Beaudry v. R., [1998] 3 CTC 2705, 98 DTC 1898

Rip T.C.J.:

The issues in these appeals by Marcel Beaudry from income tax assessments for 1982 and 1983 are whether the debt that was bad was a business loss or a business investment loss and whether the debt became bad in 1982 or 1983. Mr. Beaudry also appealed from an income tax assessment for 1981 but this appeal was withdrawn at trial and is therefore dismissed.

Marcel Beaudry is a lawyer who has practised law in the Outaouais region of Quebec for approximately 25 years. He has also participated in numerous ventures over the years. Mr. Beaudry recalled his involvement in at least 33 corporations from the early 1960s to date of trial. Although some corporations did not hold real estate - one carried on a restaurant business, for example, - the bulk of the corporations did hold real estate. Mr. Beaudry also holds, or held, interests in real estate in his own name, either as a partner, or co-owner or joint venturer. Mr. Beaudry was not in the business of lending money; he recalled only two occasions when he made loans.

Real estate owned by Mr. Beaudry in his personal capacity or otherwise or in a corporation was held as capital (investment) property and property for resale (inventory). For example, Mr. Beaudry held interests in investment properties, residential and commercial, including a hotel, in his own right as a co-owner or partner. Most corporations in which he owned shares acquired land for resale, including condominium development, but may have owned investment property as well.

The purchase of real estate was usually financed by money borrowed from a bank. Mr. Beaudry personally guaranteed any loans made to a corporation. Of course, he was personally liable for loans made to noncorporate entities. He expected to earn income from the corporations, no matter what their activity, by receiving dividends, salary or bonus.

On October 28, 1971 Mr. Beaudry along with three other persons, Messrs. Maurice Marois, Roger Lachapelle and Pierre Crevier, caused Les Investissements Mirage Inc. (“Mirage”) to be incorporated for the purpose of buying and selling land. In 1978 Mr. Crevier transferred his shares in Mirage to the other three shareholders so thereafter each of the appellant, Lachapelle and Marois held 16 /s of the 50 issued shares of Mirage.

Mr. Beaudry took an active role in running Mirage, serving as a director and officer. However all decisions regarding the acquisition or sale of land by Mirage required the consent of all the shareholders.

Starting in November 1972, Mirage acquired land in about ten transactions. Mirage purchased most of the lots as to a 100% interest but also acquired some lots with others. The aggregate cost of all the land was approximately $2,000,000, which was financed by loans secured by hypothecs and bank loans from the Bank of Montreal. The loans from the bank were guaranteed jointly and severally by Mirage’s three shareholders.

Mirage’s fiscal year terminated on October 31.

Due to poor market conditions in the mid to late 19705. Mirage had some difficulty disposing of its land. Two parcels of land were repossessed by hypothecary creditors. Another was expropriated. Mirage experienced net losses on its land sales, which were reported as business losses for tax purposes and assessed by such by the Minister of National Revenue (“Minister”). It appears that profitable sales in earlier years were reported as business income.

By 1982, apparently due to high interest rates and a fall in land values, Mirage was indebted to its bank in the amount of $1,803,000. Mirage did not have sufficient assets to pay the interest on the bank loan and the shareholders advanced hinds for this purpose.

Mr. Beaudry and the two other shareholders attempted to negotiate a settlement with the Bank of Montreal by having Mirage surrender its land to the bank in exchange for the debt. The Bank of Montreal rejected the proposal, insisting the shareholders honour their guarantees. The shareholders finally settled with the bank in 1992 as follows: Mr. Lachapelle would assume responsibility for $450,000 of the debt and the other two shareholders would be personally liable for the balance. In turn, the shareholders were subrogated to the rights of the bank.

In October 1982 Mirage transferred a one-third interest in its lands to a corporation owned by Mr. Lachapelle and the balance to Messrs. Beaudry and Marois. The land was transferred at its then estimated fair market value, $1,870,000; the cost of the land on the books of Mirage was $2,407,631. Mirage’s loss on the sales was $537,631. After the transfers of land took place Mirage had no realizable assets and ceased all business activity.

Following the transfers of property to its shareholders. Mirage was indebted to its shareholders in the amount of $575,758. [1] Total assets reported on Mirage’s balance sheet as at October 31, 1982 was $162,894. According to Mr. Beaudry the assets had no real value: an amount of $21,593 due from an affiliated company was not payable since the debtor had no assets; equity in a partnership (sometimes referred to as the “Terre Chevrette partnership”) having a book value of $132,457 was similarly worthless and the partners have yet to realize anything from the partnership. Mr. Beaudry said he knows nothing about the third asset, a receivable from an investment.

The interests in the lands transferred by Mirage to Messrs. Beaudry and Marois were held by them as co-owners under the style “Développaient Terrains Beaudry et Marois” (“Développement”). An income statement for November and December 1982 was prepared to reflect the debt and assets transferred as of October 31, 1982. The statement shows a loss of $33,940 for the two months.

The appellant says that at the end of the 1982 calendar year it was inactive, had no realizable assets and its shares had no value. Mirage owed its shareholders $575,758 as at October 31, 1982. Mr. Beaudry’s share of the debt was $194,242. Mr. Beaudry’s view at the time was that Mirage would never be able to repay any of the debt to its shareholders. The debt was bad in 1982. Therefore, in computing his income for 1982, Mr. Beaudry the amount of $194,242 as a bad debt. [2] In his view, the debt arose in the course of business and therefore all of the debt was deductible as a business loss. The Minister reassessed the appellant for 1982 by disallowing the business loss. One of the reasons the Minister considered the debt not to be bad in 1982 was that in calendar year 1983 Mirage paid dividends of $149,486. In assessing the appellant for 1983, however, the Minister considered the debt to have become bad in 1983 but was a capital loss. Mr. Beaudry was permitted to deduct the amount of $97,121 (50% of the loss) as an allowable business investment loss.

The Minister says Mr. Beaudry’s loans to Mirage were of a capital nature. He did not acquire shares in Mirage for the purpose of disposing of them at a profit. He was not in the business of lending money or making guarantees. Mr. Beaudry never received consideration for guaranteeing a loan for a corporation or anyone else. The appellant intended to make money from Mirage by receiving dividends, salaries, bonuses or other benefits from that corporation.

Mr. Gaétan Lafleur testified on behalf of the appellant. Mr. Lafleur is an Appeals Officer with Revenue Canada who reviewed the assessments in issue after the appellant filed the appropriate notices of objection. Mr. Lafleur stated, among other things, that according to the balance sheet of Mirage as at October 31, 1982, Mirage held $160,000 of assets and therefore the Minister’s officials considered that not all of the debt owing to the shareholders was bad on December 31,1982.

Mr. Lafleur also referred to paragraph 10 of Revenue Canada Interpretation Bulletin No. IT-159R3 [3] , to defend Revenue Canada’s position that a taxpayer may claim a capital loss on a debt owing to that taxpayer only when all of the debt is bad.

Mr. Lafleur also confirmed that Revenue Canada permitted Mr. Lachapelle to deduct in 1982 his portion of the shareholders’ advances to Mirage since at the time Mr. Lachapelle was no longer a shareholder, officer or director of Mirage. [4] Mr. Lafleur also stated that the shareholders’ loan account of Mirage for the period ending October 31, 1983 showed activity with respect to Messrs. Marois and Beaudry.

Also testifying on behalf of the appellant was Mr. Daniel Amyotte, a chartered accountant with the accounting firm of Levesque, Marchand. Mr. Amyotte did not prepare the financial statements of Mirage for 1981, 1982 and 1983. They were prepared by Mr. Ronald Belisle, C.A. who died in 1991. Mr. Amyotte had reviewed the working papers of Mr. Belisle to make himself knowledgeable so as to testify at the hearing of this appeal.

Mr. Amyotte testified that according to the working papers of Mr. Belisle Mirage continued to hold its interest in the Terre Charette partnership during November and December 1982. During this time Mirage incurred expenses with respect to the partnership in the amount of $8,744, (This is confirmed by Mirage’s income statement for its 1983 fiscal year.)

Mr. Amyotte was unable to determine from Mr. Belisle’s working papers the reason Mirage continued to show three assets, the Terre Charette partnership, advance to an affiliated company and receivable from investment, on its books as of October 31, 1982. He supposed it was because the assets were not income producing. The Terre Charette partnership, he said, could have been transferred out of Mirage “anytime between November 1, 1982 and December 31, 1982” and thus would still appear in an October 31, 1983 statement. Mr. Amyotte believes that as of January 1, 1983 all assets had been transferred from Mirage to Développement.

Note I to the financial statements of Développement for the two months ending December 31, 1983 described the various real estate properties acquired from Mirage in 1982. Note 3 refers to the Bank of Montreal hypothec on lands acquired from Mirage and assumed by Messrs. Beaudry and Marois.

Mirage did have expenses for the fiscal period ending October 31, 1983. Some of the expenses, Mr. Amyotte explained, were interest and bank charges and professional fees that “could have been expenses that went over the full fiscal year of the company, say from November I to October 31”. He added “[e]ven if income stops, there are still expenses to be incurred”. While Mr. Amyotte was of the view that as of December 31, 1982 all properties of Mirage, except for the Terre Charette partnership interest, and its debt had been transferred to Développement, he was not too sure when the Terre Charette partnership interest was transferred.

In cross-examination, Mr. Amyotte, after reviewing pages 14 and 15 of Exhibit A-23, agreed with respondent’s counsel that ajournai entry dated March 1983 indicates that the equity in the Terre Charette partnership was transferred out of Mirage in March 1983 and at January 1, 1983 the partnership was an asset of Mirage. Or, as he informed appellant’s counsel, the transfer of the partnership may have been entered in his firm’s file on March 1983.

With respect to activity in the shareholders’ loan account of Mirage, Mr. Amyotte’s explanation was simple: his review indicated that notwithstanding that Mirage’s bank was advised to close the company’s account as of October 31, 1982, “or somewhere before October 31,1982”, the bank had not followed those instructions and transactions were recorded in the bank account. Mr. Amyotte stated that these transactions affected only the shareholders because there was no asset left in Mirage. All the amounts that are shown on the Loan Account went through Mirage’s bank account but actually belonged to the shareholders, he concluded.

The balance sheet of Mirage as of October 31, 1982 reflects a liability to shareholders in the amount of $575,758. Appellant’s counsel led Mr. Amyotte through several financial statements of Mirage for 1983 to explain the reduction in the amount due to shareholders from $575,758 to nil at the end of 1983. The amount due to an affiliated company ($21,593) and the interest in Terre Charette partnership and other investments in Mirage’s balance: sheet as at October 31, 1982 ($141,301) were written off. Mirage also incurred a loss of $13,358 in its 1983 fiscal year, and the loss was deducted from the total amounts ($162,894) written off for a balance of $149,486. In the meantime, assets had been transferred to shareholders and compensating entries were made for balance sheet purposes.

To prevent the value of any benefit being added to the income of the shareholders due to the transfer of assets, Mr. Amyotte said, the amount of $149,486 was included in income of the shareholders as a dividend. The dividend was equal to the net value of the assets transferred to the shareholders less the expenses and the loss for the year from the Terre Charette partnership.

Rather than treating the $149,486 as a dividend Mr. Amyotte conceded the transaction could have been structured differently. However, he concluded that the dividend route was “the best means of transferring the assets and charging, at least for tax purposes, the amount equal to the value of the assets”.

In cross-examination, Mr. Amyotte agreed with respondent’s counsel that “the way” Messrs. Beaudry and Marois paid Mirage for the Terre Charette partnership interest was “by declaring a dividend”. Mr. Amyotte and respondent’s counsel agreed the dividend was “paid” in Mirage’s 1983 fiscal year and in calendar year 1983. Respondent’s counsel was concerned that Mirage could not be “effectively wound down in calendar 1982” if a dividend were paid in calendar 1983. Mr. Amyotte explained that he presumed the assets of Mirage were withdrawn before December 31, 1982. He did not think it necessary in the circumstances for the dividend to be paid in 1982 as well since a dividend is not a “commercial transaction” but a “payment to a shareholder”.

In an answer to a query put by me, Mr. Amyotte agreed, that as of October 31, 1982 Mirage had valued its assets at the glower of cost and market value and on that day the assets may have been realized in the amount of $162,000. Mr. Amyotte agreed that “it is at least certain that probably the $412,000 is not going to be paid; it’s bad”. He agreed that $162,894 [5] of the amount of $575,758 owing to shareholders was not bad. He explained that if the loss of $575,758 had been written off, assets would still be in Mirage “so in order to put these assets into the hands of the shareholders, we had to give compensation somehow, and this is the reason why the dividend was paid because the amount of the shareholders’ loan written off is the same amount as shown on the balance as of October 31, 1982 and has nothing to do with transactions after that date”.

Argument

Appellant’s counsel submitted that as a result of his client’s history of personal borrowings, guaranteeing loans, being personally liable for debt incurred by corporations in which he was a shareholder and, finally, because Mirage was in the business of buying and selling land For profit, Mr. Beaudry’s share of the loss of the debt Mirage owed its shareholders was a business loss.

There is a presumption that the purchase of corporate shares constitutes a capital investment. [6] A taxpayer’s interest in a partnership may also be presumed to be a capital asset. An advance or outlay made by a shareholder to or on behalf of the corporation is also generally considered to be on capital account. [7] The same considerations, wrote Robertson, J.A. in Easton v. R., apply to shareholder guarantees for loans made to corporations. [8]

There are, cautioned Robertson, J.A., two recognized exceptions to the general propositions that such losses are on capital account:

First, the taxpayer may be able to establish that the loan was made in the ordinary course of the taxpayer’s business. The classic example is the tax- payer/shareholder who is in the business of lending money or granting guarantees....

The second exception is ... [w]here a taxpayer holds shares in a corporation as a trading asset and not as an investment then any loss arising from an incidental outlay, including payment on a guarantee, will be on income account....9 [9]

A person who acquired shares in a venture in the nature of trade may also fall in the second exception.

Mr. Beaudry, it is true, has been, and continues to be, actively involved in making investments. As a shareholder, Mr. Beaudry may be called upon to guarantee loans undertaken by a particular corporation. It is normal and not unusual that a lender of money to a private corporation requires the loan be secured, usually by the personal guarantees of the corporation’s shareholders. A partner, of course, is liable for liabilities of the partnership. Simply because a person makes many investments and is required to guarantee loans made to the investment vehicle does not turn any such investment into a business, as appellant’s counsel suggests.

The appellant was not in the business of lending money or granting guarantees. He did not guarantee Mirage’s debt to the bank to protect the goodwill of any business he had undertaken. And, finally, he did not acquire Mirage’s shares in an adventure in the nature of trade.

Mr. Beaudry acquired the Mirage shares as an investment. He guaranteed the debt in question as a shareholder of Mirage. The guarantee was on capital account and as such the loss cannot be deducted by the appellant in computing his income: paragraph 12(1)(b) of the Act.

The appellant’s loss on the bad debt of $194,242 was a capital loss that is a business investment loss: subsection 39(1)(c).

Respondent’s counsel argued that the debt of $194,242 was not a bad debt to the appellant in 1982 because Mirage had sufficient assets to pay a dividend in 1983. He also submitted that since paragraph 50(l)(a) of the Act, which provides for the deemed disposition of a bad debt for proceeds equal to nil, refers to “a debt”, all of the debt, and not part, must be bad in the year before it can be recognized as bad.

Paragraph 50(1 )(a) provided, in part:

For the purposes of this subdivision, where

(a) a debt owing to taxpayer at the end of the taxation year ... is established by him to have become a bad debt in the year, ... the taxpayer

shall de deemed to have disposed of the: debt ... at the end of the year... [10] 10

The respondent maintained that the debt referred to in paragraph 50(1 )(a) cannot be partitioned in any way and that the whole debt must be bad before it could be recognized as bad. Section 20 of the Act, her counsel declared, refers to ongoing trade debts which are different in character from the debt referred to in section 50. Section 20 also refers to “debts”.

It is clear that in 1982 the appellant would never recover the debt as a whole. It is up to the taxpayer to establish when a debt, whether on capital or income account, is bad. If the taxpayer reasonably determines that he or she will not recover the debt as a whole then it is bad at that time. The taxpayer must objectively determine on reasonable grounds that the debt is bad or not. The question is not an objective test which allows the Minister to question the appellant’s business judgment. In the case of a debt that is capital, if the taxpayer makes an incorrect determination and all or a portion of the debt is recovered then, since the adjusted cost base is nil, he will pay tax in the year of recovery.

In Hogan v. Minister of National Revenue (1956), 56 D.T.C. 183 (Can. Tax App. Bd.), the Tax Appeal Board considered what is bad debt, albeit with respect to the predecessor of paragraph 20(1 )(/?), at p. 193:

For the purposes of the Income Tax Act, therefore, a bad debt may be designated as the whole or a portion of a debt which the creditor, after having personally considered the relevant factors mentioned above in so far as they are applicable to each particular debt, honestly and reasonably determines to be uncollectable at the end of the fiscal year when the determination is required to be made, notwithstanding that subsequent events may transpire under which the debt, or any portion of it, may in fact be collected. The person making the determination should be the creditor himself (or his or its employee), who is personally thoroughly conversant with the facts and circumstances surrounding not only each particular debt but also, where possible, each individual debtor (although this latter requirement would be unlikely, for example, in the case of a mail order department debt where reliance would most likely have to be placed on credit reports or other documentary information or on the opinions of third parties).

As already stated, I am of the opinion that this taxpayer, after consideration of the various factors known at that time or foreseeable in the immediate future, did reach an honest and reasonable conclusion that $3,190.17 of his accounts receivable were bad debts on the date of the sale of his sole proprietorship business to the new company.

Respondent’s counsel contended, also, that an account receivable could not be partially bad and partially doubtful, or even partially bad and partially collectable. I have stated above the circumstances given by the appellant in respect of at least one account which he felt was partially bad and partially recoverable. Other examples were given by the appellant in the course of his evidence, and I am satisfied that an account receivable may be considered to be partially bad and partially recoverable in certain circumstances, which may vary in each case.

The Board’s decision was followed recently by this Court in Granby Construction & Equipment Ltd. v. Minister of National Revenue (1989), 89 D.T.C. 456 (T.C.C.). Lamarre Proulx, T.C.C.J. agreed that it is the taxpayer’s determination that is important and also found that bad debts could be partitioned among years under subsection 50(1). More recently the Federal Court of Appeal approved of Archambault, T.C.C.J.’s reliance on the passage cited in Hogan: see Flexi-Coil Ltd. v. R. (1996), 96 D.T.C. 6350 (Fed. C.A.).

When Mr. Lachapelle claimed his portion of the debt due to shareholders by Mirage was bad in 1982, Revenue Canada correctly accepted his decision. Their dispute was whether the loss was on capital or income account. [11] It was suggested that Revenue Canada accepted Mr. Lachapelle’s claim of bad debt in 1982 because he was no longer a shareholder of Mirage but disallowed Mr. Beaudry’s claim for the same year since he was still a shareholder. I do not understand the Minister’s reasons for his decision. The nature of the debts by Mirage to both Mr. Beaudry and Mr. Lachapelle were similar. If there were sufficient assets in Mirage, then those assets were available to all the creditors, including both Mr. Beaudry and Mr. Lachapelle. There was no evidence that Mr. Beaudry participated in a decision of directors of Mirage that he would be paid and Mr. Lachapelle would not be paid. Also, I fail to appreciate why, in the circumstances at bar, a non-shareholder is in a better position to make a decision that a debt is bad than a shareholder, in particular if the shareholder is an officer and director of the corporation. A director of a corporation would normally have much more information available to him or her to make such a decision than someone outside the corporation. It made no difference to Mirage whether or not Mr. Beaudry was a shareholder. The debt was bad to Mr. Lachapelle and it was also bad to Mr. Beaudry.

It is for the taxpayer to determine when a debt is bad and it was reasonable for Mr. Beaudry to have found the debt in this case to have become bad in 1982.

The appeals for 1982 and 1983 shall be allowed with costs on the basis that in 1982 the appellant incurred a business investment loss of $194,242; the assessment for 1983 will be adjusted accordingly and the Minister shall, in SO assessing, apply any credits available to Mr. Beaudry that may be carried back to 1983.

Appeal allowed in part.