Central Amusement Co. Ltd. v. The Queen, 92 DTC 6225, [1992] 1 CTC 218 (FCTD)

Rouleau, J.:—In this action the plaintiff appeals the decision of the Associate Chief Justice of the Tax Court, dated January 18, 1990, which held that certain expenditures made by the plaintiff during its 1983 taxation year were payments made on account of capital, the deduction of which is prohibited under paragraph 18(1)(b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

The issue in this case, namely whether the expenditures in question constitute currently deductible expenses or whether they are outlays on account of capital is a frequently litigated subject. However, the significance of this appeal lies in the unusual nature of the fact situation.

Since 1947 the plaintiff company has been in the business of leasing, owning and servicing coin-operated amusement machines, such as pool tables, pinball machines and shuffleboard tables, and in more recent years, and most importantly for the purpose of this appeal, video-game machines. It is these video games which are the focus of this appeal.

The games consist of a wood cabinet or frame, various electronic components such as fluorescent lights and speakers, a control panel which may be comprised of buttons or a joystick or a combination thereof, a video monitor or screen, and a coin box. The electronic circuit board, also referred to as the printed circuit board or PCB, is specific to the game in question. Physically the cabinets have a long life, and subject to normal maintenance, the operation of the electronic components can be continued for an indefinite period.

Initially, when video games became popular, the plaintiff could only obtain a new game from its suppliers by purchasing an entire machine, including a new cabinet, for an approximate cost of $4,500. These machines are known in the video game industry as "dedicated games". However, in the early 1980s suppliers introduced "conversion kits" into the market which, in essence, are comprised of a circuit board containing a new video game. These kits can be inserted into the cabinet of a dedicated game after removal of the existing circuit board, and with some minor adjustments which generally take less than a day, have the effect of providing a new game in place of the old one. To the limited extent that the kits were available in 1983, they were attractive to the plaintiff as a way of providing new games because of their cost. The average price of a conversion kit in 1983 was $750.

In 1983 the plaintiffs acquisition cost for the purchase of conversion kits was $175,026. For income tax purposes, the plaintiff treated the cost of acquiring the kits as repair or maintenance expenditures rather than capital outlays and deducted the full amount paid for the kits in that year as a current deductible expense. By notice of reassessment, the Minister of National Revenue disallowed the deduction of these costs and treated them as capital expenditures, adding them to the undepreciated capital cost of the class of depreciable assets that included the video games. The plaintiff, after filing a notice of objection which in due course was confirmed by the Minister, appealed to the Tax Court of Canada which dismissed the appeal and confirmed the reassessment.

The plaintiff now appeals to this Court on the grounds that the expenditure in question was not a capital outlay within the meaning of paragraph 18(1)(b) of the Income Tax Act, since it was not made for the purpose of bringing into existence an enduring asset. It is submitted that the question of whether an expenditure is a capital outlay, should be determined, not by the expected physical life of any asset so acquired, but by its expected economic life. In the present case, the plaintiff submits, the expected economic life of a conversion kit was a matter of months rather than years, since after a few months no further economic gain would be obtained by having installed the kit as compared to having retained the game that the kit replaced.

The plaintiff maintains that recent case law supports the principle that in the case of doubt as to the enduring nature of any asset acquired, a current deduction for tax purposes should be allowed to the taxpayer, and the expenditure should not be required to be "capitalized". Furthermore, it is argued that the expenditures in question would be current deductions pursuant to generally accepted accounting principles.

The defendant, on the other hand, submits that the expenditures incurred for the video game conversion kits are outlays on account of capital, and not current expenses in that they are assets of an enduring benefit to the plaintiff's business. The effect of inserting a conversion kit into a dedicated game, it is argued, is the acquisition of a new game, and as such each kit contributes to the plaintiff's revenue earning process in more than one taxation year. Therefore, the defendant asserts, the conversion kits are depreciable property upon which capital cost allowance may be claimed.

The primary evidence proffered during the course of the hearing before me was the testimony of Mr. Robert Charlton, a chartered accountant who is employed as comptroller of the plaintiff company. In my view, his evidence is critical to a determination of the issue at hand.

This witness, who is clearly knowledgeable, provided incontrovertible evidence, setting out in detail the general nature of the video game industry as well as the specific operation of the plaintiff's business venture.

There are two integral aspects of the plaintiff's business enterprise. First, it leases amusement machines to locations owned and/or operated by other individuals, such as neighbourhood corner stores, bowling alleys, pool rooms, taverns, ferries and ferry terminals, and airports. In addition, machines are supplied to video-game arcades which the plaintiff itself owns and operates. A maintenance shop in the plaintiff's head office in New Glasgow, Nova Scotia, is responsible for the repair, maintenance and upgrading of the machines. To this end personnel are employed who install, inspect, remove and replace machines as required and who periodically collect coins from the machines.

In 1983 the plaintiff was supplying various amusement machines to approximately two hundred different locations in the Maritime provinces. At the time, it owned 900 to 1,000 machines, of which roughly 475 were video games.

Mr. Charlton's evidence is that, in most instances, a new video game earns its maximum revenue during the first 8 to 12 months after its introduction to the consumer. Thereafter, as consumers become more adept at playing the game, they obtain more playing time for their money or their interest in the game declines and the revenue obtained from a game diminishes. The major consumers of these games and the chief patrons of most of the locations which the plaintiff services are young, school age individuals.

The plaintiff's objective in the course of its business operation is to ensure maximum revenue from its machines and to ensure that each location which it services is attractive to consumers. This latter objective, the enticing of consumers to purchase its product, is achieved in a number of ways. First, the physical ambience of the plaintiff's arcades is maintained in order to ensure they are enjoyable places to frequent. Second, and most importantly, the arcades offer new games on a regular basis in order to preserve consumer interest. As Mr. Charlton explained, a video game arcade can only survive in the competitive industry if it is able to offer its customers new challenges in the form of new games.

It was for this reason that the plaintiff commenced using conversion kits in early 1983. Dedicated machines containing games which are no longer high revenue earners are transported to the plaintiff's maintenance shop. There, maintenance personnel remove the old circuit board and install the new circuit board contained in the conversion kit. Generally, this process takes less than a day. Thereafter, the machine is returned to an appropriate location to earn revenue. The replaced circuit board is generally discarded.

In order to maintain maximum revenue earning capacity in a location, the plaintiff customarily engages in a rotation of its machines whereby the top earning machines, after one or two months, are moved from a prime revenueearning location, such as an arcade, to another, less utilised location, such as a strip mall. The purpose of this rotation system is twofold. First, it maintains consumer interest in a location by offering new challenges to consumers in the form of new games. Without this patrons would quickly become adept at, or tire of the current video games and the plaintiff's overall revenue from that location would decline. Second, by moving the high-revenue machines from its top locations to less popular ones, where consumers are less likely to have played the game and accordingly, have more interest in it, the plaintiff is able to generate more revenue from the machine than if it had remained in the previous location. In short, this system allows the plaintiff to earn maximum revenue from its locations and from its machines.

However, in the highly competitive video game industry, games are outdated in relatively short order and their revenue-earning capacity at that point is meagre. To counter this economic reality, the plaintiffs practice is to either rotate the machine to a new location as a filler, that is, to fill empty floor space in an arcade or, the dedicated game is taken to the plaintiff's repair shop where a conversion kit is inserted. Thereafter, the machine is moved back to a prime location and the cycle of realizing high revenue for a short time, followed by rotation to a secondary location, is repeated.

It is noteworthy that the revenue earning capacity of a conversion kit is less than that of a dedicated game. Mr. Charlton testified that video game operators such as the plaintiff do not generally know whether a new game will be offered in the form of a conversion kit. Suppliers usually keep that information a guarded secret in an attempt to sell as many dedicated games as possible. A new game in the form of a conversion kit is not normally available until some time after the game has been on the market in the form of a dedicated machine. Accordingly, a machine into which a conversion kit has been inserted enjoys a more limited maximum earning capacity, generally six to eight months, since consumers are likely to be more familiar with it and become skilled at the game or lose interest in it in a shorter time.

The determination as to what constitutes a capital expenditure as compared to a revenue expenditure is often an arduous task. There is no hard and fast rule as to when expenditures made on capital assets will, and when they will not, be considered to be capital expenditures within the meaning of paragraph 18(1)(b) of the Income Tax Act. Although general principles can be extracted from the jurisprudence, the issue of capital expenditure versus expenses, is largely a question of fact in each case and often a question of degree. The determination cannot be made by the application of any rigid test or definition. Rather, it is derived from an appreciation of the whole set of circumstances, some of which may point to the conclusion that the expenditure is capital in nature and others which indicate it is an expense. What is required is a commonsense correlation of the legal principles as set out in the case law with the unique fact situation of any given case.

However, while no single definition or test exists, a number of criteria have periodically been expressed by the courts. In Vallambrosa Rubber Co. Ltd. v. Farmer (1910), 5 T.C. 529, Lord Dunedin made the following oft-quoted statement, at page 536:

Now I don't say that this consideration is absolutely final or determinative, but in a rough way I think it is not a bad criterion of what is capital expenditure as against what is income expenditure to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year.

This first principle, that an expense is of an annual or recurring or continuous nature, has been reiterated in a number of cases. The most renowned statement in this area appears in the decision of Atherton v. British Insulated and Helsby Cables Ltd. (1925), 10 T.C. 155, wherein Lord Cave said, at page 192:

. . .. 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 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.

[Emphasis added.]

This provides another useful criteria. Not only is a capital expenditure made once and for all, but it must be seen as offering the taxpayer more than a temporary or passing advantage. The only way to discern whether such a benefit has been realized is to examine the purpose which the taxpayer was attempting to achieve in making the expenditure. In cases of this nature, the solution is not inevitably found in the effect which the expenditure may have had, but rather, in the purpose of the outlay by the taxpayer. The question of deductibility of expenses must be considered from the standpoint of the taxpayer and its operations, as a practical matter. In Gold Bar Developments Ltd. v. The Queen, [1987] 1 C.T.C. 262, 87 D.T.C. 5152 (F.C.T.D.), Jerome, A.C.J. made the following comments in this regard, at page 264 (D.T.C. 5153):

What was in the mind of the taxpayer in formulating the decision to spend this money at this time? Was it to improve the capital asset, to make it different, to make it better? That kind of decision involves a very important elective component—a choice or option which is not present in the genuine repair Crisis.

A third consideration which has frequently influenced the courts is the magnitude of the expenditure in question in relation to the value of the asset as a whole. In Thompson Construction (Chemong) Ltd. v. M.N.R., [1957] C.T.C. 155, 57 D.T.C. 1114, the taxpayer replaced the engine in a power shovel and deducted the net cost of the engine from its income as operating expense. The Exchequer Court, in disallowing the deduction, was influenced by the magnitude of the outlay for the new engine in relation to the depreciated value of the power shovel as a whole. The same reasoning was applied in M.N.R. v. Vancouver Tugboat Company Ltd., [1957] C.T.C. 178, 57 D.T.C. 1126. In that case the taxpayer installed a new engine in one of its tugboats, the cost of which was included as part of its expenses for the year. The Court compared the normal amount of a year's repair to the tugboat ($10,000) with the expenditure made by the taxpayer to replace the engine ($42,000), and concluded that the expenditure was for the purpose of replacing a substantial portion of the capital asset rather than to renew some minor item by way of repair. The expenditure was therefore held to be an outlay on account of capital and not deductible from income.

A further consideration, which is related to the "once and for all versus continuous or recurring” criteria is the useful lifetime of the expenditure. In Damon Developments Ltd. v. M.N.R., [1988] 1 C.T.C. 2266, 88 D.T.C. 1129, the taxpayer was a corporation which owned and operated a hotel. It deducted as business expenses, outlays made in relation to the replacement of draperies and the replacement of washer and dryer equipment. The Minister reassessed the taxpayer's business expense outlays as capital expenditures. The Court found that the items of equipment replaced were not distinct capital assets but were part of larger assets used to produce income from the hotel operation. Brulé, T.C.C.J., concluded that the useful lifetime of the items replaced could not be considered "enduring", having regard to the nature of the taxpayer's operations. He stated, at page 2269 (D.T.C. 1130):

In the present case, the equipment was purchased to replace similar items used in the operation of a hotel business. Because of the nature of the business, the case before us must be distinguished from that of M.N.R. v. Hadden Hall Realty, supra. The replacement of such items as drapes must, because of the type of business, occur at a different rate than that of similar items in an apartment rental business. Appliances have shorter useful lives when used in the operation of a hotel business than when used by tenants in an apartment building.

It is clear from the evidence presented by the appellant that expenditures for the hotel such as the replacement of drapes, washers and dryers occur regularly at relatively short intervals and are therefore made to "meet a continuous demand for expenditures”. The evidence given by the appellant also indicates that the items were purchased to replace similar items and did not constitute "something that is essentially different in kind”. The purpose was not to bring in a capital asset.

[Emphasis added.]

Finally, the jurisprudence has established that it is the nature of the advantage to be gained which, more than any other aspect of an individual case will be determinative of the proper characterization of the expenditure as one of capital or of revenue expense. In Oxford Shopping Centres Ltd. v. The Queen, [1980] C.T.C. 7, 79 D.T.C. 5458 (F.C.T.D.), the taxpayer operated a shopping centre. Arrangements were made with the local municipality whereby the municipality agreed to improve roadways to ease traffic congestion and provide better access to the taxpayer's property. The taxpayer paid a lump sum to the municipality in lieu of any local improvement rates and taxes which might otherwise have been payable. The Minister disallowed deduction of the amount as a business expense, arguing that the expenditure represented a capital outlay. Thurlow, A.C.J. allowed the taxpayer's appeal on the grounds that the amount was related to the business as a whole rather than to the physical premises. From a practical and business point of view, the Court found that the payment resembled an expenditure on income account rather than a capital expenditure. His Lordship made the following observations, at page 14 (D.T.C. 5463):

That the payments viewed by themselves were in a sense made once and for all is apparent. But so is almost any item which in isolation may be somewhat unusual in one way or another. That the advantage, whatever it was, was expected to be of a lasting or more or less permanent nature is also apparent. This is perhaps the strongest feature suggesting that the expenditure was capital in nature. . . . In the test of "what the expenditure is calculated to effect from a practical and business point of view" such features, while carrying weight, are not conclusive.

For if, as I think, the expenditure can and should be regarded as having been laid out as a means of maintaining, and perhaps enhancing, the popularity of the shopping centre with the tenants' customers as a place to shop and of enabling the shopping centre to meet the competition of other shopping centres, while at the same time avoiding the imposition of taxes for street improvements, the expenditure can, as it seems to me, be regarded as a revenue expense notwithstanding the once and for all nature of the payment or the more or less long-term character of the advantage to be gained by making it.

Applying these legal principles to the facts of the present appeal, I am satisfied that the expenditure made by the plaintiff in its acquisition of conver- sion kits constitutes a revenue expense and is not prohibited from being deducted as such under paragraph 18(1)(b) of the Income Tax Act.

First, there is no question in my mind that the plaintiff, in order to survive in the competitive business of supplying amusement machines, is required to incur the expense of purchasing these conversion kits on a recurring and regular basis. The evidence is conclusive that video games simply do not enjoy a long revenue-lifetime because of the speed with which players become adept at or tire of them. The installation of a new circuit board into a dedicated game is not a“ "once and for all” measure; it must be done on a continual basis at short intervals in order to meet the continuing demand for new games.

Second, the advantage which the plaintiff realizes from its expenditure on the conversion kits is temporary or passing in nature. The fact is that six to eight months after the installation of a kit into a machine, the revenue earning capacity of that machine declines to the same level as if the kit had never been installed. Clearly, the plaintiff only realizes a short-term gain from the installation of a new circuit board in two respects. One, the profit gain is of a relatively brief duration and two, the competitive edge which a kit will afford to the plaintiff's operations is by no means enduring. If new games are not provided to consumers on a continual basis, the plaintiff's revenues would eventually decline to perilous levels.

Third, if one examines the cost of the conversion kit in relation to the value of the dedicated machine as a whole, it is apparent that the expenditure was not made by the plaintiff for the purpose of replacing a substantial portion of the capital asset but rather to renew some relatively minor item. The defendant's submission is that the circuit board, for all intents and purposes, is the whole of the machine. I cannot agree. Obviously, when a video game operator purchased a dedicated machine in 1983 for a cost of approximately $4,500, it was paying for a great deal more than simply a circuit board, which in the form of a conversion kit carried an average cost of $750. It cannot be ignored that the capital asset in question here is the machine in its entirety, including the wooden cabinet, the electronic components, the control panel, the video monitor and the coin box. In relative comparison to the value of the machine as a whole, the cost of replacing the circuit board, which is the effect of installing a conversion kit, cannot be seen as a major expenditure.

As to the fourth criteria, the useful lifetime of the expenditure, it is clear that the conversion kits enjoy a limited one for the same reasons that their advantage is only temporary in nature. Circuit boards, which it must be remembered are the main component of a conversion kit, are generally discarded once they are removed from a machine. The lifetime of the video game contained therein is, by that time, essentially over. Because of the nature of the plaintiff's business, the replacement of video games necessarily occurs at regular intervals. The purpose of the expenditure in this case cannot be seen, from the taxpayer's point of view, as being made for the purpose of improving the capital asset. In order to maintain a competitive edge in the industry, the plaintiff did not have any choice but to provide new games to consumers. In this light, the installation of a conversion kit for the purpose of providing a new game was not a matter of choice but rather of necessity. The only elective decision which the plaintiff made was in relation to which machine would be chosen to receive the new circuit board and to which location the machine containing the new game would be transported.

Finally, what was the nature of the advantage to be gained by the plaintiff in buying the conversion kits? In my opinion, the expenditure can and should be regarded as having been made as a means of maintaining and enhancing the popularity of the plaintiffs arcades as well as the other locations it serviced, while at the same time avoiding the cost of a new machine. The plaintiff's objective was to preserve the income earning capacity of the machines it owned by making them more attractive to consumers. To the extent that this is the essence of the plaintiff's business, the expenditure can only be seen as a revenue expense.

The premise of the defendant's position here, is that the installation of a conversion kit provided the plaintiff with a new machine and therefore its cost constitutes an outlay on account of capital. That reasoning, in my view, is erroneous because it fails to make any distinction between the video game machine and the video game which it contains. As previously stated the capital asset in question is the machine in its entirety, not the video game which it contains. By using the kits the plaintiff is not creating a new machine. A machine into which a conversion kit has been installed is the same machine but with a new circuit board. The fact that the video game is new does not have the effect of creating a new capital asset as contended by the defendant. The essential elements of the machine, that is, the cabinet, the electronic components, the video monitor, the control panel and the coin box for which the plaintiff initially paid $4,500 remains unchanged. The only alteration is the circuit board at a relatively modest cost in 1983 of $750.

For these reasons, the plaintiff's appeal is allowed with costs.

Appeal allowed.