William G. Docherty v. Minister of National Revenue, 91 DTC 537, [1991] 1 CTC 2409 (TCC)

Brulé, T.C.J.:—The taxpayer hereby appeals to the Tax Court of Canada from a reassessment mailed May 29, 1987 for the 1983, 1984 and 1985 taxation years by which assessments have been made against the taxpayer, William G. Docherty, on account of loans made to him by R.C. Pruefer Co. Ltd. and benefits to him on other loans.

Issue

The general issue in the present case is whether a benefit conferred on a shareholder by virtue of subsection 80.4(2) of the Income Tax Act, R.S.C. 1952,

c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") as amounts received as loans not repaid within the meaning of section 15 of the Act, can be offset and if so, what evidence must be presented to honour such a set-off.

Facts

A summary of the facts as set out by counsel for the appellant is as follows:

The taxpayer William G. Docherty is the President and sole shareholder of R.C. Pruefer Co. Ltd.

R.C. Pruefer Co. Ltd. is a major developer in the Windsor area and has completed a number of large projects in the past including the Hilton Hotel, construction of numerous high rise apartment buildings and the majority of the single family homes in the Villages of Riverside.

Depending on the development projects underway, R.C. Pruefer Co. Ltd. has had a work force ranging from three people to three hundred employees. Outstanding loans by R.C. Pruefer Co. Ltd. have in the past at any time reached in excess of $20,000,000.00.

Because William G. Docherty is the President, sole Director and sole shareholder of the company, Mr. Docherty very often acts in his corporate capacity with a minimum of documentation.

The company also operates several different bank accounts at several different banking and financial institutions. The level of documentation establishing the banking transactions of R.C. Pruefer Co. Ltd. differs greatly depending on the financial institution at which the company is dealing.

As the sole Director and shareholder of R.C. Pruefer Co. Ltd. it is Mr. Docherty’s responsibility to make sure that R.C. Pruefer Co. Ltd. has sufficient operating funds for its cash flow needs. These needs have varied greatly over the years depending on the nature and size of the development projects underway.

In taxation years during which the company is profitable, Mr. Docherty has received benefits from the company by way of dividends. In years which are not profitable for the company, Mr. Docherty has personally injected his own funds into the company and, from time to time, has caused funds from his various other companies to be injected into R.C. Pruefer Co. Ltd.

Appellant's Position

Counsel for the appellant stressed that the purpose of the shareholder loans both to and from the company and William G. Docherty was not to create a benefit to the shareholder but to make sure the company had sufficient funds to meet its day-to-day cash needs for current operations. Given the nature of the business of the company and its exclusive and long-standing relationship with William G. Docherty, the shareholder loans both to and from the company had a legitimate business purpose and were not motivated by or intended to confer a benefit on Mr. Docherty.

The taxpayer takes the position that the loans made by R.C. Pruefer Co. Ltd. to William G. Docherty in the 1983, 1984 and 1985 taxation years were not intended to create and did not create a benefit to the taxpayer William G. Docherty.

However, in the event that the loan transactions for the taxation years described above are treated as giving rise to income in the hands of William G. Docherty, the taxpayer claims a credit for having repaid the loans in question within the same calendar year.

Consistent with his intimate relationship with the company and their numerous and varied dealings over the years, William G. Docherty caused the loans owing to R.C. Pruefer Co. Ltd. to be repaid from other business ventures in which he is involved.

Specifically, repayment of loan amounts to R.C. Pruefer Co. Ltd. had taken place in 1983, 1984 and 1985 so that as of December 31, 1985 the following total amounts had been caused to be repaid out of the following five apartment building projects in which Mr. Docherty retained an ownership interest:

The apartment building projects described above have been syndicated and interests in those apartment building projects sold to various participants. The ownership interest of William G. Docherty shown above is the interest which the taxpayer has retained in each of the apartment building projects. These projects have all been structured, for the purpose of syndication, in the same manner. Basically, title to each apartment building is held by a trustee corporation. The corporate trustee holds title for the beneficial owners in each project and any income or losses in the projects flow through to the individual beneficial owners.

To the extent of his percentage of ownership the appellant is entitled to that percentage of the income or the loss of each particular apartment building in each particular year.

In past years, the apartment buildings listed above experienced a positive cash flow sufficient to generate income. The income was used, in each building, to repay loan amounts outstanding and owing to R.C. Pruefer Co. Ltd. Therefore, for the years described above, the owner of each apartment caused each apartment to repay income which would normally flow to the individual owners of the building to be paid to R.C. Pruefer Co. Ltd. in repayment of loans.

In the 1983, 1984 and 1985 taxation years, William G. Docherty, as an owner in the above-described apartment building projects caused his share of the income to be directed to R.C. Pruefer Co. Ltd. in the repayment of his outstanding loans with R.C. Pruefer Co. Ltd. The amounts repaid by William G. Docherty through his ownership in the apartment projects far exceeds the amounts claimed in the notices of reassessments to be owing by William G. Docherty to R.C. Pruefer Co. Ltd. This is because of the legitimate and usual flow of funds between R.C. Pruefer Co. Ltd. and its sole shareholder and director William G. Docherty.

In the 1983, 1984 and 1985 taxation years, William G. Docherty, as the principal officer and director and person responsible for and in charge of R.C. Pruefer Co. Ltd., borrowed money to inject funds into the company so that the various projects underway could be completed and maintained. These amounts were $100,000 borrowed in May 1979 from Ben Matthews and Associates and $500,000 in October 1979 from Coronett Investments Inc. In the years 1983, 1984 and 1985 the interest paid on these borrowings amounted to $61,411.22 and were added by Revenue Canada to the personal loan account of the appellant.

The interest on these borrowed funds was a legitimate business expense as the funds were borrowed for the purpose of injecting into R.C. Pruefer Co. Ltd. and in fact were so used.

Respondent's Position

While the appellant's counsel detailed both orally and in written material his client's position, counsel for the respondent was brief.

Basically the Minister’s position was that the financial statements did not reveal any of the transactions of lending and repayment of loans involving the appellant, nor was there any agreement as to a right of set-off. In the absence of such it was claimed that the reassessments were correct.

It was suggested that the present case was similar to that of Frederic G. Gannon v. M.N.R., [1988] 1 C.T.C. 2422; 88 D.T.C. 1282 wherein the Court held that in the absence of an agreement or proper evidence that accounts were not connected there was no right of set-off.

The loans did not qualify under the exempting provisions of subsection 15(2) of the Income Tax Act and were not repaid within one year from the end of the taxation year in which they were made. Also the imposition of interest on the appellant was proper by virtue of subsection 80.4(2) of the Act.

Analysis

In the Gannon case, supra, the general principle that mutual debts cannot coexist and gives rise automatically to a right of set-off seems to have been rejected. A requirement of an agreement or contract calling for the liquidation of the indebtedness is mandatory. This statement of law is supported by Bank of Montreal v. Tudhope, Anderson & Co. (1911), 19 W.L.R. 141; 21 Man. R. 380 (Man. C.A.).

It seems therefore that the issue revolves around how such an agreement to liquidate a debt by another will be evidenced. As was stated in Gannon, an automatic set-off between two parties will prevail only in the case of connected accounts of debt and credit. Without such connection, an equity to set off will not necessarily be granted, an intention to liquidate a debt by the other would have to be found (see section 130 Canadian Encyclopaedic Digest (Western), 3rd ed., Debtor and Creditor). This is discussed in the case of Bank of Montreal, supra. Reference is there made, at page 387, to Lundy v. McCulla, 11 Gr. 368 where the Court said:

In the view of equity the setting off one demand against another between the same parties is extremely just and, where there is any technical difficulty in the way of its being done without an agreement, the Court accepts slighter evidence of such an agreement than is usually required in order to establish disputed facts.

In the administration of a small corporation, it often occurs that decisions be made without registration of any records. Often, like in business, no written agreement between parties occurs as was pointed out by Mr. Justice Urie in Massey-Ferguson Ltd. v. The Queen, [1977] C.T.C. 6; 77 D.T.C. 5013, at 13 (D.T.C. 5017) as follows:

The whole development of commercial law over the centuries is replete with examples of the courts recognizing that businessmen do not always depend on expert documentation to prove the true characterization of their transactions. Rather, they tend to achieve their desired ends, particularly when the relationships between them are close, in informal and expeditious ways which perhaps are abhorrent to lawyers. In doing so they run the risks inherent in such a practice of determining their respective rights. Frequently no difficulties ensue, but if they do, in the absence of contracts or other documents, courts must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind.

However, more formality may be required when a third person is involved, such as the Department of National Revenue. This point was stated in The Queen v. Peter Neudorf, [1975] C.T.C. 192; 75 D.T.C. 5213, when Mr. Justice Heald stated at 196 (D.T.C. 5215):

It is my further view that since one of the parties to the arrangement was a corporation, there is more formality required (such as corporate resolutions, for example) than in the case of individuals and particularly where the details of a relationship are important as against third persons such as the Revenue.

In Samuel Tobis v. M.N.R., [1981] C.T.C. 2161; 81 D.T.C. 126 the taxpayer was a sole shareholder and officer of a company. He collected rental income on behalf of the company but retained a portion of the rental payments for himself. No record of such retention appeared in the company's financial records. The taxpayer argued, after the Minister assessed the funds retained as income, that those funds retained could be set off against money loaned by him to the company. The Board rejected the appeal on the grounds that no setoff of debts could be allowed especially where the taxpayer caused no record to be made in the company's books of the funds retained by him.

The more recent judgment David J. Groeneveld v. M.N.R., [1990] 1 C.T.C. 2314; 90 D.T.C. 1211 refers extensively to Tobis, supra. In that case the taxpayer argued that no benefit by virtue of paragraph 15(1)(b) had been conferred since at all material times the corporation [in] which he was a shareholder was indebted to the taxpayer to an amount in excess to the one at issue. The Court dismissed this argument, stating that although the taxpayer could have recorded the amount appropriated as the repayment of a shareholder loan he did not do so, and to do otherwise to include this amount in the taxpayer's income would require "rewriting history".

In the 1990 unreported decision of Murdoch Whitcomb v. M.N.R. the Court held that set-off could occur where prior years’ practices and the practices during the years in question show that there was an intended set-off. The Lundy v. McCulla case, supra was cited with approval.

There does not seem in law a requirement for a written contract in order to effect a set-off. The Court must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind as was suggested in the Massey-Ferguson case, supra.

The unrefuted evidence of the company's accountant pointed out that all the information was in the working papers provided to the Court, and which according to the plaintiff's solicitor had been offered to Revenue Canada but not looked at by them. The mere fact that the financial statements did not reflect the set-off is not sufficient to disallow this appeal. All documentary evidence such as working papers and accounting books must be taken into consideration especially when reliable evidence has shown the true facts.

The appeal is hereby allowed with costs and the assessments referred back to the Minister for reconsideration and reassessment.

Appeal allowed.