Tax Court of Canada Judgments

Docket: 2004-2557(IT)G

BETWEEN:

SUPERCOM CANADA LIMITED,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

____________________________________________________________________

Appeal heard on June 27 and 28, 2005 at Toronto, Ontario

Before: The Honourable Justice J.E. Hershfield
Appearances:
Counsel for the Appellant:	Roger Taylor, L. Michele Anderson
Counsel for the Respondent:	Ernest Wheeler, Ifeanyichukwu Nwachukwu

____________________________________________________________________

JUDGMENT

          The appeal from the assessment made under the Income Tax Act for the 1998 taxation year is allowed, with costs, in accordance with and for the reasons set out in the attached Reasons for Judgment.

Signed at Ottawa, Canada, this 16th day of September 2005.

"J.E. Hershfield"

Hershfield J.

Citation: 2005TCC589

Date: 20050916

Docket: 2004-2557(IT)G

BETWEEN:

SUPERCOM CANADA LIMITED,

Appellant,

And

HER MAJESTY THE QUEEN,

Respondent.

REASONS FOR JUDGMENT

Hershfield J.

[1]      On August 2, 2001, the Minister of National Revenue (the "Minister") assessed Supercom Canada Limited (the "Appellant" or "Supercom Canada") in respect of its 1996 through 1998 taxation years. On April 24, 2004, the Minister further assessed the Appellant in respect of its 1999 taxation year.

         

[2]      The assessment for the 1998 taxation year denied a bad debt expense claimed by the Appellant in that taxation year. The amount in issue in respect of such expense is agreed to be $3,467,794.00.[1] In addition, the assessment for 1998 and the assessments for the 1996, 1997 and 1999 taxation years disallowed deductions of interest payable in the amounts of $210,000.00, $75,000.00, $75,369.00, and $210,000.00 respectively, and assessed the Appellant for failing to withhold and remit a total of $142,592.00 in taxes for those years in respect of interest paid to a non-resident creditor.

[3]      Prior to the commencement of the hearing counsel notified the Court that the interest expense and withholding tax issues were to be resolved by agreement pursuant to subsection 169(3) of the Income Tax Act (the "Act").

[4]      The central issue remaining at trial was whether the amount claimed as a bad debt should be treated as a loan or advance of capital, giving rise to a capital loss, or as trade receivables properly expensed pursuant to subparagraph 20(1)(p)(i) of the Act.[2] Resolution of the issue turns on the characterization of certain transfers of goods that Supercom Canada made to Supercom U.K. Limited ("Supercom U.K."), a company with which it did not deal at arm's length at all relevant times.[3]

[5]      Supercom Canada carried on the business of distributing computers, computer parts and computer accessories (collectively "computer parts") to value-added resellers in Canada and in the United States. Supercom U.K. carried on a similar business in the United Kingdom. The debt in issue arose from the transfer of inventory of computer parts from Supercom Canada to Supercom U.K.

[6]      With respect to this issue the Respondent made the following assumptions in paragraph 14 of its Reply:

. . .

(h)        in the 1994 taxation year, Supercom U.K. was incorporated to engage in the business of distributing computer hardware in the U.K.;

(i)          at all material times, the Appellant delivered and purported to sell computer hardware to Supercom U.K. for redistribution in the U.K.;

(j)          most of the computer hardware the Appellant delivered and purported to sell to Supercom U.K. was at gross margins of 1% to 2% whereas it sold computer hardware to third party purchasers at gross margins in excess of 5% to 6%;

(k)        some of the purported sales from the Appellant to Supercom U.K. were for amounts below the cost amount to the Appellant;

(l)         at all material times, the Appellant did not receive any payment for the purported sales to Supercom U.K. but continued to deliver computer hardware to Supercom U.K.;

(m)        at all material times, the Appellant did not take any action to collect on the amounts of the purported sales;

(n)        the computer hardware delivered to Supercom U.K. by the Appellant was not delivered in order to generate profit in the Appellant's business;

(o)        the purported sales by the Appellant to Supercom U.K. were advances of capital.

Evidence

[7]      At the hearing the Appellant called two witnesses who described the business of Supercom Canada and that of Supercom U.K. as well as the circumstances in which the bad debt arose.

[8]      Mr. Jon Maxim, the managing director of Supercom U.K., testified as to the establishment and business of Supercom U.K.

[9]      In June 1994, the controlling shareholder of Supercom Canada, Mr. Frank Luk, and Mr. Maxim (then employed at IBM) decided to incorporate a company in the U.K. to carry on a business similar to that of Supercom Canada[4] - that is, to sell computer parts to resellers (as opposed to end-users) in the U.K. As a consequence, Mr. Maxim left IBM, for which he had worked in sales and marketing for approximately 20 years, and became a co-director of the new company. Mr. Luk and Mr. Maxim each received 50% of the capital stock and Mr. Maxim became the managing director of Supercom U.K., which I am told is the United Kingdom equivalent of Chief Executive Officer.

[10]     Mr. Maxim moved to the United Kingdom to start up and operate the new company. Supercom Canada agreed to advance £ 200,000 to Supercom U.K. to cover its start-up costs. Such costs included furniture, leasehold improvements, inventory and Mr. Maxim's moving expenses. The inventory consisted of computer parts including motherboards, hard drives, memory cards and peripheral devises which came from a number of suppliers throughout the world. The £ 200,000 advance was identified as a long-term debt in the financial statements. It does not form part of the bad debt at issue although I will mention it again later in these Reasons.

[11]     Mr. Maxim testified that the business was "up and running", with six employees (including himself and his wife), in January or February of 1995. From that time, until late 1998, Mr. Maxim testified that he was responsible for all the business decisions. One such decision was to acquire a fair amount of inventory from Supercom Canada.

[12]     Mr. Maxim testified that the computer parts it bought from Supercom Canada were often more expensive as it usually charged higher prices and did not include freight charges. It also actually took longer to get products from Canada than from other suppliers such as those in the Far East and United States. Despite the added cost and delay, Mr. Maxim purchased inventory from the Appellant because he could obtain favourable trade terms.

[13]     Mr. Maxim testified that his plan was to eventually buy all its inventory of computer parts directly from third parties (such as Fujitsu Canada, and Maxtor Corporation) because the prices were lower, the goods would arrive faster and transportation costs would be included. However, with the trade terms he was able to get from Supercom Canada, he could essentially leverage the company. In particular, he would sell the inventory acquired from Supercom Canada and use the proceeds to buy more inventory from other suppliers in the United States and the Far East.

[14]     Mr. Maxim was readily able to receive trade terms of 180 days and such terms were frequently extended well beyond that. Mr. Maxim described Supercom Canada as an indulgent creditor from whom he could often get extensions for inventory accounts payable. Mr. Maxim stated that "he always tried to hold on to money".

[15]     Mr. Maxim described the life cycle of Supercom U.K. and in doing so he referred to the auditor reports for the 1995 through 1998 fiscal years.[5] In fiscal 1995, Supercom U.K. purchased £ 1,960,895 of merchandise from suppliers, including US $1,132,055.00 from Supercom Canada. The first year Supercom U.K. had a deficit of £ 182,904 but Mr. Maxim was confident that the company would be profitable. In the notes to the financial statement, the auditor noted Supercom Canada's generous trade terms:

The accounts have been prepared on a going concern basis. In producing the accounts under this basis, the directors have relied on the continued support of a Canadian supplier, Supercom Inc.

[16]     The auditor also noted Mr. Maxim's outlook on the future of the company when he wrote, "the directors are confident that the company will achieve profitability in the near future". Mr. Maxim explained that he was the director that the auditor referred to in the reports. Mr. Maxim also testified that he had advised the auditor of the favourable trade terms he was able to obtain from Supercom Canada.

[17]     In 1996, Supercom U.K. hired approximately six more employees and more than doubled its sales to £ 3,727,304. Of these sales only US $1,175,375.00 of product was bought from the Appellant. Despite this increase in sales Supercom U.K. continued to operate at a loss ( £ 274,320). The 1996 auditor's report contained similar statements to those in 1995, including "the directors are confident that the company will achieve profitability in the near future".

[18]     In the 1997 fiscal year, Supercom U.K. sales increased dramatically due to a change in the business plan. Apparently, Supercom U.K. was having difficulties selling computer parts to re-sellers. The conditions were such that, as Supercom U.K. then operated, it was very difficult to make a profit. The scene was ripe for a new partner. In early 1997, Mr. Stern, a businessman whose strength was in marketing, proposed a joint venture with Supercom U.K. He proposed that they create a new company, Maple Computer Corporation, to sell assembled computers directly to the public. Mr. Stern was in charge of Maple's operations. This change of business plan was combined with a change in the ownership of Supercom U.K.[6]

[19]     Mr. Maxim explained that the creation of Maple Computers led to an initial surge in Supercom U.K.'s sales and that Maple Computers became its biggest buyer. That year, both companies grew so that between the two there were approximately 65 employees. Mr. Maxim noted that although Supercom U.K. and Maple Computers were separate companies there was a lot of movement of employees between the two companies. Supercom U.K. also provided management services for Maple Computers.

[20]     That year (fiscal 1997) Supercom U.K. sold £ 10,936,530 of product. £ 6,462,347 was sold from Maple Computers and only US $1,159,092.00 was bought from Supercom Canada. Although sales increased dramatically, and Maple Computers was effective in selling its product, both companies were operating at a loss. Mr. Maxim testified that Mr. Stern exceeded budgets through excessive promotions and marketing. He also attributed problems to unexpected warranty issues and also testified that they had miscalcuated the U.K. market for computers and that it was the most oversaturated market in the world. As a result, Maple closed its doors in fiscal 1998 and Supercom U.K.'s sales decreased to £ 334,479 although its purchases from Supercom Canada increased to US$ 1,745,753.00. Supercom Canada continued to ship inventory to Supercom U.K. until Mr. Luk determined in August 1998 that Supercom U.K. had failed and would not be able to pay its accounts payable to Supercom Canada.[7] As will be noted, Supercom U.K.'s last payment to Supercom Canada for computer parts acquired was on August 20, 1997.

[21]     Once Supercom U.K. was liquidated in October 1998, its leftover cash was used to pay amounts owing to Supercom Canada - including the initial long-term advance of £ 200,000. A small amount, $53,705.97, was also used to reduce the trade payable. Five thousand kilograms of furnishing, equipment, inventories and various supplies of Supercom U.K. were boxed up and sent to Supercom Canada. There was no reduction in the amounts payable from Supercom U.K. to Supercom Canada in respect of such transfers.

[22]     At this point I note that evidence of payments for computer parts acquired is rather thin. In the Appellant's written submission it is claimed that, by the end of fiscal 1996, Supercom U.K. had paid some Cdn $1,280,000.00 to Supercom Canada representing a majority of the amounts owing to Supercom Canada for 1995 and 1996 sales. While it seems impossible for me to reconstruct payments, financial statements (year-ends for which are one month apart) show sales to Supercom U.K. from Canada at the end of its 1996 fiscal year at over Cdn $3,000,000.00 and debt of £ 563,000. To this extent, the statements do suggest, as asserted, that over one-half of the inventory purchases were paid for after the first two years of operation. By August 1998 more than Cdn $4,000,000.00 of additional goods were sold to Supercom U.K. by Supercom Canada but the final debt was in the order of Cdn $3,500,000.00. Clearly, some payments were being made but it is impossible to reconcile how much was paid given the absence of aged account records and currency fluctuations.[8]

[23]     I will now review the testimony of Mr. Ho who was the other witness called by the Appellant. Mr. Ho provided further details as to Supercom Canada's business, its relationship with Supercom U.K. as well as how the cost of sales was established.

[24]     Mr. Ho has been the controller of Supercom Canada since October 1996 and as such was in charge of the accounting department of Supercom Canada. He prepared financial statements and reviewed and directed credit and internal procedures. From that position he dealt with Supercom U.K. until its eventual liquidation in October 1998.

[25]     Mr. Ho testified that Supercom Canada was in the business of buying and reselling computer parts to re-sellers. The company obtained its inventory from a number of suppliers throughout the world including some of the same suppliers.

[26]     Mr. Ho testified that as long as Supercom U.K. operated it would buy products from Supercom Canada. He reviewed various invoices that showed the quantities and base prices at which Supercom Canada sold the computer parts to Supercom U.S. He apparently had no knowledge of Mr. Maxim's plans to only buy from third parties.

[27]     Mr. Ho explained that when accounts were overdue the staff sent notices or invoices noting what amounts were overdue. When the accounts were excessively overdue the staff would talk to Mr. Ho who would call Mr. Maxim directly. Mr. Ho testified that the regular accounting staff was not to deal with overseas phone calls and had no direct contact with Supercom U.K.

[28]     No records were produced at trial to show that phone calls were made or that overdue account notices were sent to Mr. Maxim or Supercom U.K. regarding the outstanding amounts. When asked if there were any internal reports which would indicate the age of Supercom U.K.'s debt, Mr. Ho explained such treatment was not necessary here because he was personally involved with the collection. He stated that aging of debt reports and internal documents regarding the debt were usually only produced to help management get the necessary information. That was not necessary in this case as he was personally in touch with Supercom U.K. This informal treatment was exceptional even considering its dealings with another seemingly non-arm's length company where aged reports were issued.[9]

[29]     Mr. Ho acknowledged he knew Mr. Luk was generally more lenient with Supercom U.K. and that Mr. Maxim would speak directly with Mr. Luk if he, Mr. Ho, would not agree to give Mr. Maxim what he wanted. He further stated that Mr. Luk had outlined general policies in dealing with Supercom U.K. Such policies included lenient trade terms.

[30]     Mr. Ho recalled that until mid-1998 Mr. Maxim had professed that he thought the business was viable. For the most part Mr. Ho had to rely on Mr. Maxim's assessment because financial statements were not completed and sent until mid-1998. It was only then that he saw that the external auditors of Supercom Canada wrote down the 1997 year-end accounts receivable by Cdn $1,400,000.00. Mr. Ho was be concerned about this event.

[31]     Indeed once the financial statements were completed Mr. Maxim questioned whether he could accurately assess Supercom U.K.'s potential and asked Mr. Ho to come to the United Kingdom and give him an impartial second opinion.

[32]     Mr. Ho visited Supercom U.K. in July 1998 and compiled a report which was then given to Mr. Luk. The report addressed the viability of Supercom U.K. and the financial impact on Supercom Canada. It was Mr. Ho's opinion that Supercom U.K. should be closed immediately. He noted that the business was inefficient and the expectations too high. He noted also that there were a number of systems of low quality which led to warranty problems. Overall, problems were more serious than anticipated and Mr. Maxim had been too optimistic.

[33]     Despite his report, Mr. Ho testified that Mr. Luk still had concerns with cutting off Supercom U.K. immediately. Mr. Luk still thought it had a chance to repay the money it owed Supercom Canada. Supercom U.K. was trying to reduce expenses, it had laid off most of its employees and developed a new strategy to only sell goods to secure buyers. Mr. Luk it seems wanted to try a bit longer to generate cash flow in Supercom U.K.

[34]     In late August 1998, Mr. Luk went to visit Supercom U.K. to make his own assessment of the situation. When he returned, he agreed that the company had failed and did not have the capacity to continue or to repay the trade payables. It was at that time that Supercom Canada stopped shipping inventory to Supercom U.K. and in October 1998 Supercom U.K. was liquidated. As stated the remaining furniture and other goods were sent back to Supercom Canada. According to Mr. Ho, these items were of no value.

[35]     At this point I will address another factual matter not dealt with above. Paragraphs (k) and (j) of the Respondent's Reply put in issue the mark-up on goods Supercom Canada sold to Supercom U.K.

[36]     As noted, Mr. Ho testified that throughout Supercom U.K.'s existence, Mr. Luk's policies dictated lenient, preferential treatment towards Supercom U.K. One such policy was to sell goods to Supercom U.K. at thin margins.

[37]     This policy of "thin margins", although dictated by Mr. Luk, was applied by the sales team and product management team who had much discretion on how to apply the policy. Mr. Ho explained that to establish appropriate prices, or the prices at which goods were sold to Supercom U.K., one could not simply rely on the invoices.

[38]     The life cycles of computer parts were short which often meant new products were cheaper than old ones, and old products were difficult to sell. As this was a general trend in the industry, there were a number of price protections within the industry. Often when new prices and products were introduced companies would still have the old inventory. The seller (manufacturer) would respond by issuing credit notes and various rebates in respect of the old inventory.

[39]     The accounting software at Supercom Canada did not adjust the base price (as noted in the accounting records) for the item when the company gave a credit for inventory. Instead of an item-by-item deduction, Supercom Canada simply deducted the credits and rebates from its total cost of sales. This made it difficult, if not impossible, to determine margins with exactness.

[40]     Still, Mr. Ho went through records which showed how credits and rebates adjusted Supercom Canada's cost of goods. As their accounting system did not usually create such records, at the Canada Revenue Agency's request, Mr. Ho and his staff spent over 40 hours reviewing invoices to produce the records. At Tab 57 of the Appellant's book of documents he showed a breakdown of back-end rebates from the vendors which were itemized by date and added together. The actual receipts were for such things as volume discounts, marketing development funds, and purchases of a given item during a particular time frame. Mr. Ho explained that it was not a complete list but they tried to put together as much information as possible. This evidence rebutted the Respondent's assumption that Supercom Canada's mark-up on inventory supplied to Supercom U.K. was only 1% to 2%. The margins in the sample were higher.

Analysis

[41]     The Appellant was denied the deduction it claimed for the bad debt suffered in respect of the inventory that Supercom U.K. failed to pay for before it was wound-up.

[42]     The relevant provision is subparagraph 20(1)(p)(i). It states:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

...

            (p) the total of

(i) all debts owing to the taxpayer that are established by the taxpayer to have become bad debts in the year and that have been included in computing the taxpayer's income for the year or a preceding taxation year, and ...

[43]     Paragraph 20(1)(p) is an exception to the limitation in paragraph 18(1)(a) which restricts any outlay or expense unless incurred by the taxpayer for the purpose of gaining income. Under paragraph 20(1)(p) a taxpayer is entitled to deduct a bad debt once the debt has been established to have become a bad debt as long as it was included in computing the taxpayer's income for the year or a preceding year.

[44]     The Respondent did not seriously pursue factual questions raised at the hearing as to whether the Appellant included the sales revenue in calculating its income. Indeed, the Reply makes no such assertions or assumptions. Further, and in any event, I accept Mr. Luk's evidence that all the subject sales in the relevant period were included in the Appellant's calculation of income as part of its accounting of goods sold. Accordingly, one of the two requirements of the subject provision is met. As well, as noted, it is not in dispute that the subject debts were bad in the year claimed. The second and sole remaining requirement is thereby met.

[45]     Given these circumstances and the straightforward requirements of paragraph 18(1)(p) and that it exists as an exception to paragraph 18(1)(a), the Respondent's position seems somewhat unusual. The Respondent has asserted, indeed its principle line of attack, as stated in the Reply to the Notice of Appeal, is that "the purported sales by the Appellant to Supercom U.K. were not sales by rather were advances of capital and as such did not constitute an outlay or expense incurred by the Appellant to gain or produce income pursuant to paragraphs 18(1)(a) and 18(1)(b) of the Act".

[46]     Of course it is possible to argue that "sales" in non-arm's length cases should not be treated as "sales" for tax purposes to prevent "thin margin" sales, which were made on long term credit without trade receivable type record keeping and collection action, from enjoying ordinary business loss treatment (as opposed to capital loss treatment). However, such argument promotes a finding that substance prevails over form. The subject provision does not invite such approach in my view. Indeed, it is generally accepted that recognizing legally effective transactions (form) prevails in tax matters and in this case it seems entirely appropriate that that should be the case. The subject provision, in referring to the income inclusion by the lender, defines the characterization of the advance - the debt arises as a result of trade in the course of a supplier's business. It is unpaid consideration for a supply actually made which was included in the calculation of the profit of the supplier. The section does not set out differential treatment for non-arms length transactions and precludes the operation of paragraphs 18(1)(a) and (b) which recognizes that the debt in such cases is wholly incidental to and arises in the course of trade. It is not capital in nature. Nonetheless, the Respondent argued that the credit extended was capital and that the requirement in paragraph 18(1)(a), that the advances be made to earn income, was not met.

[47]     The Respondent relies on facts which indicated that the Appellant was not treating the inventory as an overdue trade account but was treating the inventory as an in-kind advance of capital:

(1) there was an apparent lack of concern for the aging or collection of debt;

(2) there were no records or documents to evidence any collection requests or notices of overdue amounts;

(3) fresh inventory was sent to Supercom U.K. up until July 1998;

(4) when Mr. Maxim was unsure whether the business was viable he called over his creditor's controller - Mr. Ho to assess the situation; and

(5) once Supercom U.K. was wound-up, five tonnes of office furniture and equipment was boxed and shipped to Supercom Canada.

[48]     The Respondent submitted that the parties' characterization of the transaction is not necessarily determinative and, as stated, urged that this Court look at the substance of the transaction instead of the form.

[49]     The principle case relied upon by the Respondent is Flexi-Coil Ltd. v. The Queen.[10] In that case, Justice Archambault determined that the cost of the inventory that the appellant had failed to pay its parent company ("Flexi") should not be considered an uncollectible debt. The Respondent relies on similarities between that case and the case at bar. Sales to a subsidiary were on favourable extended terms including recording trade debts as "loans not repayable in one year". In reviewing the notes to the financial statements of the appellant and the accounting records of the subsidiary, Justice Archambault determined the intention of the parent was to provide additional capital for the subsidiary and to maintain its presence in the U.K. through that subsidiary. Factors in this determination were that Flexi-Coil U.K., which appears to have only sold products which it and its parent company manufactured, was thinly capitalized, operated on hardly any line of credit and was almost entirely dependant on its parent for its financial needs. I agree this case has much in common with the case at bar. [11]

[50]     The Appellant submitted that the factors the Respondent pointed to were irrelevant and that the only relevant factor was the intention of the parties. The Appellant submitted that such intention was clearly expressed by the two witnesses and by the recorded sales entries in evidence. Supercom U.K. had contracted with Supercom Canada to buy inventory - the inventory was delivered and Supercom U.K. resold the said inventory to other resellers and Maple Computers.

[51]     The Appellant also took the Court through a number of cases which discussed the nature of trade receivables. Such cases established that a trade receivable remains such until specific actions are taken to change its nature. Neither the mere passage of time,[12] nor the simple writing down of a debt, change a trade receivable into a capital loan.[13]

[52]     I agree with the Appellant in these matters. The transfer of Supercom Canada's inventories were sales. The invoices reveal that the contracts that Supercom Canada entered into with Supercom U.K. were to sell computer parts to Supercom U.K. Supercom U.K. was billed for those parts and, although on lenient and extended terms, it paid for a considerable portion of such acquired goods. This is at least prima facie evidence of the intent to sell goods. As submitted by the Appellant the contract of sale indicates the seller's and buyer's intentions.[14] Moreover, the witnesses testified that the inventory transactions were regarded as creating payables and receivables in the course of the purchase and sale of that inventory. That extended credit terms help create a base from which the purchaser can better operate is not determinative, if relevant at all, in classifying the sale.

[53]     Further and in any event, that I have found that the express requirements of paragraph 20(1)(p) have been met, should be sufficient to allow the appeal. In my view, the Respondent's reliance on Flexi-Coil is entirely misplaced. That case is not authority for denying a bad debt claim under paragraph 20(1)(p) where accounts receivable arise from generous financing terms on goods sold in the normal course of business. That case is entirely about whether debts are bad and underlines the importance of vigilant scrutiny to ensure that a related creditor acts properly in determining when debts have become uncollectible. Justice Archambault's determination (upheld by the F.C.A.) was that, on the evidence before him, Flexi-Coil did not reasonably determine that its accounts receivable had become uncollectible in the relevant taxation years. The burden of proof to establish that the debts were bad in the years claimed, beyond that allowed by the Minister, had not been satisfied. That Justice Archambault, in arriving at that conclusion, considered the lack of collection activity and that certain accounting records showed trade accounts as long-term receivables and as "investments" in certain consolidated statements, does not suggest that paragraph 20(1)(p) was not the appropriate provision to apply in years that debts were established to have been uncollectible. Indeed, debts proven to be uncollectible were allowed under that provision by the Minister in that case. The case does not suggest that the disallowed debts would not have been allowable in another year under that provision as and when the debts were proven to be bad.

[54]     I note here, as well, that to ask this Court to apply the principles in Flexi-Coil, other than on the basis of the added vigilance required when determining a debt is uncollectible in the case of non-arm's length parties, is to ask it to assume a legislative role. Essentially, what the Respondent argues is that the Appellant should be regarded as having sold its inventories at an arm's length price, paid tax on the income derived therefrom, and then advanced the proceeds as a loan to its related company as an advance of funds in the nature of a capital investment. While one might envision that such treatment might have been legislated by Parliament, that is not the case. The scenario advanced by the Respondent does not reflect the transactions as entered into by the parties. It is trite law that absent a sham legally effective transactions entered into by taxpayers should be respected.[15]

[55]     Having found that the subject inventory sales were "sales" giving rise to payables included in computing income there remains the question as to whether there has been a change in the classification of the debt. That is to ask whether the trade debt should be treated as having been repaid in full and re-lent in full as an advance in the nature of capital. The Respondent did not take this position but rather it was raised by the Appellant presumably as a defensive measure to ensure that I did not take that route. Regardless, it is worth noting that the cases produced by the Appellant articulate that a trade payable can only change into a capital debt when it is the parties' intention that such a change occurs. [16] No such intention existed in the case at bar. That I agree with the Respondent that Supercom Canada permitted sales on extraordinarily generous extended terms and continued to supply inventory on credit notwithstanding it had large accounts receivable, some of which would have been at least a year old, only underlines the non-arm's length relationship between the parties but that is not sufficient to re-characterize the receivables as being something other than what they are - receivables arising from the sale of goods. Extending credit after payments stopped in August 1997, during the initial part of Maple's sales surge but before its problems became apparent, does not necessitate a finding that sales transactions had become long-term financing of a capital nature. Indeed, extending credit after Maple failed, for purchases during the short period of secured sales and reassessment of U.K.'s business viability, even without collection activity prior to or during that period, does not necessitate a finding that sales transactions had become long-term financing of a capital nature.

[56]     I note here as well that the fact that the external auditors wrote down Supercom Canada's receivables in its 1997 statements, has no affect on the intention of the parties. It may impact on the timing of the bad debt claim but that has not been put in issue. Further, there is little evidence that sales to Supercom U.K. were substantial after the write-down became known (which was after sales to Maple had surged). In any event, the Appellant asserts that the write-down, the continuance of inventory supplies and the disruption in payments cannot be taken as actions to change the nature of the trade payables at any point prior to the date that the debt was claimed as bad. I agree with the Appellant. Accordingly, I find that the receivable, the debt in question, was at no point on capital account. To acknowledge the debt as a trade receivable arising from the sale of goods in the normal course of business is clearly correct in this case and gives the result actually, expressly, dictated in any event by paragraph 20(1)(p). Accordingly the appeal will be allowed.

[57]     Before concluding however I will make a few further observations for the record. Had the reassessment raised the issue of reducing the bad debt claim by some value for the goods shipped back to Canada following the liquidation (5,000 kilograms of assets which included office furniture, internal systems equipment and software), I think such reduction may have been appropriate as to accept that the shipment had no value belies the fact that it was shipped. Similarly, I have a question as to the claiming of "bad" trade receivables where funds were available ( £ 200,000) to pay down unsecured long-term debt. The Appellant cited authority allowing this practice and the Respondent did not take issue with such authorities. Still, had the matter been raised in the reassessment, I believe the question would deserve further analysis. However, since the reassessment did not raise these questions, it is not for me to comment further.

[58]     For all these reasons the appeal respecting the bad debt claim is allowed with costs.

Signed at Ottawa, Canada, this 16th day of September 2005.

"J.E. Hershfield"

Hershfield J.

CITATION:

2005TCC589

COURT FILE NO.:

2004-2557(IT)G

STYLE OF CAUSE:

Supercom Canada Limited and Her Majesty the Queen

PLACE OF HEARING:

Toronto, Ontario

DATE OF HEARING:

June 27 and 28, 2005

REASONS FOR JUDGMENT BY:

The Honourable Justice J.E. Hershfield

DATE OF JUDGMENT:

September 16, 2005

APPEARANCES:

Counsel for the Appellant:

Roger Taylor, L. Michele Anderson

Counsel for the Respondent:

Ernest Wheeler, Ifeanyichukwu Nwachukwu

COUNSEL OF RECORD:

For the Appellant:

Name:

Roger Taylor, Michele Anderson

Firm:

Couzin Taylor

For the Respondent:

John H. Sims, Q.C. Deputy Attorney General of Canada Ottawa, Canada

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