Macdonald Engineering Projects Ltd. v. Minister of National Revenue, [1987] 2 CTC 2237, 87 DTC 545

Tremblay, T.CJ.:—This appeal was heard on April 10, 1987 at the city of Calgary, Alberta.

1. The Point at Issue

The point at issue is whether the appellant company is correct in the computation of its income with respect to the 1982 taxation year, to consider as a reserve of doubtful accounts receivable amounting to $94,608.70, the invoices receivable for Universal Explorations Limited (Universal) dated from August 27, 1981 to May 31, 1982. According to the appellant, Universal had a severe cash shortage problem and was unable to pay any of those bills.

Several lawsuits were commenced against Universal. The appellant's financial year end was July 31, 1982.

The respondent disallowed the reserve of doubtful accounts on the basis, amongst others, that the amount had been owing for a period not exceeding three months and it was collected within five months from the date of invoice, despite the fact that it is after the appellant's financial year end July 31, 1982.

2. The Burden of Proof

2.01 The burden of proof is on the appellant to show that the respondent's reassessment is incorrect. This burden of proof results particularly from several judicial decisions, including the judgment by the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195; 3 D.T.C. 1182.

2.02 In the same judgment, the Court decided that the assumed facts on which the respondent based his reassessment are also deemed to be correct. In the present case, the assumed facts are described in paragraphs 4(a) to (d) of the reply to the notice of appeal.

4. In assessing the Appellant as he did and with respect to the matters here in issue, the Respondent assumed, inter alia, that:

(a) that portion of the amount that was claimed by the Appellant as a reserve for doubtful debts but was disallowed by the Respondent was not doubtful of collection;

(b) the Appellant had not made a concerted effort to collect the said amount;

(c) the said amount had been owing to the Appellant for a period not exceeding three months;

(d) the said amount was collected by the Appellant within five months from the date of invoice.

3. The Facts

3.01 The appellant company, the main business of which being Engineering Consultants, since at least 1980 was performing engineering services for Universal.

3.02 From copies of ledger cards of the appellant re: Universal (Exhibit R-2), it appears that on January 12, 1981, the balance of account payable was $15,722.14.

3.03 It appears from Exhibit A-2 that the doubtful debts re: Universal total $105,635.40 at the end of July 1982. They were aged as follows:

3.04 All those debts are detailed as follows in Exhibit R-3:

MacDonald Engineering Projects Ltd.

Billings & Payment

Billing Paid Paid

Date Amount Amount Date Amount

Aug. 27 /81 13984.26 Nov. 12 /82 13984.26

Jan. 19 /82 2851.18 June 9 /83 2851.18

Feb. 18 /82 2614.97 June 9 /83 2614.97

Mar. 15/82 [2923.25] June 9 /83 [2923.25]

Mar. 18 /82 4882.22 June 9/83 4882.22

April 19 /82 39194.92 Sept. 13 /82 35593.34

June 9/83 3601.58

May 13 /82 45031.10 Oct. 29 /82 45031.10 Total : 105635.40 105635.40

	Repayment Schedule
Sept. 3 /82	35593.34
	Sept.28 /82 Financial Stmt dated by CA
Oct. 29 /82	45031.10
Nov. 12 /82	13984.26
	Nov. 15 /82 Return is signed
	Nov. 25 /82 Return is mailed
June 9 /83	11026.70
Total	105635.40

The three amounts which are not admitted by the respondent as doubtful are:

3.05 From Exhibit R-3, p. 2 taken from the ledger R-2), the billings, the payments and the balance from August 1981 to October 1983 read as follows: 3.06 Mr. Daniel Anthony Mercier, vice-president, production and exploration of Universal, explained the financial position of Universal in 1982:

Universal's financial position was very questionable. The history relates back to September 1981, at which time Universal Explorations purchased 65 per cent of the Petrol Oil & Gas Company Limited. The consideration of the purchase was approximately $30 million, but it was comprised of, number one, cash, which we received through bank debt, a debenture, in the amount of $6 million, and a certain number of shares, and I’m sorry, I can’t recall the exact number of shares of the transaction.

In purchasing Petrol, Universal made the assumption that we would be able to amalgamate the two companies, Petrol and Universal under a new company, and would therefore be able to use the cash flow generated from the Petrol properties to service the debt which Universal incurred in acquiring Petrol.

We subsequently made three attempts to amalgamate the two companies, and we were opposed on all three attempts by dissident shareholders of Petrol. The amalgamation was finally approved by a Court of Queen's Bench in the latter part of 1983. Again, I can’t remember the exact date, but I believe it was towards the end of October, at which time we were finally successful in amalgamating the two companies and utilizing the Petrol cash flow to service all of the debts of the company, including the debt which had been incurred to purchase Petrol, or 65 per cent of Petrol (TS, pp. 5, 6).

3.07 In cross-examination, Mr. Mercier said that in the summer of 1982, Mr. Andre Liptak, then engineer for the appellant, asked for payment. This happened on two or three occasions some of them at meetings, some over the phone. However, the witness was an engineer and he looked more at the technical side of the business, as opposed to the financial one. However, Mr. Liptak was certainly concerned by the accounts payable because he approved in September 1982, the list of doubtful debts (Exhibit A-2).

However, in cross-examination, the witness said:

The difficulty was that this problem hit us in the middle of some projects. We had contracted MacDonald to perform this work for Universal prior to the purchase of Petrol, and the difficulty was, Andre could see that he wasn't being paid for his work, and he was trying to establish, I think, most of all, whether or not he was ever going to get paid, and what should he do with the additional obligations which were building up.

Was Universal a bad debt, period, that he shouldn't touch, or, you know, and continuing to work for us, what was the possibility of being paid, and I believe that I told him that on current work, which this would have been, in approximately the middle of 1981, on current obligations, we had an agreement whereby Petrol would start to acquire, or start to compensate the contractors for Universal's obligation, and would thereby earn an interest in the properties (TS, pp. 10, 11).

3.08 He then corrected what he had said:

So, for me to say that by the middle of 1982, we had it in place, I’m afraid I’m a little uncertain, and I apologize for that. But, in and around that period, it was starting to come together. We realized we had a very severe problem from Universal and somehow we had to get this cash flow from Petrol.

3.09 He then explained that the money was required to pay current projects and clarified what he meant by current projects as follows:

Well, the current projects, these projects stretched over a period of really, the current projects, I think you'll find that these all relate to maybe four or five different projects in all, and that Petrol stepped in halfway through an ongoing design process on maybe four or five different projects, and that you'll find that all of the bills that were outstanding relate to the same projects, both those that Petrol was paying the bills for, and those that hadn't been paid.

The problem was that we didn't know how to address any obligations which had occurred, number one, prior to Universal acquiring Petrol, which was in the latter part of 1981, and secondly, during the period before we realized that we were getting ourselves into a serious probem; that this amalgamation was not going to come about in short order, as we had planned, and that we were going to have to come up with some contingency plan to carry us throug the interim period.

At the time, it was looking rather doubtful that the amalgamation would occur at all.

Q. And when you say at the time, you mean at which time?

A. During the two year period. Our first attempt to amalgamate was made, I believe, in October of 1981. It was somewhere between September and November, in that period, and we ran into some difficulties, which we thought we could overcome.

A second attempt was made in the early part of 1982, and when it was blocked, then we became, we realized we had a problem, this amalgamation was not something we should be banking on, and that it might not come about (TS, pp. 14, 15).

3.10 However, Mr. Mercier said he never indicated prior to July 31, 1982, to Mr. Liptak or any other officers of the appellant, that if the amalgamation didn't go through, they might as well forget ever being paid.

He also said Universal never received from the appellant "any nasty letter . . . accounts with red marks, and ‘please pay'" as suggested by counsel for the respondent.

3.11 From Exhibit A-2, it appears that Petrol Oil and Gas made payments, on behalf of Universal, in the amounts of $24,622.54 on July 12, 1982 and $35,593.34 on September 3, 1982. All the subsequent payments were made by Universal. However, Mr. Liptak had not realized that those two payments were made by Petrol.

3.12 Mr. Liptak said that when they checked the doubtful debts at the time of the preparation of the financial statements during September, he did not remember seeing the payment made on September 3, 1982. They then checked the accounts only until the last day of August. It is indeed the ordinary method to check always from the oldest accounts until those of the last day of the month proceeding the one during which they are doing the checking. He was responsible on a monthly basis, not on a day-to-day basis.

3.13 Mr. Dyck, CA, the appellant's accountant, said that in September 1982, the doubtful debts were set up in consultation with Mr. Liptak. The working sheet of the computation was filed as Exhibit A-2.

Moreover, Mr. Dyck indicated that in all likelihood the small business deduction was discussed with regard to the amount of income that was reported for the 1982 year.

4. Law — Cases at Law - Analysis

4.01 Law

The main provisions of the Income Tax Act (the Act) involved in the instant case are subparagraphs 20(1)(l)(i) and 20(1)(p)(i). They read as follows:

20. (1) Nothwithstanding 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:

(1) a reasonable amount as a reserve for

(i) doubtful debts that have been included in computing the income of the taxpayer for that year or a previous year, and

(p) the aggregate of debts owing to the taxpayer

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

4.02 Cases at Law

Counsel for the parties referred the Court to the following cases at law:

1. No. 81 v. M.N.R., 8 Tax ABC 82; 53 D.T.C. 99;

2. Harlequin Enterprises Ltd. v. The Queen, [1977] C.T.C. 208; 77 D.T.C. 5164 (F.C.A.); [1974] C.T.C. 838; 74 D.T.C. 6634 (F.C.T.D.);

3. Highfield Corporation Ltd. v. M.N.R., [1982] C.T.C. 2812; 82 D.T.C. 1835 (T.R.B.);

4. G.I. Norbraten Architect Limited v. M.N.R., [1983] C.T.C. 2145; 83 D.T.C. 121 (T.R.B.);

5. Geoffrey Hogan v. M.N.R., 15 Tax A.B.C. 1; 56 D.T.C. 183;

6. Berretti v. M.N.R., [1986] 2 C.T.C. 2293; 86 D.T.C. 1719 (T.C.C.);

7. Ferriss v. M.N.R., [1964] C.T.C. 491; 64 D.T.C. 5304.

4.03 Analysis

A. Appellant's submission

4.03.1 After quoting paragraph 20(1 )(I) cited above (para. 4.01), concerning a reserve for doubtful debts, counsel for the appellant said there are three issues for deciding that reserve:

(a) Who makes the determination?

(b) How must that determination be made?

(c) When must that determination be made?

4.03.2 Who makes the determination?

It is the taxpayer who has to decide. The taxpayer "who's worrying about paying the next month payroll, etc.” It is not "a Revenue Canada Auditor sitting at his desk, looking at the cold numbers . . .”

Counsel for the appellant then referred to the Norbraten case (para. 4.02(5)) in the extract quoted after in paragraph 4.01.3 of Taylor, T.C.J.

Moreover, counsel for the appellant contended, referring to Interpretation Bulletin No. IT-442 and different cases at law, Norbraten (para. 4.02(4)), Hogan (para. 4.02(5)), Highfield (para. 4.02(3)), that the principles involved for doubtful debts are similar to those of bad debts. In the latter, subparagraph 20(1)(p)(i) quoted above (para. 4.01) clearly says: "debts . . . established by him (the taxpayer)".

4.03.3 How must the determination be made?

Referring to the Interpretation Bulletin No. IT-442 entitled “Bad debts and reserve for doubtful debts", paragraph 22 compares bad debts, and doubtful debts. Concerning the degree of doubt, it is said:

For a debt to be classed as a bad debt, there must be evidence that it has in fact become uncollectible. For a debt to be included in a reserve for doubtful debts, it is sufficient that there be reasonable doubt about the collectivity of it.

The first part of paragraph 23 also says:

23. For a taxpayer to establish that a reserve for doubtful debts is reasonable in amount it is necessary to identify the debts that are doubtful of collection, having regard for such indications as the period of arrears or default the financial status and prospects of the debtor, the debtor's past credit record both with the taxpayer and, if available, with other creditors, the value of any security taken and any other factor that is relevant in judging the debtor's ability or willingness to pay.

Referring to the No. 87 v. M.N.R. case (para. 4.02(1)), counsel for the appellant applied to the instant case different factors used by Mr. Fabio Monet in the No. 87 case;

The factors that he set out were, firstly, the time element. In other words, how long overdue is the account? In this case, the account was more than 90 days old. The history of the account. In this case, Mr. Liptak knew of the lawsuit that Universal was engaged in, he knew of their problems, he knew from his bank about the problem.

The financial position of the client, previous write-off experience. Well, they had no experience. The client, in the past, had been a good client, but they went and got themselves into trouble.

The general business conditions in the country, the business conditions in the client's locality. Mr. Dyck testified, and Mr. Liptak as well, that 1982 was a year where there was difficulty in general, not specifically related, but in general in Calgary.

The final factor, and I'm not sure it's relevant, was changes in the level of sales and receivables over prior years. It’s a fact that it’s in that case, but I don't know that it’s relevant. I think that here the relevant factors are specific to collect them. He knew from the newspapers what was going on with Universal (T.S., pp. 146, 147).

Counsel for the appellant also referred to the Norbraten case (para. 4.02(4)). He quoted Taylor, T.C.J., then a member of the Tax Review Board:

In the instant case, the entire matter revolves around the opinion and belief of Mr. Norbraten that the account would not and could not be collected. I am all too aware of the arguments raised by counsel for the respondent in this matter, which would indicate a very nonchalant and unbusinesslike approach to the possibility of collection by this appellant. Nevertheless I am not aware of any requirements under the Act or in the relevant jurisprudence making it mandatory that a taxpayer make every attempt, in fact any attempt, to collect a receivable or obtain security for the debt before he is entitled to avail himself of the provisions in the Act permitting its deductibility as a doubtful debt — providing he is able to substantiate his conclusion regarding its worth or rather lack of it.

4.03.4 When the determination must be made?

The appellant contends, referring to the Hogan case (para. 4.02(5)) which deals with bad debts, that the determination must be made at the end of the fiscal year:

within a very short period after the termination of the taxation year involved .. . . and not 18 months or two years afterwards. I am of the opinion, therefore, that the explicit provisions of the legislation in respect of this particular item preclude taking into consideration facts which have not become known until many months afterwards and which could not have been foreseen by the taxpayer at the time of his determination.

In the instant case the end of the fiscal year is July 31, 1982 and not in October.

B. Respondent's submission

4.03.5 Counsel for the respondent also referred to Interpretation Bulletin No. IT-442 quoting paragraph 27:

Although the length of time that the account is in arrears is generally an important consideration in deciding whether the account is doubtful of collection, in certain circumstances, a lengthy delay may occur without the account being so considered. . . .

Similarly, a deferment of payment for a number of years agreed upon by the creditor to overcome a cash flow problem of the debtor, does not in itself entitle the creditor to claim a deduction for reserve under paragraph 20(1)(I).

He then referred to the testimony of Mr. Mercier in cross-examination. The bad financial position indeed referred only to the cash flow problem generated by the resistance of the minority shareholders of Petrol Oil and Gas (para. 3.08).

4.03.6 He also referred to the agreement that Universal had reached with Petrol in the middle of 1982 to the effect that some payments would be made on the outstanding accounts on certain projects (para. 3.07). And actually payments were made by Petrol (para. 3.11).

4.03.7 Counsel for the respondent contended that no legal action was taken, no letter was sent by the appellant to Universal, "the point was raised verbally only" (paras. 3.07, 3.10).

4.03.8 Counsel for the respondent referred to the Federal Court — Trial Division Harlequin Enterprises case (para. 4.02(2)) at page 850 (D.T.C. 6643) concerning the nature of a doubtful debt, "A doubtful debt and a slow debt are not the same thing”.

In the instant case, it is a slow debt according to him. He also referred to the Highfield case (para. 4.02(3)).

Taylor, T.C.J. at page 2829 (D.T.C. 1847) said concerning the bad debt:

Subparagraph 20(1)(p)(i) reads "that are established by him to have become bad debts in the year" (underlining mine), and I would note the emphasis to be placed on past tense and the reference to the financial period. The claim must be one that can be asserted as having become uncollectible by the end of the fiscal year.

And concerning the doubtful debts he adds:

To whatever degree “hindsight” (at the date of preparation of financial statements for example) may be permissible in the utilization of paragraph 20(1)(l) of the Act I find no similar flexibility for paragraph 20(1)(p).

So hindsight is permissible to a certain extent, counsel for the respondent concluded, "for example the time of the financial statements". In the case at bar the financial statements were prepared at the end of September. "There is no clear case that says that facts or events that are either foreseeable, or which would be brought to the attention or the knowledge of the taxpayer, before he signs his return, has to be ignored".

4.03.9 Counsel for the respondent then referred to two other precedents. In the Alber B. Ferriss case (para. 4.02(7)), a decision of Mr. Justice Thurlow of the then Exchequer Court; the learned Judge took the point of view as of the time of the making of the return.

I am moreover not impressed by the fact that by November 1963 most of the amounts had been paid. Had the appellant known in April 1957 and 1958 that he would have to wait for a matter of years for payment of these accounts he would I think have had good reason to regard them as doubtful and probably good reason to regard some of them as bad.

On the whole viewing the position as nearly as possible as of the time when the 1957 return was made and having regard both to Mr. Ferriss' opinion and to the extent to which support for it may be found in the facts which I have mentioned with respect to the accounts I do not think a sound estimate made in April 1958 of the present value of the $8,331 still remaining unpaid would have been in excess of two-thirds of the total that is to say $5,554 and I am satisfied that a reasonable reserve for doubtful debts under s. 11(1)(e) for 1957 would have amounted to at least $2,700.

4.03.10 The second precedent is the Berretti case (para. 4.02(6)) in which the taxpayer who claimed deductions for bad debts was not called as a witness. The only witness, his accountant, had no personal knowledge of some of the major factors which were supposed to have influenced the decision to claim the deduction for bad debts. The appeal was dismissed on the basis that the determination that an amount owing was a bad debt or uncollectible must be made by a taxpayer based on contemporary consideration of all known facts.

Sarchuk, T.C.J. excluded as being irrelevant, facts which became known ten months later but did not exclude the information that was compiled two months after the year end.

4.03.11 In the case at bar, counsel for the respondent contended that the only thing that Mr. Liptak said was that the account was aged more than 60 days.

Moreover, Mr. Liptak did not make an honest and thorough review of the facts that were foreseeable or known to him, either at the end of the year, or at the time when the financial statements were presented to him and surely not at the time the returns were signed. Mr. Liptak indeed had not realized that the two payments made on July 12 and on September 3,1982 were made by Petrol.

He even admitted he did not look at the ledger card which is the actual data source, said Mr. Fontaine.

The evidence of Mr. Liptak was vague. He has failed to discharge the burden, according to counsel for the respondent, despite the fact that he admits it is true that there is a certain degree of subjectivity that comes into claiming a doubtful debt and that the Minister of National Revenue is not initially in as good a position as a taxpayer to make a better decision.

4.03.12 Finally counsel for the respondent underlined that the computation of doubtful debts reserve was not extraneous to the result of the small business deduction, with regard to the reported income (para. 3.13).

C. Findings

4.03.13 In the No. 81 v. M.N.R. case, rendered in 1953, Mr. Fabio Monet, the then chairman of the Tax Appeal Board, after stating that there was no specific rule in the Act giving factors for the determination of doubtful debts, refers to the well-known rule that general accounting principles are to govern unless they are in conflict with the Act. After quoting different authorities in accounting from various countries, he listed the following factors to be taken into consideration at page 98 (D.T.C. 105):

Among the factors which may be taken into consideration by a taxpayer who claims a deduction under the provisions of section 11(1)(d) of the Act would be: the time element, the history of the account, the financial position of the client, the past experience of the taxpayer with the writing off of his bad debts, the general business condition in the country in a case like in the present one where the taxpayer is doing business all over Canada, the business condition in the locality where the client lives, the increase or decrease in the total sales and accounts receivable at the end of the year for which the deduction is claimed, as compared with previous years.

All those elements do not necessarily apply in each case. It depends on the circumstances of each case.

4.03.14 Time element

In my opinion, the time element has two facets: (a) the age of the accounts involved; and (b) the period after the financial year taken to file the appellant's return.

(a) Concerning the first element, the age of the accounts involved, the evidence is to the effect that at the end of the fiscal year on July 31st, 1982, there were three accounts aged from 69 to 361 days:

According to Mr. Liptak, the bank manager was very strict concerning the accounts payable. All those over 60 days were considered in the computation of the open line credit permitted by the bank to the appellant.

(b) Concerning the second element, it is my opinion that it is reasonable that be taken into consideration the time spent to file the taxpayer's return. It was easy for the appellant to check.

It is my opinion that the amount of $35,593.34 paid on September 3, 1982 cannot reasonably be part of the reserve. Therefore, after receiving the payment, the bank manager could not reproach the appellant not to include in the reserve the said amounts in preparing the 1982 financial statements signed on September 28, 1982.

4.03.15 It remains to state whether the balance of $51,626.94 be reasonably included in the reserve of doubtful accounts.

One of the main arguments of the respondent is that, following the verbal agreement made between Universal and Petrol, the latter would pay the “current obligations” (para. 3.07) due by Universal to the appellant. The latter was informed of that agreement in the middle of the 1982 calendar year. An amount was paid on July 12, 1982 ($24,622.54) and the last one on September 3, 1982 ($35,593.34). Is this fact significant enough to confirm that the balance of $51,626.94 must not be included in the reserve? I have a great doubt about that if I take into consideration the two following factors:

(a) the general history of the accounts due by Universal to the appellant from August 1981 to August 1982; and

(b) the general economic situation of the country in 1982.

(a) Concerning the latter factor, I do not want to insist on it, because it is well known that the period of 1981, 1982 and 1983 was a time of economic crisis not only in Canada but in the whole world. Many companies well established for decades declared bankruptcy. It was a time of economic uncertainty. At that time, no one could determine what would be the future for whatever field of economy.

(b) Concerning the general history of the accounts payable by Universal to the appellant, the evidence is to the effect that between August 1981 and August 1982, they increased from $14,410.28 to $169,425.84. Taking into consideration the amount of $35,593.34 paid on September 3, 1982, the balance was $137,869.26 (para. 3.04, Exhibit R-3, p. 2), it is an increase of nearly 1,000 per cent.

Mr. Justice Rowlatt in the Anderton case (Anderton and Halstead Limited v. Birrell, 16 T.C. 200 at 209) was quoted by chairman Fabio Monet in No. 87 v. M.N.R.:

Such an estimate is not a prophecy to be judged as to its truth by after events, but a valuation of an asset de praesenti upon an uncertain future to be judged as to its soundness as an estimate upon the then facts and probabilities.

In my opinion, the history of the accounts and the economic crisis existing in the country are sufficient "facts and probabilities" to include the amount of $51,626.94 in the reserve of doubtful accounts.

4.03.16 The respondent also stressed the point that the appellant intended no legal action. He did not even send a letter of demand to Universal. I share the opinion of Taylor, T.C.J. in the Norbraten case. He does not see in the Act such requirement to be taken into consideration in the computation of the reserve for doubtful accounts (second quotation para. 4.03.3 in fine).

5. Conclusion

For these reasons, the appeal is allowed in part with costs and the matter referred back to the respondent for reconsideration and reassessment.

Appeal allowed in part.