Rapistan Canada Limited v. Minister of National Revenue, [1973] CTC 393, 73 DTC 5316

Gibson, J:—The appellant, a Canadian corporation, obtained certain intangible assets from The Rapids-Standard Company Inc, of Grand Rapids, Michigan, hereinafter called “the US company” by a so-called Deed of Gift, which assets the appellant, after acquisition, put a value on of $500,000. The $500,000 was not a negotiated price but a value arbitrarily and unilaterally put on these assets for corporate and tax purposes. The appellant reflected this value in its books by journal entry debiting intangible assets and crediting contributed surplus with $500,000.

In computing its income from 1957 to 1968, the appellant claimed capital cost allowances under paragraph 11(1)(a) of the Income Tax Act and Part XI of the Income Tax Regulations in respect to these intangible assets on the basis that they were depreciable property of the type listed in Class 14 of Schedule B to the Income Tax Regulations based on a capital cost of $500,000. In the first fiscal period, which was only a part-year, the appellant claimed $41,667, in the following years to 1967, $50,000 and the balance in 1968. Because the appellant had losses until 1966, no practical monetary taxable issue arose until the subject taxation years 1966, 1967 and 1968. By that time, the appellant, had made substantial profits and because of the carrying forward of losses, the right to amortize the said intangible assets by claiming capital cost allowance became relevant in a practical way for the first time.

The appeal concerns three income tax reassessments each dated February 24, 1970 by which the following amounts were levied in respect of income for the taxation years of the appellant 1966, 1967 and 1968, that is to say:

The appellant was incorporated under the laws of Canada on January 21, 1957 and carries on business in Metropolitan Toronto as a manufacturer and distributor of conveyor systems under a license from the US Company.

Prior to 1968, these conveyor systems were not manufactured in Canada, but instead a Canadian company by the name of Specialty Manufacturing and Distributing Company Limited, hereinafter called “Specialty”, acted as the Canadian distributor for the US Company.

In 1956, the US Company approached and subsequently entered into a transaction with Specialty as a result of which the appellant company was incorporated as a result of which Specialty obtained a 51% equity share interest and the US Company a 49% equity share interest in the appellant. The mechanics for implementing this agreement and activating the appellant as pleaded were as follows:

(a) Under a written agreement dated January 31, 1957, Specialty sold its whale business as a going concern to the Appellant in consideration of the sum of $125,784, which was then offset against the issue price of 600 5% non-cumulative preferred shares, of the par value of $100 each, and 65,784 common shares, of the par value of $1 each, being the only shares of the Appellant which were then outstanding. The total sale price of $125,784 was determined on the basis of the net book value of the business of Specialty as of the date of sale plus an arbitrary amount of $60,000 for goodwill.

(b) The US Company then subscribed for and was issued 63,204 common shares of the Appellant, thereby acquiring 49% of the equity share interest, and in consideration therefor it paid the Appellant $63,204 in cash and, as part of the same transaction, under a deed dated February 1, 1957, (called a “Deed of Gift’, Exhibit 1E) the US Company granted to the Appellant, without further consideration, the right to hold and enjoy for a term of 10 years (subject to earlier termination in certain events which are not relevant in these proceedings) all of its manufacturing, engineering production, management and sales know-how, techniques, skills and experience, together with all of its blueprints and designs and franchises, rights and licences, limited to and exclusive in Canada,

(i) To manufacture or assemble and to market the full range of RAPISTAN products;

(ii) To use all RAPISTAN product designs and applications, productions, Sales and marketing data, methods and techniques, bibliography, library, field reports, sales aids and data;

(ill) To use the existing RAPISTAN developed Canadian sales organizations;

(iv) To use all RAPISTAN trade names, trade marks, registered or unregistered, including the right to use future acquired trade names and trade marks, and to become a registered user of the Canadian registered trade marks;

(v) To use and practice the arts disclosed in all RAPISTAN patents and applications for patents.

This Deed of Gift (Exhibit 1E) the appellant submits, represented “existing rights” as of February 1, 1957.

In addition, at the same time, the appellant entered into two other agreements with the US Company called respectively a “Service Agreement” (Exhibit 1F) and an “Internal Management Agreement” (Exhibit 2).

The appellant submitted that the Service Agreement referred to “ongoing rights”, and in evidence the so-called Internal Management Agreement was not necessary.

Prior to entering into these agreements and in particular the Deed of Gift, the US Company obtained a US Internal Revenue advanced tax ruling that the transfer of these intangible assets as set out in the Deed of Gift from the US Company to the appellant would not attract United States capital gain tax and would be a non-taxable transaction under section 351 of the 1954 US Code. At the time these intangible assets detailed in the Deed of Gift appeared on the balance sheet of the US Company at $1.00.

Subsequently to that, in October 1957, the directors of the appellant unilaterally and without independent valuation and as stated for corporate and tax purposes, fixed a value on these intangible assets in the Deed of Gift at $500,000, and made the journal entry above referred to reflect the $500,000 on the assets and liabilities side of its balance sheet.

The appellant in evidence gave details of the sale in 1962 of the share interest of one Geddes in the appellant company (which Geddes owned through Specialty by reason of the fact that Geddes owned 41% of the equity shares of Specialty and Specialty in turn owned 51% of the equity shares of the appellant). This sale was for $32,000. At that time, the unamortized value of the said intangible assets of the Deed of Gift were shown on the balance sheet of the appellant at $233,333. From this evidence, the appellant sought to prove that the Geddes shares had no value if this unamortized value of these intangible assets and goodwill of $60,000 on the balance sheet were not real asseis.

The appellant also called an independent valuator who gave evidence of the value of these intangible assets in 1957 at the time of the Deed of Gift. He made his valuation in 1972. With certain caveats and qualifications and after outlining the great difficulty normally, and especially in this case, of putting a market value on these intangible assets, he expressed the opinion that they had a market value in 1957 of $500,000.

The appellant in its pleadings claims: ..

1. The Appellant claims that by virtue of Section 20(6)(c) of the Income Tax Act it is entitled to claim capital cost allowances under Section 11 (1)(a) of the Income Tax Act and Section 1100(1)(c) of the Income Tax Regulations in respect of the value of the rights to use the patents, franchises and trade marks which it acquired from The Rapids-Standard Company Inc by way of gift in 1957, and that the value of the said rights was Five Hundred Thousand Dollars ($500,000) at the time of such gift.

2. In the alternative, the Appellant claims that, if it cannot be considered as having acquired the rights to use the said patents, franchises and trade marks by way of gift, the commercial and legal effect of the 1957 transactions in their entirety must be considered. Accordingly, the 63,204 common shares which were allotted and issued on March 20, 1957 to The Rapids- Standard. Company Inc must be treated as having been issued. for a total consideration of Five Hundred and Sixty-Three Thousand, Two Hundred and Four Dollars ($563,204), of which Sixty-Three Thousand, Two Hundred and Four Dollars ($63,204) was paid in cash and Five Hundred Thousand Dollars ($500,000) in the form of a conveyance of the rights to use the said patents, franchises and trade marks. Consequently, the Appellant is entitled to claim capital cost allowances in respect of the said rights, as assets under Class 14 of Schedule B, under Regulation 1100(1)(c) and Section 11(1)(a) of the Income Tax Act, at the maximum rate of Fifty Thousand Dollars ($50,000) per year.

The submission of the appellant was put in this way:

1. All the 1957 Agreements are part of a single transaction and must be interpreted together (Ottawa Valley Power Company v MNR, [1970] SCR; 70 DTC 6223; [1970] CTC 305 (SCC), affirming [1969] 2 Ex CR 64; 69 DTC 5166; [1969] CTC 242). -

2. The Deed of Gift and Service Agreement are distinct in that the former relates to the existing technology and know-how, and the latter provides for the use of future technology on the basis of sharing expenses through a royalty which was less than the royalties charged to other licensees.

3. The Appellant obviously received something over and above what it had to pay pursuant to the Service Agreement. These can be regarded in either of two ways:

(a) The Appellant had acquired a gift; or

(b) The consideration which the US corporation paid for its 49% interest in the Appellant consisted not only of $63,204 in cash, but also included the rights to use the existing technology which it transferred to the Appellant.

4. If the rights were acquired by a gift, Section 20(6)(c) applies and they are deemed to have been acquired at a cost equal to the fair market value at the time of the gift (J Bert MacDonald & Sons Limited v MNR, [1970] Ex CR 230; [1970] CTC 17; 70 DTC 6032; Ridge Securities Limited v CIR, [1964] 1 All ER 275; 44 TC 373; Petrotim Securities Limited v Ayres 41 TC 389; Jacgilden (Weston Hall) Limited v CIR, [1969] 3 All ER 1110; 45 TC 685).

These rights fall within Class 14 of Schedule B of the Income Tax Regulations. Therefore, the Appellant is entitled to claim capital cost allowances in respect of the deemed cost of these rights over their lifetime (ten years) pursuant to Section 11(1)(a) of the Income Tax Act and Section 1100(1) of the Income Tax Regulations (Capital Management Limited v MNR, [1968] SCR 213; 68 DTC 5041; [1968] CTC 29 (SCC), affirming [1967] 2 Ex CR 84; 67 DTC 5103; [1967] CTC 150; The Investors Group v MNR, [1965] Ex CR 520; 65 DTC 5120; [1965] CTC 192).

5. Alternatively, it may perhaps be considered that corporations which deal with each other at arm’s length cannot confer gifts on one another, but the overall business transaction must be considered (Ottawa Valley Power Company v MNR, [1970] SCR; 70 DTC 6223; [1970] CTC 305 (SCC), affirming [1969] 2 Ex CR 64; DTC 5166; [1969] CTC 242).

Therefore, in order to obtain a 49% interest in the Appellant, the US corporation had to pay $63,204 and also to assign certain valuable rights to the Appellant.

6. The cost of the property acquired by the Appellant was the fair market value of the 63,204 common shares issued to the US corporation less the $63,204 paid in cash (Osborne v Steel Barrel Co Limited, [1942] 1 All ER 634; 24 TC 293).

7. The Appellant recorded the intangibles as having been acquired for $500,000 and it treated this amount as offset by a credit of $500,000 of contributed surplus. This accounting treatment is consistent with a finding that the capital cost of the intangibles was $500,000. Tuxedo Holding Limited v MNR, [1959] CTC 172; 59 DTC 1102; [1959] Ex CR 390; J Bert MacDonald & Sons Limited v MNR, [1970] CTC 17; 70 DTC 6032; [1970] Ex CR 230; Craddock v Zevo Finance Co Limited, 27 TC 267).

8. Whether these rights were acquired by gift or as part of the overall business transaction, their fair market value can be amortized as an asset falling within Class 14 of Schedule B of the Income Tax Regulations.

9. Determining the fair market value of the intangibles acquired in 1957 involves difficult valuation problems, but they are not insurmountable.

The expert evidence reveals that:

(a) The parties made a conscious effort in 1957 to arrive at a fair valuation.

(b) They had good reason to expect that the merger of the Canadian operations of Specialty Manufacturing and the US corporation would lead to a substantial volume of sales, ($1.2 million in five years and much

more by the end of ten years);

(c) The Appellant had to share the cost of research and development through a 2% charge, but it did not have to pay for the benefit of the existing technology, although other licensees paid approximately 5% for both;

(d) Mr Geddes sold his interest in 1962, at a price which must have attributed substantial value to the intangibles.

The submission of the respondent in part was as follows:

In order to succeed, the appellant because of paragraph 11(1)(a)* [1] of the Income Tax Act, must establish (1) that a “cost” was incurred by it as a taxpayer, and (2) that the subject matter was “property”, and has failed to establish either, in that paragraph 20(6)(c)t of the Act does not apply to the appellant’s situation because in the circumstances there can be no “gift” between two corporations, the word “gift” in this subsection being used ejusdem generis with the words “bequest” or “inheritance”; and in that the subject property is not within Class 14 of the said Regulations^ [2] or at best, only some items are depreciable and it is impossible to determine which.

In addition, the subject matter of the “Service Agreement” and the “Internal Management Agreement” and the “Deed of Gift” each overlap the other, or if not completely, then partially.

Also, all of the value of the intangibles in the so-called Deed of Gift is either goodwill and therefore not depreciable, or any value arising out of their acquisition arises because their acquisition constituted an implied covenant of the US Company not to compete in the Canadian market.

In my view, it is not necessary in this case to decide a number of matters, as for example, whether or not these intangible assets constituted “property” within the meaning of Class 14 of Schedule B to the Income Tax. Regulations, whether or not they constituted a “franchise or concession or licence for a limited period” within the meaning of said class, or whether or not certain items in the three agreements, the Deed of Gift (Exhibit 1E), the Service Agreement (Exhibit 1F) and the Internal Management Agreement (Exhibit 2) overlap partially or totally; or to express any view as to the quantum or relevancy of the opinion as to 1957 market value of the intangible assets listed in the Deed of Gift (Exhibit 1E).

Instead, on the premise that the job of both the appellant and the US Company at all material times was to make a profit, it is necessary only in the determination of the issues in this case to examine the circumstances surrounding the transfer of these intangible assets to the appellant by the US Company.

At the material time when the appellant was incorporated and the Said transactions entered into by it with the US Company and also with Specialty, in order to activate the appellant, both the US Company and Specialty each got what each wanted. Specialty received $60,000 of preferred shares for alleged goodwill and 51% of the equity share interest of the appellant, and the US Company received 49% of the equity share interest of the appellant on the basis of paying $63,204 and the transfer of the so-called intangible assets for ten years by Deed of Gift and the benefits of the Service Agreement and the Internal Management Agreement.

After completion of transactions, the appellant was activated, and at that time it was the intention and hope of Specialty and the US Company that the appellant would make profits which thereby would increase the value of their respective equity share interest in the appellant.

Only later, as stated, in October 1957, did the appellant unilaterally and for corporate and tax purposes, write up these intangible assets of the Deed of Gift (Exhibit 1E) to $500,000 by journal entry as described. In doing so it purported to change the original implemented transactions and intention of the parties.

In my view, the decision in this case is one of fact. The transactions speak for themselves and the whole of all the arrangements in February 1957 must be looked at.

At that time, as stated, the US Company and Specialty each got what each wanted. in doing what it did, Specialty intended to benefit through its preferred and equity share interest in the appellant if the appellant made profits, and the US Company intended to benefit through its equity share interest in the appellant and through its three contracts with the appellant, all three of which contracts were interrelated and inseparable, namely, the so-called Deed of Gift, the Service Agreement and the Internal Management Agreement.

At the time, also, it was the intention that the appellant as a part of the whole of these transactions, would have the benefit and burden of the said three contracts. What benefit the appellant was to receive and did receive was by way of contract and not by way of acquisition of any capital assets.

As a matter of fact, therefore, in my view, there was no gift of these intangible assets listed in the so-called Deed of Gift (Exhibit 1E) by the US Company to the appellant, nor were they part of the consideration to the extent of $500,000 by which the US Company acquired a 51% equity share interest in the appellant in February 1957.

The appeal is therefore dismissed with costs.