Les Manufacturiers De Bijoux L.S.M. Inc. v. Minister of National Revenue, [1989] 1 CTC 2024, 88 DTC 1767

Couture, C.J.T.C. [Translation]:—This is an appeal from an assessment issued by the respondent for the 1980 taxation year under which $23,500 claimed as a deductible expense in the computation of the appellant's income was disallowed. The respondent contends that this expense was not incurred by the appellant for the purpose of gaining income from its business.

The evidence disclosed that the appellant (hereinafter referred to as L.S.M.) was operating a jewelry business, that is, was the owner of stores selling jewels at retail. The shareholders of L.S.M. are Mr. Roger Sabourin, Mr. Guy Martin and Mr. Yvon Larin, each of whom holds one third of the shares in the company. L.S.M. operated during the relevant years within a commercial structure composed of two other distinct companies.

One company, by the name of Moulage Yvon Larin Inc. (hereinafter referred to as Moulage) dealt with the manufacture of jewels, the process of moulding jewels, and 60 per cent of its production was sold to a company by the name of Crétions Darnel Ltée (hereinafter referred to as Darnel). Its sole shareholder since its incorporation in 1968 was Yvon Larin.

Darnel, the second company in the unit, handled the finishing of the jewels, the addition of precious stones such as diamonds, etc. In 1977, 50 per cent of Darnel's production was sold to L.S.M., and in 1987, 95 per cent. Prior to 1980, the company had three shareholders, Mr. Roger Sabourin and Mr. Guy Martin, and a man named Mr. Jean Noël.

Mr. Denis Perrier, called as a witness by counsel for the appellant, has been employed by the three companies since 1978. He explained how L.S.M. depended on Darnel as its chief supplier in operating its company, and how the three companies were interrelated in the operation of their respective businesses.

The witness said he was hired in 1978 by Adam, Trudeau, Authier, the auditors of the three companies, to work for the companies in question. At the time, he said, the companies were in serious financial difficulties and it was his task to get them back on their feet if possible.

A second witness called by counsel for the appellant, Roger Sabourin, explained that in 1977 and previously, he had been president of Darnel. He acknowledged that during these years the company's financial situation was precarious. In 1976, its liabilities exceeded its assets by $153,658. Together with his co-shareholder Martin, they had decided that it was necessary to improve the situation by reducing expenses. They had agreed that one possibility was to drop the other associate, Noël. This would eliminate one salary and thereby reduce expenses. To achieve this objective, they had to redeem the shares in the company belonging to Noël, who held one third of the shares.

The negotiations among Sabourin, Martin and Noël were wound up by an agreement duly signed by the parties, under which Noël sold his shares for $40,000. This agreement was said to have been finalized around the end of July 1977, although the agreement, a copy of which was produced as an exhibit, was signed by the parties on January 31,1977 [sic], that is, during the company's financial year terminating April 30, 1978. The signatories to this agreement were Jean Noël, Roger Sabourin, Guy Martin, Crétions Darnel Ltée represented by its president Roger Sabourin, and Yvon Larin, who at the time of this transaction became the owner of a share in Darnel. The agreement provided that Sabourin and Martin would each purchase 6 /e of Noel's shares and Larin would purchase one of Noel's shares, all for the sum of $40,000. Noël undertook to remain an employee of the company for a period of 50 weeks commencing February 3, 1978 in consideration of a weekly salary of $500 per week.

On cross-examination, the respondent's counsel showed that the shareholders had financed the cost of their shares in the following way. On August 11, 1977 the shareholders Sabourin and Martin borrowed from a man named Herman Davis on a note jointly signed by them the sum of $22,000 which they undertook to repay on January 11, 1978 together with a commission of $1,500. As well, on September 8, 1977, bills were drawn on the Toronto-Dominion Bank on behalf of Roger Sabourin, Yvon Larin and Guy Martin in the amount of $5,000 each, the bills being endorsed by Sabourin, Larin and Martin, and Jean Noël, respectively. Copies of these bills were produced as an exhibit.

Mr. Jean Noël was called as a witness by counsel for the respondent and he testified that he had sold his shares in Darnel for $40,000, as provided in the agreement, and that he had in fact been paid. In support of his statements, a deposit slip dated August 12, 1977 was produced, signed by Mrs. Suzanne Noël, the wife of Jean Noël, certifying that $3,000 in bank notes had been deposited in a bank account in addition to $22,000, for a total of $25,000. The $22,000 was represented by a cheque drawn to the order of Herman Davis, endorsed by the latter as well as by Sabourin and Mrs. Suzanne Noël. A copy of a second deposit slip was also produced showing that three amounts of $5,000 each had been deposited by Jean Noël in the same bank account, but the date of the deposit is not clear on this document. On examination by counsel, Noël confirmed that he had audited his bank account and that the date was September 1977. Interrogated on the nature of the negotiations he had entered into with the Darnel shareholders, he explained that he had been asked if he wanted to sell his shares and that he had simply established his price at the $40,000 he had been paid. The witness admitted that he had not done any analysis or consulted any experts concerning the value of the company in order to establish the sale price of his shares.

The evidence also showed that Davis was repaid his note in January 1978. The repayment was carried out following a new loan by Martin and Sabourin from a man named Gilles Bujold, in the amount of $23,500 and dated January 6, 1978. A copy of a cheque drawn on the Caisse Populaire Richelieu on the date mentioned was produced as an exhibit. The cheque is endorsed by Martin, Sabourin and Davis.

Denis Perrier was recalled as a witness by appellant's counsel and he testified that when he began working for the company he discovered that the bookkeeping records were in pitiful shape. He was told by Mr. Bujold that he was owed $23,500 but there was no record in the books concerning this. In response to inquiries among the shareholders he was told this was an amount that had been used in the companies’ operations. He explained that on the basis of this information he recorded the debt in the books of L.S.M. in 1980 or during the L.S.M. financial period ending on April 30, 1980. He paid the interest on the note to Mr. Bujold until 1981 and repaid him in 36 instalments from 1981 to 1983 paid by L.S.M.

As a result of the information he had received from the L.S.M. shareholders — and at that time he was unaware of the documentary evidence as produced in Court — he concluded that the $23,500 should have been used for purchases and accordingly he entered it under purchases. The $23,500 was therefore claimed by L.S.M. as an expense in the computation of its income for the 1980 taxation year. After an audit by Revenue Canada the amount was disallowed and an identical amount divided among the three shareholders was added to their respective incomes distributed over the years 1981, 1982 and 1983, that is, the taxation years during which the amount had in fact been repaid to Bujold by L.S.M. The reason why this amount was charged to L.S.M. was that, according to Perrier, that company was the only one that could absorb such an expense. During 1981 and subsequent years the shareholders of L.S.M. were Sabourin, Martin and Perrier.

The appellant submits, in his notice of appeal, and I quote:

[Translation]

5. Your appellant, in the interests of assuring the proper management of its business, therefore itself paid the said employee of Les Créations Darnel Inc. the said sum of $23,500.00, for the purpose of making the company Les Créations Darnel Limitée more productive and thereby assuring a proper supply of merchandise for the continuation of its business as a manufacturer of jewels.

Counsel for the appellant submitted that although the entire documentation demonstrated that the shareholders had acted in their personal names, they had in fact been acting for and on behalf of the company. To justify the deduction of the expenditure from a tax standpoint, he argued that it was essential to relieve Mr. Noël of his services if Darnel was to be refloated financially. Since Darnel was closely linked with the L.S.M. operations, it was also essential for it to protect the situation of Darnel. He adds that notwithstanding the agreement, at the date at which the L.S.M. shareholders obtained Noel's shares those shares were absolutely worthless since the company was losing money. Thus, he submits that the amount was actually paid as a separation bonus and not as the share purchase price, as provided in the agreement.

Counsel for the respondent submits that in the first place the expense or amount of $23,500 claimed by L.S.M. was not incurred for the purpose of gaining income but rather for repaying the purchase price of the shares borrowed by the company's shareholders. Secondly, although the evidence could be interpreted as the payment of a separation bonus to Jean Noël, it was not in fact paid in 1980, as claimed by the appellant.

I will not linger further on the first point raised by respondent's counsel since, without adopting the argument of counsel for the appellant that the evidence could be interpreted as a separation bonus paid by the company and hence deductible, I think that his second point, that is, that the expense incurred by the appellant was not incurred by it in 1980 but in another taxation year, is fatal to the appellant.

In fact, the evidence clearly showed that if the shareholders, who were Sabourin and Martin in 1977, had acted for and on behalf of the company in negotiating with Jean Noël, the $40,000 that was paid to him was paid in 1977, that is, in the appellant’s 1978 taxation year. This was confirmed by Noël himself, who acknowledged having received the money in 1977, and the documentary evidence corroborated this testimony. This means, therefore, assuming the shareholders were acting for and on behalf of the appellant company, that its obligation to Noël was satisfied in August 1977, in the company's 1978 financial year. Admitted, in order to meet this obligation it was necessary for L.S.M., through its shareholders, to borrow $22,000 from a certain Davis and subsequently, in order to pay this loan, borrow again in the amount of $23,300 from Bujold, whom it repaid in 1981, 1982 and 1983. What L.S.M. actually did during 1981, 1982 and 1983 was to pay a note that it owed Bujold. The original loan had been used to meet its obligation to Jean Noël, and this obligation was satisfied in 1977 and accordingly the expense was not incurred in 1980 as the appellant submits. The fact that the amount was entered on the company's books in 1980, as the witness Perrier explained, does not make the expense deductible in 1980 for the purposes of the Act. For an expense to be deductible it is necessary that it result from a contractual obligation that came into being during the year in which it is claimed. In 1980 no such obligation was created for the appellant.

In Consolidated Textiles Ltd. v. M.N.R., [1947] C.T.C. 63; 3 D.T.C. 958, the Court had to determine whether an expense incurred by a taxpayer in one taxation year could be deducted in computing his income for a subsequent year. It was a decision of the Exchequer Court of Canada as it was at that time, and the President stated the following, at page 69 (D.T.C. 960):

In my opinion sec. 6(a) excludes the deduction of disbursements or expenses that were not laid out or expended in or during the taxation year in respect of which the assessment is made. This is, I think, wholly in accord with the general scheme of the Act dealing as it does with each taxation year from the point of view of the incoming receipts and outgoing expenditures of such year and by the deduction of the latter from the former with a view to reaching the net profit or gain or gratuity directly or indirectly received in or during such year as the taxable income of such year.

Obviously, this decision was rendered on the basis of legislation that differed from the section applying in this instance, but the principles for determining the income of a taxpayer for a taxation year have not changed, despite the change in the legislation.

For these reasons the taxpayer's appeal for the year 1980 is dismissed.

Appeal dismissed.