Alteo Construction Limited v. Minister of National Revenue, [1983] CTC 2337, 83 DTC 281

D E Taylor:—This is an appeal heard in Toronto, Ontario, on April 15, 1983, against an income tax assessment for the year 1975 in which the Minister of National Revenue disallowed an amount of $337,000, the unpaid balance of a deduction claimed, which deduction was described by the appellant as “management salaries”. The critical portions of the notice of appeal read:

1. The Appellant was incorporated on March 24, 1969 and at all relevant times was in the land development and construction business.

2. The two principal active officers in its business affairs at all relevant times were Alfred Berry and Theo Schmitz who together co-managed the Appellant’s business affairs.

3. The following is a Schedule of the gross income, management compensation and profit (or losses) of the Appellant for the taxation years of 1969 to 1977 inclusive.

Year Ended
September 30	Gross Income	Salaries	Profits Profits
1969	NIL	NIL	NIL
1970	$ 3,458	—	$ (3,921)
1971	65,235	—	(14,977)
1972	275,200	16,000	11,362
1973	324,458	70,000	96,654
1974	982,744	79,334	443,408
1975	233,507	500,000	(225,999)
1976	306,596	100,000	69,253
1977	151,418	161,200	109,640

6. As a result of a management decision taken in the Appellant’s 1975 taxation year, it was decided to pay substantial increases in salaries in favour of management in the amount of $250,000 to each of the two principal officers. The decision was based on:

(a) anticipated extraordinary profits;

(b) substantial increase in cash flow; and

(c) previous modest compensation taken by management.

7. Of the amounts authorized to be paid to each of the officers $81,500 was paid to each of them in the Appellant’s 1976 taxation year.

8. With the deterioration in the land development business after 1975, . .. the Appellant discovered that its profits and cash flow had deteriorated substantially. As a result thereof the Appellant decided to withhold payment of the balance of the accrued salaries from its 1975 taxation year and include these accruals in taxable income in its 1977 taxation year.

9. At the end of its 1975 taxation year the Appellant had no bank indebtedness and had liabilities of $328,000. At the end of the Appellant’s 1977 taxation year it owed its bank $241,000 and had other liabilities of $718,000 which supports the Appellant’s contention of the substantial deterioration in its real estate activities.

13. The Appellant maintains that the accrued salaries represented genuine enforceable liabilities arising in its 1975 taxation year which were incurred firstly, for the purpose of gaining or producing income and secondly, to compensate its officers in accordance with its substantial profits and with the time and effort expended by its officers.

The Minister assessed based on the following:

10. ...

(b) the Appellant did not create and did not intend to create a legal obligation to pay the amount of $500,000.00 or $337,000.00 management salary in its 1975 taxation year;

(c) the amount of $500,000.00 or the amount of $337,000.00 was a contingent liability;

(d) the Appellant accrued management salary of $100,000.00 in its 1976 taxation year which amount was paid in its 1977 taxation year;

(e) the Appellant paid Alfred Berry and Theo Schmitz management salary totalling $174,564.73 in its 1975 taxation year and $163,000.00 in its 1976 taxation year;

(f) the management salary accrued and claimed by the Appellant as a deduction from income in the Appellant’s 1976 taxation year was not an outlay or expense incurred by the Appellant for the purpose of gaining or producing income in the Appellant’s 1976 taxation year.

By agreement, counsel filed with the Board copies of the financial statements for the years 1969 through 1980 inclusive (Exhibit A-1). In addition the resolution of the company setting up the $500,000 management bonus (Exhibit A-2) was filed and it read:

Resolution of the Board of Directors

of

Alteo Construction Limited

Payment of Management Bonuses

RESOLVED that the payment by the Corporation to the following persons of the following respective amounts as management bonuses for services performed for and on behalf of the Corporation by such persons for and during the fiscal year of the Corporation ending September 30, 1975, be and the same is hereby authorized and approved:

To Theodor Schmitz	—	$250,000.00
To Alfred C Berry	—	$250,000.00

DATED the 2nd day of September, 1975.

The foregoing resolution is hereby consented to by all the directors of the Corporation, pursuant to The Business Corporations Act, as evidenced by their respective signatures hereto, this 2nd day of September, 1975.

(Signed)	(Signed)
Theodore Schmitz	Alfred Charles Berry
(Signed)	(Signed)
Juliane Schmitz	Daisy Berry

The appellant did not dispute the Minister’s claim that an amount of $100,000 had also been set up in 1976 but noted that for the year 1977 a further $150,000 had been set up, and the resolution for 1977 was also filed as Exhibit A-3. Mr Alfred Berry outlined the development and progress of the company, and in particular emphasized the reasons as he saw them — largely unexpected and external to the operations of the business — which brought about the business decline after 1974. Mr Louis Devor, chartered accountant who had acted for a separate company providing financial assistance and managerial advice to the appellant, supported the views of Mr Berry.

In summary, the principal shareholders who had taken little or no salary during the early years of the company, believed that in 1974 the company had matured and its future as well as their own was assured, and since they had the profits and apparently the cash flow, they provided for a substantial amount of compensation. According to Mr Berry there had been no accountant or auditor at the meeting of the company at which the 1975 resolution (Exhibit A-2) had been passed, and there had been no discussion of income tax benefits or impact. He recognized that the resolution stated “authorized and approved” and could only give the ultimate shortage of funds as the reason for not paying the full $500,000. The amount at issue had been shown as a current liability in the 1975 balance sheet of the company.

Counsel for the appellant referenced and dealt with the recent cases on the subject:

Deductions Allowed

1. Brazolot Construction Limited v MNR, [1981] CTC 2468; 81 DTC 449;

2. The Queen v V&R R Enterprises Limited, [1979] CTC 465; 79 DTC 5399;

3. Len Singleton Limited v MNR, [1983] CTC 2196; 83 DTC 141;

4. Toronto Heel Limited v MNR, [1980] CTC 2277; 80 DTC 1250.

Deductions Disallowed

1. Don Fell Limited et al v The Queen, [1981] CTC 363; 81 DTC 5282;

2. G W Dorman Pulp Chip Company Ltd v MNR, [1981] CTC 2005; 81 DTC 21;

3. The Queen v Ken and Ray’s Collins Bay Supermarket Limited, [1975] CTC 504; 75 DTC 5346;

4. Kerr Farms Limited v MNR, [1971] Tax ABC 804; 71 DTC 536;

5. Totem Disposal Co Ltd v MNR, [1981] CTC 2547; 81 DTC 493.

In particular counsel noted Brazolot (supra) and contended that a distinction should not be made between the fact that in Brazolot a pattern of declaration of management bonuses had been established before the taxation year at issue therein, while in the instant case this had commenced with the taxation year at issue and continued thereafter. Counsel argued that the Brazolot (supra) case was directly relevant and supported this appeal. In addition counsel noted that a clear distinction existed between this case and Totem (supra) since the question of using the management bonus as a tax reduction mechanism had not been considered at all. In fact, if that had been the purpose, the appellant had not done the task very well since a more rewarding process of utilizing the lower corporate rate of tax could easily have been developed according to counsel.

Counsel for the Minister summarized the evidence in the following manner:

It is my submission .. . that the significance of the $500,000 amount was determined by the accountant. It was not determined because of the needs of the shareholders.

There has been some question .. . about the tax effects of what was done. In my respectful submission . . . it is clear that while the annual small business deduction was not effectively total small business deduction, (it had that) effect, at least, for the ‘76 and ’77 years by what was done in terms of the $500,000 bonus ... in determining what would have been the proper amount to have paid out, the amount which was actually paid was somewhat over $80,000 per participant, a hundred and sixty thousand some odd, certainly in the context of the amounts that had been paid out in salary historically, even though it is a relatively short history, indicate that total of amount of a little over $160,000 was more or less appropriate.

The evidence appears to be quite clear that the company itself did not have the financial capability at that particular time in terms of its planning to pay those moneys. The evidence is quite clear in my submission, and it appears to be admitted, that the money was supposed to come out of future cash flow.

Reviewing first the points made by counsel for the respondent in argument, the Board would note that while there was not immediately available the funds in the bank to pay the $500,000 at the date the management bonus was declared, there were assets — current assets which reasonably could have provided the source of funds needed. It is the testimony of Mr Berry (and there is nothing to contradict it) that unexpected business developments required the utilization of all available sources of funds late in 1976 and in 1977 for the preservation of the company and the continuation of at least part of the projects undertaken. One might easily argue that the management of the appellant company made some bad business decisions or guesses, and did get over-extended, but I fail to see how that destroys the rationale upon which the $500,000 bonus was allegedly declared at the time it was declared. With regard to the more appropriate value of some $160,000 rather than the $500,000, the Minister has not raised as an issue the question of the reasonableness of the charge — only that the appellant did not create and did not intend to create a legal obligation.

As for the influence of the accountant and/or the lower corporate rate of tax, I accept the testimony (which is also uncontradicted) of Mr Berry that neither had a bearing on the declaration of the management bonus. It may appear to the Minister that such a review might have been the case, and would be the more normal course of events, but that has not been demonstrated to the Board for the determination of this appeal.

While the respondent did not emphasize the fact that 1975 was the first year in which there is any record of such a management bonus, it appears to me that this is the only negative distinction to be made in this case and Brazolot (supra). In this connection I would quote one paragraph from the argument of Mr Farano, QC counsel for the appellant in this matter where he is referring to Brazolot (supra):

In that case it was held that a legal obligation to pay was created even without anything in writing. In that case there was not a written directors’ resolution declaring the accrued salary, but the course of conduct, the accounting entries and the financial statements were sufficient to establish the legal obligation to pay. In our case the additional factor of the written directors’ resolution would seem to make it easier to conclude that a legal obligation had been created.

And further I would note the relevant paragraph from Brazolot (supra) to be found at 2474 and 453 respectively:

There is only one question to be answered, and that is whether or not an obligation to pay the management salary had been established in 1976. While the evidence would indicate that tax considerations were never far from the minds of those directing the appellant company, the same evidence would indicate that a pattern had been established in prior years, that the amount for 1976 was reasonable and that it had been earned by Mr Brazolot. Following the judgment in McClain (supra) and the decision in Dorman (supra), it is a finding of fact that such an obligation to pay salary was established by the actions taken in the company and the record made of these actions with respect to the year 1976.

Counsel for the appellant is correct in his interpretation. In Brazolot (supra) the preceding and surrounding circumstances were sufficient, in the opinion of the Board, to find as a fact that a legal obligation had been created. In the instant case, the circumstances put forward in support of the proper declaration of the management bonus are even more striking — particularly the resolution of the Board of Directors (Exhibit A-2). While certainly a pattern of management bonus declaration preceding a particular taxation year at issue is an added and indeed important element, it cannot realistically be said that the absence of such a previous pattern must, in all circumstances, negate the other indications and evidence of a “legal obligation”. There is no basis in this matter upon which the Board can make a viable distinction from the case of Brazolot (supra).

The appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment in accordance with the above reasons for decision.

Appeal allowed.