Fred and Ted’s Construction LTD v. Minister of National Revenue, [1984] CTC 2549, 84 DTC 1530

Rip, TCJ:—This is an appeal against assessments for 1975, 1976 and 1977 taxation years which was heard on common evidence with the appeals of Theophil DeCock and Joyce DeCock. In this appeal the respondent disallowed certain amounts paid in 1976 and 1977 to Larry DeCock, son of Theophil DeCock, the sole shareholder of the appellant, on the basis that the amounts were not outlays or expenses incurred by the appellant for the purpose of gaining or producing income from a business pursuant to the provisions of paragraph 18(l)(a) of the Income Tax Act and are, in any event, not reasonable in the circumstances pursuant to section 67 of the Act. The respondent also allocated certain management fees payable to the appellant to its 1976 and 1977 taxation years and disallowed a portion of a reserve for bad debts claimed by the appellant for 1977. Any loss incurred by the appellant in its 1976 taxation year would be carried back to 1975.

The appellant carries on the business of a building contractor, building singlefamily homes and multi-unit apartment buildings in the Okanagan Valley of British Columbia. Theophil DeCock is president and sole shareholder of the appellant.

Expenses claimed

Mr Theophil DeCock has four children, one of whom is Larry DeCock. When Larry was five years old he started working for the appellant helping his father clean around work sites. When he was four and one-half years old Larry was driving a motorbike; he learned how to drive a forklift at age fourteen. He has been working on job sites with motorized vehicles since he was fourteen years of age.

In 1976, at age eleven, Larry would work for the appellant almost every day after school, during summer holidays and spring vacation. During the spring, summer and fall he would be taken to a work site and work on the site loading trucks with material and clean around the site. During the winter he would work as a carpenter in a workshop near his home making rabbit joints, painting and cutting pieces of material to size as part of a prefabrication process and assisting his father in maintaining, and making repairs to, buildings owned by the appellant.

During the summers he worked a full 40-hour week; when at school he would work daily during the week from 3:30 pm until 7:00 pm. He would also work all day Saturday and, if necessary, part of Sunday. This was continued in 1977, although in 1977 “Larry got into heavier work’’ building, for example, 5,000 balcony rails “as good as a man’’, according to his father.

In 1976 the appellant paid Larry $12,000 and in 1977 $15,000 for his services.

Larry failed grade one at school but since then he has passed his grades. He testified he enjoyed working more than going to school. He worked because “I enjoyed it’’ even when he was eleven and twelve years old. Larry never took up sports and his only friends are those children he sees at school. Any homework is done at school so that all his free time is available for work. He is now in grade twelve and hopes to graduate this year.

Witnesses who observed Larry in the years under appeal waxed enthusiastic about his dedication to work. Mr Reginald Charles, who worked as a real estate representative and managed property for Mr DeCock during the years under appeal, said that even when Larry was twelve or thirteen he did 50 per cent of the work of an eighteen year-old labourer. Larry was described by Mr Charles as “short and stocky, a hard little worker who worked with men all the time’’. He loaded trucks when he was twelve years old and later was driving a three-ton truck around the site “just like a man’’. Another witness, Mr Daniel Donovan Fergusson, hoped his son would emulate Larry’s enthusiasm for work. Mr Fer- gusson, a real estate agent, said Larry “caught my eye’’ as far back as 1972 and he “worked like a trooper’’. Mr Charles testified he sometimes helped out Mr DeCock and when he did “Larry would work me into the ground within an hour; he was a workaholic’’.

Later on, when Larry was fifteen years old, he supervised the construction of a duplex. He acted as contractor arranging for the subcontractors and making sure the work proceeded in an orderly manner.

His father described Larry as loyal, hard working, dependable, and sober, There is no question Larry performed services for the appellant in 1976 and 1977; during the conclusion of trial counsel for the respondent acknowledged Larry performed the services; the question before the Court was whether or not the amounts paid to Larry were reasonable expenses to the appellant.

Larry was not paid a predetermined salary. He was not an employee of the appellant. His remuneration was by way of “management fee”,* [1] although his activities had nothing to do with management. Sometimes his father would tell Larry “I’ll give you $100” to do a particular job and he was paid this amount in addition to the management fee. The quantum of his management fee was determined by his father and the appellant’s accountant after the appellant’s year end. Larry was not involved in any negotiation of fees and was not paid on a regular basis. His father testified the hours that he worked and the type of work he performed were entered into a “scribbler”; the “scribbler” was not produced in evidence since, according to Mr DeCock, it was lost, probably when he and Mrs DeCock moved from Kelowna to Vernon. Some invoices of Larry’s work were submitted; these invoices were prepared by Mr DeCock without Larry’s knowledge and the amounts represented thereon appeared to be amounts paid in addition to Larry’s management fees.

The reason Larry was not paid on a regular basis, according to his father, was that he was living at home and did not require the money.

Mr DeCock said that the appellant paid Larry on the basis of the work Larry performed. The appellant would pay Larry the same as it paid its other employees, except Larry did not get holiday pay or other benefits. In the years under appeal the appellant was paying Larry between $10 and $11 per hour.

Larry did not keep the moneys he earned; they were held by his father “like a trustee” in a bank account in his father’s name. The bank account included his father’s money as well. His father entered amounts Larry earned in the scribbler and photostats of the scribbler pages were given to the appellant’s accountant. Also, some cheques were endorsed by Larry to his father; a promissory note from Mr DeCock to Larry was entered into evidence. This note appears to have been prepared by the appellant’s accountant after the fact and was never delivered to Larry. Larry has not asked his father for an accounting since “‘I trust my father”. When Larry required money his father would provide him the money from the bank account; this way he was able to acquire an interest in a triplex, and purchase a forklift, semi-trailer, boat, two skimobiles and a car trailer.

Counsel for the respondent agrees Larry did perform the services for which he was paid. If the amounts paid to him were held by his father “like a trustee”, that is a matter between Larry and his father: it is not unusual for a father to hold money for his child. As previously stated, the Court is being asked to determine whether the amounts paid to Larry for his services in 1976 and 1977 and deducted by the appellant in computing its income were reasonable expenses of the appellant.

In Gabco Ltd v MNR ([1968] CTC 313; 68 DTC 5210) the taxpayer corporation was a successor of a corporation created by the father of the appellant’s two principal shareholders. In 1962 the president of the appellant hired his 19 year- old son, a shareholder of the appellant, with the intention of making him his number two man. The son immediately became an energetic and immediate driving force in the company, giving better service than anyone else in the company, including his superior. The appellant deducted the following sums from its income as expenses for the son’s remuneration: for the last three months of 1962, $20,371 representing $5,280 in salary and $30,393 as a bonus. Bonuses were paid in accordance with the appellant’s practice of paying its permanent employees mainly by way of yearly incomes proportionate to each employee’s shareholding.

The respondent relied on such facts as the son’s youth as indicating the unreasonableness of his remuneration. An expert for the appellant testified that the son was in fact the number two man in the appellant company and that as such he would normally receive 70 per cent of the most senior men’s salary. In Gabco, (supra), Mr Justice Cattanach stated, at 323 [5216]:

It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable businessman would have contracted to pay such an amount having only the business consideration of the appellant in mind.

Having regard to the son’s contemplated status in the appellant company, which he subsequently fulfilled, and to the legitimate consideration of future benefits to be derived from his employment, the Court found that the remuneration paid to the son was reasonable.

There was no direct evidence that Mr DeCock contemplated having his son join him in the business. But the inference I drew from Mr DeCock’s testimony on this issue — which was much more forthcoming than his other evidence — was that he was very proud of his son and probably would like nothing better if Larry did join the appellant corporation once he completed school. Since Larry has been working for the appellant for over twelve years I have no doubt he will be joining the family business once school is over. As the father in the Gabco appeal, Mr Theophil DeCock was entitled to have consideration other than Larry’s service to the appellant in the years under appeal in determining remuneration to Larry; in the appellant’s case a loyal employee and possible successor to Mr DeCock was getting early training.

Notwithstanding the evidence that in 1976 Larry’s work performance was equal to 50 per cent of an eighteen year-old labourer and that the scribbler recording his hours was “lost”, because of the reasoning in Gabco I am leery of making any adjustment to the deductions claimed by the appellant in respect of amounts paid to Larry.

Management fees

Sometime in 1966 the appellant and Detra Holdings Ltd (“Detra”), a company wholly owned and controlled by Mr DeCock, entered into an arrangement whereby the appellant would purportedly act as construction manager in respect of projects being undertaken, or already undertaken, by Detra. There was no written agreement between the parties and in all probability the terms of the arrangement rested solely in the mind of Mr DeCock. Mr DeCock testified that Detra engaged the services of the appellant because the appellant had knowledge of construction and access to plans which Detra required. Construction took place from May to October in 1976, Mr DeCock testified, because the appellant did not do any construction in the winter months, late fall or early spring.

While actual construction took place during the months of May to October inclusive, it is obvious some preliminary work would have had to have been done prior to the actual commencement of construction. Mr DeCock testified work would have been completed by the end of October.

The fee payable to the appellant by Detra was determined about three months after the appellant’s year end, once the incomes of the appellant and Detra had been determined. At that time Mr DeCock testified he sat down with his accountant, a Mr J Stewart, CA, of Kelowna, “calculated the value of the work to Fred and Ted’s and arrived at the appropriate figure’’. The “appropriate figure” was $240,000 for the year. The tax returns of the appellant and Detra were prepared immediately after the management fee was determined.

Detra’s year end for 1976 was October 30. The appellant’s year end for 1976 and 1977 was September 30. Since the amount of the fee was determined after the appellant’s 1976 year end the appellant’s accountant, according to Mr DeCock, advised him that all of the $240,000 is to be included in the appellant’s 1977 taxation year. In the accountant’s view, according to Mr DeCock, as at September 30, 1976, the amount of the receivable from Detra to the appellant had not been determined and therefore was not to be included in the appellant’s income for 1976. The appellant followed its accountant’s advice.

Detra deducted all of the fees payable to the appellant in computing its income for 1976.

The respondent assessed the appellant on the basis that the management fee was payable at the rate of $20,000 per month for twelve months. One of the respondent’s officials testified he obtained a working paper of Detra from Mr Stewart’s office indicating the management fee was payable on a monthly basis. The respondent assessed the appellant by adding $220,000 of the management fee to income for 1976 and included only $20,000 as income for 1977. Mr DeCock stated at trial he had never before seen this working paper and denied the fee was payable monthly. However he could give no particulars how the $240,000 was determined.

A corporation reports income on the accrual method of accounting. The appellant was performing services for Detra in its 1976 taxation year and for one month of its 1977 taxation year, ie October 1976. The management fee was determined before the date of the appellant’s 1976 financial statements, December 17, 1976. (The income tax return of the appellant for 1976 is dated on the same day.)

I can find no support for the appellant’s treatment of the fee. In my view the management fee should be allocated over the term during which the contract was performed. While the fee was not determined at the end of the appellant’s year end it was known at the time its 1976 financial statements were being prepared. To allocate all of the fee to the appellant’s 1977 taxation year distorts significantly the appellant’s income for that year. While actual construction took place during the six months from the beginning of May 1976 to the end of October 1976 surely preliminary work of at least one-month duration had to have been performed before construction started. Mr DeCock was unable to produce any of the management records nor could he advise the Court if such records were prepared. Neither could he remember when the appellant commenced its services to Detra.

Because of the lack of information before me I must allocate the fee over the period during which the services were performed. I assume the services under the contract commenced in April and continued up to the end of October 1976. Therefore on the basis the contract was performed over a period of seven months, I find that $205,920 is to be included in the appellant’s 1976 income when most of the services were performed, and $34,080 is to be included in the appellant’s 1977 taxation year when one month’s services were performed. I have allocated six sevenths of the contract to 1976 and one seventh to 1977.

Reserve for bad debt

In 1975 the appellant and a Mr Crook built an apartment block which was sold in December of that year. The sale price was $1,100,000 and was paid $100,000 on closing, $600,000 secured by a first mortgage from a financial institution and second mortgages, ranking equally, back to the appellant and Crook each in the amount of $200,000. An amount of $125,000, secured by the second mortgages to each of the vendors, was payable to each vendor on December 1, 1978.

Almost immediately after the sale the appellant encountered difficulties in collecting payments on its mortgage, either payments were not made or cheques were not honoured by the bank. The purchaser also was not making payments on the first mortgage thus causing the appellant and Crook to pay the first mortgagee in order to protect their interests in the property. The purchaser was also in default in payment of taxes.

Mr DeCock testified that he knew three weeks after the sale they were “‘in big trouble’’ and the mortgage would eventually be in default.

In the meantime the apartment block was being neglected by the purchaser and damage and necessary repairs were not being attended to.

In 1977 the first mortgage fell due and the mortgagee would not renew the mortgage; the mortgagee was prepared to foreclose. According to Mr DeCock “we were sitting there with nothing and we couldn’t borrow because it was a foreclosure building. We needed $700,000 and finally Northwest Life gave us a commitment’’. The purchaser “walked away’’ in 1977 and quit claimed the property in 1979. The appellant and Crook “cleaned up’’ the building and sold it at the end of 1979 for $1,200,000. The appellant kept the mortgage on its books in the amount of $200,000 until September 30, 1977 when it was written down to one dollar. In assessing the appellant the respondent assumed that the total debt outstanding, including principal and interest, at the end of 1977 was $156,666.

The appellant did not make any appraisal of the apartment block to determine the value of its security in the property. Since the property was sold at a profit one must assume that the appellant’s security was good as at September 30, 1977. The question to decide is whether the bad debt on September 30, 1977, was greater than the $74,211 allowed by the respondent. The onus is on the appellant to prove the Minister’s assumption that the debt outstanding at the end of 1977 was $156,666 is wrong (vide, among other cases, Kit Win v The Queen ([1981] CTC 43; 81 DTC 5030 at 54 to 57 [5038 to 5041])). There was no evidence submitted by the appellant to even suggest the Minister’s assumption was in error. The appeal for 1977 in respect of this item must be dismissed.

The appellant abandoned its appeal in respect of the respondent’s disallowance for its 1976 taxation year of an amount of $15,000 as a deduction in computing its income for the year.

Judgment will therefore issue allowing the appeal with respect to the fees paid to Larry DeCock, but otherwise the assessments will be confirmed.

Appeal allowed in part.