T-3890-80
The Ennisclare Corporation (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Mahoney J.—Toronto, September
22; Ottawa, October 29, 1982.
Income tax — Income calculation — Calculation of reserve
— Condominium developer — First mortgage assumed by
purchasers exceeded cost of construction — Reasonable in
circumstances to take into account first mortgage in calcula
tion of reserve — Fact that reserve is 92% of receivables not
per se unreasonable — Appeal allowed — Income Tax Act,
S.C. 1970-71-72, c. 63, s. 20(1)(n)(ii) (as am. by S.C. 1974-
75-76, c. 26, s. 8).
The plaintiff engaged in the construction of a condominium
project. It acquired land for $247,202 and obtained a first
mortgage loan of $7,102,288. By the end of its 1977 year, gross
sales were $7,249,593, of which $5,758,460 were first mortgage
assumptions. Gross profits were $2,308,553 and construction
costs attributable to the units were $4,739,551. Plaintiff, in
appealing its income tax assessment, sought to have the cost of
construction deducted from the gross selling price in arriving at
an amount of reserve of $969,691.
Held, the appeal is allowed. Parliament's intention in allow
ing a reserve is to permit a taxpayer to match tax liability and
realization of profit. It is considered reasonable to assume that
the profit percentage of subsequent years is the same percent
age of gross profit to gross sales. This is expressed in the
following equation:
Gross profit
Gross selling price x Amount receivable = Reserve.
Where a purchaser assumes an existing mortgage, the following
formula may be appropriate:
Gross profit
Gross selling price less x Amount receivable = Reserve.
mortgages assumed
The case is complicated by the fact the first mortgage exceeded
the cost of construction. When the plaintiff drew down the
mortgage proceeds, it received cash in hand. What was not
spent on construction had no bearing on the determination of
gross profit, i.e. the gross selling price minus the cost of land
and construction. To the extent of the excess, relief from the
plaintiff's liability entailed realization of gross profit. It is
reasonable in this instance to take account of the first mortgage
assumed by the purchasers. In this case the following formula
leads to a reasonable result: the cost of construction is subtract
ed from the gross selling price. That amount is allocated in
specific proportions to each of three elements: the first mort
gage assumed, the second mortgages back and cash. The gross
profit should then also be allocated to each of these three
elements in the same proportions. Plaintiffs formula was
rejected, apparently in that a reserve of 92% of the entire
receivable was thought per se unreasonable. But where, as here,
gross profit is extremely high relative to gross selling price, the
reasonable reserve will be extremely high relative to the
receivable.
COUNSEL:
M. A. Mogan, Q.C. and E. G. Nazzer for
plaintiff.
D. Olsen for defendant.
SOLICITORS:
Miller, Thomson, Sedgewick, Lewis & Healy,
Toronto, for plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
MAHONEY J.: The issue here is the reserve
allowed to the plaintiff under subparagraph
20(1)(n)(ii) of the Income Tax Act, R.S.C. 1952,
c. 148, as am. by S.C. 1970-71-72, c. 63, s. 1;
1974-75-76, c. 26, s. 8, for its year ended June 30,
1977. The plaintiff had, to that date, engaged in a
single business venture: construction and develop
ment of a condominium project. It acquired the
land at a cost of $247,202 and, prior to construc
tion, granted a first mortgage under whose terms
$7,102,288 was eventually drawn down as con
struction proceeded to completion.
With few exceptions, the selling price of each
unit comprised three elements: assumption of a pro
rata amount of the first mortgage, cash and a
balance secured by a second mortgage in favour of
the plaintiff. In rare cases, the cash payment was
sufficient to obviate a second mortgage and, more
exceptionally, to commute part or all of the first
mortgage share. The plaintiff had sold units in
each of its 1975, 1976 and 1977 taxation years. By
the end of its 1977 year, gross sales aggregated
$7,249,593, whereof $436,808 was cash and
$5,758,460 by first mortgage assumptions; gross
profit to June 30, 1977, was $2,308,553 and the
deferred balance of the second mortgages as at
June 30, 1977, was $1,054,325. The construction
cost attributable to the units sold to that date was
$4,739,551.
The Act provides:
20. (1) ... in computing a taxpayer's income for a taxation
year from a business or property, there may be deducted such
of the following amounts as are wholly applicable to that source
or such part of the following amounts as may reasonably be
regarded as applicable thereto:
(n) where an amount has been included in computing the
taxpayer's income from the business for the year or for a
previous year in respect of property sold in the course of the
business and that amount or a part thereof is not due,
(ii) where the property sold is land, until a day that is after
the end of the taxation year,
a reasonable amount as a reserve in respect of such part of
the amount so included in computing the income as may
reasonably be regarded as a portion of the profit from the
sale;
Parliament's obvious intention was to permit a
taxpayer to match tax liability and realization of
profit. Two applications of the provision are illus
trated in the decision of the Tax Review Board in
Makis Construction Limited v. Minister of Na
tional Revenue.' There is no material distinc
tion between the provision of subparagraph
85B(1)(d)(ii) considered there and the present
subparagraph 20(1)(n)(ii).
In computing the amount of the reserve to be granted to a
vendor, it is important to bear in mind that such a reserve
under section 85B(1)(d) is only allowable in respect of the
profit element in the amount receivable. The only requirement
in regard to the allowable amount of a reserve in respect of the
profit element in such a receivable is that the reserve must be a
reasonable amount. In practice, it is considered reasonable to
assume that the percentage of any amount of the sale price
receivable in a subsequent taxation year that should be taken to
represent the profit element included in the said receivable
' 72 DTC 1101 at pp. 1105 ff. (T.R.B.).
would be the same percentage of that receivable as the gross
profit is of the total sale price. Conceivably a reserve might be
allowed equal to the full amount of the profit so determined if
no portion at all of the selling price had been received in the
year of sale. Stated as a formula, the foregoing would be
expressed as:
GROSS PROFIT
X AMOUNT RECEIVABLE = RESERVE.
GROSS SELLING PRICE
A modification of this formula is called for in a situation
where an existing mortgage (or mortgages) is assumed by the
purchaser, provided that none of these assumed mortgages has
been placed on the property subsequent to the completion of the
building so as to reduce the owner's existing equity in the
property. In such a case, the mortgage or mortgages so
obtained are disregarded in calculating the reserve. In the case
of the assumption of an existing mortgage by the purchaser, the
above formula is modified by changing the denominator from
the amount of the gross selling price to the difference between
the gross selling price and the amount of the mortgage or
mortgages taken out on the building during construction and
later assumed by the purchaser. The formula then becomes:
GROSS PROFIT
X AMOUNT RECEIVABLE = RESERVE.
GROSS SELLING PRICE
- MORTGAGES
ASSUMED
The Makis decision is not binding authority but it
is significant in that, in concluding that the second
formula was a valid approach in the circumstances
described, the Tax Review Board was upholding
the formula adopted by the Minister, not that
urged by the taxpayer.
The evidence, illustrated by Exhibits P-28 and
P-29 respectively, which were originally marked in
the examination for discovery of the defendant's
officer read into evidence by the plaintiff, is that
either method of calculation described in Makis is
acceptable in appropriate circumstances. The
present case is complicated by the fact that the
first mortgage exceeded the cost of construction.
The formula sought to be applied by the plaintiff
takes that into account.
GROSS PROFIT
X AMOUNT RECEIVABLE = RESERVE.
GROSS SELLING PRICE
- COST OF IMPROVE
MENTS PAID FOR BY
MORTGAGE ASSUMED
The defendant, in assessing, has applied the first
formula:
$2,308,553 x $1,054,325 = $335,738.
$7,249,593
The plaintiff, in appealing that assessment, urges
the following:
$2,308,553 x $1,054,325 = $969,691.
$7,249,593 — $4,739,551
The plaintiff's formula does not, apparently,
take account of another complication arising from
the fact that the first mortgage exceeded the cost
of construction. That complication is the realiza
tion of gross profit that occurred when the pur
chasers assumed the first mortgage. When the
plaintiff drew down the mortgage proceeds, it
received cash in hand. What was not spent on
construction remained in hand in the sense that,
whatever its application, it had no bearing on the
determination of the gross profit, i.e., gross selling
price minus cost of land and construction.
Assumption by the purchasers of that excess
relieved the plaintiff of its obligation to repay the
excess of the mortgage. To the extent of that
excess, relief from its liability entailed, as one of
its elements, realization of gross profit.
It is reasonable in this instance to take account
of the first mortgage assumed by the purchasers. It
must, however, be taken account of both as it
affected the gross selling price and effected a
realization of gross profit. I have no evidence upon
which to propose a formula that would lead to a
reasonable result in every such case; however, in
this case, the following leads me to what I find to
be a reasonable result.
The gross selling price, $7,249,593, less the cost
of construction, $4,739,551, is $2,510,042. The
cost of construction being totally attributed to first
mortgage assumptions, the balance of the gross
selling price breaks down as follows:
First mortgage assumed — $1,018,909 — 40.6%
Second mortgages back — $1,054,325 — 42.0%
Cash — $ 436,808 — 17.4%
TOTAL - $ 2,510,042 — 100.0%
It seems reasonable to allocate the $2,308,553
gross profit to each of those elements in the same
proportions:
First mortgage assumed — $ 937,273 — 40.6%
Second mortgages back — $ 969,592 — 42.0%
Cash — $ 401,688 — 17.4%
TOTAL — $ 2,308,553 — 100.0%
The result is startlingly, and I trust coincidentally,
similar to that arrived at by application of the
plaintiff's formula.
The defendant led no evidence. I gather from
the argument that the rejection of the plaintiff's
formula was actually a reaction that a reserve of
$969,691, or 92%, of the entire $1,054,325 receiv
able was per se unreasonable. I do not accept that.
The ratio of reserve to amount receivable will, in
every case, reflect the ratio of gross profit to gross
selling price. If the gross profit is, as here,
extremely high relative to the gross selling price,
the reasonable reserve will be extremely high rela
tive to the receivable. That is pure arithmetic.
If adjustments in the circumstances of Makis
and of Exhibit P-29 are appropriate, then the mere
fact that the mortgage taken out by the vendor
and assumed by the purchaser is very large relative
to the selling price does not render them inappro
priate nor, in my view, does the fact that the
mortgage assumed exceeds the increase in the
value of the property attributable to its proceeds as
long as the excess is properly taken into account.
The appeal will be allowed with costs and the
plaintiff's 1977 income tax assessment referred
back for reassessment on the basis that a reason
able reserve under subparagraph 20(1)(n)(ii) is
$969,592.
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.