The Queen v. Huxtable, 77 DTC 5251, [1977] CTC 364 (FCTD)

The Associate Chief Justice:—This is an appeal from a judgment of the Tax Review Board which allowed an appeal by the defendant from a reassessment of income tax for the year 1969. In that year Bedford Investments Limited (formerly Newfoundland Canada Steamships Limited) became a personal corporation, as defined in section 68 of the Income Tax Act, and under section 67 of the Act the defendant, as owner of the company, was liable for tax in respect of a dividend deemed to have been distributed to him equal to the income of the company for the year. The issue in the appeal is whether the company in computing its income was entitled to deduct an amount of $48,750 which it allowed or credited to a newly incorporated company, named Newfoundland Canada Steamships Limited, in the transaction which is described in what follows.

The Tax Review Board, after hearing evidence, concluaed that Bedford was entitled to the deduction and accordingly allowed the appeal. In this Court, however, the case was presented on an agreed statement of facts which, with the documents therein mentioned, including the pleadings, constitutes the material on which the matter must be determined. In summary, what they disclose is that Bedford, after operating a ship known as the Bedford II for some years, on January 1, 1969, in a transaction not at arm’s length, sold the ship, the company’s goodwill and its entitlement to a tax refund to the new company (hereafter New Newfoundland), and that that company assumed certain items shown on its opening balance sheet as liabilities. Included under the latter was an item referred to as “reserves”, Quadrennial Survey, $48,750. Such an amount was included by Bedford in computing its income for the year ending December 31, 1968 as a reserve for quadrennial survey under paragraph 11(1)(ea) of the Income Tax Act* [1] and, in consequence and since the quadrennial survey was not done in 1968, it became necessary for Bedford, under paragraph 6(1)(eb),t [2] to include that amount in computing its income for 1969. Of that there is no longer any dispute. It is claimed, however, that Bedford is entitled to deduct a like amount of $48,750 as a revenue expense incurred in the course of the transaction of January 1, 1969. In this connection, the plaintiff’s statement of claim contains, among others, the following three paragraphs which were admitted by the defendant:

8. As the vessel, Bedford II, was subject to the provisions of the Canada Shipping Act for quadrennial surveys, Old Newfoundland, Bedford, had set up a reserve in its accounts of $48,750 as of December 31, 1968, in respect of the survey which was to be required to be performed during 1969;

9. Bedford transferred the vessel on January 1, 1969, to New Newfoundland at its undepreciated capital cost in the hands of Bedford;

10. Bedford also agreed to give New Newfoundland an amount of $48,750, the amount appearing on the books of Bedford as a reserve for quadrennial surveys, in respect of the estimated cost of the quadrennial survey;

In view of this and the other facts appearing from the agreed statement, it appears to me that:

(1) in the transaction, the amount of $48,750 was in fact allowed or credited by Bedford to New Newfoundland, against what otherwise would have been the balance of the consideration to be paid or given by New Newfoundland;

(2) in that sense, the amount was paid by Bedford to New Newfoundland on January 1, 1969, in respect of the estimated cost of the quadrennial survey; and,

(3) as other assets of Bedford were transferred in the same transaction, the $48,750 should not be regarded simply as a reduction of the price to be paid for the ship.

It should be noted, however, that while the owner is required by the Canada Shipping Act, RSC 1970, c S-9, to have the quadrennial survey done, and cannot get a certificate to permit further operation of the ship until the survey has been done, it is no more than a condition for further operation since the owner has at all times the alternatives of disposing of the ship to a buyer or of having her broken up for scrap in either of which instance there would be no further obligation on him to have a survey made. Or he might let her lie idle. It is only if he proposes to continue operating the ship that he must have the survey made.

The question then is whether Bedford is entitled to a deduction in respect of the $48,750 which it allowed or paid to New Newfoundland. The principal points of Mr Ainslie’s argument, as I understand it, were that there was never any actual liability on Bedford to have the quadrennial survey carried out; that at most there was a potential liability which would mature only if Bedford continued to operate the ship; that this potential liability and the state of the ship were no doubt taken into account in arriving at the value of the assets to be transferred to New Newfoundland but that this does not give rise to a deductible expense; that even if Bedford had agreed to have the survey and repairs carried out, on the authority of Montship Lines Limited v MNR, [1954] Ex CR 376; [1954] CTC 295; 54 DTC 1151, the amount would not be deductible; and that if the $48,750 is an amount allowed in respect of dilapidations, since no repairs were carried out, the amount is a mere estimate and its deduction is prohibited by paragraph 12(1)(e). On the latter point, counsel relied on Edward Collins & Sons, Ltd v Commissioners of Inland Revenue (1924), 12 TC 773; The Naval Colliery Co, Ltd v Commissioners of Inland Revenue (1928), 12 TC 1017; and Peter Merchant, Ltd v Stedeford (HM Inspector of Taxes) (1948), 30 TC 496. He also read from Southern Railway of Peru Ltd v Owen, [1957] AC 334; James Spencer & Co v Commissioners of Inland Revenue (1950), 32 TC 111; and Federal Commissioner of Taxation v James Flood Proprietary Limited (1953), 88 CLR 492.

While these cases illustrate principles applied in other jurisdictions, I do not find them of much assistance in resolving the present problem. It must, I think, be remembered that they are decisions on provisions of the statutes applicable to the situations with which they deal and that such provisions are not necessarily the same as those of the Income Tax Act. The difference between the English statute and the Australian statute is brought out in the following passage from the judgment in the Flood case at page 505; it is also apparent from the passage that both statutes are different from the Income Tax Act:

In considering such questions the difference should never be overlooked between the English income tax law and the Commonwealth statute. The Report of 1936 of the Income Tax Codification Committee, par 76, contains the following description of the English system:

“It has often been the subject of judicial comment that the existing Acts contain no general direction as to the ascertainment of business profits. Such guidance as they give is confined to a statement that the amount to be assessed is ‘the balance of the profits or gains’ of the business, Subject to a series of provisions prohibiting certain specific deductions— some of which, being in the form of limitations, are taken as authorisations of deductions within the limits. It has been left to the Courts to lay down that ‘the balance of the profits or gains’ must, in the absence of express provision to the contrary, be arrived at in accordance with ordinary commercial principles, and to formulate the principle that a proper debit item in a trading or in a profit and loss account is, in general, a proper debit item in an income tax computation.’’

The principle of the Commonwealth Act, on the other hand, is to calculate the taxable income as the amount remaining after deducting from the assessable income all allowable deductions and to restrict allowable deductions to deductions allowable under the Act. What losses and outgoings arising in the course of business are to be deducted is a matter which must be governed by s 51(1) of the Income Tax Assessment Act. Under its provisions all losses and outgoings may be deducted to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, provided, of course, they are not of a capital nature or otherwise excluded. The word “outgoing” might suggest that there must be an actual disbursement. But partly because such an interpretation would produce very strange and anomalous results, and partly because of the use of the word “incurred”, the provision has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement.

The scheme of the Income Tax Act, so far as it is applicable to the present situation, is found in sections 3, 4, and 12. By section 3, the income of a taxpayer (which, under paragraph 139(1)(av), includes any person) for a taxation year includes inter alia income from all businesses. By section 4 subject to the other provisions of Part I of the Act, income for a taxation year from a business or property Is the profit therefrom for the year. It is well established that the profit from a business is the profit as ascertained by the application of ordinary commercial principles, but for income tax purposes the profit so established is subject to such limitations or alterations as are required to give effect to the other provisions of Part I of the Act. Among these is section 12 which provides inter alia that:

12. (1) In computing income, 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 property or a business of the taxpayer,

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

Under these provisions, in order to qualify for deduction an outlay or expense that is deductible in computing profit on ordinary commercial principles must also fall within the exception to paragraph 12(1 )(a). If, on the other hand, the item to be claimed is not an actual outlay or expense but an amount set aside or taken into account to provide for some anticipated outlay or expense for which liability has not yet arisen, it will be, in substance and in fact, a reserve and will fall under the prohibition of paragraph 12(1)(e).

On the facts of the case, it appears to me to be impossible to regard the allowance or payment of $48,750 made by Bedford to New Newfoundland in the transaction of January 1, 1969 as in any relevant sense a reserve within the meaning of paragraph 12(1)(e). The amount of $48,750 set up by Bedford in its accounts for the period ending December 31, 1968 was a reserve, and was deductible as such, in computing income for 1968, under paragraph 11 (1 )(ea) and the regulations, notwithstanding paragraph 12(1)(e). But what was allowed or paid to New Newfoundland on January 1, 1969 was not a reserve. It was, if it was anything at all, an item of disbursement and the fact that its amount was calculated or arrived at as an estimate of the cost of the survey does not make it in any sense a reserve. Paragraph 12(1 )(e) accordingly has no application to prohibit its deduction.

On the other hand, adverting to paragraph 12(1)(a), while I think the disbursement must be taken to have been “made” or “incurred” within the meaning of those terms in the paragraph, I am not satisfied that it was made or incurred “for the purpose of gaining or producing income from” the business of Bedford, within the meaning of that paragraph. The business had been that of operating the Bedford II. But the amount was not allowed or paid to enable Bedford to continue to operate the ship, and the transaction in which the amount was allowed or paid was not a transaction in the course of the business. It was a transaction that disposed of the assets employed in the business and put an end to it. Such a transaction is not one for the purpose of gaining or producing income from the business. Nor is the amount which Bedford, in the transaction, agreed to pay or allow an outlay or expense incurred “for the purpose of gaining or producing income from” the business.

The exception to paragraph 12(1 )(a) is not a narrow one. Speaking generally, it includes any expense that is an incident or part of the profit-earning operation. But, even if it is broad enough to include, in some instances, an expenditure incurred in a transaction by which the business is terminated, of which there may be some question and which it is not necessary now to decide, it does not appear to me to embrace an expenditure of the kind here in question, that is to say, an expenditure not for a survey of the ship but simply to give the purchaser of the capital assets of the business, including the ship, an allowance in respect of the anticipated cost of a survey which he might thereafter use or not use for that purpose, as he might see fit. Plainly it was not an outlay for a survey because no survey was made.

The defendant’s position was that the expense of a quadrennial survey is really incurred while the ship is being operated but, as there is no annual outlay made or expenses incurred for it, nothing could be deducted in respect of it in any of the first three years because of paragraph 12(1)(e); that Parliament recognized this as being unfair and has provided for it by paragraph 11(1)(ea); that if and when a taxpayer pays anyone else to do with respect to a quadrennial survey what otherwise the taxpayer would ultimately have to do and then becomes entitled to deduct the cost, what the taxpayer pays equally relates to the operation of the vessel in the preceding years and the payment takes its character from that of the expense for which it was submitted. He cited as an instance of this the common practice of apportioning current taxes between vendor and purchaser in closing real estate transactions. It is a tempting argument, but I do not think it can prevail.

With respect to the submission that the expense of a quadrennial survey is incurred while the ship is being operated, it is to be observed that the material before me provides no guide as to how the matter is regarded or dealt with in ordinary commercial practice. It was said, however, that for income tax purposes the amount of the reserve deducted under paragraph 11(1)(ea) in 1968 was equal to three- quarters of an estimate of what the survey would cost, based on the experience of the actual cost of the previous quadrennial survey. Throughout that stage, however, there was no outlay made or expense incurred for the survey. There was only a reserve which, so far as income tax purposes are concerned, fell under the prohibition of paragraph 12(1)(e) except to the extent permitted by paragraph 11(1)(ea). It appears to me to follow that in the statutory scheme the incurring of the need for a survey is not equivalent to the making of an outlay or the incurring of expense for a survey and cannot be considered or treated as, in itself, an expense. There was, thus, in fact and in law no expense incurred by Bedford to which, in computing income for income tax purposes, the allowance or payment made by Bedford to New Newfoundland could relate or from which it could acquire or take the character of an expense for a quadrennial survey.

With respect to the practice in real estate transactions, the analogy appears to me to break down because in such situations there is, in fact, a liability for taxes which is an expense incurred by one party or the other in respect of the year in which the sale occurs. Here there was no quadrennial survey and no cost was incurred by vendor or purchaser for one.

In the course of argument, counsel for the defendant suggested that, if I should conclude that the $48,750 was simply a reduction in the price of the ship, the matter should be referred back to the Minister with a direction to deduct a terminal capital cost allowance. The point, however, was not raised in the defence and, in any case, I have not concluded that the $48,750 was a reduction in the price of the ship.

The appeal accordingly succeeds and will be allowed with costs and the reassessment will be restored.