Romualdo Berretti v. Minister of National Revenue, [1986] 2 CTC 2293, 86 DTC 1719

Sarchuk, T.C.J.:—Romualdo Berretti (Berretti) appeals from a reassessment of income tax for his 1981 taxation year. At issue is the disallowance by the respondent of the amount of $57,148 claimed by the appellant as an allowable business investment loss in that year.

The appellant is a businessman. He is the majority shareholder of Berla Holdings Ltd., a company which owns one-third of the shares of Delta Mortgage Ltd. (Delta). At all relevant times he was one of the directors of Delta. The business loss claimed by the appellant arose from his investment in that company. The business of Delta initially consisted of the borrowing of funds and reinvesting them in a portfolio of second mortgages. At some stage Delta became involved in the development of a residential subdivision in St. Albert, Alberta. In 1979 it acquired further land for development in St. Catharines, Ontario. This project failed and by 1981 the primary business of Delta had reverted to investment in mortgages, with mortgage interest accounting for all of its revenue in that and subsequent years.

Delta obtained the bulk of its working capital from the Bank of Montreal with which it had established a line of credit. Substantial amounts were also invested by its directors including the appellant and on occasion by other parties.

On or about May 11, 1977 the appellant advanced the sum of $120,000 to Delta. At some point of time between February 1, 1979 and January 31, 1980 the appellant advanced the further sum of $75,000 to Delta. In addition to these two loans, during the years 1978 and 1979 the appellant made "interest free advances” of $11,000, $3,000 and $11,400 to Delta. The loans of $120,000 and $75,000 are not documented and there is no evidence that they were recorded in the minutes of Delta. However its financial statement for the year ending January 31, 1979 lists, as a liability, an item: "loans — 10%% interest bearing, no fixed terms of repayment” and the financial statement for the year ending January 31, 1980 lists as a liability the term: “loans — 1014% interest bearing, no fixed terms of repayment; 1614% interest bearing, no fixed terms of repayment”. It is accepted that the advances of $120,000 and $75,000 formed part of the 10% per cent and 1614 per cent interest loans described in these statements.

Evidence was elicited on behalf of the appellant from Mr. L. R. Lachman (Lachman). He was associated with a firm of accountants which had been engaged solely as auditor to Delta from 1974 to January 31, 1981. The appellant's personal income tax returns were prepared by Lachman for the first time for taxation year 1979 and this retainer continued through all of the relevant years.

Lachman traced the events which led to the losses in issue. Prior to January 30, 1981 Delta’s affairs were managed by three directors one of whom was the appellant. The day-to-day responsibilities were for the most part attended to by one of the other directors, Mr. Taylor Gordon (Gordon). Although Lachman's evidence was imprecise it appears that at some point of time in 1980 Gordon ran into personal financial difficulties. On January 30, 1981 he was removed as a director of Delta and on October 13, 1981 Gordon filed an assignment under The Bankruptcy Act.

In 1979 Delta had advanced substantial sums of money to a joint venture in which the appellant and the other directors of Delta were indirectly involved. The joint venture, established to acquire and develop properties in St. Catharines, eventually failed. Delta’s statement of earnings for the year ending January 31, 1981 contains an entry indicating that it wrote-off advances due from the joint venture in the amount of $371,723.

During the first part of 1981 Lachman met with the appellant and the third director, Dr. Hallgren, to consider alternatives relative to the continued management and administration of Delta. These discussions led to a decision to bring about an orderly “winding-up” of the affairs of Delta. It was the opinion of the directors, confirmed by Lachman, that there were sufficient assets to retire all “outside creditors” and that it was not necessary to appoint a receiver. The directors dispensed with the services of Lach- man’s firm as auditor and retained Thane Management Ltd. to bring to an end the business activities of Delta.

At some point of time during March or April 1982, Lachman, acting on the basis of a Delta unaudited balance sheet “prepared by management” and dated February 28, 1982, calculated the business investment loss which the appellant ultimately claimed in the 1981 income tax return. Lachman’s calculation of the loss follows*: [1]

Berla Holdings Ltd.

Interest-free advances	20,967.25
Interest-free advances	29,400.00
	50,367.25	20,326.00
Robert Hallgren
10.25% advance	118,024.59
Interest-free advances	24,197.30
	142,221.88	57,397.00
Shaunand Development Ltd.
Interest-free advances	29,400.00	11,864.00
TOTAL	$648,614.68 $261,760.00
Total proceeds available for
Romualdo Berretti		$ 77,277.00
Total investment		191,482.00
Deficiency (Amount under
appeal $114,295 difference
due to rounding)		$114,205.00

Therefore, it is apparent that at least one loan ($116,482.65) is established to be uncollectable under Section 50(1)(a).

Lachman explained the rationale behind these calculations this way:

A. Basically what I did is I took the total assets, as were shown on this information, that was available to me, deducted any secured creditors, the bank loan, and the life insurance loan which still existed at that time, deducted the amount owing on the Halverson loan, a hundred and fifty thousand dollars, plus various liquidation costs, fees, professional fees, interest accruals and so on; and then I also deducted a loan receivable from Taylor Gordon for one hundred eighteen thousand dollars, which in my opinion would have been an offset to amounts owing to him; and then in consultation with Thane Management and Mr. Berretti, we made provision for what appeared to be uncollectable mortgages that were still included in the assets, thirty-five thousand dollars, and an estimate for liquidation costs to be incurred to bring about final liquidation of the remaining assets. This produced available net assets of some two hundred sixty-one thousand dollars which I then prorated to the three groups of the Gordons, the Ber- rettis, and the Hallgrens. I prorated this to the three groups in the ratio of their advances, loans, to Delta and the difference between the amount of assets allocated to, in this case, the Berrettis; and the amount of the loans represented the loss of a hundred and fourteen thousand dollars, half of which is claimed on tax return.

It is the appellant’s position that he is entitled to claim an allowable business investment loss in his 1981 taxation year in the amount of $57,148 in respect of his investment in Delta. In taking this position he relies principally upon the provisions of paragraph 39(1 )(c) and subsection 50(1) of the Income Tax Act. Paragraph 39(1)(c) states that a taxpayer's business investment loss is the amount of his capital loss from a disposition, pursuant to subsection 50(1) of a debt owing to the taxpayer by a Canadian controlled corporation. Paragraph 38(c) of the Act provides that an allowable business investment loss is one-half of the business investment loss. To complete the scheme subparagraph 3(d)(i) permits the deduction of an allowable business investment loss in computing a taxpayer's income.

The evidence before the Court establishes that there were two “debts” owing by Delta to the appellant at December 31, 1981. These were referred to as the $120,000 debt and the $75,000 debt. Interest on these amounts was paid to the appellant by Delta from 1977 to 1980 and was reported by him in his appropriate income tax return. There is no dispute that Delta was a Canadian controlled private corporation for the purposes of the Act and that the advances made by the appellant were to be utilized by Delta in carrying on its business. That having been said it only remains for the appellant to establish that the debt owing to him by Delta had become a bad debt in the 1981 taxation year within the meaning of subsection 50(1) of the Act. This provision reads in part:

50 (1) For the purposes of this subdivision, where

(a) a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to him in respect of the disposition of personal-use property) is established by him to have become a bad debt in the year, or . . .

the taxpayer shall be deemed to have disposed of the debt . . . at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil.

Counsel for the appellant submitted that the test of whether a debt is bad is whether it is uncollectable. The evidence relied upon by him establishing this fact falls into three categories. Each requires separate consideration.

The first category consists of facts established by direct evidence, principally documents such as the financial statements of Delta, the appellant’s personal income tax returns etc. and those portions of Lachman's testimony which were not hearsay. This evidence establishes that Delta declared dividends in each year up to and including the 1980 taxation year but not thereafter; the advance by Delta to the St. Catharine's joint venture was written off as at December 31, 1981; the increased cost of borrowing money from the Bank of Montreal was negating the return on much of the second mortgage portfolio and that some of the second mortgages were in default. It is also a fact that these concerns led to the hiring of Thane Management Ltd. to recover as much as possible on the assets and to pay Delta’s creditors.

Counsel contended that the evidence adduced also established a refusal by the Bank of Montreal to extend further credit to Delta and the fact that the loss of Taylor Gordon as the “managing director" early in 1981 left no one to manage the affairs of Delta. These facts were not established by direct evidence but appear to have been conclusions reached by Lachman based on material not before the Court.

In addition to the foregoing counsel urged the Court to accept as relevant evidence the following: financial statements for Delta for the 1982 to 1985 fiscal years; the fact that in December 1985 Delta was struck-off the record by the Registrar of Corporations in Alberta and certain financial statements of Delta for the year ended January 31,1982 which had not been prepared until October or November of that year. All of these were facts occurring well after the appellant claimed the deductions, which were not within his knowledge at the relevant time and could not have been a factor in the process of establishing the debt to be a bad debt in that taxation year.

Counsel for the appellant relied upon Geoffrey Hogan v. M.N.R., 15 Tax ABC 1; 56 D.T.C. 183; Gestion Louis Riel Inc. v. M.N.R., [1985] 2 C.T.C. 2211; 85 D.T.C. 550; Alger B. Ferriss v. M.N.R., [1964] C.T.C. 491; 64 D.T.C. 5304 and Leonidas Roy v. M.N.R., 20 Tax A.B.C. 385; 58 D.T.C. 676. Certain principles can be excerpted from these decisions. There is for example no necessity that a debt be absolutely irrecoverable (vide Hogan) and that possible recovery in the future is not per se a bar to a determination of uncollectibility (vide Riel and Ferriss). These judgments also confirm the proposition that the determination of uncollectibility is to be made by the appellant and not by an official of the respondent or some other person.

However one cannot ignore the fact that a taxpayer's decision that a debt is a “bad debt" must be made on the basis of a recent consideration of all of the known facts. In Hogan, Mr. Fisher stated at 17 (D.T.C. 193):

For the purposes of the Income Tax 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 of 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 possible, each individual debtor . . .

In Roy, Mr. Boisvert (T.A.B.) adopted the views of Mr. Fisher in the Hogan case previously referred to and added the following comment at 403 (D.T.C. 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 uncollectable in the year.

Reference should be made to one further comment in Hogan, at 11 (D.T.C. 190):

After all, the legislation indicates that it is the taxpayer who has to establish whether debts are bad or not, and his familiarity with the particular accounts and with his clients, their circumstances and all the other factors involved is, in my opinion, to be accepted if one is convinced from his evidence that he has acted honestly and on sound general principles. [Emphasis added.]

In each of the decisions cited by counsel there was evidence upon which the Court was satisfied that the taxpayer acted in a pragmatic businesslike manner. In the case at bar the evidence adduced does not meet that test. Although it is reasonable to infer that Lachman discussed his calculations with the appellant at or about the time that he prepared the appellant’s 1982 income tax return, there is little evidence as to the considerations upon which the appellant acted. It was critical to his appeal that there be some acceptable evidence as to the basis upon which the taxpayer made the “bad debt” determination.

Berretti did not testify. As a result all of the evidence relating to the source of the funds advanced by him to Delta, to the terms, if any, and as to the circumstances which eventually led Delta to discontinue payments to him came from Lachman. Although Lachman's involvement over the years provided him with some first-hand knowledge of the affairs of both Delta and the appellant, upon cross-examination it became apparent that some matters stated by him as fact were inferences he drew from conversations with other parties, and from documentary material not before the Court. Because of Lachman's involvement as the appellant’s accountant it was difficult for him to testify without alluding to information that he had received third hand, the veracity or accuracy of which he was unable to vouch for. That does not alter the fact that hearsay is a poor form of testimony and attaching much weight to it could result in a decision based upn secondary evidence rather than the best evidence available. Reference to portions of Lachman's evidence underscores this problem. For example, it was his understanding that the appellant borrowed funds for investment from a lend- ing institution or bank. These loans were secured by a mortgage on his residence which was, according to Lachman “amortized over some period of time”. Lachman had never seen any of the mortgage documents and could not tell the Court whether they were demand loans secured by a mortgage or whether they were for a specified term. It was also his understanding that the appellant then loaned the proceeds of these mortgages to Delta upon identical terms. But Lachman did not know what those terms were and indeed his evidence that terms existed is not entirely consistent with the 1979 and 1980 financial statements of Delta which state with reference to these loans, “no fixed terms of repayment” (Exhibits A-2, A-3).

Lachman believed that the Bank of Montreal's attitude was a major factor in the decision to treat the advances to Delta as a bad debt. However no evidence was adduced that the Bank of Montreal made any formal demand or had precipitated the actions taken by Delta’s directors in 1981. There was no evidence of any letter or other document advising Delta that no further financing would be extended. Lachman for his part had no personal knowledge of the bank’s position.

There is some question as well as to the validity of the calculations made by Lachman, which, one must assume, played a role in the appellant’s decision to declare the debt “bad”. At all relevant times the Bank of Montreal was the principal creditor of Delta. It was secured, holding a general assignment of Delta's accounts and mortgages receivable. The financial statements of Delta indicate that the Bank was the only secured creditor. Its priority was certain. The same does not appear to be the case with respect to certain other debts. The evidence discloses that in addition to various trade accounts the unsecured creditors were the appellant, the two other directors, their respective holding companies, and one F. Halverson. The Halverson loan in the sum of $150,000 was guaranteed by the directors of Delta. Lachman in his calculations gave this loan priority over all other creditors excepting the Bank. No evidentiary basis exists for this preferred treatment. A similar question is raised by Lachman's reference to a “life insurance loan” in the sum of $114,089 as a secured liability. This characterization does does not appear to be supported by Delta’s financial statements which show a whole life insurance policy as an asset valued at $123,737 as at January 31, 1981. Under the heading “liabilities” the same financial statement discloses a 15 per cent loan payable in the sum of $114,089 and no fixed terms of repayment. While the Court can draw the inference that this is the life insurance loan referred to, on these facts it is not possible to conclude that the life insurance loan was a secured debt and was entitled to priority.

Other questions come to mind as well. Did this taxpayer attempt to exercise his rights or make any efforts to collect from Delta? What steps did the appellant take to prevent unsecured creditors from being given priority over his claim as appears to have been the case? Although Thane was hired to supervise the affairs of Delta there is no evidence before the Court as to the creditors and priorities it was to consider or as to the instructions it received from the directors of Delta. As to the effect of loss of Gordon the Court notes only that nothing is known of the managerial potential or qualifications of Hallgren and Berretti. Answers may exist but they are not to be found in the evidence adduced.

As a result of the foregoing there is substantial doubt as to the basis upon which the appellant claims to have made a determination of uncollectibility. On the evidence before me taken as a whole I cannot find that the amounts advanced by the appellant to Delta were established by him to have become a bad debt in the 1981 taxation year. In reaching this conclusion I have acted on the basis that I ought not to take into consideration facts which were not known to the appellant until many months afterwards and which could not have been foreseen by the appellant at the time of his determination.

In view of the foregoing it is not necessary to deal with the respondent's further contention that a debt is to be considered bad for the purposes of section 50 only when the whole amount is uncollectable.

The respondent acknowledged by way of an amended reply to the notice of appeal that the appellant had an available 1982 non-capital loss carry back of $22,696.94 to the 1981 taxation year. The appeal will be allowed to that extent and the matter is referred back to the respondent to reassess accordingly.

Appeal allowed in part.