Bonner J.T.C.C.: — This is an appeal from an assessment of income tax for the 1987 taxation year. Booth Dispensers Limited (“Booth”) carried on the business of manufacturing soft drink dispensers. During its 1986 taxation year Booth “accrued” management bonuses of $1,694,300 and deducted that amount in computing income for the year. During its 1987 taxation year a $105,276 part of those bonuses was paid and the indebtedness with respect to the remaining $1,589,024 was extinguished without cost to Booth. In its domestic financial statements for 1987 Booth reversed the unpaid accrued bonuses. It entered the amount forgiven as “other revenue” in its statement of earnings for the year. However, for purposes of income tax, it deducted the $1.589 million as “section 80 settlement of debt” in the reconciliation of income per financial statements with net income for tax purposes. The Minister of National Revenue (“Minister”) assessed tax for the 1987 taxation year on the basis that the cancelled bonus formed part of the appellant’s income for the year by virtue of section 9 of the Income Tax Act (“Act”) and that section 80 did not apply by virtue of paragraph 80(1 )(f).
The issue in this case is whether, as a consequence of the cancellation of the obligation to pay bonus, the $1.589 million must be applied in the manner laid down in paragraphs 80(1 )(a) and (b) of the Act or whether those provisions are inapplicable by reason of paragraph 80(1)(f). Section 80 reads in part:
(1) Where at any time in a taxation year a debt or other obligation of a taxpayer to pay an amount is settled or extinguished after 1971 without any payment by him or by the payment of an amount less than the principal amount of the debt or obligation, as the case may be, the amount by which the lesser of the principal amount thereof and the amount for which the obligation was issued by the taxpayer exceeds the amount so paid, if any, shall be applied
(a) to reduce, in the following order, the taxpayer’s
(i) non-capital losses,
(1.1) farm losses,
(ii) net capital losses, and
(iii) restricted farm losses, for preceding taxation years, to the extent of the amount of those losses that would otherwise be deductible in computing the taxpayer’s taxable income for the year or a subsequent year, and
(b) to the extent that the excess exceeds the portion thereof required to be applied as provided in paragraph (a), to reduce in prescribed manner the capital cost to the taxpayer of any depreciable property and the adjusted cost base to him of any capital property,
unless
(f) the excess is otherwise required to be included in computing his income for the year or a preceding taxation year or to be deducted in computing the capital cost to him of any depreciable property, the adjusted cost base to him of any capital property or the cost amount to him of any other property,
It was the position of the respondent that generally accepted accounting principles (“GAAP”) require the inclusion of the forgiven bonuses in computing profit for purposes of section 9 of the Act. Accordingly, it was said, the cancelled debt must be included in computing income for 1987. Paragraph 80(1 )(f) applies to oust the rules set out in paragraphs 80(1 )(a) and (b).
It was common ground that Booth “accrued” the management bonuses in its 1986 taxation year. I take that to mean that in 1986 Booth became legally obliged to pay to the three members of management named in the evidence bonuses totalling $1.694 million. Booth did deduct the amount accrued in computing its income for 1986.
The cancellation of the obligation to pay the bonuses arose from an agreement to sell the shares of Booth. All of the outstanding shares were owned by the three persons who were entitled to receive the bonuses. In 1987 they reached a tentative agreement to sell the shares to Alco Standard Corporation. That agreement was set out in a letter of intent dated November 24, 1987 which provided in part:
(a) Shareholders/employees shall forgive accrued bonuses from prior years (totalling approximately $1,600,000) and such accruals shall be reversed back into the company’s income;
The evidence was silent on the exact manner in which the forgiveness was effected but it was common ground that it did happen in 1987.
The appellant was formed in 1988 by the amalgamation of Booth and another company.
Counsel for the respondent attempted to support the assessment on the basis that the inclusion of the cancelled bonus accrual in the income of the appellant for 1987 was in accordance with GAAP, that such inclusion resulted in an accurate statement of Booth’s profit for that year in accordance with GAAP, that the computation of income should be in accordance with GAAP unless a specific provision of the Act provides otherwise and that the amount reversed was properly included in the appellant’s income for 1987 both for financial statement purposes and for income tax purposes in accordance with sections 3 and 9 of the Act. No doubt Booth’s domestic financial statements were prepared in accordance with GAAP but that is beside the point. Subsection 9(1) of the Act 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.
In the determination of profit for purposes of section 9 it is ordinary commercial principles which govern, not GAAP. What constitutes ordinary commercial principles 1s a matter of law. A complete summary of the law on this point is set out in Ikea Ltd. v. R. (sub nom. Ikea Ltd. v. Canada), [1994] 1 C.T.C. 2140, 94 D.T.C. 1112 at page 2147-48 (D.T.C. 1117) and it need not be repeated here.
The question which must be addressed is whether any statutory rule or principle of law requires the inclusion of the cancelled bonuses in the computation of the appellant’s profit for purposes of section 9. Counsel for the appellant argued that at “common law”, debt settlement gains were considered to be capital gains unless they related to income obligations incurred in the same year as the settlement itself. His primary authority for this proposition was British Mexican Petroleum Co. v. Commissioners of Inland Revenue (sub nom. British Mexican Petroleum Co. v. Jackson), (1932) 16 T.C. 570 (U.K. H.L.) which held that income is determined on a year-to-year basis and adjustments that arise from events in subsequent years do not affect the income of either the original or the subsequent year. Counsel noted that the decision in British Mexican was followed by the Exchequer Court in J.D. Stirling Ltd. v. Minister of National Revenue, [1969] C.T.C. 418, 69 D.T.C. 5259. He referred to page 423, (D.T.C. 5262) where Jackett, P. stated:
Clearly, the release of a debt ... does not of itself give rise to revenue from the debtor’s business even though the amount released is a debt that has been taken into account as an expense of that business.
and cited British Mexican as authority. Counsel for the appellant argued further that section 80 of the Act creates a statutory scheme for the treatment of forgiven debts which supersedes common law rules otherwise applicable in the computation of profit for purposes of section 9. He noted that the paragraph 80(1 )(f) exclusion applies to amounts “otherwise required to be included in computing (the taxpayer’s) income for the year” but took the position that by virtue of the British Mexican and Stirling decisions, the amount forgiven in this case must be viewed as capital and therefore falling outside the words of the exception.
British Mexican was a case in which the taxpayer was a company carrying on the business of a dealer in oil. It built up a very large debt for oil supplied to it. Its creditors agreed to a partial remission of the debt in order to permit the taxpayer to continue in business. The revenue sought to bring the amount forgiven into income for the year in which the debt was incurred or alternatively for the period in which the debt was forgiven. It was held that the accounts of the earlier year in which the oil was purchased were closed and could not be reopened. It was observed in response to an alternative argument which was not seriously pressed that a release from liability was not a trading receipt for the year in which it was granted.
It is clear that the 1987 reversal of the liability for the accrued and unpaid bonus cannot, consistently with British Mexican, be taken into account in computing the appellant’s 1986 income and, of course, the Minister has not attempted to do that. But what is much less clear is whether British Mexican or any other case requires a finding that the release in 1987 of the liability incurred in 1986 forms a receipt on capital account in 1987. In contrast to British Mexican this 1s not a case in which the release of the liability was in any way intended to shore up the shaky financial structure of the taxpayer. Here the forgiveness was a consequence of a term in a letter of intent which required that the accrued bonuses “be reversed back into the company’s income”. The creditor’s objective is relevant in cases such as this. In a leading Canadian text on income tax law the author notes :
If a taxpayer incurs a debt in connection with his acquisition of a fixed asset and the debt is later forgiven in whole or in part, the forgiveness 1s not a revenue gain to him. If a debt was incurred in connection with the acquisition of inventory in a particular taxation year and is forgiven, in whole or in part, in the same year, the forgiveness will probably be treated as business revenue, regardless of what the creditor’s motive was in forgiving a debt.
If the forgiveness occurs in a later year and the creditor’s motive clearly was to save the debtor from what would otherwise be probable bankruptcy, the creditor is seeking to preserve the continued existence of the debtor’s business (which is part of the debtor’s capital assets), and the forgiveness therefore is a capital transaction for the debtor. If the creditor’s motive was to make the debtor’s business more profitable than it otherwise would be or to reduce or eliminate losses that the debtor would otherwise suffer (assuming that bankruptcy was not imminent), this motive would relate to the debtor’s trading activity rather than to his capital assets, and the forgiveness would be business revenue to him.
Counsel for the respondent argued that the release of the debt which has been properly deducted in a prior year is analogous to the recovery of an expense of a prior year or to a receipt of compensation for loss of profits and that, on the principles laid down in Johnson & Johnson Inc. v. R., [1994] 1 C.T.C. 244, 94 D.T.C. 6125 (F.C.A.) and in Mohawk Oil Co. v. R. (sub nom. Canada v. Mohawk Oil Co.), [1992] 1 C.T.C. 195, 92 D.T.C. 6135 (F.C.A.) the amount released must be included in the computation of a profit. In Johnson & Johnson the court dealt with a case in which the taxpayer had paid Federal Sales Tax on goods manufactured and distributed by it. It contested its liability to pay the sales tax and ultimately it was held that the goods were exempt. The tax paid in prior years was refunded. The question then arose whether the sales tax refund was re- quired to be included in computing the taxpayer’s income. It was held that there was a distinction between a case in which it was recognized by the original payee that he should never have had the money in the first place and the case ... of the recovery of expenses in the ordinary business sense of attempting to recoup what one has laid out by what one can get in.” In course of its reasons the court summarized its earlier decision in Mohawk as follows page 249-250, (D.T.C. 6130):
That case simply decided, amongst other things, that that part of compensation for damages for breach of contract which included both lost profits and expenditures thrown away was to be included in the computation of a business’s taxable income. The question of timing was not addressed at all, but if it had been I do not think the Court would have had any difficulty in concluding that the year of receipt was the relevant year for computation purposes. Expenditures thrown away and then recouped as damages do not lose their original character.
[Emphasis added. I
In light of the decision in Mohawk the release of liability to pay the bonuses cannot be treated as having changed the character of the liability.
Furthermore I will observe that the assertion that the forgiveness of the bonus is a capital transaction is clearly illogical. If the creation of an enforceable obligation to pay bonus results in a cost which diminishes profit so also must the receipt of a waiver intended to boost profit by eradicating that same obligation result in an increase in profit. A common sense commercial view of the matter must be taken. (See Minister of National Revenue v. Enjay Chemical Co. Ltd., [1971] C.T.C. 535, 71 D.T.C. 5293.) It is in my view contrary to common sense to assert that the passage of a year end effects some sort of a magical conversion of executive compensation operations from current account transactions to capital account transactions.
I have therefore concluded that ordinary commercial principles require that the release transaction be reflected in the computation of income. The only year in which it can conceivably be so reflected is the year in which the release was effected, that is to say, 1987. It follows that paragraph 80(1 )(f) of the Act applies.
Appeal dismissed.