Citation: 2006TCC172
Date: 20060418
Dockets: 2001-3596(IT)G
2002-1645(IT)G
BETWEEN:
RONALD NETOLITZKY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Sheridan, J.
[1] The Appellant,
Ronald Netolitzky, is appealing the reassessment of allowable business
investment losses claimed in 1996, 1997, 1998 and 1999. The 1996 appeal was
withdrawn at the hearing and is dismissed. The Minister of National Revenue disallowed
the allowable business investment losses ("ABIL") on the ground that
in none of these years did the amounts advanced become "bad" debts,
and in the case of 1999 only, that the funds were advanced to the debtor
company not by Mr. Netolitzky, but by his holding company.
[2] These appeals
involve Mr. Netolitzky's investments in two different corporations, Chintz and
Company Decorative Furnishings Inc. ("Chintz") and C.H. Golf Ltd. ("Golf").
A third corporation, Keewatin Consultants Inc. ("Keewatin") is Mr.
Netolitzky's wholly owned holding company and figures only in the 1999 appeal.
[3] Mr. Netolitzky
has the burden of proving wrong the assumptions upon which the Minister based
his reassessments under the Income Tax Act. He and two of his financial
advisors, Mr. John Barclay and Mr. Bob Matthews, testified at the hearing.
I was impressed with the straight-forward nature of their testimony, in
particular, that of Mr. Netolitzky. All three witnesses were knowledgeable
about the events and transactions leading to these appeals; all were thoughtful
and forthcoming in the presentation of their evidence. I found them thoroughly
credible. No witnesses were called by the Crown.
Analysis
The
Chintz Loan (1997, 1998)
[4] Mr. Netolitzky
is a geologist who started his career in Alberta in the mid‑70's preparing geological reports
and evaluations. Over time, he expanded his consulting work to include the
acquisition and disposition of mineral rights and by the early 1980's, was
providing advice to and personally investing in various public sector mining
and resource companies. By the end of the decade, some particularly rich
mineral strikes in British Columbia made him a "reasonably wealthy" man with,
at one point, an RRSP account in excess of $40 million. Around this time,
Mr. Netolitzky began seeking opportunities abroad and, between 1996 and
1998, was frequently travelling to Asia and Africa to attend to these new interests. He maintained (albeit
on a reduced scale) his geological consulting work and continued to invest in
various initiatives and projects.
[5] With his own
mining ventures and consulting practice prospering, in 1986 Mr. Netolitzky and
his spouse Nicole set up Chintz, an interior design and fabrics business in Calgary where, before
meeting Mr. Netolitzky, Nicole had run her own decorating business. Both were
shareholders in Chintz. Nicole managed the business; Mr. Netolitzky's role
was to finance it. By 1998, Chintz owed some $8 million in shareholders'
loans, 90% of which Mr. Netolitzky had advanced to the company. He claimed
allowable business investment losses of $1.65 million and $1.5 million for 1997 and 1998, respectively.
[6] The parties
agree that these amounts are not in dispute; the Minister takes the position,
however, that these amounts are not deductible under paragraph 50(1)(a)
because the Chintz debts were not "bad" in these years. Paragraph
50(1)(a) reads:
Debts
established to be bad debts and shares of bankrupt corporation.
(1) For the
purpose of this subdivision, where
(a) a debt
owing to a taxpayer at the end of a taxation year (other than a debt owing to
the taxpayer in respect of the disposition of personal-use property) is
established by the taxpayer to have become a bad debt in the year, or ...
[7] According to the Crown's argument, Mr. Netolitzky's determination of the debts' unrecoverability
was premature: he could have done more to collect the debt and to turn the
business around; he should have obtained independent advice on the value of the
inventory and of the business itself. The Crown was also of the view that because
of his spouse's involvement, Mr. Netolitzky's decision had been influenced by
personal rather than purely business considerations. For all of these reasons,
the Crown submitted, Mr. Netolitzky had failed to make his determination
as "a prudent businessman" as contemplated by the Federal Court of
Appeal in Flexi-Coil Ltd. v. The Queen, 96 DTC 6350 at page 6351:
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. M.N.R., 56 DTC 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. ...
[8] In rejecting the Crown's contentions, counsel for the
Appellant referred the Court to Rich
v. The Queen[3] , a more recent decision of the Federal Court of
Appeal in which Rothstein, J.A. (as he then was) also referred to the Hogan
decision in his consideration of what is required of a taxpayer under paragraph
50(1)(a):
[12] The
assessment of whether a debt is bad is one based upon the facts at a particular
point in time, i.e. December 31, 1995 [the end of the taxation year in which
ABIL is claimed]. The Income Tax Act does not prescribe factors to be
considered in assessing the collectibility of a debt. However, Tax Appeal Board
judgments in Hogan v. Minister of National Revenue (1956), 56 DTC 183
and No. 81 v. The Minister of National Revenue (1953), 53 DTC 98,
suggest some of the factors to be taken into account. After the creditor
personally considers the relevant factors, the question is whether the creditor
honestly and reasonably determined the debt to be bad.
[13] I
would summarize factors that I think usually should be taken into account in
determining whether a debt has become bad as:
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.
This list is
not exhaustive and, in different circumstances, one factor or another may be
more important.
[9] In my view, the evidence supports the Appellant's
submission that Mr. Netolitzky properly fulfilled the obligations imposed
on him by the Act and the related jurisprudence. In 1994, 1995, and 1996, the company's balance sheets[4] showed operating losses of $951,000, $447,500 and
$31,000[5]; respectively. In 1997, a modest operating income
of $109,000 was reported[6]. In 1998, notwithstanding the injection of a $619,000
gain on disposition of market securities[7]
(most of which was allocated, in reduction of the bank debt and the shareholder
loan), Chintz again showed an operating loss of $103,000[8]. Meanwhile, throughout 1994 to 1998, Chintz's debt to
its shareholders increased from $5.9 million to $8.2 million. None of this is consistent
with the Crown's characterization of Chintz's financial position as
"healthy".
[10] In analyzing his prospects of recovering the amounts
advanced, Mr. Netolitzky took into account the company's failure to
perform as expected. Rather than showing progressive improvement in its bottom
line, Chintz was losing money virtually
every year. There were various reasons for this. The expansion of its
Calgary-based business to include three other locations (Edmonton, Vancouver and Victoria) and
of its business activities to include furniture and soft furnishings turned out
to be overly ambitious. In 1994, a fire (for which, it was ultimately
discovered, Chintz was under-insured) temporarily sidelined the Edmonton store.
The conversion of its computer system soaked up more resources than
anticipated, the attendant delay meanwhile exacerbating Chintz's existing inventory
management problems. In the fickle market of high-end design, Chintz was being
done in by its "trendy" merchandise and its own flawed purchasing
practices: bought in container loads from off‑shore suppliers months in
advance, its inventory was often unmarketable before it hit the salesroom
floor. Known as "stale" inventory, it sat, a greedy albatross
devouring costly warehouse space. Though aware of the inventory's inflated book
value, Chintz hesitated to reduce it (the inventory being the company's only real
asset) for fear of jeopardizing its financing agreement with the bank, its
other key creditor. In such straitened circumstances, Chintz's modest increase
in sales could not keep pace with its escalating operating costs, never mind
paying down its debts.
[11] In these
difficult times, Mr. Netolitzky turned to his longtime financial advisor, John
Barclay. Their professional relationship dates back to the early '70's when, as
a Certified General Accountant, Mr. Barclay prepared Mr. Netolitzky's personal
and business tax returns. In 1976, he joined Mr. Netolitzky's consulting
practice as its Chief Financial Officer, a position he held until Mr.
Netolitzky's move to public sector companies. Following Mr. Netolitzky's
success with his mining ventures, in 1990 he recruited Mr. Barclay to become
the CFO of Keewatin, his newly established consulting company.
[12] Although not officially
part of Chintz, Mr. Barclay was well versed in the company's operations: he
knew about the lagging inventory from his own observations in the stores and at
the warehouses, from discussing the situation with staff and from examining the
company's financial statements prepared by its accountants. He was aware of the
various strategies that had been tried without success to improve Chintz's performance
- such things as slashing prices on inventory, putting money into renovations,
exploring franchise opportunities.
[13] Notwithstanding
Mr. Barclay's professional qualifications and long experience with the company,
counsel for the Respondent argued that Mr. Netolitzky ought to have
obtained an independent assessment of the amount of the loss and of the company's
potential resale value. This is an unwarranted expansion of the duty imposed on
the taxpayer under paragraph 50(1)(a) of the Act. In Flexi‑Coil,
MacGuigan, J.A. quoted Hogan to hold that "... [T]he 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, [sic] each individual debtor
...". These words
were echoed by Mr. Justice Rothstein in Rich where he stated it is
"the creditor personally" who must consider the factors
leading to a bad debt determination.
[14] This is what
Mr. Netolitzky did. As an experienced businessman in his own sphere and
familiar with Chintz's situation, he made the final determination. Though not
obliged to seek third party advice, he took the extra precaution of consulting
Mr. Barclay, a knowledgeable professional advisor in whom, at the time, he had
quite reasonably reposed his trust. I am satisfied that Mr. Netolitzky
"honestly and reasonably" made his determination of the uncollectibility
of a portion of the Chintz debt. The case law is clear that under paragraph
50(1)(a), either all or a portion of the debt may be considered bad.
[15] As for the Crown's contention that Mr. Netolitzky could have done more to collect the
debt before declaring it unrecoverable, it is difficult to see what that might
have been. There is a limit to how much the taxpayer is expected to do. The
Federal Court of Appeal held that it is not:
... necessary
for a creditor to exhaust all possible recourses of collection. All that is
required is an honest and reasonable assessment. Indeed, should a bad debt
subsequently be collected in whole or in part, the amount collected is taken
into income in the year it is received. [11]
[16] This latter
statement makes clear that even where an ailing enterprise ultimately achieves
improved fiscal health, that in itself does not foreclose its creditor, at an
earlier and more precarious moment, from legitimately declaring uncollectible
amounts advanced during that time. Mr. Justice Rothstein went on to say at
paragraph 29, "… there is no obligation on the taxpayer to try to think of
every conceivable proactive step and show that none would be productive. It is
sufficient that the taxpayer provides evidence as to the condition of the
debtor and its inability at the relevant time to repay the loan in whole or in
part. That was the evidence in this case."[12] And in my view, that was also the evidence in the
present case. The numerous strategies considered were aimed at improving
Chintz's performance to make it a profitable business or, if nothing else, attractive
to a potential buyer.
[17] Finally, the
Crown submitted that Mr. Netolitzky had been overly influenced by what he
described as his wife's "passion" for the business, sufficiently
swayed by Nicole's wishes so as not to have acted as a "prudent
businessman" when he made his "bad debt" determination. In considering the relevance of a
non-arm's length relationship between the creditor and the debtor, Mr. Justice Rothstein
stated that it "may justify closer scrutiny than in non-arm's length
situations. But a non-arm's length relationship alone, without more, cannot
lead to a finding that the creditor did not honestly and reasonably determine
the debt to be bad." Even on closer scrutiny. the
evidence supports the conclusion that the basis for Mr. Netolitzky's
determination was the financial analysis he made in consultation with
Mr. Barclay.
[18] For the above
reasons, I am satisfied that Mr. Netolitzky made an honest and reasonable
determination that a portion of the Chintz debts were "bad" and
accordingly, he is entitled to an allowable business investment loss $1.65
million and $1.5 million for 1997 and 1998, respectively, in respect of the
Chintz loan.
The
Golf Loan (1999)
[19] The appeal of the
1999 reassessment pertains only to the debt owed by the second corporation,
Golf. Before considering whether that debt became bad, it must be determined
whether the advances came from Mr. Netolitzky personally or from his
wholly-owned holding company Keewatin.
Who Advanced the Loan Funds?
[20] Golf was a British Columbia
company set up in 1990 for the development and sale of certain lots on Lake Okanagon.
Sometime in the 1990's, a former business colleague approached Mr. Netolitzky
to solicit his investment in the Golf venture. On the basis of that
individual's past successes and the proposal as presented to him, Mr. Netolitzky
decided to invest in the project. Mr. Netolitzky did not have any shares in
Golf; Keewatin, his holding company, held 35% of the shares. At that
time, Mr. Netolitzky was using Keewatin to handle, among other things, his
geology consulting work. Mr. Barclay was Keewatin's Chief Financial
Officer and it was decided that he would also look after Golf's finances.
Mr. Barclay had full signing authority on both the Golf and Keewatin
accounts.
[21] The Golf project
was initially financed through the Royal Bank but within a year of start-up,
the bank withdrew its participation. Mr. Netolitzky suddenly found himself
having to help in the scramble for alternate sources of funding. This proved difficult due, in no small part, to his former colleague's
inept management and inaccurate portrayal of what the project would involve. Even
with Mr. Netolitzky's recruitment of individual investors from his
business circles, the company had to resort to short‑term institutional
funding at ruinous rates. Ultimately, the project floundered. In 1999, Mr.
Netolitzky claimed an ABIL of $3 million, a portion of the company's total
indebtedness to him.
[22] The Minister's
position is that Keewatin, as a separate legal entity, advanced the funds to
Golf. The primary basis for the Crown's contention is a description of
Keewatin's principal business as "leasing, rental, development and sale of
real property". These words appeared in a letter from Smythe Ratcliffe, an
accounting firm specializing in tax matters, to the CCRA dated June 5, 2002. By
that date, Mr. Netolitzky had retained Smythe Ratcliffe to examine the
records and determine what steps, if any, were needed to correct Mr. Barclay's
errors and omissions. Their inquiries led to Mr. Netolitzky's filing a
voluntary disclosure and paying in full the taxes owing in his amended returns.
In doing so, Smythe Ratcliffe prepared certain documents and attached the June 5,
2002 cover letter containing the following passage from which the words quoted
above are taken:
"In preparing these schedules, which will be
the basis for amended returns, we have taken the position that the company's [Keewatin's]
principal business was the leasing, rental, development and sale of real
property, as set out in the Regulation of the Act."
[23] I am unable to
ascribe to the Smythe Ratcliffe description the significance suggested by
counsel for the Respondent. First of all, though written on his behalf, these
are not Mr. Netolitzky’s words. The circumstances in or the care with which they
were chosen are not known to the Court; the description was, however, ancillary to Symthe Ratcliffe's primary purpose of providing documentation for
the voluntary disclosure. Finally, the Smythe Ratcliffe description is
consistent with Mr. Netolitzky's explanation of it, that it reflected
Keewatin's own property holdings: in Victoria, the heritage building purchased,
extensively renovated and leased to Chintz through its holding company; in
Alberta, the buildings for which Keewatin had to take out the mortgage and
which were leased to Chintz. Keewatin leased the premises to Chintz for which it
paid rent at commercial rates.
[24] Also militating against the Crown's position is the
fact that Keewatin simply did not have the fiscal wherewithal to finance
the project. I accept Mr. Netolitzky's evidence that the Keewatin account generally
maintained a balance not in excess of $200,000. The true source of
the payments made to Golf was Mr. Netolitzky's very well-funded RRSP
account at RBC Dominion Securities.
The evidence shows how the funds in Mr. Netolitzky's RRSP account made their
way into Golf's bank account: frequently out of the country, Mr. Netolitzky
authorized Mr. Barclay to make withdrawals from his (Mr. Netolitzky's) RRSP
account and entrusted to him, RRSP redemption forms signed in blank[17] for this purpose. Mr. Barclay was also authorized to
send, under his own signature, letters[18]
instructing RBC Dominion Securities to forward the redeemed funds to him for
deposit in Mr. Netolitzky's personal account. Finally, he had
authorization to instruct the Bank of Montreal to transfer money from Mr.
Netolitzky's personal account to the Keewatin account. At no time relevant to these appeals did Mr. Netolitzky
authorize Mr. Barclay to transfer funds from the Appellant's personal account
to any account other than Keewatin's.
[25] For reasons that
are not known to the Court or relevant to this appeal, at some point in 1997 or
1998, Mr. Barclay's formerly impeccable professional competence began to deteriorate.
It would later[19] be discovered that he had abused his properly delegated
authority to transfer funds from Mr. Netolitzky's personal account through Golf
to the Keewatin account. At the hearing, he admitted he had used
Keewatin as a conduit to make his job easier. While he had always intended to
make the necessary adjustments to the respective records of the companies, Mr. Barclay
did not manage to do this before succumbing to his personal difficulties.
[26] Finally, I accept the evidence of Mr. Netolitzky and
Mr. Barclay that the intention was from the outset that Mr. Netolitzky
personally would invest in Golf.
[27] For all of these
reasons, I am satisfied on a balance of probabilities that Mr. Netolitzky
advanced the funds to Golf and accordingly, the debt was owed to Mr. Netolitzky
in 1999.
Was
the Debt "Bad"?
[28] Turning now to
the question of whether the Golf debt became bad, the Crown has not challenged
the bona fides of the Golf project or alleged that the Golf ‑ Netolitzky
transaction was some sort of sham. Nor is there any suggestion or evidence that
Mr. Netolitzky intended anything other than to realize a return on his
investment in the land development project.
[29] Applying the same factors from Rich as discussed in detail above, the law required Mr.
Netolitzky to make his determination at the end of the 1999 taxation year. At
that point, he was aware of the mounting chaos at the site. Even though under
no obligation to do so, he undertook the task of recruiting private investors
or securing affordable institutional financing. He personally experienced the
disappointing results. In consultation with Mr. Barclay (at that time,
still his trusted advisor), he began to feel he would be lucky to recover even a
portion of his investment. When he began losing confidence in Mr. Barclay's
judgment, Mr. Netolitzky sought the advice of Mr. Matthews, a former
chief financial officer for MacMillan Bloedel and fellow board member in other successful
ventures. Mr. Matthews's analysis convinced him that the Golf
project was a colossal disaster.
[30] In view of these actions, I am at a loss to see what more Mr. Netolitzky could
reasonably have been expected to do. By 1999, it was clear that Golf was
without the means to repay all of its indebtedness to him. Indeed, others would
later look to Mr. Netolitzky to do exactly that in respect of Golf's
indebtedness to them.
Although Golf continued in existence after 1999, that in itself does not render
invalid the "bad debt" determination. As
Mr. Justice Rothstein cautioned in Rich, supra at
paragraph 14:
While future
prospects of the debtor company may be relevant in some cases, the predominant
considerations would normally be past and present. If there is some evidence of
an event that will probably occur in the future that would suggest that the
debt is collectible on the happening of the event, the future event should be
considered. If future considerations are only speculative, they would not be material
in an assessment of whether a past due debt is collectible.
In
Golf's situation, the likelihood of a future turnaround would have been highly
speculative, to the point of being not "material in an assessment of
whether a past due debt is collectible."
[31] Considered in
light of the principles in Rich as discussed above, the evidence
satisfies me that Mr. Netolitzky honestly and reasonably determined a portion
of the Golf loan to be bad in 1999. It is not open to the Minister, with the
benefit of hindsight to second-guess the taxpayer's good faith objective
assessment at the relevant time. Mr. Netolitzky is accordingly, entitled to an
allowable business investment loss in respect of the Golf loan of $3 million in
1999.
[32] These appeals are
allowed, with costs, and the reassessments are referred back to the Minister of
National Revenue for reconsideration and reassessment.
Signed at Ottawa, Canada, this 18th day
of April, 2006.
"G. Sheridan"
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