Ennisclare Corp. v. The Queen, 83 DTC 5018, [1982] CTC 428 (FCTD), aff'd 84 DTC 6262, [1984] CTC 286 (FCA)

Mahoney, J:—The issue here is the reserve allowed to the plaintiff under subparagraph 20(1 )(n)(ii) of the Income Tax Act for its year ended June 30, 1977. The plaintiff had, to that date, engaged in a single business venture: construction and development of a condominium project. It acquired the land at a cost of $247,202 and, prior to construction, granted a first mortgage under whose terms $7,102,288 was eventually drawn down as construction proceeded to completion.

With few exceptions, the selling price of each unit comprised three elements: assumption of a pro rata amount of the first mortgage, cash and a balance secured by second mortgage in favour of the plaintiff. In rare cases, the cash payment was sufficient to obviate a second mortgage and, more exceptionally, to commute part or all of the first mortgage share. The Plaintiff had sold units in each of its 1975, 1976 and 1977 taxation years. By the end of its 1977 year, gross sales aggregated $7,249,593, whereof $436,808 was cash and $5,758,460 by first mortgage assumptions; gross profit to June 30, 1977, was $2,308,553 and the deferred balance of the second mortgages as at June 30, 1977, was $1,054,325. The construction cost attributable to the units sold to that date was $4,739,551.

The Act provides:

20. (1) . . . in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(n) where an amount has been included in computing the taxpayer’s income from the business for the year or for a previous year in respect of property sold in the course of the business and that amount or part thereof is not due,

(ii) where the property sold is land, until a day that is after the end of the taxation year,

a reasonable amount as a reserve in respect of such part of the amount so included in computing the income as may reasonably be regarded as a portion of the profit from the sale.

Parliament’s obvious intention was to permit a taxpayer to match tax liability and realization of profit. Two applications of the provision are illustrated in the decision of the Tax Review Board in Makis Construction v MNR, [1972] CTC 2082; 72 DTC 1101. There is no material distinction between the provision of subparagraph 85B(1)(d)(ii) considered there and the present subparagraph 20(1 ) (n)(ii).

In computing the amount of the reserve to be granted to a vendor, it is important to bear in mind that such a reserve under section 85B(1)(d) is only allowable in respect of the profit element in the amount receivable. The only requirement in regard to the allowable amount of a reserve in respect of the profit element in such a receivable is that the reserve must be a reasonable amount. In practice, it is considered reasonable to assume that the percentage of any amount of the sale price receivable in a subsequent taxation year that should be taken to represent the profit element included in the said receivable would be the same percentage of that receivable as the gross profit is of the total sale price. Conceivably a reserve might be allowed equal to the full amount of the profit so determined if no portion at all of the selling price had been received in the year of sale. Stated as a formula, the foregoing would be expressed as:

	Gross Profit
—	——	—	x Amount Receivable	Reserve
Gross Selling Price

A modification of this formula is called for in a situation where an existing mortgage (or mortgages) is assumed by the purchaser, provided that none of these assumed mortgages has been placed on the property subsequent to the completion of the building so as to reduce the owner’s existing equity in the property. In such a case, the mortgage or mortgages so obtained are disregarded in calculating the reserve. In the case of the assumption of an existing mortgage by the purchaser, the above formula is modified by changing the denominator from the amount of the gross selling price to the difference between the gross selling price and the amount of the mortgage or mortgages taken out on the building during construction and later assumed by the purchaser. The formula then becomes:

Gross Profit
—	X Amount Receivable	Reserve
Gross Selling Price —
Mortgages Assumed

The Makis decision is not binding authority but it is significant in that, in concluding that the second formula was a valid approach in the circumstances described, the Tax Review Board was upholding the formula adopted by the Minister, not that urged by the taxpayer.

The evidence, illustrated by exhibits P-28 and P-29 respectively, which were originally marked in the examination for discovery of the defendant’s officer read into evidence by the plaintiff, is that either method of calculation described inmakis is acceptable in appropriate circumstances. The present case is complicated by the fact that the first mortgage exceeded the cost of construction. The formula sought to be applied by the plaintiff takes that into account.

The defendant, in assessing, has applied the first formula:

The plaintiff, in appealing that assessment, urges the following:

$2,308,553

X $1,054, 325 =$969,691

$7,249,593-$4,739,551

The plaintiff’s formula does not, apparently, take account of another complication arising from the fact that the first mortgage exceeded the cost of construction. That complication is the realization of gross profit that occurred when the purchasers assumed the first mortgage. When the plaintiff drew down the mortgage proceeds, it received cash in hand. What was not spent on construction remained in hand in the sense that, whatever its application, it had no bearing on the determination of the gross profit, gross selling price minus cost of land and construction. Assumption by the purchasers of that excess relieved the plaintiff of its obligation to repay the excess of the mortgage. To the extent of that excess, relief from its liability entailed, as one of its elements, realization of gross profit.

It is reasonable in this instance to take account of the first mortgage assumed by the purchasers. It must, however, be taken account of both as it affected the gross selling price and effected a realization of gross profit. I have no evidence upon which to propose a formula that would lead to a reasonable result in every such case; however, in this case, the following leads me to what I find to be a reasonable result.

The gross selling price, $7,249,593, less the cost of construction, $4,739,551, is $2,510,042. The cost of construction being totally attributed to first mortgage assumptions, the balance of the gross selling price breaks down as follows:

It seems reasonable to allocate the $2,308,553 gross profit to each of those elements in the same proportions:

The result is startingly, and I trust coincidentally, similar to that arrived at by application of the plaintiff’s formula.

The Defendant led no evidence. I gather from the argument that the rejection of the plaintiff’s formula was actually a reaction that a reserve $969,691, or 92%, ‘of the entire $1,054,325 receivable was per se unreasonable. I do not accept that. The ratio of reserve to amount receivable will, in every case, reflect the ratio of gross profit to gross selling price. If the gross profit is, as here, extremely high relative to the gross selling price, the reasonable reserve will be extremely high relative to the receivable. That is pure arithmetic.

If adjustments in the circumstances of Makis and of exhibit P-29 are appropriate, then the mere fact that the mortgage taken out by the vendor and assumed by the purchaser is very large relative to the selling price does not render them inappropriate nor, in my view, does the fact that the mortgage assumed exceeds the increase in the value of the property attributable to its proceeds as long as the excess is properly taken into account.

The appeal will be allowed with costs and the plaintiff’s 1977 income tax assessment referred back for reassessment on the basis that a reasonable reserve under subparagraph 20(1 )(n)(ii) is $969,592.