Dunn Holdings LTD v. Minister of National Revenue, [1985] 1 CTC 2348, 85 DTC 348

Sarchuk, TCJ:—This is an appeal from an assessment by the Minister of National Revenue of the appellant Dunn Holdings Ltd to income tax for its 1980 taxation year whereby the Minister reduced the reserve claimed by the appellant under subparagraph 20(l)(n)(ii) of the Income Tax Act.

The evidence before the Court is set forth in a statement of agreed facts in the following terms:

1. On January 4, 1979, Dunn Holdings Ltd sold its one-third undivided interest in the Court I apartment block located in Kent, Washington, USA.

2. The sale of the apartment involved a “wrap around” mortgage wherein Dunn Holdings Ltd remained liable for its share of the first mortgage payable to a Third Party (Citizen Federal Savings & Loan Association) hereinafter referred to as (“Citizens Savings”) and received from the purchaser an ‘‘all inclusive note and deed of trust”.

3. Covered by the all inclusive note and deed of trust was the principal amount payable under the first mortgage as well as an additional unpaid portion of the purchase price.

4. Dunn Holdings Ltd’s interest in the various debts and receivables at the time of the sale were in Canadian dollars*: [1]

(a) To Citizens Savings under first mortgage $873,550.

(b) Receivable from purchaser $ 1,336,945f. [2]

(c) Cash received $364,079.

(d) Sale price $1,701,024.

5. In 1980, the purchaser desired to transfer title to the property and required that the Citizens Savings mortgage be paid and that two other properties be substituted as security for the outstanding balance covered by the all inclusive note and deed of trust.

6. The purchaser’s requirements were met with the result that at the end of 1980, Dunn Holdings Ltd was no longer liable to Citizens Savings and the receivable from the purchaser was reduced from $1,336,945 to $483,575.

7. The receivable of $483,575 was not due to Dunn Holdings Ltd in the 1980 taxation year.

8. After conversion to Canadian dollars, a reserve was calculated and claimed on the equity basis as follows:

Amount not due

X Profit

Equity

or, in figures:

483,575

X 724,975 423,675

1,701,024 - 873,550

9. Revenue Canada on reviewing the transaction, reassessed on the basis that the reserve should be calculated on a gross basis for 1980:

Amount not due

X Profit

Sale price

or, in figures:

483,575	. .
	X 724,975	206,100
1,701,024

10. In 1979, the Appellant claimed a reserve on a gross profit basis, the same basis upon which the Minister calculated and assessed the Appellant’s reserve in 1980, which reserve was calculated in 1979 as follows:

Gross profit

X balance due

Gross selling price

The 1979 reserve calculated by the taxpayer was as follows:

724,975

X 1,336,945 569,804

1,701,024

11. In assessing the Appellant for his 1980 taxation year, the Respondent calculated a reserve in the amount of $206,100 by way of Notice of Reassessment dated September 17, 1982. The Respondent assumed that the aforesaid amount was reasonable.

12. Attached hereto and marked as Exhibit “1” to this Agreed Statement of Facts is a copy of the original Purchase Agreement between Dunn Holdings Ltd et al and Dura Construction, Inc dated the 29th day of April, 1977, wherein Dunn Holdings Ltd et al purchased the subject property.

13. Attached hereto and marked as Exhibit “2” to this Agreed Statement of Facts is a copy of a Certificate dated the 29th day of April 1977, whereby Dunn Holdings Ltd et al became obligors on the Citizens Savings first mortgage referred to herein.

14. Attached hereto and marked as Exhibit “3” to this Agreed Statement of Facts is the All Inclusive Note and Deed of Trust dated January 4, 1979, referred to in paragraph 2 herein.

15. Attached hereto and marked as Exhibit “4” to this Agreed Statement of Facts is a copy of a Note Modification Agreement dated the 30th day of July, 1980, whereby the purchaser paid the Citizens Savings mortgage and the receivable from the purchaser was reduced from $1,336,945 to $483,575 as described in paragraph 6 herein.

Further evidence was adduced by the appellant through Mr Alpaugh, a chartered accountant who supervised the preparation of the appellant’s tax return for the 1980 taxation year. In calculating the reserve pursuant to the provisions of paragraph 20(1 )(n) he utilized the equity method. The rationale for that decision, in his words was:

The equity method was adopted because it results in a fairer matching of revenue to the years in which cash was received by the vendors. In this instance the vendors received a cash down payment and received no further cash from the sale until the due date, which was originally 1982. Therefore there was no cash received in 1980.

and

The equity method results in a calculation of a portion of the seller’s profit being taken into income each year that cash is received under the sale. In this case, in the second year after the sale no cash was received and the equity method results in a fairer matching of profit to that situation.

When asked what the effective result was of using the formula advocated by the respondent, Alpaugh stated:

The result of using what Revenue Canada suggested, which is known as the selling price method, results in a reserve of approximately $210,000 being calculated for 1980, which would cause some $300, I believe $360,000 approximately, of income to be taxed in 1980. The accumulative result of applying that reserve in 1980 results in approximately $520,000 of the original profit having been taxed to the end of 1980, whereas the vendor had only received $364,000 of cash, which was the down payment. For that reason it appeared to be an unreasonable matching of the profit with the years in which cash was received.

Although Alpaugh’s firm, Thorne Riddell, was responsible for the preparation of the appellant’s 1979 returns he was not able to advise the Court why the equity method had not been used by Thorne Riddell in that year, however, in his opinion it was not at all reasonable or logical to carry the method utilized in 1979 into the 1980 taxation year. As a result he changed the method of calculating the reserve to ensure that an unfair “matching situation” was not created in 1980.

The narrow issue before the Court is whether or not the appellant has established that the respondent was wrong in utilizing the “selling price” method in calculating the reserve allowable to the appellant under subparagraph 20(1) (n)(ii). This section reads:

S.20 (1) Notwithstanding paragraphs 18(l)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

. .. (n) where an amount has been included in computing the taxpayer’s income from the business for the year or for a previous year in respect of property sold in the course of the business and that amount or a part thereof is not due,

(ii) . . . where the property sold is land, until a day that is after the end of the taxation year,

a reasonable amount as a reserve in respect of such part of the amount so included in computing the income as may reasonably be regarded as a portion of the profit from the sale.

The relevant facts are as follows. In 1977 when Dunn Holdings Ltd acquired its one-third undivided interest in the Court I Apartment block in Washington, USA it assumed, as part of the purchase price, the unpaid principal balance of a debt secured by a deed of trust to Citizens Federal Savings and Loan Association (Citizens). On January 4, 1979, the appellant sold its one-third interest taking back what was described as a “wrap around” mortgage wherein the appellant remained liable for its share of the first mortgage payable Citizens and received from the new purchaser an “All Inclusive Note and Deed of Trust” (Exhibit 3) (The Note). Covered by the All Inclusive Note was the principal amount payable under the first mortgage to Citizens as well as an additional unpaid portion of the purchase price in the sum of $483,575. In 1980, the purchaser desired to transfer title to the property and required that the Citizens mortgage be discharged. The appellant agreed, subject to the substitution of two other properties as security for the outstanding balance covered by the Note. The purchaser paid out the Citizens mortgage, and as a result, the receivable due to the appellant was reduced from $1,336,945 (the amount covered by the All Inclusive Note) to $483,575 (the balance after payment to Citizens Savings of its mortgage in the amount of $873,550).

There is no dispute as to the purpose of paragraph 20(l)(n) of the Income Tax Act. As expressed in Revenue Canada’s Interpretation Bulletins it permits taxpayers to postpone, for tax purposes, the reporting of business income when receipt of the proceeds arising from the disposition of property are deferred. To qualify for such a postponement, a taxpayer’s property must have been sold or disposed of in circumstances such that the proceeds arising on the disposal of the property are not due until a year that is later than the taxation year during which the disposition occurred. More specifically this section provides that in computing income taxpayers may deduct a reasonable reserve for certain amounts which although included in computing income, are not “due” until a day that is after the taxation year. Such a reserve is allowable in respect of only the profit element in the amount due after the end of the taxation year and the only requirement in regard to the allowable amount of a reserve is that the reserve must be a reasonable amount.

Counsel urged the Court to find that the position adopted by the appellant in the taxation year at issue with respect to the method of calculating its reserve was reasonable, because the appellant did not have full equity in the property. In such circumstances:

Revenue Canada acknowledges that where the present vendor never had full equity in the property because he either assumed an existing mortgage or gave a mortgage for part of the purchase price at the time he acquired it, and that mortgage is still in existence when the property is sold, it may be said that what he sells to the present purchaser is merely his existing equity in that property. Accordingly, it is acknowledged that a reserve may be claimed with respect to an amount due to a taxpayer after the end of the taxation year in relation to his equity utilizing the (equity) formula.

Counsel submitted that certain general principles govern the application of paragraph 20(l)(n) of the Act. These principles are that tax should not be levied on more than the actual profit realized by a taxpayer in a taxation year; the amount of a reserve per se does not determine its reasonableness; the portion of the sum receivable that is not profit to the taxpayer should not be considered as a component part of the formula used in the determination of the reserve where mortgages are assumed; and that use of the equity method in cases where there is a mortgage assumed by the purchaser produces a reasonable result.

In support counsel cited Makis Construction Limited v MNR, [1972] CTC 2082 at 2087; 72 DTC 1101 at 1105; No 703 v MNR, 24 Tax ABC 129 at 132; 60 DTC 237 at 239 and The Ennisclare Corporation v The Queen, [1982] CTC 428 at 429; 83 DTC 5018 at 5019.

The Minister’s position appears to be that the appellant is disentitled from utilizing the equity method because there was not, in a strict legal sense, an assumption of the Citizens mortgage by the new purchaser. Counsel stated:

. . . In this case, it is the Minister’s contention that there has been no assumption of that mortgage, and therefore the taxpayer should be using the first of the accepted methods, not the second.

and

The vendor in this case being the Appellant, took on that mortgage when he purchased the property but that All Inclusive Deed of Trust which purported to pass on the mortgage to the new purchaser was at best an assumption in principle. It was not an absolute assumption.

In reading the documents, where I am sure Your Honour will do, you will note that there is provision whereby the new purchaser makes payments to the taxpayer as vendor who in turn continues to make payments onto Citizens Trust, who is the original holder of the mortgage.

So in that sense there has been no assumption of the mortgage and that is a very important element, I would submit, because when looking at the accepted principles, in terms of the interpretation bulletin and the reasonableness test, and step two of the overall principles in paragraph 20(1 )(n), we have to look to the amount that the taxpayer is going to receive.

Counsel agreed that where a mortgage was assumed the effect was the passing on of a debt from vendor to the purchaser and since the amount of the mortgage never becomes a receivable in the hands of the vendor therefore it should not figure into the calculation of a reserve. However, in this case respondent’s counsel submitted that there was at best a potential assumption or contingent assumption and that absent a “legal” assumption it becomes necessary to look to the gross profit method wherein the calculation of a reserve is based on the sale price and not the equity. In so suggesting counsel submitted, and I quote:

And in doing so I think it is important to show that Dunn Holdings could have, because I have been unable to locate anything in the documents which would have prohibited it, Dunn Holdings could potentially have received cash from an outside source, paid off Citizens trust and by virtue of the documents that were in place could have simply taken the money and pocketed instead of passing it along to Citizens.

I do not agree with the position taken by the respondent. To disallow the reserve claimed by the appellant would be to negate Parliament’s obvious intention which was to permit a taxpayer to match tax liability and realization of profit (The Ennisclare Corporation v The Queen, [1982] CTC 428 at 429; 83 DTC 5018 at 5019).

There is no provision in the Act defining or limiting the methods by which a reserve can be calculated subject only to the proviso that the end result be reasonable. Equally there is no provision in the Act which prohibits or even ad- dresses the question of whether a taxpayer can change his method of calculating a reserve from one year to the next. While there are provisions in the Act which specifically prohibit a change in method, for example subparagraph 28( 1 )(d)(iii) and subsection 248(1), Parliament chose not to enact restrictions in the section relevant to this appeal. Its intention with respect to the manner of calculating a reserve was commented upon by the Federal Court of Appeal in The Queen v Ennisclare Corporation, [1984] CTC 286 at 289; 84 DTC 6262 at 6265:

Parliament, of course, is free in its choice of language to produce a desired result but, as was submitted by the Respondent, failure to frame subparagraph 20(l)(n)(ii) in terms of a mathematical formula as was done in framing other provisions of the Act leaves open to serious doubt that it ever intended the determination of the amount of reserve under that section in all cases and under all circumstances to be made by applying a rigid formula. [Emphasis added.]

I am of the view that the method utilized by the appellant in 1979 has no bearing on the Court’s determination of this appeal. It may well be that the gross profit method which the appellant used in 1979 was not an appropriate method given the facts but that is not the issue before this Court. In the circumstances it would be improper to insist on a method which would have the effect of including in the appellant’s “profit” the amount the appellant owed under the first mortgage to Citizens.

This appeal cannot be disposed of without reference to an alternative position raised by the respondent. In his reply the issue of estoppel was raised on the basis that, having used the gross profit or conventional method of calculating its reserve in 1979, the appellant was thereby precluded from changing its method to the equity method in 1980. In argument it became apparent that the respondent was not pressing this ground with much vigour. Notwithstanding this apparent abandonment certain observations are warranted. On the facts of this case it should have been apparent that estoppel did not lie. At best a lame argument might have been advanced that estoppel by conduct might exist. However, the fact that it was pleaded (and in a very imprecise fashion) obliged appellant’s counsel to speculate as to the exact nature of the respondent’s position and required him to submit an extensive argument on the subject including a dissertation on the subject of res judicata. In my view the respondent’s pleadings put the appellant to a great deal of unnecessary work and expense. The Court appreciates that failure to plead an estoppel may prevent the respondent from raising it at the trial, but the facts of this case did not justify the inclusion in the pleadings of any unnecessary and insupportable allegation.

For the above reasons the appeal will be allowed with costs to the appellant on a party and party basis. The asessment of the appellant for the 1980 taxation year is referred back to the Minister for reassessment on the basis that a reasonable reserve under subparagraph 20(l)(n)(ii) is $423,675.54.

Appeal allowed.