Burrard Yarrows Corp. v. The Queen, 86 DTC 6459, [1986] 2 CTC 313 (FCTD), aff'd sub nomine Versatile Pacific Shipyards Inc. v. The Queen, 88 DTC 6352 (FCA)

Joyal, J.:—This is an appeal by the plaintiff taxpayer from the Minister's reassessments of tax for the 1979 and 1980 taxation years whereby certain claimed reserves and inventory allowances were disallowed and added back into income.

The plaintiff is a corporation which engages in the construction, conversion, and repair of ships. Two of its contracts are relevant for the purposes of this appeal. In the first, which was made in 1975, the plaintiff contracted with the Department of Supply and Services to build two “'R' Class” icebreakers for the Canadian Coast Guard. By its terms, the law of Ontario was deemed to govern its construction and interpretation. The second was entered in 1979, and by its terms the plaintiff was obliged to build two car ferries for the British Columbia Ferry Corporation. The law of British Columbia was said to govern.

Many of the terms found in these two contracts are, in essence, identical. Each established a basic contract price subject to adjustment pursuant to certain contractual clauses. The purchase prices were to be paid by progress payments. The progress payments from the Department of Supply and Services were calculated with reference to the expenses incurred by the plaintiff, while those from the British Columbia Ferry Corporation were received upon completion of various specified stages of the construction. Title to all the materials, parts, and finished work paid for by each progress payment made under the icebreaker contract was said to vest in the federal Crown. Under the contract for the ferries, property in the vessels as well as all machinery, equipment, and materials vested in the purchaser as soon as they were intended for use in the vessels; the plaintiff, however, had a lien on these items for amounts owing under the contract.

Under both contracts, the plaintiff held the vessels, machinery, equipment, and materials at its own risk until delivery and acceptance. It was also required to maintain at its own expense Builder’s Risk Insurance with losses made payable to itself and the purchaser.

The purchasers had the right to have their representatives carry out onsite supervision of the construction. Those representatives were deemed the final judges of the quality, quantity, and suitability of the vessels, their component parts and of the workmanship used therein, and as to the meaning and interpretation of the specifications. Each was empowered to reject any part of the project if, in his opinion, it did not correspond with the terms of the contract; the plaintiff would then be obliged to make good the work to the representative's satisfaction.

Each contract specified an amount to be paid by the plaintiff by way of damages for every day after the delivery date that it failed to deliver the completed vessels. Further, if the plaintiff defaulted in the performance of the contracts, the purchasers were granted certain rights. Under the icebreaker contract, the purchaser could terminate all or any part of the contract and demand delivery of any finished work as well as any materials, parts, work-in-progress, or tools which the plaintiff had acquired or produced to fulfill the contract. By the terms of the other contract, the purchaser, on the plaintiff's default, could take possession of the vessels and the materials intended to be used in their completion, and could use the plaintiff's property and equipment to complete the vessels or employ oth- ers to complete them for it. That contract further provided that if the purchaser defaulted, the plaintiff could sue for damages but would still be obliged to complete the vessels.

For the 1979 taxation year, the plaintiff claimed, in respect of both of these contracts, the sum of $44,573 as an inventory allowance pursuant to paragraph 20(1)(gg) of the Income Tax Act. By the end of that year, work under the icebreaker contract had been completed. In 1980, the plaintiff claimed an inventory allowance of $611,460, representing three per cent of the plaintiffs inventory of work in progress during the year in respect of the British Columbia Ferry Corporation contract.

In 1980, the plaintiff also included in income $23,593,000 in progress payments it had received during that year, and then deducted the same amount as a reserve. It claimed that the progress payments were included in income pursuant to paragraph 12(1)(a) as payments received on account of goods not delivered before the end of the 1980 taxation year, and that the deduction was the deduction of a reasonable amount as a reserve in respect of goods to be delivered after the end of that year pursuant to subparagraph 20(1)(m)(i).

By notice of reassessment dated March 24, 1983, the Minister disallowed the plaintiffs 1980 claim for an inventory allowance except in respect of the cost of its inventory of supplies and the cost of work-in-progress in respect of ship construction contracts expected to be completed within two years of their commencement thereby decreasing the inventory allowance deductible to $71,361. He also refused to accept the deduction of a subparagraph 20(1)(m)(i) reserve except with respect to contracts reasonably expected to be completed within two years of their commencement. As a result, the Minister added $417,451, representing income attributable to construction contracts to be completed in more than two years, to the plaintiff’s income for 1980.

On May 25, 1983, the plaintiff filed a notice of objection with respect to these reassessments. Also on that date, the plaintiff filed a notice of objection with respect to the reassessment of its tax for the 1979 taxation year to increase the inventory allowance claimed to $1,407,660. This amount was calculated in the same manner in which the plaintiff had calculated the inventory allowance claimed for its 1980 taxation year.

The reassessments were confirmed by notice dated March 7, 1984. It is from these reassessments that the plaintiff now appeals.

Inventory Allowance:

Paragraph 20(1)(gg) provides:

s. 20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(gg) an amount in respect of any business carried on by the taxpayer in the year, equal to that portion of 3% of the cost amount to the taxpayer, at the commencement of the year, of the tangible property (other than real property or an interest therein) that was

(i) described in the taxpayer’s inventory in respect of the business, and

(ii) held by him for sale or for the purposes of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into or used in the packaging of, property for sale in the ordinary course of the business

that the number of days in the year is of 365 . ..

“Inventory” is defined as

a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year . . .

and the “cost amount” to a taxpayer of any property, described in his inventory is “its value at that time as determined for the purpose of computing his income” unless otherwise provided by the Act (section 248).

Before a taxpayer is eligible to claim a paragraph 20(1)(gg) inventory allowance, four preconditions must be met. First, the allowance must be claimed on the cost amount of the property in question at the beginning of each taxation year in question. Next, the property against which it is claimed must be tangible property other than real estate or an interest therein. Thirdly, it must be established that the property was described in the taxpayer's inventory in respect of his business, and finally, that it was held for sale or to be processed, manufactured, incorporated into, attached to, or otherwise converted into property for sale in the ordinary course of that business. Failure to establish the existence of any one of these elements results in a disentitlement to a reserve under that paragraph. The position of counsel for the defendant was that the third and fourth preconditions were not met.

He advanced three arguments in support of his position. I find it necessary to deal with only one: that is the argument that the property was not held by the taxpayer for sale because property in the goods was not in the plaintiff.

The ships in question were, at the time these contracts were entered, “future goods” within the meaning of the Sale of Goods Acts of both Ontario (R.S.O. 1980, c. 462) and British Columbia (R.S.B.C. 1979, c. 370). A presumption arises with respect to future goods that the property therein passes when the goods have been completed and appropriated to the contract; however, this presumption applies only in the absence of evidence of a contrary intention on the part of the parties (Ontario section 19; British Columbia section 23).

Ship construction contracts sometimes provide that property in ships to be manufactured and sold passes to the buyer during the course of manufacture and before completion (Benjamin's Sale of Goods, London: 1974, at page 179, paragraph 372).

Where it appears to be the intention, or in other words the agreement, of the parties to a contract that at a particular stage of its construction the vessel, so far as then finished, shall be appropriated to the contract of sale, the property of the vessel as soon as it has reached that stage of completion will pass to the purchaser . . . Such an intention or agreement ought (in the absence of any circumstances pointing to a different conclusion) to be inferred from a provision in the contract to the effect that an instalment of the price shall be paid at a particular stage, coupled with the fact that the instalment has been duly paid and that until the vessel reached that stage the execution of the work was regularly inspected by the purchaser, or someone on his behalf. [per Lord Watson in Seath v. Moore (1886), 11 A.C. 350 at p. 380 (H.L.)]

It must be noted, however, that while instalment payments and inspections have been held to give rise to a “strong prima facie presumption” that the property is intended to pass (Seath v. Moore, supra, at 370), they are not conclusive, and the question remains what the contract really means (Laing v. Barclay, [1908] A.C. 35 (H.L.)).

In the present case there can be no doubt but that the property in the ships and the materials to be used therein was intended to pass to the purchasers upon the payment of the first instalment and throughout construction. I come to this conclusion after considering the clauses of the contract which are set out above. The result is that the property in the ships had already passed.

In order for a taxpayer to meet the paragraph 20(1)(gg) requirement holding property for sale, he must have property in it which he can sell. Here, as I noted above, the property in the ships was vested in the purchasers and not in the plaintiff taxpayer. As a result, the plaintiff did not have property in the ships which he could sell and, therefore, he could not be said to be holding them for sale within the meaning of paragraph 20(1 )(gg). As a result, it was not eligible to claim a reserve pursuant to that paragraph. The appeal with respect to this issue must fail.

Reserves

The essence of the plaintiff's argument before me with respect to the reserves claimed is as follows. The contract with the British Columbia Ferry Corporation was for the sale of goods, namely two car ferries. The progress payments received by the plaintiff in 1980 pursuant to that contract were received on account of the goods which were not delivered before the end of that year and therefore were brought into income pursuant to subparagraph 12(1)(a)(i). That subparagraph states:

12(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(a) any amount received by the taxpayer in the year in the course of a business

(i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year . . .

The plaintiff continued that because the progress payments were required by subparagraph 12(1)(a)(i) to be included in income, the plaintiff was entitled to deduct a reasonable amount as a reserve pursuant to subparagraph 20(1)(m)(i) which provides:

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(m) subject to subsection (b), where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer’s income from a business for the year or a previous year, a reasonable amount as a reserve in respect of

(i) goods that it is reasonably anticipated will have to be delivered after the end of the year . . .

I assume that if a reserve were available to this plaintiff at all, the amount claimed was a “reasonable amount".

Counsel for the defendant argued that it was not necessary to classify or label the contract in question. However, he added, if it were necessary to classify the contract, it was one for the sale of materials and rendering of services from time to time, rather than one for the sale of goods.

He continued by arguing that subparagraph 12(1 )(a)(i) requires the inclusion in income of all amounts received in advance of what he termed “earning events”. The "earning events” enumerated in that section, that is, the delivery of goods and the rendering of services, were not intended by the drafters to be the only possible ones. This, he argued, is made clear by the inclusion of the words "or that, for any other reason, may be regarded as not not having been earned in the year” (emphasis added). Therefore, he contended, the issue to be resolved is when the plaintiff "earned” the progress payments in question. In his opinion, once the point of construction specified by the contract as an earning event had been reached, the plaintiff became irrevocably entitled to the progress payments and they became earned income. As a result, their inclusion in income was required by section 9 rather than by paragraph 12(1)(a). Because paragraph 12(1)(a) was not applicable, a paragraph 20(1)(m) reserve could not be claimed.

I agree with defence counsel that subparagraph 12(1)(a)(i) brings into income only those which are received by the taxpayer in the year but which must be regarded as being unearned. Further, the availability of a paragraph 20(1)(m) reserve depends entirely on whether an amount described in paragraph 12(1)(a) was included in computing the taxpayer's income. Therefore, to determine whether a paragraph 20(1)(m) reserve is available with respect to the progress payments in question, it must be determined whether they were brought into income pursuant to subparagraph 12(1)(a)(i), which in turn requires a determination of when they were "earned” or, in other words, when they took on the quality of income.

A great many cases have dealt with this issue. One test which has been relied upon frequently (see for example Commonwealth Construction Co. v. The Queen, [1984] C.T.C. 338; 84 D.T.C. 6420 (F.C.A.)) is found in Robertson Ltd. v. M.N.R., [1944] C.T.C. 75; 2 D.T.C. 655 (Ex. Ct.). There, Thorson, J., as he then was, stated:

... the question remains whether all of the amounts received by the appellant during any year were received as income or became such during the year. Did such amounts have, at the time of their receipt, or acquire, during the year of their receipt, the quality of income, to use the phrase of Mr. Justice Brandeis in Brown v. Helvering . . . In my judgment, the language used by him . . . lays down an important test as to whether an amount received by a taxpayer has the quality of income. Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment?

In the present case, the plaintiff, upon completing each of the various stages of construction, became absolutely entitled to receive the progress payments which had been agreed upon. Its right to those amounts was under "no restriction, contractual or otherwise, as to its disposition, use or enjoyment”. The contract did not even contain a provision requiring refunding of the progress payments in the event of the plaintiff defaulting. As a result, I find that the progress payments had the quality of income when received and, hence, were earned amounts. It follows, therefore, that subparagraph 12(1)(a)(i) does not operate to bring the payments into income, and, further, that the Minister was correct in denying the plaintiffs claim for a paragraph 20(1)(m) reserve. The plaintiff must bring the progress payments into income in the year they are received.

In view of this finding, it is not necessary for me to deal with the expert evidence on generally accepted accounting principles which was presented at trial. While it is well established that reference may be made to generally accepted accounting principles when determining a taxpayer's income, this is only so in the absence of statutory provisions to the contrary. As Thorson,

P. said in Publishers Guild of Canada v. M.N.R., [1957] C.T.C. 1; 57 D.T.C. 1017 (Ex. Ct.):

I cannot express too strongly the opinion of the 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 . . . [T]he primary 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 accurately reflects his income position should prevail with the Court if the reasons for the opinion commend themselves to it.

The $23,593,000 received by the plaintiff as progress payments in 1980 must, therefore, be brought into its income for that year pursuant to section 9 of the Income Tax Act.

Conclusion

The plaintiffs appeal with respect to both issues fails. Accordingly, its appeal is dismissed with costs.

Appeal dismissed.