257324 Ontario Limited v. Minister of National Revenue, [1988] 2 CTC 2300, 88 DTC 1670

Sarchuk, T.C.J.: —257324 Ontario Limited, appeals from a reassessment of income tax with respect to its 1981 taxation year.

The appellant, in computing its income for the 1981 taxation year, sought to deduct accrued management salaries (bonuses) of $80,000. By reassessment the respondent disallowed the bonuses to the extent of $68,000 on the basis that they were not a genuine liability of the appellant. In so reassessing the respondent relied upon the following finds or assumptions of fact:

(a) the appellant is a Canadian-controlled private corporation and carried on a restaurant business known as Coleman's Restaurant and Delicatessen;

(b) in computing the 1981 taxation year the appellant claimed accrued management salaries of $80,000.00, the particulars of which are as follows:

Jerry Silverberg	$25,000.00
Norman Kaman	25,000.00
Carol Silverberg	15,000.00
Brenda Kaman	15,000.00
	$80,000.00

(c) in the 1982 taxation year, the appellant paid $12,000.00 of the bonuses, the particulars of which are as follows:

Jerry Silverberg	$ 6,000.00
Norman Kaman	6,000.00
	$12,000.00

The balance of the bonuses (i.e. $68,000.00) was reversed by a Directors' Resolution dated January 3, 1983;

(d) the appellant paid bonuses to Brenda Kaman and Carol Silverberg in the 1979 and 1980 taxation years, and reversed these accruals in the 1981 and 1982 taxation years respectively;

(e) the appellant did not, at any time material in this appeal, intend to pay the bonuses of $68,000.00;

(f) bonuses of $68,000.00 were not outlays or expenses incurred and if incurred they were not incurred for the purpose of gaining or producing income from a business;

(g) the bonuses to the extent of $68,000.00 represented reserves or contingent accounts.

Evidence was adduced on behalf of the appellant from Mr. Allan S. Teachman (Teachman) and from Norman Kaman (Kaman) and Jerry Silverberg (Silverberg). Briefly summarized the following facts were elicited from these witnesses. The appellant and its predecessors have carried on a restaurant business in the City of North York, at 3085 Bathurst Street, since the 1960's. It was incorporated on June 8, 1972 at which time all of the issued shares were owned by persons other than Silverberg and Kaman. Silverberg worked as an employee of the appellant since 1961 when he was 16 years of age. He met his future wife, Carol, at the restaurant, where she also worked. They were married in 1975. Since 1971 Carol Silverberg has worked in the restaurant on either a part-time or full-time basis except for a period from 1977 to 1979. She is substantially involved in its operation.

In 1972 Silverberg was approached by another employee to help with the purchase of the shares of the appellant. As a result he acquired 20 per cent of the issued shares and an option for an additional 20 per cent. In 1975 he exercised this option. In 1977 his then partner made overtures to buy him out and failing agreement, litigation erupted between them. These problems persisted until 1979 at which time Kaman, who is Carol Silverberg's brother, and Silverberg had several discussions about the situation and ultimately concluded an arrangement to buy the appellant. Both went into substantial debt to acquire the shares, Kaman borrowing some $50,000 from the bank and both of them borrowing a further $40,000 from Kaman's father. As of 1979 they have owned all the issued shares of the appellant equally.

Upon acquiring the appellant both Silverberg and Kaman worked in the restaurant which operates seven days a week. They attempted to work on a six-day schedule but it was not uncommon for them to spend in excess of 60 hours a week at the restaurant.

After Brenda Kaman's husband became involved as a shareholder she worked for the appellant on a part-time basis. Since 1980 Carol Silverberg and Brenda Kaman have been principally involved in the catering side of the business and they are responsible for its development and operation.

Teachman, a lifelong friend of both Silverberg and Kaman, was first retained as their chartered accountant in the summer of 1981. He recalled that when he took over the account he asked the principals of the firm to prepare summaries in order that he could make some determination as to the company's financial position and expected profitability. They met in the fall of 1981 but Teachman had little or no opportunity to assess the validity of the material provided to him. The summaries were reviewed; he considered their best estimates as to what the profitability of the appellant might be, and together they made a determination as to a reasonable appropriation of profits of the company to the shareholders and employees of the company. Teachman said that the decision to pay bonuses was premised on a number of factors including the fact that both Kaman and Silverberg were deeply in debt as a result of their acquisition of the shares of the appellant and the necessity of advancing operating funds to it. Other factors considered were the services rendered by the Silverbergs and the Kamans; the fact that the services were real and identifiable; and the fact that they had not taken or drawn reasonable amounts prior to the accrual of the bonuses by way of ordinary salaries or withdrawals.

Teachman then met with Silverberg and Kaman late in December 1981 to review the appellant's position and to confirm any plans, including the accrual of the bonuses previously decided upon. According to him, at that point of time instructions would have been issued to the appellant's solicitor, following which the directors' resolutions were prepared and executed. The particular directors' resolution with respect to the computation of the bonuses in the 1981 taxation year is dated December 29, 1981 (Exhibit R-9).

Of the $80,000 accrued as bonuses in the taxation year in issue only $12,000 was paid. Teachman testified that in the spring of 1982 he, Silverberg and Kaman met, and in the course of a discussion of the appellant's affairs, realized that the profits projected by the principals were not going to be there. Plans were made to attempt to increase profitability of various undertakings of the appellant and to expand into new areas to increase profitability. The final decision with respect to the 1981 appropriation was made in the fall of 1982 when it was concluded that the appellant was not in a position to pay that debt. Teachman stated that the appellant also had bank constraints which would have precluded the issuance of the cheques in payment of the accrued bonuses. The affairs of the appellant were financed, in part, by a line of credit provided by the Royal Bank of Canada. Under the terms of the line of credit the bank had the right to require the appellant to obtain authorization for payment of salaries or dividends or any other appropriation of this magnitude if the appellant exceeded the limit of its line of credit (excepting weekly or monthly draws). In 1981 and 1982, the appellant regularly operated at or above the line of credit. According to Teachman the bank’s position would have been that the appellant's ability to repay the debt to the bank might be impacted upon and there was a distinct possibility that the bank would not have authorized the payment. A decision was then made to pay only $12,000 of the $80,000 and the balance of the bonuses were reversed by way of a directors' resolution dated January 3, 1983.

In conjunction with those decisions he, Kaman and Silverberg concluded that although there had been a history on an ongoing basis of taking modest salaries, that would not be done in the 1982 fiscal year. On the other hand, a decision was made to declare dividends totalling $100,000 to Kaman and Silverberg. Payment of these dividends in December of 1982 was, according to Teachman, based on the principals’ need for personal funds in order to meet their debt obligations and interest payments. The amount declared was designed to cover such draws as Kaman and Silverberg took in 1982 and was largely based on the fact that “it would not trigger immediate taxation to the principals" and would have no immediate impact on corporate working capital.

In their testimonies both Kaman and Silverberg stated that the considerations they took into account as directors in fixing the amount of the bonuses to be paid at $80,000 were that both of them required funds to meet payments on the indebtedness incurred by them in acquiring the shares, the low level of their salaries at that time; the amount of time they and their wives were putting into the business, all of which was coupled with a belief that the corporate financial position was sound. Silverberg added that there was a fairly steady pattern of growth and he believed the possibility existed for increased revenues in 1982. The resolution dated December 29, 1981, relating to the payment of the bonus was signed in a matter of days of the taking of the decision.

With respect to the ultimate payment of of only $12,000, the reversal of the balance of the accrued bonus on January 3, 1983 was accounted for by Silverberg and Kaman on the following basis. The appellant had forecast larger growth than actually occurred. In the early part of 1982 there was a recession and sales dropped with the result that less money was taken in, when, at the same time, interest rates began to escalate, the appellant's cash flow was negatively affected. Moneys borrowed by both Kaman and Silverberg had to be repaid and their only source was cash generated by the appellant. As a result of these factors the decision to pay the $12,000 was taken in mid-year or in the fall of 1982 and the balance of the bonuses was reversed.

The appellant's annual revenues, profit and accrued bonuses, and bonuses paid, and bonuses for the years 1979 to 1983 are as follows:

On this evidence the appellant submits that:

1. The bonuses do not represent a reserve or contingent account within the meaning paragraph 18(1)(e) of the Income Tax Act (Act); and

2. The bonuses deducted by the appellant represent an expense which was a genuine liability, intended to be paid and which was incurred for the purpose of gaining and producing income from its business.

I have concluded that the appellant is not entitled to a deduction in respect of the accrued management salaries by virtue of paragraph 18(1)(e) of the Act as they were amounts transferred or credited to a reserve or contingent account. Paragraph 18(1)(e) reads:

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

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part;

Teachman's analysis of the situation in December 1981, and his conclusion that the amount of the bonuses was reasonable in comparison with the revenue generated by the appellant were ascertained at a time when its profitability for the year and for the future year as determinable within a reasonable margin of error, must be viewed with care. As he explained, Silverberg and Kaman "guesstimated their profits". He conceded that he did not have the appellant's financial history because none existed, and as a result he relied solely on their material. Subsequently Teachman discovered that the appellant’s records were not entirely up-to-date and a great deal of reliance had been made on bank deposits and cheque "outflows" and similar material. As Teachman stated “It, their estimates, would have been remarkably unscientific.” In cross-examination Teachman conceded that given the fact that the bonuses were based upon estimates of profitability, the ability of the appellant to pay the accrued bonuses was only marginally taken into account by he and the corporation at the relevant time.

The evidence of Silverberg and Kaman with respect to the manner in which these decisions were taken and the factors that were relied upon is not entirely consistent. Although both stated that a principal factor in the decision to pay the bonuses was their need for funds to pay personal debts, Kaman stated that the reason the bonuses were not paid immediately was that at the time of their declaration "the company did not have the cash available to be able to make those payments". He agreed with counsel for the respondent that the payment of the bonus that was declared in 1981 was conditional on the company having sufficient cash at a later time.

In this context it is also necessary to consider the pattern which existed in the years prior to the taxation years in issue with respect to the declaration of bonuses. In 1979 by way of directors' resolution, the appellant appropriated the sum of $32,500 as accrued bonuses to be paid to Silverberg and Kaman. Subsequently in January 1981 $10,000 of the bonus so accrued was reversed. The minutes of the directors' meeting dated January 7, 1981, state In part:

The Chairman advised the meeting that corporation is not in a position to pay the bonuses appropriated. .. . .

Kaman testified that the appellant simply did not have the cash available to make the payment at that time. Notwithstanding that fact, it was Kaman's testimony that a week earlier, on December 30, 1980, the same board of directors declared bonuses of $10,000 to be paid to each of Carol Silverberg and Brenda Kaman.

When asked about the inconsistency, Kaman stated:

When the bonus was declared in December it wasn't declared on the basis that there was cash available to pay it . . . at the time of declaration. . . . The intention was that the monies to be paid to Carol and Brenda at the time for the work they had done in that year and that when funds were available the following year to make those payments, that they would be made.

The bonuses of $20,000 which had been declared on December 30, 1980 were subsequently reversed by way of resolution dated January 8, 1982 and were added back into income. The same pattern is seen in the taxation year in issue. The bonuses in issue were declared on December 29, 1981, ten days before the reversal of the 1980 bonuses and at a point of time when the appellant lacked the funds to make payment.

There is also some question as to the evidence of both Silverberg and Kaman with respect to the increased interest rates in 1982 which allegedly were a factor in the failure of the appellant to meet its projections of profit. In cross-examining Kaman, counsel for the respondent utilized an excerpt from the Bank of Canada Review which sets out the interest rates in force during the 1981, 1982 and 1983 years. Reference to this document indicates that the prime interest rate charged by the chartered banks rose in the first half of 1981, peaked in August of that year, and then started to fall. By the end of that year the interest rates levelled off, rose a marginal amount in the beginning of 1982 and then continued to fall throughout the latter half of 1982. The trend disclosed by this document was inconsistent with the assertions of both principals of the taxpayer.

Counsel for the appellant argues that there is, on the evidence before me, no event upon which the payment of the bonuses can be said to be or was in fact contingent. He argued that it was an expense incurred within the meaning of paragraph 18(1)(a) of the Act and that the principals believed the funds would be available since they wanted the funds to reduce their personal indebtedness. Furthermore, a portion of the bonuses was paid on or before the end of the fiscal year following the accrual, and accordingly the certainty of time within which the bonuses were to be paid exists. Part of the amounts so accrued were paid and corporate resolutions were passed shortly after the succeeding year ends, reversing or cancelling the balance, a logical business decision under the circumstances. Counsel argued that there was certainty as to the intention to pay and the intention that the amounts be paid was unencumbered by any other operating consideration such as the availability of funds. I do not agree. Although the resolution dated December 29, 1981 contains the following language:

Upon motion regularly made, seconded and unanimously carried, it was duly resolved that the sum of $80,000.00 be appropriated out of the profits of the Corporation for the fiscal year ending December 31, 1981 for bonuses to be paid to the following persons at a future date:

To:	Jerry Silverberg		$25,000.00
To:	Norman Kaman		25,000.00
To:	Carol Silverberg		15,000.00
To:	Brenda Kaman	-	15,000.00

This resolution must be considered in light of all of the facts before me including the evidence of Kaman and Silverberg (The Queen v. Ken and Ray's Collins Bay Supermarket Limited, [1975] C.T.C. 504; 75 D.T.C. 5346 (F.C.T.D.)). I am satisfied that the payments referred to therein were dependent on whether the appellant might have funds available to pay the amounts and that such amounts would be paid only at such time or times as the appellant had funds available. The evidence of the two principals leaves no doubt on that score.

In this context useful reference can be made to a decision of the Tax Court of Canada in Samuel F Investments Limited v. M.N.R., [1988] 1 C.T.C. 2181; 88 D.T.C. 1106, where the following comments are to be found at page 2184 (D.T.C. 1108):

My understanding is that a liability to make a payment is contingent if the terms of its creation include uncertainty in respect of any of these three things: (1) whether the payment will be made; (2) the amount payable; or (3) the time by which payment shall be made. If there is certainty regarding the three matters just enumerated and time of payment is deferred it will still be a real liability, but in the nature of a future obligation.

In Samuel F. Investments Limited, supra, reference was also made to a decision of the House of Lords in Winter and others v. C.I.R., [1963] A.C. 235; [1963] 3 All E.R. 855. In considering the meaning of the phrase "contingent liability” Lord Reid said that:

. . . It is a liability which, by reason of something done by the person bound, will necessarily arise or come into being if one or more of certain events occur or do not occur.

In the same judgment, Lord Guest stated that:

.. I. An obligation is future when though not presently exigible it is dependent on no other condition than the arrival of the day of payment. An obligation is contingent “if its enforceability is dependent on an event which may or may not happen.”

As was noted in Samuel F. Investments, supra, the ratio decidenda in Winter has been quoted with approval in a number of Canadian cases including Cummings v. The Queen, [1981] C.T.C. 285; 81 D.T.C. 5207 and Harlequin Enterprises Limited v. The Queen, [1974] C.T.C. 838; 74 D.T.C. 6634 (F.C.T.D.) and Mandel v. The Queen, [1978] C.T.C. 780; 78 D.T.C. 6518 (F.C.A.).

On the evidence before me I have concluded that the liability to pay the bonuses was contingent in nature. Assessing the resolution in issue in light of the evidence of the directors of the appellant it is clear that there is uncertainty as to the time of payment. Furthermore, there was substantial uncertainty as to whether the payment would be made. I see virtually nothing to distinguish the case before me from Samuel F. Investments Limited, supra, and from The Queen v. Ken and Ray's Collins Bay Supermarket Limited, supra.

Accordingly, the appeal is dismissed.

Appeal dismissed.