The Queen v. V&R Enterprises Ltd., 79 DTC 5399, [1979] CTC 465 (FCTD)

Grant, DJ:—This is an appeal by the Crown from the decision of the Tax Review Board dated February 18, 1974 whereby the assessments of the Minister of National Revenue was set aside and it was held that all the amounts established as accrued salaries for the company’s officers in the years 1968,1969 and 1970 were properly accrued and deductible in the year in which they were incurred.

The assistant chairman of the Tax Review Board has dealt correctly with the issues involved and as I agree with his judgment it is not necessary that I repeat what is included therein except that there are a few points therein that I want to clarify. Because the capital of the company was limited the managerial salaries had to fit the amount of business in any year. Consequently such renumeration could not be definitely fixed until the audit at the end of the year. From the start of the company’s business in 1962 it was arranged that Mr Rhodes would draw what was termed a basic salary of $15,000 and his wife the sum of $10,000 and Mr Herman $5,000. A better term to describe the arrangement was that such parties could make drawings throughout the year to such amounts. At the end of each fiscal year the directors were to meet and on the basis of business done and profits made decide what additional amount should be allowed each of such persons. It is conceded that such amounts referred to occasionally herein as basic salary were not sufficient renumeration for the services rendered. A senior employee doing the work of Mr Rhodes would have been paid $25,000 in those years.

The Crown referred to these extra amounts as bonuses. In my opinion none of them was a bonus. The management performed their services throughout the year knowing that this further allotment would be made at the end of the year and depending upon it. The parties could safely operate in this trusting fashion as they were the owners of the company. A bonus is described in the Shorter Oxford English dictionary as: “a boon or a gift over and above what is normally due; a premium for services rendered or expected; an extra dividend paid out of surplus profits.”

No part of such salary so fixed was in any sense a gift as the services were rendered each year on the understanding that such procedure would be followed.

Michael Zin, PhD, who is the dean of the Faculty of Business Administration at Windsor university gave evidence for the taxpayer as an expert witness. His testimony related to the propriety of corporations or persons engaged in business preparing their financial statements on an accrual basis rather than on a cash basis. His evidence was as follows:

Consistent with generally accepted accounting principles businesses should prepare their financial statements on an accrual basis rather than on a cash basis so that the transactions accounted for in any given fiscal year will be reflected on the books of the business in the year in which the transaction took place rather than in the year in which the actual monies were received or paid by the business.

The income statement and the balance sheet are normally regarded as the most important financial statements of a business. In preparation of the income statement it is considered proper accounting practice to match against revenue earned in any fiscal year the expenses incurred to earn that revenue. In the preparation of the balance sheet for the business, which indicates the financial status of the business at a given date, it is essential that the financial statements will give an accurate picture of the status of the business at that date. In the statement the liabilities of the business include indebtedness to officers and employees.

One of the principal expenditures commonly incurred by the business to earn revenue is remuneration paid or payable to its officers and employees. This remuneration should be reflected on the income statement of the business in the same fiscal period in which the effort was expended to earn revenue for that period. If remuneration to officers and employees if reflected on the income statement of the business in a fiscal period other than the period in which the revenue is earned, perhaps in the fiscal period in which the remunerations is actually paid, revenues and expenses will not be properly matched and net income will be distorted in each of these two fiscal periods.

In the event that remuneration payable to officers and employees is not paid in the following fiscal period or periods the amount will remain on the balance sheet of the business as a liability. If this liability is subsequently forgiven, the effect of the reduction is to improve the financial position of the business, to increase the value of the shareholders equity and therefore to enable the directors of a corporate business to present a better financial position to its shareholders, bankers and other creditors.

Coleman Friedman who is a chartered accountant in Windsor had been auditing the defendant’s books of account, advising it’s bookkeepers and preparing it’s financial statements and income tax returns from 1967 until 1976. He had set up such books to show management salaries and other entries on the accrual basis as he felt that was the only proper way to do it. He knew of the arrangements whereby withdrawals were made during the year with the final amount of salary to be determined at the end of the year and approved of this method of fixing such remuneration. Even though moneys taken out by Mr and Mrs Rhodes throughout the year was set up in the payroll journal he did not regard it as salary as the gross amount taken was charged against the loan account and adjusted at the end of the year. They always paid the proper amounts on their personal income tax liability. His testimony convinced me that the amounts of managerial salaries unpaid in any of the years in question were properly entered in the company’s income tax returns and in accordance with the provisions of paragraph 18(3)(a) of the Income Tax Act which then read as follows:

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

The Crown contends that none of the accrued salaries in these years were deductible because they were not expenses incurred by the taxpayer company for the purpose of gaining or producing income in those taxation years. The answer to this is that management rendered their services in these years on the understanding that their remuneration would be ascertained for the year in the manner above described and a legal obligation was thereby created to pay the same. On that basis the accrued salaries were earned in the taxation year in which they were charged as disbursements and were not bonuses or a reserve or an attempt to artificially reduce the company’s taxable income.

Mr Rhodes was cross examined at length about the various entries in the company’s books but he had no knowledge of bookkeeping and depended on his accountant to perform that service for him. He was asked on discovery as to whether it would be fair to say that the notes were set up or the accrued salaries were set up to be paid, or contingent on the fact that cash would be available within two years to pay it. He answered this question in the affirmative. While this question was somewhat confusing, I was of the opinion from other questions asked that both he and counsel had in mind the requirement of paragraph 18(3)(a) to the effect that the amounts of accrued salary which might be unpaid at the end of the first taxation year following the taxation year in which the outlay or expense was incurred, should be returned to the taxpayers income for the second year following. In any event it was clear from his answers at trial that there was no such contingency attached to the obligation to pay at the time such accrued Salaries were established.

I was impressed with Friedman’s testimony and I believe that both he and Rhodes were honest in the preparation of the income tax returns of the company as well as in their testimony.

The appeal should therefore be dismissed with costs.