Totem Disposal Co LTD v. Minister of National Revenue, [1981] CTC 2547, 81 DTC 493

D E Taylor:—This is an appeal heard in the City of Vancouver, British Columbia, on May 6, 1981 against an income tax assessment for the year 1976 in which the Minister of National Revenue disallowed as an expense an amount of $100,000 claimed as part of the remuneration for management salary. In assessing, the respondent relied, inter alia, upon paragraphs 18(1)(a), (e), subsections 78(3) and 245(1) of the Income Tax Act, SC 1970- 71-72, c 63, as amended.

Contentions

For the appellant:

— Prior to the end of its 1976 taxation year, the appellant and its principal employee and shareholder, Mr Ted Easton (“Easton”) agreed that the appellant would pay Easton additional management remuneration in the amount of $110,000 in respect of the 1976 taxation year.

— In computing income for its fiscal period ending December 31, 1976 the appellant deducted the amount of its liability as an expense.

— Towards the end of its 1977 taxation year Easton agreed to forgive or waive payment of the additional remuneration to the extent of $100,000.

— In the 1977 taxation year the appellant paid Easton the management remuneration in the reduced amount of $10,000 and the portion forgiven in the amount of $100,000 was added to the appellant’s income for the said taxation year.

— The appellant, in its 1976 taxation year, entered into an unconditional oral contract with Easton to pay him management remuneration of $110,000 for services rendered by him in the 1976 taxation year and the whole of such amount was an expense incurred by the Appellant in its 1976 taxation year for the purposes of gaining or producing income from a business within the meaning of paragraph 18(1 )(a) of the Income Tax Act, S.C. 1970-71, c. 63.

— At no time in the 1976 taxation year was the liability of the appellant to pay the sum of $110,000 to Easton subject to a contingency of any nature of kind whatsoever and at all material times its obligation to pay was absolute and unconditional with the result that the whole of the amount was deductible in computing income for the 1976 taxation year.

Certain other views which are enlightening were also expressed by the appellant in filing the earlier notice of objection to the assessment:

— While no formal documentation was undertaken, the company is owned 100% by the recipient of the management bonuses and he felt that formal agreements were not required to document the decision to pay such bonuses. Under Common Law, a verbal understanding can still represent an enforceable claim as long as the parties have reached an agreement.

— The financial situation during 1977 developed to the point that it became more advantageous tax wise for the taxpayer not to pay the bonus and an understanding was reached with management to pay only $10,000 of the $110,000 bonus. Accordingly the unpaid balance was added back to income during 1977.

— The decision not to pay the balance of the bonus was not based upon any inability of the company to pay the bonus and in fact the company loaned the manager/owner in excess of $200,000 during 1977 and they had short term investments at all times in excess of $200,000.

— Section 78(3) which deals with unpaid remuneration allows a taxpayer who has not paid salaries or wages in the first year following the year the expense was incurred, to include this amount in its income in the second year following the expense being incurred. Therefore if the taxpayer had not reversed the unpaid bonus liability at the end of 1977, (it) would have added the amount into their 1978 income. In this event the taxpayer would not have been disallowed the expense in 1976 as has been the treatment given by Revenue Canada. We therefore contend that the specific treatment allowed under 78(3) should not be denied to the taxpayer, by disallowing the claim for expense in 1976.

For the respondent:

— The amount of $100,000* was set up as a liability and deducted as an expense in order to reduce the total amount of taxes payable by the appellant: (*The amount at issue in the appeal, the total was $110,000)

— There was no contract or agreement between the appellant and the persons to whom the alleged bonus was owing and a bonus would be paid;

— There was no contract of employment between the appellant and any person who was within the management category requiring the payment of the stated bonus;

— With respect to the bonuses no expense was made or incurred for the purpose of gaining and producing income for the businesses;

— The claim of the bonus expense, if it has been found to have been made or incurred unduly or artificially reduces the income of the appellant;

— The appellant did not intend to create a legal obligation to pay the bonuses;

— The claim of bonus payable as an expense was in effect a reserve which is not permitted by the Income Tax Act.

Evidence

Mr Edward R Easton, president of the appellant company, and Mr David Staley, CA, of Smith, Flynn, Staley & Co, testified for the appellant. In general that testimony substantiated the important background described by both the appellant and the respondent in the documentation. However, there were certain critical factors introduced:

— the financial statements for previous years indicated a similar process of “bonus” accrual had regularly taken place;

the 1976 financial statements showed in part:

— Mr Staley noted that it was the business policy of his firm that clients reduce corporate profits by the utilization of such accrued management bonuses where and when it was advantageous, so that such an accrual would bring the net taxable profit from active business below the small business limit. In 1976, that limit was $150,000 and since the $150,936 (Gain on sale of fixed assets) above did not enter into the calculation for tax purposes, the net income of the company for the year 1976 had been effectively reduced below the small business limit by the accrued management bonus of $110,000.

— In exactly the same way (but with the reverse result), the 1977 financial statements had been affected by the reversal of the $100,000 and its inclusion in 1977 corporate taxable income.

— The effect in both years according to Mr Staley was to utilize to the maximum the small business limit for corporate taxpayers. He was direct and candid about the objective, and regarded it as both appropriate accounting and good tax planning.

— Mr Staley presented working papers and statements from his office files that supported the contention of the appellant that both transactions under review (the accrual in 1976, and the reversal in 1977) had been carefully examined, discussed and calculated. They were not simply the result of an extraordinary or sudden decision, and recorded by journal entry without any previous thought or consideration.

— Mr Easton pointed out that he relied upon the advice and expertise of his accountants.

Argument

The Board takes the opportunity to quote extensively from the capable argument of both counsel:

For the appellant:

. . . the issue in this case can be relatively simply stated, and that really is whether or not the amount which was accrued as the bonus of $110,000 at December 31, 1976 was a deductible outlay or expense, as in the meaning of 18(1)(a) of the Act. In my submission, section 78 has nothing to do with this decision. I concur in your statement earlier this morning that one must find as a precondition to the operation of section 78, that the amount in respect of which the deduction was made was, in fact, a deductible outlay or expense.

Having said that, all section 78 does is place a timing limit on the extent or time frame within which the amount may remain unpaid before it becomes taxable in the hands of another party. . . But, quite clearly, you must find first of all that the expense is deductible in computing income. And in my respectful submission, the facts in this case very much support the view that the accrual made at the end of

December 1976 was in fact a deductible outlay or expense.

In order to find that there was a deductible outlay, one must first of all find that there was a compensation package to which Mr. Easton was, and the company were both parties, which provided for the payment of remuneration to him really consisting of two portions; one was the base salary, which was drawn throughout the year, the other was the profit in excess of the small business limit for the year

. . . the question of reasonableness doesn't really arise . . . The Crown has not pleaded it; nowhere in its reply is any reference to the reasonableness or otherwise of this amount contained.

My simple question is, what happened between 1976 and the end of 1977 that suddenly makes the accrual of the $100,000 amount at the end of December 1976 an error, or something which is not to be permitted as a deduction . . . if there is evidence of a contractual arrangement, as there is through the evidence of these two witnesses, it cannot then follow, in my respectful submission, that the amount can be anything but deductible.

Now, I would respectfully submit that you should find . . . that the contract of employment between the appellant and Easton provided for the payment in the

1976 year of salary comprised of a base amount plus an amount equal to the excess of net income after the base salary, and less the amount eligible for the small business deduction in the year. That, I would respectfully submit, was the contractual arrangement between the two. If you cannot accede to that view, then obviously the appeal must be dismissed. But if you can accede to that view . . . the answer is that the amount has become deductible. And the fact that circumstances change, and the amount is waived in a subsequent year, is an entirely independent transaction. We’re not looking at what happened in 1977, except insofar as it may offer evidence, or some evidence, as to what the real nature of the transaction in 1976 was.

Now, I would like to refer to you . . . the case of G W Dorman Pulp Chip Company Ltd v MNR, [1981 ] CTC 2005; 81 DTC 21], and I have provided you, Mr Chairman, with a copy of the reasons, but basically or essentially, the background was this: the evidence in that case was that a bonus for the 1973 year had been discussed in the fall of 1973, and there was a resolution passed in early 1974, by the

Directors approving of that payment, or that accrual. There was no evidence whatsoever of any management bonus having been paid to any person in the employ of G. W. Dorman prior to the 1973 year. There was no evidence from the auditor or the accountant for the company at the time that this bonus was settled upon, Outlining his responsibility or role in the salary determination, nor confirming the extent of the discussions which had been held in 1973.

And the auditor of the . . . or the accountant for the company at the time of the appeal testified that as far as he was aware, there was no annual custom with

respect to bonuses, or there was no custom in the company, no arrangement In the company, or understanding, with respect to the payment of bonuses.

. . . at one point during that proceeding, the president of the company had indicated that there was a good profit that year and he felt he should have part of it, and that’s really the basis upon which the amount, or the determination to pay a

bonus was actually made.

Now, from your comments this morning, Mr. Chairman, I perceive that one of the things that’s bothering you is the question of the propriety of centering tax

planning around a small business deduction, and indeed entering into management compensation packages which are calculated to some extent by reference to the income tax results which would flow to the company if such arrangements

were not concluded.

Now, I would like to refer you. . . to the Massey-Ferguson case, [1977] CTC 6), which is a decision of the Federal Court of Appeal, and it’s relevant in these proceedings, I think, not because of the issue that’s raised in it, but because of the reasoning of the Federal Court of Appeal which, I think, more accurately than any other case of which I am aware, states the present law with respect to the capacity of the taxpayer to plan his affairs in the most advantageous manner possible.

Here we’ve admitted that the reason why we wanted to conclude this contractual arrangement was to avoid having money taxed at the high business rate. There’s nothing in the Income Tax Act that says you have to keep it there so the Minister can take the greatest largest shovel and put in your stores. (Massey- Ferguson (supra)).

The purpose of the small business deduction, the purpose of the dividend gross up in tax credit rules, the purpose of the Part IV refundable tax, the purpose of special rates of tax on investment income and on capital dividends accounts, or Capital gains, were all designed to try to integrate .. . the tax costs, or the tax relationships, if one might call them that, between companies and their principal or key shareholders, and the idea was that one should not be unduly advantaged or disadvantaged by virtue of the fact that he chose to carry on a closely held private corporation’s business in a corporate form, rather than doing it in his own name as a proprietor, or in partnership with another individual.

And the whole purpose of all of those early rules, dealing with the low rate of tax on the first $150,000 of income as it is now, or the small business rate, the idea of the cumulative deduction account, the fact that it could be restored by making distributions of surplus to shareholders, the idea of the corporation being entitled to a refund of a portion of its tax upon paying dividends, making distributions to shareholders, was designed for one purpose, in my respectful submission, and that was to secure the unity of the tax system so that there was no advantage or disadvantage attaching to small closely held corporations of the kind that we’re concerned with today, by virtue of a shareholder having chosen to use a corporate form of activity rather than continuing to carry on as a proprietor.

. . . Many (tax) advisors plan the distribution of the income which is earned from year to year, precisely on the basis of what is happening as between the shareholder’s rates of tax. . . .

. . . there is nothing that requires a taxpayer to organize his affairs so that he subsidizes or pays as much tax as he possibly can pay.

. . . it’s not only good tax planning, but it’s good economic sense to plan your affairs so that you don’t pay more tax than the Income Tax Act is legitimately and lawfully able to extract from you.

The price of doing that planning is that you must put your affairs in order so that you do create the contractual arrangements, and so that you do follow the rules that are set out in the Act. Having done that, one cannot, in any sense, in my respectful submission, be offended by the fact that less tax is being paid rather than more.

The last question I’d like to address . . . is the question of what about this “add back” in the 1977 year? In my respectful submission, it is unfair to draw the conclusion or the inference form that fact that there was no intention to pay a bonus, or to pay the amount which had been accrued at December 31, 1976. You have heard the evidence of Mr. Staley, and I think, I would hope that you would concur, in my view, that Mr. Staley would do only what he construed to be legitimately proper in accordance with both the Income Tax Act and generally accepted accounting principles, and his evidence . . . was the when it became apparent to him that there was some advantage to the corporation, is the way I think he described it, to be gained, by effectively waiving and not having payment made to Mr. Easton of that $100,000 amount, he recommended to Mr. Easton that that waiver in fact be made. And having done so, he then felt that it was improper for him to continue to show the amount as being payable on the books of the company in the 1977 year end.

. . . but the Department seems to read into the fact that because he didn't pay it, he never had the intention to pay it in the first place, and that is just a narrow and, in my respectful submission, improper view when (you have) regard to all of the evidence surrounding the determination and the accrual of that bonus.

For the respondent:

. . . the Minister is taking a very initial position here, this so-called accrued management bonus was not deductible under section18(1)(a) in that it was not an outlay or expense incurred, with the emphasis incurred, for the purposes of gaining or producing income within the meaning of that subsection. Now . . . I agree with my learned friend, the only way he’s going to get within section 18(1 )(a) and have it considered an outlay or expense incurred in that year, and for the purposes of gaining or producing income, is to have the Board consider this amount as remuneration, whether we call it salary or bonus, but remuneration for services paid. And . . . remuneration for services rendered. And I think if he can convince you to that, I would probably be the first to agree that on a jurisprudence as we have it before us, you would probably then have to make the finding that it was an expense or outlay.

. . . (However) I say that even if you do find that it’s an outlay or expense incurred in that year, and comes within the ambit of 18(1)(a), I think then my learned friend has to get past section 18(1 )(e) which deals with a reserve section, and then assuming that he even gets past that, I think he has a further hurdle of getting past section 245(1).

. . . the sole purpose for setting up this management bonus was to take advantage of the low rate of corporate tax, after using the small business deduction limit . . . I would say, first of all, there were never any bonuses paid by way of bonuses or salary in any year previous to 1975. In 1975, a bonus was paid, but it was paid, it wasn't accrued. It was paid as a bonus in 1975. All of a sudden, in 1976, we get an accrual of a bonus and it’s not paid out in 1977. Now, the very strange thing (is), instead of relying on section 78 and the timing of that particular section, to bring it back into income in 1978, the taxpayer’s accountant decides to put it back in the 1977, and I submit the reason is quite obvious. The reason . . . is, (the) accountant

(was) looking after the interests of (a) client, (he) put it back into ’77, which was a bad profit year, a very low profit year.

. . . what we have here is someone declaring a management bonus basically on the basis of not whether services were rendered or any other thing, or the reasonableness of it, but solely on the basis of bringing the profit up to the small business limit, whatever it be, 50,000, 100,000 or 150,000. Bring the profit up to there, and the rest would be accrued as a management bonus. And that’s the sole purpose. The tax saving is obvious.

Findings

The Board refers to the recent decision in Brazolot Construction Limited v MNR, [1981] CTC 2468 and emphasizes the similarity of this appeal in most aspects. Indeed, the documentation, supporting evidence and testimony in the instant appeal provide very strong grounds upon which to conclude that the amount of $110,000 accrued in 1976 was reasonable, was earned, and was salary, in short that it was an “expense”. The basic conditions outlined in McClain Industries of Canada, Inc v Her Majesty the Queen, [1978] CTC 511; 78 DTC 6356; and in G W Dorman Pulp Chip Company Ltd v MNR, [1981] CTC 2005; 81 DTC 18, would appear to be fulfilled. In Brazolot (supra), it was noted that the result of the accrual in question was to take full advantage of corporate tax rates, but that was not put forward as an objective of the accrual. The coincidence of this situation warranted a particular remark in that decision. There was no evidence in Brazolot upon which to conclude that the calculation of the amount involved was determined by reducing the corporate income to the small business deduction limit. In the instant appeal, there is an ironic but major distinction from Bra- zolot (supra). The Company policy in Totem was to accrue to the credit of the president all of the corporation income over the small corporation low tax limit, and that is precisely what was done in 1976 when the gross amount of $110,000 was set up. The taxable profit of the corporation for purposes of the small business deduction was reduced to approximately $150,000 by this action. In my view, it is clear that the primary purpose of the accrual was tax reduction, and that the amount accrued to the credit of the president was incidental to that purpose, not primarily an appropriate remuneration for services rendered. I am aware that this is a fine distinction to make from Brazolot (supra), but I can reach no other conclusion. Paragraph 18(1 )(a) of the Income Tax Act does not permit deductiblity merely because the amount can be characterized as an expense. In fact, paragraph 18(1)(a) does not permit any deductions, it prohibits them, except under a specific condition. That condition is that the purpose of the expense is “to gain or produce income”.

As I understand the term “income” in paragrpah 18(1 )(a) is the profit (net income) of the company as reflected in subsection 9(1) of the Act. The “salary accrual policy” of the company ensured that the profit of the company was restricted to the limit determined by the small business low corporation rate of tax. Crediting to the president any amount (whether $110 or $110,000) could not gain or produce more net income for the company. There is no evidence that the anticipation of the accrual motivated the president to produce the first $150,000 in corporate income, or that the company would not have made that amount of net income without the alleged incentive. The “heightened efforts” of the president might increase sales but it could not have any effect on income.

Summary

The appellant company’s business policy of limiting its net income to the amount taxable at low rates for small business, and crediting any excess earnings to the president as accrued management salary is the basic argument put forward in this appeal for the deductibility of the amount in question. That policy was followed in 1976, an amount of $110,000 was set up as an expense for that fiscal year. During 1977, $10,000 of this amount was paid to the president, and the Minister has not challenged the deductibility of that part of it. The Board makes no further comment on that aspect of the amount. As for the balance of the $100,000, it is the Board’s decision that the purpose of the accrual was for tax reduction, or tax planning as it may be termed in the interest of the appellant company, and not for the purpose of gaining or producing income for the appellant company.

In the recent judgment of the Federal Court of Appeal in Stubart Investments Limited v The Queen, [1981] CTC 168, 81 DTC 5120, the issue was not one of deductibility of an expense but rather the write-off of losses. However, in Stubart the purpose of the exercise was tax reduction (as it has also been determined to be in this instant case), and a special factor then became critical — did the actions taken by the appellant accomplish and complete that which they were intended or designed to effect? It is difficult to feature a situation in which an expense incurred for the purpose of tax reduction could meet the conditions for deductibility under paragraph 18(1)(a) of the Act, but it is clear from Stubart (supra) that a detailed examination of the documentation and process involved would be in order, and that in a case such as the instant one, perhaps only payment would be sufficient to complete the transaction.

Decision

The appeal is dismissed.

Appeal dismissed.