Dibro Investments Ltd. v. MNR, 87 DTC 210, [1987] 1 CTC 2281 (TCC)

Bonner, T.C.J.:—These are appeals from assessments of income tax for the appellant’s 1978 and 1979 taxation years. The fiscal periods in question ended on April 30. The appellant carried on the business of operating weight reduction classes utilizing a programme and certain trademarks under license granted to it by The Diet Workshop, Inc. (hereinafter “Diet Workshop"). The license agreement called upon the appellant:

To pay directly to Licensor a continuing service fee, throughout the term of this Agreement and any extensions thereof, of 10% of Area Director's* [1] gross weekly receipts from clients for services rendered. Such payments shall accompany Area Director's weekly gross sales report on forms to be provided.

In the fall of 1977 the appellant discontinued payment of the fee and withheld weekly reports in an attempt to put pressure upon the licensor to renegotiate the license agreement. The licensor did not agree and a dispute developed which was not resolved for several years. In the meantime the appellant sought to deduct in the computation of its income amounts accrued as payable under the existing agreement. The respondent disallowed the deductions on the basis that they represented amounts transferred to a contingent account within the meaning of paragraph 18(1)(e) of the Income Tax Act. In an amended reply to the notice of appeal the respondent raised a related argument in support of his assessments. He took the position that the fees were not expenses “incurred" within the meaning of paragraph 18(1)(a) of the Income Tax Act.

The appellant’s position was that the deduction of the accrued license fees was proper, in accordance with generally accepted accounting principles, and did not represent a contingent liability or reserve fund the deduction of which is prohibited by paragraph 18(1)(e).

The license agreement was entered into in June of 1971 for a term of ten years. The dispute which resulted in the withholding of fees in 1977 was not the first between the parties. Complaints were made by the appellant to Diet Workshop in 1973 and 1974. Diet Workshop was based in the United States. The appellant started to withhold fees in 1973 in order to persuade Diet Workshop to “orient its concept more to the Canadian marketplace". Harvey Brooker, one of the appellant's principals, gave evidence that he wanted Diet Workshop to either prepare materials appropriate to Canadian operations or to reduce franchise fees to enable the appellant to do so itself. In 1976 the appellant paid all of the arrears owing to Diet Workshop in the expectation that negotiations would then commence for a new contract. Diet Workshop refused to negotiate and the appellant subsequently embarked upon the second period of withholding.

Detailed evidence was given at the hearing of the appeals as to the meetings, correspondence, negotiations, legal manoeuvres and other events which transpired during the period from the fall of 1977 until September 24, 1982, when a settlement was reached and an agreement was signed which, inter alia, released the appellant from all claims for arrears of license fees. The evidence of Harvey Brooker and of Jack Greenberg, the solicitor for the appellant, establishes that during the period of withholding the appellant did not dispute the fact that fees were payable but, rather, relied on the absence of any provision in the agreement specifying when the weekly reports and payments were to be submitted to Diet Workshop. That evidence also establishes that Mr. Greenberg’s opinion was that there was no legal merit in the appellant’s position. That opinion was communicated frequently to the principals of the appellant. Despite Mr. Greenberg's pessi- mism the appellant persisted with its stalling tactics in order to force Diet Workshop to negotiate with it.

During the previous dispute Mr. Brooker wrote to Diet Workshop as follows:

In spite of this, I am only able to draw an almost living wage from our company and I do feel that one of the major factors in limiting my revenue is the high rate of royalties I have to submit each week. I think if you dig deep within your soul, you have got to realize that 10% off the top, with class averages around 26, and with our overall expenses, make it just a little too high. When I became aware of what Buffalo and Cincinnati were paying, I first did a slow boil. Then after calming down, I thought the best way to approach the situation was to act calm and speak with you.

The appellant’s grievances during the second period of dispute were the same. A list thereof prepared for a meeting between the appellant and Diet Workshop included the following:

— franchises are receiving no value for their royalty fees

— there is a marked disincentive for growth since there is no assistance or subsidization when new areas are opened

— there is a marked disparity in the royalty fees paid between different franchises

— there is a lack of proper advertising, management and coordination of marketing of programs at top or senior levels

— the franchisees are in a poorer position competition-wise with organizations like Weight Watchers

The appellant retained the services of counsel in the United States who acted for a number of other Diet Workshop franchisees. On June 7, 1979, that lawyer wrote to Mr. Brooker in part as follows:

David Goldberg, counsel to The Diet Workshop, Inc., called to inform me that as a counterproposal to our offer, they would want to audit your books and would then settle for 80% of what is due and owing in the form of cash and/or notes. Further, in the event that the 3 contract is not signed regarding future royalties, they would reduce your present royalty arrangement to 9%.

Mr. Greenberg testified that he could recall no reference prior to June 7, 1979, to the possibility of settlement of the arrears at less than 100 per cent. Mr. Brooker stated that there were no negotiations earlier than the summer of 1979 with regard to settling the amount of the arrears. He had retained the U.S. attorney, however,

. . . because of his position in negotiating for the other franchisees, he would be able to offer them some amount of money less than the accumulated amount of money, really to compensate for all the expenditures that we had had to this point.

The testimony of Messrs. Brooker and Greenberg suggests that negotiations directed toward achieving a reduction in the amount of the fees outstanding did not commence prior to May or June of 1979, that is to say, after the close of the appellant’s 1979 taxation year. It does not follow, however, that at all times prior the appellant expected to eventually pay the full outstanding amount. The appellant was, of course, withholding the money in order to force Diet Workshop to the bargaining table. In light of its persistent complaint that ten per cent was too high it is quite likely that the appellant intended to seek rate relief not only for the period after the settlement of the dispute, but also for the period before. In short, it is probable that in computing income it was attempting to deduct an amount greater than it hoped it would ultimately be required to pay.

Evidence was given by Henry Finkelstein. He is a chartered accountant practising his profession in Toronto. The appellant was one of his clients. His evidence was that applying generally accepted accounting principles all expenses incurred in order to earn income for a period should be charged against that income in the preparation of the financial statement. It was his view that the unpaid fees were not a contingent liability; the fact that the appellant had not paid a legitimate debt did not lead to a conclusion that the debt was contingent. He stated that in reaching his conclusion he relied on the opinion of Mr. Greenberg who:

. . . told me many times that there was no way that they would not be obligated if it ever came to trial not to pay the full amount of the liability.

In my view the appellant, in the course of operating its business during each of the two years, became subject to a clear and unqualified liability under the licence agreement to pay a precise and ascertained amount of money. Accordingly, it had . incurred . . . expense . . .” within the meaning of paragraph 18(1 )(a) of the Income Tax Act. In Pickle Crow Gold Mines Limited v. M.N.R., [1954] C.T.C. 390 at 395; 55 D.T.C. 1001 at 1003, Cameron, J. said:

In this case, if the appellant is entitled to succeed I must first be satisfied that the expenses now claimed as deductible were “expenses incurred by the taxpayer”, that being one of the conditions laid down in the Regulation. It seems to me that these words are precise and unambiguous and that, therefore, no more is necessary than to expound them in their natural and ordinary sense. In my opinion, the words “expenses incurred by the taxpayer” have a natural and ordinary meaning of expenses either paid out by the taxpayer or which he has became liable to pay.

Counsel for the respondent argued that the paragraph 18(1)(a) words. . expense . . . incurred . . ought to be interpreted according to several principles of general application, the first being that a taxpayer's true gains for a period are to be ascertained as exactly as can be. She asserted that while the accrual of a liability is permitted it is subject to that overriding principle and deduction can only be had if there is certainty both as to quantum and ultimate payment. She relied, inter alia, on the decision of the Supreme Court of Canada in M.N.R. v. Benaby Realties Limited, [1967] C.T.C. 418; 67 D.T.C. 5275 and in particular on the statement by Judson, J. at 421 (D.T.C. 5277):

My opinion is that the Canadian Income Tax Act requires that profits be taken into account or assessed in the year in which the amount is ascertained.

She relied also on the decision of the Federal Court — Trial Division in J.L. Guay Ltée v. M.N.R., [1971] C.T.C. 686; 71 D.T.C. 5423 and in particular the following passages from the reasons for judgment of Noël, A.C.J. (a) at 691 (D.T.C. 5426):

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.

and (b) at 692 (D.T.C. 5427):

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.

Finally counsel submitted that even if a legal obligation to Diet Workshop did exist there were circumstances which indicated that the payment would not be made and in such circumstances the requisite certainty did not exist.

I do not and indeed cannot quarrel with the principles to which counsel referred. However, they do not support the disallowance of the deductions sought by the respondent. Here a clear liability to pay a fixed and certain amount existed at the end of each of the two years. The position is in no way analogous to that considered by the Court in Benaby, supra, where the taxpayer was contending that the proper year in which to include a profit on expropriation was a year prior to that during which the amount of compensation was fixed. Undoubtedly, as Noël, A.C.J. observed in Guay, supra, provisional amounts must be rejected for tax purposes. However, as previously indicated, in the circumstances of the present case the liability in question was fixed and certain in amount at least up to the end of the taxation years in question. Indeed a deduction of anything less than the amounts sought by the appellant would have been provisional in that the entry would have been dependant for its accuracy upon the happening of uncertain events. There was nothing to indicate that the appellant's stalling tactics would result in forgiveness of the whole or any part of the liability.

The present case is, in my opinion, analogous to that considered by the Supreme Court of Canada in Time Motors Limited v. M.N.R., [1969] C.T.C. 190; 69 D.T.C. 5149. There the taxpayer was a used-car dealer which paid for cars in part by cash and in part by credit note valid for a period of two years and applicable to the price of the cars purchased from it. The taxpayer sought to deduct the amounts of the outstanding credit notes as current liabilities. The respondent's position was that the amounts thereof were non-deductible contingent liabilities. Pigeon, J., speaking for the Court, dealt with the respondent's arguments as follows (at 191; D.T.C. 5150-51):

On the appeal to this Court, counsel for the Minister contended that when appellant issued each credit note there was not, in fact, created any contract or agreement which would give rise to any liability or obligation because, in particular, there was no agreement as to the price or the model of car which could be purchased by the customer upon presentment of the credit note. This contention cannot be upheld. The credit note should not be considered apart from the transaction out of which it arises. It is part of the consideration for an executed contract, the purchase of a used car. Under that contract, appellant became obliged to pay a stated sum of money, a part only of that sum was paid in cash, the balance remaining due was stipulated payable in merchandise of a stated kind. While the contract is spelled out in two separate documents, the bill of sale and the credit note, the latter cannot be considered otherwise than as evidence of the conditions of the obligation to pay the balance of the purchase price. That obligation must be considered as subsisting until satisfied or expired. No special reason was advanced, no authority was cited to support the contention that the credit note should be considered otherwise.

The fact that the merchandise to be obtained by virtue of a credit note was not specified does not mean that appellant’s customer had no enforceable obligation for the balance due. He could select any of the cars offered for sale coming within the general description in his credit note and require delivery by tendering the note and cash to make up the posted price.

Here as in the Time Motors case, supra, accounting evidence was given. Mr. Finkelstein’s evidence, summarized previously, was not rebutted. At page 192 (D.T.C. 5151) Pigeon, J. said:

Respondent’s second contention is that because appellant’s obligation was conditional it should not, until the condition was realized, be treated for purposes of income tax as a current liability but as an amount properly to be entered in a contingent account. As a result, the deduction would be prohibited by section 12(1)(e) of the Income Tax Act:

12 (1) In computing income, no deduction shall be made in respect of

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part,

The wording of that provision clearly refers to accounting practice. The only expression applicable to the present case is not “contingent liability” but “contingent account”. This means that the provision is to be construed by reference to proper accounting practice in a business of the kind with which one is concerned. In the present case, the only evidence of accounting practice is that of appellant’s auditor, a chartered accountant. His testimony shows that in appellant’s accounts credit notes are treated according to standard practice as current liabilities until they are redeemed or expired. They are not classed as contingent liabilities. When asked why he considered the obligation under a credit note as current liability and the obligation under a warranty as contingent, he said:

. . . the credit note, while it is a liability, is also an existing obligation today. A warranty may be a liability in the future. It may be determinable in the future but isn’t an existing obligation until the future. At least, this is my interpretation of the difference.

In my view neither paragraph 18(1)(a) nor paragraph 18(1)(e) apply to prohibit the deduction of the amounts in issue. The appeals will therefore be allowed with costs and the assessments referred back to the respondent for reconsideration and reassessment accordingly.

Appeals allowed.