Flexi-Coil Ltd. v. R., [1996] 1 CTC 2941

Archambault J.T.C.C.: - This is an appeal by Flexi-Coil Ltd. (Flexi) from income tax assessments by the Minister of National Revenue (Minister) for the 1988 and 1989 taxation years. The Minister disallowed part of the amounts deducted by Flexi in respect of bad debts for these two taxation years. In the Minister’s view, Flexi could not claim such deductions because it had not established that the disallowed portion had become uncollectible and had been included previously in income. For the 1988 taxation year, the Minister also included in Flexi’s income a sum of $465,560 representing the recovery of bad debts previously deducted by Flexi.

For. the 1989 taxation year, the Minister also disallowed a deduction of foreign exchange losses of $304,453 because they were on capital account and because Flexi did not report its foreign exchange gains or losses on a yearly basis. For the same year, he disallowed an amount of $1,013,481 claimed as current Research and Development (R&D) deductions because in computing Flexi’s income for the 1987 and 1988 taxation years he had allowed these deductions in order to compensate for his disallowance of bad debts for these years. Although there is no appeal before this Court for the 1987 taxation year, both parties agreed that the extent to which Flexi has a right to claim its R&D expenditures in 1989 depends on the extent to which the Minister was right in disallowing the claim for bad debts with respect to 1987. The Minister disallowed the deduction for bad debts with respect to 1987 for the same reasons he did so for 1988.

Facts

Ms. Debbie Smith is the only officer of Flexi who testified before the Court. During the relevant time, she was its corporate controller. Flexi manufactures farm machinery. Its head office is located in Saskatoon, Saskatchewan, and its year-end is September 30th. During the relevant period, Flexi had a subsidiary in the UK, Flexi-Coil (U.K.) Limited (Flexi U.K.), which acted as its distributor in Europe. Starting around 1985, Flexi UK also manufactured some of its own products. In 1987, Flexi owned all of Flexi U.K.’s shares. Afterward, contrary to what the parties had stated or admitted in their proceedings, Flexi’s interest was reduced to 75 percent.

According to Ms. Smith’s testimony, from 1979 to 1982, Flexi sold its equipment directly to Flexi U.K. Starting sometime after October 21, 1982, and up to March 1984, Flexi established an intermediate distributor in Switzerland, Flexi-Coil S.A. (Flexi S.A.), which acquired the equipment from Flexi and resold it to Flexi U.K. and to a related company in the United States, Flexi-Coil Inc. (Flexi U.S.).

After March 1984, it was decided to stop using Flexi S.A. as an intermediary because apparently it was incurring losses; however, it was never liquidated. Direct sales to Flexi U.K. resumed after March 17, 1984.

According to Ms. Smith, Flexi reported all of its sales and its income. To summarize the information obtained from her accounting records with respect to annual sales made by Flexi to Flexi U.K. and by Flexi S.A. to Flexi U.K. from 1980 to 1989 and the annual payments thereon, she produced in Court a table filed as Exhibit A-4. This table is attached to these reasons as Appendix I. It also sets out the foreign exchange gains and losses realized or incurred by Flexi and Flexi S.A. on their sales made in pounds sterling. Flexi reported its foreign exchange gains or losses yearly in its annual statements of income.

A review of this table reveals also that all purchases made by Flexi U.K. from Flexi up to 1983 were made in Canadian dollars. From 1980 to 1983, total sales amounted to $1,379,824 and were fully paid for by the end of 1985. Purchases made in 1983 and thereafter from Flexi S.A. were made in pounds sterling. Total sales by Flexi S.A. to Flexi U.K. amounted to 888,264 (U.K.). By the end of 1989, Flexi U.K. had not yet paid any amount to Flexi S.A; in Canadian dollars, the amount unpaid came to $1,690,810. In Flexi U.K.’s financial statements for 1987, 1988 and 1989, this unpaid balance owing to Flexi S.A. appears as: “a loan ... not subject to repayment within one year and is interest free. The balance has arisen from the purchase of goods for resale”. [1] Consequently, this amount Owing to Flexi S.A. does not appear in the current liabilities of Flexi U.K. Incongruously, the accounts receivable by Flexi S.A. from Flexi U.K. do appear as a current asset in the former’s financial statements.

Sales by Flexi to Flexi S.A. were made in Canadian dollars. They appear under Current Liabilities in Flexi S.A.’s balance sheet. Another table, introduced by Ms. Smith as Exhibit A-6 and attached to these reasons as Appendix II, summarizes the accounts payable by Flexi S.A. to Flexi.? [2] At the end of the 1987 fiscal period, Flexi S.A. owed Flexi the sum of $1,948,706, including an amount of $1,633,676 in trade accounts.

When Flexi resumed its direct sales to Flexi U.K. in 1984, they continued to be in pounds sterling. Sales from 1984 to 1989 amounted to 1,477,594(UK) which, converted into Canadian dollars, represents a sum of $2,595,757? [3] During this period, Flexi U.K. only paid 407,837 ($840,187 in Canadian dollars). At the end of 1987, the unpaid balance, account foreign exchange fluctuations, represented $2,364,267.

From the statements of income of Flexi U.K. from 1982 to 1989, we can obtain the following summary of earnings:

From the balance sheets of Flexi U.K. for the period from 1982 to 1989, we can obtain this summary of its financial position:

The table in Appendix II sets out the computation of Flexi’s investment in Flexi U.K. It indicates the total amounts of money invested by Flexi in Flexi U.K., either directly or indirectly through Flexi S.A., by way of shares, advances or unpaid trade accounts. As required under generally accepted accounting principles (GAAP) for the preparation of financial statements on an equity basis, Flexi’s share of Flexi U.K.’s deficit and the unrealized profits in respect of inventory purchased by Flexi U.K. from Flexi but not yet sold must be subtracted from this total investment. This table reveals also that the accounting value of Flexi’s investment in Flexi U.K. at the end of 1989 was almost the same as the taxable value. The latter represents the total value of the amounts invested in Flexi U.K. reduced by the total amount of bad debts claimed for tax purposes.

Ms. Smith stated that she established, in consultation with Flexi’s president and its auditors, that some of the accounts receivable in 1987 had become bad debts for tax purposes. This came after having realized that Flexi U.K. was not paying its accounts payable and that a substantial reduction had been made in Flexi U.K.’s consolidated investment account as a result of significant losses in the three previous years. In her view, deducting an amount of bad debts for tax purposes was consistent with the reductions in the consolidated accounting investment value of Flexi U.K. Ms. Smith stated that no collection procedures were envisaged because she knew the financial position of Flexi U.K. The amounts that Flexi claimed as bad debts in respect of accounts receivable included amounts owing by Flexi S.A. but attributable to accounts payable by Flexi U.K. to Flexi S.A. For tax purposes, Flexi claimed as bad debts $800,000 in 1987, $900,000 in 1988 and $590,821 in 1989. For accounting purposes, Flexi claimed a deduction for bad debts only in 1988 and 1989, the amounts deducted being $286,217 and $84,384 respectively, for a total of $370,701. The Minister allowed $600,000 in 1987, $300,000 in 1988 and $128,488 in 1989.

After September 30, 1988, in the preparation of the financial statement for 1988, Ms. Smith made some journal entries to simplify the reporting of foreign exchange fluctuations of Flexi S.A. The latter had two important accounts receivable at the beginning of 1988: one of $1,890,411 from Flexi U.K. and another of $534,990 from Flexi U.S., for a total of $2,425,4014. [4] At that time, Flexi S.A. owed $1,948,706 to Flexi. To reduce the number of book entries to reflect the foreign exchange fluctuations in Flexi S.A., Ms. Smith, with the agreement of Flexi’s auditor, but without mentioning it to her president, made journal entries which had the effect of transferring the accounts receivable of Flexi S.A. to Flexi, resulting in a credit balance for Flexi S.A. of $465,561. This was reflected in the financial statements of all the companies concerned. The Minister treated this credit as a recovery of bad debts previously deducted by Flexi and included it in its income for 1989.

Ms. Smith testified that Flexi, Flexi U.K. and Flexi S.A., had no intention of effecting such transfer. Nor did they prepare any document reflecting such transfer. In her opinion, the book entries did not result in any change in Flexi’s financial statements; it only reduced their number. After the reassessment for the 1989 taxation year, these journal entries were reversed.

Analysis

Having heard the evidence and the arguments of the parties, there are only three basic issues to be resolved. First, were the accounts receivable from Flexi U.K. properly established to have become bad debts for 1987, 1988 and 1989? It is common ground between the parties that the other conditions of paragraph 20(1)(p) of the Income Tax Act (the Act) have been met. Second, was there a disposition of accounts receivable by Flexi S.A. in 1988 as appears to have been the case from the journal entries made by Ms. Smith? If the answer to this question is in the negative, then the Minister concedes that there could not have been a recovery of $465,580 as bad debts in 1988. Third, is Flexi entitled to deduct an amount of $304,453 as foreign exchange losses for 1989? If according to the resolution of the second issue, there was not a transfer of accounts receivable by Flexi S.A. in 1988, counsel for the Appellant acknowledges that his client would not be entitled to a foreign exchange loss of $138,480 out of the $304,453 because this is a loss belonging to Flexi S.A.

I shall deal with the last two issues first. I have been convinced by the testimony of Ms. Smith that the journal entries were only intended as a Shortcut to reduce the number of book entries in respect of foreign exchange fluctuations. I believed her when she stated that Flexi’s president, also a director of Flexi U.K. and Flexi S.A., was not aware of these accounting adjustments and that the companies did not intend to carry out such a transaction. By making these adjustments, Flexi became vulnerable to a challenge by the tax authorities. It is usually not easy to contradict documents originating from the taxpayer itself. However, as it has often been said in tax cases - although usually where the taxpayer was trying to qualify for a tax benefit and not, as here, where the taxpayer is trying to avoid an adverse tax consequence — that bookkeeping entries do not create reality. The Court must satisfy itself that the underlying transaction actually took place. Here, I am satisfied that it did not. Therefore, no recovery of bad debts took place in 1988.

With respect to the foreign exchange loss, the only amount in issue is the amount of $165,973. This loss resulted from foreign exchange fluctuations with respect to the unpaid balance of accounts payable to Flexi by Flexi U.K. In its “Reply to the Amended Amended Notice of Appeal", the Minister stated that in making its assessment it made the following assumption of fact:

8(p) At the end of each taxation year, the Appellant did not adjust to Canadian dollars all its current accounts to reflect the exchange rate prevailing at that time and did not include any resulting foreign exchange gains or losses in income in the taxation year.

The evidence before me which, on this point, was not challenged by counsel for the Minister, clearly establishes that Flexi was converting into Canadian dollars all its sales made to Flexi U.K. in pounds sterling and that it reported any resulting foreign exchange gains or losses as income. Therefore, Flexi is entitled to its foreign exchange loss of $165,973 in 1989.

With respect to the deduction of bad debts, the governing paragraph of the Act is 20(1 )(p) which reads:

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) Bud debts.— the aggregate of debts owing to the taxpayer

(1) that are established by him to have become bad debts in the year, and

11) that have (except in the case of debts arising from loans made in the Ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year;

The question of when a debt becomes bad is a question of fact to be determined according to the circumstances of each case. Primarily, a debt is recognized to be bad when it has been proved uncollectible in the year. In Roy v. Minister of National Revenue (1958), 20 Tax A.B.C. 385, 58 D.T.C. 676, Mr. Boisvert of the Tax Appeal Board stated at page 680:

As the Act does not define a bad debt, it is necessary to turn to recognized accounting principles of business practice. A debt is recognized to be bad when it has been proved uncollectible in the year.

The question of when a debt is to be considered uncollectible is a matter of the taxpayer’s own judgment as a prudent businessman. In Hogan v. Minister of National Revenue (1956), 15 Tax A.B.C. 1, 56 D.T.C. 183, at page 193, Mr. Fisher described how this determination should be made:

For the purposes of the /ncome Tux 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 ot the fiscal year when the determination is required to be made, notwithstanding that subsequent events may transpire under which the debt, or any portion of it, may in fact, be collected. The person making the determination should be the creditor himself (or his or its employee), who is personally thoroughly conversant with the facts and circumstances surrounding not only each particular debt but also, where possibly, each individual debtor....

[Emphasis added.]

This approach has been followed in numerous judgments, including Anjalie Enterprises Ltd. v. R., (sub nom. Anjalie Enterprises Ltd. v. Canada), 11995] 1 C.T.C. 2802, 95 D.T.C. 216 (T.C.C.), and Berretti v. Minister of National Revenue, [1986] C.T.C. 2293, 86 D.T.C. 1719 (T.C.C.). In summary, to decide whether a taxpayer is entitled to a deduction for bad debts, the Court must be satisfied that the taxpayer itself made the determination that the debts had become uncollectible and that in making such determination, it acted reasonably and in a pragmatic business-like manner, applying the proper factors.

This case raises a thorny issue because the taxpayer-supplier is the parent company of the debtor-customer. On the one hand, you have two separate legal entities which carry on their separate businesses. On the other hand, the supplier of goods is also the owner, financial backer and controller of the customer: it is in a position to influence how the business of the customer-subsidiary is to be carried on, including determining whether the trade accounts owing to the parent are to be paid.

To my knowledge, the Act does not provide special rules for the determination when the debts owing by related parties are bad. Therefore, the rules applicable to arm’s length traders should apply to those not dealing at non-arm’s length. This does not mean that the courts should not be vigilant in ensuring that the related creditor acted properly in determining that some debts had become uncollectible. [5]

Here, I am not satisfied that Flexi acted reasonably and applied the proper factors in determining the amounts of bad debts for the three relevant taxation years. I think the company made several errors. First, it was more concerned with bringing the tax investment value of its investment into Flexi U.K. in line with its accounting value. Appendix II shows that this was achieved in 1989 when three substantial claims of bad debts for 1987, 1988 and 1989 dropped the tax investment value to $1,600,806, an amount almost equal to the accounting investment value of $1,598,141. It should be noted that, in reality, the accounting investment value exceeded the tax investment value because Flexi miscalculated the former. Given that Flexi only had a 75 percent interest in Flexi U.K. starting in 1988, [6] Flexi should have reported only its share of Flexi U.K.’s deficit for 1988 and 1989. In fact, Flexi deducted from the accounting value of its investment in Flexi U.K. 100 percent of the latter’s deficit. [7]

As is apparent from Appendix II and the testimony of Ms. Smith, the accounting investment value has no relation to the collectibility of accounts receivable. As I understand it, the computation of the accounting investment value is required in order to prepare on an equity basis the financial statements of a parent company. To determine this value only the pro rata share of the subsidiary’s deficit and unrealized profit should be taken into account. This value has nothing to do with the collectibility of the accounts receivable.

The primary concern of Flexi should have been whether the trade debts owing by Flexi U.K. and Flexi S.A. were collectible. In her assessment of the trade debts owing by Flexi S.A. to Flexi, Ms. Smith took into account the unpaid trade accounts from Flexi U.K. to Flexi S.A. I think this was proper. However, before determining if Flexi U.K.’s accounts payable to Flexi S.A. were uncollectible, Flexi should have determined whether they were payable in the year. The financial statements of Flexi U.K. for the fiscal periods from 1983 to 1989 show these trade accounts as “loans not repayable within one year’’. This statement is found in a note entitled “Amounts Falling Due After More Than One Year’’. As it appears from Appendix I, the balance owing by Flexi U.K. to Flexi S.A. started at $835,483 in 1983, increasing to a high of $1,890,403 in 1987, and, because of foreign exchange fluctuations, decreasing to $1,690,810 at the end of 1989. So, it is quite apparent from the Flexi U.K. financial statements that the trade accounts owing to Flexi S.A. were not due at the end of each of the 1987, 1988 and 1989 taxation years.

I do not think it is proper, in the circumstances of this case, to conclude that a portion of these trade accounts had become uncollectible. It is true that the trade accounts of Flexi S.A. payable to Flexi appear as current liabilities in the financial statements of Flexi S.A. However, since it controlled both Flexi S.A. and Flexi U.K., Flexi was aware that the accounts receivable from Flexi S.A. would not have been paid to it on a current basis. I think it is fair to assume that the arrangements between Flexi, Flexi S.A. and Flexi U.K. with respect to the sales of goods by Flexi S.A. to Flexi U.K. were made in such a way as to provide long-term financial assistance to the latter. Flexi being ultimately the parent of all the companies, this appears to be consistent with the intent of Flexi in financing its U.K. subsidiary.

Flexi U.K., it should be noted, was thinly capitalized. Its share capital was $2,665; the advances, excluding the unpaid trade accounts, varied between $33,381 and $67,084 from 1984 to 1989. This company is a farm machinery manufacturer and distributor with gross sales between 1984 and 1989 varying between 1,325,000 and 905,000 pounds (U.K.). [8] It operated on hardly any line of credit. So, Flexi U.K. was almost entirely dependent on Flexi for its financial needs. It is noteworthy that Flexi U.K.’s annual unpaid trade account balances owing to Flexi S.A. from 1987 to 1989 were almost equal to the annual accumulated deficits of Flexi U.K. for that period.

It is important to consider, in a case like this one, the long-term goals of the parent-supplier. Flexi intended to maintain its presence in Europe through its U.K. subsidiary. Although substantial losses started to accumulate in 1986, in each of the financial statements from 1986 to 1989, the directors of Flexi U.K. stated:

Over the past few years difficult trading conditions have resulted in losses to the company. However, the directors are confident that this adverse situation can be improved in the future.

This is a strong indication that the company intended to continue operating and was not about to go out of business. Flexi U.K. also had the backing of its parent company which was committed to providing the required funds. In the same financial statements, we find this note:

The parent company has undertaken to provide any additional working capital which the company may require in the next 12. [9]

For these reasons, I do not think that the unpaid accounts owing by Flexi S.A. to Flexi, attributable to the unpaid accounts owing by Flexi U.K. to Flexi S.A., should have been considered to have become uncollectible.

Different considerations apply to the accounts receivable by Flexi from Flexi U.K. They are not shown in the financial statements of Flexi U.K. as “due after more than one year,” or as “loans”. They appear as current debts.

A review of Flexi U.K.’s statements from 1987 to 1989 shows the financial position of this company with respect to its liquid assets. The current assets, i.e. assets easily realizable, are basically the stocks, the accounts receivable and the cash on hand. The current liabilities, i.e. the debts falling due within one year, are the accounts payable and the amounts owing to related companies and other creditors. These statements show the net amounts as “Net current (liabilities) assets”.

It is relevant to look at the net current assets (liabilities) of Flexi U.K. to determine if the accounts receivable could have reasonably been collected by Flexi in a particular year. For 1987, there was a net asset value of 139,694 (U.K.). In 1988 and 1989, there were net current liabilities of 76,200 (U.K.) and 163,181 (U.K.) respectively. This analysis shows that Flexi U.K. had enough net liquid assets in 1987 to pay all of its accounts payable to Flexi. Flexi U.K.’s auditor indicated in its financial statement that the stocks were valued at the lower of cost and net realizable value. Based on this assertion, the stocks should have been worth the values shown in the financial statements. There was no evidence that the accounts receivable by Flexi UK were not worth the amounts shown in the same statements. So it is difficult to see how one can reasonably conclude that Flexi’s accounts receivable could not have been collected from Flexi U.K. in 1987, especially in the amount of $800,000. It is noteworthy that no claim for bad debts was made in 1987 in Flexi’s audited financial statements. The Minister showed generosity in allowing $600,000 in computing Flexi’s income for 1987.

For 1988, Flexi U.K.’s statements show net current liabilities of $76,200, which may evidence a problem of collectibility. In Canadian dollars, this represents a shortfall of approximately $156,900. Flexi’s audited financial statements do indeed show a claim for bad debts in the amount of $286,317. I think this confirms that the deduction for bad debts of $300,000 allowed by the Minister was reasonable.

In 1989, Flexi U.K.’s financial statements show net current liabilities of 163,181 (U.K.). Given that bad debts were recognized for 1988 in excess of the net annual liabilities, I would think that only the increased amount of net current liabilities should serve as a basis for determining the proper amount of bad debts in 1989. This increase of net current liabilities represents in Canadian dollars an amount of approximately $165,600. In Flexi’s audited financial statement a claim was made for bad debts of $84,384. The Minister allowed an amount of $128,488 as bad debts for tax purposes. Given the amount of bad debts allowed by the Minister in 1988, the amount for 1989 appears reasonable.

In summary, for tax purposes, Flexi claimed as bad debts for the three relevant taxation years a total amount of $2,162,333. It deducted for accounting purposes a total of $370,701 and, based on an analysis of the net current assets or liabilities, the shortfall would have been about $322,500. The total amount claimed by Flexi as bad debts for accounting purposes is more consistent with the amount of this shortfall than the amounts claimed as bad debts for tax purposes. The amount of $370,701 claimed for accounting purposes appears to me to be a reasonable deduction for bad debts. The amount of $2,162,333 claimed for tax purposes does not. I conclude that Flexi did not reasonably determine, using the relevant factors, that its accounts receivable had become uncollectible in the relevant taxation years. Flexi has not discharged its burden of proof of showing that the assessment of the Minister was wrong as regards the computation of the bad debts. Although I find the aggregate amount of $1,028,488 allowed as bad debts by the Minister from 1987 to 1989 to be generous, I will not modify it.

For these reasons, the appeals for the 1988 and 1989 taxation years are allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that Flexi’s income for 1988 should be reduced by an amount of $465,560.36 and, for 1989, by an amount of $165,973.

Flexi shall be entitled to half of its costs.

Appeal allowed.