Enns Brothers Ltd. v. Minister of National Revenue, [1991] 1 CTC 2024, 91 DTC 82

Taylor, T.C.J.:—These are appeals heard in Winnipeg, Manitoba, on September 11, 1990, against income tax assessments for the years 1982,1983 and 1984 in which the Minister of National Revenue had reassessed as follows:

— by Notice of Reassessment dated December 1, 1986 the Respondent reassessed the Appellant's 1984 taxation year and increased its active business income by $238,212.00 as follows:

Disallowed portion of 3%

Inventory Allowance	$58,424.00
Disallowed deduction of
Finance Reserve	$179,788.00
Finance Reserve
Total	$238,212.00

— by further Notice of Reassessment dated July 17, 1987, the Respondent reassessed the Appellant's 1984 taxation year and decreased its active business income by $181,287.00;

— the Respondent assessed the Appellant's liability for tax for the 1984 taxation year on a taxable income of $199,721.00;

— by Notices of Reassessment also dated July 17, 1987, the Respondent reassessed the Appellant's tax for the 1983 taxation year to disallow a deduction in respect of the Finance Reserve in the amount of $181,287.00 and for the 1982 taxation year to reduce the Appellant's loss carry back front 1983 to nil.

At the start of the trial, counsel for the appellant stated that the amount of $58,424 for the 1982 inventory allowance, supra, was no longer in dispute; and counsel for the respondent noted that in the event the assessment by the Minister for the year 1984 was upheld by the Court the amount of $179,788, supra, should be reduced by an amount of $68,374 and reassessments where required struck by the Minister.

The position of the appellant was outlined in the notice of appeal (using the year 1984 as typical):

— At all relevant times, the Appellant was an authorized dealer of agricultural equipment and machines for John Deere Ltd. (“John Deere") under an "Authorized Agricultural Dealer Agreement" (the"Dealer Agreement").

— Pursuant to the Dealer Agreement, the Appellant purchased and acquired from John Deere agricultural equipment and machinery and John Deere sold to the Appellant agricultural equipment and machinery.

— Pursuant to the John Deere DRV Lease Agreement (the" John Deere Finance Plan")—. . .—executed pursuant to the Dealer Agreement, the Appellant sold farm equipment to its customers under the John Deere Finance Plan. The relevant portion of the John Deere Finance Plan is contained in section 4 thereof as follows:

4. Dealer’s Reserve Account

4.1 As provided in subsection (a) of Sections 1.3 and 2.4 hereof respectively, when any lease or contract is accepted by the Company, one per cent (1%) of the aggregate lease payment of the lease or one per cent (1%) of the time balance of the contract will be credited to the Dealer's reserve account. The reserve account will also be credited with interest earned at the rate of eight per cent (8%) per annum on the average of the month-end balances for each twelve (12) month period ending 31 December.

4.2 If at any 31 December, the Dealer's reserve account, including interest earned thereon, exceeds three per cent (3%) of the balance then outstanding on all leases and contracts accepted from the Dealer, the reserve account will be adjusted to three per cent (3%) of such balance and the excess will be applied to the Dealer's currently due indebtedness to the Company or to any other company affiliated with the Company. Any part of such excess which remains after all of the Dealer's currently due indebtedness has been satisfied will be paid to the Dealer in cash or as the Dealer may direct. No adjustment will be made which reduces the reserve account below one thousand dollars ($1,000).

— . . ., the Appellant says, as the fact is that the finance reserve of $181,287 is not a receivable from John Deere. The Appellant alleges that such amount is not a receivable either from an accounting point of view nor as a matter of law. The Appellant submits that in order for an amount to be a receivable there must be no legal impediment or condition precedent lying in the way of it being an amount owing. Under the John Deere DRV Lease Agreement between John Deere and the Appellant, the amount is neither owing nor can the Appellant enforce payment against John Deere.

— The Appellant asserts that the deduction of the “finance reserve" is not a deduction prohibited by the provisions of paragraph 18(1)(e) of the Income Tax Act (Canada) but rather is a consistent method of accounting taken by the Appellant inaccordance with generally accepted accounting principles applied consistently and furthermore annually accepted and approved by the Respondent since at least as early as 1974.

— The Appellant has reported its income from the "finance reserve" as calculated by John Deere on a cash basis (as per Schedule B hereto) and has done so consistently without objection of any kind by the Respondent for some years or alternatively, since at least as early as 1974. The Appellant alleges that this practise [sic] has prevailed throughout the farm implement industry and has been accepted by the Respondent as being a proper basis for calculating profit from a farm implement business.

— The Appellant further asserts that the sum of $170,814 as at December 31, 1981 being a portion of the “finance reserve" was created in years from which the Respondent is statute barred from reassessing, pursuant to the provisions of subsection 152(4) of the Income Tax Act (Canada).

For the respondent the situation was:

— the Appellant sells and leases agricultural equipment and machines of John Deere Ltd.;

— pursuant to the John Deere DRV Lease/Finance Agreement, John Deere Ltd. provides financing to the purchasers and lessees of equipment sold or leased by the Appellant;

— when John Deere Ltd. agrees to finance a contract obtained by the Appellant the proceeds thereof (less financing charges) became payable by John Deere Ltd. and receivable by and due to the Appellant;

— John Deere Ltd. pays the proceeds to the Appellant less a one percent holdback which is credited to the Appellant's reserve account;

— thereafter all payments under the contracts are made by the customer directly to John Deere Ltd.;

— the Appellant's reserve account is credited with interest at the rate of 8% per annum on the average of the monthly end balances for the 12 month period ending December 31;

— at any December 31, the Appellant becomes entitled to amounts credited to its reserve account in excess of 3% of the outstanding leases and contracts;

— when, and if, all leases and contracts accepted from John Deere Ltd. have been liquidated in full the Appellant becomes entitled to receive any credit balance remaining in its reserve account;

— the reserve is established by John Deere Ltd. to protect it against possible defaults on the leases and contracts and against possible losses on repossessions which rarely occur in practice and for which the Appellant is fully responsible;

— in preparing financial statements for its 1984 fiscal period, the Appellant included in its income the full amount of the proceeds of its sale and lease contracts and deducted from income the amount credited to its reserve account;

— the Appellant also included in its income for the 1984 taxation year the amount of $181,287 deducted as a reserve in its 1983 taxation year;

— the amounts credited to the Appellant's reserve account are neither bad nor doubtful but constitute a reserve for contingencies;

— the Respondent relies, inter alia, on sections 3 and 9, subsection 12(2) and paragraphs 12(1)(b), 12(1)(e), 20(1)(n) and 20(1)(gg) of the Income Tax Act, R.S.C. 1952, c. 148 as amended by S.C. 1970-71-72, c. 63, s. 1 for the 1984 taxation year;

— . . . the Appellant is not entitled to deduct a reserve pursuant to paragraph 20(1)(n) of the Act in respect of the amounts credited to its reserve account as the said amounts were due to the Appellant in its 1984 taxation year.

Evidence was provided through Mr. William Green, a chartered accountant, witness for the appellant. He confirmed the accounting procedures used by Enns Brothers Ltd. (Enns"), which are described above in the respondent's reply to notice of appeal, but stated that one phrase therefrom should be clarified: ”. . .and deducted from income the amount credited to its reserve account". According to Mr. Green, the term ” reserve account" used therein by the respondent must be recognized as referring to the reserve account” set up in the record of John Deere, as per the agreement, supra. There was no "reserve account" set up in the records of Enns, but the amounts which were not immediately received from John Deere (the one per cent holdback to use a simple term) were added to "cost of sales” in the records of Enns when the contract was turned over to John Deere. At the year-end, Mr. Green agreed that he did record in the financial statements of Enns an amount equal to that which John Deere informed him was to the credit of Enns, in the John Deere record. For example, at December 31, 1984, the Enns financial statements showed the following items:

Mr. Green could see how the Minister's assessors could have reached the conclusion that indeed “ reserves” were being set up in the records of Enns— but he assured the Court that had not been done, and that what appeared above had only been to make a year-end reference note to that amount which Enns hoped (and expected) it would receive some day. The Note 1 above for the 1984 financial statements read:

Finance Reserve

John Deere Limited computes the finance reserve at December 31st. The company's policy is to include finance reserve income in the year of receipt. In January 1985, $25,152 was received.

The effect of the accounting procedures followed by Mr. Green was to eliminate from actual net income of the appellant the" holdback" amounts resulting from the one per cent retained by John Deere—even though the total sales income included these amounts. The reduction of the net income by these amounts resulted from including them as part of "cost of sales” thereby producing a" wash” of the two offsetting amounts—leaving the way clear in Mr. Green's view to account for the amounts when and if received as "miscellaneous income” which he did religiously.

Argument

The main point of counsel for the appellant was that there were two reasons the “holdback” amounts from John Deere should not be taken directly into income as some form of accounts receivable. First, that because there was a pre-existing condition—the purchaser of the equipment from Enns must pay the balance of the finance contract (usually spread all over a few years) before the appellant could legally have any claim to the “ holdback” from John Deere, (and even then only after a credit in the John Deere" reserve account” of more than three per cent of all outstanding contracts had been accumulated); and second, that because there was no way of knowing if all of the contracts would be paid, no easy way of calculating the exact amount at any time was available. Therefore—conditions to be fulfilled and no exact amount, left these amounts outside of any of the terms of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") which called for these being treated as net income.

For counsel for the respondent, the situation is quite different. It was clear from the evidence of Mr. Green that the total amount of the sales contracts to its customers had been taken into sales—and that was proper, since whatever was received by Enns from a sale—a trade, some downpayment, or a contract for later payments—constituted proceeds of disposition of the equipment sold. The "sale" of the finance contract by Enns to John Deere was a subsequent event—having no effect on the requirement of Enns under the Act to bring into income all such proceeds—subject only to the possibility of some stipulated reserves under a quite different section of the Act—perhaps section 20(1)(n), but apparently that was not in issue at this hearing, counsel for the appellant having made the point that no "reserve" had been taken. However, counsel for the respondent did contend that in reviewing whether any reserve" could be considered, that question must be posed in relation to the amount of the "holdback" due from John Deere in connection with the sale of the negotiable paper—the financing contract—from Enns to John Deere, and that the question could have no relation to the original sale of the equipment from Enns to the customer, which sale created the financing contract.

Analysis

The thrust of the appellant's evidence and argument was directed towards establishing a connection between the sale of the equipment by Enns, and the one per cent "holdback" from John Deere at issue, thereby justifying the practice of increasing the "cost of sale” by the one per cent holdback which had already been credited to sales. In my view they are not connected for that purpose although they are related. The one per cent holdback has nothing whatever to do with "cost of sales” however else it might be treated. I do agree that the transaction to be considered is that between Enns and John Deere, which produces the one per cent holdback, not the transaction between Enns and the customer which produces the original amounts. The total amount of the sale of a piece of equipment must be shown as part of the gross sales of the appellant, and this has been done. Obviously, if that sale (any particular one) resulted in payment all in cash, there would be no problem area in the nature of this appeal. It is only where part of that sale is not received, at the time of the sale, from the customer, that the financing arrangement with John Deere kicks in. In effect, John Deere, by virtue of its dealer agreement with Enns, takes over the customers’ account receivable now owing to Enns and deducts therefrom when remitting the cash to Enns the one per cent holdback. This is not a "commission" to John Deere, a “discount”, or some other form of expense—which might then warrant showing it as part of "cost of sales", as the accounting practice in effect now records it.

The effect of including the one per cent holdback in "sales income", and then concurrently including the same amount as part of" cost of sales" resulted in a" wash” of the amount as far as any effect it could have on the” net income" of the particular year. That is no income tax was paid on the holdback in that year. When the amount was finally received (or at least an amount with reference to the holdback, taking into account the terms of the agreement between John Deere and Enns) it was then re-recorded under “ miscellaneous income”, and certainly tax would be paid (if there was a net income) on the amount in that year of receipt—which of course could be two, three, or several years after the sale of the equipment which had been the original transaction triggering the relevant events. That means simply that the amount of holdbacks—which are eventually received from John Deere, are in fact reported as gross income (not net income) twice, probably in different years— once when the original amount is credited to "sales" (above) and once when that amount is actually received—to “miscellaneous income". This matter before the Court, of course, is not to be decided upon the manner in which the appellant maintained its accounting records above, although it can be a factor. But at the minimum the procedure I have just described is “double entry bookkeeping” of an unusual nature. It certainly does serve to cloud the examination of the transactions somewhat, and accordingly makes a little more difficult the required determination for income tax purposes. The very fact that the appellant followed the practice of crediting to "sales income” in the years of the sale the amount of the holdback (thereby increasing sales) somewhat defeats the underlying foundation for this appeal. It might be argued that since the appellant at least in this appeal did not regard the amount of the holdback as producing "net" or "taxable" income for that year, it should have been left out of the sales—but that would have understated the total sales amount for that year. So I can see the rationale for treating it in the manner it was shown originally as part of "sales". But when it comes to treating the same amount as an increase in the cost of sales in the same year, I fail to follow the rationale. The amount at issue—an increase in the“ cost of sales”, has nothing to do with the cost of sales. It represents only one thing—an amount which Enns expected to receive at some time in the future, but to which the appellant company was not entitled until certain conditions were fulfilled—in this case effectively until John Deere had collected the amount in the first place. That is a definition of some form of receivable, as I see it—granted that there are conditions attached to its eventual receipt. So therefore, logically, as I see it, instead of the amount of the holdback increasing cost of sales an immediately deductible item, it should have been treated in some other way albeit with the attendant restrictions regarding receipt indicated, which would not have re- suited in an immediate reduction of "net" or"taxable" income. Certainly that would have also avoided the "double entry” of the amount, when it was received, which I have noted above. This judgment is based on the Court's acceptance of the assertion of counsel for the respondent at the hearing, that the transaction to be considered by the Court is that of the agreement between Enns and John Deere, not Enns and a customer. I am not called on to determine how the amount should be represented in the records, but some form of receivable appears proper. Nor am I called on to review whether this final one per cent could be qualified for consideration as part of the reserve" under section 20(1)(n) of the Act—some form of "amount receivable” from John Deere "in respect of property sold"—the property being the finance contract “sold” from Enns to John Deere (since this aspect of the matter was not raised by the appellant). But when the account is factored to John Deere—it could be argued it ceases to be a trade account receivable since the entire account is now the property of John Deere, subject to the conditions imposed on it regarding eventual payment to Enns. The one per cent which is now a holdback in anticipation or eventual receipt from John Deere, is not the same one per cent which the appellant has already included in gross sales—and which itself might have been subject to consideration for a” reserve”.

In the end analysis, as I understand the evidence presented, the existing method of accounting for the “ holdback amounts” (by increasing cost of sales by the amounts each year) is not acceptable and the respondent is entitled to reject it, and review the amounts so recorded. In the same way, it has not been shown that even if the above method of dealing with these amounts could be considered as setting up some kind of a reserve (a position not taken by the appellant, but raised by the respondent) that such a reserve has a viable basis in the Act. From either possible perspective the appellant's case has not been supported.

I would also note that counsel for the appellant raised the argument that if the Court held the amounts at issue to be income as claimed by the respondent (which has been decided above), then somewhat different amounts, respecting only the exact amounts of the holdbacks generated each individual year should be so included, as opposed to the basis of the respondent's calculations—the differences represented by the build-up of the total account at John Deere. I do not agree. I do understand that the respondent was required to start somewhere to get the reporting procedure in order—and started for the year 1982. The system as described by Mr. Green apparently had been in effect since 1974, and there well may be (as a result of the first reassessment, 1982) a dislocation of total tax payable—I really do not know, because I have made no attempt to reconcile it. But the system of reporting the holdbacks has been improper since 1974, and as I see it the respondent is entitled to make it right, at the earliest opportunity he chooses—and he chose 1982.

According to the agreement between the parties noted at the outset of these reasons, the amount of $179,788 shown for the year 1984 should be reduced by an amount of $68,374. My brief review of the circumstances of the reassessments and the details surrounding these two amounts leaves me less than completely satisfied that such an adjustment is warranted in favour of the taxpayer, but that is the prerogative of the parties and the judgment will go accordingly.

The appeal for 1984 is allowed to the extent that the amount of $179,788 in the reassessment should be reduced by an amount of $68,374 as agreed by the parties. The appeals for the years 1982 and 1983 are dismissed. No costs are to be awarded.

Appeal allowed in part.