Toronto Heel Limited v. Minister of National Revenue, [1980] CTC 2277, 80 DTC 1250

Guy Tremblay:—This case was heard at Toronto, Ontario, on June 29, 1979.

1. The Point at Issue

The problem is whether the appellant is correct in:

(a) claiming for the 1973 taxation year as declared management bonus a deduction of $191,700; and

(b) including in the computation of its income for 1975, the said cancelled management bonus on which the appellant bases its contention on paragraph 78(3)(a).

Conversely, the respondent contends that the bonus is a contingent liability of the nature of those provided in paragraph 18(1)(e) of the new Income Tax Act and since it was not deductible in 1973 it consequently must be added to the appellant’s income for the same year. Therefore, it should not be included in the appellant’s income for 1975.

2. Burden of Proof

The burden is on the appellant to show that the respondent’s assessment is incorrect. This burden of proof results especially from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. The Facts

3.01 The appellant company was incorporated in 1966. The main object of the appellant’s business is the manufacture of heels for shoes.

3.02 The appellant’s financial year ends August 31 of each year.

3.03 Since the incorporation of the company, its shareholders have remained the same—the three DiMarcantonio brothers (Alfredo, Giovanni and Luciano). They all work for the company with their fourth brother Sergio. They ordinarily work more than twelve hours a day seven days a week and carry on the day-to-day control and management of the business.

3.04 Since 1969 they have been paid on both a weekly salary basis and on bonuses.

3.05 The bonuses, declared after the end of the financial year of the company, ie during the fall of the calendar year, were paid during the following calendar year, but before August 31. The bonuses were fixed by the shareholders as counselled by the accountant. The following points were taken into account: number of hours, performance, debts of the company, and tax planning for the recipients. Such decisions, however, were verbal and were not reflected in the minutes of the appellant’s corporation.

3.06 The weekly salaries varied from $125 to $175 (SN p 8).

3.07 The bonuses varied (Exhibit A-3: Financial statements 1969 to 1973 and SN pp 29 to 32) as follows:

The shareholders treated those amounts as wages and included them in the computation of the income for the fiscal year when they were received. On p 32, line 25, the following question was put to the accountant of the appellant’s company, Mr Ayres, CA, who prepared the financial statements:

Q. Based upon the sales figures which you have earlier given to us, would it be a reasonable expectation in each such year that the bonus declared at the end of one year could be paid the following fiscal year?

A. Yes, up until and including 1973 in our opinion there was no difficulty in the company paying the bonuses to the shareholders. It would not have created any financial burden to the company if paid when accrued.

Also on p 39, lines 9 to 15:

Q. Therefore, before the end of the 1973 fiscal year, there was an intention to pay a bonus as such had been paid in the preceding years?

A. Yes, the fact that a bonus would be payable had been identified at that time. It was a matter then of determining the precise amount which would have resulted when the complete audited financial statement in draft form had been prepared.

On p 34 of the stenographic notes, Mr Ayres explained the practice of remuneration of bonuses:

It is a normal practice in corporations this size and in fact much larger corporations, public corporations where the remuneration of the officers is often tied into the results of operations and I think it is a common fact that many large corporations pay their senior executive officers on the basis of performance for the year. That is also a common approach by the smaller corporations where an attempt is being made to ensure that the corporation retains the maximum amount of working capital during the year for day-to-day operations, thereby reducing the cost of borrowing funds, vis-a-vis ensuring that from time to time adequate remuneration is given to the chief executive officers and/or the emloyees to ensure that they are rewarded. Otherwise, the shareholders would be well advised to work for another person or a corporation if their level of income cannot reach a higher level. In other words, they have to be paid for the services they are performing or else it is not a desireable venture to be in business.

3.08 The total net sales, gross profit and net income for the same years were as follows (Exhibit A-3):

3.09 To explain the incidence of the tax planning for recipients, Mr Ayres Said (SN p 36):

I believe in a letter which was directed to Revenue Canada in respect to this matter, we have outlined a series of calculations which we made for the taxation years 1969 through to 1972 and in that letter we attempted to identify the level of taxation for the corporation and compared that to the average level of taxation for the shareholders and I think the calculations more or less support the argument that a general level of equity was achieved between the corporation and the shareholders.

The figures filed in Exhibit A-4 read as follows:

Toronto Heel Limited

Schedule of Incidence of Taxation

						Combined
	Taxable					Personal rate
	income	Fed tax	Prov tax Total		%	of shareholders
1969	16,585.86	1,914.00	1,990.30	3,904.30	23.5%	24%
1970	28,658.66	3,307.21	3,439.04	6,746.25	23.5%	20%
1971	31,883.74	3,581.89	3,322.55	6,904.44	21.7%	16%
1972	16,847.96	2,035.26		2,035.26	12.1%	34%
provincial tax offset by claiming Ontario tax credit

3.10 In 1973, a management bonus in the amount of $191,700 was declared and deducted in the computation of the appellant’s net income. The said bonus was supposed to be paid before August 31,1974. In fact, it was never paid.

Q. Why was the 1973 bonus never paid?

A. Shortly after the issuing of the financial statements, approximately Jan- uary/February of 1974, the company encountered its first resistance to the product as Mr DiMarcantonio has described. In other words, the market for the Eurothane Soles disappeared completely and as the company was heavily indebted for the acquisition of machinery and inventory both for its Canadian and American corporation, the financial success immediately went the other direction and the bank became extremely concerned about the ability of the company to be able to continue its operation and therefore in various discussions and communications both between the bank and its major lender, Roynat, every effort was made to ensure that the company did not pay out sums of shareholders other than what was required for a normal weekly income for their survival. (SN p 41)

Mr Ayres, in a letter of December 1976 (Exhibit R-1), addressed to Revenue Canada explained the facts in the following manner:

Other factors also influenced the level of salaries accrued at each year end during the period 1969-1973. Most significantly, the company’s banker, The Canadian Imperial Bank of Commerce, and the company’s bondholder, Roynat Limited, placed restrictions on the company which required the company to maintain certain levels of working capital and net income. Consequently, although it may have been desirable to accrue higher amounts for salary in certain years, these restrictions had a dampening effect on the amounts calculated.

3.11 Mr DiMarcantonio had explained before in the evidence the cause of the down turn in sales in 1974:

THE WITNESS: The cause is because at the time we didn’t know it, but looking back, at the product today, it is because we are in the shoe industry and it is fashion and fashion takes place according to what the designer dictates. So Eurothane is the type of material that it is light and it being used for very high heels and very clogs, so when the high heels and the clogs came in vogue, we had a product. When the turn was to finer shoes, then we took a burden with it. Then we went down with it.

3.12 Mr Ayres explained that with the cooperation of the bankers, the payment of the bonuses would have been possible:

Q. . . . could the accrued bonus of $191,700 been imediately paid out?

A. In our opinion, the payment of that particular sum of money could have been arranged in cooperation with the corporation’s bankers. Admittedly a payment in one sum would have created some difficulty, but the company had been successful in previous times and receiving the cooperation of the bankers, in our opinion, the sum could have been paid out over a period of two or three months to the shareholders without a financial strain on the business. (SN p 41)

3.13 In cross-examination, Mr Helfield, counsel for the respondent, asked Mr Ayres concerning the consent of the shareholders to waive their right to receive the bonuses:

Q. Now, how did you receive, how did the shareholders indicate in this case that they were going to waive their right to receive these bonuses in the year in question? Was it through this letter of representation or verbally?

A. It was verbally as a result of discussions with them because of implications of the action that they were about to undertake. In other words, we reviewed with them the tax consequences and the events leading up to this decision, what would happen if in fact the amounts were paid. We also of course had to consider very strongly the information which was coming to us from Roynat Limited, a major creditor of the corporation together with the corporation bankers as to additional funds which the company wanted to borrow and therefore a requirement to ensure that no payments were being made to shareholders in excess of what was required for their day-to-day livelihood.

3.14 Actually, the payment was made during the year 1974:

Q. As a result of the non-payment of the bonus during 1974, what steps did the company thereafter take?

A. During August of 1974, we advised the company as to the tax consequences of the non-payment of the 1973 bonus. Various proposals were considered in accordance with the sections of the act dealing with accrual and payment of bonus and salaries to shareholder directors, and as a result of that action, the shareholders declared that it was not adviseable to pay the bonus to themselves therefore and in accordance with the section of the act, the bonus lapsed and came into income in their company’s 1975 taxation year. (SN p 42)

For the years ended on August 31, 1974, and August 31, 1975, the figures are as follows:

3.15 On July 27, 1977, the respondent issued notices of reassessment disallowing the management bonus of $191,700 for 1973 and deducting the same amount for 1975.

3.16 After these reassessments there was a net-capital loss for the year 1975, of $138,877.04. A part of that loss in the amount of $114,283.05 was applied as a deduction in the computation of the taxable income for the year 1974 (paragraph 111(1)(a)) leaving a “nil” revised taxable income for that year. For the year 1973, the declared taxable income of $50,524.59 increased to $298,933.18 because of various expenses which were disallowed (bad debts, legal fees, interest and management bonus). The appeals, however, do not concern expenses, but a management bonus.

4. Law— Cases—Comments

4.1 Law

The main sections of the new Income Tax Act involved in the present case are paragraphs 18(1)(a) and (e), and subsection 78(3), which read as follows:

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;

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part;

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, or

(b) where the taxpayer and that person have filed an agreement in prescribed form on or before the day on or before which the taxpayer is required by section 150 to file his return of income for the first taxation year following the taxation year in which the outlay or expense was incurred, for the purposes of this Act the following rules apply:

(i) the amount so unpaid shall be deemed to have been paid by the taxpayer and received by that person on the first day of the said second taxation year, and section 153, except subsection (3) thereof, is applicable to the extent that it would apply if that amount were being paid to that person by the taxpayer;

and

(ii) that person shall be deemed to have made a loan to the taxpayer on the first day of the said second taxation year in an amount equal to the amount so unpaid minus the amount, if any, deducted or withheld therefrom by the taxpayer on account of that person’s tax for the said second taxation year.

4.2 Cases

The parties referred to the following cases:

1. Kerr Farms Limited v MNR, [1971] Tax ABC 804; 71 DTC 536;

2. V & R Enterprises Limited v MNR, [1974] CTC 2099; 74 DTC 1089; The Queen v V & R Enterprises Limited, [1979] CTC 465; 79 DTC 5399;

3. The Queen v Ken and Ray’s Collins Bay Supermarket Limited, [1975] CTC 504; 75 DTC 5346;

4. McClain Industries of Canada, Inc v The Queen, and The Queen v Norman R J LePain, [1978] CTC 511; 78 DTC 6356;

5. Lawrence H Mandel v The Queen, [1978] CTC 780; 78 DTC 6518.

4.3 Comments

4.3.1 At first glance, it seems that the wording of subsection 78(3) applies to the present case. The management bonus declared by the appellant seems to be a remuneration in respect of an office or employment. It was deductible in 1973 because it was an accrual salary. Such an expense is deductible because the appellant’s company computed its income according to the accrual basis accounting system. The respondent, however, contends that the said management bonus is only a contingent liability because the company was liable to pay only in case sufficient cash was available. This was not certain to occur.

The precedent cases which are referred to above, concerned among other points the contingency of the liabilities.

1. The case of Kerr Farms Limited

This judgment was rendered by the former Tax Appeal Board. In January 1967 a bonus, based on 1966 profits, was authorized for those employees who had worked for the company in 1966 to be payable at the end of 1967 or 1968, or both, provided the employees had continued in the employ of the appellant during all of 1967 and 1968. In 1968 the same procedure was followed based upon 1967 profits.

A condition for receiving a share of the bonus was that a man “must be in our employ at Christmas of the succeeding year to the year in which the bonus is declared”. Mr Davis of the then Tax Appeal Board refused the deduction of the declared bonus in 1966 and in 1967 on the basis that the bonus payment was contingent upon the continuity of employment of the person to whom it was payable and concluded, as well, that the company had no legal obligation to make the payment until the expiration of the time allotted for the fulfillment of the conditions of payment.

2. The case of Lawrence H Mandel

In this case the Federal Court of Appeal decided that the balance price of an investment in a motion picture film was a contingent liability because the investors would be liable to pay the said balance only if the film was profitable. This was by no means certain to occur.

Hence, the capital cost allowance claimed on the said balance was not deductible.

3. The case of Ken and Ray’s Collins Bay Supermarket Limited

This judgment was rendered by the Federal Court of Canada, Trial Division. It is summarized as follows in Dominion Tax Cases:

The defendant taxpayer company operated grocery supermarkets. In the relevant years the issued shares of the company were beneficially owned two-thirds by E and one-third by K. Each of them worked every day and long hours operating the two stores owned by the company. They were full-time employees and officers of the company, made all corporate decisions on behalf of the company and determined management policy. In 1968 their accountants introduced a computerized accounting system for the company, which provided cumulative profit and loss and trial balance figures at the end of each month. The trial balance statement up to the end of October 1968 showed a profit of $151,366 for the first nine months of the company’s fiscal year ending February 28, 1969. Having regard to the excellent prospects of higher earnings, the level of salaries they had been taking, and the long hours they had devoted to the business, E and K decided to have bonuses of about $25,000 to $30,000 each, provided funds were available. The bonuses were to be paid out in the next fiscal year when the exact amount was determined after the year-end results were known. In April or May 1969 they decided that the bonuses for the year ended February 28, 1969 would be $58,590 divided equally between them. For its 1969 fiscal year, the company’s inocme before taxes was $34,997 after deducting $58,590 for bonuses as an expense. The bonuses were, however, not paid out. The sum of $58,590 was carried as a “deferred management bonus” under current liabilities. In 1969 the company faced severe competition and a price war, with the result that the bonuses could not be paid. The unpaid bonus was brought back into income, and a new bonus of $17,000 was set up to be paid out in the next year. For its 1970 year, after deducting the new bonuses of $17,000, the company’s income was $34,258. The new bonuses were also not paid out, and were returned to income in the following year. The Minister disallowed the deductions in both years. The Minister contended (1) that the management bonuses were not an outlay or expense made or incurred for the purpose of gaining or producing income from a busness; (2) that the deductions had the effect of setting up a reserve that was not expressly provided for under the Act; and (3) that the bonuses would unduly or artificially reduce income. The company appealed, contending that the management bonuses were bona fide and reasonable in all the circumstances. The Tax Review Board (74 DTC 1192) ruled that the bonuses were a proper deduction and allowed the appeal. The Minister appealed further.

Held: The appeal was allowed and the judgment of the Tax Review Board was set aside. The Minister had properly disallowed the deductions. (1) The bonus for each of the years was not an expense incurred by the company in that fiscal year within the meaning of paragraph 12(1)(a). The decision to grant bonuses was gratuitous. Because the bonuses depended on the availability of funds, no legal obligation was incurred to pay it. The fact that the decision to pay bonuses would have provided an incentive to E and K to continue their efforts in the business did not make the grant of the benefit other than gratuitous. (2) When the decision to pay bonuses was taken in the fall of 1968, the amount that would be paid was uncertain, and payment was contingent on necessary funds being available. Therefore the claiming of the expense of bonuses had the effect of setting up a reserve that was not expressly provided for by the Act. (3) However, tax avoidance or reduction was not a purpose of the bonus, and the expense was not one that, if allowed, would unduly or artificially reduce the company’s income. Despite the inequality in share ownership, an equal sharing of bonus money was reasonable. The deduction of $58,590 as an expense did bring the company’s net income into the $35,000 or less bracket, and the reason for fixing that specific amount was left largely unexplained. However, the result was incidental to implementation of the earlier decision to pay bonuses in the fall of 1968. The amount finally decided upon was within the range determined earlier.

4. The case of McClain Industries of Canada, Inc and Norman Roy J LePain

This judgment was rendered by Cattanach, J in the Federal Court, Trial Division. The facts are well summarized in the Canada Tax Cases:

The defendant LePain was one of three equal shareholders who controlled Maple Leaf (the plaintiff in the other action) and who sold their shares to a nonresident on June 29, 1972 for $225,000. It had been the custom for 22 years for the corporation to decide upon management remuneration at the end of each year and to record it as a liability in favour of the shareholders who would withdraw it weekly during the following year, when they would pay tax on it. The amount so accrued for the corporation’s year ended March 31, 1972 was $60,000, of which $18,464.05 had been withdrawn by the shareholders (and considered as wages) by June 29, leaving a balance of $41,535.95. The controversy concerned the fate of the latter sum and which party was taxable on it. The shareholders felt they had no claim to it in the mistaken belief that it represented unearned salary for the period following the sale of their shares and they had fixed the price of their shares accordingly. Some months later they obliged the purchaser by formally assigning their interests in the amount to the purchaser, who was in due course credited with it on the books of the company. In the Minister’s view the shareholders had directly or indirectly received the amount and were taxable thereon either under subsection 5(1), as salary, or under subsection 56(2) as a benefit conferred by them on another. When LePain’s appeal was allowed by the Tax Review Board (judgment not reported) the Minister appealed to the present Court and at the same time added the amount to the income of Maple Leaf under subsection 78(3) (“unpaid remuneration”), the inference being that if the assessment of either party were affirmed that of the other would fall.

Held: There had been a valid assignment by LePain of the unpaid remuneration due him resulting in a benefit conferred by him on another party within subsection 56(2) and taxable in his hands thereunder. Crown’s appeal allowed.

It followed that the corporation’s appeal was also allowed.

5. The case of V & R Enterprises Limited v MNR, and HMQ v V & R Enterprises Limited

The appellant company, which was engaged in a relatively small machine tool business, followed the practice of accruing salaries since its inception in 1962. The line of credit permitted the company was limited and, since considerable finances were required in the acquisition of machinery for resale, the accrued salaries were paid only when a sufficient cash flow existed. Three officers of the appellant received such amounts in addition to their annual salaries intherelevant taxation years. When the company tried to deduct these sums from income, the Minister would not allow it, arguing that they had not been incurred for the purpose of gaining or producing income from the business. Alternatively, the Minister contended the deduction of these amounts would unduly or artificially reduce the appellant’s income, contrary to section 137(1) of the Act. The appellant objected.

Board’s decision: The appeal was allowed. It had been the company’s practice to give accrued salaries or bonuses to officers since 1962, and this constituted, for the purpose of earning income an established and known incentive. Further, it was shown to the Board’s full satisfaction that the accrued amounts distributed to the appellant’s officers in each year were reasonable allocations in relation both to the company’s net retained earnings and to the services each person performed. Thus, it was clear that the appellant had satisfied the requirements of section 18(3) and was entitled to deduct the sums in question from income.

FCTD’s decision: Mr Justice Grant confirmed the judgment of the Board. According to him, however, the amounts declared payable to the shareholders were not bonuses but salary.

4.3.2 In the present case, the appellant has called the declared amounts payable to the shareholders in the financial statement: A “bonus”, “a management bonus”, but what is a bonus? A bonus is described in the shorter Oxford English dictionary as ‘‘a boon or a gift over and above what is normally due; a premium for services rendered or expected; an extra dividend paid out of surplus profits.” In McClain Industries of Canada, Inc, however, the same kind of payable amounts were called “management Commission”, and in V & Fl Enterprises Limited, they were called “bonus” by TRB and “salary” by FCTD. The words used in business to describe the reality are very important especially when there is fiscal incidence, and hence application and interpretation of the Income Tax Act.

In fact, in the present case, if “management bonus” means “wage or salary” the amount payable is deductible, but if “management bonus” means “gift” as the word “bonus” means, it is not deductible.

Indeed to be deductible, an amount provided in subsection 78(3) must be a legal obligation—a debt due by the employer to the employee. The first words of the said paragraph make it clear: “Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer . .

According to the judgment rendered in Ken and Ray’s Collins Bay Supermarket Limited:

. . . the decision to grant bonuses was gratuitous and that the company, although it really intended to pay them, provided that funds would be available, did not contract and legally obligate itself to pay them. In my opinion, if the bonuses had been paid when the decision to grant them was made in late 1968, the grant of that benefit would have been gratuitous in that payment would not have been made pursuant to a legal obligation as payment for services received by the company or pursuant to a contract for services to be received, and the fact that the decision to pay bonuses and the expectation that they would be paid provided an incentive to McEwen and Robinson to continue their efforts in the business of the company did not make the grant of the benefit other than gratuitous.

Can it be said in the present case that the amounts declared payable in the fall 1973 were in fact “gratuitous”?

The evidence shows that the shareholders work as employee more than twelve hours a day, seven days a week (par 3.03). They had a weekly salary of about $150. The Board has the same opinion of Mr Ayres (par 3.07):

Otherwise, the shareholders would be well advised to work for another person or a corporation if their level of income cannot reach a higher level. In other words, they have to be paid for the services they are performing or else it is not a desireable venture to be in business.

It is the Board’s opinion, that the payable amounts were not gifts; they were what was owed to them. The amounts were reasonable. Indeed, according to the accountant, it would have been financially possible for the company to pay these gifts in 1974 (par 3.12). The profit made in 1974 (par 3.14) shows that it was possible despite the other problems. The evidence was not contradicted.

The shareholders-employees, however, decided to waive their rights to receive the declared amounts.

The Federal Court, Trial Division in the case of McClain Industries of Canada, Inc, however, stated the contrary.

After saying that the evidence was different from the Ken and Ray’s Collins Bay Supermarket Limited case, and after emphasizing the method of the company for 22 years “of putting remuneration into the hands of management employees for their services”, Mr Justice Cattanach said:

Consistent with this practice at the end of the 1971 fiscal year the directors, after considering the income generated in that year set up the fund of $60,000 to be paid in equal shares to the three management employees throughout the 1972 fiscal year. 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.

In that case, it was considered that the former shareholder LePain was a creditor of the company for the declared commissions at the time of the sale of the shares and that he had conferred this benefit on the purchaser of the shares, and consequently LePain was taxable under subsection 56(2).

Mr Cattanach gives the ratio decidendi:

It was determined to be for such services performed by the management personnel in the preceding year to be paid in the year 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.

Mr Lesonski testified that this system was eminently suitable and widely employed in small businesses.

I would assume that a small business would include a joint stock company where the shareholders, the directors and the management employees were the same persons acting in three separate capacities.

This is not necessarily universal criterion but it was the case in Maple Leaf up to June 29, 1972.

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 it was readily susceptible of being waived by the contracting parties, there is not impediment to the directors doing so. As viewed by Maple Leaf’s side it was the cancellation of a debt which by reason of the system the management employees agreed to being done and from the viewpoint of the management employees it was the forgiveness of a debt.

In the Board’s opinion, the present case is not substantially different from the McClain case, and consequently subsection 78(3) applies in the present case. The declared amount is deductible in 1973 and taxable in 1975.

Conclusion

The appeal is allowed and the matter is referred back to the respondent for reassessment in accordance with the above reasons for judgment.

Appeal allowed.