Date: 20000328
Docket: 97-1870-IT-G
BETWEEN:
JOHN BIRD,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
McArthur J.T.C.C.
[1] These appeals are from assessments for the 1992 and 1993
taxation years. The Minister of National Revenue disallowed
claimed bad debt expenses of $330,650 in 1992 and $100,192 in
1993. The issue is whether bad debt expenses with respect to
loans are allowable pursuant to paragraph 18(1)(a) or
20(1)(p) of the Income Tax Act.
[2] The claimed bad debt expense for 1992 in the amount of
$330,650 relates to advances made by the Appellant to Adagio
Enterprises Ltd. ("Adagio") in the amount of $162,000
and to Fremont Investors Ltd. ("Fremont") in the amount
of $168,650. The $100,192 bad debt claimed for the 1993 taxation
year was made up of the following bad debts:
a) payments to the Westpac Banking Corporation in 1993
totalling $81,600;
b) payment to George Davis, in trust in 1993 in the amount of
$5,000 to settle a threatened lawsuit against the Appellant and
other directors of Adagio Investments Inc. and various other
parties;[1] and
c) $13,592 representing the balance of advances made to
Fremont in previous years which had not been claimed as a bad
debt previously.
The Appellant was the sole shareholder and director of Fremont
at all material times. From 1986 onward, the Appellant made
numerous advances to Fremont. These advances to Fremont were
accounted for as shareholder loans on the books of Fremont.
[3] The Appellant advanced money to Fremont which loaned it to
Adagio Enterprises Ltd. The Adagio Enterprises loan proceeds were
advanced to Adagio Investments Ltd. I will refer to both
corporations as Adagio. The Appellant was a shareholder and
officer of Adagio but did not control it on his own. Adagio was
petitioned into bankruptcy in July 1992.
[4] Fremont entered into a financial assistance agreement
("agreement")[2] with Adagio in August 1986. The loans to Fremont were
secured by a debenture. The agreement, prepared by Fremont's
solicitors, set out the terms of the financial arrangements
between Adagio and Fremont with no reference to a loan or loans
directly between the Appellant and Adagio. Adagio was in the
garment manufacturing business. Included in the agreement was the
following:
Re: Provision of Financial Assistance and Counsel by Fremont
Investors Ltd. ("Fremont") to Adagio Enterprises Ltd.
("Adagio")
This letter will serve to set out the agreement between
Fremont, Adagio, L.C.R. Management Ltd. ("L.C.R.")
H.E. Johnson ("Johnson") and Patricia Fieldwalker
("Fieldwalker") regarding the provision of financial
assistance and counsel by Fremont to Adagio.
1. Fremont agrees to guarantee payment to the Royal Bank of
Canada (the "Bank") of additional credit facilities
established by Adagio with the Bank in the aggregate principal
amount of $150,000 (the "Additional Loan").
2. Fremont further agrees to pledge to the Bank by way of
collateral security for its guarantee of the Additional Loan term
deposits in the aggregate amount of $150,000 (collectively the
"Fremont Term Deposit").
3. Adagio agrees to pay Fremont as a consideration for the
financial assistance provided a standby fee at the rate of 3% per
annum on the daily outstanding balance of the Additional Loan for
the period beginning August 8, 1986 and ending on the date
the Additional Loan is retired by Adagio (the "Standby
Fee"). The Standby Fee will be payable on September 30, 1986
and quarter-annually thereafter during the aforesaid period.
4. Adagio further agrees to issue in favour of Fremont a
floating charge debenture in the principal amount of $150,000
(the "Fremont Debenture"). The Fremont Debenture will
represent a second floating charge over all present and future
assets of Adagio including inventory and accounts receivable and
will bear interest at the prime rate of the Bank plus 4% per
annum.
5. Adagio will exercise its best efforts to repay the
Additional Loan in full by December 31, 1986.
...
[5] Fremont was granted considerable control over Adagio.
Existing shareholders of Adagio agreed to transfer 6 2/3 % of
their shares to Fremont who agreed to exercise its best efforts
to raise an indeterminate amount of capital for Adagio by way of
an initial public offering of Adagio's shares. Fremont was to
obtain additional shares in Adagio upon arranging a public share
issue.
[6] Adagio was in constant need of working capital not
available from banking institutions. In the years from 1986 to
1992, Fremont became a secondary banker to Adagio offering a
revolving line of credit with a total of over $2,000,000 advanced
over the years. A second investor, together with the Appellant
also advanced funds to Fremont to be loaned to Adagio.
[7] Adagio made a public share offering in April 1992. A bank
loan of approximately $2,200,000 was paid off. Approximately
$400,000 was paid to the Appellant and Fremont and $168,650 was
left owing to Fremont.[3]
[8] In June 1992, Fremont loaned Adagio $160,000 for the
purpose of paying payroll tax liability owing by Adagio to
Revenue Canada. No promissory note was signed. A further $2,000
was loaned for miscellaneous requirements of Adagio. Fremont
advanced a further sum of $13,592 in 1993 to pay miscellaneous
expenses of Adagio. The parties acknowledge that a further amount
of $5,000 paid to settle a lawsuit is not part of the
Appellant's claim. In 1993, the Appellant claimed as an
expense $81,600 paid to Westpac Banking Corporation as settlement
for personal guarantees with respect to a loan incurred by Adagio
to pay for a leasehold interest to set up a retail store in
Paris, France. There were no documents presented between the
Appellant and Adagio such as an indemnity agreement or promissory
note. The Appellant stated that some supporting documentation was
destroyed by Adagio's trustee in bankruptcy and by Revenue
Canada. He feels Revenue Canada is responsible for the missing
documentation because the auditor had access to many boxes of
documents held by the trustee and did not record their
existence.
[9] The Appellant reported no gross business income for the
years 1985 to 1993 other than management fees received from
Transfotech Limited,[4] a company owned and controlled by the Appellant. In
1993, the Appellant reported gross business income of nil.
[10] In his T1 returns for the 1990 to 1993 taxation years,
the Appellant reported no interest from any loans made to Adagio,
Fremont or any other company, he reported no taxable dividends
from any companies to which he loaned money and reported all his
dispositions of shares, including dispositions of shares of
Adagio on capital account. The Appellant made no attempt at
collecting the amounts owed by Fremont and never made request for
either repayment of principal or accrued interest. In fact, the
Appellant does not claim a bad debt for the unpaid accrued
interest, only the principal.
[11] Fremont continues to carry on business. In its 1994
taxation year, it purchased and sold securities and actually
showed a profit of over $11,000.
[12] The Respondent submits that the bad debt expenses claimed
are not allowable on the basis that they were not incurred for
the purpose of gaining or producing income from a business or
property within the meaning of paragraph 18(1)(a) of
the Act and the Appellant's ordinary business did not
include the lending of money. In the alternative, he submits that
if the Appellant's ordinary business did include the lending
of money, none of the loans were made in the ordinary course of
that business, that none of the loans were included in computing
the Appellant's income for any of the 1992 or 1993 taxation
years or any preceding taxation year and, therefore, the
Appellant is not entitled to any deductions pursuant to
subparagraph 20(1)(p)(i) of the Act.
[13] The issues that the Respondent raise are:
A. Whether the loans to Adagio in the 1992 taxation year were
made in the ordinary course of the Appellant's business for
the purpose of earning interest income or whether they were made
to provide Adagio with working capital and to protect the
Appellant's investment in Adagio.
B. Whether the loans to Fremont which give rise to the bad
debts claimed in 1992 and 1993 were made in the ordinary course
of the Appellant's business for the purpose of earning
interest income or whether they were shareholder loans to provide
Fremont with working capital.
C. Whether the loans to Fremont which give rise to the bad
debts claimed in 1992 and 1993 were established by the Appellant
to have become bad in the year.
D. Whether the bad debts claimed in 1993 in the amount of
$81,600 and $5,000 were debts arising from loans or whether they
were simply debts of the Appellant paid by the Appellant in
1993.
[14] In his Notice of Appeal, the Appellant states the issue
as: "is the amount claimed deductible pursuant to paragraph
20(1)(p) of the Act or any other provision of the
Act".
Analysis
[15] The relevant parts of paragraph 20(1)(p) of the
Act read as follows:
20(1) Notwithstanding paragraphs 18(1)(a), (b)
and (h), in computing a taxpayer's income for a
taxation year from a business or property, there may be deducted
such of the following amounts as are wholly applicable to that
source or such part of the following amounts as may reasonably be
regarded as applicable thereto:
...
(p) the aggregate of
...
(ii) all amounts each of which is that part of the amortized
cost to the taxpayer at the end of the year of a loan or lending
asset made or acquired in the ordinary course of business by a
taxpayer who was an insurer or whose ordinary business included
the lending of money established by him to have become
uncollectible in the year;
While paragraph 18(1)(a) permits the deduction of
expenses incurred for the purpose of earning income, there is a
presumption that losses arising from loans or payments on
guarantees are on account of capital and disallowed under
paragraph 18(1)(b).[5]
[16] For the Appellant to be able to obtain the deduction
provided in paragraph 20(1)(p), he must
establish:
a) the debts to be deducted arise from loans;
b) the ordinary business of the taxpayer must include the
lending of money;
c) the loans giving rise to the bad debts must have been made
in the ordinary course of the taxpayer's business of lending
money; and
d) the loans giving rise to the bad debts must have become
uncollectible in the year.
[17] The documentation provided supports that the lending
activities were transacted by Fremont. The Appellant and an
investor funded Fremont. There is abundant evidence of cheques
drawn on the account of the Appellant and his investor payable to
Fremont. Fremont in turn advanced the funds to Adagio. Adagio
granted promissory notes, a security debenture and shares[6] to Fremont.
Fremont's financial statements reflect Adagio's
transactions as its own. There was no evidence of privity of
contract between Adagio and the Appellant. Only Fremont and not
the Appellant, could enforce the loans. There was no
documentation to support a suggestion that the Appellant was in
the money lending business vis-à-vis Fremont. The
evidence leads to the conclusion that the advances from the
Appellant to Fremont were of a capital nature (shareholder
loans). There were no promissory notes, security, interest was
not called for nor was any paid, no repayments by Fremont were
made for the principal advanced to it by the Appellant. There is
evidence in the 1992 financial statement that Fremont repaid the
investor the money he advanced to it.
[18] The taxpayer presented his own appeal and called no
witnesses. No one testified on behalf of the Respondent. The
Appellant advanced the position that he was personally in the
lending business. Unfortunately, he treated the actions of
Fremont as his own in circumstances when it was to his benefit.
In the reverse, he appeared to scrupulously treat Fremont as a
separate and distinct taxpayer when it was financially beneficial
for him to do so. There was no evidence that Fremont acted as a
trustee for the Appellant. Indeed, the opposite was demonstrated.
The Appellant had incorporated several corporations and appears
to have used them extensively in the arrangement of his financial
dealings. He was the controlling director, if not the sole
officer and director of Transfotech Limited. This corporation
carried on a consulting business with the Appellant as its only
consultant. The bulk of the Appellant's income was from
Transfotech. During the relevant years, most of Transfotech's
consulting revenue came from Adagio. The Appellant's T1
returns did not reflect that he was in the money lending business
or any business at all. Transfotech and Fremont are separate
corporate entities and were so regarded by the Appellant. No
doubt Fremont was in the lending business vis-à-vis
Adagio, but Fremont's business is not the Appellant's
business. In Loman Warehousing Ltd. v. R.,[7] Bowman J. of this Court found
that the taxpayer must actually be in the business of lending
money to satisfy the requirements of paragraph 20(1)(p). I
find as a fact that the Appellant was not in the business of
lending money.
[19] The consulting business was carried on by Transfotech.
The Appellant did not, during the relevant years, earn consulting
fees or earn interest from a lending business. The bad debt
expense claimed in 1992 of $330,650 included the $162,000. The
reward Fremont was to receive in consideration for the earlier
advances, was interest, financing fees and primarily shares in
Adagio. Having done it before, the Appellant had expertise in
guiding corporations through the maze of hurdles leading to a
public share offering. When he was finally successful in making
Adagio a public company in April 1992, he and his corporations
held 20.9% of Adagio's shares valued at $1.7 million. This
was obviously the primary reward for the advances made by Fremont
to Adagio. In June 1992, when the Appellant advanced $160,000 to
Adagio, it was used to pay Revenue Canada's payroll
remittances required to keep Adagio operating. No promissory note
or other security was given. There was no binding agreement as to
terms. This is not the action of a money lender. It is more
consistent with the Respondent's position that the money was
advanced in a desperation attempt to preserve the shareholdings
of the Appellant and his corporations.
[20] With respect to the fourth criteria, no doubt the amount
was uncollectible.
[21] With respect to the $330,650 advanced by Fremont to
Adagio and claimed by the Appellant as a bad debt expense in
1992, I conclude that this amount was not loaned by the Appellant
to Adagio in the ordinary course of his business for the purpose
of earning interest income.
[22] Could it be said that the Appellant loaned the money to
earn income from or protect the goodwill of any business he was
in? From the T1 returns of the Appellant, it is questionable that
he was in business at all, let alone having money lending as an
integral part of his business.
[23] The words of LeDain J. in Charles Chaffey v.
M.N.R.[8] apply equally to the present facts. At page
6179 he stated:
... shareholder's advances do not constitute the
business of lending money; they are simply a particular form by
which capital is put into a company. The loans made by the
partnership did not have as their principal object the
accommodation of persons in return for income in the form of
interest; they were merely a device for the financing of projects
through which profit was to be made by other means.
To be successful, the Appellant had to prove that his ordinary
business included the lending of money. He has not satisfied that
onus. What exactly did he do? He made numerous shareholder
advances to Fremont. He claims $168,650 as bad debt in 1992 as a
result of Adagio's bankruptcy. How can it be said that the
Appellant was in the lending business vis-à-vis
Fremont? Adagio ceased operations in 1992, not Fremont. Fremont
continued to carry on business making a small profit in 1994
without ever, in the relevant years, paying back the Appellant
any principal or interest. There was no documentary evidence
between the Appellant and Fremont establishing a debtor/creditor
relationship. The inevitable conclusion is that the $168,650 is
not a loss on income account.
[24] In June 1992, the Appellant advanced $162,000 to Adagio,
$160,000 of which was used to pay Revenue Canada. Without the
employee deduction payments, Revenue Canada would have shut down
Adagio. I do not consider this advance to be a loan made in the
ordinary course of the Appellant's business.[9] There was no promissory note or
security. There was simply a covering letter setting out his
terms which letter was unsigned and not acknowledged. I find that
the purpose of this advance was primarily to preserve the
Appellant's and his corporations shareholding interest in
Adagio. Adagio was petitioned into bankruptcy a week later.
Obviously, it was not a borrower to whom the Appellant would have
loaned $162,000 at a modest interest rate. His motivation was not
earning interest from a lending business.
[25] The third substantial bad loan expense claimed by the
Appellant was the $81,600 he paid in 1993 to settle a claim by
Westpac Banking Corporation with respect to money borrowed by the
Appellant or by Adagio for the lease of retail space in Paris.
The Appellant was responsible for the loan as a guarantor. There
was no documentation between him and Adagio. Again, this was not
a loan in the nature of being in the lending business as
envisaged by paragraph 20(1)(p).
[26] My conclusion is supported by the analysis of Bowman J.
in Loman Warehousing Ltd. (supra). At page 2059 he
stated:
The expression "whose ordinary business includes the
lending of money" requires a determination of just what the
taxpayer's "ordinary business" is. The ordinary
business of the appellant is warehousing, not lending money to
other companies in the group. Some effect must be given to the
word "ordinary". It implies that the business of
lending money be one of the ways in which the company as an
ordinary part of its business operations earns its income. It
also implies that the lending of money be identifiable as a
business. I agree that the participation in the MNA, in which a
company in the group, depending upon whether on a given day it is
in a credit or debit position, may loan or borrow funds is an
incident of its business. The appellant's argument equates
the words "whose ordinary business includes the lending of
money" to the words "in whose business the lending of
money is an incident". I do not think the two expressions
cover the same territory.
This conclusion is reinforced by the concluding words of
clause 20(1)(p)(ii)(A):
... made or acquired in the ordinary course of the
taxpayer's business of ... the lending of money.
[27] Clearly, from the evidence, the Appellant was not in the
business of lending money. The advances may have been "in
the ordinary course of business" in the sense that
supporting Fremont and keeping Adagio afloat was an incident of
the Appellant's business, but it cannot be said that it was
made in the ordinary course of a lending business.
[28] The appeals are dismissed, with costs.
Signed at Ottawa, Canada, this 28th day of March, 2000.
"C.H. McArthur"
J.T.C.C.
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