Fradet v. The Queen, 83 DTC 5445, [1983] CTC 424 (FCTD), aff'd 86 DTC 6411, [1986] 2 CTC 321 (FCA)

Walsh, J:—This action was heard jointly on the same proof as that of Jean- Paul Demers v The Queen, No T-2897-82 with the proof being made in this record. Both actions concern capital gain assessments for the 1976, 1977 and 1978 years of the two plaintiffs as the result of a sale by them on June 8, 1976, of their shares in Chibougamau Lumber Ltée to Donohue St-Félicien Inc. Fradet held prior to the sale 374 shares, Demers 160 shares, so their respective proportional interest in the capital gain resulting from the sale of the shares was different but the same facts apply in the apportionment of the capital gain to them.

The adjusted price base of the 374 shares held by Fradet was established in the amount of $3,685,600 and in the case of Demers the adjusted price base of his 160 shares was established in the amount of $1,573,400 and these amounts are not contested in the assessments appealed from. At the closing of the sale Donohue St-Félicien Inc paid Messrs Fradet and Demers the sum of $7,800,000 and at the same time they returned to Donohue St- Félicien Inc the sum of $1,400,000 in return for Chibougamau Lumber Ltée transferring to them a claim which it had against a company known as Sa- moco which had a book value at the time of $1,400,000, the amount paid for it, with a market value of ony $600,000 which figure is not disputed by defendant.

Each of the plaintiffs was reassessed for their 1976, 1977 and 1978 taxation years, the reassessments being dated November 24, 1980, in the case of Fradet and December 23, 1980, in the case of Demers. These reassessments were opposed. The reassessments were made on or about April 1, 1982, in the case of Fradet, on or about April 16, 1982, in the case of Demers. In the reassessments the proceeds of disposition of the 374 shares of Fradet was evaluated at $5,463,921 and after deducting costs of sale established at $340,000 the proceeds of disposition were established at $5,122,921. In the case of Demers the proceeds of disposition of his 160 shares were evaluated at $2,337,079 and after deduction of costs of sale established at $145,000 the share of the proceeds of disposition wre established in the amount of $2,192,079. The total proceeds of disposition were thus set at the amount of $7,800,000, and the costs of sale admitted by defendant were distributed between the two taxpayers in accordance with their respective shareholding interest.

The issue raised by plaintiffs is that the proceeds of disposition of the 534 shares should have been established at $7,000,000 from which the cost of disposition would be deducted rather than $7,800,000. The deduction should have been made of the amount of $800,000 as a result of their being forced to acquire as a condition of the sale the claim of Chibougamau Lumber Ltée against Samco at its book value of $1,400,000 as it is admitted that at the time of the sale it was only worth $600,000, and therefore that their reassessments should be readjusted accordingly. As a consequence Fradet submits that his capital gain resulting from the sale of his 374 shares should have been established at $877,321; Demers claims that his capital gain resulting from the sale of his 160 shares should have been established at $378,679. They also both argued subsidiarily that the claim against Samoco was a bad debt in the sense of the law.

The shareholding prior to the sale indicated that Bertrand Fradet had 368 shares, Jean-Paul Demers 158, Roynat Ltée 6 shares, Alexis Fradet 1 share and Mrs Alexis Fradet 1 share. The vendors undertook to acquire from Roy- nat and the other individual shareholders all their shares so that they would own all 534 outstanding shares at the time of the sale. For purposes of payment of the price it was agreed that Fradet would possess 70 per cent of the shares and Demers 30 per cent, the price to be paid by separate cheques.

Mr Fradet testified that he had to pay Roynat $75,000 for its 6 shares and another $285,000 for the cancellation of an option Roynat had for the purchase of 43 shares of the company. Alexis Fradet, father of plaintiff Bertrand Fradet had an employment contract entered into in 1968 or 1969 for 10 years and was paid $200,000 for the cancellation of that contract.

One of the clauses of the said sale contract dated June 8, 1976, provided that at the date of the closing the company would have no subsidiaries, nor any investments in any other company or business. The company transferred to the vendors all its rights in a contract with Krueger Paper Limited. It was also specified that at the date of the closing the company would receive repayment of any advances made to the associated companies or any officers or shareholders at their book value.

Mr Fradet testified an advance had been made to Samoco, a subsidiary company, in the amount of $1,400,000. This company has been in financial difficulties and had made a proposal to its creditors on March 2, 1976. Chi- bougamau Lumber Ltée received no interest for four years on this advance. A letter from the Trustee, Samoco Inc, dated April 12, 1977, some 10 months after the sale with which we are concerned states that as a result of a proposal accepted by the creditors of Samoco Inc on March 2, 1976, approved by the Court on April 7, 1976 unsecured creditors were to be repaid 100 per cent in four annual instalments, the first payment of 5 per cent to become due on April 7, 1977, that is to say long after the sale of the Chibougamau Lumber Sales. Mr Fradet testified that they had no confidence at the time that the proposal would ever be carried out. Rexfor Ltd which controlled the operation had closed the factory because of a stroke. Eventually however after Quebec government intervention it was reopened and the terms of the proposal carried out so that he and Mr Demers eventually received repayment in full of the $1,400,000 which they had disbursed for this claim. This was not anticipated as of June 8, 1976, however, and defendant concedes that the claim had a value of only $600,000 at that date.

In cross-examination he admitted that he and Mr Fradet received payment of the $7,800,000*. [1] Two chequest were issued at the closing, one for $2,900 and another for $1,400,000, the remaining $3,500,000 being provided for, pursuant to the contract, by notes payable over the next five years. The cheque for $1,400,000 had to be endorsed back immediately to Chibougamau Lumber Ltée to purchase the claim against Samoco, so they never had the use of this money.

While defendant raised an issue as to the dates of the meetings at which the transfers and sales were concluded, I do not find that anything turns on this. The minutes of the meeting of the company at which Fradet and Demers resigned as Directors and the share transfers were approved are dated June 22, 1976 at St Prime. However the agreement to purchase the claim against Samoco from Chibougamau Lumber Ltée is dated June 23, at which time, if the dates were correct, they were no longer directors. Mr Fradet testified that all minutes of meetings and other documents required at the closing were prepared by the lawyers for the purchasers Donohue St- Félicien Inc and there was only one series of meetings, all held at their offices in Montreal at the same time, either June 22, or June 23 but no meeting at St Prime, and this seems probable so I accept this testimony.

He conceded that no legal action was taken by him or Mr Demers before the end of 1976 to try to collect the claim from Samco, which in any event would be prevented as a result of the proposal having been accepted. There had of course been no default under the proposal therefore in that year, but the first payment was in default by the time he and Demers filed their 1976 tax returns, a letter from the trustee dated April 12, 1977 indicating that he had been unable to collect the payment due on April 7, but suggesting that by May 2 Rexfor would make a decision. It should be noted that the 1977 and 1978 reassessments result from reserves permitted pursuant to the Act, the real question in issue being the basis of the 1976 reassessment.

As a matter of consistency Fradet and Demers evaluated the claim against Samoco on the basis of their proportional shares of the $600,000 which it was considered to be worth at the time they acquired it, and thus became subject to capital gains tax when eventually they made full recovery in the year or years in which such recovery was made. Defendant’s counsel concedes that if defendant is successful in the present actions in establishing that capital gains tax for them should be calculated on share sales for a total of $7,800,000 without making any deduction for the difference between the $1,400,000 which they were obliged to pay for the claim and its presumed value at that time of $600,000, no attempt will be made to collect capital gains tax when they eventually received the full amount, so that there will be no duplication of assessments. The figures will of course be different, as a result of interest calculations, differences in personal income from other sources of the taxpayers, perhaps differences in tax rates in the years in question, and so forth, but this is not an issue in the present proceedings.

The witness also pointed out that in calculating revised capital gains for him in 1976 the Minister allowed as costs of sale the cost of options in the amount of $200,000 and cost of employment contracts in the amount of $140,000 thus recognizing those provisions of the sale agreement as being necessary expenses incurred in connection with it, and argues that the apparent loss resulting from the requirement to purchase a claim worth only $600,000 for $1,400,000 should similarly have been deducted as a cost of sale.

Defendant explains this distinction by reference to the case of Automatic Toll Systems (Canada) Ltd v MNR, [1976] CTC 30; 74 DTC 6060, in which Pratte, J rendering the judgment of the Federal Court of Appeal stated at 6062:

. . . The evidence shows clearly that the payments here in question were made by the appellant for the sole purpose of being released of its obligation to pay a commission to “Les Signaux”. The appellant never wanted to acquire any asset from Mr Bastine or his companies. The various arrangements under which the sum of $60,000.00 was paid by the appellant were, as submitted by counsel for the appellant, a mere machinery created for the purpose of cancelling the contract under which the appellant was bound to pay a commission to “Les Signaux”.

Defendant makes a clear distinction between certain conditions which had to be fulfilled by the vendors of the shares in order to leave the company free and clear of employment contracts and options given for the purchase of additional shares, the cost to the vendors of such expenditures being recognized as appropriate deductions from the purchase price for the determination of the appropriate proceeds of disposal to be used for the calculation of capital gains tax, and on the other hand the expenditure of $1,400,000 made for the acquisition of an asset, namely the claim against Samoco. While it is conceded that at the date of the closing the vendor shall have repaid the company all advances made to subsidiaries (Samoco) at the cost of same to the company (ie book value), clause 4 respecting increase in price states that if financial statements prepared to April 3, 1976, show that the assets of the company are greater than $3,000,000 the sale price will be increased to an amount equal to the excess provided this does not exceed $300,000. The purchase of the claim against Samoco by Messrs Fradet and Demers at a price of $1,400,000 did not in any way increase the book assets of the company as this claim was carried in the books at that figure so no change in its financial statement was involved.

Both parties submitted far ranging arguments, with extensive reference to authorities, many of which are on substantially different issues, and only marginally pertinent or only pertinent by inferences drawn from certain statements made in the reasons for judgment therein.

There is undoubtedly, as plaintiff contends, a substantial volume of jurisprudence to the effect that in income tax matters the Court should look at the matter realistically and in applying this to the present case to determine from a commercial point of view what were the real proceeds of the sale realized by Messrs Fradet and Demers. In doing so, the fact that they were fortunate in eventually being able to realize the full amount of $1,400,000* [2] which they had paid for their claim against Samoco must be ignored. In 1976 it appeared to be unrealizable and defendant does not dispute that its value at the time of the sale was only $600,000.

In this connection plaintiff relies on subparagraph 40(1 )(a)(i) of the Income Tax Act which reads as follows

Except as otherwise expressly provided in this Part

(a) a taxpayer’s gain for a taxation year from the disposition of any property is the amount, if any, by which

(i) if the property was disposed of in the year, the amount, if any, by which his proceeds of disposition exceeds the aggregate of the adjusted cost base to him of the property immediately before the disposition and any outlays and expenses to the extent that they were made or incurred by him for the purpose of making the disposition.

and specifically directs attention to the words “to the extent that”, arguing that the purchase of this claim was necessarily made for the purpose of making the disposition of the shares. In this connection reference was made to the recent case of Geoffrey Sterling v The Queen, [1983] CTC 220; 83 DTC 5252 (which defendant states is now under appeal) in which my brother Rouleau, J, allowing the adding of interest costs and safekeeping charges to the adjusted cost base of gold bullion purchased by a taxpayer, stated at 5255-6:

. . . I agree with Section 11 of the Interpretation Act (supra) and give liberal construction and interpretation as best ensures the attainment of the objectives of the Income Tax Act which I find is to tax actual gain.

The principle of applying substance rather than form to an income tax matter also appears from the quotation from the case of Automatic Toll Systems (Canada) Ltd v MNR (supra), although as defendant pointed out its applicability in the present circumstances can be distinguished in that there was no question that the company received a capital asset or anything resembling it in return for the sum paid. In another argument plaintiff refers to paragraph 53(1 )(c) of the Act, suggesting that the excess of $800,000 paid to the com- pany over the real value of the claim at the time of its purchase was a contribution to the capital of the company, but I do not consider this to be applicable since the book value of the claim on the books of the company was $1,400,000 and this was in no way altered by the payment made nor was the capital of the company in any way increased since the company had not written down the value of the claim in its books to $600,000 before the purchase.

A British case calling for a realistic approach is that of Aberdeen Construction Group Ltd v Commissioners of Inland Revenue, 52 TC 281 in which at 296 Lord Wilberforce states:

The capital gains tax is of comparatively recent origin. The legislation imposing it, mainly the Finance Act 1965, is necessarily complicated, and the detailed provisions, as they affect this or any other case, must of course be looked at with care. But a guiding principle must underlie any interpretation of the Act, namely, that its purpose is to tax capital gains and to make allowance for capital losses, each of which ought to be arrived at upon normal business principles. No doubt anomalies may occur, but in straightforward situations, such as this, the courts should hesitate before accepting results which are paradoxical and contrary to business sense. To paraphrase a famous cliche, the capital gains tax is a tax upon gains: it is not a tax upon arithmetical differences.

Defendant points out however that the complicated facts of the Aberdeen case are quite different from those in the present case as there had been loans to a subsidiary and the price in question had to be divided between two separate transactions. In the present case the price paid for the claim against Samoco was clearly determined to be $1,400,000 and no discretion was left for division of the $7,800,000 paid between the amount to be paid to plaintiffs for their shares and what they in turn had to pay to acquire, at what appeared to be a greatly inflated price, the claim against Samoco.

Plaintiffs have yet another argument based on the contention that what they purchased was a bad debt and that a bad debt can be considered to be such in part and written off to this extent, and that in 1976 the $1,400,000 paid for the claim against Samoco had become a bad debt to the extent of $800,000. Defendant contends however that a debt does not become a bad debt until it is established that it is uncollectable. Defendant insists moreover that it is the price which was paid for the claim which must be considered. Reference was made to the case of Avril Holdings Limited v MNR, [1970] CTC 572; 70 DTC 6366, in which Pigeon, J, for the Supreme Court states at 6369:

.. . Here, as a result of the execution of the contract for the sale of the lands appellant immediately acquired a right to receive the price fixed in the contract. By virtue of Section 20(5)(c) this is “proceeds of disposition”.

A similar conclusion was reached in the Income Tax Appeal Board case of Ronald M Brickell v MNR, 18 Tax ABC 445; 58 DTC 134, in which the decision states at 136:

No definition of “proceeds of disposition’, as found above, is contained in the Act. In Tyser v Attorney-General (1938) 1 Ch 426, at p 432 Simonds, J, later to become Lord Chancellor, considered the words “proceeds of sale”, which, I think have the same significance as “proceeds of disposition”. His opinion was that they were the proceeds of sale that reached the vendor after payment of the proper expenses of sale. These included such an item, for example, as the commission paid by the vendor. In the instant matter, agent’s commission, legal fees, etc, were taken into account by the respondent’s assessors and thus they do not arise in connection with the second mortgage received. That was a part of the net proceeds, in the form of a registered charge on land, and only if it were discounted, at the behest of the appellant, would the latter obtain less than its face value. A discount and an expense are two different things.

and again

It may develop that the mortgage involved proves to be a good security and that the appellant eventually receives a hundred cents on the dollar, if he awaits payment according to its terms instead of seeking to sell the mortgage to obtain immediate payment, which necessarily would be at a loss. A second mortgage may still be a good and realizable asset, as between the parties thereto, even if not presently saleable at a reasonable discount.

In the present case however defendant recognizes that the value of the claim at the time of the purchase was only $600,000 so it is not merely the taxpayers who are seeking to write down the value of the claim they purchased.

In the case of E V Booth (Holdings) Ltd v Buckwell (Inspector of Taxes) [1980] Simon’s TC 578 the judgment states at 584:

In my judgment, where parties to a composite transaction have, as a result of negotiations between themselves, provided that part of the consideration is to be paid for one part of the transaction and part for another, they cannot subsequently seek to re-allocate the consideration for tax purposes. They have chosen to carry through the transaction in a particular manner, and the taxation consequences flow from the manner adopted. The Crown’s position may well be different in certain cases. After all, the Crown was not a party to the transaction.

So, in this case, the transaction could have been carried through by the new company repaying the debt in full, the price being paid for the shares being reduced accordingly. Alternatively, the Aberdeen method could have been adopted; that is, one lump sum could have been paid, both for the purchase of the shares and for the total extinguishment of the loan account. The taxation consequences of the method adopted would vary in each case. Once the parties have chosen to adopt one method, in my judgment the taxation consequences must follow and it is not open to them subsequently to argue that for tax purposes the transaction ought to be treated as if a different method had been adopted.

There is some doubt in my mind however as to whether this is authority for not looking at the matter realistically.

In the case of Associated Investors of Canada Limited v MNR, [1967] CTC 138; 67 DTC 5096, Jackett, P as he then was in a footnote at 5102 states:

. .. On the other hand, the appellant’s claim against Mitchell had not become a “bad debt” within section 11 (1)(f)(i) merely because it had depreciated in value. Section 11 (1 )(f) provides for the deduction of the whole of a debt that has become bad.

This appears to be the position adopted by the Income Tax Department. In its Interpretation Bulletin IT-159R2 paragraph 9 reads:

The question of when a debt becomes a bad debt is a question of fact and any decision made must be dependent upon the circumstances in each case. It is the

Deparment’s view that a debt does not become bad until it becomes in fact uncollectable. A debt is considered to be bad for the purposes of section 50 only when the whole amount is uncollectable or when a portion of it has been settled and the remainder is uncollectable. Where a portion of a debt can be considered uncollectable this portion is not considered to be bad for purposes of section 50 even though accounting practice may require a write-down to realizable value.

Plaintiff referred to the case of Geoffrey Hogan v MNR, 15 Tax ABC 1; 56 DTC 183, in which W S Fisher, QC of the Income Tax Appeal Board states at 193:

. . . And when, after considering those factors, an honest opinion has been arrived at that a debt, in whole or in part, is bad, then it is my opinion that the provisions of the Act have been wholly satisfied and that the debt should be written off. See also Schecter v MNR, 55 DTC 390, 13 Tax ABC 204.

For the purpose 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, notwith- standing that subsequent events may transpire under which the debt, or any portion of it, may in fact be collected. The person making the detemination 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 possible, each individual debtor.

In the present case, as has already been stated, there is no question of plaintiffs having exercised independent judgment in the evaluation of the claim at $600,000 since, the Minister himself admits this to be correct and subsequent developments cannot change that. Defendant submits however that on a close reading of this case it is difficult to determine how the judgment reached the conclusion that a portion of the bad debt could be written off, since it was clear that the entire debt could be written off, since it was clear that the entire debt was a bad debt.

It was also pointed out by defendant that plaintiffs did not make any claim for recognition of $800,000 as being a bad debt in their 1976 income tax return, and that while paragraph 20(1 )(l) of the Income Tax Act provides for the making of a reserve for doubtful debts and paragraph 20(1)(p) provides for deduction of bad debts that have been established to have been bad during the year, there is no such provision specifically applicable to the calculation of capital gains.

Reference was also made by defendant to subsection 50(1) of the Act which reads as follows:

For the purposes of this subdivision, where a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to him in respect of the disposition of a personal-use property) is established by him to have become a bad debt in the year, he shall be deemed to have disposed of it at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil.

Defendant renewed the argument that this refers to the whole of a debt and not a part of it.

I question therefore whether this action should be decided on the basis of allowing plaintiffs to write off $800,000 in 1976 as a bad debt. It is a capital gains tax assessment which is the issue before the Court in the present proceedings.

Plaintiffs express concern for the possible application to them of paragraph 69(1)(a) of the Income Tax Act which reads as follows:

69. (1) Except as expressly otherwise provided in this Act,

(a) where a taxpayer has acquired anyting from a person with whom he was not dealing at arm’s length at an amount in excess of the fair market value thereof at the time he so acquired it, he shall be deemed to have acquired it at that fair market value;

pointing out that in their subsequent returns they were obliged to declare the claim at its fair market value of $600,000 rather than at its purchase price of $1,400,000 and hence might be subject to double taxation, since eventually the purchase price was recovered. As previously indicated defendant’s counsel gives assurance that this would not be the case, should defendant succeed in the present action.

Of general interest, although not directly in point is the case of MNR v Henry J Freud, [1969] SCR 75; [1968] CTC 438; 68 DTC 5279, in which Pigeon, J stated at 79:

They (ie taxpayers) are not subjected to discriminatory fiscal treatment by being taxed if successful but denied a deduction if unsuccessful.

In conclusion I believe that equity as well as a liberal interpretation of the provisions of the Income Tax Act requires that the purchase of the claim at an inflated value was part and parcel of the transaction for the sale of their shares and if looked at realistically the sum of $800,000 representing the excess price, over the value of the claim which was admitted to be the case in 1976, should be deducted from the proceeds of disposition in their proportionate shares of same for purposes of capital gains tax calculation, and that the Minister should be directed to reassess Messrs Fradet and Demers accordingly for each of their 1976, 1977 and 1978 taxation years.