Wawang Forest Products Ltd. v. The Queen, 2001 DTC 5212, 2001 FCA 80

Date: 20010326

Docket: A-153-99

Citation number: 2001 FCA 80

CORAM:        ROTHSTEIN J.A.

SHARLOW J.A.

MALONE J.A.

BETWEEN:

                                      WAWANG FOREST PRODUCTS LTD.

                                                                                                                                  Appellant

                                                                   - and -

                                              HER MAJESTY THE QUEEN.

                                                                                                                              Respondent

       _________________________________________________________________

                                                                                                                  Docket: A-154-99

BETWEEN:

                                            NERAK CONTRACTORS INC..

                                                                                                                                  Appellant

                                                                   - and -

                                              HER MAJESTY THE QUEEN.

                                                                                                                              Respondent

Heard at Toronto, Ontario, on March 12, 2001

JUDGMENT delivered at Toronto, Ontario, on March 26, 2001

REASONS FOR JUDGMENT BY:                                                               SHARLOW J.A.

CONCURRED IN BY:                                                                                ROTHSTEIN J.A.

                                                                                                                        MALONE J.A.

Date: 20010326

Docket: A-153-99

Citation number: 2001 FCA 80

CORAM:        ROTHSTEIN J.A.

SHARLOW J.A.

MALONE J.A.

BETWEEN:

                                           WAWANG FOREST PRODUCTS LTD.

                                                                                                                                           Appellant

                                                                        - and -

                                                   HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

            _________________________________________________________________

                                                                                                                            Docket: A-154-99

BETWEEN:

                                                 NERAK CONTRACTORS INC..

                                                                                                                                           Appellant

                                                                        - and -

                                                   HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

            _________________________________________________________________

                                                   REASONS FOR JUDGMENT

SHARLOW J.A.

The issue in this appeal is whether Wawang Forest Products Ltd. and Nerak Contractors Inc., in computing their income for a particular year, are entitled to deduct the full cost of work completed by their subcontractors in that year. The position of the Crown is that the portion of the contract payments held back against the possibility of a failure by the contractors to meet their obligations under workers' compensation legislation is deductible only when paid or demanded. The Tax Court Judge held that the holdbacks were not deductible in the years claimed: Wawang Forest Products Ltd. v. The Queen, [1999] 2 C.T.C. 2966, 99 D.T.C. 759 (T.C.C.). The taxpayers have appealed his decision.

The relevant provisions of the workers' compensation legislation are found in subsections 11(3) and (4) of the Workers' Compensation Act, R.S.O. 1990, c. W.11, which read as follows:

These provisions were in force for most of the years under appeal. Substantially similar provisions were found in subsections 9(3) and (4) of the Workmen's Compensation Act, R.S.O. 1980, c. 539, the predecessor legislation.

It is common ground that the taxpayers complied with ordinary accounting principles in deducting the holdbacks in computing their income for the year in which the subcontractors completed their work, regardless of the date of payment. It has not been suggested that the deduction of the holdbacks in that year would provide an inaccurate picture of the taxpayers' income for that year, or that a more accurate picture would result if the holdbacks were deducted in some later year when the holdbacks were paid. Therefore, the holdbacks are deductible in the years claimed unless their deduction in that year is precluded by a provision of the Income Tax Act, R.S.C. 1985, c. 1 (5^th supp) or its predecessor legislation or some principle of income tax law: Canderel Limited v. Canada, [1998] 1 S.C.R. 147, [1998] 2 C.T.C. 35, 98 D.T.C. 6100 (S.C.C.).

The Tax Court Judge held that paragraph 18(1)(a) or alternatively paragraph 18(1)(e) of the Income Tax Act precluded the deduction of the holdbacks until the year of payment. Paragraphs 18(1)(a) and (e) read as follows:

For both taxpayers, the years under appeal include 1988, 1990 and 1991. For Wawang, 1987 is also under appeal. A slightly different version of paragraph 18(1)(e) was in effect in 1987, but the difference is not material to the issues in this case.

Paragraph 18(1)(a) imposes a purpose test for the deductibility of amounts in computing income from a business or property. The Crown does not contend that the purpose test is not met in this case. Rather, the Crown is reading paragraph 18(1)(a) as a provision that precludes the deduction of an amount that cannot properly be described as an "expense incurred". That is how paragraph 18(1)(a) has come to be applied in this Court (see, for example, The Queen v. Burnco Industries Ltd., [1984] 2 F.C. 218, [1984] C.T.C. 337, 84 D.T.C. 6348 (F.C.A.)).

The Tax Court Judge, in explaining why he had concluded that paragraph 18(1)(a) should apply in this case, said this at paragraph 12 of his reasons:

Before receiving all of its money earned for performing a contract, a contractor had to fulfil the condition precedent of providing the Appellants with a WCB clearance certificate. This is simple contract law. [...]    There was no obligation to pay the holdbacks in the years in which they were sought to be deducted unless the Appellants received clearance certificates.

and this at paragraph 20:

... unless amounts are due, they are not deductible as expenses. They become expenses in the year they are due. For example, rent owing but not payable until 1999, is not a deductible expense in the 1998 taxation year.

In my respectful view, these statements disclose a misapprehension of the meaning of "incurred" as used in paragraph 18(1)(a). Generally, a taxpayer incurs an expense when it has a legal obligation to pay a sum of money. In most situations, the legal obligation exists upon the fulfilment of the contractual obligations to which the payment relates. Whether the payment of the obligation is required at that moment or in a subsequent year is irrelevant. For example, in most cases the obligation to pay rent is an expense incurred in the year in which the tenant has the right to occupy the rented premises, whether the rental agreement says that payment of the rent is due during that year or at some later date.

Paragraph 12 of the reasons of the Tax Court Judge states a conclusion that, in this case, as a matter of contractual interpretation, there was no obligation to pay the holdbacks unless the clearance certificates were furnished. In other words, the holdbacks were a contingent liability until the clearance certificates were furnished. If this were the case, then holdbacks could not be deducted in the year of the completion of the work unless the clearance certificates were also furnished in that year. The deduction could be denied in that year either on the basis of paragraph 18(1)(e), which prohibits the deduction of contingent liabilities, or on the basis of paragraph 18(1)(a), because a contingent liability cannot be an expense "incurred" within the meaning of paragraph 18(1)(a) until the contingency is satisfied. The question, then, is whether the holdbacks were contingent liabilities of the taxpayers once the contract work was completed.

The generally accepted test for determining whether a liability is contingent comes from Winter and Others (Executors of Sir Arthur Munro Sutherland (deceased)) v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), in which Lord Guest said this (at page 262):

I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence upon an event which may or may not happen.

The same understanding of the meaning of "contingency" underlies many tax decisions in this Court and other courts, including Harlequin Enterprises Limited v. The Queen, [1977] 2 F.C. 579, [1974] C.T.C. 838, 74 D.T.C. 6634 (F.C.A.), Mandel v. The Queen, [1979] 1 F.C. 560, [1978] C.T.C. 780, 78 D.T.C. 6518 (F.C.A.), Perini Estate v. Canada, (1982), 40 N.R. 74, [1982] C.T.C. 74, 82 D.T.C. 6080 (F.C.A.), and Canadian Pacific Limited v. Ontario (Minister of Revenue), [1998] 41 O.R. (3d) 606, 114 O.A.C. 217, [2000] C.T.C. 331, 99 D.T.C. 5286 (Ont. C.A.).

The Winter test has become confused by some obiter dicta in Samuel F. Investments Limited v. M.N.R., [1998] 1 C.T.C. 2181, 88 D.T.C. 1106 (T.C.C.), one of the cases cited by counsel for the Crown in this appeal. In that case the Tax Court Judge relied on Winter in concluding that a certain obligation was contingent. In my view, he reached the correct conclusion on the facts. However, in his reasons for decision he said this:

My understanding is that a liability to make a payment is contingent if the terms of its creation include uncertainty in respect of any of these three things: (1) whether the payment will be made; (2) the amount payable; or (3) the time by which payment shall be made.

It is fair to say that these three uncertainties may be characteristic of contingent liabilities in some circumstances. However, the Crown argues in this case that the existence of these three uncertainties are now the test for determining whether a liability is contingent. In support of its position, counsel for the Crown cites Barbican Properties Inc. v. Canada, [1996] 2 C.T.C. 2615, 97 D.T.C. 122 (T.C.C.), affirmed [1997] 1 C.T.C. 2383, 97 D.T.C. 5008 (F.C.A.). In my view, that case does not stand for the proposition for which the Crown cites it. The Tax Court Judge in Barbican did recite the three uncertainties from Samuel F. Investments, but only after he had already concluded that the liability in issue was contingent because its existence depended upon the occurrence of a contingent event. In other words, the liabilities in Barbican were contingent in accordance with the definition in Winter and also met the three uncertainties stated in the Samuel F. Investments case. This Court endorsed his reasons. However, I cannot accept that the Tax Court Judge or this Court intended to replace the Winter test for contingent liabilities with a different one based on Samuel F. Investments.

The "three uncertainties" listed in Samuel F. Investments cannot by themselves determine whether a liability is contingent. For example, with respect to the uncertainty as to payment, a taxpayer may incur an obligation at a time when it is in financial difficulty, with the result that there is a significant risk of non-payment. But that uncertainty cannot mean that the obligation was never incurred. Similarly, an obligation to pay a certain amount does not become a contingent obligation merely because events may occur that result in a reduction in the quantum of the liability (see, for example, Canadian Pacific, cited above). Nor does a legal obligation to pay an amount become contingent merely because payment may be postponed in certain events or no date is stipulated for payment. Parties are entitled to rely on the ordinary contract law principle that payment for services must be made within a reasonable time.

Returning to the Winter test, the correct question to ask, in determining whether a legal obligation is contingent at a particular point in time, is whether the legal obligation has come into existence at that time, or whether no obligation will come into existence until the occurrence of an event that may not occur. For example, Winter establishes that where tax is payable on the gain realized on the sale of an asset, the obligation to pay the tax is a contingent liability unless the asset is sold. An obligation to pay an amount equal to a percentage of earned revenues is a contingent obligation unless the revenues are earned (Mandel, cited above). An obligation to pay a management bonus if the money is available is a contingent obligation unless the money is available (The Queen v. Ken and Ray's Collins Bay Supermarket, [1975] C.T.C. 504, 75 D.T.C. 5346 (F.C.T.D.), confirmed without written reasons (F.C.A.), leave to appeal to the Supreme Court of Canada refused: [1978] 1 S.C.R. ix).

It remains only to apply the Winter principle to the facts of this case. The facts are not disputed. The Wawang contractors were engaged to cut, delimb and skid logs. Their contract provided that they would be paid bi-weekly on the basis of a stipulated amount per cord. The Nerak contractors were engaged to haul wood from various logging sites to the mills. They were to be paid bi-weekly on the basis of a stipulated amount per metric tonne of wood delivered.

The amount of wood cut or delivered was determined by independent scalers, who would provide a scaling slip. The practice was that the completed scaling slip was accepted as conclusive proof as to the work done. Once the scaling slips were presented to the taxpayers, the work of the contractors was considered complete.

The taxpayers had a contractual right to hold the contractors liable for any trespass penalties levied by the Ministry of Natural Resources as a result of the contractors' negligence, and to set off such penalties against any amounts owing to the contractors.

The taxpayers were aware that if they paid a contractor in full upon completion of its work, they might find later that the contractor had failed to make the required workers' compensation contributions. In that event, the taxpayers could be in the position of having to make good a contractor's default and being left only with an unsecured right of recovery against the contractor.

This problem might have been solved in any one of a number of ways. The solution chosen by the parties was to defer payment of an amount sufficient to cover the workers' compensation liabilities of the contractor as long as necessary to remove the risk of an unsecured and therefore unrecoverable payment to the Workers' Compensation Board. To that end, special provisions were included in the contracts. One example is as follows:

The CONTRACTOR agrees to comply with the provisions of the Workers' Compensation Act of Ontario and to maintain its account in good standing during the term of this agreement and to provide the COMPANY with its WORKERS' COMPENSATION ACCOUNT NUMBER. The CONTRACTOR will at all times, including any period in which the CONTRACTOR does not have any employees other than the Executive Officers of the CONTRACTOR, either continue to furnish the COMPANY with clearance certificates from the Board confirming the CONTRACTOR's good standing, or with acknowledgements by the Board that the Executive Officers are exempt from assessment and that the CONTRACTOR has no assessable payroll.

The COMPANY agrees to holdback $ .50 per metric tonne to secure the COMPANY against liability to the Workers' Compensation Board under section 9 of the Act, or otherwise. These holdbacks, shall be released to the CONTRACTOR on receipt, by the COMPANY, of a valid Clearance Certificate from the Board, or with the acknowledgements referred to above.

If the CONTRACTOR fails to maintain its good standing with the Board or to furnish Clearance Certificates in accordance with this agreement, the COMPANY is hereby authorized to pay all or any part of the holdback monies to the Board on account of the CONTRACTOR's liability as claimed by the Board.

The amount of the holdback was based on an estimate of the labour portion of the contract, which was considered a reasonable basis for estimating the workers' compensation liabilities of the contractors.

Other contracts had similar provisions. In some cases the amount of the holdback was expressed as an additional amount payable per metric tonne of wood or per cord of wood, as the case may be, with the holdback procedure being applied only to that additional amount. In my view, the differences in the holdback provisions in the various contracts are not material to the issues under appeal.

In the ordinary course, approximately 90% of the holdbacks were paid within the same year as the completion of the work. The remaining 10% was recorded as a liability as at the year end.    There is evidence that, as of 1994, between 1% and 5% of holdbacks for the years under appeal had not been paid. Some of those amounts were unpaid for a long period because of a dispute with the Workers' Compensation Board that was not resolved until 1995. In other cases, the contractors had gone out of business for various other reasons and had not claimed the amounts in question.

The characterization of the holdbacks as absolute or contingent liabilities of the taxpayers depends on the interpretation of the terms of the contracts. The Tax Court Judge concluded that the holdback provisions deferred the existence of any obligation to pay the holdbacks to the contractors until they furnished the clearance certificates that would prove their compliance with the Workers' Compensation Act. That was a contingent event because it could not be said with certainty that the proof would be furnished.

In support of that interpretation, the Tax Court Judge relied on the construction holdback cases, the leading one being J.L. Guay Ltée v. Minister of National Revenue, [1971] F.C. 237, (1971) 6 N.R. 553, [1971] C.T.C. 686, 71 D.T.C. 5423 (F.C.T.D.)    Guay involved long term construction contracts containing stipulations for periodic progress payments to be paid by the main contractor to subcontractors. For each period, the subcontractor presented an invoice containing an estimate of the work completed during that period. The subcontracts required the payment of the invoiced amount less a percentage holdback which would become payable only if an architect certified satisfactory completion of the work to which the invoice related, and even then the amounts would cease to be payable if the contractor had a counterclaim for damages. Noël A.C.J. of the Federal Court Trial Division held that the holdbacks were not deductible. His decision was upheld by the Federal Court of Appeal, [1972] F.C. 1441, (1972) 6 N.R. 552, [1973] C.T.C. 506, 73 D.T.C. 5373 (F.C.A.), and then upheld by the Supreme Court of Canada without written reasons: (1975) 6 N.R. 550, [1975] C.T.C. 97, 75 D.T.C. 5094 (S.C.C.).

The Tax Court Judge seems to have concluded that the clearance certificates in this case are similar to the architect's certificates in Guay. In my view, the analogy is inapt. The function of the architect's certificate in Guay was to furnish proof of satisfactory completion of the work. In this case, that function is served by the scaling slips, not the clearance certificates. The clearance certificates prove only that the contractors have paid their workers' compensation assessments, with the result that the taxpayers have no further need of the security furnished by the holdbacks because they are no longer at risk of being held vicariously liable for the workers' compensation obligations of the contractors.

The same distinction can be made between this case and Newfoundland Light & Power Co. Ltd. v. Canada (1990), 106 N.R. 139, [1990] 1 C.T.C. 229, 90 D.T.C. 6166 (F.C.A.). The issue in Newfoundland Light & Power was the year in which payments under a construction contract could be recognized for income tax purposes, either as part of the capital cost of the construction for purposes of capital cost allowance or as deductible expenses. Payments required under the contract were subject to a 10% holdback "until the Contract has been substantially completed to the satisfaction of the Engineer and until the Contractor has settled all costs and claims by third parties with respect to the operations of the Contractor and any Sub-contractor, their employees and/or agents."

All three judges of this Court concurred in the result in Newfoundland Light & Power, but rendered separate reasons. Hugessen J.A. and Pratte J.A. concluded that the principle in Guay applied and that the holdbacks could not be considered part of the cost of the property or deducted as expenses until the engineer certified his satisfaction with the work. For the reasons that will be apparent from what I have already said about Guay, I do not consider the majority decision in Newfoundland Light & Power to be determinative of the issue in this case.

Desjardins J.A. added obiter dicta to the effect that the amounts could not be recognized for tax purposes in the absence of proof that third party claims had been satisfied, because until that was done the quantum of the liability was uncertain. She also relied on the fact that part of the amount claimed had not been paid. I must respectfully disagree with these comments. In my view, a legal obligation to pay an amount may exist even if there is some risk that the actual payment may be set off against potential counterclaims. Similarly, the fact that a liability remains unpaid does not mean that it never came into existence. For these reasons, I reject the argument of the Crown in this case that the taxpayers' contractual right of setoff for trespass penalties, or the fact that some of the holdbacks remained unpaid in 1994, proves that the holdbacks were contingent liabilities in the years under appeal.

The Crown also relies on Northwood Pulp and Timber Limited v. Canada (1998), 233 N.R. 196, [1999] 1 C.T.C. 53, 98 D.T.C. 6640 (F.C.A.). The issue in Northwood was whether a taxpayer who had a statutory obligation to complete certain silviculture work could add the estimated cost of the work to the cost of its inventory of harvested logs before the work was done or even contracted for. The Court held that the cost of silviculture was not an inventory cost but a running expense, and that as a running expense it could not possibly be incurred before the work was done. That case is quite unlike this one, in which the amounts sought to be deducted in each year were consideration for work actually completed in those years.

In my respectful view, the jurisprudence relied on by the Tax Court Judge does not support his interpretation of the contracts. I agree with counsel for the taxpayers that the correct interpretation is that the contract price becomes an absolute obligation of the taxpayers when the contractors complete their work, as evidenced by the scalers slips.

The holdback provisions by their terms apply only after that obligation comes into existence. They give the taxpayers some security against the risk of vicarious liability for the contractors' obligations under workers' compensation legislation. These contractual provisions are consistent with subsection 11(4) of the Workers' Compensation Act, which provides that a principal is entitled to withhold "out of any indebtedness due." The holdbacks thus constitute amounts due to the contractors and the taxpayers have a continuing obligation to pay the holdbacks even though, as long as no clearance certificates are provided, they may choose whether to pay them to the contractors or to the Workers' Compensation Board for the account of the contractors. Until payment by one of these methods (or by setoff in the event of a penalty for trespass), the obligation remains outstanding.

For these reasons, I would allow these appeals with costs, set aside the decision of the Tax Court Judge, and order the reassessments under appeal be referred back to the Minister for reassessment on the basis that the holdbacks were deductible in the years claimed.

Karen R. Sharlow

J.A.

"I agree

Marshall Rothstein J.A."

"I agree

Brian Malone J.A."

                                                                                   FEDERAL COURT OF CANADA

                                         Names of Counsel and Solicitors of Record

DOCKET:                                                        A-153-99

STYLE OF CAUSE:                                         WAWANG FOREST PRODUCTS LTD.

                                                                                                                                           Appellant

                                                                        - and -

HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

DOCKET:                                                        A-154-99

STYLE OF CAUSE:                                         NERAK CONTRACTORS INC..

                                                                                                                                           Appellant

                                                                        - and -

HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

DATE OF HEARING:                          MONDAY, MARCH 12, 2001

PLACE OF HEARING:                                    TORONTO, ONTARIO

REASONS FOR JUDGMENT BY:                  SHARLOW J.A.                      

APPEARANCES:                                           T. Nigel Campbell, and

Christopher Hersh

For the Appellant

Eric Noble

                                                                        For the Respondent

SOLICITORS OF RECORD:                       Blake, Cassels & Graydon LLP

Barristers & Solicitors

Commerce Court West

2800-199 Bay St.

P.O. Box 25

Toronto, Ontario

M5L 1A9

For the Appellant

Morris Rosenberg

Deputy Attorney General of Canada

For the Respondent

FEDERAL COURT OF APPEAL

Date: 20010326

Docket: A-153-99

BETWEEN:

WAWANG FOREST PRODUCTS LTD.

                                                                                                                                           Appellant

                                                                        - and -

HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

Docket: A-154-99

NERAK CONTRACTORS INC..

                                                                                                                                           Appellant

                                                                        - and -

HER MAJESTY THE QUEEN.

                                                                                                                                        Respondent

REASONS FOR JUDGMENT