MNR v. M.P. Drilling Ltd., 76 DTC 6028, [1976] CTC 58 (FCA)

Urie, J (concurred in by Ryan, J):—This is an appeal from a judgment of the Trial Division in which the respondent’s appeal from the appellant’s income tax assessments for the 1967 and 1968 taxation years was allowed and the assessments were set aside and referred back to the appellant for reassessment. The issue to be decided on the appeal is whether or not the learned trial judge erred in holding that in computing the loss from the respondent’s business for its 1964, 1965 and 1966 taxation years it was entitled to charge off as expense the expenditures it had incurred in those years in endeavouring to acquire liquified petroleum gases and market them in the so-called Pacific rim countries and to carry forward the losses thus incurred to be deducted in the computation of its taxable income in the 1967 and 1968 taxation years.

The factual background leading to the assessments in question is set forth sufficiently in the following excerpts from the Reasons. for Judgment of the learned trial judge.

The appellant Is a corporation Incorporated on September 30, 1963, under the Alberta Companies Act for the primary purpose of carrying on the business of marketing liquified petroleum gases in the Pacific Northwest, Hawaii, Japan and the Far East.

The result of the operations of the appellant were as follows: In 1964 a loss of $48,506.00; in 1965 a loss of $293,819.00; and in 1966 a loss of $64,502.00. It claims that with the exception of the sum of $17,520.00 paid for legal fees in 1965, all of these losses are deductible from subsequent profits. In 1966 It decided that the plan to market gas was not feasible and it commenced the operation of contract drilling which was within its corporate powers, and it has since then carried on this enterprise profitably.

The Minister has disallowed these deductions and has assessed income taxes and interest with respect to them on the ground that the expenditures which resulted In the losses in the three years in question were expended on capital account. . . .

The plan to market liquid petroleum gases originated with Mr G A Van Wielingen, a chemical engineer employed in Calgary by J C Sproule and Associates Ltd, oil and gas engineering and geological consultants. He came to the conclusion that a large quantity of these gases, such as propane and butane, could be produced from Alberta oil if a market could be developed for it in Japan, Korea, Taiwan, Hawaii and the Pacific Northwest of the United States. He convinced a successful oil driller, Mr V (sic) W Bawden, of the feasibility of the plan, and the latter incorporated Mountain Pacific Pipeline Ltd for the purpose of carrying on this marketing plan. The corporate name was later changed on July 16, 1969 to M P Drilling Ltd. Mr G A Van Wielingen joined the company as Vice-President and General Manager In August, 1964, and during the remainder of that year and during 1965 he and Mr V W Bawden devoted their efforts and expended money to bring their marketing plan to a successful conclusion. By the end of 1965 it became apparent that the plan would not succeed and Mr Van Wielingen left the company and Mr Bawden made use of the power of the company to drill for oil to operate in this business which has been very profitable.

The successful marketing of liquid petroleum gas involved many difficult problems: arranging the supply with the producing oil companies; creating extraction plants; gathering the gas and transporting it to seaboard by pipeline or other means; obtaining permits for its export from the National Energy Board and the two provinces, Alberta and British Columbia; constructing refrigerated storage and loading facilities at the west coast; acquiring or chartering refrigerated tankers to transport the gas overseas and, finally, negotiating firm contracts with overseas buyers.

A large part of the expense was for expert analysis and feasibility studies, primarily to convince the Alberta oil producers, the overseas buyers, the Officials of the three governments concerned, and financial interests, that the plan was sound and potentially profitable. Many firms were hired to conduct research, but the two largest were J C Sproule and Associates, which was paid $71,912.00, and Bechtel Corporation of California, which was paid $93,368.00. Mr Bawden and Mr Van Wielingen spent several months In Japan trying to interest potential buyers, and conducted negotiations with buyers in other parts of the world and with the Alberta oil producers. As a first step in solving the problem of transporting the gas, they arranged to have a company incorporated by Special Act of the Parliament of Canada, with the same name as the Alberta company, Mountain Pacific Pipeline Ltd. . ..

The only witness at the trial was Mr Van Wielingen. He testified that Mr Bawden had formed the appellant company to market liquid petroleum gas, and all his activities, and those of Mr Bawden, in relation to this marketing plan, were carried out through the agency of this company. Counsel for the respondent did not contend that the sums in question had not been paid, so if =l believe the evidence of Mr Van Wielingen, I must hold that it was the appellant company which incurred these expenses. I believe that Mr Van Wielingen was a truthful witness and his evidence on this point is corroborated by the numerous exhibits filed, so I hold as a fact that the items of expense set out in paragraph 8 of the Notice of Appeal were incurred by or on behalf of the appellant. It is immaterial that Mr Bawden actually provided the money since he was the owner of the company and was providing all its finances.

Counsel for the appellant took the position, firstly, that the payments made were not expenditures, outlays or expense made or incurred by the respondent for the purpose of gaining or producing income from its business within the meaning of paragraph 12(1)(a)* [1] of the Income Tax Act as it read during the taxation years in question, but were payments on account of capital and thus were not deductible because of the prohibition contained in paragraph 12(1)(b)* of the Act.

secondly, he argued that since the project never produced any revenue during the period in which the expenditures were incurred, they were not deductible bcause there was no revenue to the earning of which those expenditures might be attributable.

Counsel for each of the parties carefully and thoroughly reviewed the leading authorities on the perplexing problem of determining whether in a particular case an expenditure is of a capital or revenue nature. The main principle to be discovered from those authorities was succinctly expressed by Fauteux, J, as he then was, in MNR v Algoma Central Railway, [1968] SCR 447; [1968] CTC 161; 68 DTC 5096, at p 449 [162, 5097]:

Parliament did not define the expressions “outlay . . . of capital” or “payment on account of capital’. There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia ([1966] AC 224, [1965] 3 All ER 209) by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said, at p 264:

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.

From that base, then, it becomes useful to define generally the distinction between revenue expenditures and capital expenditures and in that regard I find the views of Jackett, P, as he then was, in Canada Starch Company Limited v MNR, [1968] CTC 466; 68 DTC 5320, at p 471 [5323] most helpful:

For the purpose of the particular problem raised by this appeal, 1 find it helpful to refer to the comment on the “distinction between expenditure and outgoings on revenue account and on capital account” made by Dixon, J in Sun Newspapers Ltd et al v The Federal Commissioner of Taxation (1938), 61 CLR 337 at page 359, where he said:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

In other words, as I understand it, gentrally speaking,

(a) on the one hand, 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

(b) on the other hand, an expenditure in the process of operation of a profit-making entity, structure or organization is an expenditure on revenue account.

Applying this test to the acquisition or creation of ordinary property constituting the business structure as originally created, or an addition thereto, there is no difficulty. Plant and machinery are capital assets and moneys paid for them are moneys paid on account of capital whether they are

(a) moneys paid in the course of putting together a new business structure,

(b) moneys paid for an addition to a business structure already in existence, or

(c) moneys paid to acquire an existing business structure.

As I understand it, it is basic to the appellant’s submissions that the expenditures incurred by the respondent in 1964, 1965 and 1966 were for the purpose of creating or acquiring a business structure. In appellant counsel’s submission its activities during those years were preparatory to or for the initiation of a business and were not outlays made for the purpose of gaining or producing income from a business. If this submission were accepted the payments would have been on account of capital, falling within paragraph (a) of Jackett, C J’s test propounded in the Canada Starch case (supra).

In my view this argument does not withstand scrutiny in that it ignores the fact that the business structure per se came into existence in late September when the respondent commenced its business operations by continuing the marketing negotiations, supply negotiations and technical studies through its consultants until June of 1964 when it opened its own office and engaged the services of its first employees, utilizing for such purposes funds advanced by its principal, Mr Bawden, or other companies controlled by him.

It also ignores the fact that in the early summer of 1964 Mr Van Wielingen joined the respondent as a full time general manager and chief operational officer. His duties at that time were, according to his testimony, firstly, to develop a market for the product, secondly, to negotiate with actual and potential suppliers of liquid petroleum gases and, thirdly, to consider the technical aspects of production, storage, transportation and the like.

In short, the company was then in existence and was engaged in doing the normal things that any new business must do to bring its wares to the market place, hopefully with profitable results. As I see it, this business activity falls within paragraph (b) of Jackett, C J’s test in the Canada Starch case (supra). Not to characterize such activity under this head is to ignore the commercial reality of the situation, which was that the respondent’s efforts at all times were directed to bring products it expected (by negotiation) to be able to acquire, to users who, through the promotional efforts of the respondent’s officers, indicated that they would be interested in becoming purchasers thereof. Negotiations proceeded with some twelve suppliers and the same number of potential foreign customers culminating in expressions of intent from some of each. The permanent structure, the market and the products all existed and the efforts of the respondent were directed to bringing them together with a resultant profit to it. The desired result was never accomplished and that part of the respondent’s business had to be abandoned although it continued in operation in the drilling business with profitable results. But the abandonment caused no transformation of the expenditures made in an effort to achieve profitability into expenditures capital in nature.

In reaching this conclusion, it is not without significance, I think, to note that the appellant made no distinction, apparently either at trial and certainly not during the argument on the appeal, between the various kinds of expenditure for which deductibility was sought. In my view, while some were clearly made in the income earning process such as, for example, expenses incurred during the negotiations of the various contracts for the supply and sale of gas, others did not so readily fall within that category. Counsel took the position that, in substance, all of the expenditures were for a like purpose, ie to ascertain the feasibility of going into the business of purchase and sale of liquified natural gas to certain Pacific rim countries and this was so. whether the work involved in such studies was carried out by the respondent’s own personnel or by outside consultants. He argued that none were made as part of the operation of the profit earning process of an existing business but were made as part of the formation of the structure necessary to engage in that process.

In my opinion, that argument is not supported by the evidence and, in fact, there is evidence which points in the opposite direction. Not the least important of that kind of evidence was the fact that negotiations undertaken by the respondent’s officers had culminated in some expressions of intent by potential customers to buy the gas and some by producers of the gas to sell it to the respondent for the purpose of resale. Quite clearly then, the respondent was in fact in business and was not simply bringing the business into existence. No particular expenditures were drawn to our attention to enable us to reach a conclusion that any one or more of them could be characterized as capital expenses while others might fall solely into the category of revenue expenses. I have no reason, therefore, to alter the view which I have previously expressed that all must be held to have been incurred for the purpose of earning income and accordingly were properly deductible in the years in which they were incurred.

It was then argued that there must be revenue before any deduction can be made for expenses which might otherwise properly be deductible as made for the purpose of earning income. I cannot agree that because the respondent had not generated any revenue, let alone profit, makes it any less "the process of operation of a profit making entity”. Nor does the fact that no revenues were generated from the activity transform what would have been deductible outlays for the purpose of gaining income, had there been any revenue, into expenditures made for the acquisition or creation of a business entity, or, to put it in the way earlier cases have put it, to bring into existence an asset or advantage of an enduring benefit of a trade*. [2]

In my opinion the short answer to the proposition advanced is that if the expenditures were made for the purpose of earning income and were not capital in nature and thus not rendered non-deductible by virtue of paragraph 12(1)(b) or by any other provision of the Act, they were proper expenses to be chargeable against income whether or not any income resulted from such expenditures. Thorson, P, in The Royal Trust Company v MNR, [1957] CTC 32; 57 DTC 1055, at p 42 [1060], put the proposition in this fashion:

. . . Thus, it may be stated categorically that in a case under the Income Tax Act the first matter to be determined in deciding whether an outlay or expense is outside the prohibition of Section 12(1)(a) of the Act is whether it was made or incurred by the taxpayer in accordance with the ordinary principles of commercial trading or well accepted principles of business practice. If it was not, that is the end of the matter. But if it was, then the outlay or expense is properly deductible unless it falls outside the expressed exception of Section 12(1)(a) and, therefore, within its. prohibition.

Again, at pages 43 and 44 [1061 and 1062] he continued:

There is a specific limitation in the exception expressed in Section 12(1)(a) on the kind of outlay or expense that may be deducted. It must have been made or incurred, in the case of a taxpayer engaged in a business, for the purpose of gaining or producing income from his business.

It is not necessary that the outlay or expense should have resulted in income. In Consolidated Textiles v MNR, [1947] Ex CR 77 at 81; [1947] CTC 63, I expressed the opinion that it was not a condition of the deductibility of a disbursement or expense that it should result in any particular income or that any income should be traceable to it and that it was never necessary to show a casual connection between an expenditure and a receipt. And I referred to Vallambrosa Rubber Co v CIR (1910), 47 SCLR 488 as authority for saying that an item of expenditure may be deductible in the year in which it is made although no profit results from it in such: year and to CIR v The Falkirk Iron Co Ltd (1933), 17 TC 625, as authority for saying that it may be deductible even if it is not productive of any profit at all. . . .

The essential limitation in the exception expressed in Section 12(1)(a) is that the outlay or expense should have been made by the taxpayer “for the purpose” of gaining or producing income “from the business”. It is the purpose of the outlay or expense that is emphasized but the purpose must be that of gaining or producing income “from the business” in which the taxpayer is engaged. If these conditions are met the fact that there may be no resulting income does not prevent the deductibility of the amount of the outlay or expense. Thus, in a case under the Income Tax Act if an outlay or expense is made or incurred by a taxpayer in accordance with the principles of commercial trading or accepted business practice and it is made or incurred for the purpose of gaining or producing income from his business its amount is deductible for income tax purposes.

I am in full agreement with this statement of the law with the result that the appellant’s second submission must be rejected.

The learned trial Judge relied on the judgment of Pigeon, J, speaking on behalf of the Court in MNR v Freud, [1969] SCR 75; [1968] CTC 438; 68 DTC 5279, in support of his judgment. It was argued by the appellant that that case had no application because the intention of the taxpayer, who through a company which he controlled had built prototype automobile, “was not to start a manufacturing operation but to interest a manufacturer to produce such a car”, while in this case it was not the intention of the respondent, as the appellant put it in its Memorandum of Fact and Law, that “this ‘scheme’ or idea would become part of their stock-in-trade to be resold at a profit whenever a suitable occasion should arise.” While I do not wish to be taken as agreeing with this submission, it is not necessary for me to express any opinion thereon since for the reasons heretofore given I am of the opinion that the trial judge correctly disposed of the appeal. However, the applicability of the following passage in Pigeon, J’s judgment to the circumstances of this. case and, indeed, all cases in which the question of the nature of an expenditure made is in issue, is unassailable and reinforces the view that the learned trial judge and I have taken in this case:

Such being the principles to be applied In cases when a profit is obtained, the same rules must be followed when a loss is suffered. Fairness to the taxpayers requires us to be very careful to avoid allowing profits to be taxed as income but losses treated as on account of capital and therefore not deductible from income when the situation is essentially the same.

I am of the opinion that both common sense and the commercial reality of the expenditures here in issue, lead irresistably to the conclusion that the judgment appealed from must be upheld.

I! would, accordingly, dismiss the appeal with costs.

MacKay, D J:—I agree with the reasons and conclusions of my brother Urie.