T-2393-75
The Queen (Plaintiff)
v.
H. Griffiths Company Limited (Defendant)
Trial Division, Dubé J.—Toronto, June 8; Ottawa,
June 18, 1976.
Income tax—Defendant establishing subsidiary mainly to
obtain competitive capability Purchasing much of its steel
elsewhere than from subsidiary—"G" personally and defend
ant company guaranteeing loans of $50,000 and $75,000 to
provide subsidiary with working capital—Defendant repaying
bank $75,000 on bankruptcy of subsidiary and attempting to
deduct $75,000 as expense incurred in producing income—
Income Tax Act, R.S.C. 1952, c. 148, s. 12(1).
Defendant established a subsidiary mainly to obtain the sheet
metal capability which it needed to compete in the field of
mechanical contracting. The subsidiary, while an "operating
arm", was a separate entity. In order to obtain "working
capital", loans were arranged. Griffiths personally guaranteed
one for $50,000, and defendant, the other, for $75,000. Upon
the bankruptcy of the subsidiary, defendant reimbursed the
bank the $75,000 and sought to deduct this amount under
section 12(1)(a) of the Income Tax Act as an expense incurred
for the purpose of producing income. The Minister assumed
that the sum was not an outlay or expense, but was overturned
by the Tax Review Board.
Held, allowing the appeal, this type of loan has been held to
be a "deferred loan", as the parent might some day have to
"step into the bank's shoes". The payment by the parent was
not made voluntarily to maintain the goodwill of strangers, but
to satisfy a legal obligation. Such outlay was made "with a view
of bringing into existence an advantage for the enduring bene
fit" of defendant's business. The establishment of the subsidi
ary was to ensure an adequate supply of sheet metal, a distinct
advantage. The guarantee was effected to provide working
capital so that the benefit could continue; the establishment of
the subsidiary was no "passing fancy". The repayment was thus
a capital outlay and not deductible under section 12(1).
D. J. MacDonald Sales Limited v. M.N.R. 56 DTC 481;
The Queen v. F. H. Jones Tobacco Sales Ltd. [1973] F.C.
825; Heap & Partners (Nfld.) Limited v. M.N.R. 66 DTC
772; L. Berman & Co. Ltd. v. M.N.R. 61 DTC 1150;
D.W.S. Corporation v. M.N.R. [1968] 2 Ex.C.R. 44;
Minas Basin Pulp & Power Company Limited v. M.N.R.
69 DTC 62 and Stewart & Morrison Limited v. M.N.R.
[1947] S.C.R. 477, discussed. M.N.R. v. Steer [1967]
S.C.R. 34; Algoma Central Railway v. M.N.R. [1967] 2
Ex.C.R. 88 and Canada Safeway Limited v. M.N.R.
[19571 S.C.R. 717, applied.
INCOME tax appeal.
COUNSEL:
R. B. Thomas and N. Helfield for plaintiff.
F. J. C. Newbould for defendant.
SOLICITORS:
Deputy Attorney General of Canada for
plaintiff.
Tilley, Carson & Findlay, Toronto, for
defendant.
The following are the reasons for judgment
rendered in English by
DuBÉ J.: The issue in this appeal is whether the
defendant taxpayer (hereinafter "Griffiths") in
computing its income for the 1971 taxation year is
entitled to deduct as an expense an amount of
$75,000 which it paid the Bank of Nova Scotia in
satisfaction of the guarantee it made in favour of
its subsidiary, Hartwil Sheet Metal (1967) Lim
ited (hereinafter "Hartwil") which went bankrupt.
The Minister acted on the assumption that the
sum was not an outlay or expense, the Tax Review
Board decided in favour of the taxpayer, now this
appeal by the Minister.
At all material times Griffiths carried on busi
ness as a mechanical contractor in Toronto, ten
dering for contracts involving plumbing, heating,
sprinkling, insulation, mostly with reference to
schools, hospitals and other institutions. A large
portion, up to fifty per cent, of its business consist
ed in the installation of sheet metal. Thus the
ability to secure and control a supply of sheet
metal at a relatively low price loomed very impor
tant in view of the very competitive market for
mechanical construction contracts in the Toronto
area. Most of the successful area competitors
already had their own sheet metal subsidiaries.
Thus in the fall of 1967 Griffiths caused Hart-
wil to be incorporated to purchase the assets of its
predecessor, Hartwil Sheet Metal Limited, which
consisted only of equipment and materials inven
tory. The purchase price of $20,000 for equipment
and $4,255.43 for materials on hand was to be
paid as follows: $14,255.43 on closing and the
balance of $10,000 within two years. (As it turned
out, the $10,000 balance was never paid). Hartwil
issued 2,000 voting shares at 10 cents each, with
Griffiths, the controlling shareholder, owning
1,598.
The owner of the former Hartwil, Andrew Hart-
man, stayed on as plant manager and chairman of
the Board of Hartwil. Robert Facey, at the time a
friend of Paul Griffiths, President and Chairman
of the Board of Griffiths, became President of
Hartwil. It should be noted at this stage that
Robert Facey engineered the purchase of Hartwil
and was later found guilty of defrauding the sub
sidiary. Hartman was also charged, but not
convicted.
Griffiths and Hartwil operated under one roof
with a common comptroller, but they had separate
offices, separate books, separate management and
separate employees. Griffiths purchased much of
its steel from Hartwil, but not all. Exhibit D-5,
covering the period from October 1, 1967 to
August 31, 1969, shows that Griffiths purchased
44% of its steel from Hartwil and 56% from other
sources. No documents were tabled to show a
breakdown of Hartwil's sales, but according to the
evidence of Paul Griffiths a greater volume of
Hartwil sales was made to other customers than to
Griffiths.
Paul Griffiths also stated that he had considered
making Hartwil a division of Griffiths but was
advised by his lawyers to incorporate a separate
company to limit liability "in view of the pitfalls of
the construction industry". He felt that with a
sheet metal subsidiary, Griffiths would be more
competitive, more secure, that "a better base cost
would help us put lower prices on our bids". In his
view Hartwil became "an operating arm to
Griffiths".
But financial troubles soon developed at the
subsidiary: there were strikes in the industry,
mechanics' lien holdbacks were slow coming in,
and President Facey was milking the treasury. As
Paul Griffiths put it, the subsidiary needed "tem-
porary working capital", so moneys were borrowed
from the bank, including a $50,000 loan guaran
teed by Paul Griffiths personally on November 28,
1969, and a $75,000 loan guaranteed by Griffiths
on December 22, 1969.
Even with the transfusion of funds, the subsidi
ary did not rally. The bad news broke out on
January 1, 1970 by way of a phone call from the
comptroller to Paul Griffiths. There were hurried
meetings with the auditors whose assessment of
the financial situation is now challenged in another
court by Griffiths. On February 16, 1970, a meet
ing of creditors bankrupted Hartwil and the
unsecured creditors remained unpaid.
Griffiths reimbursed the Bank of Nova Scotia
the guaranteed $75,000 in the course of the 1971
taxation year and attempted to deduct the amount
as an expense incurred for the purpose of produc
ing income under paragraph 12(1)(a) of the
Income Tax Act'. Subsection 12(1) reads as
follows:
12. (1) 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,
Thus if it is determined that the $75,000 repay
ment constituted an expense for producing income,
it is deductible. But if it constituted an outlay on
account of capital, it is not deductible.
R.S.C. 1952, c. 148.
A brief review of the leading cases provides
some guidelines to assist in making the
determination:
1. In D. J. MacDonald Sales Limited v.
M.N.R. 2 the Tax Appeal Board held that the
payment of a guaranteed note of one of its sup
pliers in order to ensure a continuing source of
supply was incurred for the purpose of producing
income, thus deductible. The supplier was not a
subsidiary.
2. In The Queen v. F. H. Jones Tobacco Sales
Co. Ltd.' the Federal Court found that the pay
ment of a guaranteed loan in favour of the compa-
ny's largest customer in exchange for the custom
er's undertaking to buy tobacco from it was an
operating loss incurred for the purpose of produc
ing income, thus deductible. Noël A.C.J. said [at
page 834] courts were inclined to consider "not so
much the legal aspect of the transaction, but
rather the practical and commercial aspects".
3. In Heap & Partners (Nfld.) Limited v.
M.N.R. 4 the Tax Appeal Board decided that pay
ments made by the parent company to cover guar
anteed loans to its subsidiary were made for pro
ducing income and were deductible. The Berman
cases was quoted as the authority for that decision.
4. In L. Berman & Co. Ltd. v. M.N.R. (supra)
the Exchequer Court held that the voluntary pay
ment of debts incurred by its subsidiary to sup
pliers was deductible because it was advantageous
for the parent company to maintain the goodwill of
its suppliers.
5. In M.N.R. v. Steer 6 , the Supreme Court of
Canada allowed an appeal from the Exchequer
Court and held that repayment of a guaranteed
loan for the drilling of three wells was a deferred
loan. Judson J. said [at page 37] that "the guaran
tee meant that at some time the respondent might
have to step into the bank's shoes to this extent".
2 56 DTC 481.
3 [1973] F.C. 825.
4 66 DTC 772.
5 61 DTC 1150.
6 [1967] S.C.R. 34.
The loss was held to be a loss of capital and the
deduction thereof prohibited.
6. In Algoma Central Railway v. M.N.R.', the
Exchequer Court held that the sum paid by a
railway for a survey of the volume of traffic in, an
unpopulated area was deductible as a current busi
ness expense. Jackett P., as he then was, said [at
page 92] the "usual test" whether such a payment
is one made on account of capital is "was it made
with a view of bringing into existence an advan
tage for the enduring benefit of the appellant's
business?" In a footnote at page 95 he referred to
the Canada Safeway case 8 and remarked: "There
can be expenditures that, in a broad sense, are
made to improve the position of the business and
that, nevertheless, do not escape the prohibition in
section 12(1)(a)".
7. In Canada Safeway Limited v. M.N.R.
(supra) the issue before the Supreme Court of
Canada reduced itself to the meaning of the phrase
in paragraph 5(1)(b) of the Income War Tax Act 9
"borrowed capital used in the business to earn the
income" which in turn depends on the scope of the
words "used in the business". Rand J. said [at
page 726] that "in the circumstances before us,
the interposition of a new and distinct capacity as
shareholder breaks the continuity of the company's
act as being in its own business" and further down
[at page 728] "the business of the subsidiary is not
that of the company".
8. In D.W.S. Corporation v. M.N.R. 1 o, Thurlow
J. of the Exchequer Court, now A.C.J. of the
Federal Court, relied on the Canada Safeway
decision (supra) to hold that the borrowed money
was not used for the purpose of earning income
[1967] 2 Ex.C.R. 88.
8 [1957] S.C.R. 717.
9 R.S.C. 1927, c. 97, as amended ss. 4, 5, 6.
83 [1968] 2 Ex.C.R. 44.
from the appellant's business within the meaning
of the Act.
9. In Minas Basin Pulp & Power Company
Limited v. M.N.R. ", the Tax Appeal Board held
that payment made on a guarantee on behalf of a
subsidiary could not in any way increase the
income receivable from the business of the appel
lant itself, thus not deductible. The subsidiary was
not wholly-owned and there was no intertwining of
the business operations.
10. In Stewart & Morrison Limited v.
M.N.R. 12 , the Supreme Court of Canada held that
money supplied by the parent company to an
American subsidiary which it "master-minded",
through a bank loan, in a losing cause, was an
outlay of a capital nature and not deductible.
Judson J. said [at page 479] the Court was not
concerned with "what the result would have been
if the appellant taxpayer had chosen to open its
own branch office in New York .... It financed a
subsidiary and lost its money".
Judson J. said the Berman case (supra) was not
in point, because in that case "the taxpayer made
voluntary payments to strangers, i.e., the suppliers
of its subsidiary, for the purpose of protecting its
own goodwill". He concluded at page 479:
The learned trial judge has correctly characterized these
dealings between the parent company and its American subsidi
ary. The parent company provided working capital to its sub
sidiary by way of loans. These loans were the only working
capital the American subsidiary ever had with the exception of
the sum of $1,000 invested by Stewart & Morrison Limited for
the acquisition of all of the issued share capital of its subsidi
ary. The money was lost and the losses were capital losses to
Stewart & Morrison Limited. The deduction of these losses has
been rightly found to be prohibited by s. 12(1)(b) of the Income
Tax Act.
As I appreciate the evidence in the case at bar
the parent company established a subsidiary
mainly to obtain the sheet metal capability which
it needed to compete in the field of mechanical
contracting. The subsidiary was meant to be an
"operating arm", but was also meant to be a
69 DTC 62.
12 [1974] S.C.R. 477.
separate legal entity to escape liability "in view of
the pitfalls in the construction industry". Much of
the parent's steel purchases were made elsewhere
and much of the subsidiary's sales went elsewhere.
Both worked under the same roof but were sepa
rate businesses.
The original source of capital emanating from
the sale of stock was minimal, $200 from 2,000
shares at ten cents each. The sales were expected
to generate sufficient operating capital, but did
not. Loans had to be obtained and had to be
guaranteed by Paul Griffiths personally and then
by Griffiths. The loans were described by Paul
Griffiths as "temporary working capital". This
type of guaranteed loan has been held by Judson J.
in the Steer case (supra) to be "deferred loan" as
the parent company might some day have to "step
into the bank's shoes" to the extent of the loan,
which is exactly what happened.
The payment of the loan by the parent company
was not made voluntarily to maintain the goodwill
of strangers, but had to be remitted to satisfy a
legal obligation to the Bank of Nova Scotia.
In my view, the outlay, or payment of the
guaranteed loan, or deferred loan, was made with
"a view of bringing into existence an advantage for
the enduring benefit" of Griffiths' business (See
Algoma Central Railway (supra)). When Grif-
fiths established the subsidiary it was "in view" of
securing a certain and permanent source of sheet
metal, admittedly a distinct advantage in a very
competitive field. When Griffiths guaranteed the
loan it was "in view" of advancing additional
working capital to enable Hartwil to continue pro
viding that distinct benefit and insure its endur
ance. As it turned out, the advantage did not in
fact endure, but it is quite clear that the establish
ment of the metal-producing subsidiary was not
meant to be a mere passing fancy.
It is not for me to decide what the result would
be if Griffiths had decided to annex Hartwil as a
branch of its operations. In any event the limited
liability feature of the incorporation turned out to
have been a very valuable shield protecting Grif-
fiths against the creditors of Hartwil, thus com
pensating to some degree for the lack of deducti-
bility afforded the $75,000 guarantee. Suffice it
for me to repeat Rand J.'s statement in the
Canada Safeway case (supra) that "the business
of the subsidiary is not that of the company".
In my view, therefore, the $75,000 repayment
constituted an outlay on account of capital and is
not deductible as an expense under subsection
12(1) of the Act.
It was agreed by counsel for both parties that
the counterclaim in respect of legal and trustee's
fees paid by the defendant in this matter during
the taxation year 1970 would follow the decision
on the main action.
It was also agreed that the amount of tax to be
paid as a result of the appeal would not exceed
$2,500 and that the defendant may claim costs
under subsection 178(2) of the Act.
The appeal is allowed.
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