Dutch-More Corporation v. Minister of National Revenue, [1981] CTC 2023

The Chairman:—The appeal of Dutch-More Corporation is from an assessment in respect of the 1977 taxation year by which the Minister of National Revenue disallowed a deduction of $65,000 claimed by the appellant as a bad debt within the meaning of paragraph 20(1 )(p) of the Income Tax Act, 1970-71-72, c 63, as amended or alternatively as a capital loss in 1977 from the disposition of property in accordance with the provisions of paragraph 39(1)(b) fo the Act.

Summary of Facts

The appellant corporation was formed on December 31, 1979 by the amalgamation of four related companies: More-Wood Homes Ltd, Dutch Sash and Door Company Limited, 357196 Ontario Limited and Amavic Holdings Inc. This appeal is more particularly concerned with More-Wood Homes Ltd (hereinafter referred to as “More-Wood”), and Dutch Sash and Door Company Limited (hereinafter referred to as “Dutch Sash and Door”) which were owned by Mr Adrian Heuff as indeed were the other two related companies.

Owing to the death of Mr Heuff in October of 1977, the appellant’s principal witness was Mr Glen Droppo who had been the bookkeeper of Mr Heuff’s companies for 21 years and was the Secretary-Treasurer of More- Wood and Dutch Sash and Door since 1962.

More-Wood is engaged in the construction and assembling of prefabricated homes. Dutch Sash and Door’s activities were limited to the building of doors and sashes which it supplied to More-Wood as well as to other building contractors.

Among the clients of Dutch Sash and Door was a contracting firm operating under the name Montenegrino Holdings Limited (hereinafter referred to as “Montenegrino”) with whom Dutch Sash and Door had done business for several years. In the Autumn of 1976, Montenegrino had an outstanding account of $65,000 for material purchased from Dutch Sash and Door.

Mr Droppo testified that More-Wood incorporated in December of 1971 (Exhibit A-1) and had by 1975 a surplus working capital which was generally invested in a true savings account (Exhibits A-2 and A-3).

Late in 1976, while More-Wood had a surplus of some $800,000 to $900,000, Dutch Sash and Door had an overdraft in excess of $100,000. In order to reduce Dutch Sash and Door’s overdraft, More-Wood advanced $65,000 to Montenegrino on November 1, 1976, at 12% interest, with which the latter would pay its $65,000 outstanding account to Dutch Sash and Door. The fact that Dutch Sash and Door received payment of $65,000 from Montenegrino is not in dispute. In his evidence, Mr Droppo stated that it amounted to an exchange of cheques between More-Wood and Dutch Sash and Door.

Montenegrino guaranteed the loan by way of mortgage held in trust for More-Wood by Mr Arnell Saul Goldberg, Mr Heuff’s attorney. The loan was to be repaid on a monthly basis with the balance becoming due on November 1, 1977 (Exhibit A-4). Montenegrino was unable to meet its first monthly payment on December 1, 1977.

On December 22, 1976, the Clarkson Company Limited wrote to the creditors, advising them that the formal proposal previously comtemplated by Montenegrino would not be proceeded with since Montenegrino felt that sufficient cash flow to satisfy all the creditors could be obtained from financial organizations (Exhibit A-5). Mr Droppo interpreted the Clarkson Company Limited letter as being the end of any chance of recovering the $65,000 and testified that the debt was considered by himself as being bad as of that time.

However, early in 1978, More-Wood served Montenegrino with a writ of execution in order to force the issue and salvage something of the guaranteed loan. The mortgaged land, however, was incumbered with three prior mortgages and the first mortgagee, acting under power of sale, disposed of the land. More-Wood did not receive any monies from the disposition of the land and sustained a loss of $65,000.

The appellant appealed to the Tax Review Board and I quote:

13. THEREFORE the appellant hereby appeals to the Tax Review Board:

(a) to have the Minister’s assessment vacated on the ground that the $65,000 deduction claimed by More-Wood as properly made in accordance with the provisions of the Income Tax Act, and in particular, paragraph 20(1)(p) thereof;

(b) in the alternative, to have the Minister’s assessment varied to permit a capital loss of $65,000 to be taken by More-Wood for the 1977 taxation year from the disposition of property within the meaning of paragraph 39(1)(b) of The Income Tax Act.

In his reply, the respondent submitted, and I quote:

5. He submits that the appellant only realized a loss on the mortgage to Montenegrino Holdings Limited in its 1978 taxation year.

6. He further submits that the loss on the said mortgage was a capital loss with the meaning of paragraph 39(1)(b) of the Income Tax Act and not a bad debt within the meaning of paragraph 20(1)(p) of the Income Tax Act.

Paragraph 20(1)(p) reads as follows:

Bad Debts.—the aggregate of debts owing to the taxpayer

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

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year;

The fact that $65,000 was^advanced by More-Wood to Montenegrino, which in turn paid that amount to Dutch Sash and Door in settlement of its account, is not disputed; nor is the fact that the advance was not repaid and that More-Wood sustained a loss of $65,000 contested.

As I see it, the basic question in determining the issue is whether a loss arising from a loan was sustained by More-Wood, part of whose ordinary business was the lending of money. If the answer to that question is in the affirmative, the secondary question to when the debt became bad debts becomes pertinent. If the answer is in the negative, then we are not dealing with a bad debt and paragraph 20(1)(p) is not applicable.

I agree with counsel for the appellant that no limits have been set as to the number of loans required to be made before the taxpayer can qualify under paragraph 20(1 )(p). However, the loans must clearly be part of the taxpayer’s ordinary business before that section can apply.

The only loan in issue in this appeal is a $65,000 loan made by More-wood in 1976. In his evidence, Mr Droppo stated clearly the reasons why Mr Heuff had More-Wood advance some of its surplus funds to Montenegrino viz, to cover part of Dutch Sash and Door’s overdraft while, at the same time, acquiring from Montenegrino a mortgage guarantee rather than relying on the mechanics’ lien which is all Dutch Sash and Door could have had otherwise obtained. Montenegrino was an old customer of Dutch Sash and Door, according to Mr Dropp’s evidence, and the latter must have had considerable knowledge of the financial situation of Montenegrino to state categorically that the $65,000 loan was a bad debt in December of 1976, notwithstanding the Clarkson letter of December 22, 1976 (Exhibit A-5) in which Montenegrino is reported as believing it could pay off the creditors without making a formal proposal under the Bankruptcy Act. Because of Mr Droppo’s knowledge of Montenegrino’s financial problems, it is not unreasonable to surmise that a guaranteed loan made by More-Wood was considered to have had a better chance of receiving the monies owed by Montenegrino to Dutch Sash and Door than by the mechanics’ lien.

A second loan of $100,000 was made by More-Wood in 1976 to a company known as 315285 Ontario Ltd (Exhibit A-3). Mr Droppo’s evidence, though somewhat sketchy, was sufficient to establish that Mr Lightfoot, Mr Heuff’s son-in-law, had interest in 315285 Ontario Ltd which, as I understand it, purchased, serviced and sold land on which More-Wood was assembled. That loan, for some unexplained reason, subsequently became a non-interest bearing loan.

An important part of Mr Droppo’s evidence which, because of Mr Heuff’s death, was alleged to have been the best available evidence, had to do with possible discussions Mr Droppo may have had with Mr Heuff in 1975-1976 when More-Wood’s surpluses were buoyant. Mr Heuff is alleged to have told Mr Droppo to keep an eye out for possible loans to private individuals.

I cannot accept the inference made that, at that time, Mr Heuff or anyone else had decided that part of More-Wood’s ordinary business could henceforth be the lending money.

The reason for my conclusion is not so much that the lending of money is not included in More-Wood’s articles of incorporation (Exhibit A-1) but because the facts do not support the proposition that part of More-Wood’s ordinary business in 1976 or indeed in 1977, the pertinent year, was the lending of money. Mr Droppo testified that in 1977 all of More-Wood’s surplus funds were invested in term deposits as they had been since November of 1975. No loans were made in 1977. In 1976 the Montenegrino loan was made in attempt to recover monies owed to one of Mr Heuff’s companies. The non-interest bearing loan of $100,000 to 315285 Ontario Ltd was not clearly explained but it appears from Mr Droppo’s testimony that it was made to finance another of Mr Heuff’s companies in which his son-in-law had an interest.

It is the nature and the purpose of these two loans, and not necessarily their number, which bring me to conclude that they were not loans made in the ordinary course of More-Wood’s business, part of which was the lending of money.

Counsel for the respondent objected to the production of evidence that several loans were made by More-Wood as of May 1978 as being irrelevant when the appeal is for the 1977 taxation year. The objection was noted on the basis that the Board would, under the circumstances, determine for itself the probative value of the evidence. In this instance, the loans made by More-Wood in 1978 to its employees or other individuals to help finance their purchase of More-Wood homes (Exhibit A-3) served as a useful basis of comparison with the two loans made in 1976 and more particularly with the loan made to Montenegrino.

I have no difficulty whatever in accepting that the loans made by More- Wood in 1978 were loans made in the ordinary course of its business, part of which was the lending of money. I cannot however, on the basis of the evidence, reach that conclusion for the loan of $65,000 made to Montenegrino in 1976. In my opinion, we are not dealing here with a bad trade debt of More-Wood and the provisions of paragraph 20(1)(p) are not applicable to the facts of this appeal.

Because of its nature and the purpose for which the Montenegrino loan was made, the subsequent loss arising from the non-repayment of the loan was, In my opinion, capital in nature.

The year in which that loss was sustained can only have been after Montenegrino became insolvent and after its default under the mortgage, became a fact. Notwithstanding that Mr Droppo, in retrospect, considered the dept to have become bad in December 1976 and felt that More-Wood would not receive a penny on the loan, Montenegrino, according to the evidence, had some assets in 1977 and even in 1978. Instructions were given to the More-Wood solicitors in 1978 to commence action against Montenegrino in order to put pressure on the company and realize on its current assets or on its securities.

The evidence is not clear whether the existence of a prior mortgage was known to Mr Droppo or Mr Heuff at the time the loan was made and guaranteed by the mortgage, but the fact that a prior mortgagee disposed of the mortgaged property under power of sale seems to have come as somewhat of a surprise to Mr Droppo. It is now alleged that the action was taken with no expectation that the loan would be repaid but was merely an attempt to realize on some security. It is difficult to understand why the cost of instituting action would be incurred if there was no possibility whatsoever of obtaining at least partial repayment.

No loss would have been sustained by More-Wood to the extent that the loan (or part of it) had been repaid either from assets Montenegrino had in 1978 or from realization on More-Wood’s security on the mortgaged land.

I conclude therefore that the $65,000 loss sustained by More-Wood on the non-repayment of a loan was capital in nature and was incurred in the 1978 taxation year.

The appeal must therefore be dismissed.

Appeal dismissed.