Ed Sinclair Construction & Supplies Ltd. v. MNR, 92 DTC 1163, [1992] 1 CTC 2218 (TCC)

Bowman, T.C.C.J.:—These appeals, with the consent of the parties, were heard together on common evidence. The years involved for both the individual, Edward Sinclair, and his two companies are 1979, 1980, 1981 and 1982. I was informed that the aggregate tax, interest and penalties claimed under these assessments at present amounts to over $4,200,000, of which approximately one half is interest.

Mr. Sinclair represented himself and the two companies. His evidence consisted substantially of two affidavits, one by himself and one by his former accountant, Mr. H. Douglas Trace, which were adduced with Mr. McNary's consent. Both Mr. Sinclair and Mr. Trace testified orally as well.

The thrust of Mr. Sinclair's evidence and argument was that the reassessments were unfair and inequitable; that they were not in accordance with business reality; that they had been issued in anger by the assessor; that the purpose of income taxation is to raise money for the government and not to destroy businesses. He did not, in evidence or in his argument, seek to challenge the specific "assumptions", so-called, that were pleaded by the Minister in the detailed replies that were filed. Rather, he chose to attack the assessments on the broad general basis outlined above. The relief sought by the appellants was equally lacking in specificity. Essentially Mr. Sinclair asked the Court to allow the appeals and refer the assessments back to the Minister to permit the negotiation of a settlement similar to that achieved for later years.

It is obvious that the Court cannot allow an appeal for the purpose of referring an assessment back to the Minister to permit the negotiation of a settlement that might have been reached prior to trial. The courtroom is not a forum for horse trading. This case is one that ought to have been settled, but the relationship between the appellants or their representatives and the officials of the Department of National Revenue appears to have been one of acrimony, confrontation and intransigence.

It would have been a simple matter to dismiss the appeals on the basis that the appellants had failed to adduce sufficient evidence to displace the presumption of correctness of the assessments. It is, however, important that the Court examine the assessments with as much care as is possible notwithstanding the paucity of the evidence and the unsatisfactory state of the record. This is particularly true where the taxpayer, whether for lack of funds or otherwise, is not represented by counsel and the assessments are based upon a number of technical provisions of the Act that the taxpayer does not even understand.

For this reason, I asked for argument from counsel on two somewhat technical points that had not been raised by the appellant, specifically the apparent automatic disallowance to the corporation of amounts that are treated as taxable benefits to the shareholder/manager of the corporation, Mr. Sinclair, and the inclusion in the income of the shareholder of amounts credited to his shareholders’ loan account.

The notices of appeal were virtually useless in defining the issues. Accordingly, I was obliged to rely upon the replies for details of the assessments.

Prosperous Investments Ltd.

There were two appeals for the 1981 taxation year (83-72(IT) and 86-1138(IT)). It appears that after the appellant had appealed from an assessment for 1981 dated June 7, 1982 it subsequently appealed from reassessments for 1979, 1980 and 1982 and purported to include in that notice of appeal a further appeal from the assessment for 1981 from which it had already appealed.

This company's appeal raises the following questions:

(a) Whether the appellant was entitled to the small business deduction pursuant to subsection 125 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

(b) Whether the appellant was entitled to claim a bad debt reserve of $260,688 in computing its income for 1982.

(c) Whether the appellant was entitled to deduct interest expense and management bonuses accrued in its books;

(d) Whether the appellant was entitled to deduct certain other expenses incurred by it that had been taxed in the hands of the shareholder, Ed Sinclair.

(e) Whether penalties were properly imposed on the appellant under subsection 163(2) of the Act.

The small business deduction

Prosperous Investments Ltd. was described in Mr. Sinclair's affidavit as a "holding company for the second mortgages generated by the construction company" (the appellant Ed Sinclair Construction and Supplies Ltd.). When the construction company sold property and took back second mortgages, it appears that it would sell these mortgages to Prosperous Investments at a discount. Prosperous Investments brought the interest into income and, when the discount was realized on the payment of the second mortgage, the evidence was that the amount thereof was included in its income. In addition, the appellant owned real property from which it derived rental income.

The Minister's denial of the small business deduction was based upon his view that the appellant did not carry on an active business in the years in question because the business that it did carry on was a“ specified investment business”. The definition of specified investment business” in paragraph 125(6)(h) of the Act applicable to the 1979, 1980 and 1981 taxation years was:

(h) “ specified investment business” carried on by a corporation in a taxation year means a business (other than the business of leasing property other than real property) the principal purpose of which is to derive income from property, unless the corporation employs in the business throughout the year more than five full- time employees who are not specified shareholders of the corporation or persons related thereto.

The definition applicable to 1982 is as follows:

(h) "specified investment business” carried on by a corporation in a taxation year means a business (other than a business carried on by a credit union or a business of leasing property other than real property) the principal purpose of which is to derive income from property (including interest; dividends, rents or royalties), unless the corporation employs in the business throughout the year more than five full-time employees who are not specified shareholders of the corporation or persons related thereto;

Prosperous Investments did not at any time employ more than five full-time employees. Accordingly, the sole question is whether the "principal purpose" of its business was to derive income from property. At first blush the section would appear to contain a contradiction in terms if one regards the two sources of income, business and property, as mutually exclusive (see, for example, Wertman v. M.N.R., [1964] C.T.C. 252, 64 D.T.C. 5158; Walsh and Micay v. M.N.R., [1965] C.T.C. 478, 65 D.T.C. 5923.) They are, however, not mutually exclusive. It is obvious that an individual or a corporation can actively engage in a business whose sources of revenue such as interest or rentals are property. This is implicit in paragraph 125(6)(h) and is consistent with the decision of the Supreme Court of Canada in Canadian Marconi Company v. The Queen, [1986] 2 C.T.C. 465, 86 D.T.C. 2526.

In determining the "principal purpose" of a business carried on by a corporation the stated object of the person who carries it on is not necessarily the only, or even the most important, criterion. Of critical importance is what the corporation in fact does and what its sources of income are (Ben Barbary Company Ltd. v. M.N.R., [1989] 1 C.T.C. 2364, 89 D.T.C. 242 at 2366 (D.T.C. 244)). In the years under appeal the gross revenues of Prosperous Investments were as follows, according to the financial statements.

1979:

REVENUE
Rent	$62,729.66
Interest	18,995.94
Bad debts recovered	10,077.32
Earned discounts	3,287.05	$95,089.97
1980:
REVENUE
Rents	$68,398.94
Sub-contract	50,000.00
Bonus	36,912.26
Interest	26,365.10
Earned discounts	6,880.53	$188,556.83
1981:
REVENUE
Recaptured depreciation	$140,607.29
Interest	108,870.82
Capital gains	52,577.15
Rent	51,959.25
Bonus	27 ,606.47
Deferred interest	11,387.73	$393,008.71
1992:
REVENUE
Bonus	$198,378.34
Interest	126,490.04
Rent	14,240.10
Discounts	4,76 6.63	$343,875.11

In addition, the financial statements indicate that in each year mortgages receivable and rental properties made up well over 50 per cent of the value of the company's assets.

On the basis of the above the principal portion of the revenues of the appellant was derived from rentals and interest and by far the preponderant part of the corporation's capital was devoted to rental properties and mortgages, the sources of income giving rise to those revenues.

Accordingly, I conclude that the principal purpose of the business of Prosperous Investments insofar as it related to interest and rentals was to derive income from property. Mr. Sinclair argued that the company carried on an active business with respect to the rental properties and mortgages that it held. I would agree with him were it not for the exclusion of these sources of income in the definition of active business.

The bad debt reserve

The appellant claimed as a bad debt expense the sum of $260,688 in respect of mortgages held by it. No specific evidence was adduced as to the mortgages. The Minister's basis for disallowing the deduction was set out in paragraphs 9(u),(v) and (w) of the reply which read as follows:

(u) the amount of $260,688 claimed as a bad debt expense in 1982 related to mortgages taken back on the sale of two rental properties which mortgages were capital assets of the appellant and losses in respect thereof would be capital in nature except to the extent permitted by subsection 20(4) of the Act (see Schedule III);

(v) the amount of $260,688 claimed as a bad debt expense in 1982 related to amounts which had not been included in income of prior years because of reserves claimed;

(w) the amount of $260,688 claimed as a bad debt expense in 1982 relates to debts that were not established to have gone bad in the year;

Attached to the reply was a Schedule III giving further particulars of the Minister's analysis of the bad debt expense.

In the absence of any specific rebuttal of the Minister's assumptions on this point I am unable to accept the appellant's contention that a further deduction is available to it under paragraph 20(1)(p) of the Act. Although some general evidence of the depressed economic climate in the years in question was given and it was alleged that the mortgages held by the company declined in value or became worthless at some point, no specific evidence was adduced that particular debts became bad in the years in which the deduction was claimed, nor was it established either that the amount of the debt was included in income in the year or a previous year or that the appellant was in the business of money lending.

It was conceded by the respondent in the reply that subsection 20(4) or sections 40 and 50 of the Act might have some application but no deduction was allowed to the appellant under these sections. If the sole basis for denying the appellant any deduction under these provisions is that the Minister was not satisfied that the debts became bad in the year in which the deduction was claimed, the reply should have been more specific in stating either that the Minister assumed that the debts did not become bad at all or that they became bad in some other year. If a taxpayer decides, as a matter of business judgement, that a debt has become bad in the year it would require considerably more than the pleading of a sterile recital of a provision of the Act without any reference to the factual basis for the assumption to justify the Court's substituting its or the Minister's judgment for that of the taxpayer. The Minister's position as set out in the paragraphs quoted above is ambiguous. There was some evidence that the debts became bad in one of the years included in the period under appeal and that the appellant chose to recognize the loss in 1982. Since the Minister has not asserted a specific year other than 1982 as the year in which the debts became bad, I am prepared to accept the business judgment of the appellant as to the year in which the loss on the debts should be recognized. See Associated Investors Ltd. v. M.N.R., [1967] C.T.C. 138, 67 D.T.C. 5096, at page 146 (D.T.C. 5101).

I propose therefore to allow the appeal on this point and to refer the assessments back to the Minister for the purpose of reconsidering the application of subsection 20(4) and sections 40 and 50 to the mortgage debts claimed by the appellant to have become bad in the year.

Interest expense

It appears that the appellant accrued certain interest charges on a shareholder's loan account in 1979, 1980 and 1982 in the amounts of $12,934, $21,110 and $25,151. The Minister disallowed the deduction of these amounts on the basis that they were" contingent liabilities or reserves" and were not laid out for the purpose of gaining or producing income.

They were not in my view contingent liabilities or reserves for the simple reason that it was not established that they were liabilities at all. No evidence was adduced that there was any legal obligation to pay interest on the outstanding shareholder's loan accounts.

Management Bonuses

In 1979, 1980 and 1981 the appellant made a number of book entries accruing bonuses to management. In subsequent years it reversed some of these bonuses. The Minister disallowed them on the basis that they were contingent liabilities or reserves and were not allocated to any specific individual.

I have seen no evidence that they were liabilities at all. The appellant or its accountant seems to have followed the practice of "accruing" and deducting bonuses as at the end of the fiscal period and reversing them in a later year, apparently in an attempt to comply with subsection 78(3) of the Act as it read in those years.

The determination of income must have its foundation in economic reality and genuine transactions. It cannot be based upon journal entries made after the event at the discretion of accountants where there is no intention of creating genuine legal relationships.

I am allowing the appeal with respect to both the interest expenses and the management bonuses and referring the matter back to the Minister for reconsideration to ensure that the complex series of accruals, subsequent reversals and disallowances has not resulted in the appellant being taxed on the same amount twice. In paragraph 12 of the Minister's reply he appears to concede that this in fact may have occurred.

Other expenses

The Minister disallowed a number of expenses claimed by the appellant on the evident theory that they were not incurred for the purpose of gaining or producing income. In addition the Minister added these amounts to the income of the appellant, Edward Sinclair. This assessing action was evidently premised upon a practice of long standing of automatically disallowing to a corporation all benefits conferred on shareholders even where those shareholders are employees, officers and directors unless a T-4 slip is issued in respect of the benefit. The practice has no foundation under the Income Tax Act. Many benefits form part of an employee's remuneration and are deductible expenses of the corporation whether they are reflected or not in a T-4 slip. Extensive argument was presented by counsel for the Minister on the question whether the practice resulted in double taxation. "Double taxation" has been the subject of academic comment [1] and judicial observation. [2] It is an emotive term used to attack what is perceived to be the inequity of taxing the same dollars twice. As such it is essentially a red herring, at least where the same amount is not being taxed twice in the same taxpayer's hands. The fundamental question is not whether a corresponding amount is being taxed in the shareholder/employee's hands but whether it is truly a part of the corporation's cost of doing business. The items set out in paragraphs 9(q), (r) and (s) of the reply that were disallowed to the corporation and taxed in Edward Sinclair's hands were not shown to have had anything to do with the corporation's business operations.

Mr. Trace testified that he was very careful to charge back to Mr. Sinclair any items paid for by the appellant but that in the somewhat hostile atmosphere that prevailed between the appellant and the Department of National Revenue, this fact was for some reason either ignored or not established to the satisfaction of the assessor.

I think that a prima facie case has been made out that there was double counting with respect to at least some of these items. If expenses were incurred by the appellant for the benefit of Mr. Sinclair and then charged to him it should have eliminated the effect of the appellant's attempt to deduct the amounts and, in addition, eliminated these amounts from Mr. Sinclair's income.

I am therefore referring the matter back to the Minister for reconsideration and reassessment to delete from the income of the appellant Prosperous Investments Ltd. any amounts referred to in paragraphs 9(q),(r) and (s) of the reply that have been charged back to the appellant Edward Sinclair and brought back into the appellant's income.

Penalties

No evidence was adduced by the Minister to support the imposition of penalties and Mr. McNary very fairly conceded that the penalties should be deleted.

Ed Sinclair Construction & Supplies Ltd.

Accrued management bonuses and accrued interest expenses

I shall not repeat here the observations made in connection with the related appeal of Prosperous Investments Ltd. Deductible expenses are not created by the simple expedient of entering numbers in a journal. I am however referring the assessments back to the Minister for reconsideration to ensure that there has been no double inclusion in income. The taxpayers are, of course, to some extent the authors of their own problems in this regard by reason of their confusing practice of accruing as expenses arbitrary amounts in one year and reversing them in others.

Other disallowed expenses

The same observations apply here as to similar expenses disallowed to Prosperous Investments Ltd. and added to Edward Sinclair's income. The assessments will be referred back to the Minister for reconsideration and reassessment to delete from the appellants income amounts that have been charged back to Edward Sinclair in the books of the appellant.

The sale of the Maple Court, Huff, Ambrose and Lark properties

These properties were sold by the taxpayer and the gains were treated by it as capital gains. The Minister treated the gains, except for that realized on the sale of the Maple Court Apartments, as being on revenue account on the basis that the properties were acquired with a view to resale at a profit.

The short answer to the appellant's case is that it put forward no evidence to establish that the Minister's basis for assessing these gains as income was wrong. The gains were substantial and the case deserved the skills of experienced counsel. I can do nothing for the appellant on this point.

The Castle Downs property

It appears that in 1971 the appellant purchased 40 acres in the Castle Downs area of North Edmonton for $150,000. In 1974 the Government of Alberta placed it in a Green Belt thereby frustrating whatever development plans the appellant might have had. In 1980, the property was sold to the province of Alberta for $2,210,000. The Minister treated the profit as being on revenue account. The appellant, it appears, regarded the gain as being on capital account and, moreover, as being subject to deferral pursuant to the replacement property rules in subsection 44(1) based, evidently, on its understanding of Interpretation Bulletin IT-491. Essentially subsection 44(1) permits the deferral of a gain on the disposition of a capital property that is a "former business property" where the taxpayer has within two years from the year of disposition acquired another capital property as a“ replacement property". Without considering the other technical aspects of subsection 44(1) it is at least essential that both the former business property and the replacement property be capital properties.

No evidence was adduced to rebut the Minister's assumption that the property that was sold was inventory in the appellant's hands, or to establish that the property that was acquired to replace it was capital property. I am unable, therefore, to give the appellant any relief under this head.

In disposing in this manner of these two very substantial aspects of the case, I emphasize that I do so not on the basis that I am satisfied that the lands were trading assets, but rather on the basis that no evidence has been put forward to establish that they were not.

Penalties

No evidence was put forward to support the imposition of penalties and they must therefore be deleted.

The 1981 taxation year

It was alleged that the appellant failed to file an objection to an assessment for 1981 dated November 9, 1984. No evidence was put forward to support this allegation of a formal defect nor was it mentioned in argument. Accordingly I am assuming that the Minister is not pressing this point and I am treating the 1981 taxation year as validly before the Court.

Edward Sinclair

Numerous benefits were alleged to have been conferred on Edward Sinclair or members of his family by the two corporations. As stated above some of them may have been charged back to him by the corporations without this fact being recognized by the assessor. The individual’s appeal will be allowed and the assessments referred back to the Minister to delete from his income the expenses that had in fact been charged to him.

In paragraphs 6(m) and (n) of the reply there are stated certain conjectural and largely incomprehensible assumptions about an alleged appropriation of automobiles by Edward Sinclair. These paragraphs are as follows:

(m) in the Appellant’s 1980 taxation year, Ed Sinclair Construction Ltd. showed automobile acquisitions, net of disposition with a total cost of $52,487.50 on its books while only having a truck costing $3,600 and a share of a 1980 Cadillac costing $18,257 on hand;

(n) the difference of $30,631 between the company's stated cost of vehicles and identifiable vehicles on hand was an appropriation of automobiles to the benefit of the Appellant, qua shareholder, to the extent of $12,734 in his 1979 taxation year and to the extent of $18,257 in his 1980 taxation year;

These assumptions seem to have to do with the way in which certain automobiles were recorded in the books of Edward Sinclair Construction & Supplies Ltd. Standing by themselves they do not form any factual basis that would support the taxation of the individual in the amounts of $12,734 or $18,257 as alleged. (See M.N.R. v. Pillsbury Holdings Ltd., [1964] C.T.C. 294, 64 D.T.C. 5184 at page 296 (D.T.C. 5188).) The assessor was not called and I therefore did not have the benefit of any explanation from him as to his reasoning in concluding that these alleged discrepancies in the corporate books resulted in a taxable appropriation to Mr. Sinclair. The appeal will be allowed on this point and the assessment referred back to the Minister for reassessment to delete from Mr. Sinclair's income for 1979 and 1980 the amounts of $12,734 and $18,257 respectively.

In addition the Minister sought to tax Mr. Sinclair on $50,750 credited to his loan account by Prosperous Investments. It would appear from paragraphs 6(p) and (q) of the reply, which set out the Minister's so-called "assumptions" that he assumed that the mere fact of crediting to a shareholder loan account gives rise to taxation in the hands of the principal shareholder, irrespective of whether the shareholder or employee has appropriated any funds from the account or whether the crediting of the account affects in any way the legal relationship with the corporation or indeed whether the shareholder has condoned or even knows of the bookkeeping entry. A mere bookkeeping entry in a loan account by itself does not constitute a taxable event unless there is something more, such as receipt. In Gresham Life Society Co. Ltd. v. Bishop (1902), 4 T.C. 464 at 476, Lord Brampton said:

My Lords I agree with the Court of Appeal that a sum of money may be received in more ways than one e.g. by the transfer of a coin or a negotiable instrument or other document which represents and produces coin, and is treated as such by business men. Even a settlement in account may be equivalent to a receipt of a sum of money, although no money may pass; and I am not myself prepared to say that what amongst business men is equivalent to a receipt of a sum of money is not a receipt within the meaning of the Statute which your Lordships have to interpret. But to constitute a receipt of anything there must be a person to receive and a person from whom he receives and something received by the former from the latter, and in this case that something must be a sum of money. A mere entry in an account which does not represent such a transaction does not prove any receipt, whatever else it may be worth.

The appeal will therefore be allowed and the assessment referred back to the Minister for reassessment to delete this amount from Mr. Sinclair's income.

The result of these cases is unsatisfactory. Mr. Sinclair and his companies needed professional help who could either negotiate a settlement with the department or present a case in court. Instead Mr. Sinclair, singlehanded and unarmed, chose to join battle with a formidable adversary with vast resources at its disposal when he had no knowledge of the rules of the warfare in which he was engaged. However much one may admire the courage of a man who chooses to embark on such a quixotic endeavour, it is to be hoped that if Mr. Sinclair and his companies choose to appeal this decision by way of trial de novo to the Federal Court they will retain the services of experienced counsel.

The appeals are therefore allowed and the reassessments of the three appellants referred back to the respondent for reconsideration and reassessment in accordance with these reasons.

Appeals allowed in part.