J. L. Guay Ltée (Appellant)
v.
Minister of National Revenue (Respondent)
Trial Division, Noël A.C.J.—Montreal, June 9;
Ottawa, July 9, 1971.
Income tax—Business income, computation—Reserves or
contingent accounts—General contractor—Percentage of
progress payments withheld until 35 days after architect's
approval—Whether deductible in year withheld—Income
Tax Act, s. 12(1)(e).
Appellant, a general contractor, made monthly progress
payments to sub-contractors based upon their estimates but,
in accordance with the contracts between them, withheld a
percentage of the estimates until 35 days after the archi
tect's final approval of the work. The contracts provided
that if approval was not given the sub-contract might be
cancelled and the work done be paid for at current prices.
The amount being withheld by appellant at the close of its
1965 taxation year was $277,428.48, and appellant sought
to deduct this sum in computing its taxable income for that
year. The Minister disallowed the deduction and his disal-
lowance was upheld by the Tax Appeal Board.
Held, dismissing an appeal, the amounts being withheld at
the close of 1965 were prohibited from deduction in com
puting appellant's business profit for that year by s. 12(1)(e)
of the Income Tax Act as being a reserve or contingent
account. The amounts were withheld to ensure payment of
any damages appellant might sustain from the sub-contrac
tors' breach of contract and there was accordingly no cer
tainty that those amounts would be paid in full to the
sub-contractors. An expenditure may only be deducted
from income for the period for which it is made.
John Colford Contracting Co. v. M.N.R. [1960] Ex.C.R.
433; Southern Railway of Peru Ltd. v. Owen [1957]
A.C. 334; Naval Colliery Ltd. v. LR.C. (1928) 12 T.C.
1017, applied.
APPEAL from Tax Appeal Board.
M. Paquin and M. Gilbert for appellant.
P. Boivin for respondent.
Nopi, A.C.J.—The appeal is from a decision
of the Tax Appeal Board [Mr. Boisvert], dated
June 16, 1969, dismissing the appeal of J. L.
Guay Ltée, appellant, from an income tax
assessment, dated September 20, 1968, by
which a tax in the amount of $87,664.31 was
levied for 1965.
Appellant is a general building contractor
which, in order to perform some of its building
contracts, delegates performance of certain
operations to other businesses, i.e. sub-contrac
tors. In accordance with established practice in
the construction trade, appellant pays its sub
contractors on presentation by them of a
monthly estimate showing what progress has
been made. According to the terms of the con
tract with its sub-contractors, appellant with
holds a percentage of the monthly estimates
submitted and accepted, which it pays after the
work is finally approved by the architect.
Respondent in his assessment refused to admit
as payable an amount of $277,428.48, repre
senting the balances owing to the sub-contrac
tors from appellant as a result of the amounts
withheld each month during 1965. These bal
ances, representing a percentage of the monthly
estimates submitted by the sub-contractors and
accepted by appellant, are, the latter submits,
payable at a specific date. The fact is that
appellant is under an obligation to pay on a
certain date, i.e. the thirty-fifth day after final
approval of the work by the architect, as pro
vided in the contract between it and its sub-con
tractors. Appellant stated that the existence of
this obligation is not subject to any suspensive
or resolutory condition: the obligation does
exist and only its performance is postponed till
the end of the period. At any time after the
period of thirty-five days following approval by
the architect, the sub-contractor is entitled to
demand payment of the balance owing. Thus,
the appellant contends, these balances owing at
a definite time constitute amounts payable
within the meaning of the Income Tax Act and
case law, and must, accordingly, be included in
the contract expenses and deducted from appel
lant's profits for the year. Indeed, we have here
simply to determine whether appellant was enti
tled to deduct from its 1965 income the
amounts withheld under its contracts with its
sub-contractors in 1965—amounts which are
payable, or may become payable, after the
expiry of the said year.
Respondent, on the other hand, though admit
ting that appellant, under the contracts conclud
ed with its sub-contractors, may withhold the
specified percentage from the estimates, and
not pay these amounts until 35 days after
approval of the work by the architect, states
that it is always possible that the architect may
not give his approval. The architect's final
approval would thus be a suspensive condition
to which the payment of the sums so withheld
by appellant would be subject. According to
respondent's contention, not only was the
amount of $277,428.48 thus withheld in 1965
not claimable or even due, but it was not even
payable within the meaning of the Income Tax
Act, and he was consequently obliged, in an
assessment under date of September 20, 1968,
to disallow deduction of the amount so withheld
by appellant in computing its income for 1965.
In support of his assessment respondent cites
secs. 3, 4, 12(1)(a) and 12(1)(e) of the Income
Tax Act, R.S.C. 1952, c. 148. He submits that
the amounts thus withheld by appellant were
not, during the taxation year 1965, amounts
payable to its sub-contractors. Payment of these
amounts, he claims, was subject to the express
condition that the work performed by the sub
contractors be approved by the architect in its
final form on completion of the job. As the
work for which the amounts were withheld was
not so approved by the architect in appellant's
1965 taxation year, the said amounts could
consequently not be used for a deduction in
computing appellant's income.
The parties agreed that, for the purposes of
the hearing before this Court, (1) the transcript
of the testimony presented before the Tax
Appeal Board, introduced at the hearing before
this Court, shall be used as evidence subject to
completion; (2) documentary evidence shall
consist of copies of appellant's contracts with
its clients and the sub-contractors, and of
copies of invoices from appellant and its sub
contractors, all filed under the heading "Docu-
mentary Evidence"; (3) in computing its income
appellant consistently adopted the "comptabi-
lité d'exercice" accounting method, called in
English "the accrual basis".
Referring to the decision of this Court by
Kearney J. in M.N.R. v. John Colford Contract
ing Co. [1960] Ex.C.R. 433, the learned
member of the Tax Appeal Board [Mr. Bois -
vert] stated that, although the facts in that case
were the opposite of those established in the
present case, he nevertheless felt obliged to
apply the principles contained therein. In Col-
ford, in fact, Kearney J. refused to include in a
construction company's income amounts with
held during the current year and payable on the
architect's approval. In Kearney J.'s opinion,
these amounts were not "receivables"; for them
to be receivables they must, in the learned
judge's view, be amounts which "the intended
recipient has a clearly legal, though not neces
sarily immediate, right to receive".
According to Mr. Boisvert, applying that
decision to the case which now concerns us, if
the amount withheld could not constitute a debt
due and payable to be included in a taxation
year, because it represented a contingent debt,
similarly an amount withheld which is due and
payable in the future can only constitute an
allowable deduction in the year in which it
becomes certain and mandatory. Only then does
it meet the condition set forth in s. 12(1)(a), i.e.
it becomes an outlay incurred by the taxpayer
for the purpose of gaining income from a busi
ness, or, to go back to the argument of the
learned counsel for the respondent, Mr. Boivin,
if, in Kearney J.'s opinion, these amounts could
not be regarded as income, it is because they
were not due as long as the architect's certifi
cate had not been issued; and for the same
reasons they could not be regarded as due and
payable in the hands of the person owing them.
If they were not payable, then they could not be
deducted from appellant's income for 1965.
Appellant, on the other hand, maintains just
the opposite. If I have understood its counsel's
argument correctly, its obligations and rights
are to be considered in the light of the contracts
entered into with its sub-contractors, which all
include the same clauses except for the amount
withheld. The only pertinent ones are the
following:
3. Terms of payments: % of the monthly estimates
submitted and accepted, the balance namely %, 35
days after final approval of the work by the architect.
5. If the work is not considered satisfactory by the archi
tect, we reserve the right to cancel your contract and have it
carried on by another contractor at your expense. Work
already done will be paid for at the current market price,
without your being entitled to any damages for cancellation
of the contract.
20. In the event of cancellation or termination of the
contractor's main contract or suspension of the work form
ing the subject of the said contract, including the work
specified in the present contract, for whatever cause, even
for cause attributable to the contractor, it is agreed that by
simple notice your contract shall be cancelled or terminated,
or your work suspended, as the case may be, and that you
shall only be entitled to payment in proportion to the
amount of your contract, of the labour and of the materials
incorporated in the work and delivered to the site of the
main contract, according to the reckoning of the architect,
less the total amount of prior payments.
These clauses, which counsel for the appel
lant relies on as a basis for his argument, clearly
indicate, he says, that whatever the result of the
work carried out by the sub-contractor, whether
it is approved by the architect or not, the sub
contractor is nonetheless entitled to be paid
eventually the amount withheld on the monthly
estimates received. In fact, clause 5 states that
if the work is not found satisfactory by the
architect, the contractor shall be entitled to
cancel the contract, but the sub-contractor shall
nevertheless be paid in full at the current
market prices for work already done. He con
cludes that for the work performed, for which
amounts are withheld, the sub-contractor will
then be entitled to receive the full amount with
held. If, on the other hand, the amount withheld
or a part thereof is used to pay damages
claimed by the principal contractor, it would
then be compensation for losses, and in the
event of a dispute the Court will not decide
whether the said amount is payable; rather, it
will decide the reverse, i.e. that this amount
which was due is no longer owing because it is
to be used for compensation of the damages
owing and the sums payable on the amounts
withheld and, in the event of a surplus, it would
also be paid to the sub-contractor. According to
counsel for the appellant, the principal contrac
tor is paying himself with the sub-contractor's
money, not with his own. In neither case, there
fore, does the principal contractor benefit from
the amounts so withheld. Indeed, contends
counsel for the appellant, the amount withheld
will in any event be either paid to the sub-con
tractor 35 days after the work is approved by
the architect or used to compensate the princi
pal contractor for damages incurred. Conse
quently, he says, such amounts are payable, not
under a suspensive condition, but rather with a
term. A term, he adds, differs from a suspen-
sive condition in as much as it does not suspend
the obligation, but only delays the execution of
it (cf. Articles 1089 et seq., C.C.).
Accordingly, to determine whether the
amounts withheld are payable or not, we must
in any case, according to counsel for the appel
lant, take into consideration the special situa
tion created by the contract which governs the
rights and obligations of the contractor; and, he
contends, this contract does not provide that
the sub-contractor may lose the amounts with
held. As they are to be payable eventually, i.e.
on completion of the specified term, 35 days
after approval by the architect, these amounts
may consequently not be regarded as contingen
cy payments or amounts transferred or credited
to a reserve or contingent account, and thus
they are not subject to s. 12(1)(e) of the Income
Tax Act, which prohibits the deduction of such
amounts. Consequently, concludes counsel for
the appellant, we are dealing either with
amounts payable with a term, but payable
nonetheless, or with a charge or expense which
should be deducted from income; and in either
case these amounts should not be included in
appellant's income.
As stated by appellant, the contract does pro
vide that, if the work is not found satisfactory
by the architect, the sub-contractor will never
theless have the right to be paid in full at the
current market price for the work already done;
this does not mean, however, that the contrac
tor will always have to pay the amount so
withheld in full. In fact, it must not be forgotten
that the purpose of the provision which permits
withholding of a certain percentage of the con
tract price is to ensure the payment of any
damages the owner or the general contractor
may incur from the sub-contractor's failure to
perform the work or its faulty performance of
it. If such damages correspond to, or exceed,
the amounts so withheld, the owner or the gen
eral contractor may keep the entire amount; if,
on the other hand, the damages are less, the
sub-contractor will be entitled to receive the
difference.
It seems to me, therefore, that it is far from
certain that the amounts so withheld will be
paid in full to the sub-contractor. In fact, the
payment of these amounts to the sub-contractor
is perhaps to be regarded, if damages are
incurred, as contingent. It is true that, once
fixed, such damages may be offset by the
amounts withheld, and that the general contrac
tor will not benefit therefrom, but the damages
have not yet been liquidated for 1965, and
compensation cannot be paid until they are.
Until then, and even after, until the architect
has issued his certificate and 35 days have
elapsed, the general contractor is under no
obligation to pay this amount, and it is not
claimable by the sub-contractor. In fact,
compensation takes place by the sole operation
of law only between debts which are equally
liquidated and exigible, and have each for
object a sum of money or a certain quantity of
indeterminate things of the same kind and
quality (cf. Articles 1187 and 1188 C.C.).
The Income Tax Act does not always give a
complete answer to the question as to what the
total amount of profits and earnings in the year
assessed is. In determining the taxable profits
of a taxpayer we can take as a starting point the
profit and loss statement prepared according to
the rules of accounting practice. However, the
profit shown on this statement has always to be
adjusted according to the statutory rules used in
determining taxable profits. This is because a
number of facts taken into consideration by
accountants are excluded by certain provisions
of the Income Tax Act in the determining of
taxpayers' profits. The profit and loss state-
ment, indeed, is really a statement of fact, and,
consequently, a matter of evidence. It includes
facts which cannot be questioned and state
ments of facts which may be called provisional.
It is difficult to challenge the first category
unless the figures used were taken, for instance,
from improperly kept books. When, , however, a
statement of provisional facts is involved, the
Minister is not obliged to accept what is submit
ted to him by the accountants. Such a situation
occurs when, for instance, in a case such as
this, a reserve is to be set up, for accounting
purposes, to provide for receipt of a benefit or
payment of a demand which is contingent or
conditional. In Southern Rly. of Peru Ltd. v.
Owen [1957] A.C. 334, respondent, which ope
rated a railway, was required under Peruvian
law to make compensation payments, deter
mined according to a set rule, to an employee
on termination of his employment; payment of
these amounts was, however, uncertain, since in
certain cases he could lose them. The headnote
of the judgment clearly explains how the com
pany went about determining the amount of the
reserve.
The company claimed to be entitled to charge against
each year's receipts the cost of making provision for the
retirement payments which would ultimately be thrown on
it, calculating what sum would be required to be paid to
each employee if he retired without forfeiture at the close
of the year and setting aside the aggregate of what was
required insofar as the year had contributed to the
aggregate.
The House of Lords did not agree, however,
that the company could deduct as expenses
from each year's income the amounts set aside
to cover retirement payments it might eventual
ly be called on to make. However, the Court did
not formulate any basic principle as grounds for
its refusal, and Lord Radcliffe gave his opinion
as follows (at p. 355):
It is clear, at any rate, from what I have quoted above
that there is nothing improper in admitting valuations or
estimates if by so doing a truer balance is arrived at
between the receipts of a year and the cost of earning them
or the expenses of a year and the fruits of incurring them.
Such estimates were in fact directed by the Court of Appeal
and by this House in Harrison v. John Cronk & Sons Ltd.
[1937] A.C. 185 and again by this House in Absalom v.
Talbot [1944] A.C. 204. See, too, the judgment of Lord
Greene M.R. in Johnson v. Try Ltd. [1946] 27 T.C. 167. The
decision in the last mentioned case is, I think, of value in
illustrating the point that, however desirable it may be to
bring in a valuation or estimate in order to give a better
balance to a year's accounts, it cannot be right to do so if
the figure which is to be inserted, "hedged round ... with
every kind of contingency and speculation", is too uncertain
to be fairly treated as a receipt. What is true of receipts is
true of liabilities. In my opinion, it is that point which
constitutes the real difficulty of the present case.
In most tax cases only amounts which can be
exactly determined are accepted. This means
that, ordinarily, provisional amounts or esti
mates are rejected, and it is not recommended
that data which are conditional, contingent or
uncertain be used in calculating taxable profits.
If, indeed, provisional amounts or estimates are
to be accepted, they must be certain. But then it
is always difficult to find a procedure by which
to arrive at a figure which is certain. Account
ants are always inclined to set aside reserves
for unliquidated liabilities, for, if they do not do
so, the financial statement will not reflect the
true position of the client's affairs. The difficul
ty arises from the fact that making it possible to
determine the taxpayer's tax liability is not the
main purpose of accounting. The accountant's
report is, in fact, intended to give the taxpayer a
general picture of his affairs so as to enable him
to carry on his business with full knowledge of
the facts. To achieve this end, it is not neces
sary for the profit shown to be exact, but it
must be reasonably close, while the Income Tax
Act requires it to be exact, and it is thus neces
sarily arbitrary. In Southern Rly. of Peru Ltd. v.
Owen (supra), the company's auditor stated that
he would not have signed its financial statement
if the reserve for future debts had not been
entered on the balance sheet. The House of
Lords was not influenced by this statement,
however, and decided nevertheless that the
company could not deduct the amounts payable
until the employees terminated their employ
ment. However, Southern Rly. of Peru Ltd. v.
Owen (supra) concerned a reserve made for
uncertain amounts which the company might be
called upon to pay in the future. What is the
situation when the amounts involved are cer
tain, but are not due until a subsequent account
ing period? Such amounts were involved in
Naval Colliery Co. v. LR.C. (1928) 12 T.C.
1017, (H.L.) and the Court decided neverthe
less that they could not be deducted so long as
the outlay had not been made. In that case,
Lord Buckmaster indeed stated clearly that
these amounts could only be deducted in the
period in which they were actually spent:
According to the appellants' contention, however, it is not
the actual expenditure that is deducted, but the need for
making the expenditure which is to be measured in their
favour and brought into the account. This contention would
involve the conclusion that the subject could choose which
period he liked as the one in which the allowance is to be
brought into account, either that when the expenditure
became necessary or that when it was made (p. 1040).
As a general rule, if an expenditure is made
which is deductible from income, it must be
deducted by computing the profits for the
period in which it was made, and not some
other period.
The procedure adopted by appellant, of
deducting from its income amounts withheld by
it, which it may one day be required to pay its
sub-contractor, but which the latter may not
claim until 35 days after the work is approved
by the architect, is, as we have just seen, con
trary to the rule that an expenditure may only
be deducted from income for the period in
which it was made, and this would suffice to
dispose of the present appeal. However, as we
have seen above, there is an additional reason
for dismissing the appeal: this is that we are
dealing with amounts withheld which are not
only uncertain as to quantum if partial damages
result from badly done work, but which will no
longer even be due or payable if damages
exceed the amounts withheld. How can it be
claimed in such circumstances that a certain
and current expense is involved, and that the
amounts withheld, which appellant has full
enjoyment of until it pays the amounts owing to
the sub-contractor, or until compensation
becomes due, may be deducted by appellant as
it receives them from the owner.
The appeal is therefore dismissed and
respondent will be entitled to his taxable costs.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.