Huang & Danczkay Ltd. v. Minister of National Revenue, [1998] 3 CTC 337, 98 DTC 6393

Wetston J.:

The Plaintiff, her Majesty the Queen (the “Minister”), appeals the decision of the Tax Court of Canada, dated 17 June 1993, whereby the Defendant’s appeal in respect of its 1980, 1981, 1983 and 1985 taxation years was allowed. The defendant, Huang and Danczkay Limited (the “taxpayer”), is a Canadian-controlled real estate company, incorporated under the laws of Ontario.

The parties have agreed that the following facts are not in dispute:

1. The Defendant, an Ontario corporation, incorporated in 1971, is a Canadian- controlled private corporation (‘c.c.p.c.’) owned equally by Michael Huang and Bela Danczkay.

2. The Defendant carries on the practice of consulting engineer and the business of real estate development and property management.

3. In 1979, the Silver Creek-Cedarwood Partnership (‘Silver Creek- Cedarwood’), a limited partnership, constituted under the laws of Alberta, was formed by B.P.M. (Mill St.) Developments Limited, a wholly-owned subsidiary of the Defendant, as general partner, and Michael Huang and Bela Danczkay as limited partners (‘the Promoters’). In 1979, 350 additional units were issued to the public for $10,000 per unit payable $1,500 at closing and the balance of $8,500 by way of a promissory note payable in yearly instalments of $2,500, $2,500, $1,000, $1,000, $750 and $750, together with interest on the unpaid balance at the rate of 11 72% per annum calculated and payable yearly.

4. Silver Creek-Cedarwood was organized to acquire certain lands and to construct, own and operate apartment projects on such lands (the ‘Projects’). By an agreement dated November 29, 1979 (the ‘Transfer Agreement’) Silver Creek- Cedarwood acquired the Projects in consideration for it assuming the liability of $1,700,500 owing by the vendor to the Defendant.

5 By agreement dated November 29, 1979 (the ‘Development Agreement’) among Silver Creek-Cedarwood, the Defendant and the Promoters,

i) the Defendant agreed to complete the projects for $9,522,976 and provide certain initial services essential to Silver Creek-Cedarwood as described in paragraph 6 below, and

ii) the Promoters and the Defendant agreed to provide certain covenants and guarantees in connection with the Projects.

6. Pursuant to the Development Agreement, the Defendant agreed to provide to Silver Creek-Cedarwood initial services described in the table below for the consideration set out therein.

	Silver Creek	Cedarwood	Total
CMHC mortgage insurance	$ 79,300	$ 66,536	$ 145,836
fee
CMHC mortgage application	7,350	7,735	15,085
fee
Interest during construction	1,493,823	1,217,282	2,711,105
and lease-up
Mortgage guarantee fee	80,291	67,368	147,659
Mortgage brokerage fee	64,233	53,894	118,127
Legal Fees relating to mort	25,000	25,000	50,000
gage financing and other doc
umentation
Landscaping	100,000	50,000	150,000
Administration and leasing	362,000	243,300	605,300
services
Cash flow guarantee	171,525	145,349	316,874
	$2,383,522	$1,876,464	$4,259,986

7. The total cost of the Project and initial services to Silver Creek-Cedarwood was $14,920,000. In accordance with the Development Agreement, Silver Creek-Cedarwood issued to the Defendant a promissory note in the amount of $3,107,300 (the ‘Purchase Money Note’). The terms and conditions of the Purchase Money Note provide for the principal to be paid over a period of six years, together with interest at the rate of 11 ‘/2% per annum. In addition, the Purchase Money Note includes a right of set-off in the event the Defendant defaults on its obligations under the Development Agreement.

8. In 1980, the Stonehill Partnership, a limited partnership, constituted under the laws of Alberta, was formed by 444222 Ontario Limited, a wholly-owned subsidiary of the Defendant, as general partner, and Michael Huang and Bela Danczkay as limited partners. In 1980, 450 additional units were issued to the public for $10,000 per unit, payable $2,500 at closing and the balance of $7,500 by way of promissory note payable in yearly instalments of $2,500, $1,500, $1,500, $1,000 and $1,000, together with interest on the unpaid balance on the rate of 12% per annum calculated payable yearly.

9. The Stonehill Partnership was organized to acquire, complete and operate two apartment projects in Scarborough, Ontario (the ‘Stonehill Project’). On June 30, 1980, Stonehill Partnership acquired from the Defendant land upon which the Stonehill Project was to be constructed, and partially completed buildings for an agreed purchase price of $7,000,000.

10. By agreement dated June 30, 1980 (the ‘Stonehill Development Agreement’) among the Stonehill Partnership, the Defendant and the Promoters,

i) the Defendant agreed to complete the Stonehill Project and provide certain initial services essential to the Stonehill Partnership for a fixed price, and

ii) the Promoters and the Defendant agreed to provide certain covenants and guarantees in connection with the Stonehill Project.

11. Pursuant to the Stonehill Development Agreement, the Defendant agreed to provide to the Stonehill Partnership initial services described in the table below for the consideration set out therein.

12. The total cost of the Stonehill Project and initial services to the Stonehill Project was $17,264,000. In accordance with the Stonehill Development Agreement, the Stonehill Partnership issued to the Defendant a promissory note in the amount of $4,044,000 (the ‘Purchase Money Note’), and agreed to deliver to the Defendant mortgages for the remainder of the cost. The terms and conditions of the Purchase Money Note provide for the principal to be paid over a period of seven years, together with interest at the rate of 12% per annum calculated and payable yearly. In addition, the Purchase Money Note includes a right of set- off in the event the Defendant defaults on its obligations under the Stonehill Development Agreement.

	100	Springdale	Total
	Wintergarden	Place
CMHC mortgage insurance	$ 71,875	$ 48,125	$ 120,000
fee
CMHC mortgage application	10,500	5,250	15,750
fee
Interest during completion of	736,430	477,720	1,214,150
construction and lease-up
Mortgage guarantee fee	217,958	145,938	363,896
Legal fees relating to mort	12,000	8,000	20,000
gage financing and other re
quired documentation with
respect to operations
Landscaping	90,000	60,000	150,000
Leasing services	300,000	150,000	450,000
Cashflow guarante e	448,260	293,880	742,140
Administrative services	90,000	60,000	150,000
Mortgage brokerage fee	48,000	32,000	80,000
	$2,025,023	$1,280,913	$3,305,936

13. In 1981, the Burnhill Partnership, a limited partnership, constituted under the laws of Ontario, was formed by Lachesis Developments Ltd., a wholly- owned subsidiary of the Defendant, as general partner, and Michael Huang and Bela Danczkay as limited partners. In 1981, 400 additional units were issued to the public for $10,000 per unit, payable $1,250 at closing and the balance of $8,750 by way of promissory note, payable in yearly instalments of $2,200, $1,150, $1,150, $1,300, $1,450 and $1,500, together with interest at the rate specified by formula.

14. The Burnhill Partnership was organized to acquire, construct and operate a 238 suite apartment project in Scarborough, Ontario (the ‘Burnhill Project’). On October 21, 1981, Burnhill Partnership acquired from the Defendant beneficial title to the land upon which the Burnhill Project was to be constructed for an agreed purchase price of $1,190,000.

15. By agreement dated October 21, 1981 (the ‘Purchase and Development Agreement’) among the Burnhill Partnership, the Defendant and the Promoters,

i) the Defendant agreed to construct the Burnhill Project and provide certain initial services essential to the Bumhill Partnership for a fixed price, and

ii) the Promoters and the Defendant agreed to provide certain covenants and guarantees in connection with the Burnhill Project.

16. Pursuant to the Purchase and Development Agreement, the Defendant agreed to provide to the Burnhill Partnership initial services described in the table below for the consideration set out therein.

Total Project
CMHC mortgage insurance fee...	$ 77,826
CMHC mortgage application fee...	14,400
Interest during construction and lease-up...	1,429,976
Mortgage guarantee fee...	96,688
Realty taxes, insurance and other...	119,000
Legal fees relating to mortgage financing...	20,000
Landscaping. ..	154,700
Leasing Services...	261,800
Cash flow guarantee...	450,924
Administrative services.	238,000
Mortgage brokerage fee...	63,070
Mortgage rate buydown fee...	1,221,797

Total Project
Purchase money note rate buydown fee...	359,093
	$4,507,274

17 The total cost of the Burnhill Project and initial services to the Burnhill Partnership was $13,996,000. In accordance with the Purchase and Development Agreement, the Burnhill Partnership issued to the Defendant a promissory note in the amount of $3,599,000 (the ‘Purchase Money Note’). The terms and conditions of the Purchase Money Note provide for the principal to be paid over a period of six years, together with interest at the rate specified by formula. In addition, the Purchase Money Note includes a right of set-off in the event that the Defendant defaults on its obligations under the Purchase and Development Agreement.

18. As part of the Purchase and Development Agreement, the Defendant undertook to obtain condominium registration for the Burnhill Project by January 1, 1984, failing which it agreed to reduce the purchase price by $1,589,000.

19. The Defendant was unable to comply with certain municipal requirements for condominium registration and as a result the purchase price of the Burnhill Project was reduced by $1,589,000, in accordance with the Purchase and Development Agreement.

20. In computing its net income for the 1980, 1981, 1982 and 1983 taxation years, the Defendant deducted the uncollected portion of the Silver Creek- Cedarwood Purchase Money Note and the Stonehill Partnership Purchase Money Note.

21. In computing its net income for the 1983 taxation year, the Defendant deducted the uncollected portion of the Burnhill Partnership Purchase Money Note.

22. For each of the 1981, 1982, 1983 and 1985 taxation years, the Defendant included in computing its income the amount deducted in computing its income for the immediately preceding year in respect of each of the Purchase Money Notes.

23. By Notices of Reassessment dated July 8, 1988, the Minister of National Revenue disallowed the Defendant’s deduction and included in income the full amount of each of the Purchase Money Notes in the year each of the said Notes was received, on the basis that section 3 and subsection 9(1) of the Act precluded the Defendant claiming a deduction in respect of the uncollected portion of each of the said Notes.

24. By Notice of Confirmation dated September 1, 1989, the Minister of National Revenue disallowed the Defendant’s notice of objections for the 1980, 1981, 1982, 1983 and 1985 taxation years and confirmed the reassessments as issued.

The Wrap-around mortgages were given by two of the limited partnerships [Stonehill and Burnhill] to the Defendant. The Defendant argued that these Wrap-around Mortgages should be given the same income treatment for tax purposes as the Defendant gave to the Purchase Money Notes.

At issue is whether the uncollected portions of the purchase money notes (“notes”) and wrap-around mortgages (“mortgages”) are ‘receivable’ within the meaning of s. 12(1 )(b) of the Act.

The Minister argues that the notes and mortgages were earned by the defendant in the years in question and must be included in the computation of the defendant’s income for tax purposes pursuant to ss. 9 & 12 of the Act and in accordance with generally accepted accounting principles (“GAAP”). The Minister says that the defendant has confused the recognition of income in the taxation year in which it is earned with a situation where the defendant may be entitled to a reserve for amounts not received or for contingent future payments.

It is further argued that, as the notes and mortgages were the consideration received by the defendant upon the sale of the properties in question, they were properly included by the defendant as receivables in the years in which these sales took place. Concomitant with these sales, it is acknowledged that the defendant undertook potential future obligations which might, or might not, have resulted in expenditures by it in future years. It is also submitted that these conditional expenditures were not deductions of the kind which could be the subject of a reserve under s. 20(1) of the Act, as the defendant had originally claimed.

The Minister argues that the obligations undertaken by the defendant in relation to the notes and mortgages are properly characterised as “contingent payables”, i.e. amounts that may at some time in the future become payable under the cash flow guarantee. It is further submitted that a contingent amount payable cannot be considered an expense incurred in the current year, pursuant to s. 18(1 )(e). However, regardless of whether these obligations constitute contingent payables or conditional expenditures which may be the subject of a reserve, the notes and mortgages to which they were attached are receivables which must be included in income in the years in which they were earned, in order to portray the most accurate picture of the defendant’s profit in a given year.

In other words, the Minister argues that the Defendant is attempting to transform a contingent payable, i.e. an amount which may become payable in the future under one of the obligations attached to the notes or mortgages, into unearned income, rather than a current deduction, such as a reserve, which it had originally attempted to do. It is submitted that the notes and mortgages are earned in the years in which they are received. As con- tingent amounts payable, the obligations attached to the notes and mortgages may only be accounted for as deductions in the taxation years in which the need to fulfill the obligations is actually realised.

The Minister’s expert witness, Mr. Irving L. Rosen, identified two acceptable methods for the recognition of income by a “developer” such as the defendant: the completed contract method, and the percentage of completion method. In his opinion, the defendant was acting in accordance with GAAP by initially adopting the former method to recognise the notes and mortgages as receivables. However, Mr. Rosen testified that for the defendant to apply the completed contract method, and recognise the notes and mortgages as receivables in the year in which they were incurred, for business and reporting purposes, but not recognise these same notes and mortgages as receivables for taxation purposes runs contrary to established accounting principles.

Mr. Rosen was of the opinion that the various obligations attached to the notes and mortgages do not affect the earning of the income, and thus the timing of their recognition as income earned. Rather, it is submitted that these obligations are conditions which affect only the collection of the note or the mortgage receivable. It is suggested that if a real cost arising from one of these obligations was incurred at a later date, a separate provision could be made at that time to address amounts paid out at that time.

The Defendant argues that the notes and mortgages were receivable only in accordance with the payment schedules set out in the development agreements, and then only if the Defendant continued to meet its obligations under each development agreement. Because of these continuing conditions precedent, therefore, it is argued that the defendant did not have an immediate, absolute and unconditional right to sue for the uncollected portion of the notes and mortgages in any of the particular taxation years in issue.

The Defendant argues that the uncollected amounts outstanding under the notes and mortgages ought not to have been included in its income for tax purposes for those years. It is submitted that it should not have originally included them, subject to a reserve to account for the outstanding obligations attached to them. Moreover, it is argued that to have included the notes and mortgages in income as receivables did not present an accurate picture of the Defendant’s profit, for any of the years at issue, regardless of whether a reserve was applicable for the continuing obligations, or if the obligations were regarded merely as contingent payables.

It is submitted that the most accurate picture of the Defendant’s income, for any of the years at issue, is the one in which the notes and mortgages are not regarded as receivables, until such time as the defendant has an immediate, absolute and unconditional right to the collection of the amounts as stipulated in the payment schedule provided under the notes and mortgages. The Defendant argues that this approach is in accord with the generally accepted business principles applicable to this case, i.e. U.S. Financial Accounting Standard (“F.A.S.”) No. 66, and the Recommended Accounting Practices for Real Estate Companies (“R.A.P.R.E.C.”) established by the Canadian Institute of Public Real Estate Companies (“C.I.P.E.C.”). It is argued that recourse should be had to F.A.S. No. 66 and the R.A.P.R.E.C., as the Canadian Institute of Chartered Accountants handbook does not specifically address this situation.

In the opinion of the Defendant’s expert witness, Mr. Wardell, the fundamental question of ascertaining the actual role of the defendant in the three MURB projects, must be addressed prior to arriving at the proper accounting analysis with respect to the revenue recognition criteria applicable in this case. Mr. Wardell indicates that the defendant did not act as a simple contractor, who would follow accounting procedures typically used by contractors in recognising contract revenues. Rather, the defendant acted as a real estate developer, and should have recognised its profit in accordance with GAAP standards applicable to real estate transactions.

Mr. Wardell testified that the fundamental criteria that must be met in order to recognise profit for real estate transactions under Canadian GAAP, is that the profit must be determinable, i.e. that the collectibility of the sales price is reasonably assured, and that the earnings process is virtually complete, i.e. that the defendant is not obligated to perform any significant activities after the sale to earn the profit. With recourse to FAS No. 66 and the CIPREC guidelines, Mr. Wardell has indicated that neither of these two criteria have been met in this case. This is because the cash down payments involved were not sufficient, and the defendant was required to perform various obligations prior to the notes and mortgages becoming fully payable. He also notes that the Defendant retained the risk of ownership as general partner in each MURB project, and guarantor of cash flow pursuant to the purchase and development agreements. Accordingly, the Defendant should not have accounted for the notes and mortgages as receivables in the years they were generated, rather than as per the schedules upon which they were to have been due.

The Supreme Court of Canada has recently set out the following principles, to be applied on a case-by-case basis, to the computation of profit under ss. 9 & 12 of the Act: Canderel Ltd. v. R. (1998), 98 D.T.C. 6100 (S.C.C.), at 6110:

(1) The determination of profit is a question of law.

(2) The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income: ...

(3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the defendant’s profit for the given year.

(4) In ascertaining profit, the defendant is free to adopt any method which is not inconsistent with

(a) the provisions of the Income Tax Act; (b) established case law principles or rules of law; and (c) well-accepted business principles.

(5) Well-accepted business principles, which include but are not limited to the formal codification found in G.A.A.P., are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the defendant’s financial situation.

(6) On reassessment, once the defendant has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.

In my opinion, the above passage indicates that, in determining profit, a Court should determine whether the case at hand can be resolved through a purposive approach to the relevant provisions of the Act, and to the established principles of case law. In certain cases, it may not be necessary to resort formally to the various well-accepted business principles as an interpretive aid: Canderel Ltd. supra, at 6109. “However, when no specific legal rule has been developed, either in the case law or under the Act, the taxpayer will be free to calculate his or her income in accordance with well- accepted business principles, and to adopt whichever of these is appropriate in the particular circumstances, is not inconsistent with the law, and... yields an accurate picture of his profit for the year”: Canderel Ltd. supra, at 6107.

Paragraph 12(b)(1) of the Act, as it was then drafted, provides:

(1) There shall be included in computing the income of a defendant for a taxation year as income from a business or property such of the following amounts as are applicable:

(b) any amount receivable by the defendant in respect of property sold or services rendered in the course of a business in the year, notwithstanding that the amount or any part thereof is not due until a subsequent year, unless the method adopted by the defendant for ...

The parties have agreed that recent amendments to this provision have no bearing on the issue of whether the notes and mortgages constitute a ‘receivable’. Use of the term ‘receivable’ has been considered recently by Cullen J. in West Hill Redevelopment Co. v. Minister of National Revenue (1991), 91 D.T.C. 5430 (Fed. T.D.), where a defendant who took back mortgages from purchasers of its condominium units at interest rates below the prevailing market rates was required to include in income the face value, rather than the fair market value, of such amounts secured by the mortgages as receivables pursuant to paragraph 12(l)(b). Cullen J. determined, at 5433, that the mortgages were receivable within the meaning of the subsection. He did so because ‘receivable’ has been interpreted to mean that a defendant has an unconditional legal, though not necessarily immediate, right to receive an amount in question: Imperial General Properties Ltd. v. R. (1985), 85 D.T.C. 5045 (Fed. C.A.) & Minister of National Revenue v. Colford Contracting Co. (1960), 60 D.T.C. 1131 (Can. Ex. Ct.).

In Robertson Ltd. v. Minister of National Revenue (1944), 2 D.T.C. 655 (Can. Ex. Ct.), at 661, it was noted that for an amount to be considered a ‘receivable’, the defendant must have a right to its disposition, use or enjoyment which is absolute and under no restriction, contractual or otherwise. More recently, in Ikea Ltd. v. R. (1998), 98 D.T.C. 6092 (S.C.C.), at 6099, Mr. Justice Iacobucci has noted that the characterisation of what constitutes a ‘receivable’ is guided by the ‘realisation principle’. The ultimate effect of the realisation principle is that amounts received or realised by a defendant are taxable in the year received if they are free of conditions or restrictions upon their use, subject to any contrary provision of the Act or other rule of law.

Accordingly, an amount is to be characterized as ‘receivable’ only if there is at present an immediate, absolute and unconditional right to collect it, even though it may not be actually collected until some time in the future. In this case, however, the notes and mortgages were subject to the condition precedent of being in compliance with the obligations contained within each of the purchase and development agreements. These obligations included the construction and development of the projects into functioning MURBS and the management and initial leasing of the development properties. In addition, the defendant would be required to honour the cash flow guarantees for the period of the development agreements, make payouts in relation to initial services as they fell due, and to ultimately discharge the underlying institutional mortgages. If these obligations, which extended over the period of each development agreement, were not fulfilled, the defendant would not have an immediate, absolute and unconditional right to collect the amounts receivable for a particular period as set forth in the payment schedule under the notes and mortgages.

In my opinion, the cash flow guarantee obligation did not have the character of a contingent payable, as has been suggested by the Minister. While it is uncertain what the full affect of this obligation would eventually be, in terms of the money to be paid out by the Defendant to honour it, it is nonetheless clear that this obligation was part of purchase and development agreements that required specific performance after an accounting. Similarly, in order for the mortgages to be receivable by the Defendant, as set forth in the payment schedule, over the period of the purchase and development agreement, the Defendant was required to fulfil its ongoing obligations in respect of the underlying mortgages. This obligation was an integral part of the purchase and development agreement and related directly to its right to receive payments under the development mortgages.

Accordingly, as a result of these ongoing obligations, the Defendant did not have an immediate, absolute and unconditional right to sue for the uncollected portion of the notes and the mortgages in any of the particular taxation years: Robertson Ltd., supra at 661; Colford Contracting Co., supra at 1135. Therefore, the uncollected portion of the notes and mortgages were not ‘receivable’ as contemplated under s. 12(l)(b) of the Act, and should not have been included in income in any of the taxation years, until such time as the conditions precedent attached to each development agreement had been satisfied.

I therefore find that the Defendant’s proposed method of accounting for the notes and mortgages is consistent with the Act and established principles contained within the case law.

Further, the Minister has failed to convince me that his proposed method of ascertaining profit provides a more accurate picture of the Defendant’s income than that which was obtained by the Defendant through recourse to GAAP, FAS No. 66, and the CIPREC guidelines. As indicated by the Defendant’s expert, Mr. Wardell, the fundamental criteria that must be met, under GAAP, in order to recognise profit for real estate transactions such as those undertaken by the Defendant is that the profit must be determinable. As a result of the obligations agreed to by the Defendant in the purchase and development agreements, the collectibility of the sales price in each of the three agreements was not reasonably assured at the time each agreement was concluded.

Moreover, the earnings process for each agreement was not virtually complete at the conclusion of each agreement, as the Defendant retained the risk of ownership as general partner in each MURB project, and as guarantor of cash flow, commitments which necessitated the Defendant’s involvement after the sale to earn its profit. As such, it would present a less accurate portrayal of the Defendant’s profit, as a real estate developer, if the uncollected portions of the notes, and the mortgages, were treated as receivables in the taxation years during which each purchase and development agreement was concluded.

Accordingly, the appeal shall be dismissed. The Defendant shall have its costs.

Appeal dismissed.