Porta-Test Manufacturing LTD v. Minister of National Revenue, [1977] CTC 2279

Roland St-Onge (orally: May 20, 1977):—The appeal of Porta-Test Manufacturing Ltd came before me on May 18, 1977 at the City of Edmonton, Alberta and it is with respect to its 1974 taxation year.

The facts alleged in the notice of appeal are admitted by the respondent, and I quote:

1. The appellant is a private corporation, incorporated under the laws of the Province of Alberta.

2. In the 1974 taxation year the appellant received the sum of $75,040 from SPP Group Limited, a body corporate under the laws of the United Kingdom, pursuant to an agreement between the appellant and SPP Group Limited.

3. By Notice of Reassessment dated May 10, 1976 the Minister of National Revenue reassessed the appellant by including in its income the amount of $75,040 which was described as a “gain on sale of licence agreement reassessed as royalty income’’.

4. The appellant filed a Notice of Objection in respect of the reassessment for the 1974 taxation year on August 5, 1976 and the Minister of National Revenue confirmed the said assessment by Notification dated December 1, 1976.

In his reply to the notice of appeal, the respondent alleged the following:

3. The business activities of the Appellant is that of developing, manufacturing and selling oilfield equipment.

4. In August 1970, a Licensing Agreement was entered into between the Appellant and S.P.P. Group Limited for the purpose of granting to S.P.P. an exclusive licence, with the right to sub-licence others, to make, use and sell the present Appellant’s inventions throughout certain parts of the world.

5. In consideration of the rights and privileges granted under the licences, it was agreed that S.P.P. shall pay to the Appellant throughout the term of the Agreement a royalty of 5% of the net proceeds realized by S.P.P. and/or its sub-licencees on the manufacture, use or sale of any Porta-Test equipment covered by the Agreement.

6. It was a further term of the Agreement that S.P.P. shall guarantee to the Appellant a minimum royalty of $150,000.00, for the period commencing on the date of the Agreement and ending on the third anniversary thereof.

7. In 1974, at the end of the third year of the Licencing Agreement, S.P.P. made a payment of $75,040.40 to the Appellant to meet the minimum payment as required in accordance with the terms of the Licencing Agreement.

8. In filing its income tax return for the 1974 taxation year, the Appellant reported the sum as a capital receipt with an adjusted cost base of the same amount resulting in a nil capital gain.

9. On reassessing the Respondent added the sum of $75,040.40 in the income of the Appellant.

10. In so assessing the Appellant, the Respondent assumed, inter alia, that the said $75,040.40 represents the payment in the third year to bring the minimum royalty income to $150,000.00 according to the terms of the Licencing Agreement dated Augi't 1, 1970.

12. The Respondent submits that the amount of $75,040.40 received from S.P.P. Group Limited has properly been included in computing the Appellant’s income in accordance with the provisions of Section 3, Subsection 9(1) and paragraph 12(1 )(g) of the Income Tax Act.

13. The Respondent further submits that the amount received by the Appellant pursuant to the terms of the Licencing Agreement represented an amount received by the Appellant that was dependent upon the use or production from the Appellant’s property.

Mr Swan, an engineer and president of the appellant company, testified that the appellant had two functions: the Service and Manufacturing Divisions; that the company searched to improve its equipment in order to render it more portable at more competitive prices; that the appellant’s shareholders developed a new type of separator which was patented in ten leading countries, and assigned to the appellant company; that the said new equipment was first sold in Edmonton, then in the United States to a subsidiary company, and then in England.

The appellant company did not have the financial means to manufacture the said product in England, so they decided to sell the exclusive rights to manufacture and sell this equipment to an English company, the SPP Group, which was the major supplier of similar equipment in England.

The said company was interested in manufacturing and selling the new equipment, not only in England, but also in various European countries.

The appellant company and the SPP Group entered into a written agreement by which it gave the exclusive rights during the life of the patent to the SPP Group to manufacture, use and sell the equipment for a royalty of 5% on the sales.

Mr Swan explained that the SPP Group had to pay $150,000 at the end of three years, no matter what it did with the patent; that the appellant company had never sold any similar rights before this agreement, and that the first $75,000 was received as royalty and reported as income by the appellant company.

On cross-examination, the witness said that he knew nothing about royalty and relied entirely on his patent attorney to prepare the sales agreement, and that the $150,000 minimum was put into the agreement to be certain that the SPP Group would be active in promoting the appellant company’s equipment.

Counsel for appellant argued that the appellant company granted an exclusive right to the English company for a minimum payment of $150,000 plus 5% on proceeds from sales: that $75,000 had been received and reported as taxable royalty on the proceeds of sales in an amount of $1,500,000; that the other $75,000 should not be considered royalty because it was paid in a lump sum and not for use of the equipment.

He also argued that the rights sold cannot be regarded as inventory since the appellant sold its own equipment in Canada and through a subsidiary in the United States, and that the appellant never made any dealings in the patent rights except the one which the SPP Group in England had, and that the lump sum payment was made without regard to the amount of sales effected by the English company.

He also argued that although the term “royalty” is mentioned in the agreement, the Board should look at the substance of the transaction which indicates the sale of an exclusive right and that no one would dispose of an exclusive right without getting a reasonable amount therefrom.

He terminated his argument by saying that because the transaction took place prior to 1971, the capital gain should not be taxable in the appellant’s 1974 taxation year.

In the course of his argument, counsel for appellant referred the Board to and commented on the following jurisprudence: Murray v Imperial Chemical Industries Ltd, 44 TC 175 at 210; Canadian Industries Ltd v Her Majesty the Queen, [1977] CTC 172; 77 DTC 5138.

Counsel for respondent argued that the intention of the parties was well set down in a written agreement prepared by patent experts; that nowhere in the written agreement is mention made of a lump sum payment for the sale of an exclusive right; that if the appellant had sold within the period of three years for $4,000,000 instead of $1,500,000, there would have been no minimum amount for the exclusive rights, and that the Board should look at the written agreement which speaks for itself.

Referring to the Murray decision, he argued that there was no predetermined lump sum payment for the exclusive rights in the appellant’s written agreement, and consequently, the appellant cannot rest its case on this decision. Counsel for respondent also referred the Board to paragraph 12(1)(g) and subsection 248(1) of the Income Tax Act to state that the new Act no longer mentions royalties but considers as taxable any money received by the taxpayer in the year that was dependent upon the use of, or production from, property whether or not that amount was an instalment of the sale price of the property. Also, that “property” is defined in subsection 248(1) and means:

. . . property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes

(a) a right of any kind whatever, a share or a chose in action,

As already mentioned by counsel for appellant, the Board, in the present appeal, must try to discover the true substance of the transaction. But to do so the Board must also give greater weight to the written agreement which was prepared at the time of the transaction, rather than to the testimony of a witness who, seven years later, tries to explain what happened between the parties in 1970.

The witness’s explanation can easily be the result of an afterthought and the Board believes that when a written agreement is not ambiguous, it should rely on the terms of the document to discover what was the intention of the parties at that time.

Nowhere is mention made in the document of the lump sum payment for an exclusive right. On the contrary, there are many mentions of royalties and the document does not state a minimum payment but a minimum royalty of $150,000.

Furthermore, this alleged way of fixing the amount for the payment of the exclusive rights cannot be taken too seriously into consideration, since if the amount of $4,000,000 had been the proceeds of sales, then no amount would have been left for the sale of the exclusive rights. This shows that this clause was not written as a yardstick to fix the payment for an exclusive right, but to promote the sale of the appellant’s product.

Furthermore, Mr Swan testified that this minimum amount of $150,000 was there to prevent the SPP Group from manufacturing and selling newer products to the detriment of the appellant company.

In the case at bar, the Board must rest on a very well-known principle, which states that one must not contradict a valid written document by verbal evidence.

For these reasons, the appeal is dismissed.

Appeal dismissed.