V R Enterprises Limited v. Minister of National Revenue, [1974] CTC 2099

The Assistant Chairman:—This is the appeal of V R Enterprises Limited from income tax assessments in respect of the 1968, 1969 and 1970 taxation years.

The issue in this appeal is whether certain salaries established and accrued to the appellant’s officers in the taxation years pertinent to this appeal were properly accrued in accordance with paragraph 18(3)(a) of the Income Tax Act and whether these amounts are deductible in computing the appellant’s income in those years.

The officers and directors of the appellant were at the time pertinent to the appeal as follows:

The appellant was engaged in a relatively small machine tool business which employed a warehouseman, a salesman, a delivery boy, a part-time secretary and a part-time bookkeeper. The accounting and auditing for the company was done by Mr Coleman Friedman, CA since 1966. Mr Rhodes’ assignment was declared to be the overall management of the company for which he received an annual salary of $15,000. Mrs Rhodes acted as controller looking after the accounts, for which she received an annual salary of $10,000. Mr Otto Hermann, described as an expert in cutting-tools, did not receive a regular salary from the appellant but was in fact an employee of V R Wesson Ltd (Carbide) through whom the appellant purchased products for resale. Mr Hermann is claimed, notwithstanding his employment with V R Wesson Ltd, to have rendered services to the appellant.

The practice of accruing salaries was followed since the beginning of the appellant’s operation in 1962 and was based on the cash flow of the company. It was alleged that the line of. credit permitted the company was limited and, since considerable finances were required in the acquisition of machinery for resale, the accrued salaries were paid only when a sufficient cash flow existed.

Although there are no records to substantiate the claim, it was stated that a meeting of the directors was held at the end of each fiscal year to establish an amount of so-called management salaries accruing to each officer, over and above the aforesaid regular annual salaries, on the basis of profits for a particular year and the services performed by them in that year.

Pertinent to this appeal in the 1968 taxation year, the following officers’ salaries were established and accrued:

On December 31, 1969 the officers’ salaries for 1968 were paid as follows:

The remaining amount of $12,000 of the 1968 accrued salaries was retained and included in the appellant’s taxable income for 1970 and charged as follows:

The officers’ salaries accrued in 1969 in the amount of $12,000 were not paid to these officers but were included in the appellant’s taxable income for its 1971 taxation year and charged as follows:

The 1970 accrued salaries were paid to the officers as follows:

The remaining $5,000 accrued salary to Otto Hermann was included in the appellant’s taxable income for its 1972 taxation year and charged to Otto Hermann.

The Minister’s reassessments of the above-mentioned accrued salaries for the years 1968, 1969 and 1970 are somewhat complicated and unclear.

In 1968 the appellant’s reported net

taxable income was as per assessment

	notice	$34,103.25
Assessment In assessing appellant’s 1968 taxation
of Aug. 25, year, the respondent disallowed initially
1972	an amount of	12,000.00
	and assessed appellant on a net taxable
	income of...	$46,103.25
	Appellant objected, claiming that respon
	dent’s allegation that the $12,000.00 was
	not for accrued salaries as at Dec. 31,
	1968, but in fact a “reserve”, was un
	founded.
Assessment Respondent ignored this objection and
of May 11, reassessed the appellant on May 11,
1973	1973. This time the respondent decided
	to disallow not only the $12,000.00, but
	the entire amount of accrued salaries
	of . . .	$42,000.00
	Because $12,000.00 had already been
	disallowed, this amount was added back	(12,000,00)
	The result was	$76,103.25
	In assessing appellant’s 1969 taxation
	year, the following adjustments were
	made—
	Reported Income	$30,849.00
Assessment Add back accrued salaries set up as at
of Aug. 25, Dec. 31, 1969		12,000.00
1972
		$42,849.00
	The appellant objected, whereupon res
	pondent decreased the previous amount
	of taxable Income by deducting—

Assessment

Accrued amounts as at Dec. 31, 1969

of May 11,

$12,000.00

1973

“Amount

paid

from

that

amount

pre-

viously

accrued”

$30,000.00 $42,000.00

$849.00

It is difficult to know what the assessor

meant by the last “explanation”. He pre

sumably

learned

that

$30,000.00

was

actually paid in

1969

and considered it

an expense for that year. To complicate

matters even more, the assessor added

back an accrued amount previously dis

allowed

$12,000.00

Why

he

added

to

Income

an

amount

which he had already disallowed is not

clear.

$12,849.00

In

assessing

appellant’s

1970

taxation

year, the adjustments were as follows:

Assessment

Reported taxable income

30,368.00

of Aug. 25,

Deduct: the add-back of accrued accts.

1972

of Dec. 31,

1968

12,000.00

18,368.00

Add:

accrued

salaries

as

at

Dec.

31/70

considered

to

be

a

reserve

5,000.00

$23,368.00

In support of his appeal, counsel for the appellant contends that, having complied precisely with the procedure described in subsection 18(3), all the amounts established as accrued salaries for the appellant’s officers in the years 1968, 1969 and 1970 were properly accrued and are deductible in the year in which they were incurred. The respondent, on the other hand, contends that none of the amounts established as accrued salaries in the pertinent years is deductible on the ground that these amounts were not expenses incurred by the appellant for the purpose of gaining or producing income from the business in those taxation years pursuant to paragraph 12(1)(a) of the Income Tax Act. Alternatively, the respondent contends that the deduction of the said accrued amounts would unduly or artificially reduce the appellant’s income and would be contrary to the provisions of subsection 137(1) of the Act.

Paragraph 18(3)(a) of the Income Tax Act reads:

18. (3) Unpaid remuneration.—Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer to a person as salary, wages or other remuneration in respect of an office or employment Is unpaid at the end of the first taxation year following the taxation year in which the outlay or expense was incurred, either

(a) the amount so unpaid shall be included in computing the taxpayer’s Income for the second taxation year following the taxation year in which the outlay or expense was incurred, or

Before subsection 18(3) can be considered as applicable, we must ascertain that we are dealing with a deductible outlay or expense. A bona fide salary would no doubt be a deductible expense within the meaning of subsection 18(3) but an amount of money paid to a person is not necessarily a salary simply because one chooses to call it that. In my opinion, the facts of this appeal indicate that the payments made or accrued to the appellant’s officers which are the subject of this appeal are more in the nature of “bonuses” rather than “salaries”.

Even though salaries and bonuses may sometimes be used interchangeably, I do not believe that all bonuses are deductible expenses. Before a bonus can be considered as an integral part of salary and a deductible expense, it must, in my view, meet certain criteria. Some of the criteria would be:

1. The amount of bonuses paid or accrued must be reasonable in comparison with the profit earned by the company and the services rendered by the recipients.

2. The services for which the bonuses are paid must be real and identifiable.

3. Though the quantum of the bonuses, which are usually based on the amount of profit realized by a corporation, need not necessarily be precisely determined beforehand, there must be some justification for expecting an amount of income over and above the regular yearly salary.

4. There must be some relationship between the bonuses paid or accrued and the income earned or to be earned at least in the form of a well-established and well-known incentive.

5. Bonuses to be paid or accrued in a particular year must be established within a reasonable time from the moment the corporation’s profit for that year has been determined.

Although there are, no doubt, other applicable criteria, it would seem to me that bonuses that do not meet these criteria would simply be a profit-sharing arrangement having no connection with the earning of income and would therefore not be considered as deductible outlays or expenses.

In 1968 the amounts of $20,000, $12,000 and $10,000 in accrued salaries to Mr Rhodes, Mrs Rhodes and Mr Hermann respectively are, in my opinion, reasonable allocations in comparison with the company’s net retained earnings of $108,925 for that year. In 1969 the amounts of $5,000, $2,000 and $5,000 in accrued salaries to Mr Rhodes, Mrs Rhodes and Mr Hermann respectively are reasonable allocations in comparison with the company’s net retained earnings of $133,603 for 1969. In 1970 the amounts of $15,000, $10,000 and $5,000 in accrued salaries to Mr Rhodes, Mrs Rhodes and Mr Hermann respectively were reasonable allocations in comparison with the company’s net retained earnings of $156,791 for 1970.

Mr Rhodes was general manager of the appellant corporation, Mrs Rhodes was the controller and Mr Hermann, though an employee of V R Wesson Ltd, rendered services to the appellant in its day-to-day operations.

It has been the practice of the appellant corporation, which was on an accrual system of accounting, to give accrued salaries or bonuses to officers since 1962, ‘and this constituted, for the purpose of earning income, an established and known incentive. The accrued salaries or bonuses to. the officers were determined within. a reasonable time necessary to ascertain the profit realized by the appellant in the pertinent years.

- am satisfied from these facts that the salaries or bonuses allocated to the officers of the appellant were incurred as expenses to earn income and therefore deductible. I do not believe that the accrued salaries were so allocated for the purpose of unduly or artificially reducing the appellant’s income. As to the Minister’s assessments of the accrued salaries in the years pertinent to this appeal, there is no doubt that the system of setting up accrued liabilities is an accepted accounting procedure and subsection 18(3) confirms this practice by stating special provisions as to how the accrual of remunerations should be dealt with.

It seems to me that the whole purpose and intent of subsection 18(3) of the Income Tax Act is to permit the deduction of accrued salaries in the year in which they were incurred. If, after a period of two years, the accrued salaries, or part thereof, remain unpaid then the unpaid accrued salaries must be returned to the corporation’s income, at which time the amounts so returned become taxable. However, the paid accrued salaries are deductible in the year they were incurred and accrued.

The appellant contends that he has complied with subsection 18(3) to the letter and points out that:

In the light of Section 18(3) there seems to be no reason for a reassessment of the 1968 taxable income and even less reason for the respondent to disallow the total amount of $42,000.00 as the respondent did in that year.

(b) In 1969 an amount of $12,000.00 for salaries was charged as an expense and unpaid as at the year end. The amount was not paid in 1970 and therefore added to taxable income of the 1971 taxation year.

(c) In 1970, $30,000.00 was charged as an expense and unpaid as at the year end. The next following year $25,000.00 of this amount was paid and $5,000.00 was added back to income in the 1972 taxation year.

In 1968 the respondent disallowed 100% of the accrued salaries. For 1969 he also disallowed 100% of the accrued salaries in the amount of $12,000.00 but allowed an additional deduction of $30,000.00 which was In fact the payment of part of the accrued salaries on December 31, 1968.

In 1970 the respondent again disallowed the accrued liabilities.

It appears that the respondent completely ignored the provisions of subsection 18(3) and refused to accept the validity of the accrued expenses in 1968, 1969 and 1970, and considered as expenses deductible in the year in which they were paid only those amounts actually paid to the appellant’s officers.

However, in my view, the respondent did not present any evidence which could justify his setting aside the provisions of subsection 18(3) which were scrupulously followed by the appellant; nor is there anything in the facts. of this appeal which might indicate that the accrued salaries. were false or unreasonable, or that they were so allocated to the officers of the appellant so as to artificially reduce the corporation’s income in those years.

I hold therefore that the appellant’s 1968, 1969 and 1970 taxation years were wrongly assessed by the Minister in that the provisions of subsection 18(3) of the Income Tax Act are applicable to the facts of this appeal. Consequently, the appeal is allowed.

Appeal allowed.