North West Tent & Awning Co LTD v. Minister of National Revenue, [1976] CTC 2332, 76 DTC 1227

Delmer E T aylor:—-—This is an appeal from an income tax assessment for the year 1970. There are two matters at issue. The first is an amount of $17,514 paid by the appellant company (which will be referred to as North West) on behalf of a second company, Norseman Products (1963) Ltd (which will be referred to as Norseman) contended by the appellant to be a deductible expense to North West; but regarded by the respondent as a loss on account of capital, being a loan by North West to Norseman. The second is an amount of $6,318 for an account payable by North West to Norseman but not included by the appellant in its taxable income since the amount was credited by the appellant to the capital surplus account of the company in 1971 as a result of the bankruptcy of Norseman. This amount was treated by the respondent as an amount which should have been deducted as a contra-account, from a separate amount of $16,500 charged off as a bad debt expense in the North West accounts for the fiscal year 1970, since it was uncollectable from Norseman, again as a result of the bankruptcy. The appellant contends that the amount of $17,514 should be allowed as an expense, and in particular that it was not prohibited by virtue of paragraph 12(1)(a) or 12(1)(b) of the Income Tax Act: and that there are no provisions of the Act which would require the inclusion as a taxable item of the amount of $6,318. The respondent relies, inter alia, upon sections 3 and 4 and paragraph 12(1)(b) of the Income Tax Act, RSC 1952, c 148 and amendments.

The appellant is a Private corporation which has been carrying on business for several years in the Province of Alberta. Its business activities include manufacture and sale of canvas tents, fabric structures, bed rolls, tent trailers and other similar products. The capital stock is held 55% by the president, a Mr A Bryant, and 45% by his wife. Mr Bryant is the general manager and completely in control of the operation. Norseman Products (1963) was a corporation all the capital stock of which up until 1968 was held personally by the same major shareholder in North West, Mr A Bryant. Norseman had Originally been incorporated only for the purpose of protecting the trade name “Norseman”, under which brand name many of the products of North West were sold. Norseman remained inactive until 1968 during which year the aforementioned Mr Bryant activated the company, reduced his 100% shareholdings, and recapitalized it in the following manner:

Norseman started into the business of manufacturing tent trailers, and in 1969 the appellant began purchasing tent trailers from Norseman. The first matter at issue arose as a result of the assistance provided through the appellant to Norseman. During its fiscal year 1969, the appellant advanced to Norseman a total of $38,014, of which $4,000 was repaid before the bankruptcy. Exhibit A-1 is reproduced to provide the details:

North West Tent & Awning Co Ltd

Due from Norseman Products Ltd

November 30, 1970

	Trade	Loan	Total
Sept. 30, 1968 Norseman Products
	Ch# 4706	$ 5,000.00 $ 5,000.00
30,	Lamond Dewherst	400.00	400.00
30,	Langstin et al rent	1,850.00	1,850.00
Oct. 31	Norseman Products
		14,000.00	14,000.00
31	Merchandise
	$16,500.00		16,500.00
November 30, 1968 Cash re postage		11.00
			11.00
	1966 balance	223.15	223.15
November 30, 1969 Group insurance paid
	by NWT & A	30.02	30.02
	16,500.00	21,514.17	38,014.17
	Cash received	4,000.00	4,000.00
	16,500.00	17,514.00	34,014.17
Amount written off as
uncollectable
	16,500.00	17,514.17	34,014.17

At the date of bankruptcy, approximately November 1970, Norseman was no longer owned by the three shareholders, Bryant, Fuller and McFadden, since, due to both financial and operational difficulties encountered by the company early in the year 1969 and in 1970, these three had disposed of their shares in Norseman in July 1970 to Triangle Industries Ltd, a company not associated in any way with the appellant. The appellant had been a supplier of Triangle Industries Ltd, during Triangle’s short-lived effort to salvage Norseman—lasting until about bankruptcy—and the contention of the appellant seems to be that the amount of $6,318 relates to normal business transactions with Norseman after the acquisition of the capital stock by Triangle and therefore not associated in any way with the appellant’s earlier unprofitable business affairs with Norseman.

With respect to the amount of $17,514, it must be regarded as an integral part of the total advanced of $38,014, details of which have been recorded earlier. It would appear from the relative interests of the shareholders in the recapitalization of Norseman in 1968 and by the evidence given directly by Mr Bryant that he, Mr Bryant, was required to provide as further capital contributed by him an amount approximately equivalent to the $45,000 funds advanced as a loan to Norseman by Mr Fuller. This would have maintained in balance their respective investments in this new venture, the information provided by Mr Bryant being that Norseman as a company had no assets and no value at all before this recapitalization. The “capital” contribution totalled $38,014, and it came from North West. North West did not own the 45 shares of capital stock in Norseman, these were owned personally by Mr Bryant. This would not, of itself, bring the transactions between the two companies into question, but it is contended by the appellant that Norseman was just a branch or division of North West, and therefore such advances were really within the same fundamental corporate structure. The evidence of Mr Bryant was that Mr Fuller was an experienced businessman, and when Fuller lost all his investment in Norseman (which did finally occur) he, Bryant, did not feel any direct responsibility for it. Bryant’s evidence was that Norseman probably needed about $200,000 in capital to get started properly. Obviously even with the possible contribution of $45,000 through Bryant, available capital and investment would only be about $100,000, leaving a great deal yet to be obtained or financed outside. Evidence given indicated that bank financing was obtained, and that the three shareholders personally guaranteed these bank loans.

With respect to Mr McFadden’s investment, Mr Bryant gave evidence that he was a long-time employee, and when McFadden lost his money he, Bryant, did repay McFadden.

The advances by North West represented either an investment in Norseman to fulfil the obligation incurred by Bryant in recapitalizing Norseman; or they represented an investment by Bryant personally in recognition of these same obligations. In this latter situation, the entire amount of $38,014 might have been treated as an advance first to the shareholder Bryant, in the accounts of North West, and then as a a personal loan from Bryant to Norseman. The obligation incurred by Bryant in the recapitalization of Norseman appears unrelated in any formal way to North West, the appellant. Nevertheless, the accounting treatment accorded these amounts seems to have provided the basis for allowance by the Department of National Revenue of the “inventory expense” in the amount of $16,500 during the year 1970. There was no evidence presented upon which a substantial distinction could be made for income tax purposes between the two components of the total—loans and trade. It seems obvious that the appellant could have just as easily provided an additional $16,500 in loans, and allowed Norseman to go to outside suppliers and purchase inventory, if the appellant had the funds available. The results would have been the same—to get Norseman started in business. It is this situation which has now brought forward this appeal.

The advances totalling $38,014 (now at a net amount of $34,014) were not part of a pattern of a regular account arising from normal business dealings between the two companies. The question therefore becomes one of determining whether or not the record lends itseif to the appellant’s contention that the advances were all within the same corporate structure, and the following facts are relevant:

(1) Almost the total amount had been advanced by November 30, 1968. The financial statements for the years 1968, 1969 and 1970 were submitted as evidence by the respondent and at that date the amount was shown on the balance sheet of the appellant as “Loan Receivable—Norseman Products Ltd—$37,984.00”. It increased to the amount of $38,014 by November 30, 1969. It is not shown either in 1968 or in 1969 as a “current asset”, the references indicate a longer term investment.

(2) Conversely, in the financial statements of Norseman, also submitted as evidence by the respondent, at November 30, 1968, the amount is shown as part of “Loan Payable” and described as “North West Tent & Awning Co Ltd—$37,984.00”; and at November 30, 1969, under “Long-Term Debt” as “Loan Payable to North West Tent & Awning Co Ltd—$38,014.00”.

(3) In both situations described in point (2) above, ihe amounts are included in the same grouping and content as the “Shareholders’ Loans totalling $55,000.00”.

(4) In response to questioning, Mr Bryant gave evidence that the reason he did not simply expand the existing operation of the appellant company to undertake the new role of manufacturing tent trailers commenced by Norseman in 1968, was that there was a substantial liquidity problem in the appellant company at that time. This is borne out by the balance sheet at November 30, 1968 which shows current liabilities totalling $220,354, including more than $120,000 owing to the bank either as an overdraft or loans. The comparable figures for 1969 are $387,793 and more than $130,000.

(5) Mr A Bryant also was the beneficial owner during this period of a 50% interest in another company, unrelated to the appellant, but engaged in essentially the same business as North West. This was therefore not the first business venture for Mr Bryant regarding an interest in other corporations.

The conclusion reached from examination of this part of the appeal is that the appellant could not have expanded its own operations to include the new manufacturing venture, because of a serious shortage of capital, and that a prudent investor (as Mr Fuller was described by Mr Bryant) would not knowingly have invested new funds in the appellant company to start a new division. Such prudence would have dictated using a different vehicle—in this case Norseman—and appropriately Fuller would have required his investment to be matched by Bryant. Bryant became the shareholder in the new venture, the appellant did not.

There was a substantial reason to maintain these operations as separate as possible from the position of Mr Fuller, and almost a compelling requirement from the position of Mr Bryant. That the advances in question were indeed loans, there is no doubt in my mind. The fact that the funds so provided were used for a variety of purposes by Norseman does not alter the nature of the loans made by the appellant. The appellant would only benefit by the interest, if any, to be paid on these loans. Any real profit which might arise in Norseman would devolve to the benefit of the shareholders, and the appellant was not one of these. The argument put forward that the appellant expected to benefit by an assured supply of tent trailers for its own manufacturing purposes, and an assured customer for its own canvas products does not impress me, if I am to take seriously the evidence of Mr Bryant himself regarding the experience and prudence of the major new investor, Mr Fuller. It would be highly unlikely, in my opinion, that Fuller would willingly permit the profiteering of the appellant at the unreasonable expense of Norseman, and since the appellant as a company was in no position, and Bryant as a shareholder in no better position than Fuller, to influence the course of events, the beneficial results allegedly intended for the appellant as a result of the dealings with Norseman can at best be only a matter of conjecture.

With respect to the amount of $6,318 credited by the appellant to capital surplus, an examination shows that the manner in which it developed is not as important as the reason for which this account payable was not paid. Whether it was an account payable to Triangle or to Norseman, the only reason I can determine that it would not have been paid, would be that North West considered it a contraaccount, to offset against other accounts owing to North West, either by Triangle or Norseman, at the dates these companies went into bankruptcy. There would appear to me to be no other direct explanation for North West not paying this amount to the trustee in bankruptcy for one or the other of these companies. Not paying the amount could have and probably should have resulted in action for collection by the trustee, without some acceptable explanation. Since there was no evidence brought forward that there was any account receivable from Triangle to North West, it can be assumed that the account payable in the amount of $6,318 was regarded by the appellant as a contraaccount against the outstanding account receivable from Norseman of $34,014, at least for purposes of non-payment to the trustee-in- bankruptcy. The amount appeared on the list of accounts payable as at November 30, 1970, submitted as an exhibit by the appellant. The financial statements of the appellant for the fiscal year ended on that date were dated January 10, 1971, and the corporation tax returns filed with the Department of National Revenue on March 2, 1971. Accordingly, by this time the appellant would have been well aware of the bankruptcy of both Norseman and Triangle and, not having paid the amount, and apparently not intending to do so for the reason I have given, would have been in a proper position to make the adjustment necessary relative to the 1970 taxation year. There is no evidence of circumstances which would relate the amount realistically to the 1971 taxation year in any event.

In my mind, the treatment accorded the amount by the appellant for its purposes relative to the bankruptcy was analogous to the contention now put forward by the respondent for taxation purposes, that the amount should have been treated as a reduction of the advance account to Norseman. Merely maintaining a separate accounting ledger sheet for this amount hardly seems adequate support for not regarding it also as an integral part of the total transaction. Since the Department had earlier allowed as an “inventory expense’’ an amount of $16,500, this amount of $6,318 should properly be accorded the same treatment since according to the evidence provided it probably arose from some processing done to the inventory material at Norseman, and then invoiced back to North West. Any other treatment—particularly that suggested by the appellant—would result in the shareholders of the appellant company being allowed the benefit of this amount twice; first when the material purchased from Norseman was charged in the accounts of the appellant as a manufacturing cost, thereby reducing profit and establishing the account payable to Norseman, and second when it might be withdrawn from surplus in the form of dividends upon which corporation income tax had not been paid. An accounting treatment equally satisfactory to that suggested by the respondent would be to have simply reversed the original entry establishing the account payable, when it was determined that there was no intention of paying it. This would have resulted in a correct statement of manufacturing cost, and a corresponding increase in the reported taxable corporate income for the year 1970.

The appellant therefore has failed to establish a case for the reduction of taxable income by the amount of the alleged bad debt of $17,514; and has also failed to provide evidence to support the contention that the amount of $6,318 should be treated in the records of the company in such a way as to result in the non-payment of corporation income tax on this amount.

The appeal is dismissed.

Appeal dismissed.