Holden Wild Rice Limited v. Her Majesty the Queen, [1977] CTC 76, 77 DTC 5064

Smith, DJ:—In this action the plaintiff claims that the reassessment of its income for the taxation year ending December 31, 1970 by which $81,076.25 was added to its income for that year and the confirmation thereof by the Minister of National Revenue should be set aside, or alternatively that the reassessment and confirmation should be varied and reduced.

Merrick George Holden of the Village of Lac du Bonnet in Manitoba, president of the plaintiff company, gave a brief outline of his and the company’s experience in connection with wild rice. Prior to 1953 Mr Holden carried on in his own name the business of farming, buying, selling and dealing in wild rice. In 1953 he caused the plaintiff to be incorporated to take over and operate the business. Until 1969 he owned all the shares of the plaintiff’s stock. In that year two other men each became owners of 25% of the shares, Holden retaining the other 50%. He stated that he and later the plaintiff had always sold to wholesale buyers. At first sales were made locally, but from 1953 to 1960 most of the plaintiff’s rice was sold to a wholesaler in Winnipeg, with some going to dealers in Minnesota.

In 1960 Sherman Holbert, a Minnesota businessman, approached Mr Holden and several other Canadian growers of wild rice and persuaded them, together with about a dozen Minnesota growers, to form a selling company in Minnesota to market their rice. This company, Associated Wild Rice Producers Inc (herein generally referred to as Associated), was incorporated with its head office at Isle, Minnesota. Holbert was its majority shareholder, Holden was a director and shareholder, and each of the producer members had one share. Profits were to be shared among the members proportionately to the number of pounds of wild rice supplied by each of them.

In the period 1960 to 1969 the business experience of Associated varied greatly. Its sales of wild rice fluctuated between 150,000 and 250,000 pounds per year, largely determined by the amount of rice grown. The price obtained also showed enormous variations, from a low of $1.60 per pound to a high of $6. In some years Associated made a profit, but suffered losses in others. Over the whole period its losses exceeded its profits by more than the amount of its paid-in capital. (See Exhibit P1-5E Ex A.)

In its dealings with Associated the plaintiff began to experience difficulties as early as 1962. In that year production was high. Associated did not take the plaintiff’s rice till March 1963 and paid for most of it only in the fall of that year. Part of the price was not paid that year, the plaintiff taking a note for it for $5,000 which was paid five or six years later.

In 1967, another high production year, the plaintiff shipped its rice to a bonded warehouse, billing Associated for the price, $3.95 per pound. The price was not paid at that time and later the plaintiff accepted $3 per pound for most of the rice and $2.95 for the balance.

In 1968 the plaintiff did not make use of a bonded warehouse, apparently accepting Mr Holbert’s statement that he required control of the plaintiff’s rice in order to obtain credit for Associated’s operating needs. The plaintiff’s rice was shipped to Associated. On the last shipment which was in November, only about $10,000 was paid, leaving a balance of $94,775 outstanding. This was in the autumn of 1968. Something less than half of the rice not paid for belonged to the plaintiff. The balance belonged to five other producers for whom the plaintiff was acting when it sold the rice to Associated. The evidence does not indicate whether the plaintiff sold in its own name or specifically as agent for each of the five producers to whom portions of the rice belonged nor does it indicate that the question was ever raised by anyone. What it does disclose is that later, when payment was still not forthcoming, the plaintiff paid each of the five producers the amount owing on the sale of his grain to Associated.

During the ensuing months Mr Holden telephoned Mr Holbert frequently about payment of the $94,775 owing for the 1968 crop. On these occasions Mr Holbert always gave him reasons, which differed from time to time, why Associated was unable to pay. Then, in the spring of 1969 Mr Holden and some other producers, with a chartered accountant who had been consulted by them, went to Isle, Minnesota, saw Mr Holbert and examined Associated’s inventory of rice. They found that nearly all of it was of low grade and badly broken. In Mr Holden’s evidence it was worth much less than the value shown on Associated’s books. The rice for which $94,775 was owing had apparently been sold. At any rate it was not on hand. They further found that Associated’s plant and machinery, its inventory of rice and its accounts receivable were all encumbered. Practically the only asset free of charges in favour of creditors was goodwill.

From the facts already stated it is clear to me that by 1969, and probably earlier, Associated was in a difficult financial condition. This conclusion is confirmed by the reports of Associated’s auditors, Sexton, Hartmann, McMahon & Co, to the company’s directors and the financial statements accompanying those reports, for the years ending June 30, 1968 and 1969 (see Exhibit P1-5B and 5E). I note that in the assets of the company set out in these and financial statements for other years there was always included an item for goodwill, with a value of $26,000 placed on it. In view of the financial position of the company, resulting from its trading losses, a valuation of $26,000 for the company’s goodwill is of doubtful validity.

Correspondence beginning as early as March 1969, together with Mr Holden’s evidence at the trial, indicates that Mr Holden had little hope that Associated would be able to pay the money owing to the plaintiff or that Associated, of which he was a director, would become successful, as then constituted. The other directors, including Mr Holbert, seem to have felt for at least a year that something should be done to improve the situation. At a meeting of Associated’s directors on March 7, 1968 a motion had been passed that the management proceed to negotiate a plan for merging Associated with some other company. The board was informed that two companies were interested in a merger. Management was directed to develop an alternative financing plan as a standby program in the event that a merger was not concluded. (See minutes of this meeting, Exhibit P1-7.)

Nothing materialized then or later from negotiations for a merger.

Mr Holden began to think in terms of the plaintiff and its associates gaining control of Associated. Mr Holberg welcomed proposals from Mr Holden for such a step, as appears from three letters written by him to Mr Holden dated April 18, 1969, May 7, 1969 and June 21, 1969 (Exhibits P1-8, 9 and 10). From the last of these letters it also seems that payment of the $94,775 owed by Associated to the plaintiff was involved in Mr Holden’s proposals.

By letter tc Holbert dated June 23, 1969 (Exhibit P1-11), the plaintiff made a definite proposal that a new corporation be formed, owned mainly by the present shareholders of Associated, that Associated settle in full the outstanding accounts of W Heide, Heide Brothers, Wild Rice International and the plaintiff, and also that of another described simply as MWRH, and that the “wild rice merchandising capabilities’’ of Associated (meaning its goodwill) be transferred to the new corporation for a price of $200,000 to be paid out of the money received by the new corporation from the sale of wild rice, at the rate of 15 cents per pound sold. The accounts of the plaintiff and other producers were to be the first accounts paid by Associated out of the proceeds of the agreement. If this proposal had been accepted and carried out the plaintiff would have received full payment of the debt owing it by Associated and there would have been no occasion for the present litigation.

We have no evidence of the amounts owing to the four producers which under this proposal were to be settled in full by Associated, as well as that of the plaintiff. It is therefore impossible to say how much of the $200,000 would be left in the hands of Associated, if anything. Further as the $200,000 was to be paid out of the proceeds of sales of rice over an indefinite period of years at 15 cents per pound sold, the proposal was worth substantially less than $200,000 cash.

On July 8, 1969 the plaintiff changed its offer, reducing the price to $150,000 and eliminating the requirement of payment of two of the creditors’ accounts, viz, those of Wild Rice International and MWRH (Exhibit P1-16).

Negotiations continued over the balance of 1969, with some changes being made in the terms of the offer. Finally an agreement between Associated and the plaintiff was made dated March 27, 1970 (Exhibit P1-27). In addition to its provisions for the plaintiff, the agreement required payments of only one producer account, that of W Heide. The defendant contends that under this agreement the plaintiff received values at least equal to the $94,775 owed to it by Associated. On the other hand the plaintiff contends that the $94,775 had become a bad debt, with only nominal value, and that its purpose in entering into the agreement was simply one of attempting to salvage something from what had become a hopeless situation. What then did the terms of the agreement provide?

I note first of all that in addition to matters relevant to this action, the agreement dealt with the purchase by the plaintiff from Associated, for cash, of two kinds of personal property, (1) office furnishings and equipment, of which a list with a separate price for each item, totalling $7,320.50 is attached to Bill of Sale #2 (Exhibit P1-27B) referred to in the agreement; (2) non-obsolete packaging supplies and materials, also mentioned in Exhibit P1-27B and in the agreement. All of the items included under (1) and (2) were, as indicated above, purchased for cash. They have nothing to do with any consideration received by the plaintiff in relation to the debt of $94,775.

The agreement also referred to Bill of Sale #1 (Exhibit P1-27A), by which Associated sold its goodwill and related items to the plaintiff. This exhibit will be discussed below.

The agreement provided that the First National Bank of Grand Rapids, Minnesota would, pending completion of certain steps under the agreement, hold the documents relating thereto as escrow agent for both parties.

The provisions of the agreement (Exhibit P1-27) that may be considered relevant to this litigation are as follows:

In consideration of One Dollar and Other Good and Valuable Consideration, the party of the first part (Associated) hereby agrees:

1. That contemporaneous with the execution of this agreement it will deliver to the escrow agent hereinafter provided two Bills of Sale, being Bill of Sale #1 and Bill of Sale #2, both of which shall name the party of the second part (the Plaintiff) as vendee.

2. Party of the first part agrees that it will neither directly nor indirectly engage in the business of buying or selling wild rice in the United States for a term of five (5) years from and after the date of the transfer contemplated by this agreement and that it will, within a reasonable time from and after that date of this agreement, change its name so as to eliminate therein any reference to wild rice. Party of the first part further agrees to obtain from its President, Sherman Holbert, a non-competing agreement on terms similar to those just recited. (This provision was clearly intended to eliminate completely all competition to the plaintiff from Associated and Holbert in respect of wild rice.)

4. That within twenty-one days of the date of this agreement party of the first part will furnish to party of the second part the following:

1. . . .

2(a) . . .

(b) A receipt from William Heide reflecting payment to him in full of the obligation to him of the party of the first part.

5. Upon execution of this agreement, party of the first part shall . . ., and party of the second part shall deliver to the First National Bank of Grand Rapids, Minnesota, as escrow agent, the following: a receipt naming Associated Wild Rice Producers, Inc., in the amount of $94,775.00 Dollars and the check of the party of the second part in the amount of $20,000.00 Dollars.

The cheque for $20,000 was to provide for payment for the office furnishings and equipment and non-obsolete packaging supplies and materials.

The agreement contains no reference to the debt of $94,775 or of any other amount owing by Associated to the plaintiff, nor does it indicate the purpose for which the receipt for $94,775 was to be applied. It does, however, refer to Bill of Sale #1. I therefore turn to Bill of Sale #1 (Exhibit P1-27A) to see if it provides any enlightenment on those points.

The first paragraph of this bill of sale reads:

Know all men by these presents, that Associated Wild Rice Producers. Inc., . . . party of the first part, in consideration of the sum of Five Thousand Dollars ($5,000.00) in hand paid by Holden Wild Rice, Ltd., party of the second part, the receipt whereof is hereby acknowledged, does hereby Grant, Bargain, Sell and Convey unto the party of the second part, its successors and assigns, forever, the following described Goods, Chattels, and Personal Property, to wit: all of its Customer lists, right to trade-names, brand-names and copyrights, good-will, art-work, plates and miscellaneous advertising materials.

From statements made by counsel for the parties I have concluded that the parties are agreed that the quoted paragraph amounted essentially to a sale and conveyance of goodwill. Nowhere in the bill of sale is there any reference to a debt of $94,775, or of any other amount, nor is there anything to suggest that the items being sold and conveyed were valued at any other amount than $5,000. From the fact that the items mentioned in the bill of sale were the only items acquired at the time by the plaintiff from Associated, other than those specified in Bill of Sale #2, all of which were paid for in cash, and that there is no suggestion in the evidence that the stated consideration of $5,000 was in fact ever paid, together with the plaintiff’s repeated efforts to recoup itself from the loss occasioned by what it regarded as a bad debt, it is possible and even likely that the requirement in the agreement that the plaintiff deliver a receipt for $94,775 was related to the payment or to the wiping out of the debt of that amount owed by Associated to the plaintiff. If so I find nothing in these documents or in the parol evidence of Mr Holden (the only person who was examined in the case) to support the defendant’s contention that the plaintiff ever received payment in full of the debt of $94,775. On the contrary it is a much more likely interpretation of the documents that the parties at that date regarded the consideration of $5,000 stated in Exhibit P1-27A as being the value of the goodwill and other items sold and conveyed by It.

There are other exhibits that may help to clear up the question of the true value of the items conveyed to the plaintiff by Exhibit P1-27A. But two of them, in my opinion, only serve to confuse the issue. These are two forms of receipt drawn up in connection with the transaction, and apparently intended to comply with the requirement of clause 5 of the agreement of March 27, 1970. The first of these is dated March 27, 1970 and is Exhibit P1-28. It was signed by Mr Holden as president of the plaintiff and reads:

Received of Associated Wild Rice Producers, Inc. the sum of $94,775.00 Dollars by cancellation of the accounts payable in that amount due to the undersigned as of the date of this receipt.

This is a strangely worded receipt. When a creditor cancels a debt that is owing to him, and nothing is said about consideration (as in the case of this receipt), there is nothing to show that the creditor received any money. All that the creditor appears to have done is to give up his right to be paid. He is not paid by cancelling the debt, but by the consideration given for so doing. The receipt does not help us to ascertain what the plaintiff received for the cancellation, let alone its value. The receipt does, however, acknowledge receipt of $94,775, the full amount owed by Associated.

On April 1, 1970 Mr Holden wrote his American lawyer, Mr Shaw (see Exhibit P1-30) and questioned the wording of the receipt. He suggested it

be changed to read something like—This is to certify that we, Holden Wild Rice, hereby accept as settlement of the open account due us in the amount of $94,775.00, the good will and customer lists, art work, plates, brand names, etc. to the value of $5,000 and the balance of the account—$89,775.00 is hereby cancelled in exchange for a non-competition agreement from Mr S A Holbert, president, Associated Wild Rice Producers, Inc.

His letter continued:

This in place of a receipt for $94,775.00 which would be a lie and would place us in a bad position with the tax department. You can do a better job of wording the receipt than we can but you can see what we need from this.

Mr Shaw replied by letter dated April 3, 1970 (Exhibit P1-31). The first paragraph reads:

I have enclosed a proposed form of revised receipt. Please sign and return to me and I! will attempt to substitute it for the one that is now in the file.

There is little doubt that the receipt stated to be enclosed with this letter is the one that became the second receipt.

The second receipt is Exhibit P1-29. It bears the same date as Mr Shaw’s letter, April 3, 1970, but the copy filed in Court has no signature. Mr Simonsen, the plaintiff’s counsel, said that he believed a signed copy was delivered to Mr Holbert or his solicitor, though Mr Holden did not remember it when cross-examined about it. It reads:

Holden Wild Rice, Ltd, as creditor of Associated Wild Rice Producers, Inc., in the sum of $94,775, hereby acknowledges that said obligation is cancelled in full. $5,000.00 of which is determined to be the value of the customer lists, right-to-trade names, brand names and copyright, good-will, art work, plates and miscellaneous advertising materials, now being sold to Holden, and the sum of $89,775.00 determined to be the value of the non-compete agreements as contained in an Agreement between the parties, dated this day.

In my view the net effect of these three exhibits, P1-28, 30 and 29 is not helpful to the plaintiff. In fact the unsigned receipt (Exhibit P1-29) is prejudicial to his case. It is true that it acknowledges that the Obligation of $94,775 is cancelled in full. It does not say it is paid in full, but the balance of the receipt seems to point to the conclusion that full value has been received. It says that $5,000 is determined to be the value of the goodwill, customer lists, etc now being sold to Holden and that $89,775 is determined to be the value of the noncompete agreements. The words “is determined to be’’ may be capable of intending another meaning, but the natural meaning seems to be that in the plaintiff's opinion the figures given represent the values of the goodwill and customer lists, etc, and of the non-compete agreements. If this is the intended meaning the plaintiff is acknowledging that the obligation of $94,775 has in effect been paid in full and his whole case falls to the ground. It is doubtful, however, that this meaning is what Mr Holden really intended, because in his letter to Mr Shaw (Exhibit P1-30) the changes he suggested in the receipt (Exhibit P1-28) spoke of the goodwill and customer lists, etc as having a value of $5,000, but said nothing specific about the value of the non-competition agreement, merely saying that ‘the balance of the account— $89,775.00 is herebv cancelled in exchange for a non-competition agreement from Mr S A Holbert, president, Associated Wild Rice Producers, Inc”. This was followed by the sentence: “This in place of a receipt for $94,775 00 which would be a lie and would place us in a bad position with the tax department.”

Mr Holden’s letter is consistent with the position he took at the trial, viz, that he regarded what he was buying as worth a great deal less than $94,775, and that he was simply trying to salvage what he could from a bad situation.

Some further comment is warranted about the reference in Mr Holden’s letter (Exhibit P1-30) and in the receipt (Exhibit P1-29) to consideration being given to Associated for a non-competition agreement from Associated and Mr Holden. It is clear from letters and other documents filed as exhibits at the trial that from at least as early as June 23, 1969 the plaintiff was requiring that in any agreement under which it would take over the goodwill (merchandising capabilities) of Associated there would be a provision protecting it from competition by Associated or by Mr Holbert, and that Associated was in agreement with this requirement. See letter from the plaintiff to Holbert as president of Associated, bearing that date (Exhibit P1-11). See also resolution at the end of minutes of a board of directors’ meeting of Associated, dated July 1, 1969 (Exhibit P1-15). By clause 2 of the agreement of March 27, 1970 (Exhibit P1-27) Associated agreed that it would, neither directly nor indirectly, engage in the business of buying or selling wild rice in the United States for a term of five years and that it would change its name so as to eliminate therein any reference to wild rice. It further agreed to obtain from Mr Holbert a non-competing agreement in similar terms.

Nowhere in the filed correspondence or other documents, prior to Mr Holden’s letter to Mr Shaw of April 1, 1970, have I found any suggestion that any payment be made to Associated or to Mr Holbert for a non-competing agreement. Frequently, when goodwill is purchased the purchaser insists on an agreement of this kind, the obvious purpose being to ensure that the goodwill the vendor is selling to him and for which he has paid will not be taken back in whole or in part by competition from the very person who sold it to him. From this point of view, the vendor who gives such an undertaking is simply promising not to reduce by his own actions the value of what he has sold. Thus the vendor is normally not paid anything for such an undertaking above the consideration paid for the goodwill. Even if for some reason, though in months of negotiations no evidence is found that some additional payment for a non-competing agreement has ever been considered or suggested, it is agreed that such a payment is appropriate, I find it difficult to accept as a credible document a receipt which states a value of $5,000 for the goodwill, customer lists and all other related items being purchased, and then states a value of $89,775 for a noncompeting agreement. On the other hand Mr Holden impressed me, both in the box and from his experience, as a competent businessman. I must believe that he knew what he was doing and I cannot ignore what this document, tendered on behalf of his company, states.

Under all the circumstances of this case, and no explanation having been given for the values shown in the receipt (Exhibit P1-29), I can only regard this receipt as definitely detrimental to the plaintiff’s case. I am not going to speculate about the reason why these values were stated in the receipt.

During the negotiations which ultimately resulted in the agreement of March 27, 1970, a letter dated January 13, 1970, which was filed on behalf of the plaintiff at the trial as Exhibit P1-23 and not objected to by the defendant’s counsel, was drafted. It has at the end the printed words:

Holden Wild Rice Ltd

By

but the copy filed has no signature. In Mr Holden’s evidence he stated that the letter is not on the company’s letterhead and that it was not signed by him or anyone for the company. Counsel for both parties examined Mr Holden about this letter, but his evidence that it was not signed by him or by anyone for the company was not affected. In these circumstances I can attach very little, if any, value to it. The letter contains the following paragraph:

Holden Wild Rice Ltd, offers to purchase the goodwill, customer List, exclusive right to trade names, brand names and copyrights owned and used by Associated, including the artwork, plates and other advertising materials, for a price of $94,775.00, to be paid by cancelling the obligation in that amount now owed by Associated to Holden.

As this paragraph speaks of a price of $94,775 to be paid by cancelling the obligation of that amount and contains nothing to indicate the assets were not worth the price being offered, this document, for what it is worth, is, in my opinion, favourable to the defendant.

Two earlier letters have a bearing on this question of the value of the consideration received by the plaintiff for the $94,775 debt. The first of these is from the plaintiff to its solicitor, Mr Shaw. It was filed as Exhibit P1-19 and bears date November 18, 1969. The last two paragraphs read:

The proposal being considered at this time is—Associated Wild Rice Producers sells its only asset (almost only) ie its customer list or merchandising capability to Holden Wild Rice Limited.

The payment Associated Wild Rice Producers receives for above sale is the amount presently due to Holden Wild Rice—$94,775.00. This amount is outstanding as of November, 1968.

I note that this letter does not speak of cancelling the debt, but of a sale of Associated’s customer list or merchandising capability and payment to Associated for the sale as being the amount due to the plaintiff —$94,775. While I am not completely without doubt, in my opinion the letter indicates the consideration for the customer list or merchandising capability was $94,775 and nothing in Mr Holden’s evidence has led me to a different conclusion. It therefore supports the defendant’s position, at least as of the date of the letter.

The second letter is Exhibit P1-21. It is dated December 15, 1969 and is from the plaintiff’s solicitor, Mr Shaw, to Associated’s solicitor, Mr Nyquist. It states:

He [meaning Mr Holden] has authorized me, on the behalf of Holden Wild Rice, Ltd to make the following offer.

Associated owes Holden $94,775.00 plus one year’s interest. In exchange for the cancellation of the principal obligation above stated, Associated will convey to Holden, or to any other person or organization that Holden might designate, all of the marketing facilities, all brand names or trade names, and all good will and customer relationships of Associated.

I note that, differing from Exhibit P1-19, this letter does not speak of Associated being paid $94,775, but of the cancellation of its debt to the plaintiff of $94,775, in exchange for the conveyance of certain assets of Associated to the plaintiff. In my opinion the letter leaves it open to prove that the value of the assets was less than $94,775. It certainly does not state a value of $94,775 for them.

Exhibit P1-5 consists of the reports of Associated’s auditors for the years ending June 30, 1964 to 1969, with balance sheets and other financial statements for all of those years attached. It also includes handwritten balance sheets for two or three individual months. In every balance sheet there is an asset, described usually as “good-will and customer lists’’, but sometimes simply as “good-will”, and the value stated for it is invariably $26,000. In the balance sheet for the year ending June 30, 1964 the $26,000 value for goodwill and customers lists is stated to be “at cost” The auditors’ report for that year takes objection to several asset items in the balance sheet, indicating that they should be deducted, leading to a reduction in the item for shareholders’ equity from $65,548.56 to $6,020.21. The auditors’ comment about goodwill is as follows:

Also, the item of goodwill and customer lists are recorded at cost in the amount of $26,000.00. Since goodwill is based on excess earning power we are taking exception to its value as an asset.

In my opinion this comment was fully justified. As indicated earlier in these reasons, over the whole period from the incorporation of Associated in 1960 to the end of June 1969 its losses exceeded its profits by more than the amount of its paid in capital. To be precise, the balance sheet for the year ending June 30, 1969 shows issued share and other paid in capital amounting to $102,900, with losses totalling $116,874.47, resulting in the shareholders’ equity being in a deficit position in the amount of $13,974.47. Thus, the company was in worse condition in June 1969 than it had been when the above comments by its auditors were made five years earlier.

No auditors’ reports more recent than that for the year ending June 30, 1969 are before the Court. It may be that Associated’s financial picture improved between that date and March 27, 1970, but there is no evidence that suggests a dramatic improvement during that period.

At or about March 30, 1970, perhaps earlier, Mr Holden began negotiations with Clifton E Nelson, of Grand Rapids, Minnesota, who carried on a business similar to that of Associated, under the name of Arrowhead Wild Rice Company, with a view to amalgamating the business of Arrowhead with what the plaintiff had just acquired from Associated. (See letter dated April 1, 1970 from the plaintiff to his attorney, Mr Shaw—Exhibit P1-30.) On May 12, 1970 an agreement for this purpose called a letter of intent (Exhibit P1-34), was made between Nelson and Arrowhead on the one hand and the plaintiff on the other. The parties agreed to form a new Minnesota company to be named United Wild Rice Supply, Inc, to which would be transferred the goodwill of Arrowhead in exchange for 13,000 shares of stock in the new company of $1 par value each, and also the goodwill of Associated for Similar consideration.

In his evidence Mr Holden stated that Arrowhead’s sales volume in 1968 and 1969 had been about 150,000 to 175,000 pounds of rice. Associated’s volume had varied over the years from 150,000 to 250,000 pounds. Nelson and the plaintiff had agreed that they would enter the new company on an equal footing and that the goodwill and customers lists of Arrowhead and Associated would be accorded equal value. He said Nelson valued Arrowhead’s goodwill at $13,000 and that he (Holden) felt Associated’s should be as valuable as Arrowhead’s.

This evidence is supported by a handwritten statement called a balance sheet, for United as of June 26, 1970, which shows an item for goodwill valued at $26,000 (Exhibit P1-40) and by a typed unaudited statement of financial condition of United as of November 20, 1970, which shows a similar value for goodwill (Exhibit P1-41).

50 far as the record shows, no other shares of United were ever issued. Mr Holden stated that the plaintiff and Nelson each turned over (sold) to United other assets valued at $71,046. These were not paid for in shares but promissory notes for $71,046 payable in three years were given to each of them.

United’s business was not profitable. The second page of Exhibit P1-41 indicates that for the first six months of operation, May 25, 1970 to November 30, 1970, a net loss of $39,490 was incurred and that at the latter date the shareholders’ equity was in a deficit position of $13,490. All the company’s shares were sold by agreement dated June 21, 1971, but not executed till July 18 of that year, by Nelson and the plaintiff to Continental Wild Rice Inc for a price stated as $456,632.66 (Exhibit P1-42). A letter of agreement forming part of Exhibit P1-42, which contains the formula used to determine the purchase price of $456,632.66, gives a value for goodwill and business of $480,000, to or from which the total of certain items (to be ascertained) was to be added or deducted. By Exhibit P1-42 Continental also guaranteed payment to the plaintiff and Nelson of the outstanding notes of United, stated as totalling $71,045.85 to each of them.

Apparently United’s financial position had not improved significantly between November 30, 1970 and July 18, 1971, since a special report on that company, dated October 11, 1971, but reporting as of the previous August 15, by a firm of certified public accountants, to Nelson, Holden and Continental, shows an excess of liabilities over assets of $23,376.34. This report gives no value for goodwill, for which the earlier financial statements had allowed $26,000. It therefore indicates some little improvement over the position as at November 30, 1970.

No explanation was proffered to the Court for the astonishing increase in the stated value of the plaintiff’s and Nelson’s half interests in United between May 1970 and July 1971. Their investment in United in May 1970 was, according to the documents and to the testimony of Mr Holden, $13,000 each. Between that date and July 1971 United lost money. Yet by the agreement executed on July 18, 1971 they were each to be paid half of $456,632.66, which is $228,316.33. It is true that payment was to be spread over a long time, being by payment of 5% monthly of Continental’s gross receipts, such payments guaranteed by Continental to be at least $4,000 a month, including interest. Thus the price, by the agreed on method of payment, was probably worth less to the sellers than if it had been paid in cash, notwithstanding the pro- vision for interest (which was to be at the prime rate as determined by the Northwestern National Bank of Minneapolis monthly). But this fact affords no explanation for such a tremendous increase.

Turning now to the plaintiff’s income tax returns, the return for 1968 is not before the Court, but Mr Holden’s undisputed evidence is that in the return for that year the debt of $94,775 owing by Associated was included as an account receivable. The returns for 1969 and 1970 are Exhibits P1-1 and P1-2 respectively. In Exhibit P1-1 the list of current assets as at December 31, 1969 contains an item for accounts receivable, from which is deducted as an allowance for a doubtful account the sum of $94,775. The evidence before the Court identifies this item as the amount owing by Associated, on which nothing had been paid. In the statement of revenue and expenditure for the year ending December 31, 1969 in the same Exhibit, this item appears not as a doubtful debt, but as a bad debt.

Exhibit P1-2 contains an item for the doubtful account December 31, 1969 of $94,775, and immediately below it is an item “Account recovered’’ of $13,698.75 and below it is an item “Account written off against allowance’’ of $81,076.25. The evidence of Mr Holden was to the effect that he regarded the doubtful debt of Associated as having become a bad debt and that he valued the goodwill of Associated purchased from Associated in exchange for a release of this debt at $13,000 (the amount at which it was valued on the formation of United). This valuation was in United States funds. American money was at a premium in Canada, so that when $13,000 in United States funds was converted into Canadian funds the amount was $13,698.75. This amount he entered in Exhibit P1-2 as money recovered of an otherwise unrecoverable debt.

The Department of National Revenue reassessed the plaintiff for income tax by adding back to its income the whole of the balance of the $94,775 debt shown by the plaintiff as deductible $81,076.25, claiming that the plaintiff had recovered the whole of the debt and not merely the amount reported as recovered, $13,698.75.

From the foregoing lengthy recital of facts it is clear that in the various documents and transactions there were astonishing variations in the values accorded to Associated’s goodwill. First we find a value of $26,000 in the annual financial statements of Associated, a value which its own auditors thought could not be sustained. Next we have the first two specific proposals made by the plaintiff on June 23, 1969 and July 8, 1969 in which offers were made to purchase Associated’s goodwill for $200,000 and $150,000 respectively. Then comes the value of $5,000 shown in Exhibit P1-Z7A, attached to the agreement of March 27, 1970, and in both Mr Holden’s letter of April 1, 1970 to Mr Shaw (Exhibit P1-30) and in the second form of receipt (Exhibit P1-29) given at that time. Then in May 1970 we find a value of $13,000 given by the plaintiff on the formation of United, and finally we have the agreement executed on July 18, 1971 (Exhibit P1-42) from which a value for Associated’s goodwill of $228,316.33 is derived.

In addition to the wide range of valuations given in the preceding paragraph there are one or two instances in 1969, eg, Exhibit P1-19, in which the plaintiff seems to indicate a value of $94,775 for Associated’s goodwill.

There is no doubt that Mr Holden, by early spring 1969, had come to the conclusion that the $94,775 owing to the plaintiff would probably never be paid by Associated, at least if that company, of whose financial situation he was well aware (being a director of it until January 1970), continued to operate as it had been doing. He was concerned to recoup what looked like a serious loss. The course he took to this end, after attempts by Associated to merge with another company had produced no results, was uniformly to seek control of Associated’s goodwill or merchandising capacity, supported by a strong noncompeting agreement from Associated and Mr Holbert. As a producing supplier, the plaintiff’s operations might be substantially improved if it controlled its sales outlet. Thus Associated’s goodwill which was of no great value by itself, might be much more valuable in the plaintiff’s hands. This fact may account for the high prices sometimes offered by the plaintiff, prices for which no real explanation is to be found in the evidence. Under every proposal made by the plaintiff there was the fact that in addition to avoiding or at least cutting down a business loss the plaintiff would acquire a valuable capital asset.

In the light of all the documentary evidence and the oral testimony of Mr Holden about the value of Associated’s goodwill, and noting that several of the figures were given by the plaintiff, including the three highest, $200,000, $150,000 and $228,316.33, I conclude that the plaintiff has not satisfied the onus of proving that the reassessment objected to was in error in holding that the plaintiff had received payment in full of the debt owed to it by Associated. In fact, in my opinion the weight of the evidence leads in the other direction. The plaintiff’s claim is therefore dismissed with costs.

My judgment rests on my conclusion on the facts. Counsel for the defendant raised two arguments on the law each of which, if successful, would in itself defeat the plaintiff’s claim. The first is technical, depending upon the applicable statutory provisions, the relevant sections of the Income Tax Act at all relevant times being to the following effect:

1. Subparagraph 11(1)(e)(i) provides that in computing the income of a taxpayer for a taxation year there may be deducted a reasonable amount as a reserve for doubtful debts that have been included in computing the income of the taxpayer for that year or a previous year.

2. Subparagraphs 11 (1)(f)(i) and (ii) similarly permit deduction of the aggregate of debts that are established by him to have become bad debts in the year and that have been included in computing his income for that year or a previous year.

3. Paragraph 6(1)(e) requires that in computing the income of a taxpayer for a taxation year there shall be included the amount deducted as a reserve for doubtful debts in computing the taxpayer’s income for the immediately preceding year.

The facts, in relation to these statutory provisions are:

1. The sale which resulted in the debt of $74,775 was made in November 1968.

2. Early in the spring of 1969 the plaintiff felt, justifiably, that the debt had become doubtful.

3. On Mr Holden’s evidence the debt had become bad some time in 1969.

4. In the plaintiff’s income tax return for 1968 the debt of $94,775 was included as income.

5. In the plaintiff’s income tax return for 1969 it was shown as doubtful and a reserve of $94,775 deducted from the income.

6. In the Statement of Revenue and Expenditure forming part of the plaintiff’s income tax return for 1969 this item of $94,775 is shown as a bad debt, rather than merely a doubtful one. This affords some support to Mr Holden’s statement that the debt had become bad some time in 1969. There is no reason why a debt that is doubtful early in the year may not become bad later in the same year. In that event it should simply be treated as a bad debt in the income tax return for that year, which does not seem to have been done in this case.

7. In the plaintiff’s income tax return for 1970 the item of $94,775 is dealt with as follows:

This complies with paragraph 6(1)(e) of the Income Tax Act. Counsel’s submission is that the plaintiff had not established that the debt of $74,775 had become a bad debt in the year, ie, in 1970, as required by subparagraph 11 (1 )(f)(i). It is true that the only reference in a tax return of the plaintiff to this being a bad debt is the one mentioned in 6 above, which if taken as a correct statement would mean it had become bad in 1969, not in 1970. Mr Holden’s evidence suggests this was also his opinion. However, I would be very loath to dismiss the plaintiff’s claim on such a narrow technical ground, whenever he began to treat the debt as being bad, he was doing so early in 1970. It is I think quite possible that it was not until that time that the debt was “established” as being bad. I do not dismiss the plaintiff’s claim on this ground.

The second point of law raises a question which has frequently caused difficulty. It is related to section 12 of the Income Tax Act. Paragraph (a) of subsection (1) of this section prohibits making any deduction, in computing income, 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,

The submission of counsel for the defendant, put briefly, is that, in exchanging a debt owed to it by Associated for certain assets of Associated, the plaintiff did not make an outlay for the purpose of gaining or producing income from property or a business of the plaintiff, but for the purpose of making an investment.

Counsel referred to three cases where this question arose. The earliest was No 75 v MNR, 7 Tax ABC 321; 52 DTC 439. In this case the appellant company was owed $3,800 by one company and $1,250 by another. Both companies served as outlets for the appellant’s products and therefore it was to the appellant’s interest that they continue to operate. In 1948 both companies were experiencing financial difficulties. On April 22 the first company, and on May 15 the second, wrote letters to the appellant each admitting it could not pay its debt and asking the appellant to subscribe for preferred shares in the amount owing. The appellant agreed to subscribe as requested and did so. In its income tax return for the period ending October 31, 1950 the appellant claimed deductions of these two amounts, among others, as bad debts. On appeal to the Tax Appeal Board from the Minister’s disallowance of these deductions, the Chairman of the Board dismissed the appeal. The appellant still held the shares. The relationship between the appellant and the companies was significant but the decisive factor was that the requests had been that the appellant subscribe for shares, that it did so, that the shares were transferred to the appellant and the accounts owing by the companies were removed from the list of accounts receivable in the appellant’s books. There was no doubt in the Chairman’s mind that the appellant had become a shareholder. In other words it had ceased to be a creditor and become a holder of capital. If it subsequently suffered loss on the shares, it was a loss of capital and not deductible as a loss sustained in respect of a bad debt.

The second case was United Trailer Co Ltd v MNR, [1961] CTC 279; 61 DTC 1162. The appellant in this case manufactured and sold trailers. It assigned its conditional sales contracts to a finance company, from which it received the balance due by the customer on each contract. The appellant guaranteed the performance of each contract and was liable for any unpaid account. The appellant set up a reserve for doubtful debts in respect of its conditional sales contracts outstanding. The Minister disallowed the deduction of this reserve, and the Tax Appeal Board agreed. The Exchequer Court dismissed the appeal. It was held that the appellant’s transactions with the finance company were not loans on the security of conditional sales contracts but were outright sales of such contracts. The assignments of the contracts were absolute, with the appellant guaranteeing their fulfilment. The appellant ceased to be a creditor. The purchasers under the conditional sales contracts became direct contractual debtors of the finance company, and there were no debts or amounts receivable by the appellant in respect of which a reserve could be claimed.

This case is not directly in line with the present case, but it does indicate that when a creditor ceases to be a creditor there is no debt and therefore no reserve can be set up under paragraph 11(1)(e) of the Income Tax Act.

The third case, a decision of the Federal Court of Appeal, is similar in several respects to the present case. It is Cumberland Investments Limited v Her Majesty The Queen, [1975] CTC 439; 75 DTC 5309.

This case is particularly useful because it discusses the problems that arise in seeking to decide in borderline cases whether the situation is one of recouping a doubtful business debt or otherwise attributable to income on the one hand, or one of purchasing a capital asset on the other. It further contains several judicial statements of guidelines for resolving the problem.

The appellant carried on the business of a supervising general insurance agency. All of its business was handled through local or subagents who dealt directly with the public. In 1971 the appellant entered into an agreement with Austin E Hayes, who owned and operated a general insurance agency in competition with the appellant, under the name of W R Maclnnes & Co, and also controlled and operated a company, Hayes Insurance Limited, which carried on a local insurance agency. By the agreement the appellant purchased for $150,000 a list of Maclnnes & Co’s sub-agents, a card index system containing the names of all its policyholders and Maclnnes & Co’s covenant not to compete against the appellant. The appellant sought to deduct this amount from income, claiming that it had purchased nothing more than information and data from Maclnnes & Co. The Minister refused the deduction and the Federal Court—Trial Division agreed. On appeal to the Federal Court of Appeal the appeal was dismissed. As stated in the [DTC] headnote:

The Minister was correct in disallowing the deduction. The acquisition was a capital asset capable of increasing the taxpayer company’s income. The expenditure was incurred to work an immediate and substantial expansion of the company’s business. To buy out competitors was not a recurring need of the company’s operation of receiving applications and writing insurance.

In the Federal Court of Appeal an alternative position was taken, viz, that so much of the $150,000 as was reasonably attributable to the obtaining of the covenant should be allowed as a deduction. I point out here that when making the agreement with respect to the business of Maclnnes & Co, the appellant also secured a covenant from Hayes Insurance Limited that for a 5-year period that company would offer to the appellant 75% of its applications for insurance. It was this covenant to which the alternative argument was directed. Respecting it, Thurlow, J said [p 441 [5311]]:

Here the covenant was obtained in what, in my opinion, was a transaction outside the appellant’s ordinary business. The covenant is thus, at least prima facie, a capital asset and there is nothing in the case which appears to me to indicate that it ought to be treated as anything else.

Urie, J referred to British Insulated and Helsby Cables Ltd v Atherton, [1926] AC 205, where Viscount Cave said, at page 213:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

These words have been regarded as stating a general principle which is an important guide but not an absolute rule. They have been applied frequently in English and Canadian courts.

In Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946), 72 CLR 634 at 648, Dixon, J said that in borderline cases the answer

depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

Then, in BP Australia Limited v Commissioner of Taxation of the Commonwealth of Australia, [1966] AC 224, Lord Pearce further eludi- cated the matter, at page 264:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree.

In the present case, as in the Cumberland Investments case, the plaintiff acquired the goodwill of another company, along with a noncompeting agreement that was stronger than that in the Cumberland case. In effect it acquired the ability to carry on the sales business previously carried on by Associated. In consideration it wiped out a debt of $94,775 owing to it by Associated. This was a once-for-all transaction, as was Cumberland’s which company agreed to pay a cash consideration of $150,000. Just as buying out the goodwill of competing general insurance agencies was not part of the ordinary business of Cumberland, so buying out the goodwill of the company to which it sold all its products was not part of the plaintiff’s ordinary business. In the Cumberland case the effect was that Cumberland acquired capital assets by means of which it expanded its business and its earning capacity. That was its purpose in entering into the transaction. In the present case the plaintiff also acquired capital assets, which it intended to use by putting them into a new company to carry on the same kind of business as Associated had been engaged in. This it did by joining with Nelson and setting up United. Unfortu- nately, during the 14 or 15 months of its existence United did not make a profit.

The most notable difference between the two cases arises out of the fact that in the present case the plaintiff, unlike Cumberland, was a creditor of the other party to the transaction who was greatly concerned about the debt owing him and was seeking a means of salvaging as much as he could. The plaintiff’s claim is that salvaging what he could from what might become a loss of $74,775, plus interest, was his real objective and therefore what he did was attributable to income. Is this the true picture?

I note that in seeking to salvage what he could of the debt the plaintiff did not bring an action against Associated or take steps to put that company in bankruptcy. From at least as early as June 1969 the plaintiff was negotiating with a view to taking over Associated’s goodwill, customers lists and related minor assets, at prices (on two occasions) considerably in excess of the amount due to it, including in each of those two proposals provision for payment of the debt due the plaintiff and certain other producer creditors, and a requirement for a noncompeting agreement. These proposals, as do the terms of the agreement finally made on March 27, 1970, appear motivated by a desire to acquire the indicated assets and use them in business, at least as much as by a desire simply to liquidate a business debt. The quick setting up of United gives some support to this interpretation of the facts.

Counsel for the plaintiff cited several cases for the consideration of the Court. One was Liberty Watch Case Co Ltd v MNR, [1969] Tax ABC 78; 69 DTC 129. The appellant company had two businesses, (1) the manufacturing of watch cases, (2) using its surplus funds to lend money at high interest rates. A mortgage loan made in 1962 became overdue. In 1964 the appellant took a transfer of the property and discharged the debt. Later that year it sold the property for less than the unpaid balance on the loan it had secured. It claimed, in an amended income tax return for 1964, a deduction of the loss as either a bad debt rendered uncollectable in 1964 or a loss incurred in its business of lending money. The Tax Appeal Board held that the debt had been extinguished. There was thus no debt to which paragraph 11(1)(f) of the Income Tax Act could apply. The property had become an asset of the appellant. This situation looks something like No 75 v MNR (supra), in which it was held that any loss on resale of property taken in exchange for releasing a debt was a capital loss and therefore not deductible. There is, however, an important difference. The business of lending money on security includes the realization of the security and profits or losses on such realization must be brought to account for tax purposes. The appellant was therefore entitled to deduct the loss. In the present case there had been no security given and therefore no question of realization of security. Further the agreement for acquiring Associated’s goodwill was no part of the plaintiff’s ordinary business.

A second case was Roy v MNR, 20 Tax ABC 385; 58 DTC 676. In that case the appellant had sold a theatre in June 1953 for $75,000 less $1,500 sales commission or a net of $73,500. By the agreement $24,500 of the price was paid by assignment to the appellant of a debt of that amount owing to the purchaser from a third party. In July of the same year the debtor became bankrupt and nothing was paid on the debt. The appellant included the $24,500 debt in computing his income for 1953 but claimed a deduction of the whole amount as a bad debt. The Minister ruled that the net selling price of $73,500 must be included for the purpose of computing the amount of capital cost allowance that had been recaptured by the sale. The appellant objected to a reassessment on this basis and the case was decided by the Tax Appeal Board.

The appeal was allowed. The appellant’s income was from two sources, businesses and property. The proceeds from a sale of property must be shown in his income tax return for the year, in this case $73,500. But $24,500 of the proceeds was a debt that, on the evidence, had become bad in the same year. Nothing of the $24,500 could be recovered and in fact the appellant was several hundred dollars out of pocket for legal costs incurred in endeavouring to collect. The $24,500 was therefore deductible for income tax purposes from the net selling price of the theatre, $73,500.

In my view this case does not help the appellant in the case before me. It was simply a case of deducting a debt acquired on a property sale, which became bad almost immediately and was properly reported.

Counsel further referred to an editorial in CCH which cited four cases as supporting an opinion that though, when a taxpayer accepts securities in full satisfaction of a trade account the securities become a capital asset for tax purposes, if the securities were actually worth less than the amount of the debt at the time they were accepted, the difference between the amount of the debt and the value of the securities would be deductible under paragraph 20(1 )(f) in the year in which they were accepted. The four cases are the following: Harrison v John Cronk & Sons Ltd, [1937] AC 185: Absalom v Talbot, [1944] AC 204: William Dickinson & Co Ltd v Bristow, [1946] 1 All ER 448; Himmen v MNR, 4 Tax ABC 44; 51 DTC 144.

In my view none of these cases were concerned with the deductibility of bad debts, though some references to statutory provisions and English rules of practice concerning such deductibility are found in them. The first two are House of Lords decisions and the last is a Canadian Tax Appeal Board decision. All three were concerned with builders who erected buildings and sold them to buyers subject to a first mortgage, being paid part of the balance of the purchase price by the buyer and accepting a second mortgage, payable over a considerable number of years, for the remainder. The question at issue was whether the amount of the second mortgage should be taken into the builder’s income for the year in which it was received and, if so, should it be taken in at its face value or at its actual value at that time. Alternatively, should the principal sum secured by the second mortgage be taken into income only as and when it was paid or became due over the years? A further question was whether a reserve could be set up for bad debts that might be anticipated.

The third case is an English Court of Appeal decision, dealing with a reverse situation to that of deducting bad debts. It decided that where an account has been written off in full as uncollectable, and subsequently it is paid in whole or in part, the money so paid must be taken into the payee’s income for the year in which it is received.

These are all interesting cases but they are of little help in the present case.

After considering the argument of counsel for both parties, reading all of the cases cited by counsel and considering the facts and circumstances of this case I am inclined to the view that the goodwill of Associated that was acquired by the plaintiff was acquired as a Capital asset to be used as such in the plaintiff's hands, and that any subsequent increase or decrease in its value would be a capital gain or loss not affecting income. I am, however, not completely convinced that this would be the right decision in the circumstances. I therefore prefer to rest my decision on the ground stated earlier in these reasons.