Citation: 2013 TCC 417
Date: 20131220
Docket: 2008-3796(IT)G
BETWEEN:
MICHAEL COVELEY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Docket: 2008-3797(IT)G
BETWEEN:
SOLBYUNG COVELEY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
D’Auray J.
A. Introduction
[1]
The appellants are the
co-founders of cStar Technologies Inc (“cStar”). They are husband and wife.
[2]
cStar was incorporated on March 30, 1998 and is in the
business of developing wireless communication applications which enable
machines and business systems as well as machines and people to communicate
wirelessly.
[3]
Mrs. Solbyung Coveley
is the shareholder, president and chief executive officer of cStar. She is also
an employee of cStar.
[4]
Mr. Michael Coveley
is the chief technology officer and senior vice‑president of cStar. He is
also an employee of cStar.
[5]
Starting in 1998, the appellants made loans to cStar comprising
of their unpaid remuneration, cash advances and corporate expenses that they
paid on behalf of cStar with their personal credit cards.
[6]
In filing their income
tax returns for the 2005 taxation year, each appellant claimed an allowable
business investment loss (“ABIL”).
[7]
In filing their 2006
income tax returns, each of the appellants claimed against their income a
non-capital loss carry-forward arising from their ABIL claims in 2005.
[8]
The Minister of
National Revenue (the “Minister”) disallowed the ABILs claimed by the
appellants for their 2005 taxation year, as well as the non-capital loss carry-forward
for their 2006 taxation year, on the basis that the appellants did not meet the
requirements of the Income Tax Act (the “Act”) for claiming an ABIL.
B. Issues to be decided
[9]
The issues to be decided in these appeals are the
following:
(a)
Are the appellants
entitled to deduct an ABIL in computing their income for their 2005 taxation
year?
(b)
Are the appellants
entitled to carry forward non-capital losses in computing their income for
their 2006 taxation year?
C. The evidence
The appellants
[10]
Mr. Coveley holds
mechanical and electrical engineering degrees and has studied at MIT. He has
worked in Canada, the United States, Japan, Germany and Switzerland.
Mr. Coveley stated that he has many inventions to his credit such as the
first hand-held unattended point‑of‑sale terminal, a car alarm for
Rolls‑Royce, and created one of the first homodynamic mechanical hearts
to measure variant body hypertension conditions. He was also forerunner
inventor of the aluminum foil that is used in most kitchens today. In
the early 1990s, Mr. Coveley incorporated Omega Digital Data Inc.
(“Omega”).
[11]
Mrs. Coveley
earned a Bachelor of Arts in Korea, and completed an Executive MBA at the
University of Toronto while working for Omega. She was recognized as a woman
entrepreneur of Canada in 2004.
[12]
Omega folded in 1998,
approximately 6 months after the appellants resigned. The appellants each
claimed an ABIL in the amount of $1,252,000 resulting from Omega’s dissolution,
which they carried forward from 1999 until the ABILs ran out in 2004.
[13]
During the years in
issue, the appellants did not draw their salaries from cStar, instead they
automatically loaned them to cStar. cStar issued T4s to the appellants for those
salaries. According to the T4 of Mr. Coveley, from a salary of $135,267.76
for the 2005 taxation year, an amount of $2,500 was withheld for income tax
purposes while nothing was withheld for the Canada Pension Plan. According to
the T4 of Mrs. Coveley, from a salary of $135,555.92 for her 2005 taxation
year, an amount of $2,500 was withheld for income tax purposes and $1,861.20
was withheld for the Canada Pension Plan. The same pattern of minimal
withholdings occurred in the other taxation years. Without their claims for non‑capital
losses to offset their incomes, the appellants would have owed considerably
more in taxes.
[14]
The salaries of the
appellants were determined by Mrs. Coveley with the assistance of cStar’s
accountant, Mr. Draganjac. Those salaries were based on the scientific
research and experimental development (“SRED”) credit available in each year.
The amounts received by cStar as SRED credit were based in part on the salaries
paid by cStar for scientific research.
[15]
In light of cStar’s
innovative technology, the appellants firmly believed that one day cStar would
be successful and profitable. This is why the appellants chose to continue
cStar’s operations.
cStar
[16]
During the taxation years under
appeal, Mrs. Coveley was the president, chief executive officer and sole
shareholder of cStar.
[17]
During the taxation years under
appeal, Mr. Coveley was the chief technology officer and senior vice-president
of cStar, but he was never a shareholder. He stated that he did not need to be
a shareholder because he and his wife were good partners and he trusted her.
[18]
Mr. Draganjac was cStar’s
external accountant. He began acting as the external accountant shortly after
cStar was founded and was the external accountant during the taxation years
under appeal.
[19]
Mrs. Coveley was in charge of
cStar’s financial affairs and performed the final review of its ledgers and
other accounting records before sending them to Mr. Draganjac.
[20]
Mr. Coveley was not involved
in cStar’s financial affairs. He trusted his spouse with all of his and cStar’s
financial affairs. His salary was determined by his spouse, Mrs. Coveley,
and by Mr. Draganjac. He did not review his income tax returns prior to
signing them. He knew that his salary was being loaned to cStar, but was not
aware of the amounts of the loans.
[21]
The number of cStar’s employees varied between 6
and 20 during the years under appeal.
[22]
Mr. Coveley stated that, through cStar, his engineering
team developed a virtual gateway and the world’s first wireless LAN. cStar
conceived many applications for the gateway, such as:
(a)
wireless vending equipment
and protocols to enable vending machines to communicate with technical support
and to be monitored remotely;
(b)
the world’s first
protocol for cell phone and hotel room key vending, allowing customers to use
their cell phones or room keys as e-wallets;
(c)
the “stealth tag”, a
chip about a tenth of the thickness of a human hair, used to assist in the inspection
of products shipments; the chip is connected to a “hair” that runs around the
edge of the shipping paper and act as an antenna; if that antenna is broken, as
by breaking into the shipping container, the chip in the shipping paper will reveal
this to the government inspectors; this stealth technology would assist in
tracking fraudulent medication and other such substances being shipped around
the world;
(d)
a device to track
equipment in hospitals and thus help detect thefts, and also to track where doctors,
patients and even visitors are located in a hospital;
(e)
a dispensing machine for
reagents poisons and dangerous substances used in hospital research centres;
the machine cStar invented would give researchers access to such products at
all hours; access to drugs could also be tracked by the device.
[23]
During the years under
appeal, cStar applied for SRED credits. While Mrs. Coveley was in charge
of the applications for SRED credits and the subsequent financial audits,
Mr. Coveley was responsible for the scientific side of the applications.
[24]
During the years under
appeal, cStar did not generate significant revenues. It derived its operating
funds from the SRED credits and from third-party investors.
[25]
Mr. Coveley owned
many patents. Some of them did not fit the business model of cStar.
Mr. Coveley stated that he would assign patents to cStar once they fitted
cStar’s business model.
The appellants’ investments in and loans to
cStar
[26]
Mr. Coveley could
not remember how much start-up money he invested in cStar at the time of
incorporation. He stated that with his savings he paid for the equipment and,
before the incorporation of cStar, paid the salaries of the engineers.
(a) The appellants’ loans to cStar
(i) Salaries
[27]
The appellants’ unpaid
salaries constituted the major part of the loans made by them to cStar. The
appellants’ salaries over the years were:
|
|
Mr.
Coveley
|
Mrs.
Coveley
|
|
1999
|
n/a
|
n/a
|
|
2000
|
$304,000.00
|
$200,000.00
|
|
2001
|
$200,311.00
|
$200,000.00
|
|
2002
|
$200,000.00
|
$200,000.00
|
|
2003
|
$135,418.00
|
$135,485.00
|
|
2004
|
$80,317.00
|
$140,589.00
|
|
2005
|
$135,267.76
|
$135,555.92
|
|
2006
|
$140,274.56
|
$140,572.64
|
(ii) Expenses of cStar paid by the
Coveleys
[28]
The appellants also
loaned money to cStar to cover its expenses. They used their personal credit
cards to do so. Mrs. Coveley stated that, since cStar did not have any
income, it could not apply for a credit card.
[29]
Therefore, in addition
to the unpaid salaries, cStar owed the Coveleys all the expenses incurred by
them on its behalf. The interest and annual fees on the appellants’ credit
cards were also charged to cStar in their entirety and formed part of the
appellants’ loan accounts with cStar.
[30]
Both appellants repeatedly
testified that none of the amounts credited to the cStar loan accounts were
personal in nature. Mrs. Coveley stated that only in exceptional
circumstances would the appellants use their credit cards for personal
expenses. On such occasions, the expenses would be identified on the credit
card statements as personal expenses and would not be included in the loan
accounts of cStar.
[31]
However, according to
the respondent, during the years 1998 to 2005, both appellants charged personal
expenses to cStar and had the expenses recorded as loans owing by cStar to
them. In Mrs. Coveley’s case, the personal expenses amounted to
$209,185.28, while in Mr. Coveley’s case they amounted to $19,405.47.
(iii) Mrs. Coveley’s second
mortgage
[32]
Mrs. Coveley took out
a second mortgage on the family residence for an amount of $77,000, which she
loaned to cStar.
(iv) Mrs. Coveley’s family
[33]
In 1998,
Mrs. Coveley’s family in Korea and in Japan made personal loans to
Mrs. Coveley in the total amount of $126,900 plus interest. There was no
documentation supporting the loans to Mrs. Coveley from her family.
Mrs. Coveley loaned the amounts in question to cStar, where they formed
part of Mrs. Coveley’s loan account.
(b) Interest on the
appellants’ loans
[34]
There is contradictory
evidence as to whether the loans made by the appellants to cStar were interest
bearing. Mrs. Coveley submitted in evidence two promissory notes, one for
Mr. Coveley and the other one for herself. Both promissory notes were signed by
Mrs. Coveley. The promissory notes, dated April 7, 1998 state: “The
undersigned hereby promises to repay on demand all past and future loan
advances made by [the Appellants] to 1288145 Ontario Limited [now cStar] plus
simple interest at ten percent (10%)”.
[35]
Although Mr. Coveley
relied on his promissory note to support the claim for interest, his testimony on
this point was less than clear. On cross-examination, he stated interest
accrued on his loans for the first two or three years. At that point, he stated,
cStar’s accountant, Mr. Draganjac, told him that there was no point in
claiming interest because the loans would not be repaid for quite a while, so
adding interest was pointless. As Mrs. Coveley agreed with
Mr. Draganjac’s decision and since she was in control of the management
and financial side of cStar, Mr. Coveley went along with the decision not
to accumulate interest on his loans.
[36]
The documentary
evidence did not support the contention that the appellants’ loans were
interest bearing. In their returns for the 2005 taxation year prepared by Mr.
Draganjac, it was indicated that an ABIL was claimed for “Funds advanced from
1998 to March 31, 2005 – Non interest bearing”. In addition, no
interest income was included in the income of the appellants. cStar never paid
interest to the appellants and the interest on their loans was not accounted
for in cStar’s financial statements. However, Mrs. Coveley testified that
cStar kept its own separate accounting record of the accumulated interest.
[37]
Moreover, in a letter
faxed to Dr. Waters, an important investor in cStar, on December 11, 2003,
Mrs. Coveley indicated that “[n]o interest was accrued on Unpaid Salary
and Startup Capital injected by M Coveley & S Coveley”.
[38]
On July 12, 2006,
Mr. Draganjac, on behalf of the appellants, similarly indicated on the
ABIL questionnaire faxed to the Canada Revenue Agency (the “CRA”) that the
interest on the loans was “0”.
[39]
During his testimony,
Mr. Draganjac stated that the response on the questionnaire was a mistake
by his accounting firm and that the loans bore interest. In response to a
letter dated August 16, 2007 from Ms. Paajanen, appeals officer at the
CRA, Mr. Draganjac indicated that Mr. Coveley’s loan bore interest at
the rate of 10%. No supporting document was provided by Mr. Draganjac to
Ms. Paajanen at that time.
Third-party loans and investments
(a) Victor Chen
[40]
Mr. Victor Chen,
who was a classmate and friend of Mrs. Coveley while she was studying for
her executive MBA, made two loans to Mrs. Coveley for cStar: the first one, on
October 14, 1998, was an amount of $20,000; the second, on
October 11, 2000 was an amount of $15,000. The loans were repaid to
Mr. Chen on August 18, 2005 with compound interest.
(b) Dr. William Robert Waters
[41]
Dr. William Robert Waters,
a professor of Mrs. Coveley while she was studying for her executive MBA,
started investing in cStar on October 26, 1998, when he subscribed
for 200,000 common shares at a price of $10 per share.
[42]
Beginning on October
31, 2000, Dr. Waters loaned funds to cStar in monthly instalments of
$100,000. The last such advance from Dr. Waters was made on October 31, 2003. By then, the loan amounted to $3.7
million. Although Dr. Waters tried to formalize his original purchase of
shares and the loan, he was unable to reach an agreement with Mrs. Coveley.
Hence, no written agreement existed between cStar and Dr. Waters.
[43]
cStar used the SRED
credits it had received to reimburse $1.4 million to Dr. Waters. cStar
stopped repaying Dr. Waters after January 31, 2003.
[44]
A company named XDL was
interested in buying Dr. Waters’ interest in cStar. A due diligence review
was undertaken by XDL. The deal fell through because XDL wanted more control
over the management of cStar. According to Dr. Waters, at XDL they “were
uncomfortable when all was said and done with what arrangement they could make
with Mr. Coveley and Mrs. Coveley. I think it was fair to say that
they felt that there was not enough strength in what they had to offer to
follow through with me, since any arrangement they made was not simply taking
my shares but from their perspective was involving themselves in the management
of the organization to a considerable degree”.
[45]
Dr. Waters decided
to sell his investment in cStar and his cStar debt, since Mrs. Coveley did
not want to sign a general security agreement strengthening his position
regarding his investment. Mrs. Coveley did not want to lose control over
cStar’s technology. Dr. Waters was also of the view “that the company was
not going to be able to continue effectively”.
[46]
Dr. Waters sold
his shares (for which he had paid $2 million) to Toris Investment (“Toris”) for
$20,000, and the $ 2.3 million debt owing to him, he sold to Toris for
$130,000.
[47]
In July 2006, the president
of Toris came to Dr. Waters and told him that there was hope again for
cStar. As a result, through Toris, Dr. Waters loaned $105,000 to cStar on
July 31, 2006. Dr. Waters made multiple advances to cStar in the following
months through Toris. Dr. Waters stated that by December 21, 2007,
cStar owed Toris an amount of $2,015,000.
(c) 2060845 Ontario Inc
[48]
After Dr. Waters
stopped funding cStar in 2003, cStar continued its operations with the
assistance of another investor, 2060845 Ontario Inc. (“206”). The persons
behind 206 were people that Mr. Draganjac introduced to the Coveleys. Under a
joint venture agreement, 206 agreed to contribute $3,300,000 to cStar at the
rate of $75,000 per month. Mrs. Coveley testified that the agreement was
conditional on cStar generating revenue. She stated that notice was given by 206
almost immediately upon signing that the lending would stop in December 2005.
An amount of $ 900,000 was invested in cStar by 206.
(d) Mr. Joseph Draganjac
[49]
Mr. Joseph
Draganjac loaned money personally to Mrs. Coveley for cStar. This was
quite unusual since he was the accountant for both cStar and the appellants. He
testified that he made the loans because they were “friends” and she was “desperate”.
The first loan of $50,000 was made on November 25, 2004 and repaid on
April 29, 2005. The
second loan of $50,000 was made on August 17, 2005 and paid back by
Mrs. Coveley on November 10, 2005. Mrs. Coveley stated that
she used the second personal loan from Mr. Draganjac to repay
Mr. Chen.
(e) Mrs. Coveley’s Family
[50]
As I stated earlier, in
1998 the family of Mrs. Coveley in Korea and in Japan loaned her an amount
of $126,900 plus interest. Mrs. Coveley then loaned the funds to cStar. As
of December 31, 2005, cStar still owed $116,000 to Mrs. Coveley.
The bad debt determination
[51]
Mrs. Coveley and
Mr. Coveley claimed ABILs of $1,191,757.74 and $1,659,982.92 respectively
on their 2005 income tax returns. They amended their ABIL claims on October 7,
2011, namely, the day they filed their Amended Notices of Appeal. The new ABIL
claims were $766,577.91 for Mrs. Coveley and $1,745,671.02 for Mr. Coveley.
[52]
Both appellants
testified that as of December 31, 2005, their prospects of collecting
their loans from cStar were non-existent. According to Mrs. Coveley, after
206 stopped funding cStar in November 2005, cStar was no longer able to meet
its obligations of approximately $85,000 monthly. In addition, the premises of
cStar were hit by a tornado in August 2005 and Mr. Coveley had become ill
in 2004.
[53]
With annual expenses averaging
approximately $1 million, cStar reported a net loss in each year of its
operations during the relevant period. cStar’s yearly financial statements for
its taxation years ending on March 31 reflect the following:
|
|
Revenues
|
Expenses
|
SRED Credits
|
Net Loss for
the Year
|
Accumulated
Deficit
|
|
1999
|
$0
|
$1,569,223
|
$321,580
|
$1,247,643
|
$1,247,643
|
|
2000
|
$ 49,241
|
$1,445,308
|
$300,627
|
$1,111,218
|
$2,358,861
|
|
2001
|
$ 76,905
|
$1,412,364
|
$354,200
|
$1,363,559
|
$3,368,220
|
|
2002
|
$215,810
|
$1,563,468
|
$481,649
|
$ 866,009
|
$4,234,229
|
|
2003
|
$121,379
|
$1,357,467
|
$427,694
|
$ 929,773
|
$5,164,002
|
|
2004
|
$171,972
|
$1,158,280
|
$395,068
|
$ 847,620
|
$6,011,622
|
|
2005
|
$ 82,140
|
$ 891,174
|
$335,968
|
$ 709,916
|
$6,721,538
|
|
2006
|
$0
|
$1,018,622
|
$367,352
|
$ 905,404
|
$6,676,942
|
[54]
Besides owing money to the
appellants, cStar was also indebted to Dr. Waters and 206. Furthermore, according
to Mrs. Coveley, the world economic situation was not favourable to cStar
in 2005. She pointed to the dot-com bubble, the tragic events of 9/11 and the
severe acute respiratory syndrome (“SARS”) outbreak.
[55]
A tornado hit the cStar
premises on August 19, 2005. The storm lifted the roof off the building and
forced sewage up the drains. Due to the flood, cStar lost equipment and
documents. Some compensation was recovered from the insurance company in 2005
and in 2006.
[56]
Mr. Coveley, who
was the “top gun” at cStar, had been working very long hours in order to
prepare for the demonstration of the Stealth Tag to the US Department of
Homeland Security. Exhausted by his work, he became ill and was hospitalized with
a double pneumonia in December 2004. In March 2005, he relapsed and was rushed
to the hospital, where he was in intensive care for a cardiopulmonary failure; as
a result he subsequently had to cut his hours of work to not more that nine a
day and he was no longer able to travel.
[57]
Despite these negative
events, the evidence showed that there was still hope for cStar in 2005. A
pilot project with respect to the wireless vending machine was conducted at the
Ambassador Hotel in Kingston beginning on March 7, 2005. The pilot
project was a success and created positive media coverage for cStar. A
quotation for the “WLAN Cashless SkyGate Vending Genie System for Hotels ‑ Room
Key Card Vending option only” was given to Bell Canada on July 21, 2005,
the price quoted being $2,243,000. In August 2005, Coca-Cola Inc. expressed
interest in the wireless vending machine. Mrs. Coveley stated the
following in an e‑mail to cStar’s engineers on January 5, 2006:
[M]y gut feeling is that they [Coca-Cola]
will go with our solution for these hotels in Canada . . . because they are
running out of time. (thanks to Pepsi’s announcement). They want to beat Pepsi
with real ‘deployment/pilot or not’ rather than just announcement which Pepsi
just made . . . Folks, we will have a great year! I smell it big time! – End of
a huge report!!!
[58]
In 2006, cStar entered
into a working arrangement with Lucent Technologies Inc. (“Lucent”). Lucent is
an American multinational in telecommunication technologies. Pursuant to this
agreement, Lucent was to distribute cStar products and solutions. A list of
prices was sent by cStar to Lucent on March 16, 2006 and a Master Teaming
Agreement was entered between Lucent and cStar on April 25, 2006.
[59]
After a successful emergency
triage demonstration by cStar at the Sunnybrook Hospital in the late summer of
2005, cStar was contacted in March 2006 to do a similar triage at another
location, in the United States.
[60]
cStar was also having discussions
in 2005 with the US Department of Homeland Security, which had asked cStar in
December 2004 to organize a presentation of its “stealth tag” in Washington.
[61]
As I have already
stated, in July 2006 Dr. Waters, through Toris, started re‑investing
in cStar. In addition, cStar could use its SRED credits for its 2004 and
following taxation years since cStar had stopped using the SRED credits to repay
Dr. Waters.
Timing of the bad debt
determination
[62]
Both the appellants
testified that they claimed an ABIL on Mr. Draganjac’s advice. In his
testimony, Mr. Draganjac summarized his ABIL recommendation to
Mrs. Coveley as follows:
Again if I recall, the
factors that went into the decision was no. 1, Mrs. Coveley for
herself and for her husband wanted to quantify their efforts in this business,
their sweat equity, if you will, so that was one of the issues.
The other issues or the other
issue was I believe, and again the specifics I don't know, but I believe one of
the investors Dr. Waters, I know he was an investor, there was part of his
investment was in shares, and part of it was his loans. I believe the
arrangement with him was that at some point these loans would be turned into
shares for him and for Mr. and Mrs. Coveley. So the fact that they took a
salary to reflect their efforts in the business would have increased their
loans because they were not taking the money. It was basically their
consideration was the debt from the company rather than actual funds.
Of course the third
consideration with these management salaries was the SR&ED component
because that was just like all technology companies, they depended to a great
extent on that program, and taking salaries or not taking salaries made a big
difference in terms of the SR&ED credit. That was, to the best of my
recollection, the discussion we had, and then it was at that point that I
advised Mrs. Coveley that I think we have a legitimate claim for this ABIL
to basically offset those salaries.
[63]
Mr. Draganjac
testified that he was not aware of any attempts made by the appellants to
recover their loans.
[64]
The appellants did not submit any
evidence with respect to efforts they may have made to recover their loans.
[65]
cStar continued to
operate after the determination by the appellants that their debts had gone
bad.
[66]
Throughout 2005 and
2006, the appellants continued to loan their salaries to cStar. As a result,
their loan accounts increased again after 2005. cStar continued to purchase
equipment such as computers and wireless modems, and ordered business cards for
six people. Following the flood in August 2005, cStar added new facilities to
its lab, which resulted in the creation of a network operational centre.
Amount of the ABIL
[67]
The outstanding balance of the appellants’ loans to cStar on December 31, 2005 was
$1,745,671.02 for Mr. Coveley and $766,577.91 for Mrs. Coveley. These
amounts differ from the amounts of the ABILs that were originally claimed by
the appellants in their 2005 personal income tax returns filed on April 24, 2006.
[68]
Mr. Draganjac
recognized that his accounting firm made two mistakes with respect to the ABIL amounts claimed by the appellants.
[69]
The first mistake related to the
ABIL amounts: they were based on the figures in the financial statements of
cStar for the year ending on March 31, 2005 instead of being based on
the figures for December 31, 2005. Accordingly, the transactions that
occurred in the loan accounts of the appellants between March 31, 2005
and December 31, 2005 were not
taken into account in the original determination of the ABILs.
Mr. Draganjac did not correct the amount of the ABILs claimed by the
appellants. By the time he realized that there were mistakes, the appellants’
tax issues were being handled by the law firm of Thorsteinssons.
Mr. Draganjac assumed the corrections would have been made by counsel
handling the appellants’ tax issues.
[70]
The second mistake
acknowledged by Mr. Draganjac related to the accounting for Mrs. Coveley’s
loan. He stated that he had advised Mrs. Coveley to temporarily include in her loan account amounts that cStar received from
206, namely, $75,000 per month. He intended to advise her later on as to how to
properly enter these amounts in cStar’s accounting records. Mrs. Coveley
left the amounts received from 206 in her loan account. Accordingly, Mrs. Coveley’s
loan account and hence her ABIL was overstated by $300,000 on March 31, 2005 and by $900,000 on December 31, 2005. The amounts
received from 206 should have being capitalized in cStar instead of being
reflected in Mrs. Coveley loan’s account.
[71]
Mr. Draganjac testified that
he corrected the error on cStar’s 2006 income tax return, but did not make any
adjustments to Mrs. Coveley’s loan account on her income tax return for
the 2006 taxation year. Mrs. Coveley stated that she did not notice that
her ABIL was overstated in 2005 since she had signed her 2005 income tax return
without reviewing it.
[72]
Mr. Draganjac
stated that he relied on the amounts provided by Mrs. Coveley when he made
the claim for her ABIL in 2005. Moreover, in the course of the review of Mrs. Coveley’s
ABIL, the CRA requested evidence with respect to the $300,000. On
January 7, 2008 Mr. Draganjac, on behalf of the appellants,
faxed to the CRA the backs of the four deposit slips for $75,000 in order to
justify Mrs. Coveley’s loan account.
The four deposit slips were forwarded to him by cStar on
January 3, 2008.
[73]
Mrs. Coveley admitted that the backs of the deposit slips were faxed
to Mr. Draganjac’s office,
but she stated that she was not aware that the four deposit slips had been sent
to the CRA to justify her ABIL amount. She added that this was one of the
reasons the appellants filed a statement of claim against Mr. Draganjac in
the Ontario Superior Court of Justice in February 2012.
[74]
On February 25, 2011,
the appellants recognized for the first time that Mrs. Coveley’s ABIL was
overstated by $300,000, when their newly appointed counsel filed a
supplementary list of documents. This updated list of documents provided new
calculations made by Mrs. Coveley to correct not only the failure to
include transactions that occurred between cStar’s fiscal year-end and the end
of the 2005 calendar year, but also the misallocation to Mrs. Coveley’s
loan account of funds injected from 206 in cStar. The appellants then filed an
Amended Notice of Appeal reflecting those changes on October 7, 2011.
[75]
I was not convinced by
Mrs. Coveley’s testimony that she was not aware that her ABIL was
overstated. She admitted that she had submitted to
Mr. Draganjac at the end of each year the figures for the loan account balances
for her and Mr. Coveley. The numbers she submitted to Mr. Draganjac
for her loan account in 2005 would have been overstated by $900,000 at the end
of December 2005. When asked whether she was responsible for the numbers sent
by cStar, she stated it was Mr. Draganjac’s job to correct the numbers if
they were wrong. It was clear from
the evidence, however, that Mrs. Coveley was hands-on with respect to her
and cStar’s financial affairs. She had to know that
her loan account was overstated.
[76]
Mrs. Coveley is a smart and educated
woman. I find it difficult to accept that she would have not reviewed her 2005
income tax return and noticed that her ABIL was overstated.
[77]
While this evidence does not affect her
entitlement to claim an ABIL, it does bring into question her credibility as
well as Mr. Draganjac’s.
D. Law and analysis
[78]
Both parties relied on the four
requirements to be met in order to claim an ABIL established by the Federal
Court of Appeal in Rich v Canada, 2003 FCA 38, [2003] 3 FC 493.
[79]
Pursuant to paragraph 38(c)
of the Act, a taxpayer's allowable business investment loss for a taxation year
from the disposition of any property is one half of the taxpayer's business
investment loss for the year from the disposition of that property.
[80]
“Business investment loss” is
defined in part as follows at paragraph 39(1)(c): “a taxpayer's business
investment loss for a taxation year from the disposition of any property is the
amount, if any, by which the taxpayer’s capital loss for the year from a
disposition after 1977 . . . to which subsection 50(1) applies”, exceeds any of
the amounts subsequently referred to.
[81]
Subsection 50(1)
provides:
50. (1) Debts
established to be bad debts and shares of bankrupt corporation - For the
purposes 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
(b) a
share (other than a share received by a taxpayer as consideration in respect of
the disposition of personal-use property) of the capital stock of a corporation
is owned by the taxpayer at the end of a taxation year and
(i) the corporation has during the
year become a bankrupt (within the meaning of subsection 128(3)),
(ii) the corporation is a
corporation referred to in section 6 of the Winding-up Act that is
insolvent (within the meaning of that Act) and in respect of which a winding-up
order under that Act has been made in the year, or
(iii) at the end of the year,
(A) the corporation is insolvent,
(B) neither the corporation nor a
corporation controlled by it carries on business,
(C) the fair market value of the
share is nil, and
(D) it is reasonable to expect that
the corporation will be dissolved or wound up and will not commence to carry on
business
and the taxpayer elects in the
taxpayer’s return of income for the year to have this subsection apply in
respect of the debt or the share, as the case may be, the taxpayer shall be
deemed to have disposed of the debt or the share, as the case may be, at the
end of the year for proceeds equal to nil and to have reacquired it immediately
after the end of the year at a cost equal to nil.
[82]
Subparagraph 40(2)(g)(ii)
provides:
(g) a
taxpayer's loss, if any, from the disposition of a property, to the extent that
it is
. . .
(ii) a
loss from the disposition of a debt or other right to receive an amount, unless
the debt or right, as the case may be, was acquired by the taxpayer for the
purpose of gaining or producing income from a business or property (other than
exempt income) or as consideration for the disposition of capital property to a
person with whom the taxpayer was dealing at arm's length,
. . .
is nil.
[83]
According to the Federal Court of
Appeal decision in Rich, in order to claim an ABIL under paragraph
50(1)(a) of the Act and accordingly be deemed to have disposed of their
loans for nil proceeds of disposition, the appellants have to establish that:
1. debts were owed to them
by cStar, pursuant to subsection 50(1) of the Act;
2. the debts were incurred
for the purpose of gaining or producing income from a business or property
under subparagraph 40(2)(g)(ii) of the Act;
3. in
2005, cStar was a small
business corporation as defined in subsection 248(1) of the Act, pursuant to
paragraph 39(1)(c); and
4.
their debts became bad in 2005, pursuant to
subsection 50(1).
[84]
The respondent does not dispute
that cStar was a small business corporation.
(a) Was there a debt owed to the appellants by cStar?
[85]
Mr. Coveley and Mrs.
Coveley assert that cStar
owed them $1,745,671.02 and
$766,577.91 respectively on December 31, 2005. The greater part of
the debts owed to the appellants by cStar is composed of unpaid salaries and of
expenses that the appellants had paid on behalf of cStar.
[86]
The respondent argues that the
appellants were not able to establish the amounts of the debts, since they had
modified the amounts thereof in their Amended Notice of Appeal and had tendered
no original documentation in evidence to support the new ABIL numbers. I do not
agree with the respondent. I am satisfied with respect to the new corrected
amounts claimed by the appellants. It was clear that the ABIL was computed as
of March 31, 2005 instead of December 31, 2005. In
addition, it was established that the ABIL claimed by Mrs. Coveley was
overstated by $300,000.
[87]
I will now deal with whether the
expenses paid by the appellants on behalf of cStar and the unpaid salaries can
form the basis of the debt owed to the appellants. I will later analyze whether
some of the expenses paid by the appellants were personal expenses of theirs or
were unreasonable in the circumstances.
[88]
A “debt” is broadly defined in Black’s
Law Dictionary as a “[l]iability on a claim; a specific sum of money due by
agreement or otherwise” (7th ed., 1999, at page 410).
[89]
The appellants used their credit
cards to pay the corporate expenses of cStar. By crediting these expenses to
the appellants’ loan accounts, cStar acknowledged that the amounts were owing
to the appellants. Consequently, cStar did owe a debt to the appellants with
regard to the payment of the corporate expenses.
[90]
Also, I agree with the appellants
that their accrued salaries form part of cStar’s loan accounts. This is
consistent with this Court’s finding in Sunatori v The Queen,
2010 TCC 346, 2010 DTC 1234, aff’d 2011 FCA 254, 2011 DTC 5153. In that case,
the appellant received his salary by delivery of a cheque from his employer on
December 31 of each year. On the same day, the appellant gave his employer a
cheque for the same amount as a loan. Neither cheque was ever presented for
payment. Justice Hershfield declared that the end result was “essentially a
bookkeeping entry of the indebtedness of the company for this loan the Appellant
made to the company” (at paragraph 12). Justice Hershfield concluded that the
appellant’s unpaid salary constituted a loan which could validly give rise to
an ABIL claim. The Federal Court of Appeal affirmed his decision.
[91]
The respondent submits that the finding in Sunatori is
inapplicable to the present appeals on the basis that no negotiable
instruments, such as cheques, were exchanged between cStar and the appellants.
However, there is undisputed evidence that the appellants were employed by
cStar and that their salaries, although not actually paid by cStar, were recorded
by cStar in its accounting records. The accrued salaries were credited to the
appellants’ loan accounts. In my view, this is sufficient to establish the
existence of debts owed to the appellants by cStar.
[92]
This finding is also consistent
with Justice Webb’s decision in Morrison v The Queen, 2010 TCC 429,
2010 DTC 1288, where the absence of a negotiable instrument did not prevent
Justice Webb from concluding that the amount of the accrued but unpaid salaries
had been properly added to the appellants’ loan accounts. In her written
submissions, counsel for the respondent tried to distinguish Morrison by
pointing out that, in that case, cheques had been exchanged between the
appellants and their employer to effect both the payment of the salaries and
the payment of advances to the employer for the taxation year. However, in Morrison
no cheque was issued to the appellants for the following taxation year and the
salary for that year was credited to the appellants’ respective shareholder
accounts.
[93]
For these reasons, I believe that a debt was owed to the appellants by cStar.
(b) The debt
was incurred for the purpose of gaining or producing income from a business or
property
[94]
Subparagraph 40(2)(g)(ii)
of the Act denies the loss on a debt
where the loan was not made “for the purpose of gaining or producing income
from a business or property”. As recognized by the respondent, it is not
necessary that the taxpayer’s purpose in making the loan be exclusively or
primarily to produce income. The Federal Court of Appeal held in Rich,
at paragraph 10, that a subordinate purpose is sufficient for the purpose test
to be met.
[95]
The appellants bear the onus of
establishing that they had a genuine intention to earn income from a business
or property through the advances they made to cStar: see Rondeau v The Queen,
2004 TCC 321, 2008 DTC 3874, at paragraphs 38 and 39.
[96]
As a shareholder of cStar, Mrs.
Coveley could potentially have earned dividend income. In The Queen v Byram,
99 DTC 5117, the Federal Court of Appeal held that the possibility for a
shareholder to earn dividend income may create a sufficient nexus between a
loan and an income-earning purpose. Justice McDonald stated at paragraph 22:
. . . Where a
shareholder provides a guarantee or an interest free loan to that company in
order to provide capital to that company, a clear nexus exists between the
taxpayer and the potential future income. Where a loan is made for the purpose
of earning income through the payment of dividends, this connection is
sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).
[97]
Byram is applicable to Mrs. Coveley. She meets the
requirement of paragraph 40(2)(g) of the Act, as there is a sufficient
nexus between her loans to cStar and the prospect of earning dividends.
[98]
The respondent argued that
Mrs. Coveley’s loan to cStar was not made to earn business income namely
for the period of August 4, 2005 (when cStar tax return for 2005 was
filed) to December 31, 2005, because the funds were advanced at a time where
there was no reasonable prospect of recovery.
[99]
The respondent relies on the
decision of this Court in Kyriazakos v The Queen, 2007 TCC
66, 2007 DTC 373, to assert that part of an ABIL may be disallowed if amounts
continued to be loaned to the debtor after it became clear that there was no
possibility of earning income on the loan. That case does not support the
respondent’s position. The reasons for which part of the ABIL claimed by the
appellant in Kyriazakos was disallowed were rather that (1) at the time
part of the funds were injected into the debtor corporation, the appellant had
ceased to be a shareholder, and (2) the appellant had not specified any
interest rate on the debt.
[100]
Furthermore, the respondent’s
position that no purpose of gaining or producing income form a business or
property can be inferred if the debtor was in a difficult financial position
when the funds were advanced is inconsistent with this Court’s decisions in Daniels
v The Queen, 2007 TCC 179, 207 DTC 883, and Scott v The Queen,
2010 TCC 401, 2010 DTC 1273.
[101]
In Daniels, Justice
Hershfield relied on the Federal Court of Appeal’s decision in Rich in
holding that even a faint hope of producing income is sufficient. He stated:
42 Recalling
that the purpose of the ABIL is to encourage investment in small Canadian
businesses, it is little wonder to me that a Court would accept a faint hope as
sufficient to meet the requisite purpose test. When a family business
experiences financial difficulty, the objective rationality of rescue motives
might always be questionable with hindsight. Considerable tolerance seems
essential. In my view Rich stands for such principle.
[102]
In Scott, Justice Boyle
similarly held that it is not unreasonable to continue to advance funds to an
insolvent corporation, particularly where making the advance is the only
reasonable means of recovering the initial investment. Justice Boyle therefore
allowed the appellant to claim an ABIL.
[103]
Contrary to Mrs. Coveley,
Mr. Coveley is not a shareholder of cStar. Accordingly, his loan advances
could not yield dividends. The appellants testified that Mr. Coveley’s
advances to cStar bore interest at prescribed rate of 10%, as evidenced by the promissory
notes allegedly signed by Mrs. Coveley on April 7, 1998.
[104]
The appellant have not convinced
me that the loans they made to cStar bore interest. Apart from the promissory
notes, the documentary evidence did not support the contention that the
appellants’ loans were interest bearing. I have outlined the evidence with
respect to the issue of interest at paragraphs 34 to 39 above, without
repeating all the evidence - their 2005 tax returns indicated no interest - the
letter faxed to Dr. Waters by Mrs. Coveley in 2003 indicated no interest
bearing - the ABIL questionnaire dated July 12, 2006 also indicated that the
interest on the loans was 0. I agree with the respondent that the promissory
notes were more than likely created after CRA began its audit. Therefore, the
appellants did not demolish the assumption of fact made by the Minister that
the loans to cStar did not bear interest.
[105]
In their written submissions, the
appellants stated that Mr. Coveley’s advances were made “not only to earn
interest on his promissory note, but also to earn employment income for
himself”. The appellants relied on the decisions in The Queen v F.H. Jones
Tobacco Sales Co., [1973] FC 825, Lomas Development Ltd v The
Queen, 96 DTC 1942, McKissock v R, [1997] 1 CTC 2182, and MacCallum
v The Queen, 2011 TCC 316, 2011 DTC 1225. While these cases
support the position that subparagraph 40(2)(g)(ii) should not be given
a narrow and mechanical reading, they do not hold that earning employment
income suffices to meet the purpose test. The wording of subparagraph 40(2)(g)(ii)
is clear: where there is “a loss from the disposition of a debt” the debt has
to have been “acquired for the purpose of gaining or producing income from a
business or property”.
[106]
Accordingly, I am of the view that
the condition that the debt be incurred for the purpose of gaining or producing
income from a business or property is fulfilled for Mrs. Coveley, but not
for Mr. Coveley. His ABIL claim must therefore be disallowed.
(c) Did the
debt became bad in 2005?
[107]
Pursuant to paragraph 50(1)(a),
the appellants must show that they honestly and reasonably determined that
their debt became a bad debt in the 2005 taxation year.
[108]
Unless there is some evidence that
collection of the loan was reasonably possible and that proactive steps could
have resulted in the collection of all or part of the loan, it is not necessary
for the appellants to prove that all possible recourses for collection were
exhausted. What is required is an honest and reasonable assessment by the
appellants that their debt had gone bad (Rich, at paragraph 15).
[109]
As stated by Justice Rothstein in Rich,
“[t]he assessment of whether a debt is bad is one based upon the facts at a
particular point in time” (at paragraph 12). In the present appeals, the
relevant point in time is the last day of the relevant taxation year of the
taxpayers, i.e. December 31, 2005. The appellants and the respondent
agree that, while they do not constitute an exhaustive list, the following
factors enumerated by Justice Rothstein in Rich are to be assessed to
determine if the debt had become bad at that date:
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.
1. History and age of the debt
[110]
The appellants started advancing
funds to cStar in 1998 and continued to do so until 2005. No repayments were
made with respect to the major part of the loans, namely the salaries.
2. Financial
position of cStar, its revenues and expenses, whether it was earning income or
incurring losses, its cash flow and its assets, liabilities and liquidity
[111]
Since its creation, cStar has never been profitable. With
annual expenses averaging approximately $1 million, it reported a net loss in
each year of its operations during the years under appeal. cStar’s accumulated
deficit as of March 31, 2006 amounted to $6,676,942. Mrs. Coveley
testified that she realized at the end of 2005 that she could not secure six
months of financing for cStar. cStar had payroll obligations, accounts payable,
no sales and very limited cash. The interest on Dr. Waters’ loan kept
accumulating and the appellants owed significant amounts on their personal
credit cards.
[112]
The appellants testified that
Mr. Coveley’s health problems and the tornado that hit Toronto on
August 19, 2005 negatively impacted cStar’s financial situation.
cStar received its last $75,000 monthly payment from its joint venture partner
on November 30, 2005. Both appellants stated that as of
December 31, 2005, they therefore could not recover the debt owed by
cStar.
[113]
On the other hand,
Mrs. Coveley seemed quite enthusiastic and positive about cStar’s
initiatives and events in 2005. In an e-mail dated January 5, 2006,
that Mrs. Coveley sent to cStar’s engineers, she stated: “Folks, we
will have a great year! I smell it big time! - End of a huge report!!!”
[114]
Her optimism was not mere bravado.
A number of events occurred in 2005 that held promise for cStar. On
March 7, 2005, cStar launched a successful project pilot for its
vending machine solution. Following that, on July 21, 2005, a quotation
of $2.243 million for the wireless room key card vending system was given by
cStar to Bell Canada. In the late summer of 2005, cStar conducted a
demonstration of an emergency triage at the Sunnybrook Hospital. During the
same period, cStar was having discussions with the US Department of Homeland
Security, which had asked cStar in December 2004 to organize a presentation of
its “stealth tag” in Washington. Mrs. Coveley also stated that she
regained hope when she learned in August 2005 that an executive of Coca-Cola
who had objected to contracting with cStar was leaving Coca-Cola. In addition,
after the tornado, a decision was made not only to repair cStar’s premises but
to improve their technological attributes.
[115]
While it is well established that
past and present circumstances are normally the main considerations in
determining whether a debt has gone bad, the Federal Court of Appeal left the
door open to the consideration of future prospects of the debtor company. In Rich,
Justice Rothstein declared at paragraph 14:
. . . 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.
[116]
Similarly in Sunatori,
Justice Hershfield stated that future prospects are particularly relevant if
the debt is not yet due, for example where no specific terms of repayment exist
(at paragraphs 46-56). In the present appeals, no terms of repayment were
agreed upon by the appellants and cStar. Consequently, I believe that prospects
of future repayment must be taken into account in the evaluation of whether the
appellants’ advances to cStar had become bad debts. As mentioned by Justice
Hershfield, a determination that a loan could not be repaid at the end of a particular
year does not mean that it is reasonable to consider that it constituted a bad
debt (at paragraph 55).
[117]
Although none of the negotiations
between cStar and potential clients had led to the signature of a lucrative
contract, the appellants were still of the view in 2005 that cStar would be
successful.
[118]
cStar was also quite active in
2006. A list of prices and quotations, including one for a $6.7 million
deployment, was sent to Pepsi at the beginning of 2006. Mrs. Coveley
testified that at that time she was optimistic that a large deployment of the
vending machines would occur. A Master Teaming Agreement was entered into
between Lucent and cStar on April 25, 2006. Pursuant to this
agreement, Lucent was to distribute cStar’s products and solutions.
3. Changes
in total sales as compared with prior years
[119]
Since cStar’s creation in 1998,
its sales have never exceeded its expenses. As shown in the chart below, cStar
had no revenue during its fiscal year ending on March 31, 2006.
cStar’s sales for its fiscal years ending on March 31 were as follows:
|
1999
|
2000
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
|
$0
|
$49,241
|
$76,905
|
$215,810
|
$121,379
|
$171,792
|
$82,140
|
$0
|
4. cStar's cash, accounts receivable and other
current assets at the relevant time and as compared with prior years
[120]
The following numbers representing
cStar’s current assets are taken from its yearly balance sheets for its fiscal
years ending on March 31:
|
|
1999
|
2000
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
|
Cash
|
$6,743
|
$147,254
|
$150,184
|
$74,838
|
$25,159
|
$84,663
|
$74,792
|
$17,353
|
|
Accounts
receivable
|
|
|
$38,453
|
$166,809
|
$230,375
|
$34,387
|
$7,475
|
nil
|
|
Inventory
|
$12,372
|
$42,992
|
$45,984
|
$65,031
|
$61,576
|
$44,859
|
$43,353
|
$13,353
|
|
Prepaid
expenses
|
$6,155
|
$6,155
|
$9,832
|
$11,861
|
$6,937
|
$6,887
|
$6,216
|
$6,216
|
|
SRED
tax credits
|
$361,349
|
$669,139
|
$1,031,653
|
$575,812
|
$492,066
|
$467,689
|
$350,239
|
$369,747
|
|
Loan
receivable
|
|
|
|
|
|
|
|
$50,000
|
|
TOTAL
|
$386,619
|
$865,540
|
$1,276,106
|
$894,351
|
$816,113
|
$638,485
|
$482,075
|
$456,669
|
[121]
While cStar’s accounts receivable and bank balances as at
March 31, 2005 were indeed lower than in previous years, the
differences are not significant.
5. cStar’s accounts payable and
other current liabilities at the relevant time and as compared with prior years
[122]
cStar’s accounts payable for its
fiscal years ending on March 31 were as follows:
|
1999
|
2000
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
|
$155,082
|
$229,675
|
$196,830
|
$150,056
|
$45,524
|
$48,032
|
$67,323
|
$85,404
|
[123]
Although the current liabilities
of cStar decreased over the years, there was a slight increase in 2005 and
2006.
6. General
business conditions in the country, in cStar’s community and in cStar’s line of
business
[124]
Little evidence was given by the
appellants regarding the world economic situation in 2005. Mrs. Coveley
testified that the bursting of the dot-com bubble, the tragic events of 9/11
and the SARS outbreak had negatively impacted cStar’s business. The dot-com
bubble collapse occurred in 2000-2001, 9/11 occurred in 2001, and the SARS
outbreak was in 2002-2003. I understand that these events may have had an
impact on cStar, but I fail to understand why the year 2005 would have been different
from the previous years in that regard.
7. Past
experience of the appellants with writing off bad debts
[125] The appellants each claimed an
ABIL in the amount of $1,252,000 resulting from
Omega’s dissolution in 1998. The non-capital losses were carried forward by the
appellants from 1999 until they
ran out in 2004.
[126]
The analysis of the seven factors
has showed that cStar financial position has not changed over the years. cStar
was in a difficult financial position but it was not a better or in a worse
position on December 31, 2005. Moreover, what I find problematic as
regards to the appellants’ ABIL claims is that the appellants continued to
advance funds to cStar throughout 2005 and after December 31, 2005. The
appellants continued advancing funds to cStar after 2005 by loaning their
salaries to it and by paying corporate expenses.
[127] cStar purchased nine computers and one projector for
its virtual gateway technology in 2005. Three of those computers were purchased
on November 22, 2005 and one was bought on
December 21, 2005. On November 11, 2005, cStar incurred a
$400 expense for vehicle lettering. Similarly, Mr. Coveley continued adding
new facilities to cStar’s lab after the flood that took place in August 2005,
which resulted in the creation of a network operational centre.
[128]
Furthermore, the renovations to cStar’s
premises following the tornado continued into 2006 and beyond. cStar issued purchase orders for computers and
wireless modems, and for business cards for six people in 2006.
[129] When asked why she continued to work for cStar without
being paid after 2005, Mrs. Coveley responded: “.
. . we have great assets, intellectual property, solutions, innovative
solutions but a little bit too advanced for the market, and we know someday we
will be there. Hope is there, but we know clearly this amount [of debt] we
cannot collect”.
[130]
In Giahinejad v
Canada, [2001] TCJ No 725 (QL), [2002] 1 CTC 2141, Judge Mogan of
this Court determined that because
the appellant was lending money to the debtor company at the very time that she
determined that the debt had become bad, the claim for an ABIL failed on that
basis alone. At paragraph 8, Judge Mogan stated:
8 Referring to the
Appellant not being able to recover the loans in 1997, on the evidence before
me, I could not possibly find that these debts owing to the Appellant by the
numbered company were bad debts at any time in 1997. Even on December 1, 1997,
the Appellant issued a cheque to the company for $1,830 which cheque was
deposited on December 4; and then again on December 28, she issued an even bigger
cheque for $2,975, which was deposited on December 29, 1997. She was
still investing money in this company in the last month of the year and,
indeed, in the last three or four days of the year. I cannot find, therefore,
that the company was insolvent or unable to pay her loans when she was still
lending money at the end of the year. On that basis alone, the Appellant's
appeal cannot succeed.
[131]
At paragraph 54 of Sunatori,
supra, Justice Hershfield, referring to Giahinejad,
held similarly:
54 Similarly, in Giahinejad, it is implicit that the future potential for
collection is relevant. Making advances implicitly suggests something positive
in the future which contradicts a bad debt determination at the time of the
advance. Following that rationale, a loan not due for some time cannot
reasonably be found to be bad today, where the prospects of collection when due
are promising as shown by recent advances and by the commitment and drive and
ongoing work of the debtor whose actions reflect no sign of an imminent failure
of the business.
[132]
The Federal Court of Appeal, in
confirming Justice Hershfield’s decision, declared:
7 . . . The appellant
cannot maintain at once that he made bona fide loans to his company and
that the loans gave rise to bad debts on the very day on which they were
advanced. A monetary loan, by definition, is an amount advanced in the
expectation that it be repaid and the appellant’s position throughout, which he
reiterated before us, is that he always thought that his company would be profitable.
[133]
Therefore, in my view the debt did
not become bad on December 31, 2005.
E. Objections
[134]
During the trial, the appellants
raised two objections that I took under reserve.
First objection
[135]
The appellants objected to the
respondent introducing as evidence a Statement of Claim filed by the appellants
in the Ontario Superior Court of Justice on February 12, 2012 against
cStar’s accountant, Mr. Draganjac, and his accounting firm, Draganjac
Pressman, Chartered Accountants, for breach of their duties and obligations
towards the appellants. One of the allegations in the Statement of Claim is
that Mr. Draganjac breached his duties and obligations towards the
appellants when he advised them to claim an ABIL in 2006 in circumstances where
he knew such a claim was not warranted.
[136]
The first objection of the
appellants is rejected and the Statement of Claim is to be filed as Exhibit R-1.
Mrs. Coveley acknowledged the allegations in the Statement of Claim.
Despite the contradictions, namely that before this Court the appellants argued
that they were entitled to claim an ABIL, yet before a different Court they
have submitted that an ABIL should not have been claimed and that
Mr. Draganjac and his firm should pay damages for advising them to do so.
I am prepared to view the Statement of Claim as a protective appeal in the
event that the present appeals would have been dismissed. It is clear that the
Statement of Claim is irrelevant in determining the appellant’s entitlement to
an ABIL.
Second objection
[137] The second objection by the appellants was that it was
too late for the respondent to argue in her Reply to the Amended Notice of
Appeal that some of the amounts charged to their loans account in cStar were
personal in nature and should not form part of the ABIL calculations. The
appellants argued that the respondent was barred from arguing this since the
Minister did not rely on that factual basis in reassessing the appellants. The
appellants submitted that by making these arguments the respondent was
indirectly reassessing expenses that had now been statute-barred for 5 to 11
years. In addition, the appellants argued that they were being prejudiced as
they no longer had the documents to justify their expenses, since they were
lost in the August 2005 flood.
[138]
In her Reply to the Amended Notice
of Appeal, the respondent added as an argument that some of the expenses
claimed by the appellants in computing their ABILs were personal expenses. The
appellants argued that in advancing that argument the respondent opted to ambush
the appellants with incomplete summaries from audit records. Accordingly, the
appellants submitted that the new arguments put forward in the respondent’s Reply
to the Amended Notice of Appeal should not be taken into account as it amounts
to the reopening of cStar’s 1998 to 2005 taxation years with respect to the
deductibility of those expenses.
[139]
The respondent argued that since
the appellants, through their Amended Notice of Appeal, sought to vary the
reassessments by amending the amounts that they claimed for their ABILs, the
appellants have to establish not only their entitlement to their ABILs but also
the amounts of the ABILs. According to the respondent, the appellants have to
establish that the amounts claimed as ABILs did not include personal expenses.
[140]
In addition, the respondent argued
that, by virtue of subsection 152(9) of the Act, she was entitled to argue in
her Reply that some expenses charged to cStar were personal expenses and should
not be included in the calculation of the appellants’ ABILs. Subsection 152(9)
states the following:
152(9) The Minister may advance an
alternative argument in support of an assessment at any time after the normal
reassessment period unless, on an appeal under this Act
(a) there
is relevant evidence that the taxpayer is no longer able to adduce without the
leave of the court; and
(b) it
is not appropriate in the circumstances for the court to order that the
evidence be adduced.
[141]
In light of my finding that the
appellants are not entitled to claim an ABIL, this objection is academic. However,
in case I may have erred in finding that the appellants did not prove the debt
was bad, I will nonetheless rule on the objection.
[142]
I do not agree with the respondent
that the appellants have the burden of establishing that they did not include
personal expenses in computing their ABIL claims. These facts were not part of
the Minister’s assumption. Therefore, the burden of proof is on the respondent
to establish on a balance of probabilities that they were personal expenses.
[143]
Subsection 152(9) authorizes the Minister
to advance an alternative argument in support of a reassessment after the
normal reassessment period. This Court’s decisions in Loewen v The Queen, 2007
CarswellNat 6381, 2007 TCC 703, and Toronto-Dominion Bank v The
Queen, 2008 DTC 3937, dealt with the application of subsection
152(9) of the Act.
[144]
In Toronto-Dominion Bank,
Justice Webb, relying on the unanimous decision of the Federal Court of Appeal
in Walsh, stated the following, at paragraphs 28 and 29, with respect to
the application of subsection 152(9):
[28] In Walsh v. The Queen, 2007 FCA 222,
[2007] 4 C.T.C. 73, 2007 DTC 5441, Justice Richard of the Federal Court of
Appeal made the following comments in relation to subsection 152(9) of the Act
:
18. The
following conditions apply when the Minister seeks to rely on subsection 152(9)
of the Act:
1) the Minister cannot
include transactions which did not form the basis of the taxpayer's
reassessment;
2) the right of the
Minister to present an alternative argument in support of an assessment is
subject to paragraphs 152(9)(a) and (b), which speak to the
prejudice to the taxpayer; and
3) the
Minister cannot use subsection 152(9) to reassess outside the time limitations
in subsection 152(4) of the Act, or to collect tax exceeding the amount in the
assessment under appeal.
[29] There is no
suggestion in this case that the Respondent is attempting to increase the
amount of the income of the Appellant to an amount that would be greater than
the amount included in the reassessment or to collect tax exceeding the amount
that was reassessed.
[145]
As to the interpretation to be
given to paragraphs 152(9)(a) and 152(9)(b), Justice Webb stated
that paragraphs (a) and (b) only apply where a taxpayer is before
the Federal Court of Appeal or the Supreme Court of Canada, since leave to
produce relevant evidence is not needed before this Court.
[146]
In Toronto-Dominion Bank,
Justice Webb stated that the death of the key witnesses did not fall within the
type of evidentiary problem contemplated by paragraphs 152(9)(a) and (b)
of the Act. At paragraph 48, he stated as follows:
As a result, I do not agree with the interpretation
of this provision as proposed by counsel for the Appellant and the Appellant
cannot succeed in its motion based on subsection 152(9) of the Act as this is
not a situation where the Appellant is no longer able to adduce evidence
without leave of the court. The evidentiary problem of the Appellant is not
that the Appellant requires the leave of the court to adduce evidence but that
key witnesses are now deceased. This type of evidentiary problem is not the
type of evidentiary problem contemplated by paragraphs (a) and (b)
of subsection 152(9) of the Act.
[147]
In these appeals, the respondent
is not adding a new transaction. The transaction is the same, namely the ABIL
claimed by the appellants. In my view, if
the expenses were of a personal nature, they cannot validly form part of an
ABIL claim as they would not have been incurred for the purpose of gaining or
producing income, as required under subparagraph 40(2)(g)(ii) of the
Act. In addition, the respondent is not increasing the amount of taxes owed,
and the type of evidentiary problem contemplated by the appellants does not
fall within the ambit of paragraphs 152(9)(a) and (b) of the Act.
[148]
Accordingly, the second objection
of the appellants is rejected.
[149]
The respondent submitted at trial
a list of expenses that the respondent argued were personal in nature. These
expenses amounted to $19,405.47 for Mr. Coveley and $209,185.28 for
Mrs. Coveley.
[150]
When questioned as to the nature
of some of these expenses, the appellants were able to provide an explanation
as to why they were legitimate business expenses. The only expense that
Mrs. Coveley recognized as being personal was an $8 fee for parking at the
University of Toronto, incurred when completing her MBA.
[151]
However, I believe that
Mrs. Coveley’s credibility was negatively impacted on a few occasions
during her testimony. First, Mrs. Coveley testified that the expenses at
Salon de Cal were incurred with clients or in preparation for travel or a media
appearance. However, one of these charges was incurred more than a month before
cStar was incorporated. Second, Mrs. Coveley
stated that she charged a bill from Richmond Hill Hydro for the appellants’
house to cStar because something had blown up when Mr. Coveley was
conducting a test, and that it was the only such bill charged to cStar.
However, counsel for the respondent then pointed out to Mrs. Coveley a
second bill from Richmond Hill Hydro. In addition, although she stated that she
did not have time to cook for her family she stated that all the grocery store expenses
were for office supplies and home-cooked meals prepared for cStar’s staff.
[152]
Mrs. Coveley also stated that
the expenses incurred at restaurants were all for meals with staff or clients. She
stated that all the expenses at stores such as The Bay, Sears, La Vie en
Rose, Kiddie Kobbler, Gap Kids and Moores Clothing for Men, and the expenses
for cinema tickets were for gifts she gave to clients and clients’ wives. Dues for
private clubs such as the Richmond Hill Country Club and the Mayfair Racquet Club
were also incurred, she testified, for the benefit of cStar’s clients. At one
point, when she could not explain some veterinary bills, she stated that she
did not have any pets at that time but refused to admit that there was no
business income purpose to the expenses.
[153]
In my view, the respondent was
able to demonstrate that some of the answers given by Mrs. Coveley were far-fetched.
It is clear that some expenses were personal and should not have been included
in the computation of the ABILs. On the other hand, I do not doubt that some
expenses - the dry cleaner’s invoices for lab coats, the office supplies and some
outings to name a few - were legitimately incurred for business purposes.
[154]
In light of the evidence, some of
the expenses claimed by Mrs. Coveley were personal expenses. The same is
also true for Mr. Coveley.
[155]
If I had decided that the
appellants were entitled to claim an ABIL, I would have reopened the trial or
asked for further submissions. In light of the evidence submitted, I am unable
to determine what proportion of the expenses were personal expenses.
E.
Conclusion
[156]
In my view, the appellants did not
make an honest and reasonable determination that cStar’s debt became a bad debt
in the 2005 taxation year.
[157]
As the Federal Court of Appeal recognized in Rich,
supra, owner-managers are often in the best position to determine whether
there is a reasonable prospect of collecting their debts. However, an
assessment of the considerations previously enunciated leads me to conclude
that cStar’s situation in 2005 was not different from that in previous years.
While cStar was in a precarious financial situation in 2005, this does not
suffice to justify a conclusion that the loans made to it had become bad debts.
[158]
cStar continued to carry on
business after the appellants determined that their debt had gone bad, and is in
fact still operating. The appellants are correct in stating that the Act does
not require that the debtor corporation cease operations before an ABIL claim
for a bad debt is available.
[159]
In the present appeals, the
appellants’ conduct before and after the bad debt determination does not support
a finding that there was a reasonable and honest determination that their
advances to cStar had become bad debts. Quite the opposite, their conduct
suggests that both of them were confident that the market would catch up and
that cStar would eventually become profitable.
[160]
In addition, there was no evidence
that the appellants made reasonable efforts to recover their debts. There was
no evidence that the appellants tried to sell any of cStar’s assets, such as
patents. There was no evidence that they tried to sell any of cStar’ shares.
The evidence showed that the appellants were not ready to share control of
cStar with potential investors.
[161]
For all these reasons, I am of the
view that the appellants’ debt did not become bad in 2005.
[162]
The appellants’ ABIL claims must
consequently be disallowed for the 2005 taxation year. In addition, the
appellants are not entitled to carry forward a non‑capital loss to the
2006 taxation year, for the following reasons:
(a)
As regards Mr. Coveley, the
loans were not made for the purpose of gaining or producing business income
from cStar. If I had found that the loans by Mr. Coveley bore interest,
his claim for an ABIL in 2005 would still have failed since the debt did not
become bad in 2005. Accordingly, he was not entitled to carry forward a non‑capital
loss to his 2006 taxation year.
(b)
As regards Mrs. Coveley, the
debt did not become bad in 2005. Accordingly, she was not entitled to carry
forward a non-capital loss to her 2006 taxation year.
[163]
The appeals are dismissed with
costs.
Signed at Ottawa, Canada, this 20th day of December
2013.
“Johanne D’Auray”
Email this Content