Wil Mechanical Ltd. v. The Queen, 90 DTC 6475, [1990] 2 CTC 224 (FCTD)

McNair, J.:—This is an appeal from the Minister's disallowance of sums deducted by the plaintiff as accounts payable in its taxation year ending February 28, 1983. The issue is whether the Minister acted correctly in characterizing these sums as "holdback payables”, whose deductibility was prohib- ited under paragraphs 18(1)(a) and 18(1)(e) of the Income Tax Act, R.S.C. 1970-71-72, c. 63, as amended. While the amounts actually disallowed totalled $349 581.20, counsel for the Crown conceded at the commencement of trial that the correct figure for the amounts in dispute was $347,276.08.

The Facts

The plaintiff company carries on the business of mechanical engineering and contracting in the Province of Alberta. In the taxation year in question, the plaintiff was involved, inter alia, in three major construction projects and one minor one, designated as jobs 370, 379, 382 and 391 respectively. The plaintiff's president, Lloyd E. Wilson, appeared as a witness on its behalf. He explained that his company, as one of a number of subcontractors engaged in these projects, was responsible for the installation of plumbing, heating, sprinklers and controls, and other mechanical systems. For each of the projects in issue, the plaintiff entered into a contract with a different general contractor. The general contractors, in turn, concluded “prime contracts" with the different projects' owners.

The plaintiff, as subcontractor, engaged a number of sub-subcontractors to supply and, in all but one case, also install equipment. Mr. Wilson testified that while his company might sometimes use formal contracts in its dealings with sub-subcontractors, the sub-subcontractors involved in the projects in question were retained under purchase orders. These purchase orders, copies of which were exhibited in the book of documents jointly proffered by counsel for both parties, typically provided that the different sub-subcontractors were to "supply and install" various materials "as per plans, specifications, and addenda" to the satisfaction or approval of the engineer or engineers. The subsubcontractors thus hired regularly submitted progress invoices for amounts reflecting the estimated work completed as of a certain date each month. Notations on these invoices reveal the plaintiff generally paid its subsubcontractors within several months of receipt of their invoices. However, the plaintiff retained from these payments certain amounts referred to as "H/Bs" or holdbacks. In its income tax return for the taxation year ending February 28, 1983, the plaintiff characterized the total amount of these holdbacks in the sum of $788,966 as accounts payable deductible as outlays or expenses made or incurred by it for the purpose of gaining or producing income from its business within the meaning of paragraph 18(1 )(a) of the Act. As mentioned, the defendant disallowed the deduction of $347,276.08 as holdback payables.

Paragraph 18(1)(a)

The first statutory provision on which the Minister relied is paragraph 18(1)(a) of the Income Tax Act, which in 1983 read as follows:

18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(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;

At issue is whether the amounts deducted represented expenses incurred by the plaintiff in the taxation year. The plaintiff could properly deduct the sums in question only if it was in fact under an obligation to pay them: The Queen v. Burnco Industries Ltd. et al., [1984] C.T.C. 337; 84 D.T.C. 6348. Put another way, the question is whether the holdbacks were payable within the taxation year.

Counsel for the plaintiff argued that because the terms of the formal contract between the plaintiff and the various general contractors contained no reference to the sub-subcontractors, the only contractual documents rele- vant to the appeal were the purchase orders and the corresponding invoices. While the plaintiff withheld in all cases a percentage of the amounts invoiced, counsel submitted that there was nothing in the terms of the purchase orders or any other contractual document which permitted it to do so. In his submission, the sub-subcontractors were legally entitled to the full amount of the progress estimates at the time they submitted their invoices therefor. Anticipating the argument of opposing counsel, he contended that there was neither a verbal agreement nor a practice or custom of the trade in respect of holdbacks at this level of the construction industry in Alberta.

Counsel for the defendant submitted, on the other hand, that the evidence supported the Crown's proposition that by virtue of a custom or practice respecting the retention of holdbacks by subcontractors from subsubcontractors, the relationship between the plaintiff and its subsubcontractors could be said to be governed by implied terms providing for such withholdings in the present case. Relying, inter alia, on the decision of Noël, A.C.J. in J.L. Guay Ltée v. M.N.R., [1971] F.C. 237; [1971] C.T.C. 686; 71 D.T.C. 5423 (F.C.T.D.); affd [1972] F.C. 1441; [1973] C.T.C. 506; 73 D.T.C. 5373 (F.C.A.); affd without reasons [1975] C.T.C. 97; 75 D.T.C. 5094 (S.C.C.), and on that of the Federal Court of Appeal in Newfoundland Light & Power Co. v. Canada, [1990] 1 C.T.C. 229; 90 D.T.C. 6166; affg in part [1986] 2 C.T.C. 235; 86 D.T.C. 6373 (F.C.T.D.), she raised two further arguments: firstly, because the purchase orders stipulated the performance of the sub-subcontractors’ work to engineers’ approval or satisfaction, it followed that the plaintiff's liability to disburse the amounts withheld was merely contingent; and, secondly, holdbacks were not deductible in that, by virtue of possible chargebacks, set-offs and other price reductions, the exact amounts ultimately released by the plaintiff were uncertain in the taxation year.

Purchase Orders and Invoices

A review of the purchase orders and invoices relating to the projects in issue reveals those documents indeed contain no express provisions relating to holdbacks between the plaintiff company and its sub-subcontractors. Furthermore, there is nothing in the terms of the plaintiff's contracts with the various general contractors which could be said to import any such terms into the relationship at the lower level. The subcontracts, all completed on Alberta Standard Sub-contract Forms ("A.C.A. Form A”), incorporate by reference many of the terms of the prime contract between the general contractors and the owners of the respective projects. Article Il of A.C.A. Form A, entitled “Payment”, specifically provides in part as follows:

A. The Sub-contractor shall submit proper progress estimates in writing on the day of each month to the Contractor for approval and due processing covering the value of the materials delivered for the Project and the work performed by the Sub-contractor up to such date, whereupon payment to the Sub-contractor by the above submission date of the proper estimate by the Sub-contractor or seven (7) days after certification of the proper estimate by the Architect/Engineer, whichever is the later.

Contractor in the amount of

% shall become due and payable

days after the

B. and the whole of the balance of the amount payable by the Contractor to the Sub-contractor shall be paid one day after the Builders’ Lien rights expire or ten days after receipt of such amount by the Contractor from the Owner.

The evidence indicates the subcontracts typically provided for a withholding of 15 per cent of payments. Mr. Wilson testified his company's normal procedure was to gather its sub-subcontractors' invoices at the end of each month and, partly on the basis thereof to submit a progress estimate to the general contractors. The latter, in turn assembling the progress estimates of their various subcontractors, would thereupon submit their own progress estimates to the owner. Subject to the approval of the engineers and/or architects, the general contractors would then receive the stipulated percentage of payment from the owner, and, after withholding the percentage agreed to in A.C.A. Form A, pass payment down to their subcontractors.

While the plaintiff customarily withheld moneys from its subsubcontractors engaged on the projects in the usual range of 15 per cent of the sums invoiced, there was nothing in its own contracts with the various general contractors which permitted it to do so. A.C.A. Form A used in Alberta, unlike the national subcontract form C.C.A.L. (1) apparently used elsewhere, contains no reference whatever to sub-subcontractors. Nor was there any mention of the plaintiff's entitlement to holdbacks in the documents governing the relationship at the lower level. The wording of the purchase orders pursuant to which the plaintiff retained its sub-subcontractors, as counsel for the plaintiff pointed out, was very terse. Neither the formal terms and conditions of the orders nor the descriptions therein of the various projects mentioned holdbacks. As for the invoices submitted by the plaintiff's sub-subcontractors, the only terms stipulated therein typically read: "Terms: Net 30 days. _°/o per month service charge on overdue accounts". Thus, I am satisfied that the contractual documents governing the plaintiff's relationships, both with its general contractors at the next level above and its sub-subcontractors below, did not expressly authorize withholdings from payments made to subsubcontractors.

Implied Terms

Counsel for the defendant argued that the express terms of the purchase orders and invoices were not the only things determinative of the plaintiff's dealings with its sub-subcontractors. In her submission, there was evidence of a practice or custom for the imposition of holdbacks by subcontractors on subsubcontractors in the Alberta construction industry whereby terms providing for imposition were incorporated by implication into the contracts between the plaintiff and its sub-subcontractors in the present case. I am unable to find on the evidence as a whole that such a custom or practice did, in fact, exist.

Mr. Smith, president of a sub-subcontracting company, testifying as an expert witness on behalf of the plaintiff, indicated on cross-examination that it might be common in the industry to have withholdings in cases of subsubcontractors supplying and installing equipment under a purchase order. However, on re-examination he intimated that there was no set custom or practice to that effect. The plaintiff's second expert witness, Mr. Gove, president of a general contracting company, was also cross-examined about payments to suppliers and installers working under purchase orders. He stated that holdbacks would probably be normal on larger projects, but reaffirmed the opinion proffered in his expert's affidavit that there was no practice or custom respecting subcontractors' withholdings from progress payments: "It might vary from job to job, depending on what the work is, the flexity of it, payment terms. There is a lot of things that are built into it. It’s not a thing that you do all the time."

Given Mr. Smith's confusion on the stand, both counsel were in agreement that little weight should be attached to his testimony, and I agree. As for Mr. Gove, his area of expertise was at the general contractor level, and his experience with sub-subcontractors was limited to his dealings with them on a daily work basis. Accordingly, I am unable to attach much weight to this witness’ evidence. Finally, while the plaintiff's president did indicate in his examination for discovery that sub-subcontractors repeatedly engaged by the plaintiff would probably assume part of their billed invoices would be withheld because "they must feel that that is the custom”, he repeatedly pointed out that he had no knowledge of the payment procedures followed by his competitors in the industry and restricted his testimony at trial to his own company's dealings with its sub-subcontractors.

In Georgia Construction Co. v. Pacific Great Eastern Ry. Co., [1929] S.C.R. 630; [1929] 4 D.L.R. 161, Duff, J. stated at page 633:

. . . Usage, of course, where it is established, may annex an unexpressed incident to a written contract; but it must be reasonably certain and so notorious and so generally acquiesced in that it may be presumed to form an ingredient of the contract, Juggomohun Ghose v. Manickchund, [7 Moore's Indian Appeals 263, at p. 282].

In the present case, the evidence falls far short of establishing that there was a practice in the Alberta construction industry by which subcontractors withheld moneys from progress payments to their sub-subcontractors which was so certain and notorious that I could find it to be a term of the purchase orders between these parties. Nor can I accept the argument of counsel for the defendant that terms may be implied in the plaintiff's contracts with its subsubcontractors by reason of the parties’ previous dealings. It is true that the various sub-subcontractors generally accepted the plaintiff's imposition of holdbacks without complaint and charged no interest on their invoices. It is also a fact that Wide-Lite Ltd., the only sub-subcontractor which did question the plaintiff's accounting, was apparently satisfied by a letter of explanation. These facts alone, in my opinion, do not permit me to infer that the parties always intended to contract on that basis, especially when the terms of the purchase orders and invoices were, as here, clear and unequivocal. Finally, there was no evidence of a verbal agreement applying to the Alberta construction industry generally in respect of holdbacks, and on that basis alone the present case is distinguishable from the situation in Ellis Construction Ltd. v. M.N.R., [1982] C.T.C. 2604; 82 D.T.C. 1625 (T.R.B.).

Engineers' Approval

As noted previously, each of the plaintiff's purchase orders for the projects in question referred, under the heading “description”, to a requirement that the particular sub-subcontractor perform his work as per the plans and specifications to the approval or satisfaction of the engineers and, in one case, the architect. If I apprehend the matter correctly, defendant's counsel argues that the effect of these approval stipulations is to make uncertain the plaintiff's liability to pay its sub-subcontractors the amounts due to them, thus precluding the plaintiff from asserting that the holdbacks were in fact payable during the taxation year and deductible under paragraph 18(1)(a) of the Act. In support of this proposition, counsel referred to the decisions in Guay, supra, and Newfoundland Light & Power, supra.

In Guay, Noël, A.C.J. had to decide whether the appellant general building contractor was entitled to deduct holdbacks which, pursuant to the terms of its contracts with subcontractors, it was not obliged to pay to the latter until 35 days after final approval of the work by the architect. The Minister had refused to allow their deduction under statutory provisions equivalent to the present paragraphs 18(1)(a) and 18(1)(e) of the Act. Noël, A.C.J. said at page 5427:

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 he 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 appellant in Newfoundland Light & Power was a Newfoundland company engaged in the business of generating, transmitting and distributing electrical energy to the public which, under the terms and conditions of its contracts with general contractors, was entitled to withhold ten per cent of amounts otherwise payable to the latter, pending approval or certification of the works by its engineers. In the taxation year in question, the appellant withheld both “capital holdbacks", on which it claimed capital cost allowance, as well as "service holdbacks" relating to maintenance work. At the trial level, Martin, J. accepted expert evidence that generally accepted accounting principles allowed the amounts in issue to be treated as actual rather than contingent liabilities, but nevertheless disallowed the taxpayer's deductions under paragraph 18(1 )(e). In the Court of Appeal, Desjardins, J.A. found that paragraph 18(1)(e) was inapplicable to the facts of the case, and Pratte and Hugessen, JJ.A., each writing concurring reasons for judgment, agreed that the trial judge had erred in relying on that paragraph of the Act. In the view of the appeal judges, the result of the case was dictated by the decisions in M.N.R. v. Colford Contracting Co., [1960] Ex. C.R. 433; [1960] C.T.C. 178; 60 D.T.C. 1131 (Ex. Ct.); affd without reasons [1962] S.C.R. viii; [1962] C.T.C. 546; 62 D.T.C. 1338 (S.C.C.), and Guay, supra. As Hugessen, J.A. stated at page 240 (D.T.C. 6174):

That said, however, the appellant faces the insuperable obstacle of the decisions in Colford and Guay. Each of those decisions was approved, albeit without extensive reasons, by the Supreme Court. In my view, they stand for the proposition that, as a matter of law, uncertified construction holdbacks are to be regarded as contingent both from the point of view of the payor and from that of the payee. That being so, the appellant cannot treat such uncertified holdbacks as "an outlay or expense" under paragraph 18(1 )(a) (the "service" holdbacks) or as “part of the capital cost . . . of property" under paragraph 20(1 )(a) (the “capital” holdbacks).

During his examination for discovery, Mr. Wilson was questioned about the effect of the references on each purchase order to work being done as per plans and specifications to the engineers' or architect's approval. He was asked specifically whether the plaintiff would have considered the various contracts to be completed prior to such approval being given, and he repeatedly answered in the negative. Under rigorous cross-examination, he qualified his earlier discovery answers by suggesting that he might have taken the reference to "contract" to mean those subsisting between his company and the general contractors, rather than the ones at the lower level between his company and the various sub-subcontractors. He went on to explain that while the plaintiff's payments from the general contractors were dependent upon final engineers' or architect's approval in the form of a substantial completion certificate pursuant to the specific terms of A.C.A. Form A, no such contingency obtained, in his opinion, in the case of purchase orders. The witness further testified that on large projects the engineers would frequently visit the job site and regularly issue inspection reports outlining any perceived deficiencies which needed to be corrected by the various sub-trades as the work progressed. According to Mr. Wilson, it was the engineers' approval of these deficiencies, rather than the issuance of a substantial completion certificate, which usually signalled the plaintiff to release holdbacks to the subsubcontractors, as the following excerpt from his cross-examination illustrates:

Q. And would Wil Mechanical have considered this work completed prior to the engineer's approval?

A. I have to answer it the same way, and I probably could qualify a little bit of my reasoning for that, is that in all these it says engineer's approval, but it doesn't refer to the substantial completion date, it doesn't refer to the time that is allotted for payment after the substantial completion date. All these items that are specific to the Alberta contract form or the form that I enter into with the general contractor are not in this, so in reference to the engineer's approval, it is the engineer expecting that his job inspection reports have been rectified to his satisfaction, and as it goes along the final accountability for all of this is the substantial completion.

I accept the witness' clarification of the answers given on discovery for two reasons. Firstly, the evidence shows that the plaintiff did not always await the issuance of the substantial completion certificate before releasing holdbacks to its sub-subcontractors. For instance, the completion certificate for Job 379 was issued in August of 1983. While the plaintiff did not release holdbacks to its sub-subcontractor, Green Thumb Irrigation Ltd., until that date, nevertheless it made payments totalling $45,666.30 to another sub-subcontractor involved in the same project, Wide Lite Ltd., on March 21 and May 13, 1983. To take another example, Job 370 was not substantially completed until November 1983. According to the records, the plaintiff, however, had by then paid in full all holdbacks owing to four different sub-subcontractors engaged on the same project. Counsel for the defendant endeavoured to show during cross- examination that the timing for the release of holdbacks to the subsubcontractors was directly related to the receipt by the plaintiff of holdbacks retained at the subcontract level. I am unable to find on the evidence that any such correlation existed. In any event, I would be inclined to question its relevance. The fact is that the plaintiff, more frequently than not, paid its subsubcontractors in full prior to the dates when the substantial completion certificates were issued, and this alone suffices to convince me that Mr. Wilson was right in stating that those certificates were not the ones referred to in the various purchase orders.

There is another reason for accepting Mr. Wilson's evidence. He testified that on occasion, although apparently not on the projects in issue, the plaintiff would release holdbacks to sub-subcontractors upon determining their work to be completed to its satisfaction. However, the plaintiff would still bear ultimate responsibility for any remaining deficiencies discovered at the time the final completion certificate was issued. In my view, this evidence supports the witness' contention that the release of holdbacks was dependent not upon the issuance of the certificates, but rather upon the plaintiff's satisfaction with the work of its sub-subcontractors. This subjective criterion could well be influenced by the engineers' on-site inspection reports. Not surprisingly, the plaintiff's own cash flow situation appears to have been a factor determining the timing of holdback releases. I note in this regard Mr. Wilson's testimony that cash management concerns prompted his company's imposition of holdbacks in the first place.

In my opinion, the present case is distinguishable from Guay and Newfoundland Light & Power, supra. The terms of the contracts in those cases specifically provided for the retention of holdbacks until "final approval of the work by the architect" (D.T.C. 5425) and “until the contract has been substantially completed to the satisfaction of the Engineer" (C.T.C. 236; D.T.C. 6167) respectively. I am also of the opinion that the principle enunciated by Hugessen, J.A. in Newfoundland Light & Power (C.T.C. 240; D.T.C. 6174), namely, that ”. . . as a matter of law, uncertified construction holdbacks are to be regarded as contingent both from the point of view of the payor and from that of the payee" has no application to the circumstances of this case. Moreover, I accept the submission of plaintiff's counsel that Guay and Newfoundland Light & Power are distinguishable on another ground. In Guay, the subject contracts were between a general contractor and its subcontractors. In Newfoundland Light & Power, the relevant contracts were concluded at yet a higher level, that is, between the owner and the general contractor. Furthermore, each of the contracts in those cases specifically provided for the withholding of a specified percentage of monthly progress estimates. Consequently, I cannot see that the principles enunciated by those cases apply in the present situation.

Chargebacks and Set-offs

The submission of defendant's counsel on this point is simply that the actual amounts sought to be deducted by the plaintiff in respect of the subject projects were not certain as of February 28, 1983, having regard to the plaintiff's evidence that these could involve chargebacks against the sub-subcontractors and deficiencies which the plaintiff would eventually have to correct. Because of the uncertainty as to liability and quantum, it therefore follows, in counsel's submission, that the holdbacks in the present case are analogous to those in the cases of Guay and Newfoundland Light & Power because of the similar uncertainty as to liability and quantum.

In my view, those cases are again distinguishable. It seems to me that the principles stated therein are predicated on the existence of stipulations regarding the issuance of final certificates by architects or engineers in the particular contracts involved which, as I have found, are dissimilar to the ones in the case at bar. In Guay, Noël, A.C.J. observed at page 5426:

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 sub-contractor. 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 (cf. Articles 1187 and 1188 C.C.).

[Emphasis added.]

In Newfoundland Light & Power, Desjardins, J.A. concluded that payment of the holdback amounts in that case was similarly contingent for the following reasons, stated at page 238 (D.T.C. 6172):

I agree that when the work is completed, a liability exists. Until the certificate is issued, the taxpayer however does not know for sure the full cost of the work. On December 31, 1977, the appellant could not ascertain the exact cost of the assets acquired by him since the certificate as to quality had not been issued. The costs to the taxpayer were known for an added amount of $201,783.04 only in 1978; and for another added amount of $5,276.86 only in 1979. More eloquently, an amount of $959.10 was never disbursed. The taxpayer would be acting under a wrong assumption had he been able to claim those amounts, particularly the $959.10, as a cost to him in 1977.

Based on the evidence in its entirety, I find that the plaintiff has demonstrated on balance of probability that the holdbacks in issue were expenses or outlays made or incurred by the plaintiff for the purpose of earning income from its business within the meaning of paragraph 18(1)(a) of the Income Tax Act, and that the Minister’s factual assumption to the contrary was erroneous in the circumstances.

Paragraph 18(1)(e)

The other ground on which the Minister disallowed the plaintiff's deduction from income of holdback payables was based on his assumption that the total of these holdbacks represented an amount transferred or credited to a reserve or contingent account, the deduction of which was prohibited by paragraph 18(1)(e) of the Income Tax Act. Counsel for the defendant cited several authorities, but otherwise did not press the point of the paragraph 18(1)(e) argument.

In my opinion, the evidence supports the submission of plaintiff's counsel that the present case falls more readily within the provisions of paragraph 18(1)(a) of the Act than the "contingent account" provisions of paragraph 18(1)(e). See in this regard: Time Motors Ltd. v. M.N.R., [1969] C.T.C. 190; 69 D.T.C. 5149 (S.C.C.), per Pigeon, J. at pages 192-93 (D.T.C. 5151-520). Consequently, I am compelled to conclude that the Minister was incorrect in assuming as an alternative basis of assessment that the total holdbacks of $347,276.08 represented an amount transferred or credited to a reserve or contingent account, the deduction of which was prohibited by paragraph 18(1)(e) of the Act.

Having found that the plaintiff's obligation in respect of moneys withheld from its sub-subcontractors was not contingent, the cases of Cummings v. The Queen, [1981] C.T.C. 285; 81 D.T.C. 5207 (F.C.A.), and Harlequin Enterprises Ltd. v. The Queen, [1977] C.T.C. 208; 77 D.T.C. 5164 (F.C.A.), cited by counsel for the defendant are, in my view, irrelevant.

Disposition

In the result, the plaintiff's appeal is allowed with costs, and the subject assessment is referred back to the Minister for reconsideration and reassessment in accordance with these reasons for judgment.

Appeal allowed.