Samuel F. Investments Limited v. Minister of National Revenue, [1988] 1 CTC 2181, 88 DTC 1106

Christie, A.C.J.T.C.:—By notice of reassessment dated September 8, 1982 the respondent disallowed a deduction claimed by the appellant in the computation of its income for its 1978 taxation year of $147,000 alleged to be a management bonus payable to Mr. Samuel Frustaglio for services rendered by him to the appellant during 1978. The position of the respondent is that: "The expense of $147,000 claimed was conditional and a credit to a contingent account, not permitted by Part I of the Income Tax Act, and excluded by paragraph 18(1)(e) of the Income Tax Act" [1] and further "the expense was not incurred for the purpose of gaining or producing income from a business, or otherwise, and is prohibited by paragraph 18(1 ) (a) [2] of the Income Tax Act.” The appellant included the $147,000 in computing its income for its 1980 taxation year. It is said that this was done under paragraph 78(3)(a) of the Act. [3]

On December 27, 1978 the directors of the appellant signed a document that reads:

The undersigned being all the Directors of Samuel F. Investments Limited (the "Corporation"), pursuant to subsection 23(1) of The Business Corporations Act [4] by their signatures hereby consent to the following resolution:

Whereas it is in the interest of the Corporation that the following management bonus be declared payable to the following named officer for exemplary services performed for the Corporation for the past fiscal year;

BE IT RESOLVED THAT:

(a) A management bonus of $147,000.00 be authorized, approved and paid to Samuel Frustaglio for exemplary services performed for the Corporation for the fiscal year ended December 31st, 1978;

(b) The aforesaid bonus is hereby authorized to be paid in either a lump sum or in such periodic instalments and at such time or times as the Corporation has funds available for such purpose, as the President of the Corporation may determine.

On 30 January 1980 the same directors signed a document that reads:

The undersigned being all the Directors of Samuel F. Investments Limited (the "Corporation"), pursuant to subsection 23(1) of The Business Corporations Act by their signatures hereby consent to the following resolution:

Whereas the Corporation declared a management bonus in the amount of $147,000.00 payable to Samuel Frustaglio on December 27th, 1978, which was to be payable at such time or times as the Corporation had funds available for this purpose as determined by the President of the Corporation;

And Whereas the funds have not been available for the payment of the aforesaid management bonus and it is in the interest of the Corporation that the aforesaid management bonus be considered cancelled;

BE IT RESOLVED THAT:

(a) The management bonus declared payable to Samuel Frustaglio in the amount of $147,000.00 on December 27th, 1978 be deemed cancelled;

(b) The Secretary of the Corporation take whatever action necessary to reflect the aforesaid in the books and records of the Corporation.

Frustaglio is the president, a director and the sole shareholder of the appellant. Its principal business relates to the construction of dwelling houses. The witnesses who testified at the hearing were Frustaglio and Mr. Mark Schlein, C.A., the appellant's accountant. The amount of $147,000 was fixed following consultations between Frustaglio and Schlein. A factor, among others, that was taken into consideration by them in settling on this amount was that the appellant was entitled to deduct from tax otherwise payable a prescribed amount as a small business deduction. At the time relevant to this appeal the maximum amount on which the deduction could be calculated was limited to $150,000 in any one year. The bonus of $147,000 brought the appellant within that limit.

Included in the financial statements of the appellant for the year ended December 31, 1978 is a balance sheet that includes the $147,000 under "Liabilities" and it is described as "management fees payable”. When the director's resolution of December 27, 1978 was passed it was intended that the bonus would be paid in the course of 1979. In this regard two anticipated sources of funds were identified in particular. One was the amount of $101,833 owing to the appellant that was secured by a mortgage. This debt was to become payable to the appellant by Rosam Developments that was also due in 1979. In fact the $101,833 was paid as anticipated and $104,990 of the $115,499 was paid by Rosam Developments in 1979.

The appellant's financial statements for the year ended December 31, 1979 and the evidence of Schlein show that there were significant shifts in the appellant’s financial condition from 1978 to 1979. This involved increases in both assets and liabilities. For example, loans receivable from Pine Valley Homes increased from $12,043 to $543,811 or by $531,768. Pine Valley Homes was involved with the appellant in the development of real estate for sale and the loans were used to finance construction. Real estate under development at cost increased from $58,859 to $499,871. Liabilities increased by $741,770 in 1979 over 1978. Bank indebtedness rose from $30,000 in 1978 to $257,322 in 1979. Nevertheless the evidence is that assistance from the bank in 1979 was not as great as expected. Frustaglio described 1979 as a very tough year. Sales were exceptionally slow. For example, where it was expected to sell 20 homes, 5 were sold.

The reason assigned to the cancellation of the bonus by the director's resolution of January 30, 1980 was the appellant's lack of liquidity. The decision to cancel was arrived at by Frustaglio with the benefit of Schlein's advice. The previously mentioned $101,833 and $104,990 were used for other business purposes of the appellant.

For a number of years prior to and subsequent to 1978, the year under appeal, director's resolutions similar to that of December 27, 1978 were acted upon by the appellant. The appellant had been incorporated about 1965 and, apart from the earlier years, the remuneration received by Frustaglio for services rendered to the appellant has been in the form of management bonuses. The amount of these bonuses varied considerably over the years and if in arriving at the amounts a particular method was employed, it was not explained to the Court.

Other evidence was forthcoming designed to refute certain allegations of fact contained in the respondent's reply to the notice of appeal. It is unnecessary to repeat that evidence for the purposes of these reasons. It is sufficient to say that the evidence, oral and documentary, satisfies me that the director's resolution authorizing payment of the management bonus to Frustaglio was made in good faith and with the intention that it be honoured in accordance with its terms and that the subsequent director's resolution cancelling the bonus was, having regard to all of the circumstances, the exercise of reasonable business judgment.

The determination of this appeal turns on whether the liability created on December 27, 1978 is what is sometimes referred to as a real liability in contradistinction to a contingent liability. If it is the latter the appellant cannot succeed. I repeat the operative words of the director's resolution:

BE IT RESOLVED THAT:

(a) A management bonus of $147,000.00 be authorized, approved and paid to Samuel Frustaglio for exemplary services performed for the Corporation for the fiscal year ended December 31st, 1978;

(b) The aforesaid bonus is hereby authorized to be paid in either a lump sum or in such periodic instalments and at such time or times as the Corporation has funds available for such purpose, as the President of the Corporation may determine.

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.

A leading authority on contingent liabilities is the judgment of the House of Lords in Winter and others v. C.I.R., [1963] A.C. 235. Subsection 50(1) of the Finance Act 1940 provided that in determining the value of an estate that includes corporate shares for purposes of estate duty an allowance was to be deducted from the principal value of the assets of a company for contingent liabilities, the amount being such estimation as appears to the Commissioners to be reasonable.

Sir Arthur Sutherland died on March 29, 1953. At that time he owned 98,700 shares of B.J. Sutherland & Co. In order to determine the value of these shares the relevant legislation required that net value of the assets of the company at the date of death be ascertained and in so doing an allowance was to be included for contingent liabilities as mentioned.

The contingent liability alleged by the appellants pertained to five ships owned by the company. Their cost was £847,907, but they had increased in value to an amount well in excess of £1 million at the time of death. By that time the company had received capital allowances under the Income Tax Act 1952 and if the ships were sold at or near their true value, tax would be payable on the recaptured depreciation or as it is described in the reasons for judgment, a “balancing charge" would be imposed that would result in additional tax payable by the company.

The fundamental issue in the appeal was whether on March 29, 1953, the date of the demise of Sir Arthur, liability to tax in relation to recaptured capital cost allowance was a contingent liability. It was held that it was. Some months after March 29, 1953 the ships were in fact sold and the recaptured depreciation attracted considerable tax.

Lord Reid asks this question at page 247:

If it is not yet certain whether or when tax will be payable, or how much will be payable, why should it not be a contingent liability under the same section?

The answer that follows from his reasons for judgment is that it should be a contingent liability. His Lordship went on at pages 248-9:

Perhaps the clearest statement of the Law of Scotland is in Erskine's Institute, 3rd ed., vol. 2, Book III, Title 1, section 6, p. 586, when he says:

Obligations are either pure, or to a certain day, or conditional . . . Obligations in diem . . . are those in which the performance is referred to a determinate day. In this kind . . . a debt becomes properly due from the very date of the obligation, because it is certain that the day will exist; but its effect or execution is suspended till the day be elapsed. A conditional obligation, or an obligation granted under a condition, the existence of which is uncertain, has no obligatory force till the condition be purified; because it is in that event only that the party declares his intention to be bound, and consequently no proper debt arises against him till it actually exists; so that the condition of an uncertain event suspends not only the execution of the obligation but the obligation itself . . . Such obligation is therefore said in the Roman law to create only the hope of a debt. Yet the granter is so far obliged, that he hath no right to revoke or withdraw that hope from the creditor which he had once given him.

So far as I am aware that statement has never been questioned during the two centuries since it was written, and later authorities make it clear that conditional obligation and contingent liability have no different significance. I would, therefore, find it impossible to hold that in Scots law a contingent liability is merely a species of existing liability. 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. If English law is different — as to which I express no opinion — the difference is probably more in terminology than in substance.

After observing that subsection 50(1) of the Finance Act 1940 divides liabilities in three classes, Lord Reid goes on at page 249:

The third (or last) class is "contingent liabilities,” which must mean sums, payment of which depends on a contingency, that is, sums which will only become payable if certain things happen, and which otherwise will never become payable.

The last class appears to me to cover exactly the conditional obligation dealt with by Erskine in the passage I have quoted.

At page 251 he added:

The essence of a contingent liability must surely be that it may never become an existing legal liability because the event on which it depends may never happen.

Lord Guest said at pages 262-3:

Contingent liabilities must, therefore, be something different from future liabilities which are binding on the company, but are not payable until a future date. I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence upon an event which may or may not happen.

There follows an extract from Erskine's Institute of The Law of Scotland that has already been quoted and His Lordship goes on:

In Gloag on Contract, 2nd ed., pp. 271-272, future obligations are contrasted with contingent obligations. 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." I see no reason why these principles should not be applicable to a United Kingdom statute and no authority was quoted to show that English law differed in any way.

In Cummings v. The Queen, [1981] C.T.C. 285; 81 D.T.C. 5207, Mr. Justice Heald speaking for the Federal Court of Appeal, cited with approval at pages 293 (D.T.C. 5213-4) what has already been quoted herein from Lord Reid and Lord Guest in Winter regarding their appreciation of the meaning of contingent liabilities. In Harlequin Enterprises Limited v. The Queen, [1974] C.T.C. 838; 74 D.T.C. 6634 (F.C.T.D.) Mr. Justice Mahoney, after quoting the same passage from Lord Reid's judgment, added at page 849 (D.T.C. 6642): “I see no reason not to accept the same meaning in Canadian law.”

Winter was cited at length in Mandel v. The Queen, [1978] C.T.C. 780; 78 D.T.C. 6518 (F.C.A.). [5] The appellant, eleven other individuals and a corporation formed a partnership that purchased a film in 1971 that was near completion. The price was $577,892, being the cost of production to the date of purchase. This was payable by way of $150,000 in cash and the balance of $427,892 was to be paid out of earnings. The position of the Minister of National Revenue in reassessing was that the capital cost of the film in 1971 was $150,000. The question was whether the appellant was entitled to claim by way of capital cost allowance in 1971 his share of both the $150,000 and the balance of $427,892 or was the latter excluded because the liability to pay it was a contingent liability. It was held that the obligation regarding the balance was contingent. Mr. Justice Ryan, who delivered the judgment of the Court said at page 784 (D.T.C. 6521):

There is no doubt, as the trial judge indicated, that, in contracting to buy the film on the agreed terms the purchasers incurred a liability both in respect of the cash payment and the balance. It was not, however, as to the balance, a liability to pay merely on the expiration of a period of time or on the happening of an event that was certain, or even likely, to occur. It was a liability (from which the purchasers admittedly could not unilaterally withdraw) to become subject to an obligation to pay the balance if, but only if, an event occurred which was by no means certain to occur. The obligation was thus contingent on the happening of the uncertain event.

In the earlier case of 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.) [6] the company in computing its income for 1969 and 1970 deducted "management bonuses" of $58,590 and $17,000 respectively in favour of the two principal shareholders of the company. Because of unanticipated and changed financial circumstances of the company none of the bonuses were paid. In assessing the Minister of National Revenue disallowed the deductions and the Court agreed with this course of action. In the reasons for judgment it is said that the bonuses were payable “provided that funds would be available” and this was taken to mean that "payment was contingent on necessary funds being available.” In the relatively recent case of Transport Direct System Limitée et al. v. M.N.R., [1984] C.T.C. 2845; 84 D.T.C. 1773 (T.C.C.) the appellants, who were in the motor transport business, in computing their income for the 1977 taxation year sought to deduct substantial sums representing estimated ultimate liability in relation to goods lost, stolen or damaged in transit prior to the end of the taxation year. The deductions related to two sets of circumstances: first, where a notice of a claim had been received prior to the end of the taxation year but the amount of the liability had not yet been settled; and, second, where notice of a claim had not been received prior to the end of a taxation year. The estimated amounts were based on the volume of sales revenue during the taxation year and on historical data and experience regarding the relationship between claims and sales revenue. In addition, estimated reimbursements from third parties and insurance companies were taken into consideration. The Minister of National Revenue did not dispute the reasonableness of estimated liabilities. The appeals were dismissed because (page 2851, D.T.C. 1778): "The obligations which the appellants say they have to their customers in relation to the estimated amounts claimed are . . . contingent liabilities.”

With respect to the appeal at hand it appears to me that the director's resolution declaring a management bonus of $147,000 payable to Frustaglio embodies uncertainties regarding the time or times of payment and whether payment would ever be made either in whole or in part with the result that the directors created a liability that is contingent in nature.

The appeal is dismissed.

Appeal dismissed.