Pioneer Designs Corp. v. MNR, 91 DTC 293, [1990] 2 CTC 2446 (TCC)

Garon, T.C.J.:— These appeals involve a reassessment dated February 12, 1987 for the appellant's 1983 taxation year, a reassessment dated February 17, 1986 for the appellant's 1984 taxation year and a reassessment dated July 15, 1988 in respect of the appellant's 1985 taxation year. By these reassessments, the respondent disallowed bonuses in the following amounts deducted by the appellant in the taxation years opposite these amounts:

Apart from the matter of the appellant's entitlement to deduct the aforementioned bonuses accrued in the year but not paid in that year, the pleadings show that there are two additional issues. One of the issues relates to the capital cost of a certain building for capital cost allowance purposes with reference to the appellant's 1984 taxation year. With respect to this issue, the respondent conceded in his amended reply to the notice of appeal dealing in particular with the assessment for that taxation year that the capital cost of the building was as declared by the appellant. The appeal for the appellant's 1984 taxation must therefore be allowed to that extent. The second additional issue relates to the appellant's contention that a non-capital loss sustained in 1981 should be carried forward and deducted in computing its taxable income for its 1983 taxation year. Counsel for the appellant indicated that his client no longer disputes the tax treatment of this non-capital loss by the respondent. With respect to this question, the appeal from the assessment for the appellant's 1983 taxation year should therefore be dismissed.

Facts

The appellant is a corporation incorporated under the laws of the Province of British Columbia on November 9, 1978.

The 150 shares of the capital stock of the appellant were allotted as hereinafter set out at the price of ten cents per share as fully paid and non-assessable to the following individuals and corporations:

The total contributed share capital was therefore in the amount of $15.

With respect to the individuals behind the two corporations that were shareholders of the appellant, it was disclosed that all the 35 shares of Metco Construction Company Ltd. were owned by Gerald Metheral while the 45 shares of B.FG. Developments Ltd. were owned as to one third by each of Gerald Metheral, Frank Mueller and George Mueller. In the result, Gerald Metheral owned, through Metco Construction Company Ltd. and B.F.G. Developments, 50 shares, Frank Mueller both directly and indirectly controlled 25 shares and George Mueller controlled through B.F.G. Developments Ltd. 15 shares.

At all material times, the appellant's five directors were those mentioned below and opposite each name is shown the percentage in the appellant's shareholdings held directly or indirectly by each director from the time of incorporation to October 29, 1986:

George Mueller and Gerald Metheral were respectively appointed president and secretary of the appellant, as appears from a resolution dated November 20, 1978. They continued to act in their respective capacity in the ensuing years.

The appellant was incorporated by its five directors as a joint venture corporation for the purpose of acquiring and developing raw land for resale at a profit. The appellant had at all relevant times a fiscal year end on October 31.

The appellant needed working capital and it was felt that the best way to do it was through shareholders' loans. It was decided that each shareholder was to lend money to the appellant in proportion to his percentage of shares in the appellant's capital stock. Consequently, in order to help finance the appellant's operations, the five shareholders contributed in the first year of operation $150,000 in the aggregate as shareholders' loans to the appellant. As set out in paragraph 9 of the subscribers’ resolutions dated November 20, 1978, no interest was to be paid on these shareholders’ loans and these loans were to be repaid by the appellant at the discretion of the directors by directors' resolution. It is therefore apparent that the at-risk amount for each director was in the final analysis equal to his beneficial interest in the appellant's stock. The appellant's balance sheet as at October 31, 1982 shows that the shareholders' advances had been repaid by that time to the extent of $96,666.66. As for the balance in the amount of 53,333.34 it was paid off before the end of the appellant's 1983 taxation year.

The appellant had no employees other than the above-mentioned five directors. The appellant's directors had employment income or selfemployment income from sources other than the appellant corporation. It was, however, a prerequisite that each director was expected to contribute to the management of the appellant. In the course of his examination, George Mueller stated that “it was essential that we all (meaning all of the directors) became a daily participant in the management of the appellant.”

Speaking of the contributions of each director, George Mueller started off by commenting as follows on his own input: “I really didn't have a lot of experience to contribute other than some administrative skills that I brought to, you know, to the common effort." In the case of Connie Laidlaw, she was responsible for bringing the contribution of her husband who provided all the architectural services that were required. As for Frank Mueller, he did all the drywall work for the appellant and he was therefore around the job site. He also performed some supervision of the works on the building site when such supervision was required. For his part, Laurent Lebel was basically the superintendent as there was a requirement for someone to look after the works on a continuing basis. As far as George Mueller and Gerald Metheral were concerned, they were involved in the land assembly, by getting in touch, among other things, with real estate agents, and in the construction and administrative end of the appellant's operations.

Since the appellant had no employees other than the above-named directors, it had recourse to Delco Management Corporation "Delco" to actually do the construction work. All the shares in Delco, a management company, were owned by Gerry Metheral and George Mueller on an equal basis. The appellant utilized the services of Delco, which had employees, and was charged by Delco for the cost of labour and supervision of the work. Incidentally Delco also carried out projects for other business concerns. The appellant was therefore charged at cost plus a payroll burden of 15 per cent and a ten per cent fee for the administration. The appellant would therefore contract with Delco to actually provide the labour, the construction supervision on a project by project basis. The work done by Delco for the appellant is described in some detail in the following passages of the transcript of George Mueller’s examination in chief:

A. So what Delco Management does for each project, it actually quotes a figure to Pioneer Designs that is, in my opinion, because I understand what the market rates are for work of this kind, very competitive, and it’s a guaranteed amount up front, so Pioneer understands clearly what its costs are associated with managing and administering the entire project from the inception of the land purchase, all the work associated with it to get it through rezoning, eventually to the building permit, finally constructed, and then ultimately stay involved with real estate agents to sell the project in the marketplace and generate the income.

Q. So are you saying then that Delco for its role in actually bringing the raw land to fruition, developing it for resale purposes, would charge back Pioneer its hard costs, the costs, its out-of-pocket expenses plus a mark-up for its supervision site, on the site of the project?

A. Yes, that's correct. They're paying, I mean, they're paying a management fee to Delco Management to run the operation. Laurent just looks at the day-to-day affairs of what goes on at the site. Gerry and I in the office, we look at the total picture of that project and do all the things that are associated with it.

In this connection, the financial statements of the appellant also show that the following management fee expenses were paid by the appellant to Delco in respect of the appellant's taxation years mentioned below:

With respect to management fees, the financial statements for the year ended October 30, 1984 reflect a change in accounting practice. Note 9 to these financial statements is self-explanatory:

9. Management fees

A change of procedure in drafting of financial statements has been made for clarity of presentation.

1983 management fees included all general management, project management and miscellaneous back charges by Delco Management.

In the 1984 presentation, all charges directly applicable to each project have been included in cost of sales, the balance of $19,400.00 being for general management or consulting fees only.

The evidence is to the effect that the management fee paid by the appellant to Delco had nothing to do with the work and services performed by the five directors in running the affairs and business of the appellant. For instance, it was indicated that ? the appellant had been inactive for months, Delco will not be paid anything. Also, the understanding was clear that whatever charges come from each of the directors in connection with the specific work of a project they are to be reasonable and competitive.

The time spent by the directors on managing the appellant's affairs and business was a continuous operation. George Mueller in his examination said this:

A. Well, it’s continuous. I’ve tried to figure out a way to quantify that, but quite frankly, I don't know how to do it. It’s something that stays with you every day and we talk to each other on a daily basis and develop schemes for, you know, determining what we should get involved with next and whether it's a good idea, a bad idea and basically structure a plan to carry on and then see where it goes. But it's something that everybody deals with on a continuing basis.

Q. So would you say it's fair to say that the success of Pioneer is really due to the efforts of the five directors?

A. Oh, absolutely. I know what failure means in the construction business, and if it weren't for the specific five personalities involved here, I don't think we could claim the kind of success that we've had. It has to do with quality and that's the key element here. I think Pioneer can look back on being able to have a good relationship with five people that have the same goal, and the quality of the development. So we went through some tough years and the only reason we survived is because of that.

The evidence is clear that the appellant's profitability or financial success was a product of the joint effort of its directors in carrying on the business and affairs of the appellant.

It was also established that none of the directors received a salary from the appellant in the years in issue, 1983 to 1985, for their work and efforts in contributing to the management of the appellant's operations but rather their sole remuneration for their work and efforts was their entitlement to bonuses out of the portion of the appellant's profits. Despite the fact that a shareholders' agreement entered into on January 25, 1979 provided in paragraph 2.04 that the profits of the appellant available for distribution shall be distributed upon a unanimous vote of directors firstly by way of repayment of loans and secondly by way of dividend, the evidence is clear that the payment of dividend was not so much a consideration as the payment of bonuses. Actually there was only one occasion, sometime during the appellant's 1983 taxation year when dividends in the amount of $292,000 were declared by the appellant and this was done for a special purpose. It was to avoid the Part II tax in line with a common practice at the time which may have led to the repeal of that tax in 1986. The appellant's accountant, who had been involved in preparing the financial statements for the appellant since its inception, made it clear that he advised the appellant against paying dividends for income tax reasons. It is also in evidence that for the preceding years beginning with the time of its incorporation, the appellant neither paid salary nor awarded bonuses to its directors. For the period subsequent to the years under appeal, that is from 1986 to 1989, bonuses were distributed in each year but again no salary was paid by the appellant to its directors. With reference to the basis on which the remuneration by way of bonuses was to be effected, the appellant's president, George Mueller, expressed himself as follows:

A. . . .how do you do it reasonably, or logically I guess, without offending anybody, and without making it seem that someone is worth more than somebody else. So, we thought the best way to do it is to remunerate them on the basis of the amount of investment that they had at risk right from the beginning, and that doesn't—to do it any other way would have created a real problem for us, so we thought that this is a good way to do it. Everybody is involved, needs to stay involved, and if we make some money, well then they will get a bonus paid on the basis of what their at-risk capital is with the company.

Q. So they would be remunerated by declaration of bonus and each director would share according to his original capital contribution to the company?

A. That's right, yes.

The primary purpose for paying out the bonuses was to remunerate the directors. Both the appellant's president and the accountant Dennis Frank O'Sullivan testified that the directors decided that the formula to be used for the payment of bonuses should be related to the annual business limit of $200,000 laid down in section 125 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63). The figure of $200,000 represents the maximum amount of profit from an active business carried on in Canada that is eligible to the low rate of income taxation applicable to Canadian-controlled private corporations. The directors were of the view that the amounts of bonuses declared in a particular year should not result in an income lower than $200,000 in a particular year. In their opinion, that formula would constitute a good growth rate for the appellant and would provide ample working capital and a growth factor that could enable the appellant to participate in larger projects. The directors tried to follow that course right from the beginning of the appellant's operations. The 1983 taxation year of the appellant was the first year in which it earned profits in excess of $200,000. As a matter of fact, the appellant's income statements for its 1979,1980,1981 and 1982 taxation years disclose the following results:

for 1979 a loss of $122.24

for 1980 an income of $80,038.05

for 1981 a loss of $66,252.23

for 1982 an income of $149,305.29

The bonuses declared and accrued with respect to the appellant's 1983, 1984 and 1985 taxation years allocated, as I have indicated earlier, in proportion to the shares held directly or indirectly by each director of the appellant corporation were in the following amounts for each such director:

The bonuses totalling $650,000 declared on November 15,1983 in respect of the appellant's 1983 taxation year were never paid by the appellant. George Mueller gave a fair amount of evidence respecting the reasons for not paying such bonuses. He explained that the appellant was involved in a project in Whistler, B.C., outside the local market with which the directors were familiar and costs overran by about $100,000. The appellant was therefore stuck with a project which required greater amounts of cash than anticipated. Reference was also made to a 20-unit townhouse development on Langton Court which did not turn out as planned as there was a drop in prices of about ten per cent and serious difficulties were encountered in selling with the result that the appellant was only able to dispose of its interest in that project in December of that year. A lot of money was tied up in the meantime for a much longer period than the directors had envisaged. The appellant at the same time "had real trouble" with a project on Cedar Tree Lane, a 30-unit strata development because of under-financing by the bank which the appellant was dealing with. That evidence was largely corroborated by the appellant's accountant, Dennis Frank O'Sullivan. I accept that evidence. This factual background also explains why the bonuses declared in respect of the appellant's 1985 taxation year were not paid.

Briefly, the appellant needed more working capital for financing its work-in- progress in its 1984 and 1985 taxation years than it had originally anticipated and to meet its working capital requirements, the appellant could not pay these bonuses in respect of its 1983 and 1985 taxation years.

The appellant included the full amount of its 1983 bonus in its income for 1985 and contended that this was done in accordance with paragraph 78(3)(a) of the Income Tax Act.

In respect of the 1984 bonus, the appellant and the five directors entered into an election pursuant to paragraph 78(3)(b) of the Act to include the full amount of that bonus of $240,000 in the incomes of the directors for their 1986 taxation years. This election was filed with the respondent prior to April 30, 1986. The 1984 bonus was actually paid by the appellant to the five directors in January 1986.

In 1985, the appellant declared a bonus of $723,000. The declaration of a portion of this bonus, namely $650,000, was subject to the following proviso:

Provided That if the Department of National Revenue should at anytime reassess the Company to exclude the amount of ($650,000 which was included in the Company's income pursuant to the provisions of subsection 78(3) of the Income Tax Act) from the Company's income for its 1985 taxation year, and the Company is unsuccessful in setting aside or appealing the assessment, the aggregate amount of the bonuses declared payable to the Directors of the Company shall be reduced by the amount of $650,000 and the pro rate share of the bonus payable to each Director of the Company shall be reduced accordingly.

In this connection, it must be explained that prior to the end of its 1985 taxation year and prior to the declaration of the 1985 bonus, the respondent had informed the appellant that he was questioning the deductibility of the 1983 bonus. No part of the 1985 bonus was paid by the appellant to the five directors.

It is of some significance that the ratio for sharing in the bonuses among the directors was changed on October 29, 1986 in the course of a reorganization of the appellant's capital stock brought about by amendments to the memorandum and articles of the appellant. The certificates evidencing “Class A" common shares were surrendered in exchange for certificates evidencing “Class A" preference shares in the capital of the appellant and additional “Class A" common shares were issued by the appellant. In the result, the following “Class A" common shares at ten cents per share declared to be fully paid and non-assessable were allotted as follows:

As appears from the directors' minutes dated October 29, 1986 it was also decided that the bonuses to be paid to the directors when the results for the year ended October 31,1986 have been determined were to be in the percentages set forth beside their names:

in recognition of services performed and contributions made during the fiscal period.

It will be noted from the above that the percentage of shares in the appellant's capital stock held by George Mueller was increased from ten per cent to 18.2 per cent while the percentage of shares owned by the other four directors was decreased proportionally. George Mueller, the appellant's president, gave, in the course of his examination in chief, the following explanations relative to his increased participation in the appellant's shareholdings:

Q. Now, this sharing in bonuses was based on the original capitalization or the original contribution to the capitalization of the company. Now, is this the same formula even today, or has that changed?

A. Well, we restructured the company in ‘86 I believe. We reorganized it a bit.

Q. And what was the reason for that?

A. Well, I guess it was felt by everybody that my contribution initially was ten per cent, and the reason it was ten per cent is because that's all the money I had at the time. They felt that in order to keep the scheme of being contributed on the basis of your—the money that you have invested in the company, that they would like to bring my position up somewhat equal with Connie's and Laurent's. So everybody else gave a little in order to bring my position up. And that's really the only—Q. So this happened in 1986?

A. Yes.

Q. So, for bonuses paid after 1986, then, the ratio, it changed somewhat from what it was in 19—A. That's correct.

Q. From the time of incorporation until 1986?

A. That's correct.

Q. But the new ratio was based on what everybody felt each person was contributing to the success of the company?

A. Well, again, that's a difficult thing to assess. That's generally, that was the starting formula for the whole process and it hasn't changed. I mean, the approach is still the same.

In the course of George Mueller's re-examination by counsel for the appellant, the following extracts are of some interest:

Q. And was the reason for changing this because it was felt that some of the directors were actually pulling a little bit more weight than others, and so therefore the basis of participation in bonuses should be changed?

A. Yes, the other directors felt that my position, the ten per cent position was perhaps inappropriate in terms of my contribution, and they increased it a bit and reduced theirs accordingly.

Q. So, again, notwithstanding that the bonuses are still paid based on the shareholdings of the company, it still relates now to the efforts of the directors, as before it related to the at-risk amount of capital?

A. That's right.

George Mueller's explanations relative to the reasons behind the decision to increase his participation in the appellant's shareholdings were corroborated by the appellant's accountant, Dennis Frank O'Sullivan in the following passage:

Q. Can you tell me exactly how that system works?

A. Well, it was originally based on the amount of money at risk that each investor had made, or had invested, and that was considered as close an approximation to the contribution to the profit of the company as anyone could figure out. That arrangement lasted until recently, when it was decided that Mr. Mueller had made a somewhat greater contribution than he's being rewarded for, and the shares were shifted slightly.

Q. But that must be—is that the way they share in the bonus then?

A. That's right.

The same procedure for declaring bonuses was followed starting in 1983 through to 1989. Shortly before the year end, the directors would have a good idea of the total profit made in the year and determine an approximate amount of bonuses to be declared. The intentions of the directors were then reflected in a first resolution adopted before the year end and when sometime after the year-end profit is precisely determined, a second directors' resolution would be passed setting out the exact amount of bonuses to be paid to each director.

The first directors' resolution dated October 19, 1983, and the second directors' resolution of November 16, 1983 in respect of the bonus payable for the appellant's 1983 taxation year are typical of the procedure followed and wording of resolutions adopted for subsequent years except in respect of the resolutions dated October 31, 1985 and January 8, 1986:

Be It Resolved That:

Bonuses payable to the Directors of the Company in the sum of Seven Hundred Thousand ($700,000) Dollars approximately be paid in pro rata amounts to shares held both directly and indirectly by each Director and that the exact amounts of such bonuses be determined when the results for the year ended October 31, 1983 become known.

Dated this 19th day of October, 1983.

Be It Resolved That:

Bonuses in the following sums be declared to the Directors on record hereinafter named as at the close of business the 15th day of November, 1983:

Director	Bonus
Gerry Metheral	$216,667.00
Connie Laidlaw	130,000.00
George Mueller	65,000.00
Frank Mueller	108,333.00
Laurence Lebel	130,000.00
Total:	$650,000.00

Dated this 15th day of November, 1983

Following the adoption of first resolution in a particular year there was a real expectation by the directors that bonuses will be paid during the following taxation year. The evidence is also to the effect that the directors did not want to constrain the appellant to pay these bonuses on a specific date; some flexibility was built into the procedure for paying bonuses to take into account the appellant's working capital requirements. The directors were quite content to operate in this trusting fashion as they were economically speaking the owners of the appellant's business.

It is also necessary to peruse the evidence adduced in order to determine whether it was reasonable to anticipate that at the times these dividends were declared the appellant would be in a position to pay them out.

The appellant's income statements for the 1983, 1984 and 1985 taxation years show after deducting the bonuses in the amounts set out opposite each year the following net income:

The examination of the statements of changes in financial position for the same taxation years reveals that there was a working capital deficit at the end of each year as indicated below:

A quick look at the financial situation of the appellant for its taxation years 1986, 1987 and 1988 and at the manner it carried out its policy of paying bonuses during that period is of interest in considering the appellant's conduct in the three years under appeal, 1983, 1984 and 1985. The income statements for the appellant's 1986, 1987 and 1988 show the following in respect of the appellant's net income after the deduction of the bonuses set out below:

The bonuses declared in respect of the 1986, 1987 and 1988 taxation years were in each case paid during the year following the year in which they had accrued.

Analysis

In support of the non-deductibility of the accrued bonuses, Counsel for the respondent put forward three general propositions.

As a first proposition, she contended that the bonuses were not in the nature of an expense incurred by the appellant for the purpose of gaining or producing income from its business. In support of this submission, the point was made that on the facts of this case, these bonuses represented a distribution of profits, akin to a declaration of dividends, because they were related to the at-risk capital advanced by the shareholders.

It is true that the method of sharing in the bonuses by each shareholder was precisely linked to the percentage that each shareholder had at the relevant times in the capital stock of the Company and to his share in the total shareholders' loans made to the appellant to enable it to commence its operations. As far as the contributed share capital in the appellant's shareholdings made by each shareholder, it was nominal and no inference could, of course, be made that it related to the financial resources or investment wishes of each shareholder. As far as the proportion that each shareholder had in the shareholders' loans totalling $150,000 the possibility no doubt exists that the percentage could have been determined in relation to the advances of funds that each shareholder was willing or able to make to the appellant's operations.

There is, however, another way of looking at the evidence. The percentage in the shareholdings and in the shareholders' loans may reflect, as amongst of the shareholders, the expected contributions of each director. First of all, the oral evidence of both the appellant's president George Mueller and the accountant Dennis Frank O'Sullivan points in that direction. Also, it is by far easier to explain the change in shareholdings that was made in October 1986 at a time where the shareholders' advances had been repaid in full about three years before. The contributed share capital in 1986 continued to be in a nominal amount as far as the common shares were concerned.

There is another aspect of the evidence which leads me to the conclusion that the bonuses were established in relation to the expected contributions of the directors. It is that throughout the entire period from 1979 to 1989, with the exception of two years, substantial amounts of income were derived by the appellant from its business. This financial success can only be explained, on the facts of the present case, by the good work, connections and entrepreneurial skills of the five directors. The initial infusion of the funds by the shareholders in the amount of $150,000 at the inception of the appellant's business, although no doubt required at that time, played a limited role as early as in 1982 when approximately two thirds of these shareholders' loans had already been reimbursed. The evidence is clear that each director was expected to contribute to the management of the appellant quite apart from any direct involvement that their respective companies may have had in entering into contracts with the appellant in respect of a particular project.

In my view, the weight of the evidence is that the percentage in shareholdings reflected the measure of the expected input of the directors to the management of the appellant's business and affairs. Therefore the bonuses declared were payable in respect of the services rendered by the directors to the appellant pursuant to the understanding reached between the appellant and its directors. This situation is on all fours with that considered by the Federal Court-Trial Division in the case of The Queen v. V and R Enterprises Ltd., [1979] C.T.C. 465 ; 79 D.T.C. 5399. Accordingly, the remuneration of directors by way of bonuses is an expense falling within the exception to the prohibition laid down in paragraph 18(1)(a) of the Income Tax Act. Such expense is deductible under subsection 9(1) of the Act.

The second general submission put forward by counsel for the respondent is that the bonuses accrued by the appellant during its 1983, 1984 and 1985 taxation years were contingent liabilities or reserves and accordingly were not deductible by virtue of paragraph 18(1)(e) of the Income Tax Act.

In order to establish this proposition, it was pointed out that there is no time limit on when the payment of bonuses ought to be made. Furthermore, it was contended that the payment of bonuses was at all times dependent on the cash flow requirements of the appellant. Finally it was argued that the payment of bonuses was not a legally binding obligation of the appellant.

With respect to the argument relative to the alleged requirement that the precise time by which bonuses ought to be paid should have been spelled out in a contract or other binding arrangement, I would point out that the second resolutions adopted by the directors in respect of the three years in issue (subject to what is said later concerning the $650,000 portion of the $723,000 bonuses) setting out the precise amounts to be paid to each director were not in any way conditional but rather couched in absolute terms.

The perusal of the wording of the second resolution dated November 15, 1983 leaves no doubt as to this and, as I have indicated earlier, the terminology used in that resolution is virtually identical with that found in the second resolution dated November 27, 1984 in respect of the bonuses accrued in 1984. The second resolution dated January 8,1986 is clearly a contingent liability to the extent that it involves the $650,000 portion of the $723,000 bonuses. No authority has been cited to me that would require as a necessary condition to satisfy the provisions of paragraph 18(1)(e) of the Income Tax Act the existence of a stipulation that would set out the precise time for the payment of bonuses. The many decisions to which I have been referred do not deal with this precise point. Furthermore, a court is, in my view, justified to read into the second resolutions for the taxation years in question, an implied term to the effect that the payments of such bonuses were to be made in a reasonable time.

The second reason for stating that the liability to pay bonuses in the years under appeal is contingent is that their payment depended on the cash flow needs of the appellant. I do not believe that this contention can be accepted. In a sense, all obligations dealing with the payment of money depend on the debtor having the necessary funds to meet his obligations. Obviously this approach would not be the correct one. In the present case, the obligation to pay the bonuses was not declared to be dependent on the availability of funds in the appellant's coffers for this purpose. As I pointed out earlier, these second resolutions are in their terms absolute. On this aspect, the present appeals are therefore clearly distinguishable from the case considered by Christie, A.C.J. of this Court in the matter of Samuel F. Investments Ltd. v. M.N.R., [1988] 1 C.T.C. 2181; 88 D.T.C. 1106 where the operative words of the directors' resolutions declaring a bonus to the president, director and the sole shareholder of the taxpayer corporation read as follows:

Be it resolved that:

(a) A management bonus of $147,000 be authorized, approved and paid to Samuel Frustaglio for exemplary services performed for the Corporation for the fiscal year ended December 31st, 1978;

(b) The aforesaid bonus is hereby authorized to be paid in either a lump sum or in such periodic instalments and at such time or times as the Corporation has funds available for such purpose, as the President of the Corporation may determine.

In the appeals at hand, these second resolutions do not embody "the uncertainties regarding the time or times of payments and whether payment would ever be made either in whole or in part,” referred to by Christie, A.C.J. in the Samuel F. Investments case.

Moreover, I agree with counsel for the appellant that in each of the Tax Review Board cases of Toronto Heel Ltd. v. M.N.R., [1980] C.T.C. 2277; 80 D.T.C. 1250, and Brazolot Construction Ltd. v. M.N.R., [1981] C.T.C. 2468; 81 D.T.C. 449, the fact that the taxpayer companies did not pay the accrued management bonuses in respect of the years in issue because of the insufficiency of cash flow did not lead the Tax Review Board to conclude that the liability concerning the accrued bonuses was contingent.

In the consideration of this matter of contingent liabilities or reserves within the purview of paragraph 18(1)(e) of the Income Tax Act, the following observations of Mr. Justice Cattanach in the case of McClain Industries of Canada Inc. v. The Queen, [1978] C.T.C. 511 at 524; 78 D.T.C. 6356 at 6365, referred to in both the Toronto Heel and Brazolot cases are of assistance:

The only contingency, if it is properly termed a contingency in the present appeals was that the directors might, if they considered business conditions demanded, reduce or even cancel the fund so set up. In the absence of any contractual liability forbidding them from doing so, which does not prevail in the present instance or if it did it was readily susceptible of being waived by the contracting parties, there is no impediment to the directors doing so. As viewed by Maple Leafs side it was a cancellation of a debt which was by reason of the system the management employees agreed to being done and from the viewpoint of the management employees it was the forgiveness of a debt.

On the whole of the evidence, I do not believe that the appellant's working capital position was so serious that it actually cast doubts on the appellant's real intention to pay out bonuses at the time they were declared in respect of the years under appeal. In coming to this conclusion, I take into account the portion of the then current obligations that was owing by the appellant to nonarm's length persons and the fact that out of the $723,000 bonuses declared in respect of the 1985 taxation year, the amount of $650,000 was to be subtracted therefrom if the respondent's income tax treatment of the $650,000 bonuses was to prevail. Incidentally the appellant's obligation to pay $650,000 declared on November 15, 1983 was the subject matter of waiver dated June 5, 1986 by all of the directors of the appellant.

Having regard to the wording of the resolutions discussed earlier, the reflection in the financial statements for each year in issue of the existence of both the liability and expense in respect of these accrued bonuses and generally the appellant's conduct, I conclude that the payment of the bonuses was a legally binding obligation of the appellant.

I am therefore of the opinion that the prohibition laid down in paragraph 18(1)(e) is not applicable here.

The third general submission propounded by the respondent involves the application of subsection 245(1) as it stood in the years in issue. That subsection then provided as follows:

In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

It was argued on behalf of the respondent that the accrual of the bonuses in the years under appeal was a device to minimize tax. The point was stressed that the incurring of the obligation to distribute in the form of bonuses any profits in excess of $200,000 was principally motivated by its desire to benefit by the low rate of tax that is available to Canadian-controlled private corporations in respect of the portion of active business income that is below $200,000.

Firstly, it must be stated that the payment of bonuses to management employees is a well-accepted method of compensation and is in accordance with well recognized principles of commercial accounting and business practices. This is particularly true in the case of principal shareholders-managers.

Secondly this method of accruing remuneration is expressly recognized by Parliament when it enacted section 78 of the Income Tax Act. Therein the tax treatment of the unpaid remuneration is laid down in a precise fashion.

One fundamental objection raised by the respondent is that the amounts of the bonuses bore no relationship to the services of the directors.

As is apparent from my previous observations, I do not agree with this view of the evidence which I have analyzed earlier in some detail and I find that the appellant's intention was always to pay these bonuses. Unexpected cash flow difficulties prevented the appellant from doing so in respect of the bonuses accrued in 1983 and 1985.

In my view, the main reason of the appellant in accruing bonuses in the years in dispute was to compensate directors for their successful management of the appellant's business over the years. It is true that by roughly equating the amounts of bonuses to the amounts of profits in excess of $200,000 the appellant could achieve substantial income tax savings. The evidence that the formula in question relating to the quantum of funds available for distributing bonuses represented a good growth rate for the appellant has not, in my view, been successfully challenged. I do not consider, for instance, that the respondent's position on the facts of this case would be significantly altered if the appellant had adopted as a yardstick for the distribution of profits any portion of the profits in excess, say, of $300,000. There is no question here that by resorting to the above formula the appellant wanted to minimize tax but I do not believe it was its dominant reason for doing so. In this connection, the approach adopted in the present case appears to me to be in line with the decision of Goetz, J. of this Court in the Earlscourt Sheet Metal Mechanical Ltd. v. M.N.R., [1988] 1 C.T.C. 2045; 88 D.T.C. 1029. Also, the decisions of the Federal Court of Appeal in Spur Oil Ltd. v. The Queen, [1981] C.T.C. 336; 81 D.T.C. 5168 and The Queen v. Alberta and Southern Gas Co., [1977] C.T.C. 388; 77 D.T.C. 5244, made it clear that a tax incentive motive behind the incurring of an expense does not make the expense artificial within the purview of subsection 245(1) of the Income Tax Act. Accordingly, this third submission also fails.

For these reasons, the appeals are allowed in part, with costs, and the reassessments for the appellant's 1983, 1984 and 1985 taxation years are referred back to the respondent for reconsideration and reassessment on the basis that the bonuses of $650,000, $240,000 and $73,000 accrued in 1983, 1984 and 1985 respectively are deductible in computing its income for those years.

As I have indicated at the beginning of these reasons, the appeal for the appellant’s 1984 taxation year is also allowed to the extent that it involves the determination of the capital cost of an office building referred to in the amended notice of appeal dated November 23, 1988. The appeal for the appellant's 1983 taxation year to the extent that it involves the deduction of a non-capital loss is dismissed.

In the circumstances, I believe it is appropriate for me to ask counsel for both parties to prepare for my consideration a draft judgment which is not inconsistent with these reasons.

Appeals allowed in part.