Honeybunch Bakeries (Saskatoon 1975) Ltd. v. MNR, 90 DTC 1549, [1990] 2 CTC 2148 (TCC)

Taylor T.C.J.:—These are appeals heard in Saskatoon, Saskatchewan, on November 24,1989 with respect to income tax assessments for the years 1982, 1983 and 1984. The statement of facts filed by the appellant indicated:

1. The Applicant was at all material times a corporation incorporated to carry on business in the Province of Saskatchewan.

2. In the 1982 [Correct year — 1980] taxation year, the Applicant lent Mini-Mansion Construction Ltd. the sum of $150,000 with interest being charged at a rate of prime plus one percent.

3. In the 1982, 1983, and 1984 taxation years, no interest was paid with respect to the debt outstanding from Mini-Mansion Construction Ltd.

4. On several occasions the Applicant demanded the repayment of the loan from Mini-Mansion Construction Ltd., however, Mini-Mansion Construction Ltd. was in financial difficulty and could not repay the loan.

5. On August 9, 1982, Mini-Mansion Construction Ltd. repaid the principal of the loan, being the sum of $150,000 to the Applicant.

6. Both Mini-Mansion Construction Ltd. and the Applicant acknowledged at the time this payment was made that this was a payment of principal only.

7. In the 1984 taxation year the Applicant deducted from income the amount of $20,250 pursuant to paragraph 20(1)(p) of the Act because there was no reasonable expectation that this debt would be recovered from Mini-Mansion Construction Ltd.

Reasons for Appeal

1. The Applicant says that the payment of $150,000 cannot reasonably be regarded as being a payment of part interest and part capital as both parties acknowledged that the payment was for principal only, therefore the payment should not be included in the Applicant's income pursuant to subsection 16(1) of the Act.

2. The Applicant further and in the alternative says that the amount of $20,250 can be claimed as a bad debt pursuant to paragraph 20(1)(p) of the Act and therefore, should be allowed as a deduction from income for the 1984 taxation year.

3. For the foregoing reasons and such other reasons as may be presented by counsel, the Applicant respectfully submits that the respondent's reassessments are incorrect and should be vacated and respectively submits the Tax Court of Canada should so order.

In reply thereto, the Minister of National Revenue made the following comments in the reply to notice of appeal:

A. Statement of Facts

1. Except as hereinafter expressly admitted the Respondent denies each and every allegation as set forth in the Notice of Appeal.

2. The Respondent admits paragraphs 1, 2 and 3 of the Notice of Appeal, except that Mini-Mansion Construction Limited (Mini-Mansion) agreed to pay interest at 18% in 1981 plus prime plus 1% after 1981.

3. In answer to paragraphs 5 and 6 of the Notice of Appeal the Respondent says that Mini-Mansion purported to repay the principal only of the loan referred to and purported to enter into an alleged agreement to this effect with the Appellant, but otherwise denies all the allegations contained in the said paragraphs 5 and 6.

4. In assessing the Appellant in respect of the matters in issue herein, the Respondent made, inter alia, the following assumptions of fact:

(a) The shareholders of the Appellant and the different shareholders of Mini- Minsion are not at arm's length one with another.

(b) The Appellant at the same time borrowed $150,000 from a Chartered Bank and paid interest thereon.

(c) The Appellant claims a bad debt expense of $20,250 in its 1984 taxation year.

5. The Respondent assessed accrued interest income owing the Appellant from Mini-Mansion and it was received by the Appellant in the guise of principal as follows:

1982	$27,000
1983	$ 9,690.07

and disallowed the claimed bad debt expense of $20,250 in 1984.

B. Statutory Provisions upon which the Respondent Relies and the Reasons which he intends to Submit

6. The Respondent relies, inter alia, upon Sections 9(1), 12(1)(c), 15(2), 16(1) and 20(1)(j) of the Income Tax Act, R.S.C. 1952, c. 148, as amended by S.C. 1970-71-72, c. 63, s. 1, applicable to the 1982, 1983 and 1984 taxation years of the Appellant.

7. The Respondent respectfully submits that the Appellant had an enforceable right to the interest at issue in each of the years 1981,1982 and 1983. In August 1982 payment applies first to the interest obligations of the loan agreement, subject to the benefit of Section 125(1) in respect of active business income.

The testimony established that the shareholders of Mini-Mansion and the appellant corporation were at arm's length for income tax purposes which refutes a main proposition of the respondent. The main exhibit entered was the promissory note for $150,000. It was dated May 30, 1980 and contained the following: ”. . . with interest on $150,000 payable monthly at the rate of bank prime, plus 1% per annum."

The rate agreed upon for the first year (to May 30, 1981) was 18 per cent and on that basis the appellant calculated and included in reported income the amount of $20,250 [judge's note: this appears to be $2250 per month for a period of nine months] as "accrued interest" up to the end of the fiscal year of the appellant, March 31, 1981 although none had been received. After that the appellant did not accrue and report further interest for either fiscal 1982, or for the portion of the corporation's fiscal 1983, up to August 9, 1982, on which date the debtor repaid the amount of $150,000. A letter submitted by the appellant from the debtor, although of little value to the Court because it was dated January 21, 1986, stated specifically that the $150,000 repaid was for principal only, and not interest. According to the appellant no interest has ever been collected and no further payment of any kind is expected now. The former debtor continues to reject any attempt at collection according to the witnesses.

The appellant requested that the amounts of $27,000 and $9,690.07 (alleged interest for fiscal 1982 and 1983 calculated and added into income by reassessment by the respondent), be removed, and further that the appellant be entitled to write off as a bad debt the amount of $20,250 in the year 1984.

In essence, the position of the respondent was that since the loan document, supra, contained a clause calling for interest, the appellant having made the choice of accruing that interest in 1981 was compelled by that choice to continue to so accrue for the succeeding years, irrespective of the fact that no interest was being collected. The respondent's second position was that the $20,250 could not be written off as a bad debt since the appellant had not made sufficient effort to collect the amount.

I do not agree with either proposition. It might be true that an "interestbearing obligation” of the type here in issue could be dealt with on an accrual basis, and once having done so that same method should be continued. However, by March 31, 1982 (the end of the appellant’s second year of holding the note), it was quite clear according to the evidence that not only no interest was going to be paid, the repayment of the note itself was in serious jeopardy. In my view, it was simply no longer an "interest-bearing obligation”, and irrespective of the 1981 accrual, this appellant legitimately had no further reason to inflate the income of the corporation by additional interest accrued. It would not have been out of order in my view for the appellant to have at least reserved against the already accrued amount of $20,250 by using paragraph 20(1)(n) of the Income Tax Act during that fiscal year. The respondent has no basis upon which to force the continued accrual of interest nor to take on the taxpayer's responsibility to calculate and report its own income. This was not a guaranteed debt with guaranteed interest, in any way, and should not be looked at in the same light.

On the second point—that somehow the appellant has not made sufficient effort to collect—I am satisfied that the personal encounters in the most public of places recited by the principal shareholders of the company in efforts to embarrass the debtor to pay either or both interest and principal continued unabated before and after the payment of the $150,000 on August 9,1982. The principal shareholders were satisfied—as relatives and former business partners—that the debtor had no further funds. Indeed the problem of finally realizing on even the $150,000 on August 9,1982 at the bank after receipt of the debtor's cheque was difficult enough.

The respondent appears to have been quite content to accept the tax result from the inclusion in 1981 of the accrued interest amount of $20,250, but appears to have assiduously pursued even more for 1982 and 1983, irrespective of the position of the appellant. The respondent must restore the appellant to at least the fiscal situation which existed before the appellant ever made the questionable decision to loan the money in the first place in 1980. The respondent did not raise as an issue the fact that interest expense had been charged by the appellant because of the funds borrowed from the bank to make the $150,000 loan in the first place. I can only assume that the respondent accepted the proposition that at that time, the expectation of receiving adequate interest warranted borrowing the funds by the appellant, even though this did not turn out to be the case. I would also point out that the respondent did not raise the question of the appropriate year for the write-off of the bad debt, although I can conceive of a good argument for that adjustment being in 1983 rather than 1984.

The appeals are allowed in all respects. The amounts of interest accrued for the years 1982 and 1983, $27,000 and $9,690.07 respectively are to be withdrawn and the claim for the bad debt write-off in the amount of $20,250 for the year 1984 should be granted. The entire matter is referred back to the respondent for reconsideration and reassessment. The appellant is entitled to party and party costs.

Appeals allowed.