534325 Ontario Corporation v. Minister of National Revenue, [1989] 2 CTC 2456, 89 DTC 679

Teskey, T.C.J.:— The appellant appeals its 1984 reassessment wherein the Minister disallowed the sum of $88,716 to be written off as a wage expense.

Facts

The appellant, 534325 Ontario Corporation, was a family held company, its shareholders being Bruce Albert Kingston, his brother, mother, father and possibly other members of the family.

The appellant was not an active company and had no employees. It held all of the issued shares of Harrowsmith Cheese Factory Limited ("Harrowsmith"). Bruce Albert Kingston was the only person that gave evidence at trial. He was at all relevant times, a vice-president of Harrowsmith and comanaged it with his father.

Because of poor profits in the 1970s, it was decided to create a profit sharing plan (“Plan”). This was discussed with several major individuals like foremen in 1979 and the plan started in 1980. Thirty per cent of Harrowsmith's profit before taxes was to be available to the full-time hourly paid employees being approximately 55 in number. A union did not represent the employees and there was no collective agreement.

Profit was shared with the employees in 1980, 1982 and 1983. Harrowsmith lost money in 1981. There was never a formal written agreement concerning the profit sharing scheme. The employees never asked to see the books or made any inquiries as to how it was being calculated and simply just took management's word as to how much profit (if any) was available to the employees by way of bonuses and how it was to be divided. The total bonus amount was calculated by Thorne, Riddell, Harrowsmith's auditors. The payroll employees divided the sum up according to hours worked.

In June of 1984, the appellant received an unsolicited offer to sell all of its shares of Harrowsmith to McCain Foods Limited ("McCain"). A long and detailed sale agreement was entered into on June 19, 1984. This sale was finalized on June 30, 1984. The agreement of sale which is Exhibit A-2 under the heading “Representations and Warranties of the Vendor” contains the following paragraphs:

The Vendor hereby represents and warrants to and in favour of the Purchaser as follows:

3.6 The audited financial statements of the Corporation for the year ended December 31, 1983, and reported upon by Thorne Riddell, a copy of which has been previously delivered to the Purchaser (the “Financial Statements") have been prepared in accordance with generally accepted accounting principles applied on a consistent basis with prior periods and fairly present the financial position of the Corporation as at that date and the results of its operations and the changes in its financial position during the period covered thereby.

3.7 The Financial Statements disclose all liabilities of the Corporation due and to become due except those incurred in the ordinary course of business or discharged since December 31, 1983.

3.8 The Unaudited Financial Statements of the Corporation for the period ended April 30, 1984 a copy of which has been previously delivered to the Purchaser (the "Unaudited Financial Statements") have been prepared in accordance with generally accepted accounting principals [sic] applied on a consistent basis with prior periods and fairly present the financial position of the Corporation as at that date and the results of its operations and the changes in its financial position during the period covered thereby.

3.9 Since December 31, 1983, the Unaudited Financial Statements disclose all liabilities of the Corporation due and to become due except those incurred in the ordinary course of business or discharged since April 30, 1984.

3.19 Schedule "B.1" hereto discloses all material contracts or leases of realty and chattels, contingent liabilities, insurance policies, personnel benefits and employee agreements and agreements with customers of and suppliers to the Corporation to which the Corporation is a party. For the purposes of this agreement, “material contract” means any written employment agreement and any oral or written agreement or arrangement which requires or may require the expenditure by the Corporation of an amount in excess of $5,000 or having a fixed term remaining of more than one year.

3.29 The Corporation is not a party to any collective agreements with any labour union.

3.36 All representatives and warranties contained in this agreement shall, regardless of any investigations made by or on behalf of the Purchaser, continue in full force and effect for a period of one year from the Closing including Sections 3.17 and 3.18 except those representations and warranties relating to the Vendor's ownership of the Purchased Shares and any tax liability of the Corporation all of which shall survive the closing indefinitely.

The unaudited financial statement dated April 30, 1984 prepared internally by the Harrowsmith made no mention of wage bonuses. The previous year's audited statements did show "bonuses".

Paragraph 4 of the agreement under the heading “Representation and Warranties of the Directors” reads:

THE DIRECTORS HEREBY JOINTLY AND SEVERALLY REPRESENT AND WARRANT TO THE PURCHASERS AS FOLLOWS:

4.1 The Corporation is indebted to the Directors in the aggregate amount of $288,094.00 which indebtedness is evidenced by the Director's Notes.

The agreement also sets out in paragraph 6 “Indemnification” and contains the following clauses:

6.1 The Vendor hereby agrees to indemnify and hold harmless the Purchaser from and against any and all loss, liability, damage or expense, including reasonable legal fees (hereinafter collectively referred to as the “Indemnified Loss") which the Purchaser suffers or incurs:

(a) by reason of any misrepresentation or breach of warranty, covenant, condition or undertaking made by the Vendor;

(b) by reason of any information provided in writing to the Purchaser by the

Vendor pursuant to the provisions hereof being untrue or misleading.

Harrowsmith had five directors, namely: Harold Kingston, Bruce Kingston, Hazel M. Kingston, Ralph Kingston and Raymond Kingston.

Harrowsmith had not been for sale at the time and the principals of the appellant believed the offer was far in excess of what they considered the value of the company to be. After closing, the appellant without consulting its solicitors or accountants, paid $51,516 to the hourly employees of Harrowsmith and $18,600 to Bruce Albert Kingston, a director of Harrowsmith and $18,600 to Raymond Kingston also a director of Harrowsmith.

The $51,516 was Bruce Albert Kingston's estimate of what 30 per cent of the profit would be by the end of the 1984 year. He claims that the employees were entitled to the bonus. It is argued that since the plan was not specifically disclosed to McCain, that the appellant would ultimately be responsible for the bonuses by reason of the indemnifications given in the sale agreement. The $51,516 was divided up in the usual manner and sent by the appellant with the appellant's funds to those employees of Harrowsmith entitled to a portion of the estimated profit together with 1984 T4's from the appellant. The appellant knew that McCain would not honour or have anything to do with the plan. The appellant's directors wanted to wind up the appellant and did not want any lawsuits outstanding.

In regards to the $18,600 paid to Bruce Albert Kingston and Raymond Kingston, it was claimed during the course of a year, neither drew out of the company their total annual wage and that it was the practice to top up their draws each December to their total annual wage. These two lump sums simply topped up their six-month drawing so that they were paid their full six months' wage. This was alleged to have taken place over a number of years.

Appellant's Position

The appellant argues that there was a legal obligation on Harrowsmith to pay the 30 per cent profit sharing bonus to its employees. It is further stated that a six-month notice would be required to terminate the profit sharing scheme. Rather than have the Harrowsmith employees wait till year end 1984, make a demand on Harrowsmith and have McCain, the holder of all the Harrowsmith shares, demand indemnification from the appellant pursuant to the terms of the sale agreement (because the plan was not specifically disclosed as a corporate obligation), the appellant simply made an estimate of the profit for the year, took 30 per cent and paid it directly to the Harrowsmith employees.

The appellant argues on the basis of Imperial Oil v. M.N.R., [1947] Ex. C.R. 527; [1947] C.T.C. 353; 3 D.T.C. 1090, that the sums paid were a legitimate expense and should be treated as such or alternatively the appellant's gain should be reduced by this amount.

Considering the finding of fact that this Court makes, (which is set out below) there is no need to deal with the two $18,600 payments to the Kingstons at this time.

Respondent's Position

Concerning the $51,516, the respondent claims firstly the Court should find that there was not a legal obligation on Harrowsmith to pay the bonus under all the circumstances herein. Secondly, if there was one, it was disclosed in the agreement as the 1983 financial statement showed the bonuses being paid in 1983 and 1982, which statement was an integral part of the agreement. The 1983 statement on the liability page under current liabilities showed bonuses payable 1983 — $60,000 and for 1982, the sum of $90,000 notwithstanding that the interim financial statement for April 30, 1984 had no mention of the bonuses. It is also argued that the bonus was in the normal course of business and even if Harrowsmith had to honour this obligation, McCain had no claim over against the appellant.

It is also submitted that the payment was not incurred for the purposes of gaining or producing income from a business or property and therefore could not be expensed.

Analysis

In regard to the two payments of $18,600 to the Kingstons, the Court is not satisfied with the evidence. Nothing was produced to substantiate the obligations. The 1983 T4's were not produced, as well as the December 1983 cheques to substantiate the top up. The gross annual wages were never given in evidence as neither the drawings nor wages up to June 30, 1984. This, of course, was all readily available to the appellant and its witness.

The appellant has failed to prove that these sums were even owing. If they were owing they could have paid the two sums on June 29, the day before closing. The Court finds that these two $18,600 payments were voluntary payments made by the appellant to the recipients.

The Court finds as a fact that there was a plan enforceable by the employees against Harrowsmith. Under the circumstances, six months' notice would have been reasonable notice to the employees to terminate the plan. The Court is satisfied that pursuant to the terms of the agreement of sale the appellant was liable for the 1984 bonus. The appellant cannot be criticized for its actions in this regard. If this had been discovered on or before closing, undoubtedly the sale price would have been reduced by this sum of $51,516.

For the above reasons, the appeal is allowed in part and the matter referred back to the Minister for reconsideration and reassessment on the basis that the sale price of the Harrowsmith shares to McCain should be reduced by the sum of $51,516.

The appellant shall have its costs.

Appeal allowed in part.