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Citation: 2005TCC296
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Date: 20050429
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Docket: 2004-2991(IT)I
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BETWEEN:
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SUSAN KEATING,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
CampbellJ.
[1] The Appellant appeals an
assessment for the 2000 taxation year in which the Respondent
denied a deduction of legal expenses in the amount of $25,975.00.
The Appellant also appeals the Respondent's determination
that she was not entitled to claim an allowable business loss
(ABIL) for a loss incurred in 1998 that the Appellant sought to
carry forward to the 2000 taxation year.
Evidence
[2] The Appellant met Pierre
Lafontaine in 1992 and by June 1993 they were residing together.
At Mr. Lafontaine's request, the Appellant left her
employment in 1993 and joined him in his graphics business. On at
least one occasion she borrowed money to assist him with his
business payroll. Because Mr. Lafontaine was struggling
financially, he asked the Appellant to incorporate a company
which she did in November 1993. The Appellant was the sole
shareholder of Visual Synergy Inc. but it was Lafontaine who
actually operated the business as its president and general
manager. Because Lafontaine had been involved previously with a
number of small businesses, and the Appellant had not, she was
eligible to take advantage of the small business development
loans. The maximum amount of $250,000.00 for small businesses was
borrowed. The Appellant executed a personal guarantee to CIBC and
also provided collateral to the bank with a mortgage against her
home. In December 1993 the Appellant married Lafontaine. She
worked with him in this graphics business from 1993 to 1996.
Eventually they separated in 1998. It was her understanding that
Visual Synergy operated until 1998.
[3] In 1995 Lafontaine had
incorporated a company called Sako Graphics Resource Centre Inc.
("Sako"). The Appellant, although they were still
living together at this time, was not involved in any way in this
company. Prior to their separation, Lafontaine was managing both
Visual Synergy and Sako.
[4] In 1998 Visual Synergy became
insolvent. During the summer of that year, CIBC advised the
Appellant that the bank intended to act on her guarantee and
foreclose on her home. In addition the bank seized the remaining
assets of Visual Synergy. However most of the corporate assets,
the graphic equipment, had been rolled over by Lafontaine to Sako
without the Appellant's knowledge and without the assumption
or transfer of any of Visual Synergy's debt. The Appellant
was forced to sell her home to repay CIBC the amount of
$232,321.00 in satisfaction of the personal guarantee which she
provided in support of the Visual Synergy debt.
[5] In 1999 the Appellant commenced
two legal actions, one against Lafontaine ("the matrimonial
action") for spousal and child support and one against
Lafontaine, Sako, Visual Synergy and Sak Graphic Resource Inc.
("the oppression remedy action") in respect to the
depletion of the assets and business of Visual Synergy. This
latter action asked for an accounting of the transfer of assets
and goodwill from Visual Synergy to Sako and then eventually to
Sak Graphic Resource Inc. ("Sak"), another of
Lafontaine's companies. In terms of dollar amount, the
Appellant asked for compensation of $450,000.00 in satisfaction
of all her claims. In her affidavit in support of this
application, she stated that although she was sole shareholder
and director of Visual Synergy, it was Lafontaine who ran the
business activities on a daily basis. When he incorporated Sako
in 1995, he concentrated his energy on this new company to the
exclusion of Visual Synergy. It was Visual Synergy's
resources however that funded this new company. Through time
Lafontaine decreased Visual Synergy's activities and
transferred its assets, customers and accounts to Sako. Her
affidavit states that Lafontaine successfully established Sako
with himself as its sole shareholder at the expense of Visual
Synergy and to the Appellant's detriment. By the end of 1997
Visual Synergy could no longer make payments on its loans while
Sako had been successfully established with revenue of
$890,000.00.
[6] Both the matrimonial action and
the oppression remedy action were settled in April 2001. With
respect to the matrimonial action, the interim support order was
terminated and the Appellant's consent to dismiss all her
future matrimonial claims against Lafontaine was to be held in
escrow pending the completion of all payments owing to her
pursuant to the oppression remedy order. The Minutes of
Settlement in the oppression remedy action ordered all of the
defendants (with the exception of Visual Synergy) to pay
$180,000.00 to the Appellant in accordance with a schedule of
periodic payments commencing April 2001 and ending in
July 2003. According to the Appellant's evidence, she
has never received the last payment of $30,000.00 due July 30,
2003, although she took legal action and was awarded judgment
against Sako, Sak and Lafontaine (Exhibit A-1, Tab 10). In
addition she commenced action against Lafontaine for child
support payments and received an order for support plus costs. To
date Lafontaine has not paid these support payments nor has he
made payments on the final $30,000.00 owing under the oppression
remedy action.
[7] In computing her income for the
2000 taxation year, the Appellant deducted legal fees and
expenses of $25,975.21. The Appellant produced copies of two
separate legal accounts, one for the matrimonial action (Exhibit
A-1, Tab 14) and one for the oppression remedy action
(Exhibit A-1, Tab 13). The same law firm represented the
Appellant in both matters. The legal fees in the matrimonial
action totalled $28,750.55 and the fees in the oppression remedy
action totalled $53,810.55. As I understood Appellant
counsel's submissions, she claimed most of the legal fees
relating to the matrimonial action, although counsel agreed that
she is not entitled to claim that portion of the legal fees which
relate to spousal support. The amount claimed by the Appellant as
a deduction should therefore be reduced by some amount. Counsel
also submitted that the legal fees of $53,810.55 paid in respect
to the oppression action should go to reduce her capital recovery
of $180,000.00. Besides deducting her legal fees the Appellant
wants to apply business investment losses from 1998 to the
2000 taxation years.
Issues:
[8] There are three issues:
(1) When did the Appellant incur
the business investment loss?
(2) What is the amount of the
business investment loss?
(3) Are any of the legal
expenses deductible?
Appellant's Position:
[9] The Appellant's position is
that in 1998 Visual Synergy had become insolvent. CIBC seized
those few remaining assets that had not been transferred to Sako
by Lafontaine. The bank called in the Appellant's guarantee
and commenced foreclosure proceedings against the Appellant's
home. To avoid these proceedings the Appellant sold her home on
her own and paid $232,321.00 to CIBC. By the end of 1998, Visual
Synergy had no assets or customers, was not carrying on business
and was not earning income. This loan became a bad debt in 1998
and this entitles her to a business investment loss. The
Appellant argued that the subsequent litigation, against her
former husband and his companies, is not connected to the
recovery of the debt owed by Visual Synergy to the Appellant
because the shareholder oppression action is distinct from this
debt. The oppression action was brought against Lafontaine and
several of his companies because he had stripped Visual Synergy
of its assets. The amount the Appellant may have been entitled to
under the oppression action has nothing to do with the amount
that Visual Synergy owed her. The Appellant also points out that
the action against the former husband is not a case of
contribution or indemnity in relation to the actual debt.
Therefore the Appellant suggested that the loss should be
quantified at $106,190.55, consisting of the difference between
the $232,321.00 amount paid to CIBC and $180,000.00 paid to the
Appellant under the settlement ($52,321.00) plus legal fees
($53,810.55) that were incurred in pursuit of settlement of the
oppression action.
[10] The Appellant acknowledged that the
portion of the matrimonial legal account relating to the
collection of spousal support is not deductible but that the
portion relating to child support should be a deductible legal
expense and suggested that a reasonable portion of that total
matrimonial account relating to the child support claim would be
half of the $28,750.55, (although initially in her return she had
claimed most of this amount). The legal fees of $53,810.55 paid
in respect to the oppression action is not deductible as an
expense but rather becomes a reduction of her capital recovery of
$180,000.00 from Lafontaine so that her business investment loss
is $232,380.00 - $180,000.00 + $53,810.55 or $106,190.55, thereby
increasing the allowable business loss.
Respondent's Position
[11] The Respondent argues that the legal
steps taken by the Appellant in 1999 in the oppression action
related to the recovery of the debt she had paid to CIBC.
Therefore the debt remained collectible in 2001 when the
oppression action was settled. The Appellant knew in 1998 that
she had a likelihood of collecting the debt from her former
husband. The Respondent also noted that only a few months elapsed
between the time she actually paid CIBC under the guarantee and
the time she commenced an action against her former husband. In
light of this, recovery of the debt was reasonably possible.
There was no evidence that the Appellant would have taken action
against Lafontaine and his companies if she had not been required
to pay CIBC. It is unreasonable for the Appellant to claim that
the debt was bad before taking proactive steps to recover that
debt. The only step she eventually took was successful. The debt
was therefore not a bad debt in 1998. The Respondent is prepared
to allow the Appellant an allowable business deduction for the
amount paid to CIBC ($232,320.00) less the amount paid pursuant
to the legal action ($180,000.00) or $52,320.00. The debt
remained collectible until 2001 when only that portion of the
debt became bad once the Appellant obtained a settlement.
[12] The Respondent submits that the legal
fees claimed by the Appellant were, in part, used to secure and
resolve claims for spousal support and are therefore not
deductible. That portion of the fees was not used for the purpose
of gaining or producing income from business or property but
instead was used for establishing the Appellant's right to
spousal support. Therefore those fees are not deductible. The
Respondent argued that the expenses related to the two legal
applications are intermingled and that the oppression action was
brought in part as leverage for the claim for spousal support and
vice versa. The settlement in 2001 treats the lump sum due in
respect to the oppression action as if it was a settlement of
spousal support because it split the amount into periodic
payments. Since the two legal actions are so intermingled
together with the provisions of the settlement, it follows that
the legal expenses are also intermingled and should not be
treated differently. Therefore the Appellant did not show that
the fees were incurred for the purpose of gaining or producing
income from business or property.
Analysis:
Issue 1: When
did the Appellant incur the business investment loss?
[13] Both the Appellant and the Respondent
agree that Visual Synergy owed a debt to the Appellant in the
amount of $232,321.00. The question of whether the ABIL arose in
1998 depends on whether the $232,321.00 debt became a bad debt in
that year. The Respondent has argued that the debt was still
recoverable in 1998 and did not become a bad debt until 2001 when
the legal actions between the Appellant and her former husband
were settled. The Federal Court in Rich v. The Queen, 2003
DTC 5115 set out a number of factors to be considered in
determining whether a debt is properly determined by a taxpayer
to be a bad debt. This list of factors, which is not necessarily
exhaustive, is set out at paragraph 13 of that decision as
follows:
1. the history and
age of the debt;
2. the financial
position of the debtor, its revenues and expenses, whether it is
earning income or incurring losses, its cash flow and its assets,
liabilities and liquidity;
3. changes in total
sales as compared with prior years;
4. the debtor's
cash, accounts receivable and other current assets at the
relevant time and as compared with prior years;
5. the debtor's
accounts payable and other current liabilities at the relevant
time and as compared with prior years;
6. the general
business conditions in the country, the community of the debtor,
and in the debtor's line of business; and
7. the past
experience of the taxpayer with writing off bad debts.
Some of these factors such as history and age of the debt, and
change in sales compared to other years are not relevant to the
facts of this appeal as Visual Synergy had ceased to operate at
the time the bad debt was purportedly written off. However the
factors of the corporate liquidity and overall financial position
will be more relevant in these circumstances. With respect to
these factors, the evidence indicated that the debt had existed
within the company for some time, although from the
Appellant's standpoint she had a narrow window within which
she had to take some action once CIBC called in her guarantee.
She took proactive steps to sell her house and obtain as much as
she could on the market, without the Bank actually foreclosing.
When I look at these factors, the company was no longer carrying
on business. Most of its assets had been removed by Lafontaine.
The few remaining assets had been seized by the Bank. Lafontaine
was running this company and used that position to roll over the
assets to one of his other companies, leaving all of the
corporate debt in Visual Synergy. At the end of 1998, Visual
Synergy had no revenues, customers, account's receivables or
cash flow. Any prospect for recovery of this debt was therefore
remote.
[14] I believe the oppression action for the
appropriation of the assets of Visual Synergy by Lafontaine, and
the payment of $232,321.00 by the Appellant to CIBC, are two
separate and distinct transactions. The oppression action does
not specifically mention the Appellant's guarantee, the
foreclosure or the sale of the house except that these events had
occurred in 1998. In fact the actual figure of $232,321.00 paid
to CIBC is never mentioned. The action is actually brought
pursuant to the Ontario Business Corporations Act and is
centered around a request for an accounting of all corporate
records and the transfer of assets and goodwill from Visual
Synergy to Sako and then to Sak. The Appellant's claim is
quantified at $450,000.00. In the Appellant's affidavit,
which was used to support the oppression action, she states that
at the end of 1997 Visual Synergy had a total debt of
$403,418.00. This action is clearly against Lafontaine and his
companies because he stripped Visual Synergy of its assets. The
amount claimed under the oppression action has no connection to
the amount paid to CIBC pursuant to the guarantee. I agree with
the Appellant that the action against the former husband is not a
case of contribution or indemnity in relation to the debt. While
it may be true that the Appellant's motivation for bringing
the oppression action was to recover the money that she lost when
she had to sell her house to pay CIBC, the Appellant's
intentions and motivations are not determinative as to whether or
not the oppression action and the resulting settlement are
legally distinguishable from the debt. The true legal nature of
the debt and of the oppression action is more relevant than the
Appellant's understanding of it. The legal documents which
comprise the oppression action do not attempt the collection or
recovery of a debt. As rightly pointed out by the Appellant, the
oppression action would likely have been available to the
Appellant whether or not she had ever signed a guarantee, or sold
her house to pay CIBC.
[15] The Respondent argued that there was
evidence that the Appellant took no steps to recover the debt
prior to determining it to be a bad debt in 1998. However as
pointed out in the case of Rich, this obligation only
arises where there is some evidence to show that collection of
the debt is reasonably possible. The facts here suggest that
Visual Synergy had no ability to pay this debt at any time after
1998 because there was no income and no business. There was
nothing the Appellant or the company could do to refinance the
operations. In fact although the Appellant worked in the
business, she had left in 1996 and during all of these years it
was Lafontaine who knew the business and oversaw the operations.
In these circumstances the Appellant had no obligation to take
steps to collect when faced with the imminent threat of
foreclosure proceedings against her home. It was reasonable and
prudent in these circumstances for the Appellant to take the
steps she did. Since there was no evidence that the financial
position of Visual Synergy would change in the future, she
exercised her judgment and determined the debt to be bad at the
end of 1998.
[16] Even though the Appellant and the
corporation were not dealing at arm's length, and are
therefore subject to closer scrutiny, my conclusion does not
change. I believe that according to the principles in
Rich, the predominant consideration is still the ability
of the debtor to repay the debt in whole or in part. There is
nothing in the facts which would indicate that Visual Synergy
could have paid any portion of that debt in 1998 or at any time
thereafter. If I accept the Respondent's argument that the
debt was intended to be collected indirectly via the oppression
action, I would be effectively re-characterizing the legal nature
of the parties' relationship and the supporting legal
transactions. Visual Synergy and Lafontaine are two separate
legal entities. Visual Synergy is the debtor. The debt owed by
Visual Synergy is not the equivalent of the transaction that was
commenced by the Appellant against Lafontaine and his companies
for stripping the assets of Visual Synergy. I must come to my
conclusions based on the facts as they are before me. I do not
believe that the Appellant has an onus, as the Respondent
suggests, to lead evidence as to whether she would or would not
have initiated the oppression action in the hypothetical
situation that no debt existed or that she was not liable under
the guarantee. Although I agree that there may be some connection
between the two events, they remain legally two very distinct
legal transactions.
[17] The amount of $232,321.00 was therefore
properly determined to be a bad debt at the end of 1998.
Issue 2: What
is the amount of the business investment loss?
[18] The Respondent and the Appellant each
have their own views on what the amount of business investment
loss should be. The Respondent suggests that it is $52,321.00
[$232,321.00 (paid by the Appellant to the Bank under the
guarantee) less $180,000.00 (received by the Appellant from
Lafontaine pursuant to the oppression action)]. The Appellant
suggests the figure should be $106,190.00 [$52,321.00 (the
Minister's figure) + $53,869.00 (legal fees incurred to
pursue settlement)]. Interestingly this position is different
from the position the Appellant took in the Notice of Appeal,
where at paragraph (g), the Appellant sought recovery of a
business investment loss of $232,321.00. I do not agree with the
figure proposed by either party.
[19] The parties disagree over the proper
treatment of the $180,000.00 settlement amount. The Appellant
suggests it is damages while the Respondent wants me to deem it
recovery of the debt. However as I have concluded previously, the
$180,000.00 was not recovered from the debtor corporation, Visual
Synergy, but from third parties. The settlement from the
oppression action does not equal recovery of the debt owed by
Visual Synergy to the Appellant. The legal documentation supports
my conclusion. Visual Synergy, although named as one of the
respondents in the oppression action, was not liable to pay the
Appellant under the Minutes of Settlement. It was Lafontaine,
Sako and Sak that were ordered jointly and severally to pay
$180,000.00 to the Appellant. The Respondent's treatment of
the settlement monies as payment of the corporate debt is not
supported by the documentary evidence. There is not the slightest
hint in these documents that link one to the other.
[20] I conclude therefore that the
$180,000.00 settlement amount is equivalent to damages, since the
oppression action was brought to compensate the Appellant, as
sole shareholder of Visual Synergy, for Lafontaine and his
companies misappropriating the corporate assets. Amounts received
under this settlement should be accounted for in some manner in
the years they were received. However those years are not before
me for decision.
[21] Accordingly I conclude that the
business investment loss at the end of 1998 was $232,321.00 which
may be carried forward to the 2000 taxation year. The amount of
$180,000.00 subsequently recovered cannot operate to reduce this
amount because it was recovered from a third party and arises out
of a distinct transaction.
Issue 3: Are
any of the legal expenses deductible?
[22] The Respondent's position is that
the fees were personal, a portion incurred for the purpose of
prosecuting the matrimonial action and the balance not deductible
because it was not incurred for the purpose of gaining or
producing income from a business or property, as required by
paragraph 18(1)(a) of the Act. The Respondent
submits that the matrimonial action and oppression action are so
intermingled that the legal accounts are intermingled. This was
not specifically included in the assumptions contained in the
Reply to the Notice of Appeal. Even if it had been included as an
assumption, it would not necessarily follow that the legal fees
respecting spousal and child support could not be deductible. In
any event it has not been established that the entire amount of
the legal expense was attributable to the matrimonial action. In
fact based on the Respondent's own argument that the
$180,000.00 settlement is essentially recovery of the Visual
Synergy debt, it is inconsistent for the Respondent to attempt to
argue that the fees are entirely attributable to the matrimonial
action. There is absolutely no connection between spousal support
payments and the staged payments pursuant to the oppression
action. The Respondent's attempt to characterize these staged
payments amounting to $180,000.00 under the oppression action as
somehow a settlement of spousal support is completely unsupported
by the oral and documentary evidence.
[23] Although the only consideration for the
matrimonial action was the settlement of the oppression action,
there are two distinct sets of legal accounts from the one law
firm. One set of accounts is marked at the top of each invoice
"Re: oppression remedy" and those in the second set of
invoices for the matrimonial action are marked "Re: Keating
and Lafontaine". In addition the law firm identifies the two
actions according to two separate file numbers and each of the
invoices is fully itemized. These legal accounts are clearly
identified as relating to two different matters. Since the
pleadings have put the legal fees before me and one of the
Appellant's arguments submits that the Appellant should be
entitled to claim a portion of the fees paid in respect to the
matrimonial matter, I believe the Appellant is entitled to deduct
that portion of the total fees which relate to child support. The
Appellant has suggested that a reasonable amount would be one
half the total legal fees paid on account of the matrimonial
action. I agree that this is a reasonable amount and the
Appellant should be permitted to deduct one half the total fees
incurred in the matrimonial action or $14,375.00.
[24] With respect to the fees paid to pursue
the oppression action, I do not believe those legal expenses are
deductible. However I do not come to my conclusion based on the
Respondent's position, which is that they were not incurred
for the purpose of gaining or producing income from a business or
property. Instead these fees are not deductible because they are
on account of capital and should therefore be disallowed under
paragraph 18(1)(b). According to the Appellant's own
evidence, the purpose of bringing the corporate action was to
prevent Lafontaine from stripping Visual Synergy of its assets.
Legal expenses incurred for the purpose of preserving a capital
asset are not deductible. This proposition was affirmed by Judge
Brulé in Hoffman et al. v. M.N.R., 92 DTC 2290
and by Chief Justice Bowman in Muggli v. Canada, [1994]
1 C.T.C. 2705.
[25] Therefore those legal fees which relate
to the oppression action are disallowed under paragraph
18(1)(b), as they were incurred to preserve the assets
Visual Synergy.
[26] The appeal is allowed, without costs,
to permit the Appellant to claim a business investment loss of
$232,321.00 at the end of 1998 which may be carried forward to
the 2000 taxation year under appeal. Legal expenses in the amount
of $53,810.55, respecting the oppression action, are not
deductible as they were incurred to preserve capital assets. One
half of the legal fees, or $14,375.00, respecting the child
support segment of the matrimonial action is deductible.
Signed at Ottawa, Canada, this 29th day of April 2005.
Campbell J.
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