Date: 19990212
Docket: 96-2286-IT-G; 96-2287-IT-G
BETWEEN:
WAWANG FOREST PRODUCTS LTD., NERAK CONTRACTORS INC.,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
McArthur, J.T.C.C.
[1] The Appellant, Wawang Forest Products Ltd. (Wawang),
appeals the income tax assessments for the 1987, 1988, 1990 and
1991 taxation years. Holdbacks amounting to $26,158, $14,716,
$10,365, and $146,910, respectively, claimed by Wawang as
deductions from income were determined by the Minister of
National Revenue (the Minister) not to be outlays or expenses
incurred for the purpose of gaining or producing income within
the meaning of paragraph 18(1)(a) of the Income
Tax Act (the Act).
[2] The Appellant, Nerak Contractors Inc. (Nerak), appeals
assessments for the 1988, 1990 and 1991 taxation years. Holdbacks
amounting to $4,158, $33,395, and $123,059, respectively, claimed
by Nerak as deductions from income were determined by the
Minister not to be outlays or expenses within the meaning of
paragraph 18(1)(a) of the Act. The two appeals
were heard together on common evidence.
[3] The issue is whether the holdbacks are an expense or
outlay incurred in the respective taxation years claimed pursuant
to paragraph 18(1)(a) of the Act.
Alternatively, if they are deductible expenses under 18(1)(a),
are they nonetheless contingent liabilities within the meaning of
paragraph 18(1)(e) of the Act?
Facts
[4] Both Appellants are wholly owned subsidiaries of Buchanan
Forest Products Limited and maintain common offices in
Thunder Bay, Ontario. Wawang undertakes forestry activities
that largely consist of the cutting, skidding and delimbing of
spruce, jack pine and poplar trees. Nerak's activities
largely consist of loading and hauling these logs to various
mills. Wawang and Nerak contract most of their activities to
independent contractors.[1] These contracts provide that the contractors will cut,
skid and delimb (Wawang) or haul wood products (Nerak) at
stipulated prices per cord or per metric tonne. The contracts
provide further that the contractors will comply with the
Workers' Compensation Act.
[5] During the relevant period, subsection 11(3) of the
Workers' Compensation Act, R.S.O. c. W-11 empowered
the Workers' Compensation Board (WCB) to obtain payment of
the contractor's assessment from the principal (Wawang/Nerak)
should the contractor not make the required WCB payment. That is,
if the contractors did not pay their WCB obligations, the Board
could and would "leapfrog" to the principals to collect
the delinquent accounts. The Appellants' contracts therefore
required a holdback pending receipt of valid clearance
certificates or other appropriate acknowledgements from the WCB
eliminating Wawang/Nerak's legal exposure for payment of the
contractors' WCB liability. The holdbacks were deducted from
the total contract price.
[6] In years prior to 1989, holdback amounts were paid or
cleared within a relatively short period of time. During the
relevant period, however, there was a three-year delay in
paying the holdbacks because of a dispute between the Appellants
and WCB which dispute was resolved in favour of the Appellants in
1993. Despite attempts by some contractors to obtain the holdback
money, the Appellants refused to pay until they had received
clearance certificates. At the time of the Minister's audit
for the taxation years in question, no amount on account of the
holdbacks had been paid to the contractors or to the WCB. It
would appear that at the date of trial, approximately 95% of the
holdbacks had been paid by the Appellants.
Position of the Appellant
[7] The holdbacks constitute part of the money owing by
Wawang/Nerak to their contractors for work already completed and
accordingly, constitute an outlay or expense within the meaning
of paragraph 18(1)(a) of the Income Tax
Act.
[8] There are no provisions contained in the Income Tax
Act that are inconsistent with the accounting treatment and
the reporting of income employed by the taxpayers. The accounting
and reporting method employed is consistent with generally
accepted accounting principles (GAAP). Nothing in that method is
inconsistent with any established principle of the jurisprudence
or any rule of law. Deduction of the holdbacks provides the best
matching of costs and revenues.
[9] The holdbacks are not contingent liabilities within the
meaning of paragraph 18(1)(e) of the Income Tax
Act. A contingency is an event that may or may not occur and
a contingent liability is a liability which depends for its
existence upon an event which may or may not happen.[2] There is no subsequent
event or condition upon which the liability for payment of the
holdback portion depends. The Appellants' liability for the
entire contract price arises as soon as the services are
complete. The liabilities to contractors in respect of holdbacks
as protection against potential additional WCB exposure for
contractors' unpaid WCB liabilities, are neither reserves nor
contingent liabilities but rather are genuine, very real
liabilities owing for fully completed services. They are paid
when Wawang and Nerak are absolved from WCB liability owing by
the contractors which is a completely separate matter from the
contractors' services and the fees therefor.
Position of the Respondent
[10] The holdbacks claimed by the taxpayers were not expenses
made or incurred within the meaning of
paragraph 18(1)(a) of the Income Tax Act.
Under the terms of the contracts that are in evidence, there was
simply no obligation on the part of either Wawang or Nerak to pay
the amounts of these holdbacks in the years in which the
Appellants are seeking to deduct them. Alternatively,
paragraph 18(1)(e) of the Income Tax Act would
disallow the deduction on the basis that these represent
contingent liabilities. The contracts provided that there was a
condition precedent – providing clearance certificates -
that had to be satisfied by the contractor prior to these amounts
becoming payable.
Legislation
[11] During the relevant period, subsection 11(3) of the
Workers' Compensation Act, R.S.O. 1990, c. W-11
provided:
Where a person ... in this subsection ... referred to as
the principal, contracts with any other person, in this section
referred to as the contractor, for the execution by or under the
contractor of the whole or any part of any work for the
principal, it is the duty of the principal to see that any sum
that the contractor or any subcontractor is liable to contribute
to the accident fund is paid, and if any such principal who fails
to do so is personally liable to pay it to the Board ...
Also, paragraphs 18(1)(a) and (e) of the
Income Tax Act provided that:
18(1) In computing the income of a taxpayer from a business or
property 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 the business or property;
...
(e) an amount as, or on account of, a reserve, a
contingent liability or amount or a sinking fund except as
expressly permitted by this Part;
Analysis
[12] The Wawang and Nerak contracts were similar and there is
no need to deal with them separately. In 1987 and 1988, the
contracts read, in part:
The COMPANY agrees to pay the CONTRACTOR an additional $.80
per cord for spruce and pine full tree, $.70 per cord for poplar
treelength and $1.25 per cord for spruce and pine treelength upon
the receipt of a CERTIFICATE OF CLEARANCE from the Workers'
Compensation Board for his account.
In the 1990 and 1991 taxation years, the contract wording was
different in that the words "may hold back" were used
but this does not give rise to a different result. It read as
follows:
The CONTRACTOR agrees that the COMPANY may hold back the
following sums out of any sum otherwise payable to the CONTRACTOR
until such time as the CONTRACTOR furnishes to the COMPANY a
clearance certificate or such other evidence as the COMPANY shall
require that the CONTRACTOR has paid any and all sums that the
CONTRACTOR is liable to contribute to the Workers'
Compensation Accident Fund:
...
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. "The contractor agrees that the
Company may holdback – certain amounts – ".
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. The main thrust of the
Appellants' argument is that the contractors' work had
been completed, there was nothing left to be done and the
Appellants had a very real liability for fully completed services
in the year claimed. When they received the clearance
certificates, they had to pay the holdback.
[13] However, the Appellants' submission in this regard is
not entirely accurate. If they never received a certificate from
WCB, they did not have to pay the holdback. It would appear from
the evidence that approximately 5% of the holdbacks were never
paid for whatever reasons. Further, the Appellants could deduct
levies and fines from monies owing to the contractors. These
facts cannot simply be ignored. The holdback liability was not
absolute. The Appellants may pay all of the holdback sums or they
may not. Moreover, the holdbacks were not placed in a separate
trust account when they accrued in the Appellants' books.
Rather, they were paid out of the Appellants' general account
from funds on hand at the time of payment. The contractors did
not have an enforceable claim against the Appellants for the
holdbacks until a clearance certificate was provided. Pursuant to
their contract, the Appellants also had a right of setoff from
the holdback proceeds should there be certain trespass or damage
claims against the Appellants as a result of actions by the
contractors.
[14] An expense occurs in the year the obligation to pay is
incurred.[3] An
expense cannot be said to be incurred by a taxpayer until there
is an obligation to pay,[4] and it must be an obligation to pay during the year it
is claimed as an expense.[5] Without consideration to GAAP and matching principals,
I find from a layman's view, the holdbacks were not expenses
until the Appellants received clearance certificates. It is only
then that they became payable and a current expense. An expense
cannot be said to be incurred by a taxpayer who is not under an
obligation to anyone.[6] It is a question of law that must be considered and
not simply accounting principles.
[15] This is the position taken in the case of Newfoundland
Light & Power, supra, wherein Pratte J. stated:
Indeed, in order for an expense to be incurred during a year,
the obligation to pay must be created during that year;
similarly, there is no cost of property to a taxpayer as long as
the obligation to pay that cost has not come into existence.
Also, I agree with Brulé J. in Co-operators,
supra who stated that the obligation must be an obligation
to pay in the year it is claimed and not two or three years later
as was the situation in the present appeals.
[16] The Appellants wish to distinguish the uncertified
construction lien holdback cases[7] from the present facts. The Appellants argued
that in the Colford and Guay cases, there was
uncertainty as to the quantum of the holdbacks to be paid while
in the present case there is no such uncertainty and all the work
is complete and accepted as is. It is clear from extensive
jurisprudence that construction (lien) holdbacks are not
deductible until paid.[8] The Appellants submitted that eventually the holdbacks
we are dealing with in the Wawang/Nerak appeals will be paid. The
Court in Guay, supra did not find that a similar
submission affected its decision. As in the present case, in
Guay it was not a certainty that the full amount withheld
would be paid and the Court stated:[9]
However, as we have seen above, there is an additional reason
for dismissing the appeal: this is that we are dealing with
amounts withheld which are not only uncertain as to quantum if
partial damages result from badly done work, but which will no
longer even be due or payable if damages exceed the amounts
withheld.
[17] Unlike the situation in the case of Wil Mechanics Ltd.
v. The Queen,[10] the Appellants' contracts contained express terms
permitting the Appellants to withhold money for damages.
[18] The Appellants urged the Court to follow the decision in
Imperial Financial Services Ltd. v. M.N.R.,[11]wherein
Imperial was entitled to holdback 20% of the amounts
billed to it by its subcontractors and to pay those amounts in
three consecutive five-year instalments during the
15 years following completion of the work. In fact,
Imperial accelerated the payments and had paid the
holdbacks in full within two or three years. The Minister
disallowed the claimed deductions for reasons similar to those in
the present appeals. The Court held, inter alia, that the
holdbacks were genuine liabilities and in the peculiar
circumstances, if the Appellant had reduced its expenses by the
amount of the holdbacks, its income would have been distorted.
The Court stated at page 190:
The holdbacks were a sum of money and the Appellant was under
an obligation to pay the same. They were just not due at the year
end.
[19] In Imperial Financial, supra, the Court was
dealing with appeals for the 1980 and 1981 taxation years and in
fact, all holdbacks were paid in the 1982 taxation year. This
fact may have had an influence on the decision. Further, the
taxpayer in Imperial Financial does not appear to
have had the equivalent requirements of a clearance certificate
or the right of setoff contained in the Wawang and Nerak
contracts. I am not certain I would have reached the same
conclusion as the trial Judge in Imperial Financial. I
believe that the decision is restricted to its specific
facts.
[20] Having regard to case law previously cited, I agree with
counsel for the Respondent that 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.
[21] Having found that paragraph 18(1)(a) of the
Income Tax Act bars the Appellants' claim because they
had no liability to pay the holdbacks during the years in
question, there is no need to look to GAAP for assistance[12] nor is there a need
to consider paragraph 18(1)(e) of the Income Tax
Act although it would appear that the holdbacks are
contingent liabilities. The Minister correctly disallowed the
deduction of the unpaid holdbacks because they were not outlays
or expenses made or incurred within the meaning of paragraph
18(1)(a) of the Income Tax Act. The appeals are
dismissed, with costs.
Signed at Ottawa, Canada, this 12th day of February 1999.
"C.H. McArthur"
J.T.C.C.
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