The Queen v. Terra Mining & Exploration Ltd. (N.P.L.), 84 DTC 6185, [1984] CTC 176 (FCTD)

Reed, J:—This action concerns the treatment of interest expense under paragraph 20(l)(c) of the Income Tax Act, SC 1970-71-72, c 63 as amended. The specific issue is whether a taxpayer can account for interest expense on a cash basis when he accounts for the rest of his income for tax purposes on an accrual basis and when his accounting for corporate financial reporting purposes is on the accrual basis.

The facts are not in dispute. The defendant’s mine commenced production in commercial quantities in March, 1971, with the result that the three-year period within which it could earn income exempt from tax pursuant to Income Tax Application Rule 28(1) commenced at that time. Accordingly, had the taxpayer accounted for interest expense on an accrual basis for tax purposes, it would not have lowered in any way its taxable income for those years. During all relevant periods, the defendant accounted for interest expense on an accrual basis in its financial statements, however in computing income for tax purposes interest expenses were accounted for when actually paid. As a result, reassessments were issued by the Minister of National Revenue for the fiscal periods ending August 31, 1973, December 31, 1973, December 31, 1974 and December 31, 1975. The defendant appealed these reassessments to the Tax Review Board and that board allowed its appeal by judgment dated April 22, 1981. The appeals with respect to the 1973 and 1974 taxation years were dropped at trial, these having been nil assessments. Thus only the assessment respecting the 1975 taxation year is still in dispute.

The first question is whether there must be an identity of method between the taxpayer’s accounting for tax purposes and his accounting for corporate financial reporting purposes except, of course, when specifically otherwise allowed by the Act. The Minister argues that this must be so. I find this argument miscast. It seems to me that it has long been accepted that different methods of accounting are used for different purposes. The method will vary with the purpose for which the financial statements are being prepared. Counsel for the defendant referred me to an article by B L Arnold entitled “Conformity Between Financial Statements and Tax Accounting”, (1981) 29 Can Tax L 476. He also relied on the decision in Oxford Shopping Centres v The Queen, [1980] CTC 7; 79 DTC 5458. I might also refer to a passage in Scace, The Income Tax Law of Canada (4th Ed 1981) at 72:

It must be stressed, however that while accounting principles are the basis of the computation of profit for tax purposes, they are not always synonymous with business practice; and income for tax purposes is seldom the same as the income shown on the books of the business for its own purposes. For example, capital cost allowance is taken for tax purposes as the taxpayer wishes (within the terms of the Regulations) while for business purposes capital assets are likely to be written off on a straight line depreciation basis.

The articles mentioned above are not authorities but they set out what I understand to be the correct position.

A distinction must be made between a requirement that income for tax purposes be accounted for generally in conformity with accounting principles and a requirement that the taxpayer’s treatment of his financial statements and his tax returns be identical.

As counsel for the taxpayer contended, section 9 of the Act is the starting point. It provides:

Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.

This has been interpreted as requiring a taxpayer to account for his profit “in accordance with ordinary commercial principles’’.

Profit from a business, subject to any special directions in the statute, must be determined in accordance with ordinary commercial principles. (Canadian General Electric Co Ltd v Minister of National Revenue, [1962] SCR 3 [61 DTC 1300], per Martland, J at page 12.) The question is ultimately “one of law for the court”. It must be answered having regard to the facts of the particular case and the weight which must be given to a particular circumstance must depend upon practical considerations. As it is a question of law, the evidence of experts is not conclusive. (See Oxford Motors Ltd v Minister of National Revenue, [1959] SCR 548 [59 DTC 1119], per Abbott J at page .553, and Strick v Regent Oil Co Ltd, [1965] 3 WLR 636 per Reid J, at pages 645-6. See also Minister of National Revenue v Anaconda American Brass Ltd,[ 1956] AC 85 at page 102 [55 DTC 1220].)

Associated Investors of Canada Ltd v MNR, 67 DTC 5096 at 5099 (Exch Ct)

See also Neonex International Ltd v The Queen, [1978] CTC 485; 78 DTC 6339 for the rule that in computing income for tax purposes generally accepted accounting principles such as the matching of revenues and expenses should be adopted unless the Income Tax Act expressly allows otherwise.

There is no doubt that ordinary commercial practices and generally accepted accounting principles would dictate that the taxpayer in this case should have accounted for the interest expense on the accrual basis.

Counsel for the taxpayer, however, argues that section 20(1)(c) of the Act specifically authorizes a departure from such principles and practices. This argument proceeds on two prongs: (1) an argument on the specific wording of the statutory provision 20(1 )(c), and (2) an argument by analogy to paragraph 12(1)(c) of the Act which deals with interest income.

Paragraph 20(1 )(c) provides:

. . . in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted .. . .

an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest . . .

The taxpayer’s argument is that the words in parentheses in paragraph 20(1 )(c) would be redundant and unnecessary unless they were intended to allow the taxpayer the option of choosing the method by which to account for interest expense without constraint by ordinary commercial practices or generally accepted accounting principles.

I do not read the words in parentheses this way. It seems to me they do no more than instruct taxpayers who use the cash method of accounting to account for interest expense using the same method and they instruct taxpayers who use the accrual method of accounting to account for interest expense by that method. The literal meaning of the words would seem to require compliance with generally accepted accounting principles rather than authorizing a departure therefrom. I note that in the decision rendered in MNR v Mid-West Abrasive Company of Canada, [1973] FC 911 at 920; [1973] CTC 548; 73 DTC 5429 Sweet, DJ said of these words:

Wording to be considered is “an amount paid in the year or payable in respect of the year’’ in section ll(l)(c). In my opinion the words “paid in the year’’ are applicable to theose taxpayers who, in computing income, regularly follow the cash basis accounting method and the words “payable in respect of the year’’ are applicable to those who, in computing income, regularly follow the accrual accounting method.

With respect to his second argument, counsel for the taxpayer argues that paragraph 12(l)(c) allows a taxpayer to choose the method by which he will account for interest income without constraint of ordinary commercial practices or generally accepted accounting principles because the wording of paragraph 20(l)(c) is essentially identical to that of 12(l)(c). He argues that paragraph 12(l)(c) has been interpreted to allow a hybrid method of accounting and therefore the same result should follow for paragraph 20(1 )(c). Paragraph 12(l)(c) provides:

There shall be included in computing the income of a taxpayer for a taxation year

any amount received by the taxpayer in the year or receivable by him in the year (depending upon the method regularly followed by the taxpayer in computing his profit) as, on account of in lieu of payment of, or in satisfaction of, interest. . .

I agree that there is nothing in the statutory wording of the two sections which would indicate that any difference of treatment should exist between them. The fact that paragraph 20(1 )(c) refers to “income” and paragraph 12(l)(c) refers to “profits” does not seem significant. No convincing argument was put to me that there was an intention to make a distinction between the interpretation of the two paragraphs by the use of these different words. I think that in the context of the two paragraphs the words are interchangeable.

What then does paragraph 12(1)(c) allow? Counsel for the taxpayer cites two sources for the proposition that a taxpayer is allowed under paragraph 12(l)(c) to choose to account for interest income in a “non-matching” fashion: the decision of this Court in Industrial Mortgage and Trust Company v MNR, [1958] CTC 106; 58 DTC 1060 and the Department of National Revenue’s Interpretation Bulletin IT-396 dated October 17, 1977. It is recognized that the interpretation bulletin is not authority but has some weight as to interpretation. See Nowegijick v the Queen, [1983] CTC 20; 83 DTC 5041 at 5044.

The Industrial Mortgage case involved a taxpayer who for most purposes used the cash basis of accounting. Eighty-five per cent of his income was interest income, most of it from mortgages and bonds. The only deviation from accounting on a cash basis was with respect to the interest from federal and provincial government bonds, federal and provincial guaranteed bonds, municipal bonds and the interest from some pre 1-42 mortgages which had never fallen into default. These were accounted for on an accrual basis. Mr Justice Thurlow (as he then was) at 1061 described the reason for this deviation:

There was an explanation for this difference in the appellant’s accounting practice in respect to the interest on these particular mortgages. Prior to 1931 the appellant’s accounts pertaining to interest on all bonds, mortgages, agreements of sale, and collateral loans had been on an accrual basis, while revenues other than interest on these items were being accounted for on a cash received basis. Between 1931 and 1941, as a result of defaults in payment of mortgage interest and of the appellant having taken into revenue a large amount of mortgage interest which it could not collect, a number of changes in the method of taking interest into revenue were made, each tending to some extent to bring the method nearer to a cash received basis on all items except government bonds. By January 1, 1942, when the last of these changes was made, the method of accounting for mortgage interest was that of taking into revenue the interest on all new loans on a cash received basis while carrying on the accrual basis in respect to the interest on old loans on which the interest had never been in default. If the interest on such a loan subsequently fell into default, the accounting for interest on it was immediately put on a cash received basis.

At page 1064, Mr Justice Thurlow addressed the question of the interpretation of paragraph 6(b), now paragraph 12(l)(c) as follows:

. . . what is meant by the word “method” in s 6(b) and a further question as to whether or not the appellant regularly followed a method of computing its profit. As I interpret it, the word “method” is not used in s 6(b) in any narrow or technical sense but simply means the system or procedure which the taxpayer has regularly followed in computing his profit. The system of procedure, in my opinion, may be made up of a number of practices, and I can see no valid reason why, in a diverse business such as that of the appellant, such system or procedure could not include different practices for accounting for revenue from different activities or sources, depending on the nature of such activities or sources and of the revenues therefrom, and still be regarded as a “method” within the meaning of that word in s 6(b). In my opinion, the practices followed by the appellant did amount to a “method” within the meaning of the section and, as that method had been followed by the appellant without change for the seven years immediately preceding 1949 and for 1949 as well, I have no hesitation in concluding that it was the “method” regularly followed by the appellant in computing its profit within the meaning of s 6(b).

Bulletin IT-396 issued by the Department of National Revenue states respecting interest income:

“Method Regularly Followed”

5. The words in paragraph 12(l)(c) “depending upon the method regularly followed by the taxpayer in computing his profit” are interpreted to refer to the taxpayer’s method of accounting for net interest income from a particular source and not necessarily, if he is carrying on a business, to his method of accounting for profit from the business. It is recognized that, for example, a taxpayer might choose the receivable basis of reporting interest on debts owing to him that are fully secured and the received (cash) basis for more speculative investments. Where such an arrangement was reasonable and was consistently followed, it would be acceptable as a method of reporting interest income. While, as in the above example, interest from all sources need not be reported on the same basis, it is a requirement that interest from the same source must be reported on the same basis. For this purpose, “interest from the same source” refers to interest derived from the same debtor on the same type of obligation. For example, if a taxpayer owned bonds of two different series issued by a certain corporation, interest from the same source and it would be an unacceptable method to report interest from bonds of one series on a cash basis and interest on bonds of another series on the receivable basis. The words “regularly followed” indicate that there will be a consistency from year to year.

The Department’s Interpretation Bulletin seems to me no more than a paraphrase of the Industrial Mortgage case.

Counsel for the taxpayer argues that all a taxpayer must show to bring himself within the hybrid method of accounting allowed by the Industrial Mortgage case is an established and consistent practice by the taxpayer as well as a multiplicity of lenders.

This last requirement results from the decision of Sweet, DJ in MNR v MidWest Abrasive Company of Canada Ltd, [1973] FC 911; [1973] CTC 548; 73 DTC 5429, In that case the taxpayer attempted to take into income, interest expense in the year that its parent company requested payment. Interest on the loans borrowed from the parent company were stated to be “paid if requested but not in excess of 6 per cent”, The taxpayer was required by Sweet, D J to take the interest expense into his income on an accrual basis. The Industrial Mortgage case was distinguished on the ground that (1) it dealt with interest income and not interest expense; (2) there had been an established practice in that case of many years of reporting interest income on a “non-matching” basis, and (3) there were a multiplicity of lenders. In the Mid-West Abraseve Company case, there was only one lender, the parent company. The decision proceeds at 921:

If the proper construction of the section did not confine the deduction which taxpayers who follow the accrual method (unmodified) may take in respect of interest to the year in which the borrowed money was used and if the proper construction permitted it to be deducted in some subsequent year (for whatever cause) the result would be inconsistent with the concept underlying the accrual method. In that event one might have “accrual” in respect of all matters except interest and have a cash basis for interest. In my opinion the wording of the section does not permit such a result except in circumstances such as existed in Industrial Mortgage and Trust Co v MNR (supra) and in my view such circumstances do not exist in this case.

I do not think it is sufficient on the basis of the decisions in the Industrial Mortgage and Mid-West Abrasive cases to justify a hybrid system of accounts solely on the basis of a consistent and established practice of “non-matching” and a multiplicity of lenders. The principle I take from those decisions is that both paragraphs 20(l)(c) and 12(l)(c) require accounting in conformity with ordinary commercial practices and/or generally accepted accounting principles. The Industrial Mortgage case is entirely consistent with this view. In that case, it seems to me the taxpayer was allowed a hybrid system of taxation either because

(1) he was transferring from an accrual to a cash basis of accounting, or (2) because the loans for which he adopted the accrual method were more secure than those for which he accounted on the cash basis. That is, even though not expressly articulated in that case there were valid reasons founded in ordinary commercial practice and generally accepted accounting principles for allowing a hybrid system of accounting. There was no such justification in the Mid-West Abrasive case and no such justification has been demonstrated in this case. Accordingly, I would allow the appeal and set aside the decision of the Tax Review Board.