Carling Realty Company Limited, Jack Aaron and Company Limited v. Minister of National Revenue, [1982] CTC 2323, 82 DTC 1283

The Chairman:—The appeal of Carling Realty Company Limited (“Carling”) is from reassessments with respect to the 1974, 1975, 1976 and 1977 taxation years. The appeal of Jack Aaron and Company Limited (“Aaron Company”), a company associated with Carling Realty Company Limited, is from assessments with respect to the 1975, 1976 and 1977 taxation years. At the commencement of the hearing, counsel for both appellants stated that evidence need not be adduced relative to the appeal of Jack Aaron Company Limited, an active company within the meaning of subsection 125(1) of the Income Tax Act, SC 1970-71-72, c 63, as amended, since evidence with respect to the active business issue in the Carling appeal and the decision of the Board on that point would serve in disposing of the sole issue in the Aaron Company appeal because of its association with Carling.

One of the three issues set out in the Notice of Appeal with respect to Carling was abandoned. The remaining issues to be determined are:

1. Whether or not the appellant’s income in 1975, 1976 and 1977 was also from an active business within the meaning of subsection 125(1) of the Income Tax Act;

2. Whether the amounts of $515,000 and $485,000 were deductible in 1974 and 1975 respectively and whether the provisions of subsection 78(3) of the Act were properly applied.

Summary of the evidence

Mr Jack Aaron testified that by 1966 the appellant company, incorporated in 1951, was owned by himself and his brother Irving. The company’s principal asset was 220 acres of raw land known as the Craig Henry Farm in the Township of Nepean, Ontario, acquired in 1958. The appellant also owned two office buildings situated on Carling Avenue, Ottawa, one of which was rented to Aaron Company, a company associated with the appellant.

In the years prior to 1974 the appellant was actively engaged, as a developer, in obtaining the proper zoning, planned subdivision of the land and the installation of necessary municipal services on the property. The appellant’s original plan for the Craig Henry Farm was a commercial development which however was frustrated. After a change of plan and considerable trouble and expense, some part of the property was ready for sale as simple and multiple dwelling lots by the end of 1972 and early 1973.

Verbal arrangements between the appellant and two building companies, MacVal Corporation and W L Interests, were then made by which the appellant would “on demand” supply serviced lots, as needed, to its two sole customers. In 1974, there were 77 lots sold. In 1975 some 200 lots were sold and sales continued to be made in 1976 and 1977 from the Craig Henry Farm property; other than the subject property, the appellant made no other purchase of land from 1958 to 1977.

In the 1975, 1976 and 1977 taxation years, the appellant had no place of business, no telephone and no employees. The necessary administrative functions relative to the sale of the lots were done through Aaron Company which acted as real estate agent for the appellant and was paid a fee for its services. Jack and Irving Aaron, the appellant’s only shareholders, were at no time remunerated for the work they had accomplished in the years prior to 1974 in developing the land and preparing it for its eventual sale as residential lots.

Mr Richard Winston Fage, CA, a partner of the firm of Ginsberg, Gluzman, Fage and Levitz, the appellant’s auditor, testified that up to and including 1974, the appellant’s rental income from the buildings on Carling Avenue was treated as income from an active business. In 1975, 1976 and 1977, all the appellant’s income was reported as being from an inactive business. In his reassessments, the Minister of National Revenue treated the rental income as having been generated by an inactive business but considered the income from the sale of the lots as arising from an active business.

The appellant’s profit and loss statements for 1973 and for those of prior years made no reference to salaries or bonuses in favour of Jack or Irving Aaron. In the appellant’s 1974 and 1975 fiancial statements, provisions were made for accrued bonuses or salaries to the shareholders in the amounts of $515,000 and $485,000 respectively and were claimed by the appellant as deductions in the said years. These amounts were not paid to the Aaron brothers in either of the years in which they were charged and, pursuant to subsection 78(3) of the Act, were added to the appellant’s income in the 1976 and 1977 taxation years respectively.

Submissions

The appellant

While admitting that the appellant at one time carried on an active business, counsel contended that its active business was terminated at the beginning of 1975 when the land was ready for sale and agreements had been entered into for the disposal of the lots. It was suggested that the income received from the disposition of the lots arose as a result of the appellant’s earlier activities — as an active development company — there being no need of further activity with respect to the income receivable from the subsequent sale of the lots, the appellant then became a non-active company.

It is the appellant’s contention that the Minister is wrong in assuming that the appellant’s income from the sale of the lots in 1975, 1976 and 1977 is from an active business. He submits that in 1975, 1976 and 1977 the appellant derived its income from property and not for carrying on business within the meaning of either section 9 or section 125 of the Income Tax Act. Counsel also contends that if the appellant in the pertinent taxation years did earn income from a business, it was not from an active business.

With reference to the second issue, the appellant’s position is that section 78 of the Act is clearly applicable to the salary or bonus accruals under review and that the Minister had under the circumstances no discretionary authority in its application.

The respondent

Counsel submits that the amounts received by the appellant from the sale of developed land in 1975, 1976 and 1977 was not income from property but from an active business.

As to the accrued salaries or bonuses, the respondent contends that they were not outlays or expenses incurred by the appellant for the purpose of gaining or producing income but were in effect reserves, the deduction of which is not provided for in paragraph 18(1 )(e) of the Act. Alternatively, the respondent submitted that if the bonuses were held to be expenses incurred to earn income within the meaning of paragraph 18(1 )(a), they were properly disallowed because they were not matched against the appellant’s income in the years they were incurred.

Findings of facts

The appellant in the taxation years under review was a Canadian controlled private corporation associated with Aaron Company. The appellant was actively engaged in the land development business until 1975. Without deciding at this point whether or not it was active in 1975, 1976 and 1977, the evidence clearly established that the appellant’s major source of income was not from property but from the proceeds of the sale of residential lots. The evidence also established that neither of the appellant’s owners had, in a period of ten years prior to 1974, been remunerated for their contribution in the long, difficult and frustrating process of preparing the land: first for a commercial development and subsequently for the sale of residential lots.

Both issues are questions which can only be determined by taking into account all the pertinent facts. The appellant was clearly a land development company. From 1966 all of the appellant’s activities were intended and aimed at the disposition of serviced land. There is no evidence that the owners even considered the appellant to be a holding company. On the contrary, after the appellant’s commercial project failed and the owners were unable to sell the whole parcel of 220 acres of land, considerable effort was made to convince MacVal Corporation and W L Interests to build residences on the serviced lots. By arrangement, a great number of lots were sold in the pertinent years (and indeed in subsequent years) as they were required by the builders.

Although the appellant had but two customers to whom lots were sold and had no office or telephone, no employees and no payroll in the pertinent taxation years, all of which have under different circumstances been ac- cpepted as indicia of an inactive business, they are not of themselves, determinative. The administrative work with respect to the appellant’s numerous sales was entrusted to its real estate agent, Aaron Company, an associated company which, according to the financial statements, was remunerated for its services.

Does the fact that the appellant did not itself process the sale transactions make its business inactive? In my opinion, the answer is no. The question as I see it is not whether the corporation was active but whether the corporation’s income was from an active business.

Although the degree of activity of a corporation or its principals can, in many circumstances, be a useful guide, the source of the income and the nature of the business are essential considerations in determining whether a business is active or inactive.

Subsection 125(1) of the Act as I read it, makes a distinction between a corporation and the business or businesses it may carry on. In this instance, the appellant had an inactive business in the ownership of two apartment buildings, the income from which (not in issue here) was considered by the Minister of National Revenue as income from an active business. However, the appellant’s major source of income was from the carrying on of its land development business which entails the acquisition of land, its subdivision and installation of services and the sale of lots, all phases of which constitute the business.

I cannot see how one can reasonably separate the appellant’s land development business into two distinct parts: the acquisition and servicing of land as being an active business and the process of disposing of the resulting land inventory as being an inactive business on the ground that the appellant does not itself sell the land. At the direction of the appellant, the land was sold by its associated company; the appellant earned income, the source of which can only be from the operation of its land development business.

In my opinion, the appellant’s income from the sale of serviced lots in the pertinent taxation years was from the carrying on of an active business of developing and selling land, whether or not the appellant took an active part in the actual sale of the lots.

Turning now to the second issue, I am satisfied on the evidence that Jack and Irving Aaron had not, in the 10 years previous to 1974, received any remuneration for what I accept as having been a long and trying task of rendering the Craig Henry Farm saleable.

The activities of the owners in that respect are undisputed and the appellant was, in my opinion, justified in claiming accrued salaries or bonuses in 1974 and 1975 as operational expenses. I am not at all certain of the relevancy of the respondent’s suggestion that the appellant had no intention of paying the accrued bonuses to the owners. Whether or not the bonuses were intended to be paid, there was no evidence that the liabilities were improperly charged or that they were unreasonable. Both Mr Jack Aaron and Mr R W Fage testified that as soon as the appellant began earning income in 1974, the bank insisted on the repayment of its outstanding loans before the owners were paid any part of their accrued bonuses.

It is the respondent’s contention that the amounts of $515,000 and $485,000 charged as liabilities were not incurred for the purpose of gaining or producing income and that if it is held that the expenses were incurred to earn income, the respondent submits that they were not deductible in 1974- 1975 because they were not matched against revenue in the years they were incurred.

The respondent did not offer any basis for the proposition that the said amounts were not incurred by the appellant for the purpose of earning income. The raw land could not have been sold as developed land without having incurred the expenses of developing it. There is no evidence in the appellant’s financial statements of any expenditures directly related to the development of the land other than the accrued liabilities in 1974 and 1975. Whether or not they are matched against revenue in the years they were incurred is a principle of accounting and not a principle of law on the basis of which the issue must be decided. Neither paragraph 18(1 )(a) nor any other section of the Income Tax Act requires that expenses incurred to earn income must be matched against revenue in the years in which they were incurred.

I am of the opinion that the accrued bonuses were properly deductible in each of the years 1974 and 1975 and since they were not paid in the said years, they were duly added to the appellant’s income for the 1976 and 1977 taxation years, pursuant to subsection 78(3) of the Act.

The respondent’s last contention that the accrued bonuses were not expenses to earn income but were in fact reserves was totally unsupported and indeed the nature of the amounts appears to me to be contrary to what is generally accepted as constituting reserves.

For these reasons, judgment will go allowing the appeal of Carling Realty Company Limited and referring the matter back to the Minister for reassessment on the basis that the amounts of $515,000 and $485,000 claimed as expenses incurred to earn income were properly deductible in the 1974 and 1975 taxation years respectively. The appeal is dismissed in all other respects. The appeal in Jack Aaron and Company Limited is therefore dismissed accordingly.

Appeal allowed in part.