Her Majesty the Queen v. The Ennisclare Corporation, [1984] CTC 286, 84 DTC 6262

Stone J:—Worland Holdings Limited was incorporated under the laws of Ontario and had its head office in the town of Oakville. After instituting this action in August of 1980 its name was changed to The Ennisclare Corporation, the respondent in this appeal.

In 1972 the respondent owned a parcel of land in Mississauga, Ontario on which it intended to construct two condominium apartment buildings. The taxation of profit from the sale of individual condominium units in one of these buildings is in issue in this appeal. The land was purchased at a cost of $247,202 free and clear of mortgages and other encumbrances. Individual condominium units were sold so that by the end of its fiscal year ending June 30, 1977 the respondent had realized a sales profit. A portion of the sales proceeds, which included an element of profit, was not received in that year. It was receivable over time.

By section 9 of the Income Tax Act,* [1] the respondent’s income for the 1977 taxation year was the profit from its business for that year. Under paragraph 12(l)(b) of the Act the respondent, in computing its income, was required to include the receivable notwithstanding that it was not due until a subsequent year. Paragraph 18(l)(e) of the Act prohibits the deduction of an amount as a reserve in computing income “except as expressly permitted by this Part’’. The parties agree that a reserve is expressly provided for in subparagraph 20(l)(n)(ii) of the Act, which reads as follows:

20. (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:

(n) where an amount has been included in computing the taxpayer’s income from the business for the year or for a previous year in respect of property sold in the course of the business and that amount or a part thereof is not receivable,

(ii) where the property sold is land, until a day that is after the end of the taxation year,

a reasonable amount as a reserve in respect of such part of the amount so included in computing the income as may reasonably be regarded as a portion of the profit from the sale.

The only issue in this appeal is as to the amount of the receivable reserve permitted by these provisions in the circumstances of this case.

In its 1977 income tax return the respondent claimed as reserve the amount of $1,054,335 being equivalent to the amount of the receivable. The Minister of National Revenue took the position that the reserve had been improperly calculated and reduced it to $335,738. The respondent lodged a notice of objection in which it conceded that the reserve should be reduced to $969,691. The Minister disagreed with this new amount. This action resulted. The trial was heard by Mr Justice Mahoney and, on October 29, 1982, he ordered that the respondent’s income tax assessment for 1977 be referred back to the Minister for reassessment “on the basis that a reasonable reserve’’ is $969,592. This appeal is taken from that judgment.

The remaining facts are generally agreed to by the parties and are succinctly set forth in the reasons for judgment of the learned trial judge. It will be convenient to summarize them. After acquiring the land but before construction got underway the respondent set about to arrange a way of financing the cost of construction. It was able to accomplish this by way of a first mortgage. Initially, this mortgage stood at $5,132,280 but, as construction costs escalated, it was increased to $7,224,651. Construction proceeded. The building was completed during 1975 and a campaign was mounted to dispose of the units. The original first mortgage was discharged and was replaced by a new first mortgage in the same amount secured by the individual condominium units. By the end of the respondent’s 1977 fiscal year, a total of 163 units had been sold. In connection with these sales, the learned trial judge found:

With few exceptions, the selling price of each unit comprised three elements: assumption of a pro rata amount of the first mortgage, cash and a balance secured by second mortgage in favour of the Plaintiff. In rare cases, the cash payment was sufficient to obviate a second mortgage and, more exceptionally, to commute part or all of the first mortgage share. The Plaintiff had sold units in each of its 1975, 1976 and 1977 taxation years. By the end of its 1977 year, gross sales aggregated $7,249,593, whereof $436,808 was cash and $5,758,460 by first mortgage assumptions; gross profit to June 30, 1977, was $2,308,553 and the deferred balance of the second mortgages as at June 30, 1977, was $1,054,325. The construction cost attributable to the units sold to that date was $4,739,551.

The learned trial judge thus found that the units had sold for an aggregate amount of $7,249,593 whereas the cost to the respondent of constructing the units sold was $4,739,551. As already mentioned, that cost had been financed by way of first mortgage. In calculating the amount of the reserve, the respondent reduced the gross selling price by the cost of construction, leaving a net figure of $2,510,042. In effect, the respondent considered that this latter figure more truly represented its selling price of the units in the sense that it was the price received for its equity interest in the property. The appellant rejects that approach. In her view the gross selling price was represented by the aggregate of sale prices agreed to with the individual unit purchasers, namely, the full amount of $7,249,593 which included the “three elements” identified by the learned trial judge. Otherwise, she argues, the statute would be applied unevenly depending on whether the cost of construction was paid by the taxpayer out of his own pocket or, as here, financed by way of a mortgage loan.

The learned trial judge also found that the respondent had actually realized a gross profit when the first mortgage loan was assumed by the unit purchasers. This gross profit was represented by the excess of the first mortgage loan over the cost of construction, and amounted to $1,018,909. The result was that the respondent had been relieved of repaying this amount to the lender. The learned trial judge thought that this fact had also to be taken into account in arriving at the amount of the reserve for the 1977 taxation year.

In concluding that the $967,592 represented a reasonable amount as a reserve the learned trial judge, after referring to the decision of the Tax Review Board in Makis Construction Limited v MNR, [1972] CTC 2082; 72 DTC 1101, stated:

It is reasonable in this instance to take account of the first mortgage assumed by the purchasers. It must, however, be taken account of both as it affected the gross selling price and effected a realization of gross profit. I have no evidence upon which to propose a formula that would lead to a reasonable result in every such case; however, in this case, the following leads me to what I find to be a reasonable result.

The gross selling price, $7,249,593, less the cost of construction, $4,739,551, is $2,510,042. The cost of construction being totally attributed to first mortgage assumptions, the balance of the gross selling price breaks down as follows:

First mortgage assumed	—	$1,018,909	—	40.6%
Second mortgages back	—	1,054,325	—	42.0%
Cash	—	436,808	—	17.4%
TOTAL	—	$2,510,042	—	100.0%

It seems reasonable to allocate the $2,308,553 gross profit to each of those elements in the same proportions:

First mortgage assumed	—	$ 937,273	—	40.6%
Second mortgages back	—	969,592	—	42.0%
Cash	—	401,688	—	17.4%
TOTAL	—	$2,308,553	—	100.0%

The result is startlingly, and I trust coincidentally, similar to that arrived at by the Plaintiffs formula.

The Defendant led no evidence. I gather from the argument that the rejection of the Plaintiff's formula was actually a reaction that a reserve of $969,691, or 92%, of the entire $1,054,325 receivable was per se unreasonable. I do not accept that. The ratio of reserve to amount receivable will, in every case, reflect the ratio of gross profit to gross selling price. If the gross profit is, as here, extremely high relative to the gross selling price, the reasonable reserve will be extremely high relative to the receivable. That is pure arithmetic.

If adjustments in the circumstances of Makis and of Exhibit P-29 are appropriate, then the mere fact that the mortgage taken out by the vendor and assumed by the purchaser is very large relative to the selling price does not render them inappropriate nor, in my view, does the fact that the mortgage assumed exceeds the increase in the value of the property attributable to its proceeds as long as the excess is properly taken into account.

The learned trial judge had found that in testifying at examination for discovery concerning sample calculations of a reserve (marked as Exhibits P-28 and P-29) put to him by counsel for the respondent, an officer of the appellant had agreed that “either method of calculation described in Makis is acceptable in appropriate circumstances”. These methods are referred to more fully later in these reasons.

The appellant contends that the learned trial judge erred in arriving at the amount of the reserve. She suggests that, in effect, he had accepted the respondent’s position that the sum of $2,510,042 and not $7,249,593 represented the gross selling price of the units and, accordingly, that the former figure and not the latter should be used in calculating the amount of reserve permitted by subparagraph 20(l)(n)(ii). In her submission, the learned trial judge should have determined the reserve by calculating the percentage which gross profit from sale of these units bore to their gross selling price without any reduction for the cost of construction financed by way of first mortgage. This, she contends, was the usual method of determining the reserve which, in her view, involved the application of the following formula:

In the appellant’s submission this formula has been applied in practice and, with the exception of the decision of the Tax Review Board in the Makis case, has also been applied in the decided cases.

I am not at all persuaded by these submissions. To begin with, I can find nothing in the language of subparagraph 20( l)(n)(ii) that necessarily requires the application of such a precise and inflexible formula in determining the amount of reserve permitted by its provisions. Parliament, of course, is free in its choice of language to produce a desired result but, as was submitted by the respondent, failure to frame subparagraph 20( l)(n)(ii) in terms of a mathematical formula as was done in framing other provisions of the Actf [2] leaves open to serious doubt that it ever intended the determination of the amount of reserve under that section in all cases and under all circumstances to be made by applying a rigid formula. In my view, judging from the language it used, all that Parliament intended was that the amount of reserve be “reasonable”. The very use of that word suggests that Parliament, in its wisdom, understood that the amount of reserve would need to be determined from case to case and under differing circumstances rather than simply be the product of an inflexible formula.

I am fortified in this opinion by the views expressed in the decided cases concerning the interpretation of subparagraph 85B(l)(d)(ii). J [3] It, like subparagraph 20(l)(n)(ii), permitted the deduction of a reserve in respect of the profit element of an amount receivable. Its form was somewhat similar to that of the provisions in question. In MNR v Burns, [1958] CTC 51; 58 DTC 1028 Cameron J noted (at 58 [1032]) that the reserve permitted by paragraph (d):

. . . is that which can reasonably be regarded as a portion of the profit from the sale, and does not relate in any way to a proportion or a percentage of the gross amount of the sale or to the value of the receivables.

In commenting on the intent underlying subparagraph 85B(l)(d)(ii) in Station Heights Subdivision Limited v MNR, [1973] CTC 2004; 73 DTC 13, the Tax Review Board stated (at 2006 [16]):

The Income Tax Act and the Income Tax Regulations nowhere set out any formula or any procedure for determining what is a reasonable amount. However, there are cases which deal with the issue and in which the formula, gross profit over gross selling price, less the amount of the mortgage assumed, times the amount receivable, can produce a reasonable amount.

Finally, in the Makis case, this important point was once again emphasized by that Board when it stated (at 2087 [1105]):

In computing the amount of the reserve to be granted to a vendor, it is important to bear in mind that such a reserve under section 85B(l)(d) is only allowable in respect of the profit element in the amount receivable. The only requirement in regard to the allowable amount of a reserve in respect of the profit element in such a receivable is that the reserve must be a reasonable amount.

I entirely agree with these observations. It seems to me that subparagraph 20(l)(n)(ii) calls for no more than the determination of a “reasonable amount” as a reserve. The section does not on its face or by necessary implication require that this determination be made in every case and regardless of circumstances merely by applying an inflexible formula. At the same time, in the present case it seems to me proper that the determination be made by taking into account the percentage of gross profit contained in the gross selling price of the units.

Illustrations of differing applications of the provisions of subparagraph 85B(l)(d)(ii) under differing circumstances are to be found in the Makis case. There, the taxpayer had built an apartment building on land acquired by it in 1959. The cost of construction was financed almost entirely through borrowed money under mortgage loan arrangements. As the building could not be operated at a profit, the taxpayer decided to sell it. The sale price of $680,000 was made up, in part, of $400,000 in the first mortgages assumed and in a second mortgage of $167,000 taken back by the taxpayer. The taxpayer claimed a reserve in respect of this latter amount which was not due until after the end of its 1967 taxation year. In computing the reserve the Minister, however, reduced the selling price of $680,000 to $280,000 by deducting the full amount of the first mortgages assumed. As a result, a reserve of $130,000 was arrived at. In agreeing with the reasonableness of this amount the Tax Review Board had this to say about the application of subparagraph 85B(l)(d)(ii) of the Act (at 2087-88 [1105- 06]):

In practice, it is considered reasonable to assume that the percentage of any amount of the sale price receivable in a subsequent taxation year that should be taken to represent the profit element included in the said receivable would be the same percentage of that receivable as the gross profit is of the total sale price. Conceivably a reserve might be allowed equal to the full amount of the profit so determined if no portion at all of the selling price had been received in the year of sale. Stated as a formula, the foregoing would be expressed as:

Gross Profit	x	Amount	Reserve
Gross Selling Price		Receivable

A modification of this formula is called for in a situation where an existing mortgage (or mortgages) is assumed by the purchaser, provided that none of these assumed mortgages has been placed on the property subsequent to the completion of the building so. as to reduce the owner’s existing equity in the property. In such a case, the mortgage or mortgages so obtained are disregarded in calculating the reserve. In the case of the assumption of an existing mortgage by the purchaser, the above formula is modified by changing the denominator from the amount of the gross selling price to the difference between the gross selling price and the amount of the mortgage or mortgages taken out on the building during construction and later assumed by the purchaser. The formula then becomes:

Profit	x	mount	Reserve
Gross Selling Price		Receivable
less Mortgages Assumed

On this appeal the appellant contends that, as we are not bound by the decision in the Makis case, we ought to apply the first formula rather than the second one discussed in that case.

In my opinion, having regard to the fact that the language of the provisions with which we are concerned requires only that the amount of the reserve be “reasonable”, the learned trial judge did not err in declining to apply the first formula discussed in the Makis case. It was open to him to do as he did, namely, to take the cost of construction, as financed by way of first mortgage, into account in making his determination of the reserve. The result of doing so was to accept as the gross selling price of the units the aggregate prices agreed to by their purchasers less the cost of construction financed by way of first mortgage.

In the result, I do not think that the learned trial judge erred in fixing $969,592 as a “reasonable amount” of reserve within the meaning of subparagraph 20( l)(n)(ii) of the Act. I would therefore dismiss this appeal with costs.