Flexi-Coil Ltd. v. The Queen, 96 DTC 6350, [1996] 3 CTC 57 (FCA)

MacGuigan J.T.C.C.: - This is an appeal by Flexi-Coil Ltd. (“Flexi”) a farm machine manufacturer, from a decision by Archambault J.T.C.C., which confirmed income tax assessments of the Minister of National Revenue (the “Minister”) for the 1988 and 1989 taxation years. The Minister had disallowed a portion of the amounts deducted by Flexi in respect of bad debts, for the reason that in the Minister’s view Flexi had not established that the disallowed parts had become uncollectible.

The alleged bad debts were owed Flexi by two subsidiaries, Flexi- Coil (U.K.) Limited (“Flexi U.K.”) 75 per cent owned and incorporated in the U.K., and Flexi-Coil S.A. (“Flexi S.A.”), wholly owned and incorporated in Switzerland. The amounts of the trade accounts owing from these sub-

sidiaries to Flexi were as follows:

Flexi K. Total

Flexi .A.

The amounts claimed and allowed as bad debts were as follows:

It is common ground to the parties that par. 20(1 )(p) of the Income Tax Act is the governing legislation. For the relevant period it provided as follows:

20(1) Notwithstanding paragraphs 18(l)(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:

(p) Bad debts - the aggregate of

(i) all debts owing to the taxpayer that are established by him to have become bad debts in the year and that have been included in computing his income for the year or a preceding taxation year, and

(ii) all amounts each of which is that part of the amortized cost to the taxpayer at the end of the year of a loan or lending asset made or acquired in the ordinary course of business by a taxpayer who was an insurer or whose ordinary business included the lending of money established by him to have become uncollectable in the year;

The parties are also agreed as to the learned Tax Court Judge’s statement of the case law interpreting this provision (Appeal Book V, 942):

The question of when a debt becomes bad is a question of fact to be determined according to the circumstances of each case. Primarily, a debt is recognized to be bad when it has been proved uncollectible in the year. In Roy v. Minister of National Revenue, 58 D.T.C. 676, Mr. Boisvert of the Tax Appeal Board stated at page 680:

As the Act does not define a bad debt, it is necessary to turn to recognized accounting principles of business practice. A debt is recognized to be bad when it has been proved uncollectible in the year.

The question of when a debt is to be considered uncollectible is a matter of the taxpayer’s own judgment as a prudent businessman. In Hogan v. Minister of National Revenue, 56 D.T.C. 183 at page 193, Mr. Fisher described how this determination should be made:

For the purposes of the Income Tax Act, therefore, a bad debt may be designated as the whole or a portion of a debt which the creditor, after having personally considered the relevant factors mentioned above in so far as they are applicable to each particular debt, honestly and reasonably determines to be uncollectable at the end of the fiscal year when the determination is required to be made, notwithstanding that subsequent events may transpire under which the debt, or any portion of it, may in fact, be collected. The person making the determination should be the creditor himself (or his or its employee), who is personally thoroughly conversant with the facts and circumstances surrounding not only each particular debt but also, where possibly, each individual debtor....

[Emphasis added. ]

This approach has been followed in numerous judgments, including Anjalie Enterprises Ltd. v. R., 95 D.T.C. 216 (TCC), and Berretti v. Minister of National Revenue, 86 D.T.C. 1719 (TCC). In summary, to decide whether a taxpayer is entitled to a deduction for bad debts, the Court must be satisfied that the taxpayer itself made the determination that the debts had become uncollectible and that in making such determination, it acted reasonably and in a pragmatic business-like manner, applying the proper factors.

The parties are also agreed that the threshold for intervention by this Court in the Tax Court Judge’s decision is that laid down in Stein v. “Kathy K” (The), [1976] 2 S.C.R. 802, 62 D.L.R. (3d) 1, at page 808, as restated by La Forest J. in Schwartz v. R. (sub nom. Schwartz v. Canada), [1996] 1 C.T.C. 303, 96 D.T.C. 6103 (S.C.C.): an appellate court must find a specific and identifiable error, such as the misapprehension or overlooking of material evidence, where the evidence in question and the error made by the trial judge in disregarding it were overriding and determinative of the assessment of the balance of probabilities with respect to that issue. It is over whether the Tax Court Judge in the case at bar fell into such an error that the parties are locked in combat. In particular, the appellant contended that the Judge’s finding that Flexi was principally concerned with bringing the tax value of its investment in Flexi U.K. into line with its accounting value was made without any evidentiary foundation.

I believe the appellant is correct in discounting the respondent’s contention that a passage in the testimony of Debbie Smith, the Controller of Flexi (Appeal Book I, 134, lines 21 and 22), and another in a memorandum to file by the appellant’s auditors (Appeal Book V, 916, par. 1) should be interpreted as acknowledgments of this finding of fact. Thus there is no direct evidence as to the creditor’s intention supporting the Tax Court Judge’s conclusion.

Nevertheless, he did have the financial statements of the three companies to rely on, and he did - correctly in my view — start from the position that the courts should be vigilant in ensuring that a related creditor acted properly in determining that some debts had become uncollectible. After all, Flexi, the creditor in the non-arm’s length relationship here, is not only omniscient about its subsidiaries’ affairs, but also omnipotent. It is in a clear position to influence how their business is to be carried on, including determining whether the trade accounts are to be paid.

I can therefore only agree that the Tax Court Judge was entitled to infer from the financial statements available to him as follows: (Appeal Book V, 943):

Here, I am not satisfied that Flexi acted reasonably and applied the proper factors in determining the amounts of bad debts for the three relevant taxation years. I think the company made several errors. First, it was more concerned with bringing the tax investment value of its investment into Flexi U.K. in line with its accounting value. Appendix II shows that this was achieved in 1989 when three substantial claims of bad debts for 1987, 1988 and 1989 dropped the tax investment value to $1,600,806, an amount almost equal to the accounting investment value of $1,598,141

The primary concern of Flexi should have been whether the trade debts owing by Flexi U.K. and Flexi S.A. were collectible. In her assessment of the trade debts owing by Flexi S.A. to Flexi, Ms. Smith took into account the unpaid trade accounts from Flexi U.K. to Flexi S.A. I think this was proper. However, before determining if Flexi U.K.’s accounts payable to Flexi S.A. were uncollectible, Flexi should have determined whether they were payable in the year. The financial statements of Flexi U.K. for the fiscal periods from 1983 to 1989 show these trade accounts as "“loans not repayable within one year”. This statement is found in a note entitled “Amounts Falling Due After More Than One Year”. As it appears from Appendix I, the balance owing by Flexi U.K. to Flexi S.A. started at $835,483 in 1983, increasing to a high of $1,890,403 in 1987, and, because of foreign exchange fluctuations, decreasing to $1,690,810 at the end of 1989. So, it is quite apparent from the Flexi U.K. financial statements that the trade accounts owing to Flexi S.A. were not due at the end of each of the 1987, 1988 and 1989 taxation years.

I do not think it is proper, in the circumstances of this case, to conclude that a portion of these trade accounts had become uncollectible. It is true that the trade accounts of Flexi S.A. payable to Flexi appear as current liabilities in the financial statements of Flexi S.A. However, since it controlled both Flexi S.A. and Flexi U.K., Flexi was aware that the accounts receivable from Flexi S.A. would not have been paid to it on a current basis. I think it is fair to assume that the arrangements between Flexi, Flexi S.A. and Flexi U.K. with respect to the sales of goods by Flexi S.A. to Flexi U.K. were made in such a way as to provide long-term financial assistance to the latter. Flexi being ultimately the parent of all the companies, this appears to be consistent with the intent of Flexi in financing its U.K. subsidiary....

Flexi U.K., it should be noted, was thinly capitalized. Its share capital was $2,665: the advances, excluding the unpaid trade accounts, varied between $33,381 and $67,084 from 1984 to 1989. This company is a farm machinery manufacturer and distributor with gross sales between 1984 and 1989 varying between 1,325,000 and 905,000 pounds. [1] It operated on hardly any line of credit. So, Flexi U.K. was almost entirely dependent on Flexi for its financial needs. It is noteworthy that Flexi U.K.’s annual unpaid trade account balances owing to Flexi S.A. from 1987 to 1989 were almost equal to the annual accumulated deficits of Flexi U.K. for that period.

It is important to consider, in a case like this one, the long-term goals of the parent-supplier. Flexi intended to maintain its presence in Europe through its U.K. subsidiary. Although substantial losses started to accumulate in 1986, in each of the financial statements from 1986 to 1989, the directors of Flexi U.K. stated:

Over the past few years difficult trading conditions have resulted in losses to the company. However, the directors are confident that this adverse situation can be improved in the future.

This is a strong indication that the company intended to continue operating and was not about to go out of business. Flexi U.K. also had the backing of its parent company which was committed to providing the required funds. In the same financial statements, we find this note:

The parent company has undertaken to provide any additional working capital which the company may require in the next twelve months. [2]

For these reasons, I do not think that the unpaid accounts owing by Flexi S.A. to Flexi, attributable to the unpaid accounts owing by Flexi U.K. to Flexi S.A., should have been considered to have become uncollectible.

Different considerations apply to the accounts receivable by Flexi from Flexi U.K. They are not shown in the financial statements of Flexi U.K. as “due after more than one year,” or as “loans”. They appear as current debts.

A review of Flexi U.K.’s statements from 1987 to 1989 shows the financial position of this company with respect to its liquid assets. The current assets, i.e. assets easily realizable, are basically the stocks, the accounts receivable and the cash on hand. The current liabilities, i.e. the debts falling due within one year, are the accounts payable and the amounts owing to related companies and other creditors. These statements show the net amounts as “Net current (liabilities) assets”.

It is relevant to look at the net current assets (liabilities) of Flexi U.K. to determine if the accounts receivable could have reasonably been collected by Flexi in a particular year. For 1987, there was a net asset value of 139,694 pounds. In 1988 and 1989, there were net current liabilities of 76,200 and 163,181 pounds respectively. This analysis shows that Flexi U.K. had enough net liquid assets in 1987 to pay all of its accounts payable to Flexi. Flexi U.K.’s auditor indicated in its financial statement that the stocks were valued at the lower of cost and net realizable value. Based on this assertion, the stocks should have been worth the values shown in the financial statements. There was no evidence that the accounts receivable by Flexi UK were not worth the amounts shown in the same statements. So it is difficult to see how one can reasonably conclude that Flexi’s accounts receivable could not have been collected from Flexi U.K. in 1987, especially in the amount of $800,000. It is noteworthy that no claim for bad debts was made in 1987 in Flexi’s audited financial statements. The Minister showed generosity in allowing $600,000 in computing Flexi’s income for 1987.

For 1988, Flexi U.K.’s statements show net current liabilities of $76,200, which may evidence a problem of collectibility. In Canadian dollars, this represents a shortfall of approximately $156,900. Flexi’s audited financial statements do indeed show a claim for bad debts in the amount of $286,317. I think this confirms that the deduction for bad debts of $300,000 allowed by the Minister was reasonable.

In 1989, Flexi U.K.’s financial statement show net current liabilities of 163,181 pounds. Given that bad debts were recognized for 1988 in excess of the net annual liabilities, I would think that only the increased amount of net current liabilities should serve as a basis for determining the proper amount of bad debts in 1989. This increase of net current liabilities represents in Canadian dollars an amount of approximately $165,600. In Flexi’s audited financial statement a claim was made for bad debts of $84,384. The Minister allowed an amount of $128,488 as bad debts for tax purposes. Given the amount of bad debts allowed by the Minister in 1988, the amount for 1989 appears reasonable.

I can conclude from the foregoing only that the Tax Court Judge’s conclusions were reasonable inferences from the record. It is true that he did not view the evidence as the appellant would have wished, but his role was precisely to weigh the evidence before him.

Since the appeal was heard in Ottawa by agreement of counsel, no fees or disbursements should be allowed in respect of travel to Ottawa. Also, since the respondent’s memorandum was filed only two juridical days before the hearing, no costs should be allowed in respect thereof. Otherwise, the appeal should be dismissed with costs.

Appeal dismissed.