John Walter Butcher, Grant Edward Frost and Ivan S Gray v. Minister of National Revenue, [1974] CTC 795, 74 DTC 6604

Gibson, J:—These three appeals were heard on common evidence. The three appellants and one Roderick J Smith, as chartered accountants, carried on their practice in partnership from 1955 to January 15, 1966 when the partnership was dissolved. After that time, the partner Smith practised alone and the other three partners, Gray, Frost and Butcher continued to practise in partnership in a new partnership.

From 1962 to January 15, 1966 the four partners in their partnership accounts accounted for the profits earned from their practice on an accrual basis, but individually for income tax purposes declared and paid income tax on the “cash method” permitted under section 85F of the Act at that time.

The year end of the partnership was May 31. The partnership was dissolved by formal agreement on January 15, 1966. This agreement settled all accounts among the partners including the respective shares of the profits for the 7 /2 months of the partnership year after May 31, 1965, namely, for the period May 31, 1965 to January 15, 1966.

The issue on these appeals is in respect to the categorization for income tax purposes of what Smith actually received on the dissolution of the partnership on January 15, 1966. The quantum in question is $37,972.

The three continuing partners in the partnership, Gray, Frost and Butcher, contend that this said sum was income of Smith for income tax purposes. Smith contends it represented a capital payment to him from the continuing partners upon which the continuing partners were required to pay income tax.

As of January 15, 1966: (1) the allocation of profits to Smith on an accrual basis exceeded his allocation on a cash basis by $37,972; (2) Smith’s drawings from the partnership bank account exceeded his share of the actual cash received by the partnership to which he was entitled by $25,488; and (3) the amount to which Smith was entitled [pursuant] to an allocation on accrual basis as of January 15, 1966 exceeded his drawings by $12,484.

By the said contract of dissolution dated January 15, 1966 Smith received the following which were categorized in the said contract in the following manner (see Exhibit 4):

2. (a) the sum of $20,000 in respect of goodwill;

(b) the sum of $12,484 in respect of tangible assets;

(c) a sum equal to $18,000 in respect of profit for the current fiscal year less the sum of $15,810.60 being the amount received I by Smith since May 31 st, 1965 by way of drawings.

The said sum of $20,000 in respect to goodwill, Smith and the continuing partners treated as a Capital receipt and a capital disbursement and no issue arises as to it.

The said sum of $12,484 categorized as Smith’s share “in respect to tangible assets”, the appellants attempted to categorize as something else, but the evidence at trial from them does not support any other categorization. This sum represents the dollar value of Smith’s entitlement to the physical assets used by the partnership to January 15, 1966, and belonging in undivided interest to the four partners, such as furniture and equipment. In the last balance sheet of the company, a substantial amount is shown as the cost of these tangible assets and capital cost allowance has been claimed and charged for income tax purposes.

There is no mention in the contract of dissolution dated January 15, 1966 specifically of the sum representing the difference between $37,972 and $12,484, namely, $25,488.

That sum, $25,488, represents moneys that Smith had drawn from the partnership bank account as of January 15, 1966 over and above his entitlement of the cash receipts arising from the partnership profits. Smith had not paid income tax on that sum as of that date.

That sum had not been received in cash by the partnership as of January, 1966, but instead was represented by accounts receivable and time unbilled.

The moneys that enabled Smith to draw this $25,488 excess over cash entitlement was obtained by the partners borrowing from their bank.

By the contract of dissolution dated January 15, 1966 the partners gave mutual releases to each other and also, among other things, gave to Smith a covenant to indemnify and save him harmless in respect to the bank loan made by the partnership and previously made by all the partners, including Smith.

By the contract of dissolution, as a result the continuing partners obtained full title to the accounts receivable and unbilled time and subsequently received cash for these assets, as the accounts receivable were collected, and as the unbilled time was billed and the bills collected after billing. From these cash receipts from these sources the bank loan was repaid.

At dissolution, the evidence was that the partners had not discussed among themselves, nor had their respective solicitors (who were employed to settle the contract of dissolution dated January 15, 1966), whether Smith was to pay income tax on this excess of drawings of $25,488 over cash entitlement or whether the continuing partners were to pay income tax on this sum when received by way of payments on accounts receivable even though they alone were required to pay the bank loan which was the source of the funds for this excess of drawings.

As of January 15, 1966 on the execution of the contract of dissolution, Smith was not required to repay this said sum of $25,488 representing excess drawings over cash entitlement. As of that time also, the continuing partners were entitled to accounts receivable and to the assets representing time unbilled. The continuing partners, as stated, were required to repay the bank loan /n toto including the amount of the bank loan which was represented by this excess of drawings over cash entitlement by Smith viz, $25,488.

It was suggested in alternative arguments, that this sum of $25,488 should be categorized for income tax purposes as.a capital payment and receipt, or income payment and receipt, or as a gift.

In my view, what in effect took place in respect to. this sum of $25,488 (being excess of drawings by Smith over cash entitlement) as of January 15, 1966 when the contract of dissolution was executed by the four partners, was a sale and purchase of Smith’s share of the accounts receivable and unbilled time (which under the “cash method” pursuant to section 85F of the Act were not yet included in computing income). Smith made the sale and the continuing partners made the purchase.

As a consequence, Smith should have included as income under subsection 85F(4) of the Act the sum of $25,488 representing the consideration received by him in respect to his share of such accounts receivable and unbilled time.

The appeals are therefore allowed to the extent that the relevant proportionate share of the sum of $25,488 should not have been added to the respective income of the appellants for the respective income taxation years under appeal, and as a consequence the assessments for each of the years under appeal are referred back for reassessment, not inconsistent with these reasons.

The appellants are entitled to costs.