Deputy Minister of Revenue or the Province of Quebec v. Banara Investment Corp., [1968] CTC 349

BATSHAW, J.:—The Court, having heard the parties through their respective counsel on the merits of the present case, having examined the documents of record as well as the exhibits produced, having heard the evidence at the trial, and duly deliberated, now proceeds to render the following judgment:

In this case the plaintiff, as Deputy Minister of Revenue of the Province of Quebec, claims from the defendant for the year March 1961/1962, $4,319.64 representing taxes allegedly due under the Quebee Corporation Tax Act including interest and penalty in accordance with a statement attached to the fiat. In defence it is pleaded that the financial statements of the defendant were drawn up to reflect accurately and truly its profits for the year in question as well as other years and that consequently it denies any indebtedness to the Department whatsoever.

There is virtually no dispute as to the facts adduced by the evidence and these have been substantially resuméd by the defendant as follows:

The Defendant, Banara Investment Corp., is a real estate company, which is joint owner with Real Investment Corporation and Kaud Investment Corporation of a piece of land in St. Hubert purchased in January 1960. This land was subdivided into 1,480 lots which were sold as follows: 1960—536 lots; 1961—336 lots; 1962—163 lots and 1963—366 lots. Crescent Land Corporation acted as the administrator and sales agent for these three companies.

These lots were sold by way of Promise of Sale, the sale price varying between $200-$400, depending on the location. The price was paid by way of cash payment on the signing of the Promise of Sale and as to the balance, by monthly instalments running from 36 to 48 months. The Defendant included as revenue for each of the years in issue the full sale price of the lots but only took into income the gross profit content of the payments made by the purchasers in a taxation year, that is, the amount of the payments less the proportionate costs of the lots sold.

The Plaintiff re-assessed the Defendant by including in the computation of its income in the year of sale the full profit from all the sales made in the year and imposed profits tax accordingly. As a result of representations made to the taxation authorities, the Defendant was allowed to defer the profit on sales until the full purchase price had been paid and at the request of the Plaintiff, the Defendant filed Amended Returns on that basis. Subsequently, the Plaintiff changed its mind and confirmed the re-assessments.

The defendant’s tax liability arises under the Corporation Tax Act which provides that a company must pay a tax of a given percentage of the ‘‘net revenue’’ of its financial year (Section 6). The term ‘‘net revenue’’ is not defined other than by the statement that it has the same meaning as “‘profits’’ which are defined in Section 2(12) (a) to include ‘‘the annual profits directly or indirectly made from any trade or industry or from any commercial, financial or other business;’’. This, of course, cannot be said to be a satisfactory definition since it includes the word to be defined, and as a result the term ‘‘profits’’ has not really been defined by the statute nor is any indication given of the method of calculating same.

It was held in Canadian General Electric v. M.N.R., [1961] C.T.C. 512, on the basis of many authorities cited therein, that the term ‘‘profit’’ does not have a technical meaning and whether or not a disputed sum constitutes a profit must be determined on ordinary commercial principles unless the statute requires a departure therefrom.

The foregoing leads one to a. consideration of accounting practice in general. In Publishers Guild of Canada Ltd. v. M.N.R., [1957] C.T.C. 1, Mr. Justice Thorson [as he then was], on this question had occasion to say :

A system of accounting that would be appropriate to one kind of business is not necessarily appropriate to a different kind. Only an arbitrary minded person would contend that there is only one system of accounting of universal applicability. No reasonable person would do so. But while accountants devise changes in systems of accounting to meet the changing conditions in the business world and new ways of conducting business, their guiding principle must always be the same. Accounting is really the recording in figures instead of words, of the financial implications of the transactions of the business to which it is applied. The accountant is thus the narrator of the transactions, his narrative being in the form of figures instead of words. His narrative should be such as to disclose to persons understanding his language of figures the true position of his client’s business at any given time or for any given period. The accountant cannot fulfil the duty thus required of him unless he has carefully considered the manner in which his client carries on his business and has applied to it the system of accounting that is appropriate to it and most nearly accurately reflects its financial position, including its income position, at the time or for the period required.

With the foregoing general principles no one will disagree. In order to guide the Court in applying them to the facts of the present case, it has had the benefit of the testimony and opinion of eminent members of the accounting profession who have been heard as experts and who have submitted their respective views in support of either the plaintiff’s or the defendant’s method of calculating its profit.

The problem involved has been succinctly put by Mr. Marcel Bélanger, the plaintiff’s expert, in saying that it is essential to determine ‘‘du point de vue comptable, s’il est préférable d’enregistrer le profit réalisé sur les ventes de cette nature au moment où la vente est faite ou au moment où l’argent est perçu”. He point out the difference between the cash method, which is used in exceptional cases, and the accrual method which generally applies. According to the latter the revenue is recorded at the time of the sale and not when it is received, while the expense is recorded at the time it is incurred and not at the time when it is paid. In instalment selling, however, the question arises as to whether the profit realized on the sale should be recorded at tne time of the sale or at the time when the money is received. The problem therefore becomes one of determining what is the proper synchronization between the revenue and expense.

A number of eminent accounting authorities were cited to the Court to support the view that in the case of instalment sales it is the sale which constitutes the determining event giving rise to the profit and therefore the accrual method is the most accurate to reflect the profit of the undertaking. If losses are likely to be incurred because the payments are spread over a number of years in the future it is merely recommended that a provision for bad debts be set up and the same suggestion is made for future expenses that might be incurred in connection with the sale.

It is of course obviously unfair and unsatisfactory that a method of calculation of profits should be used that takes into account only the revenue and not the expenses, merely because some of the latter are to be incurred only in the future, and that is precisely why the solution of setting up a reserve is offered by the proponents of the accrual method. However, each type of operation has to be examined as to its own characteristics to determine whether the setting up of such reserve, assuming that it is authorized by the statute, would adequately meet the situation and constitute an accurate and fair method of determining the profits of the enterprise.

In answer to the plaintiff’s contention, the defendant has submitted the following reasons as to why the accrual method, even with a reserve, if allowed, could not be applicable to the defendant :

(a) A reserve for bad debts would not be accurate or feasible in the present instance, since one is not dealing with short term accounts but with instalment sales to members of low income groups whose payments are due over a period of years in a new enterprise, so that the determination of bad debts with any degree of reasonable accuracy and in the absence of prior experience would be far from an easy, desirable or accurate method. That this contention is not without merit can be seen from Mr. Bélanger’s submission in which he frankly states that defendant’s method is applicable when possible losses are considerable and difficult to foresee ;

(b) The solution of estimating future costs to be deducted would be tantamount to taking a reserve prohibited under Sec- tion 8(c) of the Act (see in this connection Edward Collins & Sons, Lid. v. C.I.R. (1924), 12 T.C. 773 (Ct. of Session) and Bryson Graham Co. Ltd. v. M.N.R. (1953), 3 Tax A.B.C. 134) ;

(c) The fairness and accuracy of the defendant’s method is highlighted by the fact that it only brings into profits the portion of the sale price realized in the year of sale by regarding every instalment as a partial recovery of cost and also a partial realization of profit in the same proportion as those two elements are presented in the selling price. This method has the merit of allowing a better matching of revenue and expenses and thus of avoiding any undue taxation over the whole business cycle;

(d) It is an accepted accounting principle that revenue and expenses of a business must be matched in order to arrive at a true profit picture. The plaintiff’s method would insist that all the profits be taken into account in the year of sale, disregarding for income tax purposes the cost to be incurred in future years, which hardly seems fair ;

(e) A method that allows a matching of inventory and other direct costs with realized gross profit should be considered preferable to the method of deducting the same inventory and other direct costs when the major portion of the profit will be only realized in future years;

(f) As regards future collection costs it is submitted that deducting these expenses against the profit element of the instalments which these expenses have served to collect, offers a better application of the matching principle than a mere deduction in the year of sale of an estimate of these same expenses (assuming that the same would be permitted under the taxing statute). The deduction of the actual amount as opposed to a mere estimate is more capable of giving rise to the true profit;

(g) The defendant’s method is more just since it avoids any unfair tax impact because all of the expenses are deducted against profit and its exhibit D-6 shows that with regard to the losses incurred in 1964 to 1966 they cannot be carried forward due to lack of income;

(h) It is more fair also because the full losses are taken into account as opposed to the business losses that can only be deducted against the income of the immediately prior year and the income of the subsequent five years (Section 7(4)) ;

(i) The profit on which the Department would base its tax is at best only a theoretical profit since the amount taxed is in excess of the actual cash received obliging the defendant to borrow in order to pay its tax.

To meet the foregoing contentions, the Department has filed an extensive brief invoking numerous authorities. In the main, it concurs with the view that profits and gains must be ascertained on the basis of ordinary commercial principles. It is also common ground that for most enterprises the accrual method is the one that most accurately and faithfully reflects the operations. Most of the cases cited, however, do not deal with instalment sales where the purchase price is to be paid over a more or less extended future period, leaving open the question as to which method should be sanctioned in the case of the latter type of sales.

What impresses the Court most as regards the cases invoked by the Department in its favour, is the fact that the decisions always appear to take for granted that the accrual method when applied will still give the taxpayer an adequate opportunity of deducting his expenses from income. Thus in Niesner v. M.N.R., 34 Tax A.B.C. 53, Commissioner Weldon commented on the accrual method as follows:

The theory behind that method of accounting would seem to be that income (i.e. profits) should be declared in the year in which it is earned, notwithstanding that the amount is not receivable until a subsequent year, because all the expenses of a business, including those put out to earn that income, must always be entered in the Company’s daily cash book and, in due course, (italics supplied) be shown in its financial statement for the current year.

One wonders if the Commissioners would have been of the same Opinion in the case of an enterprise selling on instalments where expenses incurred to collect income in future years could not be deducted, as was shown to be the case in the defendant’s operations.

In this connection, the Court cannot accept the argument submitted on behalf of the Department that if such is the case, it is Just too bad for the taxpayer that his business was conducted in such a way that he earned no income in a particular year against which he could offset the expenses incurred in that year in connection with sales on whose profits he had been taxed earlier in the financial year when they were made. That would be requiring the taxpayer to meet the theoretical needs of the accrual method, strictly applied, without exception even in the case of instalment sales, despite the fact that this method in the case of such sales does not reflect truly the realities of the situation.

As far as judicial precedent in Canada is concerned, the case which most closely resembles the one at bar is that of Publishers Guild of Canada Ltd. v. M.N.R. (supra). Both parties have laid considerable stress in their respective briefs upon the decision of the President of the Exchequer Court, Mr. Justice Thorson in that case, the defendant seeking to invoke it in his favour while the plaintiff has tried to distinguish it on the facts. It dealt with instalment sales of an encyclopaedia and, in making some general observations, the President of the Court had occasion to write:

I cannot express too strongly the opinion of this Court that, in the absence of statutory provision to the contrary, the validity of any particular system of accounting does not depend on whether the Department of National Revenue permits or refuses its use. What the Court is concerned with is the ascertainment of the taxpayer’s income tax liability. Thus the prime consideration where there is a dispute about a system of accounting is, in the first place, whether it is appropriate to the business. to which it is applied and tells the truth about the taxpayer’s income position and, if that condition is satisfied, whether there is any prohibition in the governing income tax law against its use. If the law does not prohibit the use of a particular system of accounting then the opinion of accountancy experts that it is an accepted system and is appropriate to the taxpayer’s business and most nearly accurately reflects his income position should prevail with the Court if the reasons for the opinion commend themselves to it.

After examining all the facts in minute detail, moreover, the Court came to the following conclusions:

(i) That the instalment system of accounting is appropriate to the taxpayer’s business and accurately reflects its income and profit position ;

(ii) That the accrual basis system of accounting is inappropriate to the taxpayer’s business;

(iii) That the unrealized gross profit content of its accounts receivable at the end of any year is not income for the year ;

(iv) That the instalment system more accurately reflects the taxpayer’s income position than any other system would do.

Whilst, as already noted, the plaintiff has sought to distinguish this case from the present one, the Court considers nevertheless that despite any variance as to the facts, there is sufficient similarity to warrant the application of the same basic principles which are involved and it concurs with the reasoning on which this decision is based.

Furthermore, the Court holds the view that, as the evidence in the present case amply demonstrates, an accounting method that obliges the taxpayer to pay tax on income without adequately taking into account offsetting expenses incurred and to be incurred in the future in the collection of outstanding instalments must be considered to be both inadequate and unfair. By the defendant’s method, the Department will in the end get its full tax, but not all of it in the first year, irrespective of any expenses or losses which the defendant may subsequently incur.

Accounting theory when faced with constantly evolving and ever more complex forms of business transactions, should be flexible enough to disregard traditional labels and preconceived notions in order to adapt itself to the need of reflecting in figures the truest possible picture of the operations of a particular enterprise. It is in accordance with this view that the so called "instalment” method has been adopted and approved by eminent accounting authorities whose opinions have been cited on behalf of the defendant.

Accordingly, on the whole, the Court has come to the conclusion that it should approve the method of accounting adopted by the defendant in submitting its annual returns under the statute for the year in question as being acceptable in accordance with the terms thereof. Consequently, the plaintiff has failed to establish that a further liability still exists in accordance with the statement forming the basis of the present claim.

For the foregoing reasons, therefore, the Court dismisses the plaintiff’s action with costs.