Morscher v. MNR, 92 DTC 2214, [1992] 2 CTC 2534 (TCC)

Brulé, T.C.C.J.:—This is an appeal with respect to the taxpayer's 1981, 1982 and 1983 taxation years in which the Minister of National Revenue (” Minister”) disallowed certain interest expenses after computing partnership income from the practice of law. In addition certain interest expenses claimed were disallowed to the appellant personally.

Facts

The appellant was a partner in the law firm of Morscher & Fehrenbach. In filing his Income tax returns for the years under appeal the taxpayer sought to deduct as interest expenses in arriving at his net income certain interest payments on borrowed funds. These deductions involved both the partnership and the taxpayer personally hereinafter referred to respectively as "partnership interest” and "individual interest".

The amounts disallowed in calculating the appellant’s partnership interest were $3,164.50 in 1981, $4,008.50 in 1982 and $2,989.50 in 1983. The individual interest amounts disallowed were $2,035.27 in 1981 and $1,186.27 in 1982.

Both the partnership and the taxpayer borrowed funds to carry on the partnership and that portion over ana above partnership profits was disallowed.

Issues

The principal issue is whether or not the appellant may deduct his share of interest expense incurred on borrowed funds in order to finance work in progress of a law firm notwithstanding that the interest claimed on the borrowed funds was in excess of the reported partnership profits.

A secondary issue was the deductibility of the interest expenses incurred by the appellant personally relating to a personal loan, the proceeds of which it was maintained was injected into the partnership.

Income tax provisions (as they read in 1983)

The relevant sections of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") are listed below:

Paragraphs 18(1)(b) and (h) read,

18. General limitations

(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

(h) personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on his business;

Paragraph 20(1)(c) states as follows:

20. Deductions permitted in computing income from business or property.

(1) Notwithstanding paragraphs 18 (l)(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.

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

Subsections 34(1) and (2) stipulate that:

34. Professional business.

(1) In computing the income of a taxpayer for a taxation year from a business that is the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor, the following rules apply:

(a) paragraph 12(1)(b) is not applicable;

(b) every amount that becomes receivable by him in the year in respect of property sold or services rendered in the course of the business shall he included;

(c) for the purposes of paragraph (b), an amount shall he deemed to have become receivable in respect of services rendered in the course of the business on the day that is the earliest of

(i) the day upon which the account in respect of the services was rendered

(ii) the day upon which the account in respect of those services would have been rendered had there been no undue delay in rendering the account in respect of the services, and

(iii) the day upon which the taxpayer was paid for the services; and

(d) where the taxpayer so elects in his return of income under this Part for the year, no amount shall be included in respect of work in progress at the end of the taxation year, except as otherwise provided by this section.

(2) Where a taxpayer has elected that paragraph (1)(d) be applicable in computing his income for a taxation year from a business that is the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor, that paragraph shall apply in computing his income from the business for all subsequent taxation years unless the taxpayer, with the concurrence of the Minister and upon such terms and conditions as are specified by the Minister, revokes his election to have that paragraph apply.

Relating to the valuation of inventory property, subsections 10(4), (5) and (6) of the Act read as follows:

10. Valuation of inventory property,

(4) For the purpose of subsection (1), the fair market value of property (other than property that is obsolete, damaged or defective or that is held for sale or lease or for the purpose of being processed, fabricated, manufactured, incorporated into, attached to, or otherwise converted into property for sale or lease) that is

(a) work in progress at the end of a taxation year of a business that is a profession means the amount that can reasonably be expected to become receivable in respect thereof after the end of the year; and

(b) advertising or packaging material, parts, supplies or other property (other than work in progress of a business that is a profession) described in an inventory means the replacement cost of the property.

(5) Without restricting the generality of this section,

(a) property (other than capital property) of a taxpayer that is work in progress of a business that is a profession, advertising or packaging material, parts or supplies is, for greater certainty, inventory of the taxpayer; and

(b) anything used primarily for the purpose of advertising or packaging property that is included in the inventory of a taxpayer shall be deemed not to be property held for sale or lease or for any of the purposes referred to in subsection (4).

(6) For the purpose of computing the income of a taxpayer from a business that is a profession, the amount of the cost of his work in progress, and the amount of the fair market value thereof shall be deemed to be

(a) at the end of his 1982 taxation year, nil, and

(b) at the end of his 1983 taxation year, /2 of the amount thereof determined without reference to this paragraph,

if an election under paragraph 34(1)(d) is applicable in respect of the business for his 1982 taxation year.

The words "inventory and property” are defined in subsection 248(1) of the Act:

“inventory” means 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;

"property" means property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes

(a) a right of any kind whatever, a share or a chose in action,

(b) unless a contrary intention is evident, money,

(c) a timber resource property, and

(d) the work in progress of a business that is a profession;

Appellant's position

It was submitted to the Court that Revenue Canada admitted that their assessment was based on a cash basis and such was inappropriate when the taxpayer's accounting was done on an accrual basis. Of significant importance is that work in progress should be considered as part of the assets of a law partnership. The appellant said “nowhere in the Act is there provision to pay tax on moneys borrowed over and above the annual profit,” and he submitted that he had followed the provisions of the Act and its regulations.

The Act prescribes in section 20 that a deduction may be made in respect of a legal obligation to pay interest on money borrowed to earn income and ina law practice work in progress, accounts receivable and other assets are all there for the purpose of gaining or producing income. Such borrowings are an accepted way of doing business and while profit is determined after billings and expenses are deducted it is only proper to be able to deduct what will produce profits in the future.

As to the secondary issue the Court was told that the money that was borrowed personally went into the partnership. At the time interest rates were very high and the bank would not loan the partnership further funds. The taxpayer did and so feels justified when these funds went to the firm that the interest thereon should be deductible. It was alleged by the Minister that the borrowed funds were used for home renovations but this was denied saying that the home renovations had all been completed and paid for at a much earlier time.

Minister's position

Counsel for the Minister stressed that a portion of the interest claimed financed the appellant's drawings and was not for the purpose of earning income. The loans were not traced to this purpose both for the partnership and the appellant. This was an obligation of the appellant which counsel said was not discharged. The Court was referred to the following cases:

The Queen v. Phyllis Barbara Bronfman Trust, [1987] 1 C.T.C. 117, 87 D.T.C. 5059;

Colin C. Mills v. M.N.R., [1985] 2 C.T.C. 2334, 85 D.T.C. 632;

Livingston International Inc. v. M.N.R., [1991] 1 C.T.C. 155, 91 D.T.C. 5066 (F.C.T.D.); aff'd [1992] 1 C.T.C. 217, 92 D.T.C. 6197 (F.C.A.); and

Andrew Kiss v. M.N.R., [1976] C.T.C. 2112, 76 D.T.C. 1093.

Basically these cases affirm that borrowings must be traced to the earnings of the organization or individual where applicable and that the principle is that where borrowings exceed profits the excess cannot be for business purposes.

In the present case the appellant has not demonstrated that the money borrowed by him personally was given to the partnership as a capital infusion.

It was argued that as a result of these allegations the appeal should be dismissed.

Analysis

Inasmuch as no current cases were cited to the Court by either party on this point and as there does not seem to be any reported case that is to be considered a review of the law and the problem may be best considered in detail under various headings.

1. Professional businesses

Professional businesses, such as legal firms, report income on a modified accrual basis. In addition, these individuals may elect, pursuant to section 34 of the Act, to exclude work in progress in the computation of income at the end of a taxation year. In other words, the inventory of work in progress of a professional may be valued at" nil”. Where such an election is undertaken, the income is calculated on the basis of fees billed. The election is subsequently binding on the taxpayer for future years and can only be revoked with the Minister's consent. Generally, where a professional chooses to revoke the election, he must demonstrate that the change is reasonable in the circumstances, that the results reflect a more appropriate method of accounting for work in progress and that there does not appear to be any undue tax advantage.

For income tax purposes, where an election to exclude work in progress has not been made, the term “inventory” will include the work in progress. In other words, work in progress is treated as an asset in computing taxable income and therefore an inventory of work in progress must be established. The cost of unbilled services would be included in the inventory of the professional business at the end of the taxation year. The decision not to exclude work in progress should be taken at the time of filing the return of income for the year.

2. Meaning of "work in progress”

Interestingly, the Act defines the term "property" as including the work in progress of a taxpayer who is a member of a professional business. The Act does not specifically define the concept of "work in progress". However some assistance may be gathered by Interpretation Bulletin No. IT-457R (July 15, 1988) at clauses 11 and 12,

11. The term "work in progress" is not defined in the Act and therefore must be given its ordinary meaning which it has in business usage, i.e., partly finished goods or services which are in the process of completion and have not reached the stage where the taxpayer is required to include an amount in income pursuant to paragraph 12(1)(b). When an election under paragraph 34(a) is not in force, work in progress of a designated professional business must be included in computing a taxpayer's income. The amount to be included will be determined on the basis of the expenses incurred that relate to services performed for which an amount has not become receivable or on the basis of what the billing for those same services would have been (including a profit element) if it had been rendered, depending on the method regularly followed in valuing this work in accordance with allowable inventory valuation principles.

12. Subsection 10(5) provides that work in progress of a business that is a profession is inventory. This status will not change if an election is made under paragraph 34(a)

A closer examination of subsection 34(1) of the Act would suggest the following necessary requirements:

1. In computing income from a business that is a profession, the taxpayer shall include all amounts receivable at the end of the year in respect of property sold Or services rendered, notwithstanding that the cash value will not be received until the following year.

2. Amounts are considered receivable” at the earliest of:

(a) the day on which the account was rendered;

(b) where there was "undue delay”, the day on which the account should have been rendered before the delay; and

(c) the day on which the taxpayer was paid for his services.

Consequently, it is evident that the definition of "work in progress" refers to "an estimated value of" partly finished goods or services which are in the process of completion and have not yet reached the stage where the taxpayer can render a billing to the client.

Furthermore, there appears to be some choice as to valuation of work in progress where the election to exclude has not been undertaken by the taxpayer. In other words, the amount to be included in income is based on either:

(a) the amount of expense that relates to services to be performed for which an amount has not become receivable, or

(b) the amount that would have been billed for those services, including some profit element, if the bill had been rendered.

Interpretation Bulletin No. IT-473 (March 17, 1981) discusses the various methods of valuation for various types of inventory. For our purposes clauses 2, 4 and 8 read as follows:

2. Subsection 248(1) defines “inventory” 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. Normally inventory includes all such materials to which the taxpayer has title, regardless of their location. Whether goods in transit or goods on consignment are to be included or excluded from an inventory should be decided on the basis of whether or not the taxpayer has title to the particular goods.

4. Except where an individual has elected under subsection 10(6) to value inventory at nil in computing income from an artistic endeavour (see IT-504), subsection 10(1) of the Act and section 1801 of the Regulations provide three alternative methods of valuing inventory. These are:

(a) valuation at the lower of cost or fair market value for each item (or class of

items if specific items are not readily distinguishable) in the inventory;

(b) valuation of the entire inventory at cost;

(c) valuation of the entire inventory at fair market value.

Once a taxpayer has adopted, or has been required to adopt, one of the foregoing methods of valuing his inventory, he must continue to use that method on a consistent basis in subsequent years. . . .

8. In the case of inventories of work in process and finished goods, cost means the laid-down cost of materials plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production. Either direct costing, which allocates variable overheads to inventory or absorption costing, which allocates both variable and fixed overheads to inventory, will be accepted by the Department as a method of costing inventory, but if overhead is included in inventory on an acceptable basis for financial statement purposes, the method of valuation used for tax purposes must not be inconsistent with the method used for financial statement purposes. .. . .

The fair market value of a professional business means the amount that can reasonably be expected to become receivable in respect thereof as the Act read at the time in this appeal and after the year-end for 1983 and subsequent taxation years. It is important to note that subsection 10(6) determines the value of work in progress to be included in the 1983 taxation year as one-half of either the cost of work in progress or its fair market value at the end of the 1983 taxation year. This transitional provision was available only where the election in paragraph 34(1)(d) had been made for the taxpayer's 1982 taxation year. Moreover, subsection 10(4) defines the fair market value of work in progress of a business that is a profession as the amount that can reasonably be expected to become receivable at the end of the year. This expected net realizable value appears to include partners' time, profit margins, and other elements of overhead that can reasonably be expected to be recovered on billing the specific unbilled work done before year-end.

3. Deductions for professional businesses

Generally, a taxpayer is taxed on the "profit" from his business. Profit is measured by calculating income from the business and subtracting various expenses that are allowable as deductions. These expenses must be reasonable and must be incurred for the purpose of generating income. Similarly, the deductions permitted for professionals must have been incurred for the purpose of earning income from a business (paragraph 18(1)(a)); they must not be a Capital expenditure (paragraph 18(1)(b)); and they must have been reasonable in the circumstances (section 67).

4. Interest on borrowed funds

Subparagraph 20(1)(c)(i) of the Act, allows for the deduction of interest on borrowed money used for the purpose of earning income from a business or property. It is important to note that earning income does not necessarily mean that you have to earn a profit. Interest expense is deductible if you own the related investment throughout the period of time the funds were borrowed. Moreover, where the deduction of interest exceeds the taxpayer's income for the year, the resulting loss can be carried back one year and forward five years against other employment, business or property income or taxable capital gains.

The word interest” is not defined in the Act, however the case law suggests that an amount to be characterized as "interest" must meet the following criteria:

(a) it must be calculated on a day-to-day accrual basis;

(b) it must be calculated on a principal sum; and

(c) it must be compensation for the use of the principal sum or the right to the principal sum. (see Miller v. The Queen, [1985] C.T.C. 139, 85 D.T.C. 5354 (F.C.T.D.))

In addition to the above characteristics, the amount of interest payable must reflect a reasonable amount.

The leading case on the deductibility of interest is the Supreme Court of Canada decision in The Queen v. Bronfman Trust, supra. It was held that only the direct use to which a taxpayer utilized borrowed money would determine whether interest payments could be deductible. As a result of this case, taxpayers are required to trace the use of borrowed money to a specific eligible use in order to qualify for the deduction. Notwithstanding this conclusion, the Supreme Court held that where there are exceptional circumstances, it may be appropriate to allow a deduction on interest from borrowed funds for an eligible use because of an indirect effect on the taxpayer's income earning capacity and on the basis that it was the taxpayer's bona fide purpose to use the borrowed moneys to earn income.

In Livingston International Inc. v. The Queen, supra, (a decision upheld by the Federal Court of Appeal), Pinard, J. held that a determination as to what portion of a loan is used to earn income and what portion is used for personal or living expenses, so that the part used to earn income can be deducted pursuant to paragraph 20(1)(c) of the Act, is essentially a question of fact; depending upon the evidence adduced by the taxpayer. (See also Kiss v. M.N.R., supra, and Mills v. M.N.R., supra).

In summary, subparagraph, 20(1)(c)(i) requires a taxpayer before deducting interest expenses to:

(a) trace the borrowed funds to an identifiable use which triggers the deduction; and

(b) demonstrate that the borrowed funds were used directly and immediately to earn income from a business or property.

The appellant in the case at bar explained that generally speaking, in a commercial litigation law practice (which amounted to approximately 80 per cent of his firm) given the delay in court actions, work in progress tends to accumulate for years. As such, he explained that the work in progress in essence amounted to the largest asset of his partnership which consisted of hours docketed to a file but not billed to a client.

The appellant submitted that the Minister’s assessment was made on a cash basis notwithstanding that the taxpayer's accounting was made on an accrual basis. He argued that the Minister refused to credit any amount for work in progress. He asserted that had these amounts been considered there would have been more than enough asset value to offset the amounts borrowed. He concluded that the interest was in fact interest to finance the asset base, namely work in progress, which in the future may convert to accounts receivable.

Conversely, the Minister disallowed interest relating to the partnership drawings in excess of the profit reported in the computation of income. The Minister submitted that given the inability of the appellant to trace the borrowed funds to ensure that they were utilized for business, and not personal use, the full deductions could not be allowed. The Court felt that the appellant gave a Satisfactory explanation.

5. Generally accepted accounting principles versus commercial practice

In The Queen v. Metropolitan Properties Co., [1985] 1 C.T.C. 169, 85 D.T.C. 5128 (F.C.T.D.) reference was made to the case of The Queen v. Marchand, [1978] C.T.C. 763, 78 D.T.C. 6507 (F.C.T.D.) wherein Addy, J. approved the statement of Thorson, P., in Daley v. M.N.R., [1950] C.T.C. 254, 50 D.T.C. 877, who indicated that a taxpayer can deduct an amount from income only if two conditions are satisfied:

1. that it would be normal practice according to generally accepted accounting principles to deduct the amount in question from an income account;

2. that the prohibitory provisions of subsection 18(1) do not prevent such a deduction.

In addition, reference was also made to the Supreme Court of Canada decision in Dominion Taxicab Ass’n. v. M.N.R., [1954] C.T.C. 34, 54 D.T.C. 1020, at pages 36-38 (D.T.C. 1021) where Rand, J. stated,

The expression "profit" is not defined in the Act. It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.

Interestingly, the decision in Neonex International Ltd. v. The Queen, [1977] C.T.C. 472, 77 D.T.C. 5321, was also quoted wherein the decision of Marceau, J. was subsequently approved by the Federal Court of Appeal in the same case ([1978] C.T.C. 485, 78 D.T.C. 6339, at pages 499-500 (D.T.C. 6348)),

There is no doubt that the proper treatment of revenue and expenses in the calculation of profits for income tax purposes with a view to obtaining an accurate reflection of the taxable income of a taxpayer, is not necessarily based on generally accepted accounting principles. Whether it is so based or not is a question of law for determination by the Court having regard to those principles.

In other words accuracy of the result must be considered. On the same point Thurlow, J., as he then was, in Silverman v. M.N.R., [1960] C.T.C. 262, 60 D.T.C. 1212 (Ex. Ct.) stated at pages 264-67 (D.T.C. 1214-15):

[S]ince what is declared to be the income from a business is the profit therefrom for the year, the method adopted must be one which accurately reflects the result of the year's operations, and where two different methods, either of which may be acceptable for business purposes, differ in their results, for income tax purposes the appropriate method is that which most accurately shows the profit from the year's operations.

In conclusion, Walsh, J. in The Queen v. Metropolitan Properties, supra, held at page 180 (D.T.C. 5137):

1. General Accepted Accounting Principles (GAAP) should normally be applied for taxation purposes also, as representing a true picture of a corporation's profit or loss for a given year.

2. By exception they need not be applied for income tax purposes if there is some section or sections in the Income Tax Act which justify or require a departure from them or do not correspond with what are commonly accepted business and commercial practices.

In the case of 74712 Alberta Ltd. v. M.N.R., [1990] 2 C.T.C. 2001, 90 D.T.C. 1401, Judge Teskey of the Tax Court dealt with the question of whether a corporation could deduct in computing income the interest paid on a loan. Referring to the decision in The Queen v. Bronfman Trust, supra, the Court emphasized that there is a trend in tax cases towards attempting to ascertain the true commercial and practical nature of the taxpayer's transaction. A trend towards what Lord Pearce has referred to as a "common sense appreciation of all the guiding features of the events in question”. (See B. P. Australia Ltd. v. Commissioner of Taxation of The Commonwealth of Australia, [1966] A.C. 224 (P.C.) at page 264; The Queen v. F.H. Jones Tobacco Sales Co., [1973] F.C. 825, [1973] C.T.C. 784, 73 D.T.C. 5577 (F.C.T.D.) at page 834 (C.T.C. 790-91).

The Tax Court judge cited the following passage from Chief Justice Dickson in Bronfman, supra at page 128 (D.T.C. 5067):

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers" transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

He continued to emphasize that notwithstanding the characterization as indirectly preserving income, borrowing money for an ineligible direct pur- pose ought not entitle the taxpayer to a deduction for interest payments. The Tax Court dismissed the appeal on the grounds that the use of the borrowed money fell outside the ambit of paragraph 20(1)(c) of the Act.

It has been seen in other cases dealing with whether an appellant is in the business of manufacturing or processing in Canada goods for sale or lease, that a "common sense, realistic and businesslike appreciation of all the facts” is essential. (See Industrial Forestry Service Ltd. v. M.N.R., [1992] 1 C.T.C. 2182, 92 D.T.C. 1060 and Design One Creative Graphic Production Ltd. v. M.N.R., [1991] 2 C.T.C. 2667, 92 D.T.C. 1006 (T.C.C.).)

In the decision of Dacen v. M.N.R., [1989] 2 C.T.C. 44, 89 D.T.C. 5297 (F.C.T.D.), Muldoon, J. referring to generally accepted accounting principles stated at pages 53-54 (D.T.C. 5303):

Surely such principles must exact that the departing partner's work in progress be accounted for at the date of his departure, instead of inflicting him with a burden of unreceived taxable income just because his departure did not occur exactly coincidentally with the end of some more or less arbitrarily chosen accounting period, as Mr. Middleton blithely asserted.

It is plain and obvious either that generally accepted accounting principles are woefully deficient, or the defendant's argument, depending as it does on the ethics and/or competence of LKH & H, is woefully deficient. In either case the plaintiff is not to be excessively reassessed by the Minister. The decision of the Tax Review Board affirming, as it does, the Minister’s faulty reassessment is to be set aside.

Finally, in Maritime Telegraph and Telephone Co. v. Canada, [1992] 1 C.T.C. 28, 92 D.T.C. 6191 (F.C.A.), MacGuigan, J. discussed two methods of accounting namely, the "earned" method which is based on an estimate of the amount of revenue earned at the end of the year and the “billed” method of reporting income. Both methods are in accordance with generally accepted accounting principles however, the earned method was held to give a truer picture of the taxpayer's income. MacGuigan J. noted that section 34 of the Act, permitted certain professionals to use the "billed" method of reporting income.

In agreement with the trial judge, MacGuigan, J. concluded that the purpose behind section 34 was to require taxpayers who report on a “billed” method, when there is undue delay in billing, to account for the income which has not yet been billed. Paragraph 12(1)(b) indicates that the income from a business is computed on an accrual basis not cash basis and that a taxpayer is required to include any amount receivable in respect of property sold or services rendered even though the amount may not be due until the next year. Therefore, he concluded that the receivables in question were to be included as income.

6. “Work in progress?' versus "accounts receivable"

The cases that discuss the treatment of work in progress do not in any significant manner address the issue under analysis in the present appeal. Moreover, the facts in each of the cases differ from those in the case at bar. Consequently, they are useful only to a limited extent.

In Carbert, Howe, McKeen Adjusters Ltd. v. M.N.R. (1965), 39 Tax A.B.C. 257,65 D.T.C. 628, the Tax Review Board allowed a deduction corresponding to fees earned by the vendor company for work done by it on files of work in progress completed by the appellant. Judge St. Onge stated at page 262 (D.T.C. 631):

The issue at stake is an accountancy matter and appellant thought proper to deduct from its profit the money paid for such work in progress, in order to find the true income derived from its insurance adjusting business. There is no question of an enduring benefit element in the acquisition of the files in progress as already mentioned in the chartered accountants” letter because “ each file is a single entity from which there is no continuity in the future”. For this reason, the cost for files in progress cannot be considered as a non-deductible capital outlay. It also can be said that appellant company was merely the assignee of these fees which it did not and could not earn.

In Wilson v. M.N.R. (1956), 15 Tax A.B.C. 24, 56 D.T.C. 194 (T.A.B.), a doctor retired and sold his interest in respect of accounts receivable to the remaining partners. The Board held at page 29 (D.T.C. 196-97):

The amounts received by him in respect of these outstanding accounts receivable would, in my opinion, be a capital receipt in his hands, representing the sale price received by him for his interest.

The services in respect of the said accounts receivable had already been performed, and the income in respect of those accounts receivable had already been gained although not actually realized. All that remained to be done by the partnership was the collection of the amounts outstanding. I am of the opinion, therefore, that the amount paid by the appellant and in question herein cannot be said to have been an outlay or expense which was made or incurred by him for the purpose of gaining or producing income, but rather that it was a payment which comes within the provisions of paragraph 12(1)(b) of the Act as a payment on account of capital.

In closing, the Tax Appeal Board held:

Correspondingly, the remaining partners have purchased a capital asset, namely, the retiring partner's interest in the book debts of the previous partnership, and thus any amounts paid by them in respect of the retiring partner's interest therein are to be considered a capital outlay which is not an allowable deduction.

Finally, in McGregor and Nelson v. M.N.R. (1969), Tax A.B.C. 1031, 69 D.T.C. 716, the Court held at pages 1039-40 (D.T.C. 720-21) that:

It must always be kept in mind that, although the income itself had actually already been earned, accounts receivable as such are not profits and are not yet income, although they may to some degree become income at the end of a fiscal year after all proper deductions have been applied to them. Until that final point of time, they remain a capital asset of the partnership, and, in the event of the sale and purchase of that asset, the positions of the vendor and the purchaser are not identical.

When the accounts were established, they represented fees already earned: it only remained to collect them. This would therefore clearly establish the accounts as an asset of the partnership from the time they were set up until they were paid in full, and during that period they could have been dealt with in any number of ways.

His interest in this asset was similar to his interest in any of the other assets of the partnership such as goodwill, furniture, reference books and equipment. Furthermore, the appellants admitted that, in acquiring this additional share in this particular asset, they had acquired, at the same time, what they recognized to be, and what in fact was, an enduring benefit.

The Court concluded that the two appellants had acquired a capital asset and that any outlay made by the appellants in respect thereof, was a capital outlay for which no deduction from income is permitted.

Interestingly, the Tax Court decision in Brock v. M.N.R., [1991] 2 C.T.C. 2121, 91 D.T.C. 1079 (T.C.C.) dealt with the computation of income from a law practice under section 34. In this instance, this Court was asked to examine whether certain amounts were receivables or work in progress. The appellant contended that the amounts were only interim billings sent only for information purposes to the respective clients. The Court held at pages 2127-28 (D.T.C. 1083-84) :

What is work in progress? It is not defined in the Act. It should then be given meaning that is consistent with the natural meaning of these words in the context of subsection 34(1) of the Act. It has to consist of services rendered about which an account has not been rendered or should not have been rendered if there had not been an undue delay. Because the services have been rendered, a proportionate amount of the fees should be included in the receivables but because they have not been invoiced, or should not have been invoiced, they may be excluded from the computation of income if an election is made to this effect by the taxpayer. This is the extent of the reserve allowed under subsection 34(1) of the Act since that reserve is allowed "except as otherwise provided by this section”. This section stipulates that an amount is deemed to be receivable in respect of that part of the services rendered that is invoiced or that should have been invoiced if it had not been for an undue delay, and therefore the part that remains for the exclusion of the work in progress is that part of the services rendered but not invoiced.

I am therefore of the view that the words "work in progress" mean that part of the services rendered which have not yet been invoiced or should not have been invoiced. In the case at bar, the services rendered have been invoiced.

The Tax Court dismissed the appeal on the grounds that the statements at issue were statements of account within the meaning of subsection 34(1) and were receivables.

Conclusion

It is common business practice in small law firms to finance work in progress in the manner followed by the appellant. In other words, borrowing large sums of money well above the profit range of a legal business and maintaining only one bank account, from which the partners make deposits and withdrawals jointly, are not unusual business practices.

The Canadian Master Tax Guide, Don Mills: CCH Canadian Ltd., 1991, at page 194, paragraph 3561, discusses the treatment of lawyers’ disbursements in the following manner:

Disbursements that a lawyer customarily makes in the ordinary course of his practice which are not chargeable directly to funds advanced by clients are considered to be his own expenses which may or may not be recoverable from his clients through his regular billing. Consequently, such expenses of a business nature incurred in a taxation year are deductible in computing his income for that year, unless the lawyer chooses to defer, for income tax purposes, that part of such expenses that relate to work in progress.

Furthermore, the work in progress of a lawyer is different from that of i.e., a manufacturer and therefore should not be accorded the same treatment.

In order that a deduction may be made by a professional in computing income from a business, the expense must be incurred by the professional for the purpose of earning income from the business. In addition, the expense must not be a capital expenditure and it must be reasonable in light of the circumstances. In examining the various facts in the case at bar, it appears that the appellant has adduced sufficient evidence to suggest that the interest expense was in essence incurred for the purpose of earning income from the partnership business and that the amounts were not of a capital nature nor were they unreasonable.

I have found no legal authority that would squarely prohibit the appellant from deducting interest expenses used to finance the work in progress of the partnership. The case law is clear that at times commonly accepted business and commercial practices must be adhered to in order to derive an accurate reflection of the profit of a business. These practices are allowed provided they are not prohibited by the Act and its corresponding Regulations. Furthermore, the Courts seem to indicate that although the treatment of accounts receivable is somewhat different from work in progress files upon the sale of a taxpayer's business, both are essentially characterized as assets of the business itself.

There is no question that work in progress is for the purpose of earning income for that year, but there is no requirement that it be for that year under the Act.

When work in progress becomes a receivable or is billed and paid for, the amount is taxed. To disallow the interest paid on borrowed funds needed to build this work in progress would be most unfair. The disallowed interest portion would result in a higher tax, and when the work in progress became a reality there would be imposed a tax without any credit. This almost amounts to double taxation.

All that is required is that the use of the borrowed funds be traced to the income earning process. This has been done here to the satisfaction of the Court.

The appeals for the 1981, 1982 and 1983 taxation years are allowed, with costs and the matter referred back to the Minister for reconsideration and reassessment.

Appeal allowed.