Minister of National Revenue v. Stewart & Morrison Limited, [1970] CTC 431, [1970] DTC 6295

KERR, J.:—This is an appeal by the Minister of National Revenue from a decision of the Tax Appeal Board with respect to the Minister’s assessment of the respondent for income tax for its 1966 taxation year.

In determining its taxable income for that year the respondent deducted $72,348.14 as ‘ advances to New York office written off’’. The so-called New York office was Stewart & Morrison Inc. a wholly owned subsidiary of the respondent. The Minister disallowed the deduction. The respondent appealed to the Tax Appeal Board against the disallowance of the deduction and the Board allowed the appeal and referred the matter back to the Minister for re-assessment accordingly.

The respondent is a company incorporated under ‘the laws of the Province of Ontario. It is a firm of industrial designers. At all relevant times it was the beneficial owner of all the issued shares of its subsidiary, Stewart & Morrison Inc. This subsidiary was incorporated in December 1963 under the laws of the State of New York under the name Stewart Morrison Roberts Inc., subsequently changed to Stewart & Morrison Inc.

The respondent claims that its New York subsidiary was incorporated to serve as a branch office of the respondent and that the office in New York was a branch office of the respondent. In its Reply to Notice of Appeal it states, inter aha:

4. (c) Stewart & Morrison Inc. was incorporated as a branch of

the Respondent in order to emphasize to potential U.S. clients that the Respondent was in business in the U.S.A, and because the Respondent was aware of a reluctance of U.S. clients to deal with a “limited” company incorporated in a foreign jurisdiction;

(d) only a nominal amount of capital in the New York office was subscribed for by the Appellant as most of the financing of the New York office was to be provided by direct advances from the Respondent and bank loans guaranteed by the Respondent and one of its officers;

(e) the New York office did not prosper and eventually ceased operations in March of 1966. On June 30th, 1966, the New York office owed the Respondent $72,343.14 which debt was made up of funds which had been expended for operating expenses such as rent, salaries, travel expenses, etc. None of this amount was expended by the New York office on capital investment. Since it was obvious that no part of this amount could be recovered the whole amount of $72,343.14 was written off the books of the Respondent on the 30th day of June, 1966.

6. (a) the said amount of $72,343.14 represented expenses or disbursements

incurred or laid out by the Respondent for the purpose of gaining or producing income from property or a business of the Respondent;

(b) the funds advanced to the New York office were expenditures reasonably made by the Respondent as a business person for operating expenses of the New York office and for the purposes of gaining or producing income from a branch of its business operations;

(d) the New York office was incorporated for the purpose of attracting clients in the U.S.A. and for convenience of operation of the Respondent’s business and in fact the affairs of the New York office were fully integrated with the business operations of the Respondent;

(e) the business operations of the Respondent would have been seriously damaged if the Respondent had not assumed responsibility for and paid the expenses of the New York office.

As I understand the Reasons for Judgment of the Tax Appeal Board, the Board found that the situation was as so claimed by the respondent. The Board said, inter alia, that the New York office ‘‘was no more than a branch office of the appellant, despite its corporate name ’ ’ and that ‘ in financing it, the appellant was really striving to promote what was actually a part of its business’’, and “while the appellant had set up its New York office within a corporate structure, the resulting corporation was never more than such in name only’’.

The appellant disputes the respondent’s claim and says, inter alia, in the Notice of Appeal:

(a) the said amount of $72,343.14 was not an expense or disbursement incurred or laid out by the Respondent in the 1966 taxation year;

(b) it was not an outlay or expense made or incurred for the purpose of gaining or producing income from property or a business of the Appellant in the 1966 taxation year;

(c) it was a payment on account of capital

and that accordingly the deduction of this amount was prohibited by Sections 12(1) (a) and 12(1) (b) of the Income Tax Act.

In the alternative, the appellant submits that if the amount was incurred or laid out by the respondent for the purpose of gaining or producing income from property or a business of the respondent, it is income that is exempt in the hands of the respondent under Section 28 of the Act and accordingly the deduction of the amount is prohibited by Section 12(1)(e) of the Act in determining the taxable income of the respondent (para. 10 of Notice of Appeal). Also that if any of the payments are deductible, they are deductible only in the year in which they were made.

The subsidiary never prospered and it ceased operations in the spring of 1966, owing the respondent the amount in issue, $72,343.14, which was written off the respondent’s books in June 1966 as a non-recoverable debt. Additional amounts paid by the respondent on a guarantee that it gave to the bank in respect of a bank loan to the subsidiary were written off by the respondent in subsequent years, but they are not in issue for determination in this appeal.

Evidence was given by Clair Stewart, who is the respondent’s president and principal shareholder, and by its Chief Financial Officer, Harry Pope. The company started its business in 1960, operating from Toronto. It extended its business to other parts of Canada and into the United States. It had clients from that country, including General Foods, Eastman Kodak and Nestles, some of whom suggested that the company could get more business in the United States if it would open an office in New York. But it was thought that a purely Canadian incorporation with ‘‘Limited’’, rather than “Inc.”, as part of the company’s name, would be a disadvantage in doing business there, so it was decided to incorporate the subsidiary in New York to deal with clients and potential clients in the United States. It was also thought that an office in New York and an American name, in addition to being necessary or at least better for business dealings in the United States, would also assist the respondent’s operations in Canada, for its principal competition came from the United States, and Canadians appeared to have some preference for designs originating in the United States. Accordingly, the subsidiary was incorporated and commenced its operations from an office in New York. In the evidence and in these Reasons “the New York office’’ is distinguishable from the respondent’s Toronto office and sometimes the words are used synonymously with Stewart & Morrison Inc.

At the organization meeting of the subsidiary, held in New York in December 1963, 1,000 common shares were allotted to the respondent at an aggregate price of $1,000, and the following officers were elected :

Name Office

Stewart, Roberts and Morrison were elected directors. They were also directors of the respondent.

Roberts was entrusted with the organization, development and operation of the New York office. He spent about four days per week there, the remainder with the respondent in Toronto, and carried on in that way until April 1964. He was succeeded by Ziegler, who also went from the Toronto office to New York about four days per week until the fall of that year when another manager, Robert Fraser, took over.

A Procedure Plan for the New York office (Exhibit 5) was prepared in December 1963 by Roberts and approved by Stewart. It called, inter alia, for the Toronto and New York offices to interchange, weekly, a record of projects; setting up of a system of bookkeeping for New York dovetailed with Toronto; publicity in the United States; budget forecasts; payment by the New York office of Roberts’ living expenses in New York and payment by the respondent of his salary until July 1964, and also of expenses of the respondent’s directors on all their visits to the New York office from Toronto.

The New York office had a total staff of 4 persons, as compared with 40 to 50 in the respondent’s Toronto office. Officers and staff went from Toronto to the New York office from time to time, with their travelling expenses charged directly to Toronto. Stewart said that the New York office was masterminded from Toronto, with day-to-day details carried on in New York. He also said that the New York operation was entered upon with enthusiasm and in a hurry, he expected that it would make profits but the concern was to get it started and provide necessary money for it to do business; and not much thought was given to the mechanics or manner by which profits would flow back to the respondent by dividends or otherwise. Nor was any consideration given to charging interest to the subsidiary on advances made by the respondent.

The New York office was required to furnish weekly to the Toronto office a statement of business, expenses, bank account, clients and firms being solicited for business, and short, medium and long range business prospects.

The subsidary had its own corporate organization, letterhead and office. It solicited clients in its own name and billed them accordingly. It had accounts and bookkeeping separate from its. parent. It had employees of its own. When it did work for the Toronto office, it billed the respondent for it. The reverse was also the case. All of the subsidiary’s revenues came from its clients, except charges for work done for its parent company.

Loans from the Bank of Nova Scotia, Toronto, aggregating $40,000, were arranged for the New York office by the respondent. Payment of the funds was made to the New York office directly by Bankers Trust Company, New York, under arrangements with the Bank of Nova Scotia. They were guaranteed by the respondent and by its president in his personal capacity. Apart from the money so obtained, the respondent made advances of money from time to time to the New York office, sometimes using Bankers Trust Company as an intermediary between the respondent, the Bank of Nova Scotia and the New York office.

A summary, in round figures, of such advances and other payments by the respondent that make up the $72,343.14 written off by the respondent and claimed as a deduction, is set forth in Exhibit 14 as follows :

(Canadian Funds) $72,345

Those advances and payments, together with amounts aggregating $40,000 obtained through the bank loans, are also included in a letter, Exhibit 13, from Stanley Katz & Company, of New York, the accountants of Stewart & Morrison 1110., to Mr. Pope. The letter states:

In response to your request we are pleased to submit below a record of amounts received by Stewart & Morrison, Inc. from Stewart & Morrison Limited as capital contributions and loans payable. Please note that for December 1964 and December 1965, we indicate the month only since the corporate records do not show the day of receipt.

Jan. 17, 1964			$15,000.00
Mar.	5, 1964 _. ...		10,000.00
July 29, 1964			15,000.00
Dec.	1964:		10,000.00
Feb. 24, 1965			5,000.00
Mar. 25, 1965			5,000.00
May 17, 1965		_2._	5,000.00
July	7, 1965		5,000.00
Aug. 2, 1965			1,500.00
Sept. 13, 1965			5,000.00
Oct. 25, 1965			5,000.00
Dec.	1965		5,000.00
Dec.	1965		4,000.00
Jan. 24, 1966		....	1,650.00	(Total check is for
				$1,900 of which $250
				was allocated to
				A/C’s receivable.)

Jan. 27, 1966		...	152.00
Feb.	4, 1966		1,000.00
Feb. 14, 1966			1,400.00
Feb. 28, 1966			962.00
Mar. 21, 1966			1,474.52
April 25, 1966			1,520.51
TOTAL			$98,659.03

and after listing the advances adds the following :

Of the total amount $1,000.00 was allocated to Capital Stock and $97,659.03 was carried on the books of Stewart & Morrison, Inc. as Loans Payable—Stewart & Morrison, Limited.

The balance sheet of Stewart & Morrison Inc. for 1965, Exhibit 7, shows “Stockholders Equity” as follows:

Represented By:
Loans and/or Capital			$65,000.00
Less:	Net Loss for
	period ended
	June 30,	1965	54,528.23*
			$10,471.77

An accompanying covering letter from Katz & Company states that the total capital and loans are to be considered as $1,000 capital stock and $64,000 corporate loans.

A different method was used in its balance sheet for 1966, Exhibit 8, and Exhibit A to the respondent’s 1966 tax return, in which $97,105.85 was shown as ‘‘Due to Stewart & Morrison, Ltd.” and the Stockholders Equity was shown as follows:

Katz & Company explained the change in the following terms :

We have reviewed the reports for this corporation prepared by us for the fiscal years ended June 30, 1964, 1965 and 1966. In the first two years of this period, we presented the investment in Capital Stock and the loans advanced by Stewart & Morrison Limited as

“The balance sheet for 1964 (Exhibit 6) shows a similar method.

a combined figure in arriving at the total stockholder’s equity. In the year 1966, we showed as “Other Liabilities” the amount due to Stewart & Morrison Limited. We felt that this presented a clearer report since it did not require the reader to refer to the letter of transmittal to see the breakdown between Capital Stock of $1,000.00 and the loan balance for the remainder.

The respondent’s balance sheet, as at June 30, 1966, in its income tax return for that year, shows as an asset, investment in other companies, Stewart & Morrison Inc., a sum of $29,463.78 in 1965 and a corresponding item of $1 in 1966, with a note to the effect that the subsidiary has ceased business, its accounts have not been consolidated and no audited figures were available at that time, also that there is a contingent liability in respect of a $40,000 bank loan to the subsidiary.

Up to June 30, 1966 the subsidiary had gross profits of $22,589.34, expenses of $119,773.73 for rent, salaries and other operational expenses, and a loss for that period of $97,184.39, all as shown in detail in Exhibit 10. The advances from the respondent were used by the New York office in the operation of its business and were applied, along with revenues from its clients and loans from the bank, to pay the expenses of doing business. They were treated in the respondent’s books as loans to the New York office and were carried forward until written off in June 1966.

In a letter to Stewart & Morrison Inc., dated November 7, 1966, with which the company’s financial statements for its 1966 taxation year were enclosed, Katz & Company said that the company had available for carry-forward tax offsets of $97,000.

The question for determination is what was the true nature of the advances that made up the amount claimed as a deduction by the respondent.

The evidence adds up to this, as I appreciate it. The respondent decided that an American subsidiary, to be wholly owned by the respondent, would be incorporated and would carry on business in the United States and be a source of income and profit for the respondent. The subsidiary would carry on business as a separate American company in its own name and right, but it would, to use Stewart’s words, be master-minded” by its parent company and their affairs would be closely related and managed. The subsidiary needed capital, but had none. The respondent would supply, or arrange to supply, the needed capital. It arranged and guaranteed a bank loan direct to the subsidiary and also made direct advances of money to enable it. to get started and continue to operate. The advances were treated by both companies and by. their auditors, and in the respective books and accounts, as. loans from the respondent. Book entries do not necessarily denote the true nature of transactions, but I. think that the advances in question were correctly treated as loans: The fact that the money so provided was used by the subsidiary to pay its operating expenses, and was lost in a losing cause, does not determine or change its nature of money lent by the respondent to the subsidiary.

In my opinion, the advances were outlays by the respondent of a capital nature, so far as it is concerned, the deduction of which is prohibited by Section 12(1)(b). of the Act and the appeal may be disposed of on that finding alone.

Accordingly, the appeal will be allowed, the decision of the Tax Appeal Board set aside, and the re-assessment made upon the respondent by the Minister will be restored. The appellant is also entitled to his costs of the appeal, to be taxed.