Harrowston Corporation v. The Queen, 93 DTC 995, [1993] 2 CTC 2247 (TCC), aff'd 96 DTC 6544 (FCA)

Lamarre Proulx, T.C.C.J.:— This appeal involves the appellant's 1984 taxation year.

The uestion at issue concerns the deductibility of a bad debt, incurred as a result of the appellant's failure to withthold the tax owed by a U.S. resident under Part XIII of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), on an amount of interest of US$2,160,000 paid by the appellant to the non-resident.

By virtue of section 212 of the Act, every non-resident person shall pay an income tax of 25 per cent on every amount that a person resident in Canada pays to that person on account of interest. (However, under Article XI of the Canada-United States Income Tax Convention in force at that time, this tax is limited to 15 per cent). By virtue of subsection 215(1) of the Act, a person who pays an amount on which an income tax is payable under Part XIII of the Act shall withhold the amount of the tax and forthwith remit that amount to the Receiver General of Canada, on behalf of the non-resident person. Where a person has failed to deduct such amount, that person is liable, by virtue of subsection 215(6) of the Act, to pay as tax, under Part XIII, on behalf of the nonresident, the whole of the amount that should have been deducted, and is entitled to deduct or otherwise recover, from any amount paid to the nonresident person, any amount paid as tax under that Part on behalf thereof.

The facts

Mr. Lancaster, who was, at the time the events in question in the present instance took place, the chief financial officer of the appellant, testified on behalf of the appellant. The appellant is a public corporation engaged in business operations in several economic sectors in Canada and the United States and holds a substantial portfolio of Canadian and American securities. On April 22, 1982, the appellant purchased from Clabir Corporation ("Clabir"), a U.S. non-resident corporation, 2,081,000 common shares of U.S. Industries Inc., for a purchase price of US$18,729,000 apportioned as follows: US$6,729,000 in cash and a promissory note (the "note") for the balance of $12,000,000.

The note contemplated that the amount of US$12,000,000 was to be repaid on account of capital by five annual instalments of US$2,400,000. The interest for the first 12 months, was in the amount of US$2,160,000 and payable at the time of purchase. The second interest payment was to be made at the end of the second year of the loan, that is April 22, 1984. The first interest payment, in the amount of US$2,160,000, was paid to Clabir without deducting the tax owed under Part XIII of the Act.

Mr. Lancaster, the chief financial officer of the appellant, said that he was not involved in the negotiations that led to the purchase of the shares. The president of the appellant, Mr. Belzberg, initiated the project. An American lawyer was hired to act as an intermediary for the appellant and he drew up the purchase agreement and the note. These documents are reproduced at pages 43 to 63 of the joint book of documents (Exhibit R-1) and are entitled "stock purchase agreement" and“ promissory note". They are dated April 22,1982 and are signed by the appellant's authorized signatory, the American lawyer. The purchase documents make no mention of the tax owed under the Act on the interest to be paid by the appellant to Clabir.

Mr. Lancaster said that the employees in his financial sector, who looked after the taxation matters, were not involved in the drafting of the agreement, nor were they involved in the issuance of the cheque for the prepaid interest. He stated that the manner in which the purchase of the shares was done, was not in accordance with the appellant's usual practice. It was the first time that the appellant borrowed from the vendor of the shares at the time of such a purchase. It is accepted by the respondent that the failure to withhold the tax owed under Part XIII of the Act was an oversight on the part of the appellant or an honest mistake. It is at the end of the year, when the appellant prepared the usual interest returns for the shares held by it, that this failure to comply with Part XIII of the Act was discovered.

In September 1982, the appellant sold the shares that it had purchased from Clabir and realized a gain of $5,202,500, as shown on page 166 of Exhibit R-1. The profit was first reported as a capital gain. However, as there was ample trading in shares, the appellant was reassessed on the basis that this was a gain on account of income. This was not disputed by the appellant.

On January 26, 1983, Clabir sold its interest in the note to Executive Life Insurance Company ("Executive Life"). On April 22, 1983, the appellant was required to make its first payment regarding the annual instalment of $2,400,000 on account of principal. The appellant deducted from this amount the amount of US$324,000 of tax owed on the amount of interest prepaid on April 22, 1982. Thus, the appellant reduced its instalment payment to $2,076,000. (It should be recalled that the second interest payment was only required to be made on April 22, 1984.) Executive Life did not agree with the deduction of the whole amount of tax because it had held the note for a portion of the year only and not for the entire year.

On June 9, 1983, the appellant paid the Receiver General of Canada the amount of $399,589.20 for the non-resident tax in question.

At about the same time the appellant was negotiating with the investment banker Drexel Burnham Lambert Inc. ("Drexel") the issuance of debt instruments for a value of US$30,000,000. Drexel had for clients Executive Life and Clabir. Executive Life became the major subscriber of the debt instruments in subscribing US$21,000,000 of those in August 1983. The appellant attempted to secure assistance from Drexel in either obtaining payment of the tax owed under Part XIII of the Act from Clabir or convincing Executive Life that it should properly bear the tax. Drexel, however, advised the appellant that it could do nothing and suggested that the appellant would be well advised to resolve the matter in an amicable way with Executive Life.

On November 18, 1983, the appellant paid Executive Life the amount of US$265,189.87. This amount was determined as follows, as described in the accompanying letter shown at page 135 of Exhibit R-1:

To the refundable amount were added interests totalling the aforementioned paid amount. The letter also contained the following paragraph : "We believe that this payment is a satisfactory settlement of the matter between Executive Life ana First City. In seeking this settlement, we have been acting in good faith to retain a solid business relationship with Executive Life. We hope we have achieved our objective."

Through the end of 1983, the appellant treated the amount of $265,189.87 as a receivable from Clabir. The appellant made some effort to collect from Clabir but did not succeed and it is accepted by the respondent that it was not collectible and had become in 1984, a bad debt.

Appellant's position

The appellant's submission is that the payment made to Executive Life was made for the purpose of gaining or producing income from the appellant's business of trading in securities, in that the appellant's purpose in paying Executive Life the amount in question, was to maintain a positive business relationship with a major holder of its debt instruments. It is also the appellant's submission that this amount need not be deducted in the year it was expended. It may be deducted in the year where the debt, having for source the repayment of what was allegedly owed by Executive Life, became a bad debt.

Two other principal propositions are that the payment may be deducted as a cost of acquiring the appellant's inventory of securities or as a cost of financing a loan under paragraph 20(1)(e) of the Act.

The appellant's alternative arguments are that the amount should be considered as a bad debt pursuant to subsection 215(6) of the Act, and be deductible under paragraph 18(1)(a) or paragraph 20(1)(e) of the Act.

Respondent's position

Counsel for the respondent stated that the payment to Executive Life was the payment of a debt and was not made for the purpose of gaining or producing income from a business. It was not a cost of acquiring the appellant's inventory of securities nor a cost of financing a loan under paragraph 20(1)(e) of the Act. He submitted that all the events pertaining thereto did not occur in the course of the appellant's current business operations but took place by reason only of the appellant's failure to withhold and remit the tax exigible under Part XIII of the Act on the interest payment it had made to Clabir.

He stated that the amount in question, US$265,189.87, cannot be taken into account as a loss or a bad debt in computing the appellant's income for tax purposes and that at best, the bad debt was a loss on account of capital that was not deductible in computing the appellant's income by virtue of subparagraph 40(2)(g)(ii) of the Act.

Analysis

Respecting the appellant’s submission that the repayment to Executive Life was made to preserve its business relationship with a major lender, I do not think that it is the proper categorization of the payment made to Executive Life. The payment of U.S. $265,000 was a payment of a debt owed by the appellant to Executive Life with respect to the annual capital instalment of the note held by the latter. The appellant had tried to deduct the amount of tax owed by Clabir, the first holder, against the capital amounts owed to the second holder, Executive Life.

Paying one’s debt is a good way to maintain a good business relationship, but this payment cannot be considered as a payment made for that purpose. A payment will be considered to have been made for that purpose when there is no legal obligation to make the payment. In Frappier v. The Queen, [1976] C.T.C. 85, 76 D.T.C. 6066 (F.C.T.D.), Mr. Justice Walsh thoroughly reviewed the jurisprudence on this matter at pages 93-96 (D.T.C. 6071-72). These cases deal with payments made voluntarily without legal obligation for the purpose of either commercial morality or commercial expediency. This is not the legal situation here.

There is no legal certainty and I would even say that there does not appear to be any likelihood that Executive Life was the debtor of the amount of tax. There has never been, by Executive Life, any acceptance of its status as debtor, nor is there a court judgment or even a legal opinion showing that it may have been the debtor.

I therefore find that the payment made to Executive Life was made because the appellant was indebted to Executive Life for the annual capital instalment. This is not in the nature of a voluntary payment made for business relationship as in the Frappier case, supra.

It is not that payment, however, that the appellant seeks to deduct, because that payment was made in the year 1983, and the claim for deduction is for the year 1984. What the appellant seeks to deduct is the bad debt which, according to the appellant, has its source from the repayment. The appellant had entered this bad debt in its books under the name of Clabir. Whether it was entered under the name of Clabir or Executive Life would not change the outcome of this case. I believe that the only way to deal with this question is to examine how the whole matter arose. The appellant did not withhold, at the appropriate time, the tax owed by Clabir. Subsection 215(6) of the Act provides that in this circumstance, the amount is then owed as tax by the appellant. Subsection 215(6) of the Act allows the taxpayer the power to claim the amount against the non-resident, but a taxpayer cannot, in the calculation of his income, deduct the amount of tax paid.

In Quemont Mining Corp. Ltd. v. M.N.R., [1966] C.T.C. 570, 66 D.T.C. 5376, Mr. Justice Cattanach, at pages 598-601 (D.T.C. 5393-94), analyzes whether a tax on income is an outlay or expense incurred for the purpose of gaining or producing income from the business. He thoroughly reviews the case law on the subject, including the case of Roenisch v. M.N.R., [1928-34] C.T.C. 69, 1 D.T.C. 199. The case law is consistent to the effect that a tax on income is not deductible as an expense incurred for the purpose of gaining or producing income.

By virtue of subsection 215(6) of the Act, a person is liable to pay as tax on behalf of the non-resident person, the amount that should have been withheld. The object of this provision is to impose a tax on the person who has failed to withhold. This tax is paid on behalf of the non-resident but it is paid as tax by the resident and it is not an amount paid to earn income. In the perspective that this tax is paid on behalf of the non-resident, that tax relates to the non-resident's business and not to the appellant's business.

Subsection 215(6) of the Act allows the taxpayer to collect the tax from the non-resident. If he does not succeed in recovering it, it does not become a bad debt that may be included in the calculation of income. It keeps its nature as a disbursement not incurred for the purpose of earning income.

In the course of his argument, counsel for the appellant referred the Court to the decision of Day & Ross Ltd. v. The Queen, [1976] C.T.C. 707, 76 D.T.C. 6433 (F.C.T.D.), where fines resulting from the day to day operation of its business were allowed as deductions. Though subsection 215(6) of the Act uses the expression “is liable”, this section is not a penalty clause. The French version shows clearly that it is a section that creates an obligation. However, whether or not it was a penalty, it would not change the outcome of this case. An income tax is not an expense to produce income.

Respecting the cost of the appellant's inventory of shares, it is true that in the end, the appellant paid for the shares an amount increased by the amount of tax paid to the Canadian authorities. To allow that the cost of the shares be increased by the amount in question would be to allow a taxpayer to include in the calculation of his income, the amount of tax that he pays or has paid.

To conclude, the amount of tax paid on behalf of a U.S. resident, and that the appellant did not succeed in collecting from the non-resident, cannot be deducted in the calculation of the appellant's income. This would not be in accordance with the object and spirit of the Act and would be contrary to the case law. (Paragraph 18(1)(t) of the Act, recently enacted, would now make it clear that such a deduction is prohibited).

Accordingly, the appeal is dismissed with costs.

Appeal dismissed.