F H Jones Tobacco Sales Co LTD v. Minister of National Revenue, [1972] CTC 2433, 72 DTC 1355

Maurice Boisvert:—This appeal concerns the taxation year 1966. It was heard at Montreal, Province of Quebec, on October 19, 1971 under the authority of the Income Tax Act (RSC 1952, c 148) then in effect, by the undersigned, at the time a Member of the Tax Appeal Board.

In its tax return for 1966, appellant deducted from its income the sum of $115,369.33, representing a loss which was explained by appellant’s auditors as follows:

“The extraordinary loss of $115,369.33 was from payment of debts of a customer upon liquidation, honoring endorsements given to said client, who was committed with F H Jones Tobacco Sales Co Ltd for tobacco purchases of some $400,000.00. A further amount of $30,866.71 is included in bad debts for unpaid tobacco sales.”

Respondent did not see fit to accept the deduction of the sum of $115,369.33 and added this amount to the declared income, thereby levying a tax of $67,957.47. The assessment is dated November 24, 1967. Pursuant to an objection to the assessment, dated February 15, 1968, respondent amended the latter by reducing the amount of the tax to $65,666.02. The position of the parties in the case appears, so far as appellant is concerned, from the following allegations:

(TRANSLATION)

“3. This amount of $115,369.33 was paid by appellant in the following circumstances:

(a) For several years appellant had sold tobacco to Tabacs TransCanada Ltée;

(b) These purchases of Tobacco by Tabacs Trans-Canada Ltée prior to 1966 were valued at several hundred thousand dollars;

(c) Discovering the poor financial situation of Tabacs Trans-Canada Ltée, and realizing that the latter could not pay for and take delivery of the considerable quantities of tobacco ordered, appellant agreed to act as surety in favour of La Société des Tabacs Québec Inc for the amount of $200,000.00, to enable the latter company to purchase the shares of Tabacs Trans-Canada Ltée;

(d) Appellant was neither a shareholder nor had any interest in La Société des Tabacs Québec Inc, nor in Tabacs Trans-Canada Ltée, other than as a supplier of tobacco;

(e) In consideration of its surety appellant was assured of retaining Tabacs Trans-Canada Ltée as a customer, and continuing to receive orders for tobacco from the latter;

(f) The purpose of this surety was to enable Tabacs Trans-Canada Ltée to make good considerable orders for tobacco placed with appellant;

(g) During 1966 appellant was called on to pay the sum of $115,- 369.33 under this surety.”

Respondent stated as follows in his Reply to the Notice of Appeal:

(TRANSLATION)

“2. In making its assessment for the taxation year 1966. Respondent assumed the following facts:

(a) In its tax return for the taxation year 1966 Appellant claimed an expense in the amount of $115,369.33 as a deduction from its gross income;

(b) Appellant has never been able to document or prove the existence of such an expense to Respondent;

3. As the sum of $115,369.33 was not spent by Appellant during the taxation year 1966 to gain or produce income from property or a business, it was duly disallowed in computing Appellant’s taxable income, in conformity with section 12(1)(a) of the Income Tax Act;”

Appellant cultivates tobacco and purchases from other producers tobacco which it processes for resale to cigarette manufacturers. Among its customers are Imperial Tobacco, Rothmans, Bastos etc. For several years it had sold from ten to fifteen percent of its production to Tabacs Trans-Canada Ltée. In 1963, the aforementioned company changed its name and its shareholders. It became “La Société des Tabacs Québec Inc’’, which launched a new cigarette known as “La Québécoise”. It needed money to make a strong push with this venture, and on September 27, 1963 the following agreement was concluded between La Société des Tabacs Quebec Inc and Mr F H Jones:

(TRANSLATION)

WHEREAS business dealings are proposed between the company, Mr Jones and F H Jones Tobacco Sales Co Ltd;

AND WHEREAS Mr Jones has agreed to guarantee repayment of a loan of $200,000 contracted by the company for the purpose of acquiring control of Tabacs Trans-Canada Ltée, for repayment at the rate of approximately $5,000 monthly;

ACCORDINGLY, the parties agree as follows:

1. — The company hereby appoints Mr Jones, and undertakes to have him appointed by Tabacs Trans-Canada Ltée, exclusive agent for the pur- chase and supply of leaf tobacco, at the best possible price in view of market conditions.

2. — The company further undertakes to appoint Mr Jones, and have him appointed by Tabacs Trans-Canada Ltée, technical adviser with the right to be present at the directors’ and shareholders’ meetings of both companies.

3. — Both personally and in his capacity as president and majority Shareholder of F H Jones Tobacco Sales Co Ltd, Mr Jones undertakes to Supply the company and Tabacs Trans-Canada Ltée with leaf tobacco, at the best possible price regard had to market conditions.

4. — In addition to the guarantee in respect of the loan of $200,000 provided by Mr Jones, the company undertakes to deposit as collateral security the controlling shares in Tabacs Trans-Canada Ltée purchased with the proceeds of the loan, as well as the shares held personally by the directors of the Company in their own company, and any shares which the latter shall acquire in the said company.

5. — Further, subject to the additional guarantees contained in the preceding paragraph, the company undertakes on its own behalf as well as that of Tabacs Trans-Canada Ltée, not to make any capital expenditures or loans other than bank loans without the consent of Mr Jones so long as the latter’s personal commitment remains in effect. Similarly, the salaries of the executive officers of both companies shall not exceed the sum of $40,000 per annum overall.

6. — In the event that the company merges with Tabacs Trans-Canada Ltée it is agreed that the merged company will have the same obligations towards Mr Jones as the two aforementioned companies.

7. — Mr F H Jones’ guarantee will be provided by his endorsement of one or more promissory notes for a total amount of $200,000. In the event of merger or purchase of one company by the other, and mortgaging and pledging of the capital assets of the business to guarantee repayment of the said debt of $200,000, Mr F H Jones shall be a party to the pledge or mortgage deed to act as surety.

8. — In view of the importance of guaranteeing a supply of raw materials to the company Mr Jones undertakes, personally and in his capacity as president and majority shareholder of F H Jones Tobacco Sales Co Ltd, not to dispose of his business directly or indirectly before offering it at book value to the company or its representatives, with at least 90 days’ notice.

9. — Finally, in consideration of the benefits conferred on him and the collateral guarantees furnished by the directors, Mr F H Jones undertakes in respect of each of the directors, namely Messrs Jacques Hurtubise, Jean Hurtubise, Richard Moranville and Maurice Martel, not to hold them responsible for the obligations they have incurred personally in acting as surety for the repayment of the loan of $200,000, undertaking in respect of them to pay personally any monies which might be claimed from them by way of surety.

The consideration for appellant is found in paragraph three; it was to increase its tobacco sales considerably. Its financial report indicates that between 1965 and 1966 its sales rose from $145,859.98 to $968,- 199.86. This increase was due in large part to purchases related to “La Québécoise”. This may have been a very good cigarette, which was to supplant the others in Quebec; however there was a tragic development. The manufacturers did not pay the excise duties, and this caused the Government of Canada to seize everything. The result was that appellant had to pay the piper, and along with its tobacco lost the money invested for its business objectives.

Respondent claims, “This is a loss on capital account”, but I cannot accept that point of view: it is an operating loss. We are not dealing with advances made apart from normal operations, or even with the purchase of goodwill. We are dealing with an undertaking which is very much part of appellant’s normal operations, one which would enable it to increase its purchases and sales. Therefore, if it resulted in a loss in 1966, this can only be an operating loss, since it derives from an expense to the extent that it was made because it was to produce income. In fact this undertaking in 1963 returned income and profits annually. A case very similar to the circumstances found in this appeal is that of Reid’s Brewery Company Ltd v Male (Surveyor of Taxes) (1891), 3 TC 279.

Neither Tabacs Trans-Canada Ltée nor La Société des Tabacs Québec Inc were subsidiaries of appellant. This was established without question. In the circumstances this was a bad debt which originated from business operations and for business purposes.

Subparagraph 11 (1 )(f)(i) of the Act states:

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(f) the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year,

In 1966 appellant paid the amount in question. It had a debt which was guaranteed under paragraphs 4 and 5 of the 1963 agreement. The amount of $115,369.33 is explained by the fact that two of the shareholders of La Société des Tabacs Québec Inc, who were also guarantors of the debt, paid the sum of $38,500, reducing appellant’s obligation by that amount. With the seizure and liquidation of Tabacs Trans-Canada Ltée and La Société des Tabacs Québec Inc, it is clear that (again in 1966) the debt had become a write-off. In my view appellant was justified in deducting the latter as it did. Appellant has discharged the burden of proof that was incumbent on it.

Counsel for the respondent raised a point in the argument which was not contained in the Reply to the Notice of Appeal, namely, that it was not appellant who incurred the bad debt. We must look at the gist of the matter rather than its form and outward appearance. It is true that the 1963 agreement was signed by Mr Jones personally; it was appellant that was bound. Paragraphs 3 and 8 of the agreement must be read in order to realize this, and these paragraphs are supported by the following extract from appellant’s minutes:

CERTIFIED EXTRACT FROM THE MINUTES OF A MEETING OF THE BOARD OF DIRECTORS OF F H JONES TOBACCO SALES CO LTD, HELD IN THE CITY OF JOLIETTE ON THE 26TH DAY OF AUGUST 1963 AT 2.30 HRS PM.

ON MOTION DULY MADE AND SECONDED, IT WAS RESOLVED THAT MR F H JONES, THE PRESIDENT, BE AND HE HEREBY IS DULY AUTHORIZED FOR OR ON BEHALF OF THE COMPANY TO SIGN OR ENDORSE AGREEMENTS WITH PROSPECTIVE CUSTOMERS WHO MANUFACTURE TOBACCO IN THE PROVINCE OF QUEBEC.

WHEREBY THE COMPANY, NAMELY F H JONES TOBACCO SALES CO LTD, WILL HAVE EXCLUSIVE RIGHTS TO PURCHASE AND PROCESS TOBACCO WITH A MUTUAL UNDERSTANDING AS TO THE PRICE AND WILL TAKE ALL MEASURES AT HIS DISPOSITION TO SEE THAT THE TOBACCO PURCHASED FOR ANY COMPANY IS WELL PROTECTED AND IS THE PROPERTY OF F H JONES TOBACCO SALES CO LTD UNTIL FULLY PAID.

The foregoing resolution is dated August 26, 1963, while the agreement is dated September 27 of that year. It is clear that Mr Jones was appellant’s guiding spirit.

Before concluding I would cite the following cases: L Berman & Co Ltd v MNR, [1961] CTC 237; 61 DTC 1150, a judgment of the Exchequer Court; Heap and Partners (Nfld) Ltd v MNR, 42 Tax ABC 278; 66 DTC 772; MNR v The Kellogg Company of Canada Ltd, [1943] SCR 58.

With regard to the case of Supertest Petroleum Corporation Limited v MNR, 35 Tax ABC 117; 54 DTC 244, cited by counsel for the respondent, it should be noted that there was an appeal from the Board’s decision, and in the Exchequer Court the appeal was allowed in part by consent. As to the other cases, they do not apply here.

I would therefore allow the appeal.

Appeal allowed.