Thomas Fritz v. Minister of National Revenue, [1985] 2 CTC 2185

Goetz, TC} [ORALLY]:—This is an appeal concerning the appellant’s income tax assessment for the 1979 taxation year. The appellant sought to "write-off" the sum of $81,050 as a debt owed to him by Fritz Concrete Limited which was disallowed by the Minister of National Revenue.

The issue in this appeal is whether the sum of $81,050 was a bad debt and, if so, does subparagraph 40(2)(g)(ii) of the Income Tax Act (the "Act") apply.

The facts are as follows: The appellant has, for eight years, carried on the business of a building contractor and specifically in the construction of prestressed concrete slabs for barn floors. In 1978 he had so many orders he could not fill them and decided the expansion of his facilities was vital. On the advice of his banker and accountant he incorporated Fritz Concrete Limited (hereinafter referred to as "the Company"). On March 4, 1978 he transferred his whole business to the Company pursuant to the provisions of section 85 of the Income Tax Act. The consideration was $110,248, secured by a promissory note payable to the appellant and the issuance of shares whereby the appellant became the majority shareholder of the Company.

The Company also assumed the liabilities and bank debts of the appellant's proprietorship. At this point in time the appellant employed 20 to 25 employees. As of today he employs six to seven people.

The shares according to the appellant's accountant represented the appellant's equity in the proprietorship. The accountant felt no need to charge interest on the note because any gains to the appellant would accrue by way of salary, dividends and other benefits. The financial statements as of December 31, 1978 showed a substantial increase in assets from March to December 1978 and a net income of $49,098. As a result, the accountant felt the note was collectable because the Company was in such a healthy financial position.

The expansion program embarked upon in the spring of 1979 included expansion of his building, the acquisition of a flatdeck trailer and tractor, construction forms, etc. The Bank had assured the appellant of extending credit prior to and for the expansion costs. Unfortunately the agricultural business went into a sharp decline and interest rates were rising rapidly. Many of the numerous large orders (the reasons for the expansion) were cancelled and new orders fell off markedly. Fixed asset additions in 1979 totalled $314,834 and the Company had a net loss of $7,214 in 1979. The inventory level rose to $232,363 in 1979 as opposed to $86,082 in 1978.

The Company was on the verge of bankruptcy and was forced to return $40,000 worth of reinforcing steel bars to its supplier at a two per cent discount. The Company could not pay its accounts payable in the course of business and prevailed upon its suppliers to hold off demands for payment. The Bank of Montreal exacerbated the situation by reneging on commitment to advance funds for the expansion program and would only renew loans of $60,000 and $90,000, respectively, with interest at the rate of 17 /2 per cent.

The appellant was able to obtain loans from the Federal Business Development Bank totalling approximately $300,000. To renew the Bank loans the Bank insisted that the appellant write-off $81,000 of his note from the Company which he did in 1978. The appellant sold a $40,000 mortgage for $30,000 and sold his farm for $50,000, with all proceeds going into his Company. He received no salary in 1979 when the business soured. He received $6,000 nevertheless in 1980 but has received no salary since that time and is living on his wife’s salary.

Was the write-off of $81,000 a bad debt? The accounts receivable were not sufficient to pay the accounts payable. The appellant's accountant, when things went bad for the business in 1979, knew that the Company had no funds to pay on the appellant’s promissory note. The declaration of $81,000 as a bad debt would have been valid regardless of the usurious demand by the Bank of Montreal to write that amount off.

The debt of the Company to the appellant simply could not be repaid in the foreseeable future. The Company forestalled payments to its suppliers. The write-off consisted of two-thirds of the appellant's note.

In 1979 the appellant as a businessman and in his judgment considered, and reasonably so, that the debt owing by the Company was uncollectable.

Reference is made to Associated Investors of Canada Limited v MNR, [1967] CTC 138; 67 DTC 5096; and to Greensteel Industries Ltd v MNR, [1975] CTC 2099, 75 DTC 63. At 2103 and 66, respectively, my colleague Cardin, TCJ states:

. . . the decision as to whether the principal shareholder wishes to consider it (the debt) (those are my words) bad or not rested entirely with him and his business judgment.

Counsel for the respondent relied very strongly on the decision in Panelling Unlimited of London Incorporated v MNR, [1982] CTC 2178; 82 DTC 1178. I do not, however, consider the facts in that case applicable here. It concerned three companies, one of which (Company No 1) was controlled by three men; the second (Company No 2) where the sole shareholders were the husbands’ wives; and the shareholders of the third company (Company No 3) were the children of the husbands and wives. Company No 1 was supplying capital by way of inventory to Company No 2 and Company No 3, that is the wives’ and children's companies.

The case before me involves the sale of a proprietorship to a company in consideration of a promissory note and other consideration given to the appellant whereby the appellant happened to have business income from salaries and dividends from the company.

Counsel for the respondent argued that the debt was forgiven to obtain financing from the Bank. That to me is a semantic argument because the facts here before me force me to the view that the debt was clearly uncollectable and therefore bad and comes within the provisions of paragraph 50(1)(a) of the Act. In any event, there was no point in leaving the amount of $81,000 on the books since it was uncollectable.

The debt, being uncollectable, is deemed to have been disposed of for nil and therefore meets the requirements of subparagraph 39(1 )(c)(iv) of the Act as a business investment loss because it was a debt to acquire property within the meaning of subparagraph 40(2)(g)(ii) of the Act which reads as follows:

40. (2) Notwithstanding subsection (1),

(g) a taxpayer's loss, if any, from the disposition of a property, to the extent that it is

(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length, . . .

As a result, I allow the appeal.

Appeal allowed.