1 November 1990 Internal T.I. 900479 F - Manufacturing & Processing Profits Deduction

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

SUBJECT:  24(1) Manufacturing & Processing ("M&P") Profits Deduction

We are writing in reply to your memorandum of April 19, 1990, wherein you requested our comments as to whether or not the activities of the above-noted taxpayer qualify for the M&P profits deduction under section 125.1 of the Income Tax Act (the "Act"). We apologize for the delay in responding to your memo.

Our understanding of the facts of the situation are as follows:

Facts

24(1)

5.     The Cabana case was overturned by a Consent to Judgement at the Federal Court-Trial Division dated October 13, 1983. At that time the Crown agreed that the taxpayer was entitled to the M&P profits deduction in respect of its advertising design activities (on the basis that those activities constituted M&P of goods for sale) in light of the decision of the Federal Court of Appeal in McGraw-Hill Ryerson Ltd., 82 DTC 6142.

     24(1)

Taxpayer's Position

24(1)

Appeals' Position

1.     Paragraph 44 of IT-145R and the decision in the McGraw-Hill case supports the view that a company may qualify for the M&P profits deduction if it contracts out production provided it maintains control over that production.

     24(1)

Audit Review's Position

1.     The major issue in the Cabana case was whether or not the taxpayer provided a service or was involved in the sale of goods. On the other hand, the major issues in the McGraw-Hill case were 1) the taxpayer's control over the production of the books and 2) whether the taxpayer sold a good, i.e. a book or merely the information in the book.

2.     A Consent to Judgement does not necessarily overturn or revoke a decision of a lower court. The memo from Head Office was issued after the Consent, yet still cites the Cabana case as support for its view.

     24(1)

Audit Review's Questions

1.     How does the decision in the McGraw-Hill case relate to the Cabana case which was initially decided on whether or not a service was provided?

2.     Is the opinion expressed in the memo from Head Office dated March 3, 1987 still applicable?

3.     24(1)

4.     Should the Audit Division continue to disallow the M&P profits deduction to other taxpayers in the graphic design business?

5.     In absence of specific instructions from Head Office Appeals, should the Appeals Division use a Consent to Judgement as a basis for allowing the objections of another taxpayer?

Our Comments

1)     Before providing our comments on the impact that the decision in the McGraw-Hill case had on the fact situation in Cabana, it is necessary to identify the issues involved in both cases as presented below.

a)     Cabana, Seguin Inc., 82 DTC 1360

     On page 1362 of Cabana, it indicates that the taxpayer earned revenue from three different sources: 1) professional consultation, 2) creation of trademarks and layouts delivered to the customers who then made their own arrangements for printing, and 3) a comprehensive agency agreement which involved, among other things, making colour proofs, printing and binding colour brochures, folders, etc. which Cabana, Seguin Inc. ("Cabana") delivered to its customers as part of its contract price. Even though the printing and colour photography were contracted out, the taxpayer claimed to handle the execution, production and manufacture of folders, catalogues etc. as "the work carried out by the printer was subject to very strict monitoring by the officer responsible to the client and each phase of the production was closely supervised".

     It was the Minister's position that following the common law distinction between the sale of goods and the provision of a service (i.e. labour and materials), the work actually performed by the taxpayer fell into the latter category. Although the taxpayer contracted out the work in respect of printing and colour photography, that is in itself a M&P activity, in order for that work to be considered M&P activities of the taxpayer for the purposes of section 125.1 of the Act, that taxpayer "must perform the manufacturing himself and not assign it to a subcontractor".

     The Tax Review Board accepted the Minister's arguments. As the taxpayer had no raw materials that it used in the M&P of a finished product nor any equipment of substantial value, the Board held that the majority of the taxpayer's operations must involve the provision of a service. The delivery of the finished product was incidental compared to value of the services provided. The Board did recognize, as did the Minister, that had the stages of printing and colour photography not been assigned to a subcontractor, these activities would have qualified for the inclusion in the category of manufacturing.

b)     McGraw-Hill Ryerson, 82 DTC 6142 confirming 80 DTC 6211

     In summary, the issue of this case was whether the taxpayer was engaged in the M&P of books, when it did not itself do the typesetting, printing and binding necessary to the metamorphosis of creating a book from its conceptual to tangible state. As in the case of Cabana, the taxpayer maintained strict control over those M&P activities contracted out to other parties. Again, it was the Minister's position that as the above activities were not performed by the taxpayer, that the taxpayer did not manufacture or process the goods for sale, i.e. the books. In addition, even though the information contained in the books could be considered to have been processed, since that information was subject to copyright it could not sold.

     The Federal Court-Trial Division held and the Federal Court of Appeal confirmed that the extensive involvement and control of the taxpayer in the production of the books from inception to the final sale constituted manufacturing and processing. Furthermore, the taxpayer sold not only the information contained in the books, but the books themselves which represented goods manufactured and processed for sale.

     As a result of losing this case, paragraphs 4 and 44 of IT-145R were amended by Special Release dated February 28, 1985 and Special Release (Revised) dated February 28, 1986, respectively. Consequently, the Department now accepts that where manufacturing activities are carried on by another party on the taxpayer's behalf and the corporation exercises extensive involvement and control over the content, design and physical qualities of the goods from inception to completion, the corporation will qualify for the M&P profits deduction in respect of goods produced by those activities.

c)     Impact of McGraw-Hill on Cabana

     As previously mentioned, Cabana earned revenue from three sources. The activities related to the services provided of professional consultation and creation of trademarks end layouts delivered to its customers were considered to be the provision of a service at the time of the hearing of Cabana, and the nature of these activities did not change as a result of the decision in McGraw-Hill. What did change as a result of the decision in the McGraw-Hill case was that the two activities subcontracted out by Cabana, colour photography and printing, could now be considered, in effect, M&P activities carried out by Cabana. Under the comprehensive agency contracts, which involved providing intellectual work as well as a final tangible product such as brochures, catalogues etc. incorporating that artwork, the M&P activities of producing tangible goods attributable to Cabana result in the production of tangible goods that are considered to be available for sale by Cabana as part of the terms of its contract. It should be noted that in order for the principles in McGraw-Hill to apply to Cabana it was necessary that 1) the work performed by the subcontractor was closely monitored and supervised by Cabana and 2) Cabana was involved in the content, design and physical qualities of the goods from inception to completion.

2.     At the time the memo from Head Office dated March 3, 1987 was written, Rulings Directorate was not aware of the Consent to Judgement far Cabana, nor does it appear that the principles in McGraw-Hill were taken into account in responding to the query. As requested, we have reviewed that memo in order to determine whether it is still applicable.

     It appears that the taxpayer described in the memo was interested in knowing whether profits earned from two different types of situations would be considered earned from M&P goods for sale. The activities of providing creative graphic design and the implementation of these designs into finished artwork which are sold to the clients are virtually the same activities as those conducted by Cabana. As previously mentioned, even after the decision in McGraw-Hill was issued, these activities are still considered to be the provision of a service rather than the M&P of goods for sale. The second type of situation considered was an arrangement similar to the comprehensive agency contract entered into by Cabana. The taxpayer would not only create and design the artwork but would also deliver the tangible finished Product, pamphlets, brochures etc. incorporating the artwork to the customer as part of the contract. Although the printing of the tangible product would be subcontracted out, the taxpayer would maintain complete control over the form and quality of all material therein. In view of the Department's acceptance of the "contracting-out principle" in McGraw-Hill, as expressed in revised paragraph 4 of IT-145R, the response to this arrangement was incorrect and should not be relied upon. Where the two conditions in paragraph 4 are met, i.e. extensive involvement and control over the work contracted out and the taxpayer's involvement in the product from inception to completion, the taxpayer will be considered to be carrying on the activity of M&P of goods for sale and have income therefrom.

3.     As discussed in paragraph 2 above.   24(1)

     In order to qualify for the small manufacturer's rule in section 5201 of the Relations it is necessary that, inter alia, the activities of 24(1) during the year were primarily M&P in Canada of goods for sale or lease.  As indicated in paragraph 16 of IT-145R, the "primarily" test is met where the activities of the corporation's employees are more than 50% M&P, or in some industries where the assets of the corporation are used principally in M&P activities. Where all revenue earned by 24(1) is from contracts under which a tangible product is produced and conditions in revised paragraph 4 of IT-145R are met is our opinion that the "primarily" test will be met and that 24(1) would be entitled to use the small manufacturers' rule assuming the other conditions in the rule are met.

4.     A taxpayer in the graphic design business will be considered to be carrying on the activities of M&P goods for sale only for those contracts which clearly meet the conditions in revised paragraph 4 of IT-145R. However, before allowing this treatment for a particular contract, the onus should be on the taxpayer to prove that he does in fact exercise complete control over the content, design and physical qualities of tangible medium produced and delivered to its customer.

5.     A Consent to Judgement may be entered into for a number of different reasons. The information on the Cabana file indicates that the sole reason for doing so was the "contracting-out principle" addressed in the subsequent higher court decision of McGraw-Hill. As the Department was obliged to accept this principle under the circumstances outlined in revised paragraph 4 of IT-145R, other taxpayers in the graphic design business who meet those conditions are also eligible in law to receive similar treatment to that accepted in the Consent to Judgement for Cabana. However, where a Consent is agreed upon for reasons other than a subsequent decision of a higher court, it would depend on the facts of the situation whether it could be relied upon to assess other taxpayers.

We trust that these comments will be of assistance.

R. ThompsonChiefMerchandising, Manufacturing and Construction SectionRulings DirectorateLegislative and Intergovernmental Affairs Branch