Philippe Ewart v. Minister of National Revenue, [1978] CTC 2315, 78 DTC 1221

Guy Tremblay [TRANSLATION]:—This case was heard at Montreal on December 17, 1976 and January 20, 1977.

1. Summary

The Board must decide principally whether the appellant is justified in fact and in law in deducting $32,339 and $58,200 in the computation of his personal income for the 1970 and 1971 taxation years respectively. He had invested these sums in a company he controlled which went bankrupt.

J

2. Burden of Proof

The appellant has the burden of showing that the respondent’s assessments are unjustified. This burden of proof derives not from one particular section of the Income Tax Act but from a number of judicial decisions, one of which is the judgment of the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. Facts Alleged

3.1. Arguments of the Appellant

In his notice of appeal of October 14, 1976 the appellant stated the following facts:

1. On or about August 3, 1973 the Minister^of National Revenue issued notices of assessment No 60407182 and No 60237762 against the appellant for the 1970 and 1971 taxation years, respectively the whole as shown in the copies of the notices of assessment filed herein as Exhibit A-1, and to have effect as if stated at length;

2. By his notices of reassessment dated January 8, 1975 and numbered 362826 for the 1970 taxation year and 362827 for the 1971 taxation years, the Minister. confirmed the notices of assessment described in the preceding paragraph and made minor adjustments for each of the years in question;

3. The taxpayer is a professional engineer and, during the 1970 taxation year, tried to develop and market a prototype of an automatic multiple-coin newspaper vending machine, the whole as already stated to the officials of the Department of National Revenue and as will be established in more detail at the hearing;

4. In view of the appellant’s profession and the commercial requests made to him, he was justified in thinking that such a venture would prove to be very profitable and that the sale of the prototype in question to interested manufacturers would produce substantial income:

5. After consulting his advisers and for very obvious professional reasons, the appellant decided to use, as a corporate vehicle, a corporation entitled Namofil Inc, of which he was the president and principal shareholder;

6. In order to develop the prototype of the aforementioned newspaper vending machine, the taxpayer made an outlay and incurred expenses and advances amounting to $32,339.00 during the 1970 taxation year;

7. For the same reasons as those mentioned in the preceding paragraphs and because of the liabilities and income which he anticipated, the appellant made an outlay and incurred expenses amounting to $58,200.00 during the 1971 taxation year;

8. For reasons beyond his control, the appellant was unable to complete his project; his business venture therefore showed a deficit, and he incurred substantial business losses during the 1970 and 1971 taxation years, as described in the two preceding paragraphs;

9. The appellant is justified in fact and in law in deducting $32,339.00 and $58,200.00 from his income for the 1970 and 1971 taxation years respectively;

10. Furthermore, because of his professional skill and extensive knowledge as a consulting engineer, the appellant is called upon to work regularly on international projects and, in that capacity, to participate in technical discussions, analyses of plans and numerous meetings with the parties concerned, such as various provincial governments, the federal government and representatives of foreign countries involved in such projects;

11. In order to make it easier to obtain contracts and to make the aforementioned meetings and discussions possible, the appellant had to incur, during the 1970 and 1971 taxation years, all manner of expenses which are directly related to the structure of his income and which amounted to $12,394.71 for 1970 and $14,460.11 for 1971;

13. By his notices of reassessment for the 1970 taxation year, the Minister also tried to add to the appellant’s income an amount of $5,167.80 as a taxable dividend received from a Canadian corporation.

3.2. Arguments of the Respondent

In reply to the notice of appeal, the respondent stated the following facts:

1. He admits the allegations contained in paragraphs 1 and 2 of the notice of appeal;

2. He knows nothing of the allegations contained in paragraphs 3, 4 and 5 and does not admit them;

3. He denies paragraphs 6 to 9 of the notice of appeal;

4. He knows nothing of the allegations contained in paragraph 10 of the notice of appeal and does not admit them;

5. He denies paragraphs 11 and 12 of the appellant’s notice of appeal;

6. He admits paragraph 13 of the appellant’s notice of appeal;

7. He denies paragraphs 14 and 15 of the appellant’s notice of appeal:

8. The respondent based his assessment of the appellant for the 1970 and 1971 taxation years on the following facts:

(a) during the years 1970 and 1971 the appellant practised his profession as an engineer;

(b) the appellant has never operated a money-lending business;

(c) the appellant had been the principal shareholder in a company by the name of Namofil Inc since approximately 1968;

(d) at that time Namofil Inc operated a business manufacturing electrical fixtures;

(e) the Namofil company reported sales of $692,744.00, $183,252.00 and $334,221.00 during 1968, 1969 and 1970 respectively;

(f) although Namofil Inc reported operating profits of $61,835.00 in 1968, losses of $62,745.00 and $16,375.00 were recorded for 1969 and 1970 respectively;

(g) on or about February 12, 1971 Namofil Inc. made an assignment of its property;

(h) during 1970 and 1971 the appellant advanced such substantial sums to his company that he appears in the bankruptcy as an ordinary creditor for an amount of approximately $100,000.00;

(i) in his tax returns for the 1970 and 1971 taxation years the appellant claimed, as a deduction from his income, amounts of $32,339.00 and $58,200.00, as sums advanced to his company;

(j) by his assessments dated January 8, 1975 the respondent refused to allow the aforementioned amounts;

(k) the respondent also refused to allow, as a deduction from the appellant’s income, amounts claimed as interest paid on money borrowed by Namofil Inc, as well as certain other expenses not incurred to earn income.

4. Facts Admitted and Facts at Issue

Independently of the facts alleged in the above proceedings, the parties admitted and established certain facts in the office of the Board Member before the case was heard:

For 1970

—The appellant admitted additional income of $1,748.50.

—The respondent withdrew from the appellant’s income the sum of $5,167.80 as corporate dividends.

—The parties agreed that the points at issue are the following: 5. Facts Submitted in Evidence

5.1. The appellant is now 58 years old. He is an engineer and a member of the engineering firm Philippe Ewart et Associés.

5.2. He qualified as an engineer in 1944 and was employed by the Government of Quebec, where he remained until 1961 when he opened his own firm of consulting engineers.

5.3. The appellant testified that a few years after opening his own engineering firm he participated in several contracts and invention projects, for which his firm received substantial fees:

(a) the Pole Lite project, which consisted in helping to invent and manufacture a truncated tube pole; the appellant was a shareholder in the company which began development of this project; in 1967 the project brought the appellant. personally $20,100 in professional fees;

(b) the Eclactec project, which was begun by a company 95% of the initial capital of which came from Quebec and 5% from France; the purpose of the project was to develop a special street lighting system, known as grazing lighting; the engineering firm shared fees on a contract worth $1,200,000.

5.4. The appellant participated, through the company, in several international contracts: building roads and bridges in Africa, planning a transportation system in Haiti and other projects in Israel.

The Prototype of the Newspaper Vending Machine

5.5. In 1970 the appellant participated in another project, known as the project to develop a prototype of a newspaper vending machine. The special feature of this machine was that it was to be designed to sell newspapers whose thickness (during the week and at the weekend) and price varied. Weekly mechanical adjustments could be carried out by the distributing agents. Furthermore, only one copy of a newspaper could be obtained at a time, in contrast with other vending machines which allow the user to take several copies while paying for only one.

The invention had been begun in 1969 by Mr J M Branchaud, a mechanical draftsman. Mr Branchaud testified that he has been an “idea man”—someone who conceived inventions, registered and tried to sell them—for 25 years. The income derived from his inventions constituted 80% of his total income. He had spoken to a friend, Mr Péland, about his initial work on a newspaper vending machine. Mr Péland spoke about it to the appellant, who showed an interest in the subject. A meeting subsequently took place in the offices of Namo- fil Inc.

5.6. This company, in which the appellant had been the principal shareholder since 1968, manufactured electrical fixtures.

5.7. When Mr Ewart learned about the invention project, he contacted a local newspaper, Montréal Matin, which expressed interest in the project. The appellant asked Mr Branchaud how he could help him. It was decided that part of the premises of Namofil Inc would be made available to Mr Branchaud. If<labour was needed, Namofil employees would be used.

5.8. It was not intended that the company itself would build all the vending machines in Montreal once the invention was completed. Transportation costs to various parts of Canada and the United States would make the product too expensive. Therefore, it was planned that the product would be designed in Montreal and manufactured at various locations both in Canada and the United States. The evidence as a whole shows—although not explicitly—that Namofil Inc would continue to manufacture the product. The document filed as Exhibit A-1 clearly states that Namofil Inc had exclusive rights to manufacture the machine. If royalties were to be paid to the appellant and Mr Branchaud, they were normally to be based on each machine sold.

5.9. Mr Branchaud and the appellant agreed that they would share the royalties equally. They both testified to this effect. Moreover, in a letter dated October 13, 1970, filed as Exhibit A-5, Mr Jean H Dubuc, an engineer and patent agent, wrote:

Furthermore, please inform us whether the transfers from Mr Branchaud . to. Namofil Inc must also be prepared for Canada and the United States.

No answer was ever given to this request.

5.10. Through Namofil Inc, the appellant allowed the project to develop the prototype of the vending machine to be carried out as follows:

(a) following a series of. designs and work which lasted one and a half months, an initial prototype was produced;

(b) after improving the designs, a second prototype was produced; however, Mr Branchaud thought it was still too complicated and not practical enough;

(c) a third and fourth prototype were subsequently produced, as shown in Exhibit A-1.

5.11. Five or six employees of Namofil Inc (draftsmen, tinsmiths, welders and so on) helped to manufacture the prototype under the direction of Mr Branchaud.

5.12. In addition to manufacturing the prototype, other work was done: advertising, marketing, translating documents into French and preparing for the convention of circulation managers of various newspapers, which was to be held in August 1970 in Sherbrooke. Several companies showed an interest in the project. Several letters to this effect were filed by the appellant as Exhibit A-8.

5.13. Considerable time was also spent on research in the United States and Canada to determine if any similar invention existed. The evidence shows that no patent application had been filed either in Canada or in the United States. In a letter dated October 13, 1970, and filed as Exhibit A-5, Mr Jean H Dubuc, an engineer and patent agent, wrote the following:

We shall proceed with the preparation of a patent application, to be filed in Canada and the United States, as soon as we receive written instructions from you to this effect.

Mr Dubuc testified at the inquiry that he never received an answer to this request. He also testified that there were no further developments in this case regarding patents.

5.14. Mr Branchaud stated that at a certain point his financial position began to deteriorate, and Namofil Inc, which was working on something else, could not provide employees for his project. Thus, everything was held up. However, attempts were still made to interest newspaper owners, since on February 4, 1971 a meeting took place between Mr Don Gaspar and Mr Branchaud at the Hilton Hotel near Montreal airport. The report of this meeting was filed as Exhibit A-9. The machine was found to be unacceptable because 20% of the time it would not deliver a newspaper.

5.15. It was at the end of February that Namofil Inc declared itself bankrupt, thereby putting an end to the project for developing the prototype of the newspaper vending machine.

5.16. Exhibit A-27 shows that in a letter dated December 8, 1972 the appellant calculated the cost of the newspaper vending machine project to Namofil Inc:

5.17. The Hydro-Quebec Co nt r acts

At the time Namofil Inc went bankrupt, in February 1971, the following three contracts, amounting to $652,568.56, were pending with HydroQuebec; they had to be transferred to other contractors:

(a) Supplying pylons for the Beauceville-Thetford line: the contract was signed on January 28, 1970 in the amount of $341,164.90.

(b) Supplying pylons between Varenne and Tracy: the contract was signed on June 15, 1970 in the amount of $225,201.06.

(c) Supplying pylons between Heming Falls—Grantham—St-Dominique: the contract was signed on June 16, 1970 in the amount of $86,202.60.

5.18. All these contracts required the services of a firm of consulting engineers, which in this case was the appellant’s firm. The average fee for these services was 10% of the gross amount of the contract, which came to $27,600 in the case of the first contract, $16,993 in the case of the second, and $16,950 in the case of the third, thus making a total of $61,543.

5.19. The appellant stated that one of the causes of the bankruptcy of Namofil Inc was that its work for Hydro-Quebec was sabotaged.

5.20. The guarantee that the work described in the three contracts would be performed was given by the Prudential Assurance Company Ltd. The forms entitled “Proposals for tender or contract surety” were filed as No A-28.

5.21. The appellant personally guaranteed the Prudential.

The appellant’s Losses in the Bankruptcy of Namofil Inc: Capital and Interest

5.22. The appellant testified that he personally lost over $250,000 in the bankruptcy of Namofil Inc. However, the notice of appeal shows that in the case at bar the appellant claimed only a loss of $32,339, resulting from his investment in the prototype of the newspaper vending machine, plus a loss of $58,200 resulting from the loss of contracts with Hydro-Quebec.

5.23. With respect to the loss of the contracts with Hydro-Quebec, it can be seen from the letters of the Prudential Assurance Company dated July 10, 1973, July 23, 1973 and January 17, 1974, filed as Exhibits A-29, A-30 and A-31, that the appellant’s debt to the said company was reduced from $45,176.71 to $40,000, on condition that payment was made before December 31, 1974. The appellant testified that this agreement was respected. However, no evidence of payment was submitted.

5.24. The appellant is categorical that money was used for purpose of the Hydro-Quebec contracts from the sum of $168,000 transferred during 1970 from his personal account to the account of Namofil Inc, as shown in the series of bank transfers filed jointly as Exhibit A-11.

The accountant, Mr Joseph Ste-Marie, testified that of the $168,000 loaned in 1970, $106,300 was reimbursed, thus leaving an outstanding balance of $61,700, as shown in the calculations on Exhibit A-12.

Furthermore, the accountant also testified that $42,339 of the money advanced by the appellant to Namofil Inc had not been reimbursed as of December 31, 1969, and that as of December 31, 1970 Namofil Inc owed the appellant $104,039. It was alleged that the appellant recovered a further $3,500 in 1971, thus leaving a balance of $100,539. Moreover, if this $3,500 is subtracted from the $61,700, the difference is $58,200, which is the amount claimed by the appellant as a loss in 1971. The respondent admitted the amount of $58,200.

Exhibit A-11 refers to the transfer of $168,000 from the appellant’s personal account to the account of Namofil Inc during 1970. It was noted that Mr Ewart’s signature does not appear anywhere on the bank transfer forms. The appellant pointed out in his testimony that, after dealing with the same bank and the same manager for 25 years, there are many procedures and understandings which do not have to be confirmed in writing.

5.25. However, no supporting voucher was filed to show a similar transfer in 1969 from the appellant’s personal account to the account of Namofil Inc, or to show the balance outstanding as of December 31, 1969, which amounted to $42,339. The accountant, Mr Ste-Marie, testified that this balance, which constituted a loss for 1969, was applied to 1970. He also said that it was because of a clerical error that $32,339 was being claimed in the case at bar. The figure should read $42,339.

5.26. However, it was clearly established that as of March 20, 1970 the appellant’s personal debt to the bank was nil. It was $120,000 as of January 1, 1971 and nil again as of July 15, 1971, the whole as shown in the photocopy of the bank vouchers concerning loans made to the appellant, and filed as Exhibit A-21 with the vouchers concerning the loans made to Namofil Inc.

These exhibits show that as of March 16, 1970 Namofil Inc owed the bank $8,040 for “tender loans”, that is “a loan granted to tender for a contract”, as explained by the witness Gérald Arsenault, who is the loans officer of the Royal Bank of Canada. As of January 20, 1971, which is approximately the date the company went bankrupt, the debt for this item was $1,540. Moreover, the banking voucher regarding the company’s ordinary loans increased to $45,000 as of March 16, 1970, and to $140,816.10 as of February 12, 1971, the date the company declared itself bankrupt. After the bankruptcy date, instructions were given on the bank vouchers that interest on these loans was to be debited to Philippe Ewart’s bank account No 104-356-1.

5.27. By comparing the transfers made during 1970 from the personal account to the Namofil Inc account, as shown in Exhibit A-11, with the bank accounts filed as Exhibits A-20 and A-21, the Board was able to observe that a number of loans and transfers had been made from one account to the other.

5.28. The original copies of the guarantees produced as Exhibit A-15 show that the appellant personally guaranteed the Namofil Inc debt jointly and severally with the company.

5.29. Basing his testimony on Exhibits A-14 (statement of account of the Namofil Inc account for the period ending December 31, 1971), A-16 (statement of account of interest payments for 1971) and Exhibits A-20 and A-21 (bank accounts), Mr Arsenault said that the bank was reimbursed for the capital debt of Namofil Inc, which amounted to $140,816.10 plus interest of $9,548.68, through payments of $305,000 made by appellant into his own account from the end of January 1971. The interest payments were made from July 20, 1971 to February 16, 1972. The respondent admitted the payment of interest of $9,548.68 made by the appellant.

5.30. The interest of $1,900 claimed as a deduction and allegedly paid by the appellant in 1970 for loans incurred by Namofil Inc or by the appellant but concerning business income has not been clearly established, and the Board has not been able to ascertain, from the documents filed, that these payments were made.

5.31. The accountant Joseph Ste-Marie, CA, who entered the appellant’s employment in January 1971, prepared the appellant’s tax returns for 1970 and 1971.

One of the important services rendered was to draw up an estimate of the appellant’s income and expenditure, so that the appellant personally could obtain credit from the bank. In view of the work under way with the Government of Quebec, bankruptcy was not a desirable course of action. The appellant testified that credit was absolutely essential. An estimate of the appellant’s income and expenses for 1971 (filed as Exhibit A-17) was prepared and submitted to the bank. The bank required, as surety, 10,000 common shares of Pole Lite Inc which, according to the evidence submitted, were then valued at $23 a share (according to the appellant’s profit and loss statement for 1967, professional fees of $20,100 were earned with Pole Lite Inc; the same year the appellant also received $2,794.50 in dividends). With this surety, the bank granted the appellant credit of $300,000. After this credit was obtained, the Government of Quebec awarded other contracts, as shown in the letter of August 11, 1971 from R T Trudeau, an engineer in the Office des Autoroutes to the Ewart, Tremblay & Associés firm of consulting engineers, and concerning three contracts between the latter’s engineering firm and the Office des Autoroutes.

Political Contributions in 1970

5.32. Four cheques signed by the appellant were filed as exhibits: two to the order of General Trust of Canada (account No 2600), dated February 18, 1970 and April 28, 1970, in the amounts of $500 and $2,500 respectively; a third cheque dated April 13, 1970 to the order of Montreal Trust (unit 1000), in the amount of $6,000; and a fourth dated January 6, 1970 to the order of Quebec Trust Company (No 558731) in the amount of $200. On the back of the cheque for $2,500 was written: “For the Laprairie riding.’’

5.33. Appellant testified that he had been asked to write these cheques by the treasurers of political parties. He had received specific instructions regarding the banking institution to which the cheques should be made. There was no doubt in his mind that these moneys were duly passed on to the political parties he wished to help.

5.34. The appellant testified that these contributions were necessary to ensure that the government would continue to award him contracts. The appellant’s firm of consulting engineers participated in engineering work for the Government of Quebec, the total gross cost of which was between $25 million and $30 million. The various projects listed by the appellant were located inter alia in the riding of Laprairie, at Candiac and at Ville Brossard. Professional fees amounted to approximately $1,000,000. The appellant said that, at that time in the political life of Quebec, political contributions were considered an insurance for obtaining or retaining contracts.

Residence Expenses for Professional Purposes

5.35. The appellant testified that he had an office in his private residence where he received business clients. He also had a large living room where he received prospective clients, some of whom were even often from outside Canada. He said that when he was able to bring these people to his home to discuss business, he was already halfway toward securing the contract.

An expense account, filed as Exhibit A-10, showed that the accountant calculated outlay, “according to the best information available”, at $9,420.11, including $1,425 for repairs and painting and $840 for mortgage interest. These figures do not refer to any year in particular. The appellant claimed $1,500, $300 of which was for upkeep, for 1970, and $2,200, $100 of which was for upkeep, for 1971.

Security and Entertaining Expenses

5.36. The appellant claimed a deduction of $1,634.81, $1,000 of which was for entertainment expenses and the remaining $634.81 for “Security—miscellaneous” for 1971. No specific evidence was submitted under “Security—miscellaneous”. No verbal evidence or voucher was submitted in support of the entertainment expenses. The sum of $2,892.70 was claimed under “entertainment and advertising expenses” in his 1971 tax return, and the respondent refused to allow the sum of $1,000 which, inter alia, is the point at issue in this appeal. In 1971 the appellant’s gross income was $99,737.05. In 1970 the respondent allowed entertainment expenses of $12,295.13 for gross fees of $254,658.86.

6. Comments and Precedents

Because the claims contained in the notice of appeal are numerous and they differ in nature in several cases, and because even among claims of the same nature, the evidence was bound to differ as a result of the different years at issue, the Board feels it necessary to deal with the said claims separately, in view of their nature, the evidence submitted and the years at issue.

The Loss of $32,339 incurred by Namofil Inc applied for 1970 to the Project to Develop the Prototype of the Newspaper Vending Machine

6.1. Irrespective of the evidence submitted to show the nature of the project to develop the prototype of the newspaper vending machine, and to show that the expenses were incurred to produce personal income for the appellant, there is a more fundamental fact which the Board must consider. The sum of $32,339 claimed for this purpose is a loss for 1969 (Exhibit A-12), whereas the expenses incurred for the project were incurred in 1970. It was only an accounting principle that enabled a loss incurred in 1969 to be applied to 1970.

6.2. The loss of $32,339 ($42,339 according to the accountant), which was allegedly incurred in 1969 and comprises the difference between the appellant’s personal loans to Namofil Inc and repayments by Namofil Inc to the appellant, was by no means established. The only evidence, in fact, is the statement by the accountant, Mr Ste-Marie. Although Mr Ste-Marie was under oath and the Board does not question his credibility, more substantial evidence is required in view of the nature of the claim at issue. In any event, it should have been shown that the loss was the result of another project related to the appellant’s personal income.

Even if the evidence had been duly submitted with supporting bank vouchers, we may question why this loss should be entered under the project to develop the prototype of the newspaper vending machine, when all the expenses for this project were incurred in 1970.

Moreover, the principle of applying a loss for one year against the income of another year is allowed under the Income Tax Act within very specific machinery which is not applicable in the case at bar. If the appellant incurred a personal loss in 1969, should he not have first applied it against personal income for 1969? and, irrespective of the provisions of the Income Tax Act to this effect, do the general rules of accounting admit the principle that losses for one year may be applied to another year? If so, theoretically, could they be applied nevertheless?

Since the Income Tax Act has provided specific machinery for applying such a principle, is the taxpayer not therefore bound to comply with this legislative machinery?

Even if it was lawfully possible to apply a general principle of accounting providing for the application of losses, irrespective of the machinery provided in the Income Tax Act, the question is how, in the case at bar, a loss for 1969 (which the Board considers unproven) can be applied against this project to develop the prototype of a newspaper vending machine, the expenses for which were incurred in 1970, and which has of course produced no income.

The Board must also consider whether this sum of $32,339, which the appellant considers a loss for 1969 and which he applied to 1970, was in fact at that time only an account receivable. Did it not become a loss only when it was certain that it would not be reimbursed by Namofil Inc, that is in February 1971 when the company went bankrupt?

It might perhaps be argued that although the Board might refuse the sum of $32,339 on the grounds that it is not an expense relevant to the prototype of the newspaper vending machine, it could allow the sum of $34,980 in accordance with Exhibit A-27, as explained in paragraph 5.16. However, the evidence shows that this expense was incurred by Namofil Inc, not by the appellant. No evidence was submitted to show that the appellant explicitly reimbursed this expense.

The Board feels that the burden of proof on the appellant has not been discharged with respect to the loss of $32,339 claimed for 1970 which is related to the project to develop the prototype of the newspaper vending machine.

Namofil Inc’s 1971 Loss of $58,200 related to Hydro-Quebec Contracts

6.3. We should recall that the appellant stated (as explained in paragraphs 5.23 and 5.24) that this loss of $58,200 was the result of the difference between the loans of $168,000 which he made to Namofil Inc in 1970 and reimbursement of $109,800. Pursuant to the evidence submitted, the respondent admitted this outstanding balance of $58,200. It should be noted that $106,300 of the $109,800 was received in 1970 and the remaining $3,500 in 1971.

6.4. The Board must decide whether this loss can be applied against the appellant’s personal income, and for what year.

The Board must conclude that the year at issue is 1971. The sum of $61,700, which was due as of December 31, 1970, was only an account receivable at that time.

It was only after the payment of $3,500 at the beginning of 1971 and the bankruptcy of Namofil Inc on February 12, 1971 that the $58,200 really became a loss for the appellant. The Act requires that this loss be first applied against the income for 1971. However, the question is whether a loss of this type may be applied against the appellant’s personal income. If it can, is the whole loss of $58,200 applicable? If not, what percentage is applicable?

Is the Appellant’s Loss applicable against his Personal Income?

6.5. Was the expense of the nature of that of $58,200 incurred in order to gain income? If so, it must be allowed as a deduction. However, if this expense constitutes a capital outlay the deduction must be allowed [sic].

That is the problem, and it is based on paragraphs 12(1)(a) and (b) of the old Act:

12. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part,

6.5.1. In The Queen v H Griffiths Company Limited, [1977] 1 FC 476; [1976] CTC 454 at 457; 76 DTC 6261 at 6262, Dubé, J of the Federal Court of Canada—Trial Division gave a summary of the case law which indicates certain guiding principles regarding the application of paragraphs 12(1)(a) and (b) of the old Act. The Board feels it would be helpful to report these summaries here.

1. In D J MacDonald Sales Limited v MNR, 16 Tax ABC 49; 56 DTC 481, the Tax Appeal Board held that the payment of a guaranteed note of one of its suppliers in order to ensure a continuing source of supply was incurred for the purpose of producing income, thus deductible. The supplier was not a subsidiary.

2. In Her Majesty the Queen v F H Jones Tobacco Sales Co Ltd, [[1973] FC 825] [1973] CTC 784; 73 DTC 5577, the Federal Court found that the payment of a guaranteed loan in favour of the company’s largest customer in exchange for the customer’s undertaking to buy tobacco from it was an operating loss incurred for the purpose of producing income, thus deductible. Noël, ACJ said [at page 834] courts were inclined to consider “not so much the legal aspect of the transaction, but rather the practical and commercial aspects’’.

3. In Heaps & Partners (Nfld) Limited v MNR, 42 Tax ABC 278; 66 DTC 772, the Tax Appeal Board decided that payments made by the parent company to cover guaranteed loans to its subsidiary were made for producing income and were deductible. The Berman case [infra] was quoted as the authority for that decision.

4. In L Berman & Co Ltd v MNR, [1961] CTC 237; 61 DTC 1150, the Exchequer Court held that the voluntary payment of debts incurred by its subsidiary to suppliers was deductible because it was advantageous for the parent company to maintain the goodwill of its suppliers.

5. In MNR v George H Steer, [1967] SCR 34; [1966] CTC 731; 66 DTC 5481, the Supreme Court of Canada allowed an appeal from the Exchequer Court and held that repayment of a guaranteed loan for the drilling of three wells was a deferred loan. Judson, J. said [at page 37] that “the guarantee meant that at some time the respondent might have to step into the bank’s shoes to this extent’’. The loss was held to be a loss of capital and the deduction thereof prohibited.

6. In Algoma Central Railway v MNR, [1967] 2 Ex CR 88; [1967] CTC 130; 67 DTC 5091, the Exchequer Court held that the sum paid by a railway for a survey of the volume of traffic in an unpopulated area was deductible as a current business expense. Jackett, P, as he then was, said [at page 92] the “usual test’’ whether such a payment is one made on account of Capital is “was it made with a view of bringing into existence an advantage for the enduring. benefit of the appellant’s business?’’ In a footnote at page 95 [137, 5095] he referred to the Canada Safeway case [infra] and remarked: “There can be expenditures that, in a broad sense, are made to improve the position of the business and that, nevertheless, do not escape the prohibition in section 12(1 )(a).”

7. In Canada Safeway Limited v MNR, [1957] SCR 717; [1957] CTC 335; 57 DTC 1239, the issue before the Supreme Court of Canada reduced itself to the meaning of the phrase in paragraph 5(1)(b) of the Income War Tax Act [RSC 1927, c 97 as amended, ss 4, 5, 6], “borrowed capital used in the business to earn the income’’ which in turn depends on the scope of the words “used in the business’’. Rand, J said [at page 726] that “in the circumstances before us, the interposition of a new and distinct capacity as shareholder breaks the continuity of the company’s act as being its own business’’ and further down [at page 728] “the business of the subsidiary is not that of the*company”.

8. In DWS Corporation v MNR, [1968] 2 Ex CR 44; [1968] CTC 65; 68 DTC 5045, Thurlow, J of the Exchequer Court, now ACJ of the Federal Court, relied on the Canada Safeway decision [supra] to hold that the borrowed money was not used for the purpose of earning income from the appellant’s business within the meaning of the Act.

9. In Minas Basin Pulp & Power Company, Limited v MNR, [1969] Tax ABC 11 ; 69 DTC 62, the Tax Appeal Board held that payment made on a guarantee on behalf of a subsidiary could not in any way increase the income receivable from the business of the appellant itself, thus not deductible. The subsidiary was not wholly owned and there was no intertwining of the business operations.

10. In Stewart & Morrison Limited v MNR, [1974] SCR 477; [1972] CTC 73; 72 DTC 6049, the Supreme Court of Canada held that money supplied by the parent company to an American subsidiary which it “master-minded” through a bank loan, in a losing cause, was an outlay of a capital nature and not deductible. Judson, J said [at page 479] the Court was not concerned with “what the result would have been if the appellant taxpayer had chosen to open its own branch office in New York . . . It financed a- subsidiary and lost its money.”

Judson, J said the Berman case [supra] was not in point, because in that case ‘the taxpayer made voluntary payments. to strangers, ie, the suppliers of its subsidiary, for the purpose of protecting Its own goodwill”. He concluded at page 479 [74, 6050]:

‘‘The learned trial judge has correctly characterized these dealings between the parent company and its American subsidiary. The parent company: provided working capital to its subsidiary by. way of loans. These loans were the only , working capital the American subsidiary ever had with the exception of the sum of $1,000 invested by Stewart & Morrison Limited for the acquisition of all of the issued share capital of its subsidiary. The money was lost and the losses were capital losses to Stewart & Morrison Limited. The deduction of these losses has been rightly found to be prohibited by paragraph 12(1)(b) of the Income Tax Act.

In The Queen v H Griffiths Company Limited, in which all the above decisions were cited, the Federal Court refused to allow the taxpayer’s expenses, as can be seen from the summary of the facts and the headnote, at [1977] 1 FC 476:

Defendant established a subsidiary mainly to obtain the sheet metal Capability which is needed to compete in the field of mechanical contracting. The subsidiary, while an “operating arm”, was a separate entity. In order to obtain “working capital”, loans were arranged. Griffiths personally: guaranteed one for $50,000, and defendant, the other, for $75,000. Upon the bankruptcy of the subsidiary, defendant reimbursed the bank the $75,000 and sought to deduct this amount under section 12(1)(a) of the Income Tax Act as an expense incurred for the purpose of producing income.

Held, allowing the appeal, this type of loan has been held to be a “deferred loan”, as the parent might some day have to “step into the bank’s shoes”. The payment by the parent was not made voluntarily to maintain the goodwill of strangers, but to satisfy a legal obligation. Such outlay was made “with a view of bringing into existence an advantage for the enduring benefit” of defendant’s business. The establishment of the subsidiary was to ensure an adequate supply of sheet metal, a distinct advantage. The guarantee was effected to provide working capital so that the benefit could continue; the establishment of the subsidiary was no “passing fancy”. The repayment was thus a Capital outlay and not deductible under section 12(1).

6.5.2. In order to solve the problem in the case at bar, pursuant to paragraphs 12(1)(a) and (b) and the principles stated in the aforementioned judicial decisions, the following three questions should be answered.

First question: Are the activities of Namofil Inc and the appellant’s personal income related, or are they not?

Second question: If they are related, does the appellant’s income constitute a capital gain, or does it not?

Third question: If this personal income is taxable, is it a consideration which is directly and closely related to the activities of Namofil Inc? Is the personal income the result of an enduring advantage acquired by the expense incurred by the appellant?

Answer to the First Question

6.6. In answer to the first question, it is immediately obvious that the evidence shows that not all the activities of Namofil Inc are related to the appellant’s income. Namofil Inc manufactured electrical fixtures, and generally its income was in no way related to that of the appellant; there was not even any evidence to show that the appellant received dividends from Namofil Inc in any way. However, the evidence did show that some of the company’s activities had or may have had some relation to the appellant’s personal income. The activities in question are those respecting the prototype of the newspaper vending machine and the Hydro-Quebec contracts. The facts stated in paragraphs 5.1 to 5.20 are sufficiently clear on this matter, particularly as it was shown that income of the same nature had been obtained in previous years.

Answer to the Second Question

6.7. In order to answer the second question—whether the appellant’s income was or was not a capital gain—the Board must first consider the two aforementioned activities: the project to develop the prototype of a newspaper vending machine and the Hydro-Quebec contracts.

6.7.1. The Hydro-Quebec Contracts

The Board considers first that the professional fees of over $60,000 to be derived from the company’s contracts with Hydro-Quebec do not constitute a capital gain for the appellant. This type of income is taxable pursuant to section 3 and paragraph 139(1)(e) of the old Act, and it would have been taxed if the company had not gone bankrupt and if the appellant had been paid the said fees.

6.7.2. The Prototype of the Newspaper Vending Machine

The Board also considers that the royalties which would have been derived from this project, according to the facts submitted in evidence as explained in paragraphs 5.8 and 5.9, would have constituted taxable income pursuant to paragraph 6(1 )(j) of the old Act.

Answer to the Third Question

6.8. With respect to the third question—whether the activities of Namofil Inc and the appellant’s income were directly related—a further distinction must be made between the prototypes of the newspaper vending machines and the Hydro-Quebec contracts.

6.8.1. The Hydro-Quebec Contracts

Pursuant to the evidence submitted, the Board concludes that the expenses incurred in the Hydro-Quebec contracts were directly related to the professional fees which the appellant received on the Same Namofil Inc contracts. The contracts were obtained not only because of the organization of the company and the quality of its products, but equally because of the appellant’s connections and the professional competence of his engineering firm. In certain respects the experience of previous years with Eclactec Inc was similar. In any event, the expense was certainly not incurred in order to obtain an advantage, an enduring asset which would produce income. These contracts would have earned fees only once. In order to earn further fees, engineering work on other contracts would have had to be carried out. From a business viewpoint, the two are closely linked. Like Noël, J in Her Majesty the Queen v F H Jones Tobacco Sales Co Ltd, [1973] CTC 784; 73 DTC 5577, the Board considers not so much the legal aspect of the transactions as the practical and commercial aspect.

The Board therefore considers that the advances by the appellant to Namofil Inc, which were used to perform the Hydro-Quebec contracts, were made in order to gain income. The losses resulting from these advances should be allowed as a deduction. The question is how much of the money advanced was used for these contracts, and therefore, what proportion of the loss of $58,200 is applicable against the appellant’s personal income. This question will be examined below.

6.8.2. The Prototype of the Newspaper Vending Machine

In view of the evidence submitted and described in paragraphs 5.8 and 5.9, the Board concludes that the advances made by the appellant to Namofil Inc, which could have been used in the newspaper vending machine project, were made in order to acquire an advantage which would have earned royalties as long as Namofil Inc produced and sold newspaper vending machines. The income is not immediate. It is too distant.

Is the case at bar so different from MNR v Freud, [1968] CTC 438; 68 DTC 5279? Really, it is not very different. In taxation the dividing line between taxable and non-taxable income or a deductible and non-deductible expense is narrow. The case at bar is a difficult one to decide. In Freud the transaction was deemed to be an act of a commercial nature and the expense was therefore allowed as a deduction, just as the income would have been taxable. In the case at bar the income is taxable because it comes within the provisions of paragraph 6(1 )(g) of the old Act. The expense is not deductible as a result. The invention patent was to be the advantage, the asset acquired by the expense, as is the case with an apartment building built to be let. The construction cost is not allowed as a deduction unless through the capital cost allowance provision. However, if an apartment building is built to be resold, the resulting profit will probably be considered business income, and the transaction might also be classed as an isolated act of a commercial nature.

In the case at bar, though, the patent was to be rented and to produce income for each machine sold, which would therefore be annual. At least, this is what the Board has been able to deduce from the evidence submitted to it, which the appellant had the burden of producing. While the facts are different in Freud, the judgment does not refer to the collection of royalties for each machine sold but only to the sale of the prototype of the automobile. It is not very clear how the sale was to be carried out. However, as it was not stated in Freud that the proceeds of the sale were to be paid by the piece, it seems that it must be concluded from the judgment that they were to be paid in a lump sum, and that the profit from the sale should be taxable. As explained in paragraph 5.8, it is not clear either that these royalties were to be paid to the appellant for each machine sold, but this was the conclusion deduced by the Board. In any event, if the evidence was not clear, the appellant cannot blame anyone for that. He had the. burden of proof. The Board therefore considers that the expense was incurred to obtain an enduring advantage and that is cannot be allowed as a deduction.

6.9. The question is, therefore, whether the loss of $58,200 incurred by the appellant as a result of the loan of $180,000 he made to Namo- fil Inc, is allowable as a deduction against the appellant’s personal income. The Board must answer affirmatively in part.

What part of the $58,200 should be alowed as a deduction?

The Amount of the Loss Adressable

6.10. In order to solve this problem, the Board must first determine the use to which the sum of $168,000 loaned by the appellant to Namo- fil Inc was put.

On the other hand the Board notes that the evidence was not very specific on this matter, and on the other hand, the Board is also aware that it may have been difficult to provide specific evidence. It is a known fact that in the general management of a business, money in the bank is used as needed. Needs arise as the firm’s various projects and business interests develop. What were the various projects and business interests in which Namofil Inc was involved throughout 1970 and at the beginning of 1971 ?

We know that the principal operation of Namofil Inc was the manufacture of electrical fixtures. What were the company’s various expenses? It can be seen from the company’s tax return for 1970, filed as Exhibit 1-1, that expenses for that year amounted to $350,596. If all this money was connected with projects directly related to the appellant’s personal income, the entire loss of $58,200 could be allowed as a deduction against this personal income.

What are the expenses which, in the appellant’s view, are related to projects connected with the appellant’s personal income? The evidence shows that in 1970

(a) the project to develop the prototype of the newspaper vending machine cost the company $34,980 (Exhibit A-27; paragraph 5.15).

Because of the conclusions which the Board reached in paragraph 6.8.2, this expense cannot be taken into consideration in the computation of deductible expenses.

(b) the work concerning the loss at Hydro-Quebec.

The evidence showed that the Hydro-Quebec contracts amounted to $652,568.56, that the appellant’s professional fees allegedly came to $61,543, and that following the bankruptcy of Namofil Inc the HydroQuebec claim was $45,176.71. However, we cannot deduce from any of these figures the amount spent by Namofil Inc in 1970 for these contracts. Such an amount over the company’s total expenses for 1970, namely $350,396, would have given a ratio which, if applied to $58,200, would in the Board’s view have given the equitable amount of the loss which the appellant could have applied against his personal income.

6.11. As it is impossible to determine the amount of this expense, which was incurred for the Hydro-Quebec contracts during 1970, and as an equitable amount for the loss cannot be determined by any other means, the Board is obliged to dismiss the appellant’s claim regarding the loss of $58,200. It may be beneficial to recall once again that the appellant had the burden of proof.

6.12. Pursuant to the decision of paragraph 6.8.1 that there was a direct relationship between the Hydro-Quebec contracts performed by Namofil Inc and the appellant’s personal income, and that the appellant’s personal losses with respect to these contracts are deductible from his personal income, the Board also considers it should rule on the sum guaranteed by the appellant to the Prudential Assurance Company with regard to the Hydro-Quebec contracts. According to the evidence described in paragraph 5.20, 5.21 and 5.23, the sum of $45,176.71 had to be paid. It was later agreed that this sum should be reduced to $40,000. However, no evidence of payment of this sum of $40,000 by the appellant was submitted. That is undoubtedly why he did not claim it. The Board considers that it would have been deductible.

Losses on the Interest Paid

6.13. Pursuant to the evidence dealt with in paragraph 5.28, the appellant paid the sum of $9,548.68 as interest in 1971 on behalf of Namofil Inc. This payment is even admitted by the respondent.

The question is whether this sum can be allowed as a deduction in computing the appellant’s personal income.

There is an old rule that interest follows capital, as the accessory follows the principal. Can the principal debt of $140,816, which it has been proven that the appellant paid in 1971 to reimburse the com- pany’s debt, be itself allowed as a deduction against the appellant’s net income? The appellant has not claimed it.

Counsel for the appellant contended that the debt of $140,816 stemmed from the loan of $300,000, for which appellant is alleged to have given the 10,000 shares in Pole Lite Inc as surety. However, the evidence, as described in paragraph 5.30, shows that this sum of $300,000 was borrowed by the appellant personally and not by Namofil Inc. Nonetheless, the debt of $140,816 was incurred by Namofil Inc, as described in paragraph 5.28.

Here the appellant is not the borrower; he is the guarantor. Moreover, if the guarantor pays an amount, including interest owed by the debtor, and this amount is deductible under paragraph 12(1)(a), the interest owed by the debtor is then deductible.

The evidence did not show clearly whether part of the interest came from the sum of $300,000 which had been borrowed. The appellant had the burden of showing this. If evidence to this effect had been submitted, the Board would have considered that the said interest was deductible. As the evidence showed, the sum of $300,000 was in fact really borrowed in order to gain income within the meaning of paragraph 12(1)(a). Moreover, this interest was perhaps claimed and admitted by the respondent.

The interest paid after the appellant endorsed the Namofil Inc debt can only be allowed as a deduction to the extent that the loan was contracted by Namofil Inc and endorsed by the appellant for the purpose of producing income for the appellant.

It is true that evidence was submitted showing that a number of projects had been carried out by Namofil Inc in the past (Eclactec, Pole Lite Inc and so on) and during 1970 (Hydro-Quebec) which brought the appellant income, principally in the form of professional fees. However, the evidence did not show that all the work performed by Namofil Inc was directly related to the appellant’s income. The proportion involved had to be determined. The appellant had the burden of proof, and the proof was difficult to establish.

The ratio which the Board tried to find in paragraph 6.10 could certainly have been applied—for want of any better method—in the case of the capital of $140,816 and the interest of $9,548.68.

However, counsel for the appellant stated that there was more evidence. The appellant personally had the same bank as Namofil Inc. From a personal viewpoint, he still had an interest in keeping a good credit rating with the bank so as to be able to continue in business.

Counsel for the appellant cited in this respect Trans-Prairie Pipelines Ltd v MNR, [1970] CTC 537; 70 DTC 6351. The Federal Court of Canada there held that all the interest paid on the principal of $700,000 was deductible because the sum of $700,000—and not just $300,000— had been borrowed for the purpose of gaining income. This con- dition that the money borrowed and used should be “for the purpose of earning income from a business or property’’ is essential for application of paragraph 11(1)(c) of the old Act. . ~

The Board considers that these precedents are relevant to the interest resulting from the $300,000 borrowed by the appellant personally in January 1971. However, as explained above, the evidence was not sufficient to distinguish between the amount of interest resulting from this personal loan and the amount of interest of Namofil Inc.

6.14. With respect to the interest of $1,900 paid by the appellant in 1970 the appellant has not discharged the burden of;proof, as explained in paragraph 5.29. Furthermore, the Board considers that this payment—if any such payment was made—constituted an account receivable as of December 31, 1970. It was only after the bankruptcy that it became a loss and therefore applicable to 1971, and then if the said interest was paid on capital “borrowed . . . [and] used for the purpose of earning income from a business or property” (subparagraph 11 (1 )(c)(i) of the old Act).

Political Contributions

6.15. Pursuant to the evidence submitted and described in paragraphs 5.32 to 5.34, the Board considers that the political contributions, which were made during 1970 and amounted to $9,200, were made for the purpose of earning income. The gifts made by the taxpayer had no other purpose than to obtain and to retain contracts. The work done for the government, which amounted to between $25 million and $30 million and in which the appellant’s engineering firm participated, cannot be dissociated from a certain policy on “goodwill” expenses in the broad sense. This is an economic and business reality which must be taken into consideration.

Evidence was submitted that in 1971, after obtaining a credit margin of $300,000 from the bank, the appellant obtained further contracts from the Office des Autoroutes, as described in paragraph 5.31. In the Board’s view, the gifts made in 1970 are as directly linked to these contracts as the credit of $300,000 obtained from the bank at the beginning of 1971.

An expense of this nature—although not linked explicitly to a particular contract—is, nevertheless, deductible. Many expenses are incurred to produce income but do not do so. They are, nevertheless, deductible in the computation of income.

Counsel for the respondent argued that, since the officers of the General Trust of Canada, Montreal Trust and the Quebec Trust Company were not present during the inquiry to identify the cheques and the political parties involved, the evidence cannot be accepted. However, given the appellant’s experience both with political parties, the machinery for making gifts to those parties, and with the Quebec Government (for which he worked for 16 years), given the indication on one cheque of the riding in which the money was to be spent, and given also the fact that the Board believes the appellant, the Board considers that, following the requests of the treasurers of the political parties concerned, the sums amounting to $9,200 were duly paid and deposited with the agents of the political parties in question.

The sum of $9,200 should therefore be allowed as a deduction for 1970.

Residence Expenses

6.16. The Board is satisfied that, given the nature of his business, the appellant’s private residence was used for his professional purposes. However, the Board considers that it is reasonable to allow an amount of $1,200 for each of the years 1970 and 1971.

Security and Entertainment Expenses

6.17. As no evidence was submitted in support of security expenses in the amount of $634.81, and the Board does not even know exactly what this expense comprises, it has no other choice than to refuse it.

6.18. For gross income of $99,737.05 earned in 1971, the Board considers that, in view of the nature of the taxpayer’s business, the sum of $2,892.70 claimed as entertainment expenses, as explained in paragraph 5.36, would have been reasonable in the circumstances. However, since no evidence was submitted regarding these expenses, the Board has no other choice than to dismiss the claim.

7. Conclusion

The appeal is allowed in part in accordance with the reasons stated above.

Appeal allowed in part.