Bonner, T.C.C.J.:—This is an appeal from an assessment of income for the appellant's 1986 taxation year. The fiscal year ended on December 30. At issue is the timing of recognition of income earned by the appellant under three contracts, called the first and second CN contracts and the Indonesian contract. The appellant calculated its income for 1986 from the first CN contract on the completed contract basis, that is to say, it disregarded the receipt of instalments of the price payable to it under the contract until all of its obligations were fulfilled. The Minister rejected that basis. The first issue is whether the Minister was right in doing so. It is convenient to defer the description of the second issue.
The appellant carries on the business of manufacturing equipment for the production of gelatin capsules for pharmaceutical use. As well, it furnishes to its customers the technology required to enable them to become self- sufficient in the production of such capsules. In a typical case the appellant performs the engineering design work required to erect a factory building suitable to house production operations, it supplies production and quality control machinery and equipment and it trains indigenous personnel in the assembly, disassembly, maintenance and operation of the equipment.
On December 30, 1984 in the course of carrying on its business the appellant entered into a contract with China National Technical Import Corporation (the "first CN contract") for the supply of equipment and technology. CN was required to make payments to the appellant from time to time as the contract was being carried out. The appellant did not include in income any of the payments received by it under the contract until 1987 when the equipment supplied under the contract had been installed, staff training had been completed and the equipment was operating at production levels specified in the contract and was accepted by CN. It took the position that the amounts received by it in 1985 and 1986 were ” pre-payments" or " deposits” on a contract which it had yet to complete.
The first CN contract called for the sale to CN of two hard gelatin capsule machines having a specified production capacity together with spare parts and other materials. The contract also called for the supply of technical documentation and services of technical personnel. The personnel were required to furnish instruction during the installation and test runs of the machinery and to participate in test runs.
The first CN contract contained detailed provisions for an acceptance test to determine whether the required rates of production capacity could be achieved. It stipulated in a "devaluation term" that if the equipment eventually failed to attain those rates:
. . . then the Contract Equipment should be devalued. The extent of devaluation should be fixed by both parties through friendly negotiations, depending upon the difference between the stipulated indices and reached data. If no agreement can he reached through negotiations, the Buyer shall be entitled to cancel the Contract partly or completely and the Seller shall compensate the Buyer's direct losses in manpower and materials incurred thereof.
The terms of payment both for equipment and for technical assistance called for payments totalling 85 per cent of the price by the time the goods were delivered. Delivery, of course, preceded the acceptance test.
A second contract was entered into by the appellant and CN (the "second CN contract") for the supply of an additional hard gelatin capsule machine for a price of $480,000 (U.S.) payable upon delivery of the machine f.o.b. Montreal and presentation of the invoice and shipping documents. Shipment was to be made in April of 1986. This contract made no reference to an acceptance test.
The assessment of tax now under appeal rested on findings that before the end of the appellant's 1986 taxation year all equipment and technical documentation under both CN contracts had been supplied to CN, title had passed, and the appellant had received 85 per cent of the total contract price under the first contract and the entire price under the second. The evidence adduced at the hearing did not suggest that those findings were incorrect.
The amount added to 1986 income on assessment was the total of:
(a) a deposit of 10 per cent of the price under the first CN contract which deposit had been received in 1985;
(b) an amount equal to 75 per cent of the price under the first CN contract which amount was received by the appellant upon shipment in 1986 of the goods; and
(c) the entire price under the second CN contract which price was received upon shipment in 1986 of the goods.
Evidence was given by James Berner, a chartered accountant with the firm which prepared the appellants financial statements and tax returns. He stated that revenues received from CN were set aside as customer deposits until the time that the appellant had completed or fulfilled its obligations under the contract and that such method of accounting was known as the completed contract method. Thus the appellants financial records showed at the end of 1986 a liability equal to the amounts received under the contracts. The inventory account reflected the cost of the goods which had previously been shipped to and become the property of CN. Mr. Berner indicated on cross- examination that he characterized the amounts which the appellant had received from CN as deposits because he believed the appellant was entitled to keep the money only if it completed its contractual obligations. Mr. Berner felt that the appellant had not done so before the end of 1986.
It was the position of counsel for the appellant that the deposit received by the appellant in 1985 and the amounts received by it in 1986 under the CN contracts were ” prepayments". The appellant, she contended, did not fulfil all its obligations until 1987 and the amounts received before that time were therefore 1987 income and not 1986 income. Counsel relied on the evidence of Julien Hradecky, president of the appellant. Mr. Hradecky testified that he viewed the "devaluation" term of the first CN contract as one which, in the event that the production did not reach the stipulated rates, required the appellant to take back the equipment, refund the money with interest and compensate the buyer for loss of manpower and material in connection with the failed effort. He added that he assumed that in such circumstances CN would also claim reimbursement of the capital expenditures made for the single purpose building erected to house the factory. Counsel submitted that the first CN contract was one which required the appellant to furnish production capacity and that the appellant had not fulfilled that obligation until the equipment acceptance tests demonstrated that the required quantity and quality of capsules could be produced by the personnel, plant and machinery trained and supplied by the appellant. This submission amounts to a gloss on the contract. To the extent that it is an attempt to analyze the rights and obligations created by the terms of the contract I can only say that it is wholly unsupported by them.
Counsel for the appellant submitted that, if CN had failed to make payments at the times stipulated in the contracts, no action to recover such payments could succeed until the equipment passed the acceptance tests. The short answer to that argument is that it flies in the face of the terms of both contracts. It is irreconcilable with the oft repeated language of the first CN contract calling for payment" not later than 30 days after. . .” named events. It is equally irreconcilable with the unqualified language of the second CN contract calling for payment upon delivery and presentation of the shipping documents. When read in context, the "devaluation" provision of the first CN contract relates to damages for non-performance. It is unrelated to the timing of the payments to be made prior to the performance of the equipment acceptance tests.
It is unnecessary to consider whether the completed contract method of accounting can in any circumstances be properly used in computing profit for income tax purposes. It is quite unacceptable for present purposes. The arguments supporting its use are founded upon a misapprehension of the rights to payment which the appellant had under the CN contracts. The payment under the second CN contract and the instalment payments which were due to and received by the appellant before the end of 1986 under the first CN contract were not held by it subject to any restriction as to disposition, use or enjoyment once the goods were shipped. The payments therefore possessed the “quality of income” under the well known test laid down in Kenneth B.S. Robertson Ltd. v. M.N.R., [1944] C.T.C. 75, 2 D.T.C. 655, at page 91 (D.T.C. 660):
Did such amounts have, at the time of their receipt, or acquire, during the year of their receipt, the quality of income, to use the phrase of Mr. Justice Brandeis in Brown v. Helvering (supra). In my judgment, the language used by him, to which I received by a taxpayer has the quality of income. Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment?
The treatment of the payments received in 1986 as deposits constitutes a disposition of profits already earned by means of the creation of a reserve That treatment is prohibited by paragraph 18(1)(e) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").
I turn to the second issue raised by the appellant. That issue is whether payments received by the appellant in the 1986 taxation year under a contract called the Indonesian contract were taxable in 1986, as originally reported by the appellant, or in 1985, as suggested in an alternative argument raised by the appellant. The appellant contended that accounting principles must be applied consistently. Thus, it was said, if the Minister was right in disallowing the application of the completed contract method to receipts under the CN contracts, he could not apply that method in the case of the Indonesian contract. That argument rested on the premise that the payments made to the appellant under the Indonesian contract in the 1986 taxation year had become receivable by the appellant in the 1985 year upon shipment of the machinery to the appellant's Indonesian customer. Thus, those payments could be taxed only in 1985 and not in 1986, the year in which the appellant reported them in its tax return. This argument fails. Its factual foundation was not established.
The evidence of the terms of the Indonesian contract was vague and contradictory. It is not clear when it was made or what it provided. Mr. Hradecky stated that the Indonesian contract was made in 1984 and that it called for the expansion of a production facility which had been furnished by the appellant pursuant to a contract dated June 2, 1983 between the appellant as vendor and P.T. Kapsulindo Nusantara as purchaser. The June 2, 1983 contract was entered in evidence but the 1984 order which formed the Indonesian contract and which gave rise to the payments now in question was not. That order was apparently given in writing because Mr. Hradecky testified that it was "signed" in 1984. The appellant's notice of appeal suggests that the Indonesian contract was made by telex orders dated November 2, 1985. The June 2,1983 contract was produced because Mr. Hradecky stated that the terms were similar to those of the contract which gave rise to the payments in question. The June 2, 1983 contract called for payment of the purchase price upon delivery f.o.b. Kitchener and presentation of shipping documents.
The evidence shows that the goods covered by the Indonesian contract were shipped late in 1985. They crossed the border into the United States en route to Indonesia on December 29, 1985 a date before the end of the appel* lant's 1985 taxation year.
Mr. Hradecky, the only witness who had any knowledge of the relevant events, testified that the payment now in issue was received by the appellant on February 18, 1986 following the signing of the acceptance certificate by the purchaser of the goods. His testimony included the following:
Q. In terms of the payment arrangements, it seems that the China contract was different in that there you were getting most of your money up front, whereas in the Indonesian contract you were getting most of your money basically after acceptance, and by this I mean the acceptance certificate being signed by both parties.
A. Right.
Q. Saying they are happy with what they have got.
A. And I mentioned that that was to my detriment in the Indonesian contract because I waited over a year.
That passage suggests to me that the Indonesian contract provided that the appellant's right to call for payment did not arise until the goods were accepted by the purchaser. That conclusion is consistent with the conduct of the parties because the goods were accepted on February 18, 1986 and payment followed immediately. In the circumstances, there is no basis for a conclusion that the payment became receivable in 1985. The appellant has failed to show that the assessment is wrong.
The appeal will therefore be dismissed.
Appeal dismissed.
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