Imperial Financial Services Limited v. Minister of National Revenue, [1991] 1 CTC 2031, 91 DTC 184

Teskey, T.C.J.:—The appellant appeals from reassessments for its 1980 and 1981 taxation years.

Issue

The respondent added to the appellant's 1980 and 1981 income $1,054,462 and $12,348,538 respectively claiming they were not an outlay or expense made or incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), but were contingent liabilities which are disallowed by the provisions of paragraph 18(1)(e) of the Act.

The appellant submitted that:

(a) it properly reported its income for financial statement and income tax purposes from its construction activity for its 1980, 1981 and 1982 taxation years pursuant to a method acceptable under generally accepted accounting principles (GAAP);

(b) paragraph 18(1)(a) of the Act does not require a departure from GAAP;

and

(c) the allocation of expense against income earned by the appellant from its construction projects over the 1980, 1981 and 1982 years is in accordance with the "matching principle”.

Facts

1. The appellant was incorporated pursuant to the Canada Business Corporations Act, R.S.O. 1980, c. 54, on February 15, 1980, and is a resident of Canada.

2. The appellant's fiscal year end is October 31.

3. In May 1980, the appellant began carrying on its business of developing and syndicating rental real property projects in Western Canada.

4. The appellant's business was to purchase and sell land to syndicates of investors from the general public and to enter into an agreement (the "project agreement") with the investor syndicate to construct a specified high-rise residential project for the investor syndicate on the land and to provide certain development services in connection therewith. The syndications were done through a prospectus or offering memorandum as required under governing securities legislation. In each project agreement, the appellant agreed to:

(a) sell the land to the investor syndicate for a fixed price;

(b) complete construction of a high-rise residential project for a fixed price;

(c) supply all furnishings for a fixed price; and

(d) provide certain development services (e.g., interim construction financing, marketing and lease-up services and cash flow guarantees) for a fixed price.

5. At the end of its 1980 taxation year, the appellant was engaged in construction of four projects, and by the end of its 1981 taxation year, it had completed or was engaged in construction of 21 projects. All 21 projects were completed and Architect's certificate of completion were obtained by October 31, 1982.

6. The project agreements provided that the investor syndicate would be billed on a monthly basis according to the percentage of construction completed to that particular time (i.e., the value of the work completed and materials delivered at the work site expressed as a percentage of the total construction price to the investor syndicate). The investor syndicate was required to pay the full amount of each month's billings within five days of the monthly billing.

7. The appellant purchased the land upon which the residential high rise building was to be erected and subcontracted the construction component, the furnishings and the development services of the project all at fixed prices with interrelated companies within the "Imperial" group of companies.

8.. The agreements under which the appellant subcontracted the construction component of the projects called for:

(a) the subcontractor to bill the appellant monthly according to the percentage of construction completed (i.e., the value of the work completed and materials delivered at the work site expressed as a percentage of the fixed price);

(b) the appellant to pay 80 per cent of the amount so billed within a certain number of days; and

(c) the appellant to pay the remaining 20 per cent of the amount so billed in three equal consecutive instalment on November 15 in the 5th, 10th and 15th years following the calendar year in which substantial completion occurred (in fact all holdbacks were paid in full during the 1982 fiscal year).

9. The appellant calculated its income for its 1980 and 1981 taxation years for all purposes by including the amount of income earned from the construction component for each of the twenty-one projects determined on the basis of the following formula applied as at the particular year end:

10. As to the four projects under construction on October 31, 1980, the aggregate of the long-term billings (i.e., the 20 per cent of the billings from its construction subcontractors to be paid by the appellant as set out above) was $1,054,402.

11. As to the 21 projects completed by or under construction on October 31, 1981, the aggregate of the long-term billings (i.e., the 20 per cent of the billings from its subcontractors to be paid by the appellant) was $12,348,538. (At the opening of trial, the respondent agreed that the appellant could expense $5,686,199 leaving $6,662,339 still in dispute.)

12. The appellant reported its income from the construction component of the projects as follows:

The respondent's reassessments for the said years resulted in income being added in the 1980 and 1981 years and being deducted in 1982 as follows:

For comparison purposes see Schedule"A" attached. Also see Schedule” B" which shows all the projects for comparison:

13. The appellant called two witnesses namely Rudy Henry Beyer, C.A., who was comptroller of the appellant and Ralph Palmer, C.A., a partner in the firm of Ernst and Young (formerly Clarkson Gordon). Both witnesses gave evidence as to GAAP and the principle of matching expense against income. It was acknowledged by the respondent that the appellant kept its records and reported its income to its shareholders by using GAAP. The respondent alleged that, for income tax purposes the method used by the appellant to report income, was not appropriate because paragraphs 18(1)(a) and 18(1)(e) amend, modify or alter the GAAP.

Respondent's Position

The respondent submits that construction holdbacks are not deductible and refers the Court to:

Ellis Construction Ltd. v. M.N.R., [1982] C.T.C. 2604; 82 D.T.C. 1625 (T.R.B.); J.L. Guay Ltd. v. M.N.R., [1969] Tax A.B.C. 691; 69 D.T.C. 490 (T.A.B.); [1971] C.T.C. 686; 71 D.T.C. 5423 (F.C.T.D.); [1973] C.T.C. 506; 73 D.T.C. 5373 (F.C.A.); [1975] C.T.C. 97; 75 D.T.C. 5094 (S.C.C.) and Newfoundland Light & Power Co. v. The Queen, [1986] 2 C.T.C. 235; 86 D.T.C. 6373 (F.C.T.D.); [1990] 1 C.T.C. 229; 90 D.T.C. 6166 (F.C.A.).

The respondent also referred the Court to The Queen v. Burnco Industries Ltd., [1984] C.T.C. 337; 84 D.T.C. 6348 wherein the Court said at page 337 (D.T.C. 6348): “In our opinion, an expense, within the meaning of paragraph 18(1)(a) of the Income Tax Act, is an obligation to pay a sum of money. An expense cannot be said to be incurred by a taxpayer who is under no obligation to pay money to anyone."

Appellant's Position

The appellant acknowledges that the Income Tax Act would override GAAP if there were a conflict between them. He referred the Court to the language of Mr. Justice Cartwright who wrote the majority decision for the Supreme Court of Canada in Dominion Taxicab Assn. v. M.N.R., [1954] S.C.R. 82; [1954] C.T.C. 34; 54 D.T.C. 1020 wherein he said at page 37 (D.T.C. 1021):

The expression "profit" is not defined in the Act. It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.

The appellant further referred the Court to Wilchar Construction Ltd. v. The Queen, [1979] C.T.C. 117; 79 D.T.C. 5086 (F.C.T.D.); [1981] C.T.C. 415; 81 D.T.C. 5318 (F.C.A.). In that case the taxpayer was a general contractor who was subject to holdbacks and had holdbacks. He brought into income all the money that was owing to him and he expensed all the construction holdbacks that he owed to his subcontractors. Mr. Justice Mahoney of the Trial Division said at page 119 (D.T.C. 5087):

The Minister did not object to the defendant's reporting of its holdbacks and uncertified progress claims as receivable and payable since, in the ordinary course of events over a period of years, that practice had the effect of anticipating, rather than deferring, tax liability.

The appellant points out that the taxpayer in Ellis included holdbacks as payable expenses but excluded from income the holdbacks receivable thus decreasing his income.

In Guay, the taxpayer carried construction contracts on its own account and contracted some work to subcontractors. When it did work on its own account it was subject to a ten per cent deduction of the contract price which was paid to it only upon completion and approval of the work. In the case of work that it subcontracted out the appellant withheld ten per cent of the subcontract price. That is, there was a ten per cent holdback on both sides receivables and payables. The taxpayer therein took into income 90 per cent of the receivables and deducted 100 per cent of the payables. The Federal Court of Appeal stated at page 507 (D.T.C. 5374):

Our conclusion is that appellant's profit cannot be computed by taking, on the one hand, 90 per cent of the value of all work done for the owner and, on the other hand, deducting the total sums paid by the appellant to the subcontractors for their work.

The Supreme Court of Canada did not call upon the Minister of National Revenue (the respondent) and simply said the appeal was not well founded. This Court was advised that Guay was inconsistent in the manner of reporting its income.

The appellant concedes in argument that Newfoundland is the appellant's highest hurdle to overcome. The corporate taxpayer therein was in the business of generating, transmitting and distributing electrical energy. It engaged general contractors to perform work. Under the terms of these contracts, the taxpayer was permitted to holdback ten per cent of the stipulated price upon completion of the work and final certification by its engineers. The Minister disallowed the taxpayer's deductions from income, the holdbacks as operating expenses and its deduction of capital cost allowance in respect to these holdbacks.

The Court therein decided that paragraph 18(1)(e) concerning contingent liabilities had no application in that case. It held that paragraph 18(1)(a) applied and that the taxpayer therein could not take into expense the holdbacks. It also held that the capital holdbacks could not be computed for purpose of capital cost allowance under paragraph 20(1)(a). The respondent submits that the difference between the Newfoundland case and the Wilchar case is that Newfoundland was dealing with capital outlays whereas Wi/char was dealing with revenue and expense.

In Associated Investors of Canada Ltd. v. M.N.R., [1967] 2 Ex. C.R. 96; [1967] C.T.C. 138; 67 D.T.C. 5096, the Exchequer Court was dealing with paragraph 12(1)(a) (now 18(1)(a)). The appellant therein advanced to a sales manager more money than the commissions earned by him. The appellant sought to deduct its loss to the extent of $25,000 annually of the sales managers' indebtedness by writing this amount off to sales promotion expense. The Court allowed the appeal. Jackett, P. in the footnote at page 142 (D.T.C. 5098) quoted the then paragraph 12(1)(a) (now 18(1)(a)) and said:

12. (1) In computing income, 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 property or a business of the taxpayer.

must be interpreted as prohibiting the deduction in the computation of profit from a business for a year of any outlay or expense not made or incurred in that year. In support of this submission, reliance was placed on Rossmor Auto Supply Ltd. v. M.N.R., [1962] C.T.C. 123, per Thorson, P. at p. 126, where he said, “As I view Section 12(1)(a), the outlay or expense that may be deducted in computing the taxpayer's income for the year. . .is limited to an outlay or expense that was made or incurred by the taxpayer in the year for which the taxpayer is assessed" (the italics are mine). If this view were a necessary part of the reasoning upon which the decision in that case was based, I should feel constrained to follow it although, in my view, it is not based on a principle that is applicable in all circumstances. In that case, however, the loan was clearly not made in the course of the appellant's business and the President so held. In my view, while certain types of expense must be deducted in the year when made or incurred, or not all. (e.g., repairs as Naval Colliery Co. Ltd. v. C.I.R., (1928) 12 T.C. 1017, or weeding as in Vallambrosa Rubber Co., Ltd. v. Farmer, (1910) 5 T.C. 529), there are many types of expenditure that are deductible in computing profit for the year" in respect of which they were paid or payable. (Compare Sections 11(1)(c) and 14 of the Act.) This is, for example, the effect of the ordinary method of computing gross trading profit (proceeds of sales in the year less the amount by which opening inventories plus cost of purchases in the year exceeds closing inventories) the effect of which (leaving aside the possibility of market being less than cost) is that the cost of the goods sold in the year is deducted from the proceeds of the sale of those goods even though the goods were acquired and paid for in an earlier year.

This case appears to accept the matching of income and expense as a proper consideration.

Walsh, J. of the Federal Court-Trial Division in The Queen v. Metropolitan Properties Co., [1985] 1 C.T.C. 169; 85 D.T.C. 5128, said at 173 (D.T.C. 5130) that the Crown's case was based on three propositions, namely:

1. Profits and gains for income tax purposes should be ascertained on ordinary principles of commercial trading. Since it is conceded that the financial statements presented a proper method of accounting for public purposes the taxpayer must bring itself under the umbrella of specificprovisions in the Income Tax Act in order to justify a different method of calculating the income for tax purposes.

2. The method that ought to be accepted for tax purposes is that which will best reflect the taxpayer's true income position.

3. Costs of inventory should include land development costs.

At page 174 (D.T.C. 5131) he quotes Collier, J. in M.N.R. v. Tower Investment Inc., [1972] C.T.C. 182; 72 D.T.C. 6161 wherein Collier, J. said:

[I]t was appropriate to allocate advertising expenses for sale of apartment buildings constructed over a period of years on the basis of the accounting principle of matching costs with revenues, since he did not find any prohibition in the statute against the matching system and the method adopted by the taxpayer more accurately set forth its true income position.

He also, at page 178 (D.T.C. 5135), referred to:

Associate Investors of Canada Ltd. v. M.N.R., [1967] 2 Ex. C.R. 96; [1967] C.T.C. 138; 67 D.T.C. 5096 wherein Jackett, P. said at page 179 (D.T.C. 5099):

Profit from a business, subject to any special directions in the statute, must be determined in accordance with ordinary commercial principles.

Walsh, J. in conclusion said at pages 180-81 (D.T.C. 5137):

1. General Accepted Accounting Principles (GAAP) should normally be applied for taxation purposes also, as representing a true picture of the corporation's profit or loss for a given year.

2. By exception they need not be applied for income tax purposes if there is some section or sections in the Income Tax Act which justify or require a departure from them or do not correspond with what are commonly accepted business and commercial practices.

5. The fact that there is nothing in the Income Tax Act to prevent such deductions from being treated as current expenses and deducted as such from income in the year in which they are made is not sufficient justification for departing from GAAP principles in dealing with them in this way. It is the converse argument which should be adopted to the effect that these principles should only be departed from if something in the Act specifically requires or authorizes this. Parliament has addressed itself to and dealt with the treatment to be given to other types of developers' expenses but has not specifically dealt with the type of expenses with which we are concerned here, and failure to do so results in the desirability of applying generally excepted commercial business practice as reflected in the GAAP principles.

Thorson, P. of the Exchequer Court of Canada in M.N.R. v. Publishers Guild of Canada Ltd., [1957] C.T.C. 1; 57 D.T.C. 1017 (a case which dealt with instalment sales of books and magazines sold door-to-door) dealt with the role of accountants as experts at page 17 (D.T.C. 1026):

But the Court must not abdicate to accountants the function of determining the income tax liability of a taxpayer. That must be decided by the Court in conformity with the governing income tax law. But while the Court must be mindful of this principle it must in its effort to apply the law objectively keep a watchful eye on arbitrary assumptions on the part of the tax authority such as, for example, that it is within its competence to permit or refuse any particular system of accounting and that its decision in the matter is conclusive. I cannot express too strongly the opinion of this Court that, in the absence of statutory provision to the contrary, the validity of any particular system of accounting does not depend on whether the Department of National Revenue permits or refuses its use. What the Court is concerned with is the ascertainment of the taxpayer's income tax liability. Thus the prime consideration, where there is a dispute about a system of accounting, is, in the first place, whether it is appropriate to the business to which it is applied and tells the truth about the taxpayer's income position and, if that condition is satisfied, whether there is any prohibition in the governing income tax law against its use. If the law does not prohibit the use of a particular system of accounting then the opinion of accountancy experts that it is an accepted system and is appropriate to the taxpayer's business and most nearly accurately reflects his income position should prevail with the Court if the reasons for the opinion commend themselves to it.

He goes on further at pages 27-28 (D.T.C. 1032) and sets out the then provision of the Act that was being dealt with, namely, paragraph 6(1)(d) which is now 18(1)(e) and he said:

What the taxpayer did was to exclude from its computation of income for the year the unrealized gross profit of its accounts receivable at the end of the year on the ground that such gross profit did not constitute income for the year that could enter into the computation of profits or gains to be assessed. It was not a case of deduction from income at all.

The appellant further submitted that it did not deduct the holdbacks since the holdbacks are ignored when percentage of completion basis, is used to prepare financial statements. Therefore since the appellant's income was based on percentage of completion, the expenses relating to that percentage of completion must be matched thereto. Both witnesses for the appellant said that in using the percentage of completion basis, you ignore holdbacks whether they be holdbacks from the appellant or by the appellant. In this case, the investor syndicates were not holding any holdbacks of money from the appellant but the appellant was holding back money from its subcontractors. The appellant argues alternatively that paragraph 18(1)(a) does not prevent the expense of the holdbacks. The appellant further referred the Court to the Federal Court of Appeal decision of Qualico Developments Ltd. v. The Queen, [1984] C.T.C. 122; 84 D.T.C. 6119 wherein the Chief Justice at page 125 (D.T.C. 6122) said:

[W]hile it may not always be easy to find harmony and consistency in the provisions of the Income Tax Act the Court must, as it seems to me, strive to give to particular provisions, even though broadly worded, an interpretation which will conform to and give consistency as far as possible to the apparent scheme of the Act.

He went on further to say at page 128 (D.T.C. 6124):

It appears to me, as well, that to interpret the wording of paragraph 20(1)(aa) as applying to landscaping costs incurred in respect of property included in inventory produces, without any reasons for doing so being apparent, distortion and inconsistency in the system and scheme established by the provisions of the Act which I have mentioned.

Finally, there is the consideration that to permit the deductions as claimed tends to distort the computation of the appellant's income for the years in ques- tion, a result which I do not think the language used should be presumed to intend and which should be avoided if the statute can be so interpreted.

Analysis

The two provisions of the Act that this case deals with are under the heading "deductions" and read:

18.(1) General limitations.—In computing the income of taxpayer from a business or property no deduction shall be made in respect of

(a) general limitation.—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) reserves, etc.—an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part;

There is no doubt that in the situation of this appellant (in that the costs to complete each project could be estimated with a reasonable degree of accuracy) the most appropriate method of accounting was on a percentage of completion basis.

The financial statements of the appellant as prepared using the percentage of completion method gave to the reader thereof the most accurate picture of the appellant's financial affairs and its true income position. If the appellant had reduced its expenses as the respondent has assessed, the income would have been distorted and misleading. The appellant would have shown a profit as of October 31, 1981 of $13,038,865 whereas schedule "A" shows there was only a total net profit of $2,808,799 in the 21 projects over the three-year period.

The Canadian Institute of Chartered Accountants Handbook under general accounts section 1000 at pages 106 and 107 deals with liabilities. It provides:

Liabilities

Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

Liabilities have three essential characteristics:

(a) they embody a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand;

(b) the duty or responsibility obligates the entity leaving it little or no discretion to avoid it; and

(c) the transaction or event obligating the entity has already occurred.

Liabilities do not have to be legally enforceable provided that they otherwise meet the definition of liabilities; they can be based on equitable or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is one that can be inferred from the facts in a particular situation as opposed to a contractually based obligation.

Both witnesses referred to the above passage and said that in their opinion, the liabilities in issue were not contingent liabilities. I am satisfied that they are not contingent liabilities.

The Court is satisfied that these sums of money are liabilities of the appellant. Whether they are contingent or not has been put to rest by the Federal Court of Appeal in the Newfoundland decision, they are not contingent liabilities.

The Ellis decision being a decision of the Income Tax Review Board is not binding on this Court. It should be given careful consideration and is of great persuasive authority. I accept the appellant's comments on this decision and since Ellis did not properly match its income against its expenses that it should be interpreted with regard to the factual situation therein. In this case, there is a matching of the expense to the income. This same reasoning distinguishes the Guay decision. The Guay decision stands for the principle that a taxpayer contractor cannot compute profit by taking into income only 90 per cent of the value of all work done and deduct 100 per cent of the expenses (i.e., expense the holdbacks).

Although the respondent referred and relied upon the Burnco decision, I am satisfied that the disallowed expenses herein fall within the Burnco dicta. 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.

The Court accepts the appellant's argument that Newfoundland is properly distinguished in that the Court therein was dealing with capital expenses. The corporate financial statements of Newfoundland more accurately reflected the true economic picture after the Federal Court of Appeal decision than what they originally showed.

The respondent's position herein would totally distort the true income of the appellant and is contrary to GAAP and the principle of matching expense to revenue.

For all of the above reasons and adopting the argument of the appellant as expressed herein, and in particular the peculiar facts of this case in that there were no holdbacks receivable (whereas the normal contractor is subject to holdbacks and retains holdbacks) the appeal is allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that he is not to add back into income the sums of $1,054,402 and $12,348,538 in the years 1980 and 1981 respectively and on consent he is to allow the appellant in 1981 to deduct the full amount of $781,287 as claimed for financing costs.

Normally costs follow the event. However in this case, the appellant filed with the Court approximately 31 cm of exhibits made up of two binders and 21 file folders each containing all the documentation for each project. This trial should have proceeded with only two exhibits, namely A-4 that has been reproduced herein as schedules "A" and "B" and one file folder with its contents out of "A-3" with an agreement between counsel that the documents therein were similar to all projects together with a further agreement as to the essence of all the other exhibits. The appellant shall have its usual costs less the costs of producing the many exhibits.

Appeal allowed.

Schedule “A”

Comparison of Construction Profits as Reported by IFSL and as Assessed by Revenue Canada

	IFSL Reported Constr. Profit	Revenue Canada Assessed
1980	$ 175,450	$ 1,229,852
1981	1,744,729	13,038,865
1982	855,620
	(11,462,918)
	$2,805,799	$ 2,805,799
For project-by-project analysis see schedule attached.