreed number (the Target Number) and was granted a right of first refusal over any seedlings grown in excess of the Target Number at the Excess Rate stipulated therein. The Crown was to pay Birchill in three instalments, the first upon receipt of the first crop inventory taken six weeks after the initial sowing of the seeds in the greenhouses. The second payment was to be made upon receipt of the second inventory taken during the week of September 12th. The final instalment was to be paid when all seedlings were ready for delivery (usually in May of the following year). [3] The Crown contract also provided that where the final instalment calculation resulted in a negative amount neither party was obligated to pay any further amount to the other. [4]

This contract permitted the Crown, upon Birchill’s failure to satisfactorily perform an obligation of the contract and after giving Birchill a period to “make good” the default, to terminate the contract and demand partial repayment of the start-up grant. [5] This repayment was set as “an amount of money equal to 20% of the delivery amount (being the payment by the Crown to Birchill for the erection and operation of the greenhouses) multiplied by the number of years from the year of any such termination to the year 1987, both inclusive”.

The 1988 Contracts: The Crown contract expired in 1988 with the delivery of the 1987 crop. According to Russell Skidmore (Skidmore), by that time the Ministry had instituted a bidding system for growers of seedlings. As a result, Birchill bid, was successful and on February 1, 1988 entered into an agreement with the Crown to grow and deliver 1,935,000 seedlings, the same number as in previous years. [6] In that year, Birchill also entered into a contract with Abitibi Price Inc. (Abitibi) which required it to seed, grow and over-winter 1,000,000 seedlings. The Abitibi terms were somewhat similar to those of the first Crown contract in that payments to Birchill were to be made in three instalments. However, the Abitibi contract called for payments amounting to 50%, 20% and 30% of the rate specified. [7] The payment schedules were also similar - two advance payments based on inventories to be conducted by Birchill prior to the winter dormancy period, the first to take place on or before July 15, 1988 and the second after the seedlings had been prepared for over-wintering with the results to be submitted to Abitibi by October 15, 1988. Assuming the seedling crop met the contractual specifications, the remainder of the contract price was to be paid following the completion of the third inventory, to be conducted between May 1st and May 15th of the following year.

Two further differences between the original Crown contract and the Abitibi contract should be noted. First, the Crown contract was for a five- year term, whereas the Abitibi contract was for one year and contained no termination provisions comparable to those found in paragraphs 1(a), 6(1) and 6(3) of the Crown contract. Second, the payments contemplated in the Abitibi contract could result in a negative amount if, for example, the number of containers in which there were single germinants had declined by the time of the second inventory. Pursuant to paragraph 5(4) of the original Crown contract, if Birchill suffered a total crop failure after receiving the first and second instalments, i.e. 90% of the contract price, it would not be required to pay any of this amount back to the Crown. [8] The Abitibi contract made no similar provision for negative amounts and repayment by Birchill might have been required. [9]

The Nursery Operation: At the relevant time, Black Spruce seedlings were grown in nurseries utilizing a process known as container seedling production. Skidmore testified that each spring, seeds delivered by the Min- istry [10] to the Appellants were planted in special containers by Birchill staff. These containers were kept in the greenhouses from June until September during which time they were exposed to specific ventilation, fertilization and hydration conditions designed to maximize the seedlings’ growth. Towards the end of August, the seedlings “go into bud” at which stage the heat was turned off in the nurseries and the seedlings were left there for four to six weeks in what Skidmore described as a dormant stage. At this point the seedlings, in their containers, were placed in outdoor “holding areas” where specialized watering equipment was available to completely saturate the plants and were left there to over-winter. Critical to the survival of the seedlings at this stage is the availability of good snow cover to provide protection from winter’s harsher elements. The following spring, the seedlings were delivered to the Ministry for its tree planting programs.

It is not disputed that during the years in issue, the seedling nursery business was risky. Dr. Colombo [11] described a number of biological and environmental risks some of which were preventable and others which were beyond the control of the operators. During the greenhouse phase, the problems were both natural and man-made. Certain difficulties were attributable to the Ministry which on occasion, provided seed lacking an inherent capacity to grow rapidly and fail to reach minimum acceptable size. Other difficulties were attributed by Colombo to the nursery operators themselves such as: poorly constructed greenhouses and watering and/or ventilation problems which prevented the seedlings from reaching the required size. Insect infestations were a constant threat as were plant diseases such as “damping off”. Such problems, in the opinion of Colombo, were preventable. Others were beyond the control of nursery operators. The dormancy period had its own set of hazards, most of which were caused by harsh weather conditions including high winds and extreme low temperatures, which could kill the crop of seedlings. Colombo testified that in the years 1982 to 1989, the Birchill nursery was remarkably successful suffering only one minor setback. This was attributed to the superior sanitation practices which it followed and the abundance snow cover which that area typically received. It was one of the few nurseries engaged in this program which suffered no significant crop failures.

Sale: In 1988, the Appellants decided to sell the nursery business. The Appellants’ children, Glen Skidmore and Jane Fox, and Dirk Birkman of Birkman & Associates incorporated Birchill Forest Renewal Centre Inc. which purchased all of the outstanding shares in Birchill for $645,000. [12] The consideration was paid by way of $445,000 cash on closing and a $200,000 mortgage granted to the Appellants over the property of the company. One of the terms of the agreement stipulated that term deposits in the amount of $160,000 held by Birchill were to form part of its assets and that $145,000 of the purchase price was allocated to their acquisition.

Appellants’ Position

The Appellants contend that all or substantially all of the assets of Birchill were used in an active business, the seedling nursery. In addition to owning the land and buildings, Birchill also held an inventory of seedlings as well as large cash reserves. Counsel submitted that there were several good reasons for Birchill to hold such reserves. First, since conventional bank financing and crop insurance were not available, they were maintained in order to finance the cost of planting seedlings in the year following a total or partial crop failure. Second, it was to protect the business of Birchill in the event that its failure to perform the specific terms of the contract led the Crown to terminate and demand repayment of the grant. Third, to protect Birchill in the event it failed to produce the target number of seedlings and was therefore required to repay some or all of the amounts previously paid by way of advances.

Counsel for the Appellants contended that the term deposits were employed and risked in Birchill’s operation and that the holding of the deposits was linked to a definite obligation or liability of its business. [13] In particular, the deposits existed as a “necessary and reasonable backup asset of liquidity” as demanded by the particular nature of this business. Thus, it was argued that the term deposits’ fundamental purpose was to sustain the business operations during difficult times if such arose. [14]

Counsel for the Appellants further argued that the term deposits were incident or pertaining to an active business because there was a financial relationship of dependence of some substance between the deposits and the active business. Such financial relationship has been established since the operation of the business relied on the term deposits in the sense that recourse could be had to them as a backup asset to be called upon in support of its operations when necessary. [15]

Respondent’s Position

Counsel for the Respondent contends that there was no financial relationship of dependence between Birchill’s business and the term deposits nor was there any evidence supporting the Appellants’ contention that the removal of the term deposits in question would have de-stablilized the business. It is also the Respondent’s position that money set aside for a form of self-insurance ought not to be considered to be an asset used in an active business. [16] Last, it is contended that the evidence failed to establish a rational relationship between the amounts held by Birchill and reasonably determined reserves. [17]

Conclusion

Subsection 110.6(2.1) of the Income Tax Act allowed a taxpayer to deduct from his taxable income certain amounts which represent the capital gain on the disposition of qualified small business corporation shares. Subsection 110.6(1) sets out the following conditions:

110.6(1) For the purposes of this section,

“qualified small business corporation share’’ of an individual (other than a trust that is not a personal trust) at any time (in this definition referred to as the “determination time”) means a share of the capital stock of a corporation that

(a) at the determination time, is a share of the capital stock of a small business corporation owned by the individual, the individual’s spouse or a person or partnership related to the individual,

The condition at issue in this appeal is the requirement in paragraph 110.6(1)(a) that the shares in question must be shares of a small business corporation. The term “small business corporation” is defined in subsection 248(1) of the Act:

248(1) In this Act,

“small business corporation” at any particular time means a particular corporation that is a Canadian-controlled private corporation all or substantially all of the fair market value of the assets of which at that time was attributable to assets that were

(a) used in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it,

and, for the purposes of paragraph 39( 1 )(c), includes a corporation that was at any time in the 12 months preceding that time a small business corporation;

The term “active business” is also defined in subsection 248(1) as follows:

248(1) In this Act,

“active business”, in relation to any business carried on by a taxpayer resident in Canada, means any business carried on by the taxpayer other than a specified investment business or a personal services business;

It is not disputed that the business of Birchill was an active business. The issue is whether all or substantially all of its assets were used in that active business so as to qualify it as a small business corporation. In order to be considered an asset of the active business, such assets must have been employed or risked in the business. In Ensite, the Court held that the term

1 8supra.

°supra.

“risked” meant more than a remote risk and that the withdrawal of the property would have a destablizing effect on the business operations themselves.

For an amount set aside as a reserve to be considered a backup asset used in the business, as claimed by the Appellants, there must be a rational relationship between the amounts being held by the taxpayer and reasonably determined reserves. [19] Two of the reasons advanced by the Appellants for the amounts allegedly held for that purpose were the risk of cancellation of the Crown contract and repayment of the grant and second, the potential repayment of advances in the event of a crop failure or the production of seedlings of substandard and therefore unacceptable quality. [20]

First, with respect to repayment of the Crown grant, the Appellant, Skidmore, himself considered the possibility to be remote. He said, in the course of his testimony, that he did not believe that the Crown would have cancelled the contract since “in the first five years, the Ministry of Natural Resources wanted to ensure that they were provided with tree seedlings, it wasn’t as serious”. Even assuming that Birchill was potentially at risk vis-à- vis repayment of the grant, that risk must be viewed in the context of the fact that the repayment schedule was based on the number of years remaining in the contract. Thus, in contract year 1983, the possible repayment was $215,000. However, by 1987, it had been reduced to $43,000 and by 1988 to nil. On the other hand, Birchill’s financial statements fail to provide any evidence that a relationship existed between the “at risk” amounts and the reserves held as “investment-type” assets. [21] In 1984, 1985, 1986 and 1987, the assets so held were $42,000, $190,000, $182,000 and $238,000, respectively. In 1988, the year in which Birchill negotiated new contracts with the Crown and Abitibi, it held $200,000 in term deposits and $112,000 in mutual funds, stocks and loans. In 1989, prior to the disposition of the Appellants’ shares, Birchill held investment-type assets in the amount of $271,000. For 1986 and 1987, Birchill’s balance sheets also disclose that it held assets described as “outstanding deposits” in the amounts of $247,347 and $97,334, respectively. Thus, while the risk of repayment of the grant was gradually being reduced to nil, the amounts kept on hand as “reserve funds” were increasing. No rationale for this state of affairs was advanced by the Appellants.

With respect to the possible repayment of advances, the evidence is clear that by virtue of paragraph 5(4) of the Crown contract, Birchill would not have been required to make what have been described as negative payments. Although such a repayment was a possibility pursuant to the Abitibi contract, there was little substantive evidence as to what amount might have been required to plant the next year’s crop in the event of substantial failure in the preceding growing season. Asked about the basis for the reserve allocation of $160,000 in 1988, Skidmore said it was a judgment call related to what he perceived to be the amount of money that would enable Birchill to start up in a new year. He offered no explanation of what his “perception” was based on. It is not disputed that the initial stage, i.e. the planting of the seeds in the containers, was labour-intensive but there is no evidence as to what such costs might have to be incurred in this regard. Were matters such as the fact that at all relevant times, and with respect to all contracts, the seeds were provided by the Ministry at no cost to Birchill, or that each contract that Birchill entered into entitled it to receive the first instalment payment following the first crop inventory taken some six weeks after the initial sowing of the seeds factored into his judgment call? The evidence adduced by the Appellants in this regard does not provide any clear answers.

Last, it was implied by the Appellants that a crop failure could lead to termination of their contract and put them out of business. There is no evidentiary support for such a proposition. As well, it is unlikely that a crop failure resulting from circumstances beyond their control, such as inclement weather, lack of snow cover, the provision by the Minister of seed lacking the capacity to reach minimum acceptable standards, etc., would inevitably have led Abitibi or the Crown to refuse to enter into a new contract in the following year, particularly with a reputable and consistent provider of seedlings such as Birchill.

The Appellants argued that a financial relationship of dependence of some substance existed between the “reserves” and Birchill’s business. More specifically, they argued that Birchill relied on these reserves because of its financial exposure to the risk of crop failure compounded by its inability to purchase crop insurance since such insurance was unavailable to private growers. It is generally accepted that such a relationship can be es- tablished when the business has some reliance on the property in the sense that recourse is had to it regularly or from time to time. In this case, the evidence is that Birchill never drew upon the reserves. [22] It is not sufficient to state that the assets were held as a form of self-insurance against crop failure generally. It must be demonstrated that the risk was real and that the amounts set aside were not excessively greater than the amount required to permit the business to continue operating should a crop failure occur.

In McCutcheon^ [23] and Egerton^, [24] it was observed that a failure to utilize the reserves as backup may provide evidence that the funds were not truly risked in the business. More importantly, it suggests that the risk of seedling crop failure was, in Birchill’s case, no greater than the risks facing ordinary farming businesses. In McCutcheon^ [25] Strayer J. made the following comments:

It was contended that these large capital sums are required by the plaintiff in case of emergencies or crop failures - failures which would not only drastically reduce or eliminate farm income but would badly affect sales of seed grain, fertilizer, and chemicals. But the evidence indicates that these capital sums were not drawn on for such purposes, not just in the years in question but never since the incorporation of the farm in 1976. While both the evidence and common knowledge indicate that there are many risks in farming, the risk that sums in the amount of the principal sums in question here would be required must, in the absence of more precise evidence, be regarded as “remote” and this, according to the Ensitdecision, is not sufficient. One can readily understand, and admire, the position taken by Mr. McCutcheon, the President of the plaintiff company, that he would not want to farm without cash reserves, having seen many farm failures in the past by those who had in adequate reserves. But there is a basic problem in that the plaintiff has not shown clearly what would be a reasonable reserve nor does the evidence indicate any rational relationship between the principal sums accumulated and the reserves required. Mr. McCutcheon spoke of wanting the equivalent of two years (sic) expenses available in cash reserves. But the principal sums in question here have simply been allowed to grow by reinvestment of interest and by transfers from the current account without any indication of a rational plan or any evidence that such a plan was being followed.

(Emphasis added).

It was argued that the plaintiff carried no insurance of any kind during the years in question either on buildings, crops, or equipment and therefore required these large capital sums as a form of “self-insurance”. But the day-to-day operations of the business would not be dependent on the existence of such a fund nor, indeed, would the corporation necessarily draw on the fund in case of loss. There is no evidence, not only in respect of the three years in question, but over the whole period since the plaintiff was incorporated in 1976, that these principal amounts have ever been drawn on to pay for any loss by hail, or even theft, for example. The prospect of a wide-spread disaster to a value represented by these capital amounts again must be regarded as remote. The investment of surplus funds in these interest-bearing deposits is no different from any other investment the corporation might make in order to ensure that it was solvent enough, in the face of some disaster, to either resume this business or undertake some other business.

These comments are equally applicable to the present appeals.

In my view, the Appellants’ argument that the amounts in issue were required as a form of self-insurance cannot succeed. They have also failed to demonstrate that the amounts which Birchill held as reserves were related to the amounts which were reasonably required as backup assets. On the whole, the Appellants have not established that Birchill relied on the term deposits as an integral aspect of its business operations. The testimony adduced on their behalf as to the basis for the reserve policy and when it commenced was imprecise and there was no cogent evidence as to the amount of cash reserves required on an on-going basis.

On the evidence, it is not possible to conclude that there existed a relationship of financial dependence of some substance between the amounts in issue and the seedling nursery business. As previously noted, the possibility of the reserves being drawn upon to sustain Birchill’s business was remote. In result, I am not able to find that all or substantially all of Birchill’s assets were used in an active business within the meaning of the relevant legislation. The appeals are dismissed, costs to the Respondent.

Appeal dismissed.

Appendix

The phrase “all or substantially all” found in subsection 248(1) of the Act is not defined. The word “all” means “the whole amount, extent, substance, or compass of; the whole; all that is possible. The entire number of, without exception. “Substantially” which is used in that definition as a modifier, means in substance or substantially or in the main. In Wardean Drilling Co. v. Minister of National Revenue, 6 [26] Cattanach J. had occasion to consider the phrase ‘all or substantially all of the property’. In subsection 83A(3) of the Act, he observed at page 6169 the words used in subsection 8(a) of section 83A are “all or substantially”. Used in this context, the words “substantially all” must mean the substantial portion of the whole business.

The phrase “substantially all” has also been considered by the Saskatchewan Court of Appeal in 85956 Holdings Ltd. v. Fayerman Brothers Ltd. [27] as follows:

If one examines the sale from a purely quantitative perspective, that is, a percentage of the total assets of the company which have been sold, it is obvious that “substantially all of the assets” have not been sold. In my opinion, the issue cannot be determined on a quantitative basis. The purpose of the statutes like the one under consideration was to protect the shareholders from a fundamental change in the corporation and to ensure that the means to accomplish the object of the corporation were not impaired. ... The phrase “substantially all” (in s. 184(1)(9e) of the Business Corporations Act, R.S.S. 1978, See B - 10) is ... intended to mean a sale which would effectively destroy the Corporate business.

No attempt was made by the Appellants to quantify in the first instance how much money was at risk in each year of Birchill’s operation and perhaps more particularly, in 1987 and 1988.

As to the allocation of $160,000 in 1987 and 1988 as a cash reserve, Skidmore’s testimony was simply that it was a judgment call related to what he perceived to be the amount of money that would enable Birchill to start up in a new year.

… There might well be some justification for having liquid assets such as a portion of the term deposits available to cover short-term cash shortages. But it is difficult to see that in these particular facts there was a relationship of financial dependence on them “of some substance” as referred to in the Atlas Industries Limited case. As was said in that case, the relationship between the term deposits and the Appellant’s businesses “was tangential at best”. Or in the language of Ensite, the risk of such sums being needed was “remote”. If some reasonable amount of reserves was in fact required, this amount was not demonstrated by the evidence.

Skidmore’s testimony also effectively conceded that a substantial percentage of the assets in each year consisted of investment-type assets, totalling 37% in 1985, 59% in 1986, 41% in 1987, 35% in 1988 and 38%??? in 1989. The proportion here is not as important as the relationship between the amount of reserve assets and the amounts at risk. Such comparison is not really of substantial assistance.