T-3489-82
Sedgewick Co-operative Association Limited
(Plaintiff)
v.
The Queen (Defendant)
Trial Division, Strayer J.—Toronto, November 15;
Ottawa, December 2, 1983.
Income tax — Income calculation — Deductions — Appeal
from 1980 assessment — Plaintiff Co-operative Association
doing 91 % of business with members — S. 135 permitting
deductions from income of co-operatives of certain amounts
paid as patronage dividends — S. 125 permitting small busi
nesses deductions of 21 % of active business income — Plain
tiff contending deduction percentage of net income or business
income plus taxable capital gains — Defendant contending
deduction percentage of business income only — Plaintiff also
contending in calculating active business income for purposes
of s. 125, deductible amount of patronage dividend subtracted
from total income — Defendant contending subtracted from
business income — Appeal allowed in part — S. 135 including
capital gains in income — S. 135(2)(b)(i) limiting deductible
patronage dividends to part of income of taxpayer attributable
to business done with members when patronage dividends paid
to members but not to non-member customers — S. 135(4)(d)
defining income as proportion of income that value of goods
sold to members is of total value of goods sold to all custom
ers — Reference to goods sold only for purpose of fixing
deductible "proportion" of "income" — "Income" calculated
on basis of general rules in the Act — S. 3 providing income
including taxable capital gains — S. 135 not dependent on s.
20(1)(u) in that s. 135 starting with words "Notwithstanding
anything in this Part" — S. 20(1)(u) only creating exception to
general rule in s. 18(1)(a) taxpayer cannot deduct from income
from business or property any expense except to extent made
for purpose of producing income from business — "Income...
from an active business" in s. 125(1)(a)(i) referring to "busi-
ness income" as defined elsewhere in Act — S. 9 providing
income from business is profit therefrom, not capital gains —
S. 20(1)(u) appropriate authority for deduction of patronage
dividends from business income — Income Tax Act, S.C.
1970-71-72, c. 63, ss. 3, 9, 18(a),(b),(h), 20(1)(u), 125(1)(a)(i)
(as am. by S.C. 1979, c. 5, s. 38 and by S.C. 1980-81-82-83, c.
48 s. 70), 135(2)(b)(i),(4)(d).
This is an appeal from an assessment for 1980. Plaintiff is a
co-operative association. In 1980, 91% of the plaintiffs total
business was done with its members. It also realized a taxable
capital gain on the disposition of real property held in connec
tion with the business. The plaintiff paid patronage dividends to
its members, but paid no dividends to non-member customers.
Section 135 of the Income Tax Act deals with permissible
deductions from the income of co-operative corporations of
certain amounts paid out in patronage dividends. Subparagraph
135(2)(b)(i) provides that where a co-operative has done some
business with non-members, the permissible deduction is lim
ited to "the part of the income of the taxpayer for the year
attributable to business done with members". The plaintiff
contends that the proper deduction is 91% of the net income,
that is, business income plus taxable capital gains. The defend
ant asserts that the deduction should be 91% of the business
income only. The defendant's position results in a higher assess
ment, but the defendant is not seeking an increased assessment
but merely dismissal of the appeal. The plaintiff argues that the
defendant cannot appeal from its own assessment previously
made by the Minister. The second issue relates to section 125
which allows small businesses a tax deduction equivalent to
21% of active business income. The question is whether for the
purpose of computing "income ... from an active business" the
deductible amount of patronage dividends should be subtracted
from the total income or from only the business income. The
plaintiff submits that subsection 125(1) does not indicate that
the income referred to therein can be only business income, and
accordingly section 135 also governs permissible deductions for
the purposes of determining active business income. The
defendant asserts that paragraph 20(1)(u) applies in computing
the base figure for the purposes of section 125, so as to limit the
application of the permissible patronage dividend so that it may
be used to reduce only business income.
Held, the appeal should be allowed in part.
As to the plaintiffs objection that the defendant cannot
appeal from its own assessment, since a question of law as to
the proper interpretation of section 135 is involved, the Court
cannot be prevented from coming to its own conclusion as to
what the law means. The plaintiff has not suffered irreparable
prejudice by the denial of administrative remedies since it has
the full opportunity to argue the issue in Court. Section 135
allows the inclusion of capital gains in the income base to which
the percentage of membership business is applied in order to
calculate the deductible amount of patronage dividends. The
subparagraph 135(2)(b)(i) limitation on the deductible patron
age', dividend to "the', part of the; income of \\the ,taxpayer .. .
attributable to business done with members" is defined in
paragraph 135(4)(d) as "that proportion of the goods sold" to
members is of the total value of goods sold to all customers.
The reference to goods sold is only for the purpose of fixing the
deductible "proportion" of the "income" of the co-operative.
That "income" is to be calculated on the basis of the general
rules of the Act. Section 3 provides that income includes
taxable capital gains. Section 135 is not dependent on para-
graph 20(1)(u), which permits a patronage dividend deduction
from income from a business, for its operation since it starts
with the words, "Notwithstanding anything in this Part". Sub
section 20(1) creates an exception to the general rule in para
graph 18(1)(a) prohibiting deductions from income from a
business unless it was made for the purpose of producing
income. The word "business" does not precede "income" in
either subsection 135(1) or paragraph 135(4)(d).
When subparagraph 125(1)(a)(i) refers to "income ... from
an active business" it is referring to business income. Section 9
provides that income from a business is the profit therefrom.
This does not include capital gains. Section 18 then prohibits
certain deductions in computing income from a business, but
paragraph 20(1)(u) excepts patronage dividends, calculated on
the proportion of member-business as prescribed by section
135, from the prohibition. Because, in order to calculate the tax
deduction as authorized by subsection 125(1), it is necessary to
use business income as the base, paragraph 20(1)(u) is the
appropriate authority for the deduction of patronage dividends.
CASES JUDICIALLY CONSIDERED
DISTINGUISHED:
Harris v. Minister of National Revenue, [ 1966] S.C.R.
489 affirming [1965] 2 Ex.C.R. 653; The Queen v.
Scheller, [1976] 1 F.C. 480 (T.D.).
COUNSEL:
Robert Couzin and Kevin Wark for plaintiff.
E. A. Bowie, Q.C. and B. J. Hobby for
defendant.
SOLICITORS:
Stikeman, Elliott, Robarts & Bowman,
Toronto, for plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
STRAYER J.: This is an action by way of an
appeal by the plaintiff against an assessment made
by the Minister of National Revenue with respect
to its 1980 taxation year. The facts were agreed to
be as follows.
The plaintiff is a co-operative association duly
incorporated under the laws of Alberta, with a
membership of approximately 1,682. During the
year in question the total value of its sales and
services was $2,571,144. Of this, $2,339,402 or
91% represented business done with its members.
Its business income, prior to any payment of
patronage dividends, was $132,815. During this
same year it realized a taxable capital gain of
$5,906 from the disposition of real property which
had been used or held in connection with the
plaintiff's business.
While the parties are agreed on the foregoing
facts they have each at various times asserted two
different ways of applying the Income Tax Act
[S.C. 1970-71-72, c. 63], thereto, with the result
that four possible methods were described in the
pleadings and in argument. These varying ap
proaches all relate essentially to the application of
two sections of the Income Tax Act: section 135
which deals with permissible deductions from the
income of co-operative corporations of certain
amounts paid out in patronage dividends, and sec
tion 125 which allows small businesses a tax
deduction equivalent to 21% of active business
income. I shall deal in turn with the issues related
to each of these sections.
Section 135
The relevant parts of section 135 provide as
follows:
135. (1) Notwithstanding anything in this Part, there may be
deducted, in computing the income of a taxpayer for a taxation
year, the aggregate of the payments made, pursuant to alloca
tions in proportion to patronage, by the taxpayer
(a) within the year or within 12 months thereafter to his
customers of the year, and
(b) within the year or within 12 months thereafter to his
customers of a previous year, the deduction of which from
income of a previous taxation year was not permitted.
(2) Notwithstanding subsection (1), if the taxpayer has not
made allocations in proportion to patronage in respect of all his
customers of the year at the same rate, with appropriate
differences for different types or classes of goods, products or
services, or classes, grades or qualities thereof, the amount that
may be deducted under this section is an amount equal to the
lesser of
(a) the aggregate of the payments mentioned in subsection
(1), and
(b) the aggregate of
(i) the part of the income of the taxpayer for the year
attributable to business done with members, and
(ii) the allocations in proportion to patronage made to
non-member customers of the year.
As indicated above, the plaintiff did 9% of its
business with non-members and 91% with its
members. It had actually paid patronage dividends
to its members during the year in question in the
amount of $179,668 but had paid no dividends to
non-member customers. Thus the relevant limita
tion on the amount of patronage dividends which
the plaintiff could actually deduct from its income
is found in subparagraph 135(2) (b) (i).
The dispute now with respect to the application
of subparagraph 135(2)(b)(i) is as to whether the
allowable deduction from income should be 91%
(that is, the proportion of business done with
members in 1980) of net income (that is, business
income of $132,815 plus taxable capital gains of
$5,906) or just of business income ($132,815).
Calculated the former way, the allowable deduc
tion would be $126,236. Calculated the latter way
it would be $120,862. The plaintiff, both in its tax
return and in its pleadings, asserts that the former
method is correct. The Minister in his assessment
also accepted that position as correct, but in the
present pleadings on behalf of the Crown the
defendant now asserts that the latter method is
correct. While the defendant now takes a position
which would support a higher assessment than that
made by the Minister in his assessment of July 13,
1981, the defendant does not ask for an increase in
that assessment but only asks for dismissal of the
appeal.
As an initial objection the plaintiff argued that
the defendant could not appeal from its own
assessment previously made by the Minister.
Counsel cited in support of this proposition Harris
v. Minister of National Revenue, [1965] 2
Ex.C.R. 653, at page 662 (affirmed on other
grounds, [1966] S.C.R. 489); and The Queen v.
Scheller, [1976] 1 F.C. 480 (T.D.), at pages 487-
488. It seems to me that these cases are distin
guishable. In the Harris case the Minister's asser
tions would, if accepted, have required the Court
to order an increase in the amount of tax payable.
In the present case the defendant is not asking for
the tax to be assessed higher; it is simply asserting
that the appeal should fail because the law if
anything would require a higher assessment than
the one against which the plaintiff appeals. With
respect to the Scheller case, it does, I think, only
stand for the proposition that if the Minister has
admitted through the assessment that certain facts
exist, he cannot later withdraw that admission. In
the present case a question of law is involved as to
the proper interpretation of section 135. Even if
the Minister's assessment were based on a certain
view of the law the Court cannot be prevented, by
this "admission" or otherwise, from coming to its
own conclusion as to what the law means. Counsel
for the plaintiff argued that the failure of the
Minister to assert in the assessment or in a reas
sessment the position now taken by the defendant
had the effect of denying the plaintiff administra
tive remedies that would have been available to
him such as the filing of an objection. While it is
true that the defendant, by not taking this position
until its pleading in this Court, did preclude the
use of these administrative remedies, the plaintiff
now has the full opportunity to argue the issue in
Court and I fail to see where it suffered any
irreparable prejudice by being obliged to deal with
the issue here for the first time.
With respect to the issue itself, the plaintiff
refers to subparagraph 135(2)(b)(i) which pro
vides that where a co-operative has done some
business with non-members, the permissible deduc
tion is limited to "the part of the income of the
taxpayer for the year attributable to business done
with members ...." This phrase is defined in
paragraph 135(4)(d) as follows:
135. (4) ...
(d) "income of the taxpayer attributable to business done
with members" of any taxation year means that proportion
of the income of the taxpayer for the year (before making
any deduction under this section) that the value of the goods
or products acquired, marketed, handled, dealt in or sold or
services rendered by the taxpayer from, on behalf of, or for
members, is of the total value of goods or products acquired,
marketed, handled, dealt in or sold or services rendered by
the taxpayer from, on behalf of, or for all customers during
the year;
It is contended that the term "income" here must
be taken in its normal meaning to include the
whole of the net income of the corporation includ
ing both its "business income" and its taxable
capital gains. The plaintiff says that in the absence
of some qualifying words the reference to
"income" must be taken to be a reference to the
income of the taxpayer as computed in accordance
with Part I of the Act and there is no justification
for reading into the term "income" the word
"business". Counsel for the plaintiff further point
ed out that income tax form T2S(16) with respect
to the patronage dividend deduction also confirms
this interpretation in that it describes the item to
which the percentage of member-customer busi
ness is to be applied as "net income before patron
age dividend deduction". It does not refer to "busi-
ness income". This of course cannot alter the legal
position of the parties but it may be relevant to
finding a rational interpretation for section 135.
The defendant, on the other hand, asserts that
one must look at the whole scheme of the Income
Tax Act and if one does so it is apparent that
the deductions referred to in subparagraph
135(2)(b)(i) can only be made from "income from
business or property" and therefore only such
income should be used as a base for calculating, on
the basis of the percentage of member business,
the amount of deductible patronage dividends.
In making this argument, the defendant con
tends that the scope of deductions under subpara-
graph 135(2)(b)(i) is limited by sections 18 and 20
of the Act. Section 18 generally limits the kind of
deductions which may be made "in computing the
income of a taxpayer from a business or property".
Section 20 provides in part as follows:
20. (1) Notwithstanding paragraphs 18(1)(a),(b) and (h), in
computing a taxpayer's income for a taxation year from a
business or property, there may be deducted such of the
following amounts as are wholly applicable to that source or
such part of the following amounts as may reasonably be
regarded as applicable thereto:
(u) such amounts in respect of payments made by the
taxpayer pursuant to allocations in proportion to patronage
as are permitted by section 135;
Thus, the defendant argues that the deductions as
referred to in section 135 must be deductions only
from income "from a business or property" as
specifically authorized by subsection 20(1). It is
further argued that, according to section 9 of the
Act, income from a business or property is the
"profit therefrom" and does not include any capi
tal gain.
On the basis of the foregoing, then, the defend
ant appears to argue that if section 135 only
authorizes the deduction of patronage dividends
from income from business or property, which does
not include capital gains, then the capital gains
may not be included in the base income of the
co-operative to which the percentage of member
business is applied in order to calculate the deduct
ible amount of patronage dividends.
The defendant further reinforces this argument
by referring to subsection 135(7) which provides
that patronage dividends paid to the patrons of a
co-operative, other than those in respect of con
sumer goods or services, are taxable in the hands
of the recipient. The defendant argues that if
capital gains may also be distributed by consum
ers' co-operatives, then they would escape taxation
completely since the patronage dividends would be
deductible from the income of the co-operative and
would not be taxable in the hands of the recipients
since they would be distributed on the basis of the
recipients' purchases of consumer goods and ser
vices. On the other hand, capital gains of a produc
ers' co-operative would be taxable in the hands of
the recipient producers because they would not
enjoy the exemption allowed in subsection 135(7)
to purchasers of consumer goods and services.
Whether capital gains of a co-operative can be
included in its income base for the purpose of
calculating deductible patronage dividends is a
question which has apparently not yet been
authoritatively answered in the courts. The Income
Tax Act is, in my view, far from precise on the
point. I have come to the conclusion, however, that
the proper interpretation of section 135 is that it
allows the inclusion of capital gains in that income
base to which the percentage of membership busi
ness is applied in order to calculate the deductible
amount of patronage dividends. More specifically,
as regards the present case, this means that the
plaintiff was entitled to add the taxable capital
gain of $5,906 to its business income before
patronage dividend deduction, in the amount of
$132,815, and apply to the total of these two
figures, $138,721, the percentage of business
transacted with members, namely 91%, in order to
claim a total patronage dividend deduction of
$126,236.
In reaching this conclusion I have started with
the wording of subparagraph 135(2)(6)(i) which,
for present purposes, limits the deductible patron
age dividends to "the part of the income of the
taxpayer for the year attributable to business done
with members". This income is defined in para
graph 135(4)(d) as "that proportion of the income
[underlining added]" that the value of goods sold,
etc., to members is of the total value of goods sold,
etc. by the co-operative (that is, including sales to
both members and non-members). The reference
in this definition to the goods sold, etc., is only for
the purpose of fixing the deductible "proportion"
of the "income" of the co-operative. That
"income" presumably is to be calculated on the
basis of the general rules provided by the Income
Tax Act. Section 3 of that Act says that the
income of a taxpayer includes, inter alia, its tax
able capital gains.
While counsel for the defendant is no doubt
correct in arguing that subsection 20(1) only deals
with deductions from income "from a business or
property", which would not include capital gains, I
am not convinced that section 135 is dependent on
paragraph 20(1)(u) for its operation. It seems to
me that the main purpose of subsection 20(1) is to
create an exception to the general rule in para
graph 18(1)(a) that a taxpayer cannot deduct
from his income from a business or property any
outlay or expense except to the extent that it was
made or incurred for the purpose of gaining or
producing income from the business. A patronage
dividend is not, at least in the normal sense, an
expense incurred for the purpose of producing
income. Therefore to the extent that section 18
would preclude a deductible patronage dividend to
reduce business income, section 20 makes it possi
ble. But section 135 starts with the words "Not-
withstanding anything in this Part" (that is, Part I
where section 20 is also found) and it independent
ly provides a general right to deduct from income
the amounts of patronage dividends as defined
therein. It must be kept in mind throughout that
subsection 135(1) provides that "... there may be
deducted, in computing the income of a taxpayer
... the payments made, pursuant to allocations in
proportion to patronage ...." Similarly, as noted
above, paragraph 135(4)(d) says that the income
attributable to business done with members
"means that proportion of the income" of the
taxpayer. The word "business" does not precede
the word "income" in either of these critical
provisions.
As noted above, counsel for the defendant
argued that such an interpretation would mean
that capital gains by a consumers' co-operative
would never be taxable if they were distributed to
the patrons of the co-operative. I do not find this
particularly anomalous. The capital gains in ques
tion here are relatively small in relation to the
volume of business and are simply incidental to the
operation of the co-operative in providing service
to its members. Similarly, no doubt, a co-operative
could earn other sums of money, such as interest
on its bank accounts, which might find their way
into patronage dividends. It is unrealistic to insist
that the only sums which may be regarded as
"income" for the purpose of declaring a patronage
dividend are precisely those sums earned through
mark-up in the sale of goods to consumers. Indeed,
the Act does not attempt to prescribe that a given
consumer may only receive tax-free patronage
dividends of an amount strictly limited to mark-up
on the specific purchases made by him. Consumer
co-operatives can exercise considerable discretion
in categorizing different kinds of goods and assign
ing to each a somewhat arbitrary percentage of
patronage dividend depending, perhaps approxi
mately, but not precisely, on the margin of profit
involved in handling different kinds of merchan
dise. A member of a consumers' co-operative
belongs in order to acquire consumer goods more
cheaply. He might, to achieve a similar result,
arrange with a retailer to give him a discount in
return for undertaking to do all business with him,
or he might for example purchase from a whole-
saler if he had the proper connections to do so. If
instead he uses the vehicle of a consumers' co
operative and if in the process of supplying his
consumer needs at cost the co-operative incidental
ly makes some money which further reduces the
costs of doing business, that money should be
available for distribution on a tax-free basis to the
consumer just as is the money made from the
mark-up on the price of goods sold to that consum
er. If it is not distributed, then it is of course
taxable.
Section 125
There remains the question of the proper basis
for calculation of the small business tax deduction
as provided in subsection 125(1) [as am. by S.C.
1979, c. 5, s. 38 and by S.C. 1980-81-82-83, c. 48,
s. 70]. This subsection provides in part as follows:
125. (1) There may be deducted from the tax otherwise
payable under this Part for a taxation year by a corporation
(other than a corporation that carried on a non-qualifying
business in Canada in the year) that was, throughout the year,
a Canadian-controlled private corporation, an amount equal to
21% of the least of
(a) the amount, if any, by which the aggregate of
(i) the aggregate of all amounts ... which is the income of
the corporation for the year from an active business ....
The plaintiff now argues that in computing "active
business income" for the purposes of this section,
the deductible amount of patronage dividends
(which I have determined above to be $126,236)
should be subtracted from the total income of the
co-operative corporation. This would leave a base
of $12,485, (minus charitable donations) on which
to apply the 21% prescribed by subsection 125(1)
in order to calculate the authorized tax reduction.
The plaintiff contends that there is no indication in
subsection 125 (1) that the income referred to
therein can be only business income, and thus
there is no reason to calculate the permissible
patronage dividend deduction on, or to subtract it
from, only the business income rather than the
total income, in establishing the base on which the
21% can be applied. In other words, the plaintiff
says that section 135 governs permissible deduc
tions both for the purposes of determining the total
taxable income of the co-operative and for the
purposes of determining its active business income
under section 125.
The defendant, on the other hand, argues that
paragraph 20(1) (u) applies in computing the base
figure for the purposes of section 125, so as to
limit the application of the permissible patronage
dividend deduction so that it may be used to
reduce only business income, with the amount of
the permissible patronage dividend deduction
being calculated as the member-business percent
age of that business income. In the present case on
this basis the permissible patronage dividend
deduction would be 91% of $132,815, that is
$120,862. This latter amount, deducted from the
business income of $132,815, would leave an active
business income of $11,953 according to the
defendant.
I have concluded that the defendant's position in
respect to the application of section 125 is correct.
I do not believe that the base for calculation of the
permissible patronage dividend deduction from
total income, as provided in section 135, is in this
case the same base as should be used under section
125 to calculate the "income ... from an active
business" for the purpose of applying the small
business tax reduction. I am satisfied that when
subparagraph 125(1)(a)(i) refers to "income ...
from an active business" it is referring to "business
income" as defined elsewhere in the Act. Section 9
provides that income from a business is the profit
therefrom for the year. This does not include
capital gains as such. Section 18 then provides that
certain outlays or expenses may not be deducted in
computing income from a business. But subsection
20(1) provides that, notwithstanding paragraphs
18(1) (a),(b), and (h), certain deductions are per
mitted. As provided by paragraph 20(1) (u),
among the permitted deductions are such patron
age dividends calculated on the proportion of
member-business as prescribed by section 135.
Because in order to calculate the tax reduction as
authorized by subsection 125 (1) it is necessary to
use business income as the base, paragraph
20(1)(u) is the appropriate authority for the
deduction of patronage dividends. In the present
case this means that the income on which the
permissible patronage deduction must be calculat
ed is the business income which is $132,815.
Applying to that figure the percentage of member-
business as required by subparagraph 135(2)(b)(î)
the permissible patronage dividend deduction from
business income would be 91% of $132,815, that is
$120,862. Then, to ascertain the income of the
co-operative from an active business, for the pur
poses of calculating the tax reduction pursuant to
subparagraph 125(1)(a)(i), it is necessary to sub
tract from the business income of $132,815 the
patronage dividend deduction of $120,862, leaving
an active business income of $11,953. The small
business tax reduction would then be 21% of that
amount, namely $2,510.
In reaching a conclusion as to the proper dispo
sition of costs in this matter I have kept in mind
that each party has succeeded in part. I have also
noted that the parties regarded this as a test case
in which the decision might govern the disposition
of several other cases.
ORDER
It is therefore ordered and adjudged that the
assessment be referred back to the Minister for
reconsideration and reassessment in accordance
with the principles set out in the reasons for judg
ment, provided that no such reassessment shall
exceed the amount assessed in the notice of assess
ment of July 13, 1981. There will be no costs
awarded.
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