J.L. Guay Ltée v. MNR, 71 DTC 5423, [1971] CTC 686 (FCTD), aff'd 73 DTC 5374, [1973] CTC 506 (FCA), aff'd 75 DTC 5094, [1975] CTC 97 (SCC)

NoëL, A.C.J.:—The appeal is from a decision of the Tax Appeal Board, dated June 16, 1969 and reported [1969] Tax A.B.C. 691, dismissing the appeal of J. L. Guay Ltée, appellant, from an income tax assessment, dated September 20, 1968, by which a tax in the amount of $87,664.31 was levied for 1965.

Appellant is a general building contractor which, in order to perform some of its building contracts, delegates performance of certain operations to other businesses, i.e. sub-contractors. In accordance with established practice in the construction trade, appellant pays its sub-contractors on presentation by them of a monthly estimate showing what progress has been made. According to the terms of the contract with its sub-contractors, appellant withholds a percentage of the monthly estimates sub- mitted and accepted, which it pays after the work is finally approved by the architect. Respondent in his assessment refused to admit as payable an amount of $277,428.48, representing the balances owing to the sub-contractors from appellant as a result of the amounts withheld each month during 1965. These balances, representing a percentage of the monthly estimates submitted by the sub-contractors and accepted by appellant, are, the latter submits, payable at a specific date. The fact is that appellant is under an obligation to pay on a certain date, i.e. the oth day after final approval of the work by the architect, as provided in the contract between it and its sub-contractors. Appellant stated that the existence of this obligation is not subject to any suspensive or resolutory condition: the obligation does exist and only its performance is postponed till the end of the period. At any time after the period of 35 days following approval by the architect, the sub-contractor is entitled to demand payment of the balance owing. Thus, the appellant contends, these balances owing at a definite time constitute amounts payable within the meaning of the Income Tax Act and case law, and must, accordingly, be included in the contract expenses and deducted from appellant’s profits for the year. Indeed, we have here simply to determine whether appellant was entitled to deduct from its 1965 income the amounts withheld under its contracts with its sub-contractors in 1965 — amounts which are payable, or may become payable, after the expiry of the said year.

Respondent, on the other hand, though admitting that appellant, under the contracts concluded with its sub-contractors, may withhold the specified percentage from the estimates, and not pay these amounts until 35 days after approval of the work by the architect, states that it is always possible that the architect may not give his approval. The architect’s final approval would thus be a suspensive condition to which the payment of the sums so withheld by appellant would be subject. According to respondent’s contention, not only was the amount of $277,428.48 thus withheld in 1965 not claimable or even due, but it was not even payable within the meaning of the Income Tax Act, and he was consequently obliged, in an assessment under date of September 20, 1968, to disallow deduction of the amount so withheld by appellant in computing its income for 1965.

In support of his assessment respondent cites Sections 3, 4, 12(1) (a) and 12(1) (e) of the Income Tax Act, R.S.C. 1952, e. 148. He submits that the amounts thus withheld by appellant were not, during the taxation year 1965, amounts payable to its sub-contractors. Payment of these amounts, he claims, was subject to the express condition that the work performed by the sub-contractors be approved by the architect in its final form on completion of the job. As the work for which the amounts were withheld was not so approved by the architect in appellant’s 1965 taxation year, the said amounts could consequently not be used for a deduction in computing appellant’s income.

The parties agreed that, for the purposes of the hearing before this Court, (1) the transcript of the testimony presented before the Tax Appeal Board, introduced at the hearing before this Court, shall be used as evidence subject to completion; (2) documentary evidence shall consist of copies of appellant’s contracts with its clients and the sub-contractors, and of copies of invoices from appellant and its sub-contractors, all filed under the heading ‘‘Documentary Evidence;’’ (3) in computing its income appellant consistently adopted the "comptabilité d’exercice’’ accounting method, called in English ‘‘the accrual basis".

Referring to the decision of this Court by Kearney, J . in John Coif ord Contracting Co. Ltd. v. M.N.R., [1960] C.T.C. 178, the learned member of the Tax Appeal Board stated that, although the facts in that case were the opposite of those established in the present case, he nevertheless felt obliged to apply the principles contained therein. In Coif ord, in fact, Kearney, J. refused to include in a construction company’s income amounts withheld during the current year and payable on the architect’s approval. In Kearney, J.’s opinion, these amounts were not ‘ ‘ receivables ’ ’ ; for them to be receivables they must, in the learned judge’s view, be amounts which ‘‘the intended recipient has a clearly legal, though not necessarily immediate, right to receive".

According to Mr. Boisvert, applying that decision to the case which now concerns us, if the amount withheld could not constitute a debt due and payable to be included in a taxation year, because it represented a contingent debt, similarly an amount withheld which is due and payable in the future can only constitute an allowable deduction in the year in which it becomes certain and mandatory. Only then does it meet the condition set forth in Section 12(1) (a), i.e. it becomes an outlay incurred by the taxpayer for the purpose of gaining income from a business, or, to go back to the argument of the learned counsel for the respondent, Mr. Boivin, if, in Kearney, J.’s opinion, these amounts could not be regarded as income, it is because they were not due as long as the architect’s certificate had not been issued; and for the same reasons they could not be regarded as due and payable in the hands of the person owing them. If they were not payable, then they could not be deducted from appellant’s income for 1965.

Appellant, on the other hand, maintains just the opposite. If I have understood its counsel’s argument correctly, its obligations and rights are to be considered in the light of the contracts entered into with its sub-contractors, which all include the same clauses except for the amount withheld. The only pertinent ones are the following:

3. Terms of payment: % of the monthly estimates submitted and accepted, the balance namely %, 35 days after final approval of the work by the architect.

5. If the work is not considered satisfactory by the architect, we reserve the right to cancel your contract and have it carried on by another contractor at your expense. Work already done will be paid for at the current market price, without your being entitled to any damages for cancellation of the contract. 20. In the event of cancellation or termination of the contractor’s main contract or suspension of the work forming the subject of the said contract, including the work specified in the present contract, for whatever cause, even for cause attributable to the contractor, it is agreed that by simple notice your contract shall be cancelled or terminated, or your work suspended, as the case may be, and that you shall only be entitled to payment in proportion to the amount of your contract, of the labour and of the materials incorporated in the work and delivered to the site of the main contract, according to the reckoning of the architect, less the total amount of prior payments.

These clauses, which counsel for the appellant relies on as a basis for his argument, clearly indicate, he says, that whatever the result of the work carried out by the sub-contractor, whether it is approved by the architect or not, the sub-contractor is nonetheless entitled to be paid eventually the amount withheld on the monthly estimates received. In fact, clause 5 states that if the work is not found satisfactory by the architect, the contractor shall be entitled to cancel the contract, but the subcontractor shall nevertheless be paid in full at the current market prices for work already done. He concludes that for the work performed, for which amounts are withheld, the sub-contractor will then be entitled to receive the full amount withheld. If, on the other hand, the amount withheld or a part thereof is used to pay damages claimed by the principal contractor, it would then be compensation for losses, and in the event of a dispute the Court will not decide whether the said amount is payable; rather, it will decide the reverse, i.e. that this amount which was due is no longer owing because it is to be used for compensation of the damages owing and the sums payable on the amounts withheld and, in the event of a surplus, it would also be paid to the subcontractor. According to counsel for the appellant, the principal contractor is paying himself with the sub-contractor’s money, not with his own. In neither case, therefore, does the principal contractor benefit from the amounts so withheld. Indeed, contends counsel for the appellant, the amount withheld will in any event be either paid to the sub-contractor 35 days after the work is approved by the architect or used to compensate the principal contractor for damages incurred. Consequently, he says, such amounts are payable, not under a suspensive condition, but rather with a term. A term, he adds, differs from a suspensive condition in as much as it does not suspend the obligation, but only delays the execution of it (cf. Articles 1089 et seq., Civil Code).

Accordingly, to determine whether the amounts withheld are payable or not, we must in any case, according to counsel for the appellant, take into consideration the special situation created by the contract which governs the rights and obligations of the contractor; and, he contends, this contract does not provide that the sub-contractor may lose the amounts withheld. As they are to be payable eventually, i.e. on completion of the specified term, 35 days after approval by the architect, these amounts may consequently not be regarded as contingency payments or amounts transferred or credited to a reserve or contingent account, and thus they are not subject to Section 12(1) (e) of the Income Tax Act, which prohibits the deduction of such amounts. Consequently, concludes counsel for the appellant, we are dealing either with amounts payable with a term, but payable nonetheless, or with a charge or expense which should be deducted from income; and in either case these amounts should not be included in appellant’s income.

As stated by appellant, the contract does provide that, if the work is not found satisfactory by the architect, the sub-contractor will nevertheless have the right to be paid in full at the current market price for the work already done; this does not mean, however, that the contractor will always have to pay the amount so withheld in full. In fact, it must not be forgotten that the purpose of the provision which permits withholding of a certain percentage of the contract price is to ensure the payment of any damages the owner or the general contractor may incur from the sub-contractor’s failure to perform the work or its faulty performance of it. If such damages correspond to, or exceed, the amounts so withheld, the owner or the general contractor may keep the entire amount; if, on the other hand, the damages are less, the sub-contractor will be entitled to receive the difference.

It seems to me, therefore, that it is far from certain that the amounts so withheld will be paid in full to the sub-contractor. In fact, the payment of these amounts to the sub-contractor is perhaps to be regarded, if damages are incurred, as contingent. It is true that, once fixed, such damages may be offset by the amounts withheld, and that the general contractor will not benefit therefrom, but the damages have not yet been liquidated for 1965, and compensation cannot be paid until they are. Until then, and even after, until the architect has issued his certificate and 35 days have elapsed, the general contractor is under no obligation to pay this amount, and it is not claimable by the subcontractor. In fact, compensation takes place by the sole operation of law only between debts which are equally liquidated and exigible, and have each for object a sum of money or a certain quantity of indeterminate things of the same kind and quality (ef. Articles 1187 and 1188, Civil Code).

The Income Tax Act does not always give a complete answer to the question as to what the total amount of profits and earnings in the year assessed is. In determining the taxable profits of a taxpayer we can take as a starting point the profit and loss statement prepared according to the rules of accounting practice. However, the profit shown on this statement has always to be adjusted according to the statutory rules used in determining taxable profits. This is because a number of facts taken into consideration by accountants are excluded by certain provisions of the Income Tax Act in the determining of taxpayers’ profits. The profit and loss statement, indeed, is really a statement of fact, and, consequently, a matter of evidence. It includes facts which cannot be questioned and statements of facts which may be called provisional. It is difficult to challenge the first category unless the figures used were taken, for instance, from improperly kept books. When, however, a statement of provisional facts is involved, the Minister is not obliged to accept what is submitted to him by the accountants. Such a situation occurs when, for instance, in a case such as this, a reserve is to be set up, for accounting purposes, to provide for receipt of a benefit or payment of a demand which is contingent or conditional. In Southern Railway of Peru Ltd. v. Owen, [1957] A.C. 334, respondent which operated a railway, was required under Peruvian law to make compensation payments, determined according to a set rule, to an employee on termination of his employment; payment of these amounts was, however, uncertain, since in certain cases he could lose them. The headnote of the judgment clearly explains how the company went about determining the amount of the reserve :

The Company claimed to be entitled to charge against each year’s receipts the cost of making provision for the retirement payments which would ultimately be thrown on it, calculating what sum would be required to be paid to each employee if he retired without forfeiture at the close of the year and setting aside the aggregate of what was required insofar as the year had contributed to the aggregate.

The House of Lords did not agree, however, that the company could deduct as expenses from each year’s income the amounts set aside to cover retirement payments it might eventually be called on to make. However, the Court did not formulate any basic principle as grounds for its refusal, and Lord Radcliffe gave his opinion as follows:

. . . It is clear, at any rate, from what I have quoted above that there is nothing improper in admitting valuations or estimates if by doing so a truer balance is arrived at between the receipts of a year and the cost of earning them or the expenses of a year and the fruits of incurring them. Such estimates were in fact directed by the Court of Appeal and by this House in Harrison v. John Cronk & Sons Ltd. ([1937] A. C. 185 and again by this House in Absolom v. Talbot ([1944] A.C. 204). See too the judgment of Lord Greene M.R. in Johnson v. Try Ltd. ([1946] 27 T.C. 167). The decision in the last mentioned case, is, I think, of value in illustrating the point that however desirable it may be to bring in a valuation or estimate in order to give a better balance to a year’s accounts, it cannot be right to do so if the figure which is to be inserted, “hedged round . . . with every kind of contingency and speculation” is too uncertain to be fairly treated as a receipt. What is true of receipts is true of liabilities. In my opinion, it is that point which constitutes the real difficulty in the present case.

In most tax cases only amounts which can be exactly determined are accepted. This means that, ordinarily, provisional amounts or estimates are rejected, and it is not recommended that data which is conditional, contingent or uncertain be used in calculating taxable profits. If, indeed, provisional amounts or estimates are to be accepted, they must be certain. But then it is always difficult to find a procedure by which to arrive at a figure which is certain. Accountants are always inclined to set aside reserves for unliquidated liabilities, for, if they do not do so, the financial statement will not reflect the true position of the client’s affairs. The difficulty arises from the fact that making it possible to determine the taxpayer’s tax liability is not the main purpose of accounting. The accountant’s report is, in fact, intended to give the taxpayer a general picture of his affairs so as to enable him to carry on his business with full knowledge of the facts. To achieve this end, it is not necessary for the profit shown to be exact, but it must be reasonably close, while the Income Tax Act requires it to be exact, and it is thus necessarily arbitrary. In Southern Railway of Peru Lid. v. Owen (supra), the company’s auditor stated that he would not have signed its financial statement if the reserve for future debts had not been entered on the balance sheet. The House of Lords was not influenced by this statement, however, and decided nevertheless that the company could not deduct the amounts payable until the employees terminated their employment. However, Southern Railway of Peru Ltd. v. Owen (supra) concerned a reserve made for uncertain amounts which the company might be called upon to pay in the future. What is the situation when the amounts involved are certain, but are not due until a subsequent accounting period? Such amounts were involved in The Naval Colliery Ltd. v. I.R.C., 12 T.C. 1017, and the Court decided nevertheless that they could not be deducted so long as the outlay had not been made. In that case, Lord Buckmaster indeed stated clearly that these amounts could only be deducted in the period in which they were actually spent:

According to the appellant’s contention, however, it is not the actual expenditure that it deducted but the need for making the expenditure which is to be measured in their favour and brought into account. The contention would involve the conclusion that the subject could choose which period he liked as the one in which the allowance is to be brought into account either that when the expenditure became necessary or that when it was made.

As a general rule, if an expenditure is made which is deductible from income, it must be deducted by computing the profits for the period in which it was made, and not some other period.

The procedure adopted by appellant, of deducting from its income amounts withheld by it, which it may one day be required to pay its sub-contractor, but which the latter may not claim until 35 days after the work is approved by the architect, is, as we have just seen, contrary to the rule that an expenditure may only be deducted from income for the period in which it was made, and this would suffice to dispose of the present appeal. However, as we have seen above, there is an additional reason for dismissing the appeal: this is that we are dealing with amounts withheld which are not only uncertain as to quantum if partial damages result from badly done work, but which will no longer even be due or payable if damages exceed the amounts withheld. How can it be claimed in such circumstances that a certain and current expense is involved, and that the amounts withheld, which appellant has full enjoyment of until it pays the amounts owing to the sub-contractor, or until compensation becomes due, may be deducted by appellant as it receives them from the owner.

The appeal is therefore dismissed and respondent will be entitled to his taxable costs.