Brazolot Construction Limited v. Minister of National Revenue, [1981] CTC 2468, 81 DTC 449

D E Taylor:—This is an appeal heard in London, Ontario, on April 6, 1981, against income tax assessments for the years 1976 and 1977 in which the Minister of National Rvenue disallowed an amount of $150,000 charged as “management salary” for the year 1976, and refused to consider it as income in the year 1977 when the charge was reversed.

The notice of appeal sets out appropriately and precisely the position adopted by the appellant:

FACTS AND GROUNDS FOR APPEAL

(1) Brazolot Construction was incorporated in 1959 and since incorporation has operated as a residential home builder specializing in speculative and custom built homes. Mr. Peter Brazolot is the owner-operator principal. He owns 75% of the issued common shares. The remaining 25% is held equally by his children.

(2) Each and every year since incorporation there has been unpaid management remuneration at each year end. Each time this said remuneration was paid or credited to employees within the next twelve months. The following information applied to the March 31, 1974-76 fiscal years.

	Management	Unpaid					Paid Or
	Salary	At	At	Allocated		Credited
	Expense Claim		Year End To		To	By	By
March 31. 1974	$171,524	$158,200		Peter Brazolot		March 31, 1975
March 31, 1975	$173,063	$140,000		Peter Brazolot		March 31, 1976
March 31, 1976	$195,000	$195,000		Peter Brazolot			—
(3) The Corporate Position at March 31, 1976 as follows:

Operations

The March 31, 1976 year was the best year in the corporation’s history. Sales were almost $1.5 million with an excellent gross profit margin per house. The company continued to build and acquire subdivision lots. Profitable sales aggregating more than $250,000 were scheduled to close within 90 days.

Financial Position

(a) The Company had cash on deposit of $50,984.

(b) The Company held an Agreement for Sale Receivable of $150,000 with a maturity date of September 21, 1976.

(c) The Company had no bank indebtedness. It had however a line of credit of $150,000.

(d) The Company had retained earnings of $526,737 at March 31, 1976.

(e) The net worth of the Company was approximately $600,000.

(4) As indicated in Item (2) the corporation allocated a management salary to Peter Brazolot in the amount of $195,000. A letter was issued to company auditors dated March 31, 1976 confirming same and indicating that the said salary would be paid or credited before March 31, 1977. A copy of this letter is attached herewith as Schedule #1. This allocation was reflected in the 1976 financial statements.

These statements were approved in the corporate minutes and distributed to the usual recipients.

(5) The Company Auditor, as was customary, provided a list of tax instalments to be made in the next twelve months. The auditor’s copy of this list taken directly from his files is enclosed herewith as Schedule #2. The bottom four lines indicated that in December, 1976 and March, 1977 employee tax deductions totalling $101,000 were to be remitted on behalf of Peter Brazolot.

(6) In the three month period to July 1, 1976 the houses refered to in Item (3) were sold as follows:

(7) Following the above sales, the 1977 fiscal year was a disaster. No more houses were sold. Houwes in progress could not be sold and consequently construction could not be commenced on raw subdivision lots. Carrying costs of interest, taxes, insurance, utilities and maintenance were incurred on all work in progress. Sales declined in the March 31, 1977 year from $1.5 Million to $406,417. This was comprised as follows:

		Sale	Gross
Project	Closing Date	Proceeds	Profit
E2	June 25, 1976	$ 48,574	$ 10,459
E9	June 30, 1976	75,450	10,743
E15	July 1, 1976	148,931	$ 29,480
		$272,955	$ 50,682

House Sales (3) — made Apr. 1/76- July 1/76	$272,955
Lot Sale (1) — with a cost of $27,571	27,000
Renovations and Repairs	106,462
	$406,417

(8) In January 1977, a nine month interim financial statement to December 31, 1976 was prepared for management and banking purposes. A copy of the operating statement and the master typing sheet are enclosed herewith and market Schedule 3. This interim statement indicates under “Other Income” that management salary totalling $120,000 was to be cancelled. The key point is that by this time events had turned so unfavourably that such a cancellation was required even in private and internal management statements.

(9) On March 21, 1977 Peter Brazolot provided Brazolot Construction Limited with a Consent Letter agreeing to cancel the outstanding upaid balance of $150,000. A copy of this letter is attached as Schedule 4. Such consent being given, the company by minutes dated March 28, 1977 formally cancelled a management salary of $150,000. A copy of these minutes are enclosed as Schedule 5.

(10) The disposition of the $195,000 liability was as follows:

Paid to Peter Brazolot
April 1, 1976 to December 31, 1976	$ 20,260
January 1, 1977 to March 31, 1977	24,740
Total	45,000
Portion Cancelled	150,000
Total Claim	$195,000

(11) The corporate position at March 31, 1977 was as follows:

Operations

The March 31, 1977 year was the worst year in the corporation’s history. Sales declined over $1 Million. There had been no house sales since July 1, 1976. The company only had one committed sale to close within 90 days and it was simply a realization of inventory without any profit.

Financial Position

(A) The Company had Cash on Deposit of $6,317.

(B) The Company had bank indebtedness of $100,000. Its credit limit remained at $150,000.

(C) Peter Brazolot had injected an additional $47,000 in loans into the Company in February and March 1977.

(D) The following inventory was owned by the company:

Subdivision Lots	— 31	$ 831,298
Unsold Houses	— 17	956,319
	48	$1,787,617

(12) To finance operations in the March 31, 1977 year the following funds had been utilized:

Bank Loan	$100,000
Realization of Agreement for Sale	150,000
Loans from Peter Brazolot	47,000
	$297,000

(13) A management salary charge of $27,000 was made for the March 31, 1977 year. The letter allocating same to Peter Brazolot is dated March 31, 1977 and a copy is attached as Schedule #6. The $27,000 was paid to Peter Brazolot within the next calendar year.

(14) The Canadian Imperial Bank of Commerce was and remains the company’s banker. They supported the Company but kept its position under constant scrutiny in the latter part of 1976 and early 1977. The position at that time might be described as frightening with the seventeen unsold houses and thirty-one building lots and their resultant carrying costs. While the company was within its credit line the local manager made it clear that any large management withdrawal would be looked upon with disfavour. The bank liked the treatment given the unpaid management salary on the December 31, 1976 internal interim statements and gently suggested that this policy be followed on the year-end statements.

(15) The company registered with the H.U.D.A.C. home warranty program on May 1, 1976. At that time it submitted financial statements to prove its credit worthiness. The program became mandatory January 1, 1977 and all builders were required to submit annual statements. The company wanted to show a favourable balance sheet in its first renewal submission. It was also concerned that a loss would be thoroughly investigated by H.U.D.A.C. The cancellation provided relief to any fears that registration might be withdrawn by H.U.D.A.C.

SUMMARY OF GROUNDS

(1) The Management salary was indeed a valid expense under the Act as the amount was comparable to prior years’ expense claims (1974 and 1975).

(2) The practice of claiming an expense in a fiscal year and paying it within the next twelve months had consistently been followed by the company since incorporation. There has been no prior cancellations.

(3) The company was in a position to pay the management salary payable as evidenced by its balance sheet at March 31, 1976. In fact it has earmarked the $150,000 Agreement for Sale Receivable to be specifically applied to extinguish this liability. With a net worth of $600,000 and retained earnings of $526,737 and no bank indebtedness the Company was well able to manage this liability at March 31, 1976. Payment of the related employee’s tax deduction was duly noted by the auditor in his schedule of tax instalments.

(4) The cancellation occurred solely because of an incredible change in the company’s operations. The change came in one year. It went from the best position in history in March 1976 to a fight for survival in 1977. The very methods of speculative building and land acquisition which had been so successful in the past had now reversed and were threatening the operation’s existence. The cancellation greatly assisted the company’s financial position for presentation to its bankers and the H.U.D.A.C. warranty program.

(5) The decrease in cash deposits, the increase in the bank loan to $100,000 by March 31, 1977 and the injection of $47,000 in loans by Peter Brazolot in early 1977 are hard evidence of the deteriorating financial position of the company and its resultant inability to discharge this liability by March 31, 1977.

(6) In view of the financial circumstances of the company as previously outlined it is the company’s contention that the entire matter was done solely for good and valid business reasons and therefore the corporation’s reporting was proper as Originally submitted.

(7) Recently released tax cases confirm the treatment by the company. These are — The Queen v V & R Enterprises Limited, [1979] CTC 465; 79 DTC 5399; Toronto Heel Limited v M.N.R., [1980] CTC 2277; 80 DTC 1250.

The contentions of the respondent were:

— The appellant did not create and did not intend to create a legal obligation to pay the amount of $150,000 as management salary;

— The managment salary payable in the amount of $150,000 claimed as a deduction from income in the appellant’s 1976 taxation year was not an outlay or expense incurred by the appellant for the purpose of gaining or producing income in the appellant’s 1976 taxation year;

— The appellant was not required by its banker of HUDAC to take any particular course of action with respect to management salary.

Evidence

Mr Peter Brazolot, president of the appellant company, testified that it was his practice to accept the advice of his accountants in such matters. Mr William Brohman, CA, the partner in the firm of Robinson, Lott and Broh- man, Chartered Accountants, testified that in the particular year at issue, the cash flow problem had intervened to restrict payment of the amount in question, but that the obligation to pay had been established according to the regular pattern for such remuneration followed in the company.

Argument

The case law referenced by the parties included:

G W Dorman Pulp Chip Limited v MNR, [1981] CTC 2005; 81 DTC 21;

Toronto Heel Limited v MNR, [1980] CTC 2277; 80 DTC 1250:

Her Majesty the Queen v V & P Enterprises Limited, [1979] CTC 465; 79 DTC 5399;

McClain Industries of Canada, Inc. v The Queen, [1978] CTC 511; 78 DTC 6356;

Ken & Pay’s Collins Bay Supermarket Limited, [1975] CTC 504; 75 DTC 5346.

Significant points made by the agent for the appellant were:

(Mr. Brazolot) had been consistent since 1959 in the treatment of accrued salaries and payment of salaries and in fact we have submitted a schedule to show the consistency. . . . he had substantial (personal) cash requirements and in fact did take the cash out of the company. There is no indication that the situation he was

involved with was strictly a bookkeeping type of entry. He did feel he was entitled to take the money and did take the money until 1976.

Mr. Justice Cattanach said in the McClain Industries case (supra), [1978] CTC 523-4; 78 DTC 6365;

“Consistent with the practice at the end of the 1971 year the directors, after considering the income generated in that year set up a fund of $60,000 to be paid in equal shares to the three management employees throughout the 1972 fiscal period. That fund was shown in the financial statement as at March 31, 1972 as a debt owing to those employees. That entry is of itself evidence of a liability existing.

It was determined to be for such services performed by the management personnel in the preceding year to be paid in the year and the fund was set up after careful consideration being given by the directors whether the business operations and returns of the prior year justified a fund in the amount determined to be paid in the next ensuing year. In reality it was a delayed payment for services previously performed.

The only contingency, if it is properly termed a contingency in the present appeals was that the directors might, if they considered business conditions demanded, reduce or even cancel the fund so set up. In the absence of any contractual liability forbidding them from doing so, which does not prevail in the present instance or if it did was readily susceptible of being waived by the contracting parties, there is no impediment to the directors do so. (Italics mine.)

.. . accrued management salaries are an acceptable method of accounting, that properly followed with a consistent history are acceptable to the courts. I think Mr. Brohman has indicated that as the auditor of the company he was satisfied that the accrual was proper. He gave an auditor’s report without reservation. He felt that it was a reasonable matching of income and expenses consistent with past treatment, that the timing was the same as every other year, that is cash had been withdrawn on a consistent basis after the fiscal period and before the end of the next year.

I believe the Dorman case (supra) deals with an isolated bonus which was not part of the pattern or history of the corporation. I believe in Mr Brazolot’s case that management salary accrual certainly was in discussion with Mr. Brohman, but it was done evey year on the same basis. Therefore, I feel that with (sic) that isolated comment about the Dorman case is not particularly applicable to Mr. Brazolot’s Situation.

. . . a comment that Mr. Justice Cattanach made about remuneration being by way of an established system . . . only serves to emphasize that Mr. Brazolot was following the same type of approach. There is no indication that that system was a written contract from year to year. It appears to have been a general resolution of the directors passed in 1950 and followed consistently from year to year.

.. . the practical view (is) that the cash was not there. The reality of it was that the corporation’s financial position had deteriorated to the point where it had no sources of funds to even arrange that case and in fact was facing a future year which did not look any better.

.. . an interesting point (is) about the corporation being a small business and therefore eligible to claim $150,000 of income at the low rate of tax. I don’t think it is any secret that that plays some part in determining management remuneration in a particular year. I think the taxpayer is certainly entitled to arrange his affairs in such a way as to take advantage of an available low rate of tax. We would point out I think that if the management salary had not been accrued in the 1976 year, that the total tax cost would have been somewhat less than it has anticipated to be as a result of paying out the bonus. The tax would have been levied in the corporation as 46 per cent. Mr. Brazolot would have been paying tax somewhat higher than that, the marginal rates being 62 per cent . . .

And by counsel for the respondent:

... IN my submission, with the somewhat difficult tests that we have to apply, as indicated by the cases, as to was there a clear legal liability at the time the moneys were set aside, the indications are that that was a clear legal liability (in some of those cases) and (it) is not to be found either in the paper documentation or even In the mind of the appellant (in this appeal). The money was there and he was going to take it so long as it remained there. As soon as there was some difficulty about it, then of course no problem at all about just cancelling that again.

Findings

The significant evidence and testimony as I see it was:

— The amount accrued in 1976 ($196,000) was based on the perceived value of the president’s services to the company, and his personal requirement for cash flow.

— It was also recognized that accruing that amount provided potential for income tax saving.

— After the management salary accruals, the net profit before taxes in 1975 had been $99,352 (the small business limit had been $100,000 that year) and in 1976 the net profit before taxes had been $149,919 (the small business limit had been $150,000 for that year).

— It was not put into evidence that the main criterion for the accrual was to reduce net profit to the small business limit.

— There had been no “reversals” in prior years.

— There was no indication in the evidence at the time of accrual of an intention or plan to reverse the 1976 amount.

— The appellant company, and the president were not dealing at arm’s length.

— At the date of the 1976 accrual, the company was in a very healthy financial and potential cash flow position.

— 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.

— The major reason advanced for the reversal in question was the dramatically deteriorated financial position of the company in 1977, and the possibility of serious liquidity damage to the company if the amount had been paid.

— No evidence was provided to the Board which would indicate that Mr Brazolot’s personal requirement for cash had diminished merely because the appellant company found itself in a difficult financial Situation.

Added to these points, it was asserted by the witnesses for the appellant that Mr Brazolot had indeed earned the amount involved.

There is only one question to be answered, and that is whether or not an Obligation to pay the management salary had been established in 1976. While the evidence would indicate that tax considerations were never far from the minds of those directing the appellant company, the same evidence would indicate that a pattern had been established in prior years, that the amount for 1976 was reasonable and that it had been earned by Mr Brazolot. Following the judgment in McClain (supra) and the decision in Dorman (supra), it is a finding of fact that such an obligation to pay salary was established by the actions taken in the company and the record made of these action with respect to the year 1976.

With regard to the year 1977, since the actions and record pertaining to 1976 are adequate to establish the obligation (and it has been decided above that they were), the same management is capable of producing exactly the opposite result by their reversal.

The Board has carefully reviewed a significant recent judgment of the Federal Court of Appeal — Stubart Investments Limited v The Queen, [1981] CTC 168; 81 DTC 5120 — which dealt with a situation in which the purpose of the transaction involved was to reduce income tax liability. It was contended that the purpose of the accrual in question in the instant appeal was to properly remunerate the president, not to save tax, and therefore the accrued amount was an expense “to gain or produce income”. The Board has accepted the appellant’s assertion in this regard but notes that it is an interesting coincidence that the perceived value of the president’s services when calculated and accrued, reduced the taxable income of the company to meet the small business deduction limits for both 1975 and 1976. Had the Board not accepted the appellant’s assertions regarding the purpose for the accrual, then payment itself might be required as an integral part of evidence for a completed transaction (according to Stubart) (supra), and that would leave the appellant at considerable risk in this case.

It is also noted that no reference was made by either part to the possible effect of subsection 56(2) of the Income Tax Act, SC 1970-71-72, c 63, as amended, on the taxable situation of Mr Brazolot, to the degree that cancellation of the right to collect might be equated with the “transfer” of a “benefit” to the company. The board makes no further comment thereon.

Decision

The appeal for the taxation years 1976 and 1977 is allowed and the matter referred back to the respondent for reconsideration and reassessment accordingly.

Appeal allowed.