DR John L McCans v. Minister of National Revenue, [1984] CTC 2286, 84 DTC 1270

Cardin, TCJ:—The appeal of Dr John L McCans is from assessments of tax dated April 3, 1980, with respect to the 1977 and 1978 taxation years. The appellant claimed, among other items, automobile expenses which were disallowed by the respondent. As a result, the appellant’s income was increased by $2,868.27 and $5,589.20 and assessed as such in the 1977 and 1978 taxation years respectively.

Neither the dissallowance nor the quantum of the expenses is in dispute. The issue arises from the resulting increases in the appellant’s 1977 and 1978 income which raised the appellant’s total income above a predetermined limit. Owing to a contractual obligation, the surplus income was to be paid back to the other contracting party, Queen’s University.

The facts and the issue can best be understood from the agreed statement of facts filed by counsel which reads as follows:

AGREED STATEMENT OF FACTS AND ISSUES

The parties hereto, without prejudice to their right to lead accounting evidence in relation to the matter, agree upon the following agreed statement of facts:

1. The Appellant is a cardiac physician engaged in the private practice of medicine in the Kingston area in conjunction with his appointment as a member of the geographical full-time medical staff (GFT) at Queen’s University.

2. The terms of this appointment are covered in a document entitled “Geographically Full-Time Staff — Faculty of Medicine, Terms of Appointment” (hereinafter referred to as the “GFT Document”), and a true copy of the Document is attached hereto and marked as Exhibit “A” to this Agreed Statement of Facts.

3. In 1977 and 1978, the Appellant’s ceiling, as defined in Article 1.3 of the GFT Document, was set at $44,500 and $50,500 respectively.

4. In his 1977 and 1978 income tax returns and statements of income from his medical practice, true copies of which are attached as Exhibits “B” and “C” hereto, the Appellant claimed certain expenses which were reduced by net amounts of $2,868.27 and $5,589,20 respectively in Notices of Reassessment dated 3 April 1980. A true copy of the Notice of Reassessment dated 3 April 1980 and attached form T7W-C with respect to the 1977 taxation year is attached as Exhibit “D” hereto. A true copy of the T7W-C form attached to the Notice of Reassessment dated 3 April 1980 with respect to the 1978 taxation year is attached hereto as Exhibit “E”.

5. The Appellant does not dispute the net expenses disallowed by the Respondent.

6. Both parties agree that, at some point in time, the disallowance of expenses by the Respondent will result in the Appellant being obliged to made additional “ceiling payments” of $2,868.27 and $5,589.20 pursuant to Article 6.1 of the GFT Document.

7. The parties further agree that, at some point in time, the Appellant is entitled to deduct the additional “ceiling payments”.

8. The appellant acknowledges a debt to Queen’s University for these additional “ceiling payments” but has not yet made payment, with the concurrence of the University pending the outcome of this appeal.

9. The sole issue in dispute is whether the Appellant is entitled to deduct the “ceiling payments” in the 1977 and 1978 tax years respectively or whether the deduction must be made in a subsequent taxation year.

Attached to the agreed statement of facts is a document entitled “Queen’s University’s Geographically Full-Time Staff — Faculty of Medicine — Terms of Appointment”. This document referred to as the “contract” was published in May 1975 and revised in April 1977. The contract was applicable to some 120 doctors on Queen’s University medical staff, including the appellant.

The pertinent portion of the terms and conditions of the contract are repeated here for convenience. Part 1.3 of the contract reads in part as follows:

“net professional earnings” (NPE) means total earned income, including salary, less the expenses of practice which are incurred directly to earn professional income and which are allowed by the Department of Naational Revenue for the medical profession in general.

Part 6 of the contract refers to “PROCEDURES RELATING TO THE REPORTING PROFESSIONAL EARNINGS”. Parts 6.1 and 6.2 of the said contract read as follows:

6.1 Occasions for Rendering Statements and Payments

A member shall forward, or arrnge to have forwarded, to the Dean a duplicate audited Statement of Professional Earnings, at the following Times:

a. within four months of the end of each fiscal period

b. within four months of the termination of his appointment

c. on reassessment or adjustment of his net professional earnings by the Tax Department

Any ceiling payment is due at the same time that the statement is due.

6.2 Determination of Net Professional Earnings

A member shall apply federal income tax rules and practices, in determing professional earnings in any fiscal period except where otherwise individually agreed.

Counsel agreed that in the appellant’s financial statements for 1977 and 1978 references made to amounts of rental payments were in fact the ceiling payments referred to in the contract and for purposes of this appeal are deemed to be synonomous.

In order to identify the principal issue more clearly, counsel for the appellant conceded the amounts of expenses disallowed by the respondent in his 1980 assessments. On reading together paragraphs 6 and 7 of the agreed statement of facts, I conclude that the respondent is admitting not only that the additional “ceiling payments” in the amounts of $2,868.27 and $5,589.20 arising from the disallowance by the respondent of certain expenses must be paid by the appellant to Queen’s University, but that these amounts are deductible at some point in time. The issue is in what taxation years are these ceiling payments deductible.

Counsel for the appellant suggested that accounting was a pertinent and an important factor to be considered in the determination of the issue. He called, as an expert witness, Mr W J Blakely, a chartered accountant and a partner in the accounting firm of Thorne Riddell, to give his opinion as to the taxation years in which the ceiling payments deductions could be included in computing the appellant’s net income according to generally accepted accounting principles (GAAP).

Mr Blakely’s written opinion was filed as Exhibit A-1, which reads as follows:

September 16, 1982

Mr D H Bonham, FCA

Cunningham, Swan, Carty,

Little & Bonham

Barristers & Solicitors

Empire Life Building

Suite 500

259 King St East

Kingston, Ontario

K7L 4W6

Dear Mr Bonham

Re: Dr John McCans v MNR

In your letter of April 27, 1982, you have asked for my professional opinion on certain questions of an accounting nature with respect to the above matter. You have advised me that I may assume the following facts relative to this case:

1. Dr McCans during the years 1977 and 1978 held a geographically full time appointment (GFT) as a Professor of Medicine at Queen’s University. In this connection he received a salary and was entitled to earn professional income from his medical practice. By the terms of his appointment, any excess of total income (salary and professional earnings) above an established ceiling became payable to Queen’s University. In other words, his income for these years was limited to a stipulated dollar amount.

2. More specifically, each member of the GFT Staff is required to forward to the University through the Dean an audited statement of professional earnings within four months of the end of each fiscal period. In addition, a further statement of professional earnings is to be forwarded on reassessment or adjustment of net professional earnings by the tax department. Any ceiling payment (being the amount by which a member’s net professional earnings including salary exceed his ceiling) is due at the same time as the statement is due.

3. In both 1977 and 1978, Dr McCans’ net professional earnings exceeded his ceiling. Accordingly he filed his returns, recorded the then apparent ceiling payment as a liability to the University for tax purposes and paid that ceiling payment to the University.

4. Subsequently the Tax Department reassessed Dr McCans’ 1977 and 1978 income by disallowing certain car expenses. For purposes of this opinion, you may assume that these disallowed amounts represent appropriate adjustments for income tax purposes.

Based on these foregoing assumed facts and after considering the matter in some detail, it is my opinion that:

Applying generally accepted accounting principles to this situation, no additional net income would arise in either 1977 or 1978 in Dr McCans’ hands as a result of the reassessment referred to in point 4 above, because the reduction in automobile expense necessitates a redetermination of the ceiling payments for each of these years, the amount of which increases by the same amount as the decrease in automobile expense, thereby causing no change to the amount of net income retained by Dr McCans.

Should you require further explanations or clarification of my opinion in these matters, please advise.

Yours very truly

THORNE RIDDELL

Per (signature)

W J BLAKELY:ap

Mr Blakely stated that, in accordance with GAAP, the appellant’s net income was determined by the application of the accrual basis of accounting which is defined in a publication of the Canadian Institute of Chartered Accountants (Exhibit A-2), which reads as follows:

accrual basis of accounting

The method of recording transactions by which revenues and expenses are reflected in the accounts in the period in which they are considered to have been earned and incurred, respectively, whether or not such transactions have been finally settled by the receipt or payment of cash or its equivalent.

In summary, the appellant’s position 1s:

1. No increase in the appellant’s taxable income for 1977 and 1978 should have been assessed as a result of the disallowance of expenses incurred by the appellant in those years. By virtue of the contract, the appellant became automatically liable to Queen’s University for additional ceiling payments in amounts corresponding to that portion of the expenses disallowed by the respondent in 1977 and 1978. Applying the “accrual basis of accounting’’, the increase in the appellant’s income in 1977 and 1978 was effectively offset by the appellant’s corresponding liabilities to Queen’s University.

2. The appellant’s liabilities to Queen’s University were, according to the terms of the contract, incurred and existed in 1977 and 1978 and were in no way contingent.

In his argument, counsel for the appellant contended that, in his assessment, the respondent did not consider nor give effect to the contractual arrangements which provide for what counsel described as “an absolutely hard ceiling’’ for each fiscal period by which all income earned by the appellant above the fixed ceiling had to be paid to Queen’s University.

With respect to the sole issue which is in what taxation years the ceiling payments can properly be deducted, the appellant argued that the 1980 assessment did not create the appellant’s liabilities to Queen’s University. For that proposition, counsel for the appellant relied on the decision of the Federal Court (Appeal Division) in The Queen v Simard-Beaudry Inc et al, [1974] CTC 715; 74 DTC 6552, where at 5515 Mr Justice Noël stated:

Here the re-assessment issued on August 14, 1969, for income earned in previous years seem to me to be at most a confirmation or acknowledgement of the amounts owing for these earlier years. Indeed, in my opinion, the assessment does not create the debt, but is at most a confirmation of its existence.

In Léo Beauchesne Inc v The Queen, [1977] CTC 398; 77 DTC 5308, Mr Justice Marceau at 5310, on the same point said:

Assessment is a specifically regulated administrative act, . . .

. . . but there is no basis, in my opinion, for saying that it is more than the determination of a tax debt and a claim for it in the form required by law. To prove the debt, the Minister must assess, but the debt exists and it is certainly provable on its own before assessment, in the same way as any other present or future debt.

The appellant submitted that if the 1980 assessments did not create the appellant’s liabilities, then they must have been incurred and were in existence in 1977 and 1978 and no provision of the Income Tax Act, SC 1970-71-72, c 63, as amended, prohibits their deduction in those years. Counsel for the appellant pointed out that, under the accrual basis of accounting, admitted by Mr McColm, the respondent’s expert witness, as being fundamental in determining the appellant’s net income, the increases in the appellant’s income and the corresponding liabilities to Queen’s University must be considered as having been respectively earned and incurred in 1977 and 1978 if the appellant’s true taxable income for those years is to be properly determined.

Counsel for the appellant further suggested that the respondent, in not giving effect to the income ceiling clause of the contract, assessed tax on an amount to which the appellant had no legal right and which he could not retain at any point in time. Counsel for the appellant concluded that the amounts in issue could not, by any standard, be considered as taxable income to the appellant in any year.

For his part, counsel for the respondent called as expert witness, Mr William McColm, a chartered accountant who taught tax law and business law at McMaster University and is currently employed in the non-corporate ruling section of the Department of National Revenue.

Mr McColm’s written opinion was filed as Exhibit R-2, which reads as follows:

Mr Gaston Jorré

Room 409, Justice Building

Wellington & Kent Streets

Ottawa, Ontario

KIA 0H8

October 6, 1982

Dear Mr Jorré:

Re: John L McCans v MNR

This is to reply to your letter of October 4 in which you asked for my opinion on certain matters of an accounting nature. As I understand your inquiry, the facts are as follows:

1. In 1977 and 1978 Dr McCans was a full-time faculty member in the Faculty of Medicine, Queen’s University and was also engaged in the private practice of medicine in the Kingston area. As a faculty member he received a salary and was permit- ted, by the terms of his appointment, to continue his medical practice. However, the terms of his appointment stipulated that any excess of total salary and practice earnings over and above an agreed ceiling amount would be payable to Queen’s University. The excess amount (referred to as a ceiling payment) is payable to the University within four months after the calendar year end. An audited financial statement of professional earnings is required to be forwarded to the University each year.

2. You have asked me to assume that Dr McCans had net income in excess of his ceiling amount in 1977 and 1978 and thus was required to make a ceiling payment for each year. When preparing his financial statements for those years, the ceiling payments were recorded as expenses incurred in those years.

3. In 1980, Revenue Canada Taxation reassessed Dr McCans for 1977 and 1978 and disallowed certain expenses claimed in those years as deductions in computing his income for income tax purposes. As a consequence of these reassessments, the excess amount payable to the University with respect to those taxation years has been increased.

Given these facts you have asked for my opinion on the following questions:

A. In accordance with generally accepted accounting principles, do the reassessments of 3 April 1980 create a liability that arose in 1980 or did they create a liability which existed in 1977 and 1978 respectively?

B. Further, do the additional ceiling payments form part of the financial results of 1980 or of 1977 and 1978 respectively?

Based on a review of the facts, my opinion is as follows:

When the 1977 and 1978 financial reults of Dr McCans were prepared in accordance with generally accepted accounting principles (“GAAP”), the reassessments of 1980 and the resulting liability for additional income tax, interest and ceiling payments were, of course, unknown and, therefore, could not be a part of the financial results of those years. As these liabilities became known in 1980, it was only then that they could, in accordance with GAAP, become a part of Dr McCans’ financial results. Whether they in fact became a part of his financial results for 1980, or some subsequent year, would depend on whether it was reasonable to expect that the reassessments could be successfully appealed and, if ultimately appealed, the success of the appeals.

I trust that this is the information you desire.

Yours truly,

(signature)

William R McColm

Non-Residents & Business and Property Income

Non-Corporate Rulings Division

Mr MCColm introduced into debate the concept of prior period adjustments defined by section 3600, paragraph 05 of CICA Handbook which reads as follows:

05 The financial statements of prior periods presented for comparative purposes are restated as necessary to reflect the retroactive application of a prior period adjustment, including any related income tax effect. The income statement of the prior period to which the adjustment relates is restated and the opening balance of retained earnings in subsequent periods, including the current period, is adjusted accordingly. When the adjustment relates to a period prior to the earliest period for which financial statements are presented, the opening balance of retained earnings for the earliest period is adjusted to reflect the prior period adjustment.

On examination-in-chief, Mr McColm stated that when financial statements are audited, as was required by the terms of the contract with Queen’s University, they reflect the results fairly and as accurately as possible. Although, the possibility of errors and incomplete information in a financial statement of a prior period is recognized, the audited statement for the current period is, in Mr McColm’s opinion, final. Inaccuracies or additional information with respect to items in the statements of prior years that are subsequently found are dealt with in the current fiscal year. If the amounts involved are insignificant, they are, according to Mr McColm, simply incorporated in the current financial statement without special mention. If the amounts are substantial, then, they are reflected in the current financial statements as prior period adjustments, as defined in the CICA Handbook (above); but the financial statements for the fiscal period in which the inaccuracies may have originated are, according to Mr McColm, not to be altered.

The respondent’s position is that automobile and other expenses having been disallowed, the Minister in his assessments properly increased the appellant’s taxable income for 1977 and 1978. He held that the resulting increase in ceiling payments to be paid by the appellant to Queen’s University were not made nor were they incurred in 1977 and 1978 and therefore were not deductible in those years by virtue of paragraph 18(l)(a) of the Income Tax Act, as amended. Counsel for the respondent further contends that the additional ceiling payments could not have been known in 1977 and 1978 — their deductions as contingent liabilities were also prohibited by virtue of paragraph 18( l)(e) of the Income Tax Act and could only be deducted in the year of assessment (1980) or in subsequent years.

Findings

As stated by both counsel, there appears to be no case law exactly on point. Although, the issue is unusual, 120 doctors on Queen’s University staff nevertheless found themselves in a tax situation identical to that of the appellant.

Leaving aside, for the moment, the interpretation to be given to some of the provisions of the University contract and the applicability in this instance of prior period adjustments, the basic question is how the Minister, in 1980, assessed the appellant’s tax liabiities for each of the 1977 and 1978 taxation years.

The Minister, with the taxpayer’s returns as a starting point, assessed the appellant for specific taxation years and for specific amounts of tax owing in those years. The Minister in his assessments must, of course, take into account all the pertinent facts that exist in a given taxation year and he must be consistent in his appreciation and consideration of these facts.

In filing his tax returns for 1977 and 1978, the appellant in computing his taxable income claimed certain expenses incurred in the exercise of his profession. His reported income was greater than the $44,500 and $55,500 the permissible income limit set out in the University contract for 1977 and 1978 taxation years respectively. In each of these years, the appellant duly paid to Queen’s University the surplus income reported in each of the pertinent years.

In his assessments, the Minister had found that the appellant, in his return, had overstated his expenses and had understated his income for 1977 and 1978. The Minister disallowed certain of the appelant’s expenses; increased the appellant’s 1977 and 1978 income and assessed the appellant additional tax. While he increased the appellant’s 1977 and 1978 taxable income the Minister ignored the existence of the appellant’s contractual obligations to pay to Queen’s University in each fiscal year all income in excess of the permissible income limit set out in the contract. It is significant, in my view, that the Minister, in the same assessment, had already taken this contractual obligation into account and had accepted it as valid in his consideration of the appellant’s own computation of his income for 1977 and 1978.

In 1980, the Minister was seeking to determine the appellant’s true tax liability for the 1977 and 1978 taxation years. His assessment disclosed the concurrent existence of three related factors:

1. An increase in the appellant’s income with the resulting increased in his liability for additional tax payable which the Minister assessed.

2. A sequential liability for the appellant to pay to the University in 1977 and 1978 additional ceiling payments in amounts identical to the appellant’s increased income in those years which the Minister ignored.

3. The use by the appellant of the accrual system of accounting in his books and records was disregarded by the Minister.

The Minister confirmed the appellant’s liability for the payment of additional tax for 1977 and 1978. Regardless of the year in which the assessment was made or when the additional taxes were paid, there can be no doubt that additional tax liabilities were incurred and existed in the appellant’s 1977 and 1978 taxation years. Indeed, the appellant is also liable for accrued interest on unpaid taxes as of 1977 and 1978.

The Minister could not, in my view, arrive at the appellant’s true taxable income for 1977 and 1978 without also taking into account in his computation of tax the appellant’s contractual liability to pay to Queen’s University all additional ceiling payments for each of the appellant’s 1977 and 1978 taxation years.

Counsel for the respondent contended that the University’s contract did not support the appellant’s contention that the additional ceiling payments were deductible in 1977 and 1978. He stated that according to the contract, the additional ceiling payments as determined by the respondent’s 1980 assessments became due and payable to Queen’s University in 1980. Clause 6(l)(c) of the contract, to which I believe the respondent alluded, may determine when the additional payments become due and payable; it does not in my opinion determine in which year the appellant’s liability for additional ceiling payments were incurred. Nor can the contract, by itself, determine in what taxation year these payments could properly be deducted within the meaning of paragraph 18( l)(a) of the Act.

With respect to prior period adjustments they are clearly very useful guidelines in the determination of income. However, they are not, nor should they be seen, as mandatory and universally applicable in computing income for tax purposes.

in his written opinion Mr McColm stated that the appellant’s 1977 and 1978 financial statements were prepared in accordance with generally accepted accounting principles (prior period adjustment). In the last paragraph of his written opinion, Mr McColm wrote and I quote:

. . . As these liabilities (additional ceiling payments) became known in 1980, it was only then they could in accordance with GAAP become part of Dr McCans’ financial results. . . . (the italics are mine)

Although prior period adjustment may be a practical and convenient accounting method of recording and correcting in a current financial statement, errors, omissions and inaccuracies which may have occurred in and pertain to transactions of prior years, they are not always, as in this case, a reliable method of determining the appellant’s true taxable income for 1977 and 1978 which is exactly what must be determined here.

In ths instance, including the appellant’s 1977 and 1978 liability for additional ceiling payments in the appellant’s financial statement for 1980 — is for income tax purposes a distortion of the facts which lead to erroneous computation of the appellant’s true income for 1977 and 1978.

Counsel for the respondent submitted that the Income Tax Act should be interpreted in a manner which allows a taxpayer to compute his taxable income at the time he is obliged to file his returns. No one would disagree with that proposition. However, counsel for the respondent suggested that the appellant’s position (the deductability of additional ceiling payments in 1977 and 1978) would not permit the taxpayer to properly compute his taxable income in 1977 and 1978. If I understand the respondent’s argument correctly, his opinion was that an amended tax return would have had to be filed by the appellant after the Minister’s 1980 assessment.

I do not see why the appellant who was on an accrual system of accounting, and who filed his 1977 and 1978 tax returns on the basis of his current financial statements, would be obliged to amend his tax return in 1980. In 1980, it is the Minister who assessed the appellant and increased the amount of taxable income for 1977 and 1978. As a result of the assessments, the appellant’s additional tax liability was normally incurred and became due and payable in 1977 and 1978.

The facts of the cases cited by the Minister were quite different from those in the present appeal.

In MNR v Benaby Realties Limited, [1967] CTC 418; 67 DTC 5275, a Supreme Court decision, one of the cases — cited by counsel for the respondent — Judson, J stated at 5277:

My opinion is that the Canadian Income Tax Act requires that profits be taken into account or assessed in the year in which the amount is ascertained.

At 5276, Judson, J said:

In my opinion, the Minister’s submission is sound. It is true that at the moment of expropriation the taxpayer acquired a right to receive compensation in place of the land but in the absence of a binding agreement between the parties or of a judgment fixing the compensation, the owner had no more than a right to claim compensation and there is nothing which can be taken into account as an amount receivable due to the expropriation.

At 5277, Judson, J also stated:

Under the Canadian Expropriation Act, there is no doubt or uncertainty as to the right to compensation, but I do adopt the principle that there could be no amount receivable under s 85B(1)(B) until the amount was fixed either by arbitration or agreement.

Judson, J quoted a passage of the decision in Try v Johnson, [1948] 1 AER 532, which reads as follows:

Try v Johnson, [1948] 1 AER 532, is much closer to the point in issue here. The claim was for compensation under legislation which imposed restrictions on “Ribbon Development”. When the case reached the Court of Appeal, the amount of compensation was admitted to be a trade receipt. The argument in that Court was directed to the appropriate year of assessment. The judgment was that the right of the frontager to compensation under the Ribbon Development Act contained so may elements of uncertainty both as to the right itself and the quantum that it could not be regarded as a trade receipt for the purpose of ascertaining the appropriate year of assessment until the amount was fixed either by an arbitration award or by agreement.

In Benaby (supra) Judson, J at 420 and 5277 respectively also cited a passage in MNR v Lechter, [1966] SCR 655; [1966] CTC 434; 66 DTC 5300, which reads as follows:

The judgment says no more than this, that the respondent, operating on an accrual basis, was bound to treat the profit of $234,506.91 on the disposition of part of lot 507, as having been earned prior to January 31, 1955, and that it was not taxable income in his taxtion year ending January 31, 1956. The governing factor was the settlement made in the 1955 taxation year.

As I see it, in Benaby (supra), Judson, J stressed the existence of two important factors which do not exist in the present appeal:

(a) The issue was in respect of a profit from an expropriation;

(b) The absence of a binding agreement between the parties on judgment fixing the amount of the compensation.

In this appeal, which is not concerned with the taxability of profits arising from expropriation, the respondent, in assessing the appellant’s 1977 and 1978 taxable income, had before him the provision of a valid contract which established the time frame: each taxation year of the appellant’s liabilities to Queen’s University. The contract also fixed the quantum of the appellant’s liabilities: all income in excess of a specific amount of income predetermined under the Contract.

Unlike the circumstances in Benaby and Lechter (supra), the appellant’s liabilities to Queen’s University were ascertainable and calculable at the time the Minister assessed the appellant’s true taxable income for 1977 and 1978.

On the facts of the present appeal, the applicable assessing principle, in my opiinion, is that found in Leo Beauchesne (supra). The Minister’s assessments did not create the appellant’s tax liabilities for 1977 and 1978. However, it did confirm what the appellant’s true liabilities were for each of those years. In assessing the appellant in 1980, the Minister could have and should have considered and given effect to the ceiling payment clauses of the University contract in his computation of the appellant’s 1977 and 1978 true taxable income.

For these reasons the appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment on the basis that the expenses in the amounts of $2,868.27 and $5,589.20 claimed by the appellant were not contingent liabilities and were deductible under paragraph 18( l)(a) of the Act in the appellant’s 1977 and 1978 taxation years respectively.

Appeal allowed.