Date: 19990318
Docket: 97-2301-IT-G
BETWEEN:
ARGUS HOLDINGS LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
Mogan, J.T.C.C.
[1] The Appellant was incorporated in February 1980 to operate a racquetball club in Langley, B.C. It purchased a property (land and building) from the Federal Business Development Bank and converted the building to contain nine courts for racquetball. It opened for business on November 1, 1980. As the popularity of racquetball declined, the Appellant expanded into other fitness activities and now operates a health and fitness club under the name "Fitness Unlimited Athletic Club" at three locations in the Vancouver area.
[2] From the beginning, the Appellant charged a one-time initiation fee or membership fee for the right to become a member of the club and gain access to and use of the club's facilities. Whether the Appellant included the whole initiation fee received from a particular member in computing income for the year of receipt and whether it then deducted a portion of the initiation fee in computing income for that year is a matter of dispute. It is a fact, however, that the Appellant included in its net income for the year of receipt and for each of the nine succeeding years one-tenth of the initiation fee.
[3] The Minister of National Revenue has taken the position that the whole of any particular initiation fee should be included in computing income for the year of its receipt. By notices of reassessment, the Minister added the following four amounts as "additional initiation fee income" to the Appellant's reported income for the four respective taxation years shown below:
Taxation Year Amount
December 31, 1992 $696,860
December 31, 1993 $335,003
February 18, 1994 $ 71,736
October 31, 1994 $132,693
The amount of $696,860 in the above table was calculated as follows:
Initiation fees received in 1992 $357,210
Add initiation fees deferred from prior years 441,154
Subtotal 798,364
Less initiation fees reported as part of
net income for 1992 101,504
Additional initiation fee income $696,860
[4] The Appellant claims in paragraph 5 of its Amended Notice of Appeal that, if it does not provide continuous access to and use of its club facilities to a particular member over a ten-year period commencing on the date of initial membership, it is obliged to refund a pro rata portion of the initiation fee which relates to the portion of the 10-year period during which its facilities are not provided to the particular member. Accordingly, the Appellant states (paragraph 13, Amended Notice of Appeal) that the issue in this appeal is whether the initiation fees were properly amortized and included in income over a 10-year period on the basis of the Appellant's obligation to refund a proportionate part of the initiation fee over that period.
[5] In its Amended Notice of Appeal, the Appellant claimed that none of the four amounts added to its reported income for the respective taxation years listed in paragraph 3 above should be including in income. At the commencement of the hearing, counsel for the Appellant stated that his client was abandoning its appeal with respect to the taxation years ending December 31, 1993; February 18, 1994; and October 31, 1994; and was restricting its appeal for 1992 to the amount of $441,154 identified as "initiation fees deferred from prior years". In summary, the Appellant now claims that because it did not deduct in computing income for the years prior to 1992 any reserve with respect to deferred initiation fees, the Minister does not have the right to carry forward to 1992 any amount (i.e. $441,154) with respect to such deferred initiation fees. That is the only remaining issue in this appeal.
[6] Gregory Andron was the principal witness for the Appellant. He is a director, the president and majority shareholder of the Appellant. In 1979-1980, he was an active racquetball player and conceived the idea for the Appellant and its business. The first club location was in Langley, B.C. When the club opened on November 1, 1980, the membership was sold out and there was a waiting list of 150 individuals wanting to join. Prior to opening, the Appellant had charged initiation fees on the following basis: individual $99, couple $149 and family $199. After opening day, the initiation fees were increased by $100 as follows: individual $199, couple $249 and family $299. The initiation fees never went any higher and, in fact, as other fitness centres were built and competition increased the initiation fees were reduced. In March 1999, the initiation fee for an individual was $29.
[7] In the beginning, when the Appellant's business was new and the initiation fees were high, some prospective members were concerned about what would happen to their one-time initiation fee if the Appellant did not prosper but closed its doors after a short life. To those concerned members, Mr. Andron made the following promise. If the Appellant failed to provide its racquetball and fitness facilities to a new member for 10 years, the Appellant would refund to such member a pro rata portion of the initiation fee equal to the portion of the first 10 years when the facilities were not provided.
[8] The Appellant has been successful since its inception. It now operates at three separate locations. There is no evidence that it has ever had to close or suspend its operation at any location, and so I infer that no portion of any initiation fee has ever been refunded to any member. It is Mr. Andron's testimony that he made the "refund policy" promise to many concerned prospective members and the Appellant would have had a moral (and perhaps legal) obligation to refund part of the initiation fee to some (and perhaps all) members if the Appellant had been forced to close or suspend its operations. I use the word "perhaps" because the precise nature of this so-called refund obligation was not pursued in evidence. The refund policy promise was not made to all members but only to those who expressed concern.
[9] In its Amended Reply, the Respondent alleges that in reassessing the Appellant for income tax, the Minister assumed that:
6(b) prospective members of the Club are required to pay a one-time non-refundable initiation fee (the "Initiation Fee") in order to become a member and thereafter are required to pay either monthly or yearly dues to cover the costs associated with their use of the services and facilities of the Club;
6(d) the Initiation Fee's (sic) received in any given taxation year were earned in that taxation year and were received on account of services rendered before the end of that taxation year;
6(f) the Appellant has unrestricted use of the Initiation Fee's (sic) in the taxation year they were received.
In response to those assumed facts, the Appellant had the onus of proving that it had a legal obligation to refund a pro rata portion of the initiation fees in certain circumstances if the Appellant were to maintain the following claim alleged in paragraph 5 of the Amended Notice of Appeal:
5. If the Appellant does not provide continued access to and use of the Facilities to a particular member or members over a ten year period commencing on the date of initial membership, the Appellant is obligated to refund a pro rata portion of the Membership Fee that relates to the portion of the ten year period during which the Facilities are not provided to the member.
[10] No membership agreement was produced in evidence and Mr. Andron indicated in his testimony that the standard membership agreement did not contain any terms requiring the Appellant to refund any part of the initiation fee under any circumstances. What I am left with is Mr. Andron's testimony that he made the refund policy promise to certain concerned prospective members in the circumstances described above. If the Appellant had been required to suspend operations, I do not know how it would have distinguished those members to whom the refund policy promise was made from the other members who expressed no concern when they joined. Without an explicit term in the membership agreement, it may have been difficult for any member to prove that a refund policy promise had been made.
[11] Having regard to paragraph 6(d) of the Respondent's Reply (quoted above) and the absence of any document in evidence showing that the Appellant was either willing or obliged to refund any part of an initiation fee, I find that no such obligation existed. In my opinion, the initiation fee received by the Appellant from a member in any year was earned by the Appellant in the year of receipt; and there was no collateral obligation to refund any part of that fee. In substance, I think the Appellant has admitted this conclusion by abandoning its appeals for all taxation years except 1992, and by restricting its claim for 1992 to the amount of $441,154.
[12] Exhibit A-1 contains the following resolution of the Appellant's directors passed on January 31, 1982:
The Company acknowledge (sic) its obligation to provide continuous and satisfactory services and facilities to its members in exchange for the initiation fees charged to members. If the Company can no longer provide such services and facilities, the Company will refund the initiation fees to the following extent:
120 months less the number of membership months
Initiation fees X for which services were provided 120 months
[13] Monique Rivard was the Appellant's second witness. She described herself as the Appellant's controller responsible for the day-to-day bookkeeping and accounting. She said that the Appellant maintained a "Members Office" with a clerk who recorded every payment by a member. In addition to the initiation fees described above, there were monthly or annual dues necessary to maintain membership. The membership clerk would enter an initiation fee into an account bearing that name. Ms. Rivard would not pick up that payment until the end of the month when she would make the following journal entry based on the net initiation fees received in the preceding month:
Debit: Bank Account (an asset account)
Credit: Deferred Initiation Fees ( a liability account)
At the same time, she would make a second journal entry as follows:
Debit: Deferred Initiation Fees (1/120 of the balance in this liability account)
Credit: Initiation Fee Income (the same 1/120 amount)
[14] The denominator 120 in the above journal entry is the number of months in a 10-year period. It is this second journal entry which brings into the Appellant's income all initiation fees over a 10-year period one month at a time. There would be 12 such journal entries in each calendar year. To be precise, an initiation fee paid after the first month of a full fiscal year would be spread over 11 years with fractions of less that 1/10 included in income for the first and last year but precisely 1/10 included in income for each of the intervening nine years.
[15] Robert Schultz, C.A. was the Appellant's third witness. He is a chartered accountant who has been preparing the Appellant's financial statements and income tax returns since the Appellant opened for business. When he first met Mr. Andron in the fall of 1980, he was told that other similar clubs were deferring part of their initiation fees. Mr. Schultz was also concerned that reporting all of the initiation fees as income in the year of receipt could overstate income which was contrary to conservative accounting. He could not recall who designed the formula for deferring initiation fees which was part of the directors' resolution in Exhibit A-1.
[16] Mr. Schultz's working papers were entered as Exhibit A-2. He demonstrated from the first page of Exhibit A-2 how the amount of $60,469.62 (total of column 5) was included in computing the Appellant's 1992 income. For a given year like 1989, the net initiation fees received in that year were $87,704.69 (column 3). The aggregate brought into income in 1989, 1990 and 1991 was $26,311.41 representing 3/10 (column 4). The one-tenth contribution to 1992 income was $8,770.47 (column 5). The aggregate in column 6 ($35,081.88) represented the total of amounts in columns 4 and 5 and was also the aggregate of amounts included in income for the years 1989 to 1992 inclusive. And finally, the "deferred balance" in column 7 is the amount in column 3 less the amount in column 6. Mr. Schultz's working papers appear to be consistent with the bookkeeping entries described by Ms. Rivard.
[17] Exhibit A-3 is the Appellant's 1992 income tax return and Exhibit A-4 is the 1991 income tax return. The Appellant's financial statements are attached to its tax returns for the respective years. Schedule 1 to the 1992 financial statements shows sales and direct costs. According to Mr. Schultz, the revenue of $1,248,398 from Health Club and Racquetball includes the amount of $60,649.62 described on the first page of his working papers (Exhibit A-2) as the current year (1992) initiation fees included in income.
[18] The 1991 financial statements are part of Exhibit A-4. Note 5 to the 1991 financial statements describes long-term liabilities and includes deferred initiation fees of $441,154 which is the only amount in issue. Mr. Schultz confirmed that the Schedule T2S(1) Reconciliation of Net Income for Income Tax Purposes attached to each income tax return did not contain any adjustment for deferred initiation fees. Specifically, there was no amount entered for "Prior years' reserves not included in statements" nor for "Current year's reserves not deducted on statements".
[19] Mr. Schultz stated that there was nothing in Ms. Rivard's journal entries to indicate that the deferred initiation fees were reserves. He did not regard them as reserves because (i) on the facts, the Appellant credited the whole initiation fee to a liability account and then brought into revenue only 1/120 of that account each month; and (ii) as an accountant, he thinks of a reserve as an appropriation of retained earnings and there was no such appropriation in the Appellant's financial statements. Mr. Schultz may be correct in his thoughts as a professional accountant but, in this case, there is no expert evidence with respect to generally accepted accounting principles (GAAP). Therefore, I am left with only the relevant provisions of the Income Tax Act as they apply to the amount in dispute.
[20] According to the Respondent's Amended Reply filed about two weeks before the hearing, the Respondent relies on the following provisions of the Act: paragraphs 12(1)(a), 12(1)(e), 18(1)(e) and 20(1)(m), the relevant portions of which are set out below:
12(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:
(a) any amount received by the taxpayer in the year in the course of a business
(i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, or
(ii) ...
...
(e) any amount
(i) deducted under paragraph 20(1)(m) (including any amount substituted by virtue of subsection 20(6) for any amount deducted under that paragraph), paragraph 20(1)(m.1) or subsection 20(7), or
(ii) deducted under paragraph 20(1)(n),
in computing the taxpayer's income from a business for the immediately preceding year;
18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
...
(e) an amount as, or on account of, a reserve, a contingent liability or amount or a sinking fund except as expressly permitted by this Part;
20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), 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:
...
(m) subject to subsection (6), where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer's income from a business for the year or a previous year, a reasonable amount as a reserve in respect of
(i) goods that it is reasonably anticipated will have to be delivered after the end of the year,
(ii) services that it is reasonably anticipated will have to be rendered after the end of the year,
(iii) ...
[21] Subparagraphs 12(1)(a)(i) and 20(1)(m)(ii) speak respectively of "services not rendered before the end of the year" and "services that will have to be rendered after the end of the year". Mr. Andron was clear in his testimony that he made the refund policy promise to concerned prospective members because he thought 10 years was a reasonable life expectancy for a new membership, and because similar clubs were making the same kind of promise. In his mind, the initiation fee could be earned by the Appellant only if it provided continuous access to and use of its facilities over a 10-year period. Considering that the fee is paid up front at the commencement of membership, Mr. Andron's concept of earning that fee over 10 years is very similar to a service that "will have to be rendered after the end of the year" in which the fee is received, applying the words from subparagraph 20(1)(m)(ii).
[22] I have already concluded in paragraph 11 above that the Appellant had no obligation to refund any part of an initiation fee but I am not concerned here with any obligation, legal or moral or non-existent, on the Appellant. I am concerned only with Mr. Andron's understanding of his refund policy promise because it was his understanding that shaped the bookkeeping and accounting procedures of the Appellant. If Mr. Andron thought, rightly or wrongly, that initiation fees were earned over 10 years, it was his thoughts which influenced the directors resolution and refund formula in Exhibit A-1.
[23] I asked Mr. Schultz at the end of his testimony if he regarded the initiation fees as having a revenue character as distinct from being capital or something else. Mr. Schultz said that he regarded the initiation fees as being only revenue. I accept without hesitation Mr. Schultz's view that initiation fees are revenue. His view is consistent with my own instinct. Also, his view is consistent with the two simultaneous journal entries which Ms. Rivard made at the end of each month as described in paragraph 13 above.
[24] The Appellant argues that it did not in fact deduct a reserve under paragraph 20(1)(m) nor did it think that it had deducted such a reserve. This argument is based on the journal entries actually made in the Appellant's books and records. Those journal entries are described in paragraph 13 above and show that initiation fees were first credited to a liability account (Deferred Initiation Fees) and then month-by-month fed into the Appellant's income stream using a formula based on the 120 months in a 10-year period. Mr. Schultz's working papers (Exhibit A-2) appear to be consistent with the journal entries. Although there is no expert accounting evidence in this case and Mr. Schultz did not describe an alternative method of recording the initiation fees, I speculate that the Appellant could have first credited those fees directly to initiation fee income and then, at year end, deducted a reserve with respect to what it regarded as the unearned portion of such fees by a journal entry which would (i) debit initiation fee income; and (ii) credit deferred initiation fees. This is only speculation on my part because the evidence is restricted to what the Appellant in fact did.
[25] If I consider the effect of the Appellant's bookkeeping and accounting procedures, there is no doubt that the whole initiation fee was not included in income in the year of receipt notwithstanding Mr. Schultz's view that such fee had a revenue character. Only a small fraction (not more that 1/10) of a particular initiation fee was included in income in any year. It is a fact that approximately 9/10 of each initiation fee was withheld from income in the year of receipt and deferred to be included in the income of later years. Accepting Mr. Andron's mistaken concept that a particular initiation fee was earned over a 10-year period, and accepting Mr. Schultz's view that all initiation fees have a revenue character, the Appellant's bookkeeping and accounting procedures failed to comply with subparagraph 12(1)(a)(i) which requires that a taxpayer include in computing income any amount received in the year that is on account of services not rendered before the end of the year, or that may be regarded as not having been earned in the year.
[26] Expressing the above thought in a different way, if I accept Mr. Andron's mistaken concept of initiation fees earned over 10 years and Mr. Schultz's accurate view that such fees are revenue, those fees had to be included in computing income under subparagraph 12(1)(a)(i). If the Appellant had complied with subparagraph 12(1)(a)(i) as was required, the only way to remove a portion of the initiation fees from income would be the deduction of a reserve under paragraph 20(1)(m).
[27] In my opinion, the effect of the Appellant's bookkeeping and accounting procedures is more important that the mechanical order in which certain accounting entries were made or the nomenclature applied to those entries. The Appellant maintained a liability account under the name "Deferred Initiation Fees". It is the account in which the Appellant stored that portion of initiation fees already received but not yet included in income because that portion was set aside to be included in the income of later years. I find that that account was a reserve within the meaning of paragraph 20(1)(m) because it deferred income, already received, to a later year. The effect of the Appellant's bookkeeping and accounting procedures was the creation of a "reserve" whether it was called by that name or not.
[28] In the preceding paragraph, I referred to the Appellant's liability account under the name "Deferred Initiation Fees". That account appears as part of "Long-Term Liabilities" on the Appellant's balance sheet forming part of its financial statements for 1991 and 1992. In Exhibit A-4 (Appellant's 1991 income tax return), Note 5 to the financial statements as at December 31, 1991 lists the many components of Long-Term Liabilities including an item identified as "Deferred initiation fees $441,154" being the precise amount in dispute. Similarly, in Exhibit A-3 (Appellant's 1992 income tax return), Note 6 to the financial statements as at December 31, 1992 lists the same components of Long-Term Liabilities including Deferred initiation fees of $696,860 which is the amount analyzed in detail in paragraph 3 above. In Note 6 for 1992, the comparable amount shown for 1991 is $441,154.
[29] Having found in paragraph 11 above that the Appellant had no obligation to refund any part of an initiation fee, I have no hesitation in concluding that the amount identified in the notes to the Appellant's financial statements as "Deferred initiation fees" was not a liability at all, long-term, short-term or otherwise. It was a reserve for deferred fees even it if was a contingent reserve and, therefore, prohibited by paragraph 18(1)(e) of the Act. If that amount had been extracted from "Long-Term Liabilities" and credited to a separate reserve account for deferred initiation fees, the balance sheet would still be in balance. And if the initiation fees had all been included in computing income for the year of receipt without any deferral as they should have been, they would be part of retained earnings (less any referable taxes) and the balance sheet would still be in balance.
[30] To summarize, for all years prior to 1992, the Appellant had deducted in computing income a contingent reserve for deferred initiation fees contrary to paragraph 18(1)(e) of the Act. Because Mr. Andron thought and believed, in error, that the Appellant had a potential obligation to refund part of an initiation fee and that it would be "earned" over a 10-year period, the Appellant thought that it was deducting a reserve under paragraph 20(1)(m). This is apparent from paragraph 7 of the Appellant's Notice of Objection (Exhibit R-1) dated August 19, 1996. See also page 6 (last paragraph) of Exhibit R-2, a letter from the Appellant's lawyer dated February 27, 1997. It was only when the Appellant abandoned its claim to deduct a reserve under paragraph 20(1)(m) that it decided to argue that it had not in fact deducted any reserve at all for deferred initiation fees in years prior to 1992. That argument is without merit.
[31] In this case, for the years prior to 1992, certain amounts were in fact deducted as reserves in computing income. Those deductions were accepted by the Minister even though they were not permitted under the terms of the Income Tax Act. The only question which remains is whether amounts deducted in fact as reserves in years prior to 1992 but not permitted in law as deductions under the Act must be included in the computation of income for 1992. The Federal Court of Appeal has considered this precise question. In The Dominion of Canada General Insurance Company v. The Queen, 86 DTC 6154, in somewhat similar circumstances, Stone J.A. delivering judgment for the Court stated at page 6164:
In my view, it would require an unduly narrow construction of paragraph 85B(1)(e) to say that its language did not require inclusion of the amount deducted in 1968 in the appellant's 1969 income. Though, undoubtedly, it applies to an amount that is properly deducted, I can see no reason for restricting its application to that circumstance alone. On the contrary, its language seems sufficiently wide to bring within its reach an "amount" that was in fact "deducted" in a previous year by a taxpayer complying or purporting to comply with the provisions of paragraph 85B(1)(c). This is particularly so where, as here, the assessment of that income has been made and accepted and cannot now be challenged by the appellant but, rather, must be taken as valid and binding. I am unable to conceive that Parliament intended anything more by this paragraph than that a taxpayer must bring into income in its current taxation year that which it had deducted as a policy reserve in its immediately preceding taxation year.
[32] In Sears Canada Inc. v. The Queen, 89 DTC 5039, Mahoney J.A. stated:
In our view, the learned trial judge did not err in disposing of this issue on the basis of this Court's decision in Dominion of Canada General Insurance v. H.M., 86 DTC 6154, which, dealing with the precise issue, held that a reserve in fact deducted and allowed was required by s. 12(1)(e) to be added back notwithstanding that its deduction had not been according to law.
[33] In I.B. Pedersen Limited v. The Queen, 94 DTC 1085, Rip J. referred to the Dominion of Canada and Sears cases and then stated at page 1091:
... An amount purported to be a reserve was deducted by the appellant pursuant to paragraph 20(1)(m) in computing its income for 1987. Paragraph 12(1)(e) provides that any amount so deducted "as a reserve" in the immediately preceding taxation year is to be included in computing income for the year. It does not matter that the taxpayer was not entitled to the reserve so long as it deducted the amount as a reserve in the previous year.
[34] In this case, the Appellant in fact deducted amounts as reserves in years prior to 1992 when such deductions were not permitted in law because the Appellant had no obligation to refund any part of an initiation fee. The amount of $441,154 must be included in computing the Appellant's income for 1992 under paragraph 12(1)(e) of the Act. The appeals are dismissed, with costs.
Signed at Ottawa, Canada, this 18th day of March, 1999
"M.A. Mogan"
J.T.C.C.