Earlscourt Sheet Metal Mechanical Limited v. Minister of National Revenue, [1988] 1 CTC 2045, 88 DTC 1029

Goetz, T.C.J.:— This is an appeal heard at the City of Toronto, Ontario, on July 31, 1987, against reassessments disallowing the following deductions for the 1974 and 1975 taxation years:

(1) accrued management salaries in the amount of $180,000 and $150,000 for the appellant's 1974 and 1975 taxation years respectively; and

(2) an expenditure for land transfer tax in the amount of $3,027 claimed in the appellant's 1975 taxation year as an outlay or payment on account of capital.

Prior to trial, however, the appellant conceded the respondent's position regarding the second issue and accordingly the only question remaining to be determined is the deductibility or non-deductibility of the "accrued salaries".

Facts

At the hearing, two witnesses appeared — both for the appellant.

Mr. Stanley Dodson is the recipient of the accrued salaries at issue in this appeal. From 1965 through 1975 he was the sole shareholder, director and sole officer of the appellant corporation. In that capacity he exercised control over the appellant’s operations and expended an average of at least 50 hours a week on its behalf throughout this period, including 1974 and 1975. In 1977, Mr. Dodson turned the management of the appellant over to other employees of the corporation to devote his time to farming.

The second witness, Mr. Hubert Teunissen, is a certified general accountant who has worked as an accountant for the appellant since November 24, 1974. At all material time after November 24, 1974, Mr. Teunissen was responsible for the recording and preparation of financial statements of the appellant.

Both witnesses’ testimony has served to constitute the following summary of facts:

The appellant is a corporation incorporated in 1965 which has continuously carried on business as a fabricator and installer of sheet metal products since that date. It has always operated on a contract basis and has employed in the mid-1970’s up to 15 full-time employees including Mr. Dodson.

Ever since the appellant's incorporation including the two years under appeal (1974 and 1975) Mr. Dodson never received a salary or dividend to remunerate him for his effort. Instead, in each year and without exception, the appellant followed an accrued management wages system to remunerate Mr. Dodson. Under that system, Mr. Dodson would track the appellant's profits on a monthly basis so that by the end of the appellant's fiscal year (December 31) or shortly thereafter, he would have an accurate indication of the appellant's profits for the year. Based on those monthly estimates and what Mr. Dodson felt the appellant could afford to pay, he would determine his accrued salary for the immediately preceding taxation year. Such accrued salaries were reflected as “salary expenses" in the appellant's Auditors' Report.

With the exception of the two years under appeal all accrued salaries established by the appellant in favour of Mr. Dodson were paid to him.

Aside from the appellant, Mr. Dodson had other ongoing business ventures, such as the purchase and the commercial development of real estate.

On November 6, 1974, Mr. Dodson signed an offer to purchase a six-acre parcel of land ("the land") for the price of $495,000 (see Exhibit A-1). This land purchase closed on January 15, 1975. At that time, although he was short of available funds to develop the land, his monthly tracking of the appellant's profits indicated that the funds needed could be supplied in the course of 1975 as the amount of the 1974 accrued salaries was expected to be substantial.

In June 1975 the 1974 accrued salaries in the amount of $180,000 were effectively recorded in the books (see Exhibit A-2). At that time the appellant's financial statements for its 1974 fiscal year (ending December 31) were released. They showed that the appellant was in a sound financial position (see Exhibit A-3):

— Per Schedule of Selling, General and Administrative Expenses, aggregate salary expenses for 1974 in the amount of $260,215 (including $180,000 in accrued salaries);

— Per Statement of Operations, net profits before corporate taxes for 1974 in the amount of $204,172 (after deduction of $180,000 in accrued salaries);

— Per Statement of Retained Earnings, balance of retained earnings for 1974 in the amount of $345,624 (after subtraction of $180,000 in accrued salary expenses).

In August 1975, Mr. Dodson discussed the development of the land with Mr. Teunissen. The development project was conceived as a two-commercial building complex on three of the six acres of the land. Its estimated cost was $600,000 over and above the land. In the course of the same discussion, Mr. Teunissen pointed out that if Mr. Dodson chose to develop the land himself, he would have to receive approximately $1.2 million (before taxes) from the appellant in order to be able to afford the construction cost of the complex. As this option was found to be too costly for both the appellant and Mr. Dodson, Mr. Teunissen suggested that arrangements be made for the appellant to buy the land from Mr. Dodson with a view to developing the project through the appellant. On October 14, 1975, Mr. Dodson transferred the land by Deed of Sale (see Exhibit A-5) to the appellant.

During the latter half of 1975, the appellant determined that it should not pay the 1974 accrued salaries of $180,000 before the end of construction, which was predicted for August 1976. By the end of 1975, the appellant had committed around $600,000 to developing the project.

In May 1976 the 1975 accrued salaries in the amount of $150,000 were effectively recorded in the books (see Exhibit A-8). At that time the appellant's financial statements for its 1975 fiscal year (ending December 31) were released. They showed that the appellant was in a sound financial position (see Exhibit A-9):

— Per Schedule of Selling, General and Administrative Expenses, aggregate salary expenses for 1975 in the amount of $254,951 (including $150,000 in accrued salaries);

— Per Statement of Operation, net profits before corporate taxes for 1975 in the amount of $164,757 (after deduction of $150,000 in accrued salaries);

— Per Statement of Retained Earnings, balance of retained earnings of 1975 in the amount of $441, 270 (after subtraction of $150,000 in accrued salary expenses).

By the end of the summer of 1976 the project was completed on schedule and permanent financing in the amount of $660,000 was placed thereon by way of a mortgage from Eaton Life Assurance Company dated September 16, 1976 (see Exhibit A-7).

Some time after August 5, 1976, the appellant received an offer to lease the other three acres of the land. This lease required the appellant to acquire five acres of adjoining land and to construct another building on the five- acre and three-acre parcels. The appellant felt it had a "hot" property and decided to accept this offer and proceeded to expand its initial project into a second phase.

The first phase and the second phase of the project cost $1,800,000.

By the end of 1976, Mr. Dodson and Mr. Teunissen met to discuss the payment by the appellant to Mr. Dodson of his $150,000 1975 accrued salary. Mr. Teunissen advised that in light of the anticipated cost of the second phase of the project and the financial commitment required by it, the appellant was not in a position to pay the 1975 accrued wages.

In view of the following “History of accrued bonuses for Mr. Stanley Dodson" (Exhibit A-10), prepared by Mr. Teunissen, it would appear that the foregoing of the 1974 and 1975 accrued salaries were the exception rather than the rule:

In filing the appellant's income tax return for the 1974 and 1975 taxation years, the amounts of $180,000 and $150,000 respectively were deducted from the appellant's taxable income pursuant to paragraph 18(1)(a) of the Income Tax Act (the Act). This provision states:

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

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

As neither of the aforementioned amounts of $180,000 and $150,000 was actually paid to Mr. Dodson at the end of the first taxation year following the taxation year in which they were claimed as deductible, the appellant added back the unpaid accrued salaries to the computation of its income for 1976 and 1977. This accounting operation, which was disallowed by the respondent, was made relying on paragraph 78(3)(a) of the Act which states:

78. (3) 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, . . .

Appellant's Position

The main allegations brought forth by counsel for the appellant are summarized in the notice of appeal:

The management salaries in question were properly accrued and were liabilities of the Appellant, were incurred for the purpose of earning income for its business, were reasonable in the circumstances, and were not incurred on account of capital. Accordingly, these amounts were properly deductable (sic) in the years in which they were incurred.

Respondent's Position

As for the respondent, it is argued that the accrued salaries were not amounts expended for the purpose of gaining income from a business and may not be deducted in the computation of the appellant’s income for its 1974 and 1975 taxation years by virtue of paragraph 18(1)(a) of the Act. Further as the respondent assumed in his reassessment that there was no legal obligation on the part of the appellant to pay the amounts in question and as such amounts were not in fact paid, the respondent submits that the said amounts were non-deductible reserves or contingent amounts as provided in paragraph 18(1)(e) of the Act.

In the alternative, it is contended that even if the so-called "management salaries" were construed as being expenses, their deduction would artificially reduce the income of the appellant and thus their deduction is prohibited by virtue of subsection 245(1) of the Act.

Findings

Referring first as to whether the payment of the accrued salaries was expended for the purpose of earning income from a business or as to whether the salaries were reserves or contingent amounts, I note the following excerpt from the decision of the Tax Review Board in the case of V.R. Enterprises Limited v. M.N.R., [1974] C.T.C. 2099 at 2103; 74 D.T.C. 1089 at 1091, where L.J. Cardin, Esq., P.C., Q.C. (as he then was) writes:

Even though salaries and bonuses may sometimes be used interchangeably, I do not believe that all bonuses are deductible expenses. Before a bonus can be considered as an integral part of salary and a deductible expense, it must, in my view, meet certain criteria. Some of the criteria would be —

1. The amount of bonuses paid or accrued must be reasonable in comparison with the profit earned by the company and the services rendered by the recipients.

2. The services for which the bonuses are paid must be real and identifiable.

3. Though the quantum of the bonuses, which are usually based on the amount of profit realized by a corporation, need not necessarily be precisely determined beforehand, there must be some justification for expecting an amount of income over and above the regular yearly salary.

4. There must be some relationship between the bonuses paid or accrued and the income earned or to be earned at least in the form of a well-established and well-known incentive.

5. Bonuses to be paid or accrued in a particular year must be established within a reasonable time from the moment the corporation's profit for that year has been determined.

Applying the above five-part test to the facts of the present case, I find in accordance with criterion (1) that accrued salaries of $180,000 for 1974 and of $150,000 for 1975 are reasonable in view of the appellant's profits and Mr. Dodson's participation as sole director and officer of the appellant during these years. Conversely, as set out in criterion (2), I am satisfied that Mr. Dodson did not expend in excess of 50 hours per week on behalf of the appellant without the intention and the expectation of being remunerated for his service and thus I find that Mr. Dodson's services were real and identifiable.

Before discussing criteria (3) and (4), which for practical purposes will be analyzed together, I wish to address criterion (5). Under criterion (5), accrued salaries should be set up within a reasonable time of determining the appellant's profit. Given that it was established in Mr. Teunissen's testimony that the 1974 and 1975 accrued salaries were set up and recorded in the books at or about the same time the 1974 and 1975 financial statements were released, that is in May 1975 and June 1976 respectively, I am also prepared to accept that Mr. Dodson's accrued salaries for the years at issue were set up in conjunction with the drafting of the financial statements for those years.

Returning to the third and fourth criteria as articulated in the case of V.R. Enterprises (supra), it should be stressed that of the five criteria the third and fourth have undergone the greatest degree of redefinition since 1974. Instead of simply requiring "some justification for expecting an amount of income" based on a “well-known incentive”, the Courts have now come to expect proof that there is a legal obligation to pay the accrued salaries, before same can be considered deductible expenses incurred for the purpose of earning income.

In the case of Brazolot Construction Limited v. M.N.R., [1981] C.T.C. 2468; 81 D.T.C. 449 (T.R.B.), a clear statement is made of what the Courts will generally consider sufficient evidence of a legal obligation to pay accrued salaries. At page 2474 (D.T.C. 453), Mr. D.E. Taylor (as he then was) states:

—The evidence for the existence of a “legal obligation” to pay was

(a) the previous years' established pattern;

(b) the standard accounting entries in the record setting it up; and

(c) the reference to it in the financial statements for the year.

In the case at bar, as written evidence of journal entries and references in the financial statements of 1974 and 1975 were filed of record (see Exhibits A-2, A-3, A-8 and A-9), the only obstacle which could prevent the appellant from establishing a legal obligation to pay Mr. Dodson's accrued salaries, would be if the existence of a systematic pattern of accruing Mr. Dodson's salaries was not clearly proven by the appellant.

On that question, counsel for the appellant argues that the chart entitled "History of accrued bonuses for Mr. Stanley Dodson" (see Exhibit A-10 reproduced in my summary of the facts) clearly proves that the appellant has consistently followed the same pattern since 1967 regarding Mr. Dodson's remuneration. On the one hand Mr. Dodson's salaries were accrued at the end of each fiscal year while, on the other hand, the same accruals were paid within the following year (except in 1971 and 1972, when payments were made in the following two years of the year the salary expense was incurred). In contrast, counsel for the respondent submits that "although the appellant has a history of declaring bonuses, it does not have a history of paying them". In counsel's view, the appellant has no history of payment since amounts alleged to have been "paid" between 1967 and 1975 were not in fact always paid in cash to Mr. Dodson.

In so far as the latter argument is concerned, I would agree that evidence shows that payments of Mr. Dodson's accrued salaries were indeed executed in one of two ways, i.e. in cash to Mr. Dodson, or by cheque to the shareholder account. However, I disagree with counsel's argument in this assumption that because some amounts were paid by cheque to the shareholder account, those payments should not be considered as "amounts paid” (see Exhibit A-10). In my opinion, payments by crediting the shareholder account is payment. Whether Mr. Dodson was paid cash or via the shareholder account (of which he is the sole shareholder) should make no difference — either way the result is a reduction of the accrued liability account. As Mr. Justice Cattanach puts it in the case of The Queen v. Canadian-American Loan and Investment Corporation Limited, [1974] C.T.C. 101 at 106; 74 D.T.C. 6104 at 6108 (F.C.T.D.):

The mere fact that there was no handing of money back and forth and the embodiment of the transactions consisted of book entries is still the equivalent of the payment and receipt of money.

In view of the above, I have no objection to considering the uncontradicted testimony of both Mr. Dodson and Mr. Teunissen (which testimony was supported by the financial records of the appellant) as sufficient evidence of the existence of a well-established system of accrued salaries. This, in turn, confirms that the appellant had an obligation to pay Mr. Dodson for his services and that Mr. Dodson's accrued salaries were indeed deductible business expenses within the meaning of paragraph 18(1)(a) of the Act.

Turning now to the second question in this appeal, that is whether the deduction of Mr. Dodson's accrued salaries for 1974 and 1975 was artificial, the leading case on the subject is the pronouncement of the Supreme Court of Canada in Stubart Investments Limited v. The Queen, [1984] C.T.C. 294; 84 D.T.C. 6305. In that decision, the Court provided certain interpretative guidelines (see pages 316-17 (D.T.C. 6323-24)) as to what transactions should be considered inoperative on the basis of their artificiality.

According to Stubart (supra), ”. . . Where the facts reveal no bona fide business purpose for the transaction, section 137 [now subsection 245(1)] may be found to be applicable depending upon all the circumstances of the case.” In the instant case, although it may well be that Mr. Dodson's remuneration was set up with an eye to the tax implication, there was in the accruing history of the appellant no evidence of "the heights of 'artificiality'" envisioned in Stubart (supra).

Alternatively, ”. . . In those circumstances where section 137 does not apply," such as in the present case, the Supreme Court affirmed that "the older rule of strict construction of a taxation statute, as modified by the Courts in recent years (supra), prevails but will not assist the taxpayer" where the transaction is incomplete or a sham. Here, again, I think that the appellant's deduction of Mr. Dodson's 1974 and 1975 accrued salaries cannot be put aside. In the circumstances there is no sham as there was no deceit, and it is held that there is no question that there existed in 1974 and 1975 an incomplete transaction as a legal obligation to pay Mr. Dodson.

Lastly, it is stated in Stubart (supra) that even if a transaction is made with the avowed purpose of minimizing tax, it should not be declared inoperative unless it runs counter to the apparent “object and spirit" of the statutory provision or the principle on which relies the transaction.

In the circumstances of this appeal one may be forgiven for believing that paragraph 78(3)(a) of the Act is the basis on which the appellant was able to redistribute substantial amounts of income from years of unusually high profits (i.e. 1974 and 1975) to years of losses or low profits (i.e. 1976 and 1977). This clearly is not so. Paragraph 78(3)(a) is not an estate planning provision since it does not allow any deduction, deferral of income or exclusion. What this provision simply sets out is a statutory bar compelling a taxpayer to either (1) pay, or (2) include in the computation of his income unpaid amounts of deductible expenses within two years from the year the expenses were incurred.

Instead of looking at paragraph 78(3)(a), I trust that the legal basis on which the appellant can rely is partly paragraph 18(1)(a), which I have previously determined to have been properly adhered to and partly the “accrual method", which allowed the appellant to defer the payment of Mr. Dodson's salaries within the two-year limit set out in paragraph 78(3)(a). Given that the canons of the accrual method were followed by Mr. Teunissen, in that he kept record of the set-up of Mr. Dodson's accrued salaries, and as the unpaid amounts of $180,000 and $150,000 were effectively computed in the appellant’s income for 1976 and 1977 respectively, I am satisfied that the apparent "object and spirit" of the relevant provisions of the Act were respected and that the deduction of Mr. Dodson's accrued salaries for 1974 and 1975 was not artificial.

The appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment on the basis that the appellant is entitled to deduct the amounts of $180,000 and $150,000 for the 1974 and 1975 taxation years respectively. The appellant is entitled to party and party costs.

Appeal allowed.