Deduction of Business Expenses

Transcription

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CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
Deduction of Business Expenses
Edwin C. Harris, QC*
P RÉCIS
Les critères de la déductibilité des dépenses d’entreprise demeurent un
domaine d’incertitude et de controverse. Au début, les tribunaux
canadiens se sont fondés sur la jurisprudence britannique, même si elle
n’était pas appropriée à l’interprétation de la législation fiscale
canadienne. Après qu’une nouvelle Loi de l’impôt sur le revenu ait été
promulguée en 1949, instaurant certains changements à la formulation
de la déductibilité des dépenses d’entreprise, nos tribunaux ont
graduellement libéralisé leur approche.
Cet article présente l’historique du lien entre les règles relatives au
terme «en vue de tirer un revenu» et celles sur les «dépenses en capital»
ainsi que la mention de «bénéfice», contenues dans les alinéas 18(1)a) et
b) et dans le paragraphe 9(1), respectivement, de la Loi de l’impôt sur le
revenu actuelle, et les dispositions précédentes. Il est maintenant accepté
que la déductibilité générale des dépenses dans le calcul du revenu tiré
d’une entreprise à l’égard de l’impôt est implicite dans la mention
«bénéfice» et que les règles sur le terme «en vue de tirer un revenu» et
celles sur les «dépenses en capital» imposent des limites distinctes et
indépendantes sur cette déductibilité.
De nos jours, la plupart des dépenses d’entreprise normales respectent
sans difficulté le critère relatif au terme «en vue de tirer un revenu». Celui
sur les «dépenses en capital» constitue un obstacle un peu plus difficile à
surmonter. La tendance des tribunaux vers une approche plus libérale a
touché ce dernier critère, mais dans une moindre mesure. La capacité
d’un contribuable de déduire les dépenses engagées afin de réparer et
d’entretenir un bien d’entreprise est encore assujettie à certaines limites,
dont la portée est incertaine.
Les tribunaux n’ont pas encore clarifié la pertinence de la pratique des
entreprises et des principes comptables dans le cadre de l’établissement
des dépenses qui peuvent être déduites dans le calcul de «bénéfice»
d’une entreprise en application du paragraphe 9(1) ni la portée
appropriée des questions de droit ou de fait dans ce domaine. Les
principes comptables semblent pertinents dans le cas de l’opportunité,
mais ils pourraient l’être ou ne pas l’être dans le cas de la question de
savoir si une dépense devrait être déduite. Dans ce dernier cas, la
pratique des entreprises semble constituer le principal critère.
* Of Daley Black & Moreira, Halifax.
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DEDUCTION OF BUSINESS EXPENSES
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ABSTRACT
The criteria for deductibility of business expenses remain an area of
uncertainty and controversy. In the early years, Canadian courts followed
British precedents, even where those precedents were not appropriate to
the interpretation of Canadian tax legislation. After a new Income Tax Act
came into effect in 1949, introducing some changes in wording relating
to the deductibility of expenses, our courts gradually liberalized their
approach.
This article traces the history of the relationship between the
“income-earning purpose” and “capital outlay” rules and the reference to
“profit” in paragraphs 18(1)(a) and (b) and subsection 9(1), respectively,
of the present Income Tax Act and their predecessor provisions. It is now
accepted that the general deductibility of expenses in computing
business income for tax purposes is implicit in the reference to “profit”
and that the income-earning purpose and capital outlay rules place
separate and independent limits on that deductibility.
Today most normal business expenses will pass the income-earning
purpose test with little difficulty. The capital outlay test is a more difficult
hurdle. The judicial trend toward a more liberal approach has affected the
latter test, but to a lesser extent. There are still some limits, of uncertain
scope, to a taxpayer’s ability to deduct expenses incurred to preserve or
maintain a business asset.
The courts have yet to clarify the relevance of business practice and
accounting principles in determining what expenses may be deducted in
computing business “profit” for purposes of subsection 9(1) and the
appropriate scope for questions of law and of fact in this area.
Accounting principles appear to be relevant to matters of timing but may
or may not be relevant to the question whether an expense is of a type
that should be deducted. On the latter issue, business practice seems to
be the primary criterion.
INTRODUCTION
The deductibility of expenses in computing income from business has
been a source of frequent disputes throughout the history of income taxation in Canada. The ability to deduct an expense—both where the
alternative is no deduction at all and where the timing of a deduction is in
issue—is often of great importance to a taxpayer and to Revenue Canada,1
but even now the criteria to be applied are not well defined.
1 Where a precedent may be set on a question of deductibility, the amount at stake for
Revenue Canada may be greater than for the particular taxpayer.
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The Statutory Context
In addressing the deductibility of business expenses under successive versions of Canadian income tax legislation,2 the courts have been concerned
with questions of fact and of law, as well as with the relevance of commercial practices and accounting principles. In addition to general rules,
the legislation has included specific prohibitions against certain deductions and specific rules allowing certain other deductions. While, for the
most part, the statutory rules for the deduction of expenses are the same
for income from business and income from property, 3 most of the jurisprudence relates to business expenses. 4
Early Judicial Attitudes
In the early judicial decisions under the Income War Tax Act,5 a “colonial” mentality, reinforced by the realization that ultimately any Canadian
tax appeal could be disposed of by the Judicial Committee of the Privy
Council, 6 led Canadian courts to look to decisions of British courts, including the Judicial Committee, for authoritative pronouncements on the
deductibility of business expenses. Few of these decisions offered enlightened analyses of the issues of measurement of business income in
the context of the purpose of the relevant legislation.7 Seldom did the
Canadian courts, or the Judicial Committee on appeals from Canada, recognize that the tax legislation of the United Kingdom and of other British
Empire and Commonwealth jurisdictions referred to in those earlier decisions was significantly different from the analogous Canadian legislation.8
On the other hand, in one of the least satisfactory early Canadian decisions,
2 Income War Tax Act, SC 1917, c. 28, later RSC 1927, c. 97; Income Tax Act, SC
1948, c. 52 (herein referred to as “the 1948 Act”), later RSC 1952, c. 148 (herein referred
to as “the former Act”); and Income Tax Act, SC 1970-71-72, c. 63, now RSC 1985, c. 1
(5th Supp.), as amended (herein referred to as “the present Act”).
3 See, for example, subsection 9(1) and the opening words of subsections 18(1) and
20(1) of the present Act.
4 The scope for deducting expenses in computing employment income is considerably
narrower than in computing business or property income: see section 8, particularly subsection 8(2), of the present Act. The deductions specifically allowed in sections 60 to 66.8
of the present Act do not necessarily relate to income from employment, business, or
property.
5 There were very few decided cases in the early years after the enactment of the
Income War Tax Act in 1917.
6 The significance of this right to appeal was underlined as late as 1955 in MNR v.
Anaconda American Brass Ltd., 55 DTC 1220 (PC), rev’g. 54 DTC 1179 (SCC) on a
significant issue concerning the measurement of business income.
7 The “purpose” approach did not receive definitive approval until Stubart Investments
Limited v. The Queen, 84 DTC 6305, at 6322-23 (SCC).
8 For an excellent discussion of the issue, see Janice McCart, “Deductibility of Business Expenses—Recent Developments,” in Report of Proceedings of the Thirty-Seventh
Tax Conference, 1985 Conference Report (Toronto: Canadian Tax Foundation, 1986),
41:1-70, at 41:32-42.
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the Supreme Court of Canada,9 purporting to apply British precedents,
departed from British case law as well as from accepted business principles.
The adoption in 1948 of a new Income Tax Act, effective in 1949, gave
Canadian courts an opportunity to relax their previous restrictive approach
to deductibility and to bring the concept of business expenses for tax
purposes closer to business practices and understandings. After some hesitation and backsliding, and not without many inconsistencies, they did so
to a substantial extent.
Scope of This Article
This article will concentrate on the general principles of deductibility of
business expenses under Canadian income tax law and on broad trends
that have developed; however, it does not purport to be a complete treatment of the subject. It will address some aspects of the relevance of
accounting principles, particularly as they relate to deductible expenses,
but will not provide a comprehensive analysis of this important question.10 The significant question of “reasonable expectation of profit” will
only be mentioned, since it is discussed fully elsewhere in this issue;11
also, the deductibility of specific expenses will not be considered here,12
nor will the specific rules relating to “reserves,”13 “personal or living
expenses,”14 or the reasonableness of the amount of an expense.15
EARLY APPROACHES
Statutory Language
The Income War Tax Act, in section 3, attempted to define income by
reference to “annual net profit or gain”:
9 In Minister of National Revenue v. Dominion Natural Gas Co. Ltd. (1940), 1 DTC
499-133 (SCC), discussed below in the text accompanying footnotes 50 to 58.
10 The literature is extensive. See, for example, Edwin C. Harris, “Timing of Income
and Expense Items,” in Corporate Management Tax Conference 1975 (Toronto: Canadian
Tax Foundation, 1975), 84-101; Glen E. Cronkwright, “The Dilemma of Conformity: Tax
and Financial Reporting—A Perspective from the Private Sector,” in Current Developments in Measuring Business Income for Tax Purposes, 1981 Corporate Management Tax
Conference (Toronto: Canadian Tax Foundation, 1982), 22-40; B.J. Arnold, Timing and
Income Taxation: The Principles of Income Measurement for Tax Purposes, Canadian Tax
Paper no. 71 (Toronto: Canadian Tax Foundation, 1983); William J. Strain, “Now You See
It, Now You Don’t: The Elusive Relevance of GAAP in Tax Accounting,” in the 1985
Conference Report, supra footnote 8, 38:1-34; and Canada, Report of the Royal Commission on Taxation (the Carter report) (Ottawa: Queen’s Printer, 1966), vol. 3, at 71-76 and
387-88, and vol. 4, at 249-52.
11 See the article by Cy M. Fien in this issue of the journal.
12 See the articles by Brian J. Arnold and Tim Edgar, Israel Mida, and Kenneth J.
Murray in this issue of the journal.
13 Present Act paragraph 18(1)(e).
14 Ibid., paragraph 18(1)(h).
15 Ibid., section 67.
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For the purposes of this Act, “income” means the annual net profit or gain
or gratuity, whether ascertained and capable of computation as being wages,
salary, or other fixed amount, or unascertained as being fees or emoluments, or as being profits from a trade or commercial or financial or other
business or calling, directly or indirectly received by a person from any
office or employment, or from any profession or calling, or from any trade,
manufacture or business, as the case may be whether derived from sources
within Canada or elsewhere.
Section 6 (which later became subsection 6(1) of that Act), as amended,
provided:
In computing the amount of the profits or gains to be assessed a deduction
shall not be allowed in respect of
(a) disbursements or expenses not wholly, exclusively and necessarily
laid out or expended for the purpose of earning the income; and
(b) any outlay, loss or replacement of capital or any payment on account of capital or any depreciation, depletion or obsolescence, except as
otherwise provided in this Act.
The 1948 Act followed this pattern but with some important changes,
the significance of which only gradually became apparent to our courts.
Section 4 of the 1948 Act purported to define “income” on a less ambitious basis than had its predecessor:
Subject to the other provisions of this Part, income for a taxation year from
a business or property is the profit therefrom for the year.
Paragraphs 12(1)(a) and (b) of the 1948 Act read as follows:
In computing income, no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income
from property or a business of the taxpayer,
(b) an outlay, loss or replacement of capital, a payment on account of
capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part.
It is apparent from the grammatical structure of paragraphs 6(1)(a) and
(b) of the Income War Tax Act and of paragraphs 12(1)(a) and (b) of the
1948 Act that these provisions were framed in negative terms and represented two independent restrictions on the deductibility of expenses. I
shall refer to the paragraph (a) restriction as the “income-earning purpose” rule and to the paragraph (b) restriction as the “capital outlay” rule.
These rules did not grant any right to a deduction: a general right to
deduct business expenses could be found only in the reference to “profit”
in section 3 of the Income War Tax Act and section 4 of the 1948 Act.
The courts have recognized that “profit” in this context is a net concept
contemplating the deduction of appropriate expenses against revenues.
The One-Test Approach
Nevertheless, in interpreting the Income War Tax Act and in the early
years of interpreting the 1948 Act, most courts, relying heavily on British
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precedents, treated the income-earning purpose and capital outlay rules as
if they contained, at least inferentially, positive grants of deductibility.
They usually ignored the logical problems inherent in this approach by
treating the two rules as opposite sides of the same coin, leading to a
single test of deductibility. This one-test approach was also reflected in
Revenue Canada’s assessing practices at that time. In most such cases, on
the facts, the expense in question was obviously made or incurred for the
purpose of earning income from the business, and the real issue should
have been whether it was a capital outlay.
By a series of decisions, President Thorson, of the Exchequer Court of
Canada, began the process of demolishing the one-test fallacy. He first
placed emphasis on section 3 of the Income War Tax Act as the starting
point for determining the deductibility of a business expense. This, in his
view, called for a consideration of business practices as implied by the
reference to “profit.” Once it was established that a challenged expense
was properly taken into account in determining “profit,” the expense was
prima facie deductible; its deduction would then fail only if it fell within
one of the specific prohibitions in the Act, particularly the income-earning
purpose rule or the capital outlay rule.16 These principles are now generally accepted.17
The erroneous assumption by most Canadian courts in the early years
that the income-earning purpose rule represented a positive grant of
deductibility, coupled with the implied view that, if a challenged expense
passed that test, there was no further issue of capital outlay, might seem
to imply a liberal approach to deductibility. In practice, the opposite result followed. The relationship of the net income concept to “profit” was
disregarded, and business practice was treated as irrelevant. The courts
read a “remoteness” restriction into the income-earning purpose test: they
said that, to meet this test, and therefore to be deductible under the one-test
approach, an expense must have been made or incurred in the process of
earning the income. To most courts of this period, this phrase meant a
close relationship, in both time and result, between the expense in question and the earning of business income. Only gradually, as the significance
of the reference to “profit” became more widely recognized, did the remoteness restriction fade from view. 18
Again, some significant decisions of President Thorson were instrumental in bringing about this change. In Imperial Oil Limited v. Minister
16 See especially Imperial Oil Limited v. Minister of National Revenue (1947), 3 DTC
1090 (Ex. Ct.); Gordon Kenneth Daley v. Minister of National Revenue, 50 DTC 877 (Ex.
Ct.); and The Royal Trust Co. v. MNR, 57 DTC 1055 (Ex. Ct.).
17 These developments are discussed in Edwin C. Harris, “The Annulment of a Marriage” (1961), vol. 9, no. 5 Canadian Tax Journal 370-78; and McCart, supra footnote 8,
at 41:42-45. For a recent summary, see the judgment of Iacobucci J in Symes v. The Queen
et al., 94 DTC 6001, at 6009 (SCC).
18 See, for example, K.E. Eaton, “The Death of the ‘Profit Earning Process Test’ ”
(1957), vol. 5, no. 4 Canadian Tax Journal 271-73; and Harris, supra footnote 17.
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of National Revenue, 19 he held that a large damages settlement paid by an
oil company arising from a collision between its tanker and another vessel was deductible.20 He pointed out that, under the income-earning purpose
rule, it is the purpose and not the result of the expenditure that is in issue;
an expenditure “may . . . be deductible even if it is not productive of any
income at all and even if it results in a loss.”21 Looked at narrowly, the
payment could not earn income, but being exposed to the risk of having
to make such a payment was an integral part of the taxpayer’s oil business; accordingly, in this broad sense, the expense was incurred for the
purpose of earning income from the business. President Thorson said that
the deductibility of disbursements or expenses is to be determined according to ordinary principles of commercial trading or well accepted principles
of business and accounting practice unless their deduction is prohibited by
reason of their coming within the express terms of the excluding provision
of the section. 22
Here it was clear that the expenses were ordinary (even if rarely occurring) business expenditures.
Again, in The Royal Trust Co. v. MNR, 23 President Thorson broke new
ground in holding that social club dues and initiation fees paid to a club
by a trust company for its senior employees were deductible. He recognized the broader scope for deducting business expenses under the 1948
Act than under the Income War Tax Act and summarized the portion of
his judgment in Imperial Oil where he had referred to “ordinary principles of commercial trading or well accepted principles of business and
accounting practice.” 24 He went on to say, however, that he “should have
omitted the reference to accounting practice which I made in that case.” 25
No reason was given for this cryptic correction, but I shall consider it
further at a later point. 26 Since “the payments made by the appellant were
made in accordance with principles of good business practice for trust
companies,”27 the key test of business practice had been met, and nothing
in paragraph 12(1)(a) or (b) of the 1948 Act prohibited the deduction. 28
19 Supra
footnote 16.
While Thorson P referred to “the process of earning the income” as part of the
income-earning purpose test (ibid., at 1097), he understood the phrase in a manner quite
different from that of his judicial colleagues who had used it as a basis for restricting
deductibility.
21 Ibid., at 1098.
22 Ibid., at 1092.
23 Supra footnote 16.
24 Imperial Oil, supra footnote 16, at 1092.
25 Royal Trust, supra footnote 16, at 1059 and also 1060.
26 See the text below accompanying footnotes 109 to 116.
27 Royal Trust, supra footnote 16, at 1061.
28 See, however, present Act paragraph 18(1)(l).
20
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The restrictive approach to deductibility under the Income War Tax
Act is illustrated by the decision of the Judicial Committee in Montreal
Coke & Mfg. Co. v. Minister of Nat’l Revenue. 29 Expenses of corporate
refinancing were held to be non-deductible under the income-earning purpose rule, though the Judicial Committee indicated that, if it had been
necessary to do so, it would also have found the expenditures in question
to be non-deductible capital outlays. The restrictive interpretation of the
income-earning purpose rule is underlined in the following statement by
Lord Macmillan:
Expenditure to be deductible must be directly related to the earning of
income. . . . It is not the business of either of the appellants to engage in
financial operations. . . . [T]heir financial arrangements are quite distinct
from the activities by which they earn their income.30
Capital Outlays
With the more liberal reading of the income-earning purpose rule under
the 1948 Act and its successors,31 it seems unlikely that that rule would
be invoked today as a basis for denying the deduction of financing expenses. The more difficult problem is whether expenses of corporate
financing, in the broadest sense, are capital outlays and therefore nondeductible except where the Act specifically authorizes their deduction.32
Presumably, the policy justification for the capital outlay rule is that
capital outlays are expected to give rise to assets of lasting value (“capital assets”);33 charging this cost to current income would distort the annual
measurement of income. As well, those assets, except to the extent that an
allowance for depreciation or amortization based on their cost was specifically granted, were outside the pale of the income tax system until—as
happened in Canada in 1972—capital gains and capital losses became
potentially relevant for income taxation.34
There is no logical reason, apart from confusion between two meanings of “capital”—a reference to fixed assets, on the one hand, and a
reference to owners’ equity, on the other—why a prohibition against the
immediate deduction of the cost of a long-term asset should be extended
to a prohibition against the deduction of the cost of borrowing money for
29 [1944]
3 DLR 545 (PC), summarized in (1944), 2 DTC 654.
at 549. In Royal Trust, supra footnote 16, at 1062, Thorson P indicated that
Lord Macmillan’s reference to directness was intended to distinguish financing from operating activity and did not mean that an expenditure, to be deductible, must directly produce
income.
32 See, for example, present Act paragraphs 20(1)(c) through (g).
33 This is a broader concept than “capital property,” as defined in section 54 of the
present Act.
34 In any event, restrictions on claiming depreciation and similar expenses are spelled
out in paragraph 18(1)(b) of the present Act.
30 Ibid.,
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business purposes.35 Nevertheless, it appears to be widely accepted that
expenses of financing are capital outlays and are non-deductible except
where the Act specifically provides otherwise.36
The classical test of capital outlay, which has been much quoted since
its pronouncement in 1926, was that of Viscount Cave in British Insulated and Helsby Cables v. Atherton:
But when an expenditure is made, not only once and for all, but with a
view to bringing into existence an asset or an advantage for the enduring
benefit of a trade, I think that there is very good reason (in the absence of
special circumstances leading to an opposite conclusion) for treating such
an expenditure as properly attributable not to revenue but to capital.37
While the quoted passage did not purport to be a comprehensive definition of capital outlay, it is a remarkably clear formulation. As in the case
of the income-earning purpose rule, it indicates that the purpose, rather
than the result, of the expenditure in question determines whether it is a
capital outlay. The consequence, unfortunately, was that, where such an
outlay failed of its purpose and became a loss, there was no tax relief—
current or future—even though the income-earning purpose rule had been
satisfied. Similarly, even where the capital outlay resulted in the acquisition of or the addition to a capital asset, if the asset (particularly if it was
of an intangible nature such as goodwill) did not qualify for depreciation
or amortization under specific rules of the income tax law, no present or
future tax relief was available. This led the Royal Commission on Taxation to recommend that current or future deductibility be provided for all
these former “nothings.” 38 The commission’s recommendation was partially fulfilled by the recognition of a right to amortize “eligible capital
property” in the 1972 version of the Income Tax Act.39 As well, some
Canadian courts have consciously leaned away from holding an expenditure to be a capital outlay where it would become a “nothing,” on the
plausible ground that such an interpretation would be contrary to the
purpose and scheme of the Act.40
An expenditure to rid the taxpayer of a long-term disadvantageous
situation has been held to be analogous to an expenditure to acquire a
35 See Brian J. Arnold, “Is Interest a Capital Expense?” (1992), vol. 40, no. 3 Canadian
Tax Journal 533-53. A limited exception was recognized in Silverman v. MNR, 60 DTC
1212 (Ex. Ct.), where the cost of borrowing money for a temporary working-capital purpose was held to be deductible.
36 See Distillers Corporation Seagrams Ltd. v. MNR, 58 DTC 1168 (Ex. Ct.), which
applied a one-test approach.
37 [1926] AC 205, at 213-14 (HL).
38 Carter report, supra footnote 10, vol. 4, at 228-30 and 247.
39 See present Act paragraph 20(1)(b).
40 See, for example, Johns-Manville Canada Inc. v. The Queen, 85 DTC 5373, at 5384
(SCC).
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long-term asset and therefore to be a capital outlay.41 As well, it has long
been recognized that an expenditure to acquire inventory for a business is
not a capital outlay, since, by definition, inventory 42 is not capital property. While generally the cost of inventory is not immediately deductible,43
the right to a deduction arises when the inventory is sold. This timing
effect is only implicit in the specific provisions of the Act relating to
inventory but was recognized at an early stage by British courts in a
somewhat uncharacteristic adoption of accounting principles.44 Similarly,
an expenditure or loss incurred in the course of an “adventure in the
nature of trade” is not a capital outlay, because the advantage sought or
asset to be acquired is not a capital asset.45 On the other hand, expenditures on scientific research have been held to be capital outlays46 and
therefore deductible only as specifically provided in the Act.47
There has been a long history of case law attempting to distinguish
between deductible repairs and maintenance expenditures on a capital asset
and improvements or additions that are regarded as capital expenditures.48
These cases require the exercise of judgment on where to draw the line,
taking into account the degree of permanence of the expenditure, and the
decisions are not all easily reconciled.49 In most such cases, the issue is
one of timing, since the capital assets involved are generally depreciable
property owned by the taxpayer and since capital expenditures to add to
or improve such an asset will increase the capital cost of depreciable property and the potential deductions of capital cost allowance over a period
of years. This subject will not be further considered here.
41 See, for example, BC Electric Railway Co. Ltd. v. MNR, 58 DTC 1022 (SCC). Such
an expenditure today will likely qualify as an “eligible capital expenditure”: see present
Act subsection 14(5). Courts today, however, are generally reluctant to find that a disadvantage being removed is of a capital nature: see Johnston Testers Ltd. v. MNR, 65 DTC
5069 (Ex. Ct.).
42 See the less than helpful definition in subsection 248(1) of the present Act.
43 See, however, present Act sections 28 and 34.
44 See Whimster & Co. v. The Commissioners of Inland Revenue (1925), 12 TC 813, at
823 (Ct. Sess.)—a statement that was relied upon, but misapplied, in MNR v. Anaconda
American Brass Limited, supra footnote 6, at 1224. See also The Queen v. Metropolitan
Properties Co. Limited, 85 DTC 5128 (FCTD).
45 MNR v. Freud, 68 DTC 5279 (SCC). See also Williams Brothers Canada Ltd. v.
MNR, 62 DTC 1276 (Ex. Ct.); Tomenson Inc. v. The Queen, 86 DTC 6267 (FCTD); and
The Queen v. Kaiser Petroleum Ltd., 90 DTC 6603 (FCA).
46 International Nickel Co. of Canada Ltd. v. The Queen, 74 DTC 6096 (FCTD), ultimately affirmed on this point in The Queen v. The International Nickel Co. of Canada
Ltd., 75 DTC 5460, at 5462 (SCC).
47 See present Act section 37.
48 See, for example, MNR v. Haddon Hall Realty Inc., 62 DTC 1001 (SCC); Canada
Steamship Lines Ltd. v. MNR, 66 DTC 5205 (Ex. Ct.); and Shabro Investments Limited v.
The Queen, 79 DTC 5104 (FCA).
49 See also Interpretation Bulletin IT-128R, “Capital Cost Allowance—Depreciable Property,” May 21, 1985, paragraph 4.
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Expenses of Preserving a Capital Asset
The decision of the Supreme Court of Canada in Minister of National
Revenue v. Dominion Natural Gas Co. Ltd. 50 is one of the least creditable
efforts of the Canadian courts. Legal expenses incurred by the taxpayer to
defend its natural gas franchise were held to be non-deductible under
both paragraphs 6(a) and (b) of the Income War Tax Act. While the court’s
approach to the income-earning purpose rule (to which it applied criteria
more appropriate to the capital outlay rule)51 has been superseded by later
statutory and judicial developments,52 its decision on the capital outlay
issue remains troublesome. The expenditures in question were not incurred to bring a new capital asset into existence, as contemplated in
Viscount Cave’s test in British Insulated, 53 but were for the purpose of
preserving or defending an existing capital asset—namely, the exclusive
right to supply natural gas within the city of Hamilton. Nevertheless, the
court purported to apply Viscount Cave’s test, while misquoting and misconstruing it.
Chief Justice Duff concluded that the expenditure in question “was
incurred ‘once and for all’ and it was incurred for the purpose and with
the effect of procuring for the company ‘the advantage of an enduring
benefit’.” 54 The settlement of the litigation challenging the taxpayer’s
franchise was considered to be such an enduring benefit. Of course, the
franchise and the rights it conferred had remained unchanged.
Worse still, Mr. Justice Kerwin, after accurately quoting Viscount Cave’s
test, concluded that
the payment of the costs was not an expenditure laid out as part of the
process of profit earning. It was a “payment on account of capital” and it
was made (to use Viscount Cave’s words) “with a view of preserving an
asset or advantage for the enduring benefit of a trade” [emphasis added].55
Thus, contrary to prevailing British jurisprudence before and since,56 an
expenditure made merely to preserve a capital asset, without adding to it,
was held to be a capital outlay.57 It is hard to conceive a result more opposed to business practice and understanding. The decision is inconsistent
50 Supra
footnote 9.
at 134-35.
54 Dominion Natural Gas, supra footnote 9, at 135.
55 Ibid., at 137.
56 See Southern v. Borax Consolidated, Ld., [1941] 1 KB 111 (KB); and Morgan v. Tate
& Lyle, Ltd., [1954] 2 All ER 413 (HL).
57 Hudson’s Bay Company v. The Minister of National Revenue (1947), 3 DTC 968 (Ex.
Ct.), held that legal expenses to protect the taxpayer’s exclusive right to use its name were
deductible and purported to distinguish Dominion Natural Gas. In view of subsequent
Canadian case law, infra footnotes 67 to 72, it is doubtful that Hudson’s Bay represents the
law in Canada.
51 Ibid.,
(1995), Vol. 43, No. 5 / no 5
1201
with case law58 allowing the deduction of repair expenditures, which would
obviously have been made to preserve a capital asset. The same problem
arises in the case of insurance premiums against fire or accident, salaries
to custodial personnel, and many other ordinary and necessary business
expenditures that are not expected to give rise to any long-term benefit and
therefore are not within the policy rationale for denying the deductibility
of capital expenditures. In practice, few of these types of expenditure have
been challenged by Revenue Canada; and in some of the cases where Revenue Canada has relied upon Dominion Natural Gas to disallow a deduction, the courts have attempted to narrow the scope of that judgment.
In Minister of National Revenue v. Kellogg Co. Ltd., 59 the Supreme
Court of Canada held that the expenses of a successful defence by the
taxpayer of an action for infringement of the plaintiff ’s alleged exclusive
right to use the words “shredded wheat” were deductible, notwithstanding
Dominion Natural Gas. The court noted:
The right upon which the respondents relied was not a right of property, or
an exclusive right of any description, but the right (in common with all
other members of the public) to describe their goods in the manner in
which they were describing them. 60
In other words, unlike an exclusive franchise, a right shared with the
public in general is not a capital asset, and the cost of defending such a
right is not a capital outlay.
In Evans v. MNR, 61 the Supreme Court of Canada allowed the taxpayer
to deduct legal fees incurred to establish her right to a lifetime income
from her father-in-law’s estate. Mr. Justice Cartwright purported to distinguish Dominion Natural Gas as follows:
The “asset” or “advantage” under consideration in Dominion Natural Gas
was a valuable, exclusive perpetual franchise; this franchise did not of
itself yield any income to the Company which held it; it was a permanent
right used and useful in the earning of the company’s income by the sale of
its product to the persons residing in the territory covered by the franchise;
it was rightly regarded as an item of fixed capital. 62
He referred to MNR v. L.D. Caulk Co. Ltd. et al., 63 where
Rand J . succinctly explained the judgment in Dominion Natural Gas as
having been based on the view that the legal fees there in question were
“expenses to preserve a capital asset in a capital aspect.”64
58 See
supra footnote 48.
2 DTC 601 (SCC).
60 Ibid., at 601.
61 60 DTC 1047 (SCC).
62 Ibid., at 1050.
63 54 DTC 1011, at 1013 (SCC).
64 Evans, supra footnote 61, at 1050. Rand J’s attempt to limit the damage caused by
Dominion Natural Gas does not offer much help in drawing the line between deductible
and non-deductible expenditures.
59 (1943),
(1995), Vol. 43, No. 5 / no 5
1202
Here Mr. Justice Cartwright concluded:
The payment of the legal fees in question did not bring this right or any
asset or advantage into existence. . . . I cannot agree that the fact that a
bare right to be paid income can be sold or valued on an actuarial basis at
a lump sum requires or permits that right, while retained by the appellant,
to be regarded as a capital asset. . . . In the Dominion Natural Gas case, on
the other hand, the expenses were incurred in litigation the subject matter
of which was an item of fixed capital.65
The limited scope of this decision is best appreciated by considering
what the result would have been if the taxpayer had been seeking to
establish that she had a right to capital from the estate. While the concept
of “capital” under trust law has peculiarities of its own, such an expenditure likely would have been difficult to distinguish from the outlays
disallowed in Dominion Natural Gas.66
In 1967, the Supreme Court of Canada had an excellent opportunity, in
two tax appeals decided by it at the same time, to eliminate the mischief
and uncertainties created by Dominion Natural Gas by finding that its
holding on the capital outlay rule no longer reflected the law. 67 British
Columbia Power Corp. Ltd. v. MNR68 involved the deductibility of legal
expenses in successful proceedings to challenge an expropriation by a
provincial government of the taxpayer’s shares of its subsidiary company,
resulting in a recovery of additional compensation from the expropriation; Farmers Mutual Petroleums Ltd. v. MNR69 concerned the deductibility
of legal expenses incurred in defending the validity of arrangements that
enabled the taxpayer to acquire mineral rights and in opposing proposed
legislation that would have forced the taxpayer to renegotiate the contracts in question. The court noted that, while the income-earning purpose
rule had been liberalized since Dominion Natural Gas, 70 the test of capital expenditure had remained essentially unchanged.71 The law was declared
to be that an expenditure to preserve a capital asset is a capital outlay. 72
While this formulation does not expressly allow for the qualification
offered by Mr. Justice Rand73 that the capital asset in question must have
been preserved in a capital aspect, the Supreme Court of Canada probably
did not intend to override this qualification. To make some sense of the
65 Evans,
supra footnote 61, at 1050.
also The Queen v. Burgess, 81 DTC 5192 (FCTD).
67 In Evans, supra footnote 61, the Supreme Court of Canada had expressly avoided
deciding this question because it felt that it could distinguish Dominion Natural Gas.
68 67 DTC 5258 (SCC).
69 67 DTC 5277 (SCC).
71 This approach ignored the misquotations in Dominion Natural Gas and also the
distorting effect that the one-test approach of that era had had on both tests.
72 Farmers Mutual Petroleums, supra footnote 69, at 5281.
73 In L.D. Caulk, supra footnote 63.
66 See
(1995), Vol. 43, No. 5 / no 5
1203
illogical state of the law, expenditures to preserve a capital asset should
be regarded as capital outlays only when the capital asset is fundamental
to the taxpayer’s business. This qualification seems to fit the leading
cases, though some courts have applied the Dominion Natural Gas rule to
relatively mundane capital assets.74 It is not clear to what extent a tolerable accommodation in this area is dependent on Revenue Canada’s
forbearance.
Further Liberalization
Many judicial decisions in the last years of the Income War Tax Act and
under the 1948 Act further liberalized the deductibility of expenses, particularly under the income-earning purpose rule. Thus, at least in some
circumstances, fines and penalties incurred in the course of a business
were held to be deductible.75 It is not clear whether there are any public
policy limitations on the right to deduct fines and penalties and, if so, on
what statutory basis.76
The apparent suggestion in Montreal Coke 77 that expenses incurred to
reduce expense, rather than to increase revenue, might not be deductible
received currency for a while but has long since disappeared. Such a
position is untenable, since income is a net concept and is gained or
produced just as directly by reducing expenses as by increasing revenues.
In many cases, the purpose of an expense, such as a payment in settlement of a threatened lawsuit, is to avoid having to face a larger expense.
Subject to the normal criteria, such as that the expenses being saved are
not part of a long-term disadvantageous relationship that is being severed, 78 such expenses are generally allowed.79
This process of liberalization of the income-earning purpose rule was
substantially assisted by a definitive recognition in BC Electric Railway
Co. Ltd. v. MNR80 that the changes in wording from paragraph 6(1)(a) of
the Income War Tax Act to paragraph 12(1)(a) of the 1948 Act had the
effect of expanding deductibility. 81 It established as well that this rule and
74 See BP Oil Limited v. The Queen, 80 DTC 6331 (FCA); and McLaws v. MNR, 72
DTC 6149 (SCC).
75 Day & Ross Ltd. v. The Queen, 76 DTC 6433 (FCTD); contra, MNR v. Pooler and
Co. Ltd., 62 DTC 1321 (Ex. Ct.).
76 It has long been held that the expenses of an illegal business, if proved, are deductible: see MNR v. Eldridge, 64 DTC 5338 (Ex. Ct.). Revenue Canada’s views are very
restrictive: see Interpretation Bulletin IT-104R2, “Deductibility of Fines or Penalties,”
May 28, 1993. See generally Eva M. Krasa, “The Deductibility of Fines, Penalties, Damages, and Contract Termination Payments” (1990), vol. 38, no. 6 Canadian Tax Journal
1399-1451. See, however, present Act section 67.5.
77 Supra footnote 29, at 549.
78 See the text above accompanying footnote 41.
79 See, for example, Bedford Overseas Freighters Ltd. v. MNR, 59 DTC 1008 (Ex. Ct.).
81 Ibid., at 1027-28.
(1995), Vol. 43, No. 5 / no 5
1204
the capital outlay rule are separate and independent. In BC Electric Railway, a lump-sum payment made by the taxpayer in order to be relieved of
its money-losing long-term responsibility to provide a commuter rail service was held to meet the income-earning purpose test but to be a
non-deductible capital outlay.
THE MATURE SYSTEM
The Royal Commission on Taxation, which reported in 1966, recommended
that the existing statutory rules relating to deductible expenses be dropped
and replaced by a broader rule allowing the deduction of expenses that
are reasonably related to the earning of income.82 Subsection 9(1) and
paragraphs 18(1)(a) and (b) of the 1972 Act, however, are virtually identical to section 4 and paragraphs 12(1)(a) and (b), respectively, of the
1948 Act. Although the commission’s recommendations in this area have
not been implemented by way of amendment to the Act, much of the
subsequent case law has moved in the direction of those recommendations.
Directness of Result
While the application of both the income-earning purpose and the capital
outlay rules depends on the purpose of the outlay in question, the case
law has taken a different approach, in applying each rule, to the directness of the connection required between the expenditure and the desired
result. Both approaches have had a liberalizing effect. As illustrated in
Royal Trust 83 and Imperial Oil,84 an expenditure may be found to be for
the purpose of earning business income even though the expected income
is delayed or the connection is indirect, while an expenditure that only
incidentally or indirectly may give rise to, or add to, a capital asset will
not be held to be a capital expenditure.
In Algoma Central Railway v. MNR ,85 the taxpayer, which operated a
railway through an undeveloped region, paid for a geological survey of
the mineral possibilities of the area. Its plan was to make its findings
widely available in the hope of attracting development to the area and
thereby increasing the business of its railway. The Exchequer Court held
that these expenditures were not capital outlays. Pointing out the analogy
to advertising expenses, President Jackett held that, while there was a
possibility of long-term benefit, in terms of increased markets, to the
82 Carter
report, supra footnote 10, vol. 4, at 228.
footnote 16.
84 Supra footnote 16. See also Premium Iron Ores Ltd. v. MNR, 66 DTC 5280 (SCC),
which allowed a taxpayer to deduct legal expenses incurred to contest its liability to US
income tax, despite the longstanding rule that income taxes are not expenses incurred to
earn income (codified in paragraph 18(1)(t) of the present Act for Canadian income taxes)
and that (subject now to paragraph 60(o) of the present Act) expenses incurred to reduce
these taxes therefore are not deductible. The court referred vaguely to the protection of
working capital, and the ability to earn future income, as sufficient to meet the incomeearning purpose test.
85 67 DTC 5091 (Ex. Ct.).
83 Supra
(1995), Vol. 43, No. 5 / no 5
1205
taxpayer’s business, creating this benefit was not the immediate purpose
of the expenditures. This decision was approved by the Supreme Court of
Canada.86 In the course of his judgment, Mr. Justice Fauteux quoted87
with approval the following language of Lord Pearce in BP Australia Ltd.
v. Comr. of Taxation of the Commonwealth of Australia, 88 referring to the
appropriate test for identifying a capital outlay:
The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of
circumstances some of which may point in one direction, some in the other.
One consideration may point so clearly that it dominates other and vaguer
indications in the contrary direction. It is a commonsense appreciation of
all the guiding features which must provide the ultimate answer.
If this formulation, which has often been quoted by Canadian courts,
were intended to be comprehensive, it would make the determination
whether an expenditure is a capital outlay totally irrational.89 Presumably,
Lord Pearce simply intended to recognize that matters of judgment and
the weighing of relevant factors are involved, and was not saying that
none of the relevant factors, such as those expressed by Viscount Cave,90
can be articulated. 91 Later in his judgment in BP Australia, Lord Pearce
mentioned some criteria, even though they are quite vague. He referred to
the character of the advantage sought, and in this both its lasting qualities
and the fact of recurrence may play their parts. Under this head one might
also take account of the nature of the need or occasion which calls for the
expenditure. 92
In Canada Starch Co. Ltd. v. MNR ,93 a taxpayer was held to be entitled
to deduct a lump sum paid to another company to withdraw its opposition
to the taxpayer’s application to register a trademark. President Jackett,
applying traditional criteria, noted that
86 MNR
v. Algoma Central Railway, 68 DTC 5096 (SCC).
at 5097.
88 [1966] AC 224, at 264 (PC).
89 Some support for an irrational approach may be found in British Salmson Aero
Engines, Ltd. v. Commissioners of Inland Revenue (1938), 22 TC 29, at 43 (CA): “[I]n
many cases it is almost true to say that the spin of a coin would decide the matter almost
as satisfactorily as an attempt to find reasons.”
90 Supra footnote 37. Viscount Cave’s test was described as “the usual test” in BC
Electric Railway, supra footnote 41, at 1028.
91 This “common-sense” approach to capital outlays is discussed in McCart, supra
footnote 8, at 41:57-59.
92 Supra footnote 88, at 265. The reference to recurrence may be compared with the
limited scope given by Viscount Cave, supra footnote 37, to the “once and for all” criterion of capital outlay that had been suggested in Vallambrosa Rubber Co., Ltd. v. Farmer
(1910), 5 TC 529, at 536 (Ct. Sess.). In Royal Trust, supra footnote 16, at 1063, however,
Thorson P used the recurring nature of the payment of club admission fees by the taxpayer
trust company for its officers as a basis for concluding that the fees were not capital
expenditures to the company.
93 68 DTC 5320 (Ex. Ct.).
87 Ibid.,
(1995), Vol. 43, No. 5 / no 5
1206
an expenditure for the acquisition or creation of a business entity, structure
or organization, for the earning of profit, or for an addition to such an
entity, structure or organization, is an expenditure on account of capital,
and . . . an expenditure in the process of operation of a profit-making entity, structure or organization is an expenditure on revenue account. 94
Next, he addressed the indirect effects of a challenged expenditure:
Once goodwill is in existence, it can be bought, in a manner of speaking,
and money paid for it would ordinarily be money paid “on account of
capital.” Apart from that method of acquiring goodwill, however, as I conceive it, goodwill can only be acquired as a byproduct of the process of
operating a business. Money is not laid out to create goodwill. Goodwill is
the result of the ordinary operations of a business that is so operated as to
result in goodwill. The money that is laid out is laid out for the operation
of the business and is therefore money laid out on revenue account. . . .
[T]he moneys laid out in the operations that incidentally give rise to trade
marks are moneys laid out on revenue account. 95
Mixed Purposes
Similarly, when an expenditure has both revenue and capital aspects, the
former will generally be emphasized, and the expenditure will not be held
to be a capital outlay.
In Denison Mines Limited v. MNR ,96 a mining company cut passageways through ore deposits to provide access to its main ore body. The
sale value of the ore retrieved from the passageways exceeded the cost of
their construction. Because the construction occurred during a three-year
tax holiday that was available for new mines, 97 the taxpayer claimed that
the construction costs were capital outlays forming part of the capital cost
of a depreciable asset. It accordingly claimed capital cost allowance commencing in the first year after the tax holiday. The amounts in question
were held to be currently deductible expenses, and the taxpayer had no
option to “capitalize” them. Chief Justice Jackett in effect applied the
accounting principle of “matching” expenses and related revenues. Emphasizing the current over the capital aspect of the expenditures in question,
he said that “[n]o single disbursement can be reflected twice in the accounts.” 98 His decision and reasons were approved by the Supreme Court
of Canada.99
In Johns-Manville Canada Inc. v. The Queen,100 the taxpayer operated
an open-pit mine, which became progressively deeper as the mining operation continued. To maintain the appropriate wall slope for its mine, it
94 Ibid.,
at 5323.
at 5324.
96 72 DTC 6444 (FCA).
97 Former Act subsection 83(5).
98 Supra footnote 96, at 6447.
99 Denison Mines Limited v. MNR, 74 DTC 6525 (SCC).
95 Ibid.,
(1995), Vol. 43, No. 5 / no 5
1207
purchased pieces of adjacent land, which it excavated but which did not
contain ore. The Supreme Court of Canada held that, even though the
cost of land acquired for purposes other than resale is generally a capital
outlay, the cost of this land was currently deductible.101 Mr. Justice Estey
quoted BP Australia 102 and then noted:
The removal of the ore here was obviously the continuous and recurrent
struggle in which the taxpayer was principally engaged, and the expenditure
here was . . . part of the essential profit-seeking operation of the taxpayer. 103
Referring to Comr. of Taxes v. Nchanga Consolidated Copper Mines Ltd.,104
he acknowledged that “enduring,” in Viscount Cave’s formulation, 105 did
not necessarily mean permanent or perpetual.106 Nevertheless, there was
no intention here to acquire a lasting asset. Where the considerations pointing for and against characterizing an expenditure as a capital outlay are
evenly balanced, the court should find that it was not a capital outlay. 107
This decision, however, “did not provide specific guidelines that might
help determine the application of the decision in future borderline cases.”108
What Is “Profit”?—Business Practice and Accounting
Principles
Although some four decades have elapsed since the courts established the
relevance of the reference to “profit” in the determination of the
deductibility of business expenses,109 a number of important issues of
interpretation have been left vague and confused—notably, the meaning
of “the ordinary principles of commercial trading” and more or less similar phrases that the courts have used in applying the term “profit,” and
the relevance, if any, of generally accepted accounting principles (GAAP).
There has been a growing acceptance by our tax courts, and indeed by
Revenue Canada,110 of the relevance of accounting principles in the measurement of business income for income tax purposes. In some cases,
GAAP have been treated as controlling.111 Yet we saw that, in Royal Trust,112
101 The
decision is fully discussed in McCart, supra footnote 8.
footnote 88.
103 Johns-Manville, supra footnote 40, at 5378.
104 [1964] AC 948, at 960 (PC).
106 Johns-Manville, supra footnote 40, at 5378.
107 Ibid., at 5382.
108 McCart, supra footnote 8, at 41:23.
109 See the text above accompanying footnotes 16 to 28.
110 See, for example, Interpretation Bulletin IT-417R, “Prepaid Expenses and Deferred
Charges,” July 5, 1982, paragraphs 2 and 8; and Robert C. Reed, “The Dilemma of Conformity: Tax and Financial Reporting—A Perspective from Revenue Canada,” in the 1981
Corporate Management Tax Conference, supra footnote 10, 1-21.
111 The case law is extensive. See, for example, the discussion in McCart, supra footnote 8, at 41:45-52.
112 See the text above accompanying footnote 25.
102 Supra
(1995), Vol. 43, No. 5 / no 5
1208
President Thorson regretted that he had referred to “accounting practice”
in Imperial Oil, 113 and he now preferred to speak only of “ordinary principles of commercial trading” or “principles of good business practice.”
After finding that the use of a social club was an accepted method for
trust companies to promote their business, he noted that the court had
heard the opinion of a prominent chartered accountant,
for what it is worth, that from an accounting point of view the deduction of
the amount of the payments made by the appellant was a proper and necessary one for the ascertainment of its true profits and gains. Thus I find as a
fact that the payments made by the appellant were made in accordance with
principles of good business practice for trust companies [emphasis added].114
It is not clear whether President Thorson was saying that the expert
accounting evidence was irrelevant or that it was helpful but not controlling. Nor is it clear whether an innovator, such as the first trust company
to use a social club for the purpose of promoting business, would be
denied the deduction of the expenses in question on the ground that they
were not incurred in accordance with general commercial practice. To
avoid this absurdity, it should be sufficient that the action was commercially reasonable, even if not general practice.
A determination of what expenses are in accordance with accepted
commercial practice presumably depends on whether the expenses in question are regarded as reasonable in the commercial community. 115 The
expenses in Royal Trust were found to have been made in accordance
with accepted commercial practice. In the last quoted passage, President
Thorson indicated that he made this determination as a finding of fact
after hearing testimony of prominent business people. This is a different
question from whether accountants would treat the expenses in question
as proper deductions in computing business income for accounting purposes. President Thorson’s correction regarding his earlier reference to
accounting practice may have reflected a recognition of this distinction
and his conclusion that only the first question was relevant in determining the meaning of “profit” in what is now subsection 9(1). On the other
hand, many cases, particularly in recent years, have held that accounting
principles are relevant, if not controlling, in determining the timing of
deductibility of expenses—which is also an aspect of the meaning of
“profit.”116 The failure of most courts to recognize that these questions
are separate and distinct has been a source of much confusion, which is
compounded by the statements of several courts that the meaning of
“profit” in present subsection 9(1) is a question of law.
113 Supra
footnote 16.
Trust, supra footnote 16, at 1061.
115 These issues overlap those specifically addressed in paragraphs 18(1)(a) and (h) and
section 67 of the present Act, as well as their predecessors. See, for example, Symes, supra
footnote 17.
116 See the text below accompanying footnotes 143 and 144.
114 Royal
(1995), Vol. 43, No. 5 / no 5
1209
In Associated Investors of Canada Ltd. v. MNR ,117 President Jackett
held that advances by an employer to its commission salesmen were deductible as of the time when its inability to recover them was established.
In a much-quoted footnote,118 he gave some support to the application of
the matching principle, except in the case of “running” expenses that
cannot be easily related to specific revenues. The “matching” principle
had been held inapplicable under the Income War Tax Act,119 but this
rigidity had been overcome by the changes in wording in the key statutory provisions and the development by the courts of a more sophisticated
approach to timing issues. President Jackett went on to say:
Profit from a business, subject to any special directions in the statute, must
be determined in accordance with ordinary commercial principles. . . . The
question is ultimately “one of law for the court.” It must be answered
having regard to the facts of the particular case and the weight which must
be given to a particular circumstance must depend upon practical considerations. As it is a question of law, the evidence of experts is not conclusive
[emphasis added]. 120
This statement does little to alleviate the confusion. As in the judgment in Royal Trust, the reference here to the relevance of expert evidence
is equivocal. When a court decides a pure question of law, expert evidence should be irrelevant, not merely inconclusive. When, on the other
hand, the application of a principle of law requires certain determinations
of fact, expert evidence may or may not be relevant. We saw, not surprisingly, that President Thorson in Royal Trust regarded his conclusions
concerning commercial practice as findings of fact. Clearly, the interpretation of “profit” involves more than a pure question of law.
In Symes v. The Queen et al., 121 the taxpayer sought to deduct child-care
expenses that she paid to enable her to earn income from practising her
profession as a partner of a law firm. In addition to the basic principles of
deductibility, the Supreme Court of Canada had to consider, among other
issues, the specific prohibition in present paragraph 18(1)(h) of the deduction of “personal or living expenses” 122 and a limited grant of
deductibility in present section 63. In the course of his judgment, Mr.
Justice Iacobucci discussed at length 123 the general principles of
deductibility of business expenses. Echoing earlier cases, he stated that
the determination of profit under s. 9(1) is a question of law. . . . Perhaps
for this reason . . . courts have been reluctant to posit a s. 9(1) test based
upon “generally accepted accounting principles.” . . . Any reference to
117 67
DTC 5096 (Ex. Ct.).
at 5098.
119 See, for example, Consolidated Textiles Limited v. MNR (1947), 3 DTC 958 (Ex. Ct.).
120 Associated Investors, supra footnote 117, at 5099.
122 The term is defined in subsection 248(1) of the present Act.
123 Symes, supra footnote 17, at 6008-17 and 6033-38.
118 Ibid.,
(1995), Vol. 43, No. 5 / no 5
1210
G. A . A. P . connotes a degree of control by professional accountants which is
inconsistent with a legal test for “profit” under s. 9(1). Further, whereas an
accountant questioning the propriety of a deduction may be motivated by a
desire to present an appropriately conservative picture of current profitability, the Income Tax Act is motivated by a different purpose: the raising of
public revenues. For these reasons, it is more appropriate in considering the
s. 9(1) business test to speak of “well accepted principles of business (or
accounting) practice” or “well accepted principles of commercial trading.”124
This passage is partially helpful in clarifying that the tests to be applied in determining “profit” under present subsection 9(1) are legal tests;
but it perpetuates the confusion concerning the relevance of business
practice and accounting principles in applying those legal tests in a concrete situation. 125 It seems clear that what are commercial practices, and
what are accounting principles, in a given situation and at a given point
of time, are questions of fact. As in many questions of fact, different
witnesses, including expert witnesses, may disagree, and the court will
have to reach its conclusions of fact after receiving their testimony. Any
judicial decision on a question of fact should not set a precedent for
future courts, which should be free to recognize the evolving nature of
business practices and accounting principles. 126 The extent to which, and
the circumstances in which, these questions of fact are relevant to the
determination of “profit” are questions of law. A judicial clarification of
these points would be welcome to eliminate the confusion and vagueness
in dicta such as those just quoted.127 Mr. Justice Iacobucci recognized that
“the existence of a business purpose within the meaning of s. 18(1)(a) is
a question of fact”;128 the question of fact, however, must be considered
in the context of the judicial interpretation of the legal rule in present
paragraph 18(1)(a).
Some guidance may be obtained from the approach to capital outlays
in a passage from the judgment in Johns-Manville.129 After commenting
124 Ibid.,
at 6009.
however, Sun Insurance Office v. Clark, [1912] AC 443, at 455 (HL), per Lord
Haldane: “[T]he question of what is or is not profit or gain must primarily be one of fact,
and of fact to be ascertained by the tests applied in ordinary business. Questions of law
can only arise when . . . some express statutory direction applies and excludes ordinary
commercial practice, or where, by reason of its being impracticable to ascertain the facts
sufficiently, some presumption has to be invoked to fill the gap.”
126 If this inherent flexibility had been more fully appreciated at an earlier stage, many
of our detailed and often arbitrary statutory rules relating to the measurement of business
income might have been recognized as being inappropriate.
127 At a later point (Symes, supra footnote 17, at 6014-15), Iacobucci J may be suggesting that the only function of accountants under subsection 9(1) is to offer an opinion
whether an expenditure “is widely accepted as a business expense.” The language, however, is unclear and ignores the extensive scope that courts have granted to accounting in
determining timing questions.
128 Ibid., at 6016.
125 See,
(1995), Vol. 43, No. 5 / no 5
1211
that generally the courts have said that whether an expenditure is a capital outlay is a question of law, Mr. Justice Estey observed:
No doubt in the predominant sense that is true. However, the underlying
facts upon which the question of law is determined are so interwoven with
the principles of law that it is difficult to say that it is not at least a mixed
question of law and fact.130
“Reasonable Expectation of Profit”
One important recent judicial development in the interpretation of the
provisions of the present Act relating to business income—apparently as
part of the meaning of the term “business”131—has been the concept of
“reasonable expectation of profit.” Although the legitimacy of its genesis
may be questioned, it has been eagerly seized by Revenue Canada, with
substantial judicial support, as a new and effective means of restricting the
ability of taxpayers to deduct expenses that appear to have been incurred
for the purpose of earning business income, where in fact the taxpayer has
suffered a series of losses. Since the subject is dealt with elsewhere in this
issue of the journal,132 it will not be discussed further here.
Timing of Deduction of Expenses
It took some time for our tax courts to recognize that the 1948 Act, by the
use of phrases such as “made or incurred” in paragraph 12(1)(a), was
designed to override the cash method bias of the Income War Tax Act. 133
Over time, the courts’ attitude to timing issues in the measurement of
business income evolved. 134 It was often stated or implied, however, that
a reference to GAAP on questions of timing
is subject not only to the specific provisions of the Act, but also to any
overriding principles of income tax law established by judicial decision.135
As the case law has continued to evolve, and as growing (though not
universal) reliance is being placed on GAAP to resolve various timing
questions, including those related to the deduction of expenses,136 it appears increasingly difficult to identify “overriding principles of income
tax law”; rather, the exceptions to the general rule appear to follow no
130 Ibid.,
at 5379.
logically it should not apply to property income, the same approach has
been followed by some courts in that area. See, for example, McGovern et al. v. MNR, 93
DTC 1001 (TCC).
132 See the article by Cy M. Fien. See also Sheldon Silver, “Great Expectations—Are
They Reasonable?” in Real Estate Transactions: Tax Planning for the Second Half of the
1990s, 1995 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation,
forthcoming).
133 See Harris, supra footnote 10, at 85.
134 See, generally, Arnold, supra footnote 10.
135 Ibid., at 27.
136 For a review of earlier developments, see Edwin C. Harris, “When To Deduct?”
(1965), vol. 13, no. 6 Canadian Tax Journal 536-44.
131 Though
(1995), Vol. 43, No. 5 / no 5
1212
consistent principle.137 As we have seen, 138 the criteria concerning the
circumstances in which GAAP should apply are a question of law, but
they have never been well articulated. Increasingly, the courts seem to be
moving toward a presumption that GAAP should apply. 139
The Matching Principle
These broad developments cannot be discussed in detail here, but they
can be illustrated, in the case of deductible expenses, by the growing
acceptance of the “matching” principle in the measurement of business
income for tax purposes. It is a basic principle of accounting that the
deduction of expenses and the recognition of any related revenues should
be “matched” in the accounting period in which the revenues can be
regarded as having been earned. The cash method bias under the Income
War Tax Act, which persisted in the early years under the 1948 Act,
prevented any significant judicial recognition of the matching principle.
Even under the accrual method recognized by the 1948 Act, the courts
initially required expenses to be deducted when the taxpayer became legally required to pay them, although the related revenue may not be
recognized until a later year. Subsequently, without any statutory
changes, 140 many courts accepted that the use of the matching principle
was permitted, though not necessarily required, with respect to what accountants would regard as prepaid expenses. 141 Where, however, there
was no clear relationship between an expense and expected future revenues, the expense (if not a capital outlay) was called a “running” expense
and was allowed as a current deduction, regardless of the way it was
treated in the taxpayer’s books of account.142 This approach, while welcome to most taxpayers to whom it applied, raised difficult questions of
how to distinguish between expenses that are currently deductible in full
and those that could or should be deferred.
The latest stage in the evolution of the application of the matching
principle for tax purposes has been to require its use in cases where it
would apply under accounting principles. In The Queen v. Canderel
137 See Edwin C. Harris, “Measuring Business and Property Income,” in W. Neil Brooks,
ed., The Quest for Tax Reform: The Royal Commission on Taxation Twenty Years Later
(Toronto: Carswell, 1988), 103-19, at 105.
138 See the text above accompanying footnotes 124 to 130.
139 See, for example, The Bank of Nova Scotia v. The Queen, 80 DTC 6009, at 6013
(FCTD), aff ’d. with apparent approval, 81 DTC 5115 (FCA).
140 Subsection 18(9) was later added to the present Act. It does not deal with all
prepaid expenses.
141 See, for example, Associated Investors, supra footnote 117; MNR v. Tower Investment Inc., 72 DTC 6161 (FCTD); Canadian Glassine Co. Ltd. v. MNR, 74 DTC 6089
(FCTD), rev’d. on other grounds, 76 DTC 6083 (FCA); and Tobias v. The Queen, 78 DTC
6028 (FCTD).
142 See the text above accompanying footnote 118; and The Queen v. Oxford Shopping
Centres Ltd., 81 DTC 5065 (FCA).
(1995), Vol. 43, No. 5 / no 5
1213
Limited,143 the taxpayer, which managed and developed commercial real
estate, sought to deduct certain tenant inducement payments in the year in
which they were paid. The court held that the payments must be deferred
and amortized as expenses over the term of the related leases, on the
basis that the reference to “profit” in present subsection 9(1) implied an
adoption of accounting principles relating to the timing of measurement
of income. Speaking for the majority of the court, Mr. Justice Stone
began his judgment as follows:
In my view, the matching principle of accounting has, at least in this Court,
been elevated to the status of a legal principle.144
Since the matching principle could be readily applied in this case, the
expenses in question were not mere running expenses and therefore were
not eligible to be written off in full in the year incurred. 145
The last word on the matching principle remains to be written by the
Supreme Court of Canada. The present state of the law, however, seems
to give the courts ample opportunity to achieve a result on the timing of
recognition of expenses that is reasonable from a business standpoint. No
longer are they faced with the choice of allowing full current deductibility
of an expenditure or denying any deduction (perhaps forever) on the
ground that the expenditure was a capital outlay.146 Only expenditures
designed to achieve permanent or very long-term benefits need be characterized as capital outlays; and in most cases, these expenditures can be
amortized over a period of years. Expenses that are not of that nature but
benefit one or more future years can be deferred, under either the provisions of present subsection 18(9) or the general matching concept, and
allocated to the appropriate years. Expenditures (“running expenses”) that
may not result in identifiable future benefits, and cannot readily be matched
against expected future revenues, can be allowed in full as current deductions. One can hope that the anomalous treatment of expenses for the
protection or preservation of capital assets will continue to be confined to
a narrow scope. A mandatory application of the matching principle in
appropriate cases should lead the courts to restrict further the scope for
labelling an expenditure as a capital outlay.
143 95
DTC 5101 (FCA) (appeal sought).
at 5102, citing West Kootenay Power and Light Company Limited v. The
Queen, 92 DTC 6023, at 6028 (FCA), which was concerned with the timing of recognition
of revenue.
145 See Canderel, supra footnote 143, at 5102-3. The concurring judgment of Desjardins
JA addresses the tax treatment of timing questions where accounting opinions accept more
than one approach. While from time to time reference is made in the case law to “true
income” (which is a near-meaningless phrase, particularly if it is isolated from accounting
thinking), the courts have not definitively addressed this issue. For an example of a reversion to the one-test approach, see the dictum of Desjardins JA, ibid., at 5103.
146 Compare Cummings v. The Queen, 81 DTC 5207 (FCA), and Canderel, supra footnote 143.
144 Ibid.,
(1995), Vol. 43, No. 5 / no 5
1214
FUTURE TRENDS
Many of the issues of deductibility that are yet to be resolved relate to the
proper application of accounting principles. Obviously, ease of administration and compliance are facilitated to the extent that income for tax
purposes is measured in accordance with GAAP, which are widely used in
the business community to determine income as reflected in financial
statements.147 Of course, there will be important areas of income measurement, such as those relating to capital cost allowance, where a departure
from accounting principles will be regarded as appropriate. 148 The state of
our case law, however, indicates that, for certainty and clarity, these areas
of difference are better dealt with by specific statutory provisions than by
allowing the courts, as a “question of law” on which they have no guiding
principles apart from occasional vague references to “true income,” to
decide when they will apply accounting principles and, if not, what rules
will be substituted for them.
Assuming that there is little prospect of early statutory amendment in
this area, the following issues relating to the application of accounting
principles require further attention and clarification from our tax courts:
1) Whether the deductibility (as distinguished from the timing of deduction) of an expense for accounting purposes is relevant in interpreting
“profit” in present subsection 9(1). Some, but not all, case law suggests
that it is not. In any event, the accounting profession does not appear to
have developed clear criteria of deductibility that go beyond commercial
reasonableness and the restrictions contained in the present Act relating
to income-earning purpose and personal expenditures.
2) Whether accounting principles will apply, subject to specific provisions of the present Act, on questions of timing of the deduction of
expenses. Recent case law appears to have reached that position.
3) If so, where accounting principles recognize the validity of alternative approaches to timing, whether the taxpayer will be free to choose
between the alternative acceptable methods, whether Revenue Canada
will be in a position to enforce its choice on the basis that the taxpayer
cannot sustain the burden of proving149 that Revenue Canada’s assessment
is wrong, or whether the courts will impose their own choice by reference
to some vague criterion such as “true income.” Subject to the requirement
of consistency,150 it seems appropriate to leave the choice to the taxpayer.
The only issue of fact, to which a burden of proof applies, is what are
147 See Edwin C. Harris, “Application of Accounting Principles and Practices,” in Report of Proceedings of the Nineteenth Tax Conference, 1967 Conference Report (Toronto:
Canadian Tax Foundation, 1967), 93-103, at 95.
148 Harris, supra footnote 137, at 103.
149 See Charles MacNab, “The Burden of Proof in Income Tax Cases” (1978), vol. 26,
no. 4 Canadian Tax Journal 393-411.
150 This basic principle of accounting has been accepted for tax purposes in The Queen
v. Cyprus Anvil Mining Corporation, 90 DTC 6063 (FCA).
(1995), Vol. 43, No. 5 / no 5
1215
GAAP in the circumstances. There should be no burden of proof that the
taxpayer’s selection of an accepted method is better than an alternative
accepted method supported by Revenue Canada. A choice between accepted methods should not raise a question of fact.
The existence of two separate issues in the interpretation of “profit” in
present subsection 9(1) needs to be identified: first, the determination of
what is business practice, a question on which accountants, as such, may
not be regarded as having any particular expertise; and second, the application of accounting principles to the measurement of income. To the
extent that answers to these questions are relevant (an issue that is a
question of law), the answers are questions of fact. We may hope that tax
courts will take the opportunity to clarify their approach to these issues.
The anomalous treatment as capital outlays of at least some expenditures made to preserve capital assets remains to be addressed. If the
Supreme Court of Canada cannot be persuaded to reject its previous position151 as being inappropriate,152 the courts at least can limit the application
of the rule to the preservation of the existence, and not merely the value,
of a capital asset that is of long-term value and is fundamental to the
taxpayer’s business.
Our law concerning the deductibility of business expenses has evolved
significantly since its early and difficult beginnings. Most of the progress
that has been achieved has been the work of the courts, though they
received some assistance from changes in the wording of certain key
statutory provisions with the adoption of the 1948 Act. For the most part,
future improvements and clarification in this area will likely remain the
responsibility of the courts. One may hope that they will continue to
move in the direction of recognizing that business income is essentially a
business concept.
151 Supra
footnotes 67 to 74 and the accompanying text.
One factor is the reluctance of taxpayers to incur the cost of appealing to the
highest court to overturn a previous inappropriate decision.
152
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Deduction of Business Expenses

Transcription

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