Alfred C Huxtable v. Minister of National Revenue, [1974] CTC 2294

Judge K A Flanigan (orally: September 26, 1974):—This is an appeal by Alfred C Huxtable against a reassessment of the Minister of National Revenue for the 1969 taxation year. The appeal arises out of an expense disallowed to a personal corporation, Bedford Investments Limited, the shares of which were owned by the appellant in the year 1969. The deduction was claimed in connection with a reserve for a quadrennial survey originally set up in 1967 by Mr Huxtable as the beneficial shareholder of Bedford Investments Limited when it was known as Newfoundland Canada Steamships Limited.

The facts of the case deal mainly with corporate entities but find their way back to Mr Huxtable in this reassessment by virtue of the fact of the personal corporation.

I am, quite frankly, amazed at the dearth of authorities and cases dealing with quadrennial surveys. None have been cited to me in the course of argument, which has been detailed and well prepared by both parties, and I can only assume that there are no cases directly on this point.

Editorial comments on the sections of the Act (namely, paragraph 11(1)(ea), which permits the reserve, and paragraph 6(1)(eb), which provides for the usual treatment of reserves being brought back into income in the following year), in the respective annotated copies of the Act and in the commentaries that I have looked at, contain no reference to any case law.

The facts briefly are that, in or about 1964, Newfoundland Canada Steamships Limited was an operating company that was purchased by F C Warren Limited through ACH Limited, a personal corporation, the shares in both the last-named companies being owned by the appellant, and the appellant thereby became the beneficial owner of all the shares in what has been referred to as the old Newfoundland Canada Steamships Limited company.

Included in the assets of that company when purchased by Mr Huxtable in the manner aforesaid was a ship or vessel known as “the Bedford Il’. In or about the year 1968, Mr Huxtable decided, for two major reasons, that it would be better to create a shell company and an operating company rather than have all his assets tied up in the old Newfoundland Canada Steamships Limited company because, as he said, some of his competitors were experiencing litigation prob- lems and he was concerned about some $200,000 worth of assets that the old company owned. He thought that if he could create a shell company he would be able, perhaps, to sell the new Newfoundland Canada Steamships Limited company.

Therefore, as of the end of December 1968 the old company changed its name to Bedford Investments Limited and another company was incorporated under the name of Newfoundland Canada Steamships Limited, which I will refer to as “the new company”. It is admitted that Bedford Investments Limited, from and after January 1, 1969, carried on no active business and, for the year in question, was a personal corporation within the meaning of the Income Tax Act.

At the time of the creation of the new company, the assets of the old company, which was now Bedford Investments Limited, were sold to the new company in a non-arm’s length transaction for the sum of about $260,000, as evidenced by the balance sheet filed as appellant’s Exhibit 6. The old company, pursuant to paragraph 11(1)(ea), had completed a quadrennial survey some years before at a cost of $60,000, and, through agreement with the local taxation office, had been using this as the basis for setting up the sum of $15,000 per year as its quadrennial survey reserve.

The Act provides that, in the third year prior to the year of the next survey, one-quarter of the estimated cost may be deducted. in the following year, carrying out the scheme of the Act in dealing with reserves, that sum is brought back into income and one-half of the cost of the survey is allowed in the second year. Then in the first year prior to the new survey the one-half estimate is brought back in and three-quarters of the estimated cost is allowed as a reserve.

Basing their reserve on the sum of $60,000 or $15,000 a year, and taking the fiscal year end in both the old and the new company at September 30, as at the end of December 1968 the reserve for quadrennial survey in the old company stood at $48,750.

The vessel in question was classified or used as a cargo Carrier between Halifax and Newfoundland. It was a conventional general cargo vessel with three holds, built in 1943, and was an ageing vessel when it came into the possession of this appellant. As he said in his evidence, “the older the ship, the more likely you are to incur extensive replacements and repairs following each quadrennial survey”.

The $60,000, it should be noted, is not for the estimated cost of the result of the survey, that is, the cost of taking the ship into dry dock and repairing or renewing her as ordered by the survey. This is a survey that Is required by the Canada Shipping Act. It is also required by various societies or associations dealing with the owners of vessels and is in no small way directly connected with the availability of insurance to the owners of the vessel.

At the beginning of 1969, when the assets were transferred from the old company to the new company, the old company, by then known as Bedford Investments Limited, took into income the sum of $48,750, as stated in evidence by Mr Kuipers, the accountant for the company. It also showed as an expense the sum of $48,750 which was, in effect, the adjustment allowed to the new company on the purchase price of the assets of the old company.

Call it what you may, in substance that was, in effect, one way of reducing the amount owing by the new company to Bedford. In other words, Bedford assumed an expense that had been built up as a result of the operation of this vessel for a period of three years and three months.

It seems to me that the accountant could have avoided a great deal of misunderstanding if he had eliminated the “reserve” by crediting the book value of the vessel with the amount of the reserve. After all, the reserve was in fact a valuation adjustment which should be brought out at the time of the transfer. Crediting income from operations with the amount of the reserve at the beginning of the year was illogical as there were no operations by Bedford any more. The fact that this entry would have turned the asset account into a credit position should not have prevented such journal entry. The asset account was never meant to express the current fair market value of the asset.

Although this is of no consequence to the outcome of this appeal, it may be noted that in May of 1969, I believe it was, the new company sold “the Bedford ll” in an arm’s length transaction to some purchasers from the United States for the sum of $74,000 US. Included in that sale, according to the evidence of Mr Huxtable, was a negotiated adjustment of $34,000 with respect to the cost of an American survey similar to, if not the same as, the quadrennial survey referred to in the Canada Shipping Act and the Canadian Income Tax Act.

It may well be, as Mr Huxtable said, that in various locations around the world the cost of surveys and regulations with regard to other shipping requirements may not be as exacting as in this country, but in all countries a similar type of survey is required. So, instead of receiving $74,000 US, the new company received approximately $40,000 US for the ship.

It should be noted that by this time the ship had, of course, been written down to a very low figure. Capital cost allowance recapture resulted. There was still a capital gain, and the difference between the $34,000 negotiated adjustment and the $48,750 survey reserve, which difference amounted to approximately $12,000 Canadian after adjusting for foreign exchange rates at the material time, was taken into income.

The question now before me is whether or not, putting aside the subtleties of argument, the cost, or the estimated cost, of the quadrennial survey can be transferred from one owner to another and written off as an expense to successive owners, using the formula set out in the Canadian Income Tax Act prior to 1972—though I do not believe there is any change in the new Act.

The respondent argues that there was, first of all, no expense incurred by either the new company or by the old company in the transfer of “the Bedford II” from Bedford Investments Limited to the new Newfoundland Steamships Limited company, and no expense was incurred in the transfer in the arm’s length transaction to the Americans. Counsel for the Minister also contends that, if it is anything, the quadrennial survey reserve is a contingent liability that never came to pass, and therefore is excluded as a deduction by paragraph 12(1)(e) of the Income Tax Act. Thirdly, although not as specifically mentioned, but evident from assessing his argument and from reading the reply to the notice of appeal, it is submitted on behalf of the Minister that this was not an expense incurred for the purpose of earning income in the operations of a business.

Under subsection 12(2) of the old Act the question as to whether or not the outlay was reasonable is not in issue here because clearly the sum was reasonable in relation to the actual experience of the quadrennial survey of “the Bedford II” in 1966 or 1967.

The reserve as at December 31, 1968 represented the accumulated charges against operational income on account of the anticipated costs resulting from the foreseeable quadrennial survey. The charges had been real expenses and their accumulated amount was in fact the adjustment one should take into account when considering the book value of the vessel. It was a very real encumbrance if the vessel was to remain in operation or even be saleable as an operating vessel. It is clear that it requires a special licence, as declared in evidence by Mr Huxtable, to operate a ship up to a maximum of one year beyond the time of her quadrennial survey date, and such extensions are frowned upon, to say the least, by the insurers. Indeed, it is questionable whether or not insurance on a vessel such as this could have been maintained without the quadrennial surveys and the repairs and renewals required thereby.

I think that the annual charge of a proportionate part of the estimated anticipated cost of the quadrennial survey is a very real expense incurred in earning income. There is evidence that, after it was taken over by Mr Huxtable through his various corporate vehicles, the old company made a reasonably good profit. The evidence, although sketchy, is that in 1969, 1970 and 1971 the business was still successful. It fell off after 1971 because of a reduction in subsidies, a change in the method of operation, and many other factors that, in my view, do not affect the outcome of this appeal.

Counsel for the Minister cross-examined at great length on the question of subsidies, presumably expecting or hoping that the Board would infer from that that the transaction between the old company and the new was really a sham to rid itself of its liabilities because of the prospective loss of subsidies.

The accountant, Mr Kuipers, has said in evidence that each year these subsidies had to be negotiated and that “you could not count on them from year to year”. There was a subsidy negotiated and granted for the year 1969 after the transfer of assets that I have previously described.

The appellant says that, by taking the $48,750 into income in Bedford and allowing or charging the same amount as an expense, the net tax result is zero because the liability to Bedford, though it had ceased at that time, had been in effect met at the time of the transfer by crediting the sum of $48,750 to the new company and by the new company thereupon setting the said amount up in its opening balance sheet as a liability. It is a roundabout way of reaching the same result as could have been realized in a more simple manner, as I have indicated hereinbefore.

Appellant’s counsel contends that there is no prohibition in the Act against a transfer of such a liability (reserve), whereas counsel for the Minister says that it is not permitted by the terms of either section 11, section 6, or the regulations pertaining thereto. As I look at the terms of paragraph 11 (1)(ea) with regard to the reserve for quadrennial survey provisions, I see no reason why what has been stated to be an accumulated decrease in value or rather increase in encumbrances of the vessel could not be transferred to a new owner, especially in a non-arm’s length transaction.

Clearly, the transfer of this vessel in the arm’s length transaction to Thomas Cuni and Jack Trainer of Miami by contract dated May 13, 1969 lends credence, I think, to the ultimate result which the accountant achieved through his complicated way of recording the transaction of January 1, 1969. Clearly it was the recognized existence of an expense incurred by virtue of the need for a quadrennial survey that reduced the purchase price from $74,000 to $40,000 in the arm’s length transaction of May 13,1969.

Though I would have preferred another accounting procedure, it is obvious that the final result would have been the same.

The net income of Bedford Investments Limited for 1969 was, in so far as it concerned the quadrennial survey and related charges, in my opinion correctly reported and the Minister failed to show that the company’s income, due to an allegedly incorrect charge of $48,750, was understated by that amount.

I therefore allow the appeal.

Appeal allowed.