Watson Construction Limited v. Minister of National Revenue, [1979] CTC 2516, 79 DTC 528

M J Bonner:—The appellant appeals from an assessment of income tax for its taxation year ending April 30, 1973. The appellant, in computing income for the year, had claimed a deduction for “bad debts’’ in the amount of $84,296. No debt was at that time bad. The claim was in reality a claim for a reserve for doubtful debts, one of which was in the amount of $150,000. The respondent refused to allow any reserve in respect of that debt, it being his position that:

(a) on July 21, 1972 the appellant received a security or other right or a certificate of indebtedness (hereafter ‘‘the security’’) wholly or partially as, in lieu of payment of, or in satisfaction of, a debt of $150,000 that was then payable;

(b) the fair market value of ‘‘the security’’ as at July 21, 1972 was $150,000;

(c) the trade account indebtedness of the new corporation to the appellant as at April 30, 1973 was $23,129.57.

The appellant carried on the business of a general contractor specializing in the construction of commercial buildings. In October of 1971 it entered into a contract with Kimbrook Holdings Limited (hereinafter called “Oldco”) to construct a hotel in the City of Cranbrook. Oldco suffered financial difficulties and, by the end of January of 1972, it had failed to pay the appellant any amount in respect of progress billings totalling $364,692.50. As a result, the appellant notified Oldco that it was terminating the contract. Although the appellant then stopped work, it later received claims from its subcontractors and reflected them in a further invoice sent to Oldco. At July 21, 1972, the appellant had incurred costs (exclusive of overhead) on the hotel project totalling $339,219.

There is no doubt that at this point the appellant was in real danger of suffering a serious financial loss. If it did terminate it would be obliged to negotiate the premature termination of each subcontract. It viewed its lien rights as being of little value. The appellant therefore conferred with Oldco and it was decided that the best way to minimize the loss was by carrying the construction to completion. One of Oldco’s mortgage lenders refused to advance further funds. The other agreed to adhere to its loan commitment. The venture was therefore reorganized in a manner which the Appellant regarded as involving (inter alia) “deferring the $300,000 which it had in the project already’’.

The appellant entered into an agreement with Oldco on July 21, 1972, which provided for the incorporation of a anew company, Kimbrook Holdings (Cranbrook) Limited (hereinafter called “Newco”). That agreement recited:

(d) Kimbrook and Watson have agreed to the assignment by Kimbrook to the said Company of the aforesaid contract dated the 19th day of October, 1971, and to the assumption by the said Company of all the obligations of Kimbrook for and in respect to the said contract.

(f) Watson has agreed upon the terms and conditions and in the manner hereinafter provided to advance to the said Company the sum of $300,000, which sum is to be applied by the said Company to the payment of the first $300,000 due by the said Company on the said contract dated the 19th day of October, 1971, and shall not be used for any other purposes.

It required the parties to cause Newco to:

(a) 1.2(1) issue its obligation to Watson in the amount of $300,000 with interest at 6% per annum in payment of the sum of $300,000 referred to in paragraph (f) herein, with interest payable half-yearly commencing six months from the date of such advance.

and to

(b) 1.2(5) accept an assignment from Kimbrook of the said contract dated the 19th day of October, 1971, made between Watson and Kimbrook,

The agreement further provided:

2.0 Kimbrook and Watson mutually agree that the new Company and Watson will proceed to carry out all the terms and conditions of the said contract dated the 19th day of October, 1971, in accordance with the original terms thereof, including interest at 9% per annum on monies due thereon up to the date of this agreement and hereafter except as specifically provided for in paragraphs 2.1 to 2.3 hereof.

2.1 Watson agrees to defer the amount of any over-run on the construction contract in excess of $1,206,000, including interest referred to in paragraph 2.0 accumulated to the date of this agreement and hereafter, such amount to be the Obligation of the new Company and together with legal costs referred to in paragraph 4.0 hereof to be repayable by Kimbrook on behalf of the new Company to Watson as provided in paragraph 3.0 hereof.

5.0 Kimbrook covenants and agrees to purchase from Watson and Watson agrees to sell to Kimbrook all of Watson’s interest in the new Company as the same is represented by the obligation provided for in paragraph 1.2(1), in accordance with the provisions of paragraph 5.1 hereinafter set out (such purchase to include Watson’s Class “B” Common voting shares).

The last quoted provision refers to the purchase by Oldco of the appellant’s interest in Newco. That “interest” comprised the $300,000 receivable and shares which gave the appellant voting control of Newco until it was paid its $300,000. The agreement required Oldco to sell and Newco to purchase the lands on which the partly completed hotel stood. Thus, by completing the hotel, by means of such control and by segregating the hotel from other assets of Oldco, a company of doubtful financial viability, the appellant hoped to ultimately recover its $300,000.

At this point it should be noted that the appellant, in all its dealings with Oldco and Newco, was in a fifty-fifty joint venture relationship with another company. Thus, its beneficial interest in the $300,000 debt was $150,000, the amount in respect of which the doubtful debt reserve was claimed.

George Kermack, the manager of the appellant, testified that the appellant had reluctantly entered into somewhat similar arrangements at least in cases where owners were unable to pay accounts for construction cost overruns. In such cases amounts payable to the appellant were carried by it as receivables.

The parties proceeded to fulfil their obligations under the agreement of July 21. The construction of the hotel was completed and the hotel opened for business in February of 1973. The hotel was leased by Newco to Oldco.

Mr Kermack testified that the 50% reserve was claimed on the basis of the advice of the appellant’s accountants and because of the appellant’s experience with Oldco. Its financial performance was poor.

Many submissions were directed to questions of the applicability and effect of section 76 of the Income Tax Act. The appellant submitted that section 76 did not apply because the appellant did not in fact receive from Newco, as a result of the reorganization, a security or other right in satisfaction of its trade account receivable; that at April 30, 1973, the trade account receivable from Oldco due to the appellant was a doubtful debt; and that if the appellant did receive a security of some form, it was taken as collateral security only. Finally, it contended that if the appellant did receive a security, 50% of the amount was doubtful at the time of receipt and that the value required to be taken into income must therefore be 50% of face value.

The unstated premise of the first set of submissions appears to have been that no deduction is available under paragraph 20(1)(l) of the Act in respect of an amount, the inclusion of which is required by section 76. It is not necessary to consider whether that premise is valid. The first set of submissions must fail on any proper interpretation of the contract of July 21, 1972. In fact, the appellant’s counsel virtually conceded that point following argument by the respondent. Quite plainly, in my view, as a result of the implementation of that contract the $300,000 obligation of Oldco was eradicated and there was substituted for it a $300,000 obligation of Newco. It is plain that the latter obligation was an “other right’’ which was “received”.

However, I cannot see how section 76 applies. The $300,000 debt of Oldco was not one, . . the amount of which would be included in computing (the appellant’s) income if it had been paid ..The requirement that the debt be included in income was not, by virtue of paragraph 12(1 )(b) of the Act, in any way dependent upon payment. The accrual method of accounting applied. It is therefore unnecessary to consider the question of the value of the receivable in the context of section 76.

The appellant argued further that if it “did receive a security of some form, then it did so as part of its ordinary commercial practice”.

It seems to me that the $300,000 receivable from Newco arose from a loan which, on the facts set forth above, was plainly made as an integral part of the appellant’s business operations. The appellant’s clear objective was to substitute for the Oldco receivables, which, I assume, had been included in computing its income, a receivable which it was more likely to collect.

A part of the reorganization plan called for lease of the hotel, when completed, to Oldco. Retention of the hotel by Newco was dependent upon the generation of Oldco of sufficient funds to pay to Newco to permit mortgage payments on the hotel to be met and to permit the purchase of the $300,000 receivable from the appellant pursuant to paragraph 5.1 of the July 21 agreement. Oldco’s financial position and record were not, according to Mr Kermack, good. I accept Mr Kermack’s evidence. It was, at April 30, 1973, likely that the appellant would collect no more than approximately 50% of the face amount of Newco’s indebtedness.

The situation here, as I see it, is analogous to that considered by Jackett, P, (as he then was) in Associated Investors of Canada Limited v MNR, [1967] CTC 138; 67 DTC 5096. The following analysis to be found at pp 146 and 147 [5100 and 5101] is particularly on point:

The situation was therefore that, at the time that the advance was made, the appellant had exchanged its money for a “right” that was, from a businessman’s point of view, of equal value. It had substituted one asset in money for another of equal amount. As of that time, therefore, the making of the advance did not affect the overall value of the appellant’s assets. The advance cannot, therefore, as of that time, be regarded, from a businessman’s point of view, as having affected the appellant’s profit from his business. Similarly, if the advance was entirely repaid, there was again a substitution of one asset for another of equivalent value and there was no overall effect on the appellant’s asset position. When, however, the chose in action depreciated in value, there was an effect on the appellant’s asset position and accordingly, at that time, for the first time, the advance transaction resulted in the appellant having sustained a loss. As that loss arose out of a transaction in the course of the appellant’s currrent business operations, it must be taken into account in computing the profits from the appellant’s business or they will be overstated. In my view, it must be so taken into account in computing the profit from the business for the year in which the appellant, as a “businessman”, recognized that the loss had occurred. It cannot properly be taken into account in computing the profit for a previous year. There is no sound basis for taking it into account incomputing the profit for a subsequent year.

I therefore find that the appellant was not wrong in making the deduction claimed, although paragraph 20(1 )(l) of the Act was not necessary to deductability.

In the result the appeal is allowed and the assessment is referred back to the respondent for reconsideration and reassessment on the basis that the appellant is entitled to deduct the sum of $75,000 in respect of the diminution in value in 1973 of the note received from Newco.

Appeal allowed.