Walter K Mis v. Minister of National Revenue, [1979] CTC 2156, 79 DTC 162

The Chairman:—These are the appeals of Walter K Mis from income tax assessments in respect of the 1972 and 1973 taxation years.

With reference to the said taxation years, the Minister, in his replies to the notices of appeal, states in part:

3. The appellant in filing his 1972 individual income tax return reported $21,908.32 as the proceeds of disposal of his partnership interest, and $25,804.71 as the adjusted cost base, for a capital loss of $3,896.39 of which he claimed $1,000 as his allowable capital loss for 1972. On his 1973 individual income tax return, the appellant claimed the allowable balance carried forward of $948.20.

4. By notice of reassessment dated April 25, 1975, the Minister of National Revenue reassessed the appellant to effect the following two adjustments:

(1) an adjustment to the capital loss on the disposal of the appellant’s partnership interest in that proceeds of disposal were assessed as $22,619.82 as compared to the appellant’s declared amount of $21,908.32, a difference of $711.50; and that this adjustment reduced the allowable capital loss carried forward from 1972 from $948.20 to $592.45, a difference of $355.75. This adjustment did not change the actual dollar amount of taxable income in that the appellant had claimed the maximum allowable capital loss of $1,000 for 1972, but it did effect the allowable net capital loss carried forward for 1973 from $948.20 to $592.45.

(2) an adjustment in respect of the amount of $7,481.57 which amount was added to the appellant’s 1972 income as his share of 1971 accounts receivable and brought into income pursuant to income tax application rule 23.

6. In reassessing the appellant for his 1972 taxation year, the respondent assumed, inter alia:

(a) that the calculation of the total capital loss on disposition of the partner interest was correctly calculated in that the proceeds of disposal of the partnership interest was the amount of $22,619.82 as compared to the declared amount of $21,908.32 and that this gave rise to allowable capital loss of $1,592.45 and Since the appellant claimed the maximum $1,000 his allowable capital loss for 1972, then the capital loss that could be carried forward for 1973 was the amount of $592.45.

(b) that the amount of $7,481.57 was the amount of 1971 receivables allocated as the appellant’s share of the accounts receivable at June 30, 1971 of the law firm of Milner & Steer.

(c) that in determining his income from his professional business the appellant should have made the following calculations:

Net income per financial statement	$23,524.34
Add: Pursuant to paragraph 23(3)(c) the amount
deducted under paragraph 23(3)(a) in computing
income from the business for the immediately
preceding tax year.	$ 7,481.57
Deduct: Pursuant to paragraph 23(3)(a) the lesser of
(i) the amount deducted under paragraph 23(3)(a)
in computing income from the business for the
immediately preceding taxation year, and	$7,481.57
(ii) his investment interest in the business at the end
of the year	NIL
	NIL
	$31,005.91

(d) that paragraph 23(3)(b) requires that in the appellant’s 1972 taxation year, the amount to be included for the purpose of computing income pursuant to paragraph 23(3)(c) is an amount equal to the appellant’s 1971 receivables in respect of the business, which amount is $7,481.57.

The Issues

At the hearing counsel for the appellant stated that he was no longer disputing the figures used by the Minister in computing an allowable capital loss of $1,592.45 from proceeds of the sale of the appellant’s interest in a law partnership; $1,000 being claimed in the 1972 taxation year and $592.45 claimed in the 1973 taxation year.

The principal issue, therefore, to be determined is whether the amount of $7,481.57, representing the appellant’s share of the partnership’s 1971 receivables, was properly brought into the appellant’s 1972 income pursuant to Rule 23 of the Income Tax Application Rules, 1971.

The Facts

The facts, as stated by the appellant, are not disputed by the respondent. The appellant purchased an interest in the law firm of Milner & Steer on June 30, 1969, and disposed of that interest on June 30, 1972.

In his notice of objection the appellant referred to Paragraph 10.01 of the partnership agreement between himself and George Steer et al, which provided . . .

that a retiring partner “shall sell” and the continuing partners “must purchase all of the interest of the retiring partner of the new firm of, in and to the new firm, including accounts receivable, work in progress, good will, furniture, fixtures, equipment, books, stationary, other supplies and all other capital and revenue assets of whatsoever nature or kind”, for a price to be determined by the stated formula.

In disposing of his assets in the law firm, the appellant allegedly sustained an allowable capital loss, reassessed by the respondent and subsequently agreed to by the appellant, at a figure of $1,592.45. The appellant stated that the partnership had always computed its income on a cash basis until June of 1972. The appellant’s own income was computed on a cash basis but was adjusted to take into account the conversion to the required modified accrual system of accounting for the 1972 taxation year. At the time the partnership agreement was entered into by the appellant, the provisions contained therein were drafted in the light of the existing cash basis of accounting.

Appellant's Contentions

As his first ground of appeal the appellant contends that the partnership agreement did not envisage nor provide for the accrual basis and that in selling his interest in the partnership he did not expect, nor did he in fact ever receive as part of the proceeds of the sale of his interest, his share of the partnership’s 1971 receivables. The appellant stated that the wording of the partnership agreement precluded him from making any legal claim to the $7,481.57 as his share of the partnership’s 1971 receivables.

The appellant’s second point is that ITAR 23(3)(b), on which the respondent bases his assessment and which is mandatory, is incompatible, leading to a lack of clarity and confusion when read with ITAR 23(3)(a), which is optional. The appellant points out that a charging section must be clear and precise before taxation can be imposed and cites Oriental Bank Corporation v Henry B Wright, 5 App Cas 842.

The appellant adds that ITAR 23 is certainly not clear enough to impose a tax on an amount that has not been received. In argument, the appellant made two alternative submissions.

The appellant’s first alternative point is that if his share of the partnership’s 1971 receivables can be attributed to him as income pursuant to paragraph 23(3)(b), then an equivalent amount should be deducted from his income as a bad debt since the receivables are not, will not and cannot be paid to the appellant.

The second alternative point is based on section 98.1 of the Income Tax Act, SC 1970-71-72, c 63, as amended. The appellant claims that since the last payment on the sale price of his interest in the partnership was made in January of 1978, he is deemed not to have completely disposed of his interest and, therefore, had a residual interest in the partnership in 1972 and consequently had the right to claim a reserve. The appellant concluded that the Minister’s account for the 1972 year cannot stand on that ground.

Minister’s Contentions

With reference to the appellant’s second alternative submission, counsel for the respondent appeared to be unaware that the appellant might have had a residual interest within the meaning of section 98.1 of the Act in the partnership during the taxation years under review. The Minister, in assessing the appellant, assumed that he had no further interest in the partnership. The respondent admitted that if indeed the appellant had a residual interest, he would be entitled to reserve under 23(3) of ITAR. There was some disagreement between counsel as to whether or not the Department of National Revenue had been made aware that the final payment for the appellant’s partnership interest was made only in January of 1978.

This alternative submission made by the appellant at the hearing was not alleged in either the appellant’s notice of objection or in his notice of appeal. The appellant did not seek to amend his notice of appeal accordingly but simply stated as a fact in argument that he had a residual interest in the partnership in the 1972 and 1973 taxation years.

Basing myself on the Supreme Court decision in R W S Johnston v MNR, [1948] CTC 193; 3 DTC 1182, it is open to the appellant to present facts in the course of a hearing other than the assumptions on which the Minister based his assessments. However, the basic rule of not taking the opponent by surprise must be followed and in this instance, would have required the appellant to amend his notice of appeal, at least orally, to include his residual interest as a ground of appeal. The appellant would then, of course, have had the onus of proving to the Board the newly introduced allegation and in my view that cannot be done by simple statement in the course of argument. Other than the appellant’s statement to that effect, no evidence was presented to the Board to establish whether or not the appellant did retain a residual interest in the partnership after June of 1972, and the Board must conclude that that alternative allegation was not satisfactorily established or proven and must be dismissed.

Minister’s Position On Main Issue

The Minister’s general position is that section 34 of the Income Tax Act makes it mandatory for certain taxpayers to change from the cash basis of accounting to the modified accrual basis and that the whole of ITAR 23 spells out the rules and the mathematical formulas to be followed in effecting the change. It is the Minister’s contention that in drafting the legislation, considerable care was taken to deal as equitably as possible with the unavoidable transitional period and to foresee the consequential and far- reaching effect of the change from the cash to the accrual bases or other related aspects of the taxpayer’s reported income.

Counsel for the respondent, though not disputing the fact that the appellant did not receive his share of the partnership’s 1971 receivables, claims that the appellant nevertheless benefitted from the 1971 receivables which were taken into account in arriving at the adjusted cost basis of his interest in the partnership as at December 31, 1971.

Counsel referred to Form 12065 filed by the appellant with his 1972 tax return which indicates that the deemed cost of the partnership to the ap- pellant was $26,521.93, which takes into account the appellant’s share of the 1971 receivables.

Counsel for the respondent also referred to a chart prepared for the law firm, Milner & Steer representing the calculations of the figures used in Form T2065-1972. The chart indicates, among other things, that the cost figure of $26,521.93 used was the tax equity value which takes into account the appellant’s share of the 1971 partnership receivables. All the calculations included in Form T2065 and the chart are made according to certain rules laid down in the Income Tax Application Rules. Counsel for the respondent points out that in arriving at a calculated cost of $26,521.93 for his partnership interest by taking into account the amount attributable to him as his share of the partnership’s receivables, the appellant was able to claim a capital loss which indeed he did in the amount $1,592.45. Counsel argues that the appellant cannot have it both ways. Having used the receivables in arriving at the adjusted cost base of his partnership interest, he must, pursuant to ITAR 23(3)(b), include them in his 1972 income.

Finding of Facts

I have no difficulty in agreeing with counsel for the respondent as to the intent and indeed the wording of ITAR 23 and I am in complete accord with the statement of Mr Justice Collier in the Federal Court, Trial Division decision in Richard Robert Easton v Her Majesty the Queen, [1976] CTC 285; 76 DTC 6174, where he states that “there is no ambiguity, or gaps, in section 23”. I believe that the wording of ITAR 23 is clear and its aim to enforce the use of a modified accrual basis of accounting is evident. The prescribed forms, mathematical formulas, the options, the reserves, etc, have been written into the Income Tax Act to facilitate the change-over while ensuring that all income received by a taxpayer before and during the transitional period be reported and all tax eventually paid thereon.

However, it appears to me that ITAR 23(3)(b) is predicated on the assumption that the 1971 receivables to be included in the taxpayer’s 1972 income must indeed be receivable by the taxpayer. The facts in this appeal are, in my view, radically different from those in the Easton (supra) case where the 1971 receivables were in fact received by the taxpayer, whereas in the present instance, the partnership agreement specified that the receivables were not included in the sale of the appellant’s interest in the partnership, and the appellant, at no time, received his share of the partnership’s 1971 receivables. This fact is admitted by the respondent.

It appears to be the respondent’s position, that although it led to unfortunate results, the law firm’s accountants should not, in the circumstances, have made any allocation of the partnership’s 1971 receivables to the appellant. That, in the circumstances as I see them, would probably have been the correct accounting of the facts. It would be most unrealistic to ignore the fact that in June of 1972 there was general confusion as to the application of the new Income Tax Act and the Income Tax Application Rules, and rule 23 was no exception. In this instance, I do not believe that an accounting error can be used as a proper basis for an assessment.

(5) In this section, . . .

(c) “1971 receivables’’ in respect of a business of a taxpayer means the aggregate of . ..

(ii) the aggregate of amounts each of which is an amount, in respect of each partnership by means of which the taxpayer carried on that business before 1972, equal to such portion of the aggregate that would be determined under subparagraph (i) in respect of the partnership, if the references therein to “the taxpayer” were read as references to “the partnership”, as is designated by the taxpayer in his return of income under Part I of the amended Act for the year to be attributable to him, except that where the aggregate of the portions so designated by all members of the partnership is less than the aggregate that would be so determined under subparagraph (i) in respect of the partnership, the Minister may designate the portion of that aggregate that is attributable to the taxpayer, in which case the portion so designated by the Minister in respect of the taxpayer shall be deemed to be the portion so designated by the taxpayer.

For the 1971 taxation year, the appellant was a member of the partnership and had he not sold his interest, he would normally have had attributed to him his share of the receivables for that year. Moreover, the Minister reserved his right to make the proper allocation if a taxpayer failed to do so. In the circumstances, an accountant might well have decided to record in 1972, the appellant’s allocation of receivables as it appeared in 1971. However, I do not believe, because the appellant was recorded as having an allocation of $7,481.57 as his share of the 1971 receivables, that no further consideration should be given to the partnership agreement which specifically excludes the receivables from the sale price of the appellant’s interest, nor can I ignore that the appellant had no legal right to the receivables in 1972 and that the respondent admits that the appellant never received them. In my view, both the wording and the intent of ITAR 23(3)(b) do not apply to the facts of the instant appeal and the amount of $7,481.57 should not have been added to the appellant’s 1972 income because it is not an amount equal to the appellant’s 1971 receivables. At the time of the sale, the appellant’s share of the partnership’s 1971 receivables was nil. It must be noted that the application of ITAR 23(3)(b) is retroactive in nature.

It would, in my view, be contrary to basic taxing principles to tax as income an amount that was never received. However, it is equally inequitable for the appellant to include in any computations of his 1972 income, an amount other than zero as his share of the partnership’s 1971 receivables.

Having reached my decision on the principal issue in this appeal, I do not find it necessary to comment on the other points raised by the appellant as grounds for appeal.

Decision

The appeals are allowed in part and the matter referred back to the Minister for reassessment on the basis that the amount of $7,481.57 was not the amount equal to the appellant’s share of the partnership’s 1971 receivables and should not be added to the appellant’s 1972 income and that the appellant’s share of the partnership’s 1971 receivables was nil and should be considered as such in any computations of the appellant’s 1972 income. The appeals are dismissed in all other respects.

Appeal allowed in part.