COMMENTS
COMMENTAIRES
Deductibility of Expenditures: A Liberal and Fair Approach
Canadian Income Tax legislation has always contained expressed
or implied limitations or restrictions respecting the deduction of
“capital” expenditures. These limitations are an exception to the
general rule of computing income for tax purposes, which is that an
expenditure is deductible in the year incurred and to the extent it
has been incurred to earn income, as implied in section 9 of the
present Income Tax Act,’ and specifically stated in paragraph 18(1)
(a) of the Act. On the other hand, it is the scheme of the Income]
Tax Act to permit the deduction or amortization of certain types
of capital expenditures made to acquire a capital asset of a de-
preciable or deteriorating nature to be used in the process of
earning income from either a business or property.
The Income Tax Act does not provide (and has never provided)
any specific definition2 of “capital receipt” (or capital gain) or
“capital expenditure”.
(hereinafter referred to as the present Act).
1 R.S.C. 1952, c.148, as amended from time to time, esp. by S.C. 1970-71-72, c.63
2 However, despite the general recognition that the Income Tax Act does not
contain any definition of capital gain or expenditures, officials of the Depart-
ment of National Revenue have recently contended that para.39(1)(a) does
constitute a definition of “capital gain” and that the definition is to the effect
that a capital gain includes any profit not otherwise required to be included
in the computation of income of the taxpayer. Para.39(1)(a) reads as follows:
“(1) For the purposes of this Act,
(a) a taxpayer’s capital gain for a taxation year from the disposition of any
property is his gain for the year determined under this subdivision (to
the extent of the amount thereof that would not, if section 3 were read
without reference to the expression ‘other than a taxable capital gain
from the disposition of a property’ in paragraph (2) thereof and with-
out reference to paragraph (b) thereof, be included in computing
income for the year or any other taxation year) from the disposition
of any property of the taxpayer other than
(i ) eligible capital property,
(ii) property, any amount receivable by the taxpayer for the disposi-
tion of which is required to be included in computing his income
for the year by virtue of section 59, or
(iii) a life insurance policy within the meaning of section 138 (except
an annuity contract), or
(iv) a timber resource property;”
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COMMENTS – COMMENTAIRES
The absence of statutory guidance with respect to “capital expenditu-
res” obliged the courts to establish various tests which, until re-
cently, have been considered to be almost statutory law.3 For
instance, Eugene Labrie4 pointed out in 1965 that the fundamental
test formulated by Viscount Cave in British Insulated and Helsby
Cables5 was being used so often that the dictum was almost con-
sidered to be a statutory pronouncement. Viscount Cave formulated
the test for determining capital expenditures in the following terms:
But 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 a 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.6
Accordingly, unless the “capital” expenditure comprised a “de-
preciable” property (and was thus deductible within the provisions
However, the interpretation of the nature of para.39(1)(a) as constituting
a definition appears untenable since it implies that certain types of transac-
tions when carried out by a resident of Canada would form part of ordinary
income (as opposed to capital gain), but in the hands of a non-resident would
comprise capital gain. The reason for this turns on the interrelationship of
the provisions of s.3, s.39 and s.115 of the Income Tax Act. In the case of a
resident earning income from any source, including trading profits wherever
earned, this income must be brought into account for tax purposes within
the provisions of s.3.
However, in the case of a non-resident, business activities are not brought
into account unless either the business activities are carried out in Canada
or the business activities comprise a sale of certain types of Canadian
property known as “taxable Canadian property” within the provisions of s.115.
Accordingly, where a resident engages, for example, in land trading on a
speculative basis, the gain (within the criteria established in the past by the
courts) would be a trading gain fully included in income under the provisions
of para.3(a) and not a capital gain, only half of which is to be included in
income pursuant to the combined provisions of para.3(b) and ss.38 and 39.
Where, however, a non-resident carries on a similar business but outside of
Canada and with respect to Canadian land, the theory put forward by certain
tax authorities is that since the person is not carrying on a business in
Canada, and thus is not to be taken into account for Canadian income tax
under para.3(a), then it is deduced within the terms of para.39(1)(a) that
the trading gain not otherwise included in income becomes a capital gain.
In this view since the transaction is with respect to Canadian land, it is
subject to Canadian tax as a capital gain, despite the fact that the gain is
clearly on trading account and not on capital account within the extensive
Canadian jurisprudence on the subject.
3 As outlined below, the statutory basis for prohibiting the deduction of
“capital expenditures” is set forth in s.18 of the Income Tax Act, supra, f.n.1.
4 Labrie, The Principles of Canadian Income Taxation (1965, CCH Canada),
193.
5British Insulated and Hesby Cables v. Atherton [1926] A.C. 205.
6 Ibid., 213.
McGILL LAW JOURNAL
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of the capital cost allowance system of the Income Tax Act and
Income Tax Regulations), the application of Viscount Cave’s funda-
mental test led to the result that some expenditures, at least prior
to 1972, even if incurred to earn income, were not at all deductible
in computing income. However, the amendments to the Income Tax
Act brought in by Tax Reform in 1971 concerning eligible capital
expenditures partly cured this inequitable result.’ In addition, the
Canadian courts have recently applied the fundamental test(s) for
determining capital expenditures in a much more liberal and fair
manner. In particular, the decision of the Supreme Court of Canada
in M.N.R. v. Algoma Central Railway” originated the liberal trend
which led to the decision of the Exchequer Court in Canada Starch,9
extending the ambit of deductibility of expenses so as to include
expenditures which previously would have been categorized as out-
lays on account of capital. The Canada Starch decision had an impact
on subsequent related decisions such as Bowater,10 Elias Rogers,”
Canadian Glassine,2 Automatic Toll Systems, 3 Aluminium Company
of Canada4 and M.P. Drilling Limited. 5
Under the present Act, all expenditures incurred to earn income
are deductible in one way or another. The importance of characteriz-
ing the expenditure remains, however, in light of the fact that eligible
capital expenditures, e.g., an expenditure to acquire goodwill, are not
fully deductible: Only half of the amount is allowed as a deduction
in the computation of the income of a taxpayer pursuant to para-
graph 20(1)(a) and paragraph 14(5)(a) of the Act, and then at the
modest rate of 10% per annum on the declining balance basis. In
addition, the timing of the deductibility is still important, as a
current expenditure would normally be fully deductible in the year
incurred, whereas a depreciable capital expenditure would be
written off over a period of years.
In addition to section 9, subsection 18(1) provides the rules for
deductibility of an expense in computing the income of a taxpayer:
S.18 General limitations
(1) In computing the income of a taxpayer from a business or property,
no deduction shall be made in respect of:
7Para20(1)(b) and s.14.
868 D.T.C. 5096 (S.C.C.); 67 D.T.C. 5091 (Ex.).
9 Canada Starch Company v. M.N.R. 68 D.T.C. 5320 (Ex.).
-0 Bowater Power Co. Ltd. v. M.N.R. 71 D.T.C. 5469 (F.C. T.D.).
11 The Elias Rogers Co. Ltd. v. M.N.R. 73 D.T.C. 5030 (F.C. A.D.).
12 Canadian Glassine Co. Ltd. v. M.N.R. 74 D.T.C. 6089 (F.C. T.D.).
13 Automatic Toll Systems (Canada) Ltd. v. M.N.R. 74 D.T.C. 600 (F.C. T.D.).
14 Aluminium Company of Canada v. The Queen 74 D.T.C. 6408 (F.C. T.D.).
15 M.P. Drilling Limited v. M.N.R. 74 D.T.C. 6343 (F.C. T.D.).
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COMMENTS – COMMENTAIRES
(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 the business or property;
(b) an outlay, loss or replacement of capital or an allowance in respect
of depreciation, obsolescence or depletion except as expressly
permitted by this Part;
Therefore, an expenditure will be fully deductible and on a
current basis when:
1. it has been made for the purpose of gaining or producing
income; and
2. it is not capital in nature.
Generally speaking, a current expenditure would be deductible in
the year in xvhich it is incurred. On the other hand, an expenditure
giving rise to a lasting advantage would normally be considered as a
capital expenditure in light of the test laid out by Viscount Cave,
referred to above. However, in the Tower Investment16 case, Collier J.
of the Federal Court of Canada, Trial Division, concluded that ad-
vertising expenses incurred in one year could be spread and deducted
over three years since the benefit to be derived from such an ad-
vertising campaign would extend over more than one year. The
Court referred to the principle arising from section 9 of the Income
Tax Act to the effect that general accounting and business principles
should be relied upon in computing profit of a business (and applied
the accounting theory of matching revenues and expenses), unless
expressly prohibited or modified by provisions of the statute.
Before discussing the distinction made by the courts between
current and capital expenditures, consideration should be given to
the meaning of the words “for the purpose of gaining or producing
income”. An expenditure will be deductible only if it is regarded
as having been incurred for the purpose of gaining or producing
income. At one point, there was a school of thought advocating that
an expenditure should be deductible only to the extent that a tax-
payer could prove that it actually produced income.17 This inter-
pretation was rejected by the Exchequer Court in Royal Trust v.
M.N.R. 18 where Thorson P., as he then was, expressed the following
criteria for deductibility of an expense:
1. the expenditure incurred is usual and appropriate to the
particular commercial enterprise being conducted as deter-
ined by other similar expenditures in the same industries; and
16 M.N.R. v. Tower Investment Inc. 72 D.T.C. 6161 (F.C. T.D.).
17 See Eugene Labrie’s discussion of some of the different views as to the
meaning of para.[18(1)(a)], supra, f.n.4, 159-170.
18Royal Trust v. M.N.R. 57 D.T.C. 1055 (Ex.).
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2. the taxpayer’s intention and purpose for incurring the ex-
penditure is to realize a profit.
To the extent that this intention can be demonstrated, the actual
results of the transaction are not of prime concern.
In addition to the above mentioned criteria, the Supreme Court
of Canada in B.C. Electric Co. Ltd. v. M.N.R. 9 had postulated a
prima facie presumption that any expenditure incurred in the course
of carrying on a business is for the purpose of gaining or producing
income: “The main purpose of every business undertaking
is
presumably to make a profit”.2
The criteria established in the Royal Trust decision and the
presumption arising from the decision of the Supreme Court in B.C.
Electric has been followed regularly so that an expenditure will be
disallowed only when it is shown to the court that the expenditure
has been motivated by considerations other than profit, that the ex-
penditure reduces artificially the income of the taxpayer”‘ or that
the expense would be unreasonable 22
Once it is established that the expenditure has been incurred
“for the purpose of gaining or producing income”, it must then be
categorized either as a current or a capital expenditure. As was
indicated, if it is a current expenditure, it will normally be fully
deductible in the year in which it is incurred. However, in exceptional
circumstances, the expenditure may be spread over more than one
year, as was found in the Tower Investment’ case and in Canadian
Glassine Co. Ltd. v. M.N.R. 24 If the expenditure is of capital nature,
it will be deductible either under the capital cost allowance rules25
or the eligible capital expenditure rules 20 In either case, the ex-
penditure may also be restricted or entirely prohibited by specific
provisions of the Act, such as the thin capitalization rules of sub-
section 18(4) and the restrictions for land speculators of subsection
18(2).
It is mainly with respect to expenditures incurred either to
preserve a capital asset or in the course of operating an ongoing and
19 B.C. Electric Co. Ltd. v. M.N.R. 58 D.T.C. 1022.
20 Ibid., 1027 per Abbott J.
21 See, for example, Shulman v. M.N.R. 61 D.T.C. 1213, [1961] Ex. C.R. 410;
and Susan Hosiery v. M.N.R. 69 D.T.C. 5278 (Ex.).
22See s.67 of the Act and also No.511 v. M.N.R. 58 D.T.C. 307, where the
Court reduced an expense of $22,500 to $5,000 on the basis that the expense was
unreasonable.
23 Supra, f.n.16.
24 Supra, f.n.12.
25 Para.20(1)(a) of the Act and Part XI of the Income Tax Regulations.
20Para.20(1) (b) and s.14.
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COMMENTS – COMMENTAIRES
established business that the courts in recent years have broadened
the concept of “current expenditure” to include expenditures which
would have been thought to come within Viscount’s Cave famous
dictum. The breakthrough in this respect came from President
Jackett (as he then was) in Canada Starch Co. v. M.N.R.2
7 While
dealing with an expenditure to settle an infringement of trademark,
Jackett P. expressed the more liberal approach in the following
terms:
… in distinguishing between a capital payment and a payment in current
account, in my view, regard must be had to the business and commercial
realities of the matter.2 8
Such a liberal and seemingly fair approach by the courts culmin-
ated in the decision of the Federal Court of Canada, Trial Division, in
Aluminium Company of Canada Ltd. v. The Queen.29 In that case,
the Court was concerned with the deductibility of a payment of
$1,447,000 by Alcan to its Jamaican subsidiary, Aljam, as a re-
troactive price adjustment on the price of alumina sold by the
Jamaican subsidiary to the Canadian company. The evidence revealed
that such a retroactive price adjustment arose from a tax settlement
between Jamaica and Aljam, which was agreed upon by the latter
in order to maintain good relations with the Jamaican Government
and therefore preserve a source of supply. Mr Justice Heald cited
the Exchequer Court decision of Canada Starch Co. Ltd. v. M.N.R2
and concluded that the expenditure “was incurred in the process of
operating a profit making organization and, as such, was an ex-
penditure on revenue account”.
Despite the fact that the ultimate goal may have been to preserve
a source of supply, a capital asset, the Court nevertheless concluded
that the expense was deductible. Such a conclusion is indeed
evidence of the more liberal approach recently adopted by the courts
in considering the deductibility of expenditures.
It is possible that the courts may modify this trend as a result
of the new eligible capital expenditure rules. However, in view of
the rather limited relief provided by these rules, taxpayers un-
doubtedly will continue their efforts to have expenditures categorized
as being of a “current” rather than a “capital” nature.
Andr6 Gauthier*
27Supra, f.n.9.
28 Ibid., 5325.
2 Supra, f.n.14.
3o Supra, f.n.9.
* Of Verchere, Primeau & Gauthier, Barristers and Solicitors, Montr6al.
