Tax Court of Canada Judgments

Date: 20000328

Docket: 97-1870-IT-G

BETWEEN:

JOHN BIRD,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

McArthur J.T.C.C.

[1] These appeals are from assessments for the 1992 and 1993 taxation years. The Minister of National Revenue disallowed claimed bad debt expenses of $330,650 in 1992 and $100,192 in 1993. The issue is whether bad debt expenses with respect to loans are allowable pursuant to paragraph 18(1)(a) or 20(1)(p) of the Income Tax Act.

[2] The claimed bad debt expense for 1992 in the amount of $330,650 relates to advances made by the Appellant to Adagio Enterprises Ltd. ("Adagio") in the amount of $162,000 and to Fremont Investors Ltd. ("Fremont") in the amount of $168,650. The $100,192 bad debt claimed for the 1993 taxation year was made up of the following bad debts:

a) payments to the Westpac Banking Corporation in 1993 totalling $81,600;

b) payment to George Davis, in trust in 1993 in the amount of $5,000 to settle a threatened lawsuit against the Appellant and other directors of Adagio Investments Inc. and various other parties;[1] and

c) $13,592 representing the balance of advances made to Fremont in previous years which had not been claimed as a bad debt previously.

The Appellant was the sole shareholder and director of Fremont at all material times. From 1986 onward, the Appellant made numerous advances to Fremont. These advances to Fremont were accounted for as shareholder loans on the books of Fremont.

[3] The Appellant advanced money to Fremont which loaned it to Adagio Enterprises Ltd. The Adagio Enterprises loan proceeds were advanced to Adagio Investments Ltd. I will refer to both corporations as Adagio. The Appellant was a shareholder and officer of Adagio but did not control it on his own. Adagio was petitioned into bankruptcy in July 1992.

[4] Fremont entered into a financial assistance agreement ("agreement")[2] with Adagio in August 1986. The loans to Fremont were secured by a debenture. The agreement, prepared by Fremont's solicitors, set out the terms of the financial arrangements between Adagio and Fremont with no reference to a loan or loans directly between the Appellant and Adagio. Adagio was in the garment manufacturing business. Included in the agreement was the following:

Re: Provision of Financial Assistance and Counsel by Fremont Investors Ltd. ("Fremont") to Adagio Enterprises Ltd. ("Adagio")               

This letter will serve to set out the agreement between Fremont, Adagio, L.C.R. Management Ltd. ("L.C.R.") H.E. Johnson ("Johnson") and Patricia Fieldwalker ("Fieldwalker") regarding the provision of financial assistance and counsel by Fremont to Adagio.

1. Fremont agrees to guarantee payment to the Royal Bank of Canada (the "Bank") of additional credit facilities established by Adagio with the Bank in the aggregate principal amount of $150,000 (the "Additional Loan").

2. Fremont further agrees to pledge to the Bank by way of collateral security for its guarantee of the Additional Loan term deposits in the aggregate amount of $150,000 (collectively the "Fremont Term Deposit").

3. Adagio agrees to pay Fremont as a consideration for the financial assistance provided a standby fee at the rate of 3% per annum on the daily outstanding balance of the Additional Loan for the period beginning August 8, 1986 and ending on the date the Additional Loan is retired by Adagio (the "Standby Fee"). The Standby Fee will be payable on September 30, 1986 and quarter-annually thereafter during the aforesaid period.

4. Adagio further agrees to issue in favour of Fremont a floating charge debenture in the principal amount of $150,000 (the "Fremont Debenture"). The Fremont Debenture will represent a second floating charge over all present and future assets of Adagio including inventory and accounts receivable and will bear interest at the prime rate of the Bank plus 4% per annum.

5. Adagio will exercise its best efforts to repay the Additional Loan in full by December 31, 1986.

...

[5] Fremont was granted considerable control over Adagio. Existing shareholders of Adagio agreed to transfer 6 2/3 % of their shares to Fremont who agreed to exercise its best efforts to raise an indeterminate amount of capital for Adagio by way of an initial public offering of Adagio's shares. Fremont was to obtain additional shares in Adagio upon arranging a public share issue.

[6] Adagio was in constant need of working capital not available from banking institutions. In the years from 1986 to 1992, Fremont became a secondary banker to Adagio offering a revolving line of credit with a total of over $2,000,000 advanced over the years. A second investor, together with the Appellant also advanced funds to Fremont to be loaned to Adagio.

[7] Adagio made a public share offering in April 1992. A bank loan of approximately $2,200,000 was paid off. Approximately $400,000 was paid to the Appellant and Fremont and $168,650 was left owing to Fremont.[3]

[8] In June 1992, Fremont loaned Adagio $160,000 for the purpose of paying payroll tax liability owing by Adagio to Revenue Canada. No promissory note was signed. A further $2,000 was loaned for miscellaneous requirements of Adagio. Fremont advanced a further sum of $13,592 in 1993 to pay miscellaneous expenses of Adagio. The parties acknowledge that a further amount of $5,000 paid to settle a lawsuit is not part of the Appellant's claim. In 1993, the Appellant claimed as an expense $81,600 paid to Westpac Banking Corporation as settlement for personal guarantees with respect to a loan incurred by Adagio to pay for a leasehold interest to set up a retail store in Paris, France. There were no documents presented between the Appellant and Adagio such as an indemnity agreement or promissory note. The Appellant stated that some supporting documentation was destroyed by Adagio's trustee in bankruptcy and by Revenue Canada. He feels Revenue Canada is responsible for the missing documentation because the auditor had access to many boxes of documents held by the trustee and did not record their existence.

[9] The Appellant reported no gross business income for the years 1985 to 1993 other than management fees received from Transfotech Limited,[4] a company owned and controlled by the Appellant. In 1993, the Appellant reported gross business income of nil.

[10] In his T1 returns for the 1990 to 1993 taxation years, the Appellant reported no interest from any loans made to Adagio, Fremont or any other company, he reported no taxable dividends from any companies to which he loaned money and reported all his dispositions of shares, including dispositions of shares of Adagio on capital account. The Appellant made no attempt at collecting the amounts owed by Fremont and never made request for either repayment of principal or accrued interest. In fact, the Appellant does not claim a bad debt for the unpaid accrued interest, only the principal.

[11] Fremont continues to carry on business. In its 1994 taxation year, it purchased and sold securities and actually showed a profit of over $11,000.

[12] The Respondent submits that the bad debt expenses claimed are not allowable on the basis that they were not incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the Act and the Appellant's ordinary business did not include the lending of money. In the alternative, he submits that if the Appellant's ordinary business did include the lending of money, none of the loans were made in the ordinary course of that business, that none of the loans were included in computing the Appellant's income for any of the 1992 or 1993 taxation years or any preceding taxation year and, therefore, the Appellant is not entitled to any deductions pursuant to subparagraph 20(1)(p)(i) of the Act.

[13] The issues that the Respondent raise are:

A. Whether the loans to Adagio in the 1992 taxation year were made in the ordinary course of the Appellant's business for the purpose of earning interest income or whether they were made to provide Adagio with working capital and to protect the Appellant's investment in Adagio.

B. Whether the loans to Fremont which give rise to the bad debts claimed in 1992 and 1993 were made in the ordinary course of the Appellant's business for the purpose of earning interest income or whether they were shareholder loans to provide Fremont with working capital.

C. Whether the loans to Fremont which give rise to the bad debts claimed in 1992 and 1993 were established by the Appellant to have become bad in the year.

D. Whether the bad debts claimed in 1993 in the amount of $81,600 and $5,000 were debts arising from loans or whether they were simply debts of the Appellant paid by the Appellant in 1993.

[14] In his Notice of Appeal, the Appellant states the issue as: "is the amount claimed deductible pursuant to paragraph 20(1)(p) of the Act or any other provision of the Act".

Analysis

[15] The relevant parts of paragraph 20(1)(p) of the Act read as follows:

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 aggregate of

...

(ii) all amounts each of which is that part of the amortized cost to the taxpayer at the end of the year of a loan or lending asset made or acquired in the ordinary course of business by a taxpayer who was an insurer or whose ordinary business included the lending of money established by him to have become uncollectible in the year;

While paragraph 18(1)(a) permits the deduction of expenses incurred for the purpose of earning income, there is a presumption that losses arising from loans or payments on guarantees are on account of capital and disallowed under paragraph 18(1)(b).[5]

[16] For the Appellant to be able to obtain the deduction provided in paragraph 20(1)(p), he must establish:

a) the debts to be deducted arise from loans;

b) the ordinary business of the taxpayer must include the lending of money;

c) the loans giving rise to the bad debts must have been made in the ordinary course of the taxpayer's business of lending money; and

d) the loans giving rise to the bad debts must have become uncollectible in the year.

[17] The documentation provided supports that the lending activities were transacted by Fremont. The Appellant and an investor funded Fremont. There is abundant evidence of cheques drawn on the account of the Appellant and his investor payable to Fremont. Fremont in turn advanced the funds to Adagio. Adagio granted promissory notes, a security debenture and shares[6] to Fremont. Fremont's financial statements reflect Adagio's transactions as its own. There was no evidence of privity of contract between Adagio and the Appellant. Only Fremont and not the Appellant, could enforce the loans. There was no documentation to support a suggestion that the Appellant was in the money lending business vis-à-vis Fremont. The evidence leads to the conclusion that the advances from the Appellant to Fremont were of a capital nature (shareholder loans). There were no promissory notes, security, interest was not called for nor was any paid, no repayments by Fremont were made for the principal advanced to it by the Appellant. There is evidence in the 1992 financial statement that Fremont repaid the investor the money he advanced to it.

[18] The taxpayer presented his own appeal and called no witnesses. No one testified on behalf of the Respondent. The Appellant advanced the position that he was personally in the lending business. Unfortunately, he treated the actions of Fremont as his own in circumstances when it was to his benefit. In the reverse, he appeared to scrupulously treat Fremont as a separate and distinct taxpayer when it was financially beneficial for him to do so. There was no evidence that Fremont acted as a trustee for the Appellant. Indeed, the opposite was demonstrated. The Appellant had incorporated several corporations and appears to have used them extensively in the arrangement of his financial dealings. He was the controlling director, if not the sole officer and director of Transfotech Limited. This corporation carried on a consulting business with the Appellant as its only consultant. The bulk of the Appellant's income was from Transfotech. During the relevant years, most of Transfotech's consulting revenue came from Adagio. The Appellant's T1 returns did not reflect that he was in the money lending business or any business at all. Transfotech and Fremont are separate corporate entities and were so regarded by the Appellant. No doubt Fremont was in the lending business vis-à-vis Adagio, but Fremont's business is not the Appellant's business. In Loman Warehousing Ltd. v. R.,[7] Bowman J. of this Court found that the taxpayer must actually be in the business of lending money to satisfy the requirements of paragraph 20(1)(p). I find as a fact that the Appellant was not in the business of lending money.

[19] The consulting business was carried on by Transfotech. The Appellant did not, during the relevant years, earn consulting fees or earn interest from a lending business. The bad debt expense claimed in 1992 of $330,650 included the $162,000. The reward Fremont was to receive in consideration for the earlier advances, was interest, financing fees and primarily shares in Adagio. Having done it before, the Appellant had expertise in guiding corporations through the maze of hurdles leading to a public share offering. When he was finally successful in making Adagio a public company in April 1992, he and his corporations held 20.9% of Adagio's shares valued at $1.7 million. This was obviously the primary reward for the advances made by Fremont to Adagio. In June 1992, when the Appellant advanced $160,000 to Adagio, it was used to pay Revenue Canada's payroll remittances required to keep Adagio operating. No promissory note or other security was given. There was no binding agreement as to terms. This is not the action of a money lender. It is more consistent with the Respondent's position that the money was advanced in a desperation attempt to preserve the shareholdings of the Appellant and his corporations.

[20] With respect to the fourth criteria, no doubt the amount was uncollectible.

[21] With respect to the $330,650 advanced by Fremont to Adagio and claimed by the Appellant as a bad debt expense in 1992, I conclude that this amount was not loaned by the Appellant to Adagio in the ordinary course of his business for the purpose of earning interest income.

[22] Could it be said that the Appellant loaned the money to earn income from or protect the goodwill of any business he was in? From the T1 returns of the Appellant, it is questionable that he was in business at all, let alone having money lending as an integral part of his business.

[23] The words of LeDain J. in Charles Chaffey v. M.N.R.[8] apply equally to the present facts. At page 6179 he stated:

... shareholder's advances do not constitute the business of lending money; they are simply a particular form by which capital is put into a company. The loans made by the partnership did not have as their principal object the accommodation of persons in return for income in the form of interest; they were merely a device for the financing of projects through which profit was to be made by other means.

To be successful, the Appellant had to prove that his ordinary business included the lending of money. He has not satisfied that onus. What exactly did he do? He made numerous shareholder advances to Fremont. He claims $168,650 as bad debt in 1992 as a result of Adagio's bankruptcy. How can it be said that the Appellant was in the lending business vis-à-vis Fremont? Adagio ceased operations in 1992, not Fremont. Fremont continued to carry on business making a small profit in 1994 without ever, in the relevant years, paying back the Appellant any principal or interest. There was no documentary evidence between the Appellant and Fremont establishing a debtor/creditor relationship. The inevitable conclusion is that the $168,650 is not a loss on income account.

[24] In June 1992, the Appellant advanced $162,000 to Adagio, $160,000 of which was used to pay Revenue Canada. Without the employee deduction payments, Revenue Canada would have shut down Adagio. I do not consider this advance to be a loan made in the ordinary course of the Appellant's business.[9] There was no promissory note or security. There was simply a covering letter setting out his terms which letter was unsigned and not acknowledged. I find that the purpose of this advance was primarily to preserve the Appellant's and his corporations shareholding interest in Adagio. Adagio was petitioned into bankruptcy a week later. Obviously, it was not a borrower to whom the Appellant would have loaned $162,000 at a modest interest rate. His motivation was not earning interest from a lending business.

[25] The third substantial bad loan expense claimed by the Appellant was the $81,600 he paid in 1993 to settle a claim by Westpac Banking Corporation with respect to money borrowed by the Appellant or by Adagio for the lease of retail space in Paris. The Appellant was responsible for the loan as a guarantor. There was no documentation between him and Adagio. Again, this was not a loan in the nature of being in the lending business as envisaged by paragraph 20(1)(p).

[26] My conclusion is supported by the analysis of Bowman J. in Loman Warehousing Ltd. (supra). At page 2059 he stated:

The expression "whose ordinary business includes the lending of money" requires a determination of just what the taxpayer's "ordinary business" is. The ordinary business of the appellant is warehousing, not lending money to other companies in the group. Some effect must be given to the word "ordinary". It implies that the business of lending money be one of the ways in which the company as an ordinary part of its business operations earns its income. It also implies that the lending of money be identifiable as a business. I agree that the participation in the MNA, in which a company in the group, depending upon whether on a given day it is in a credit or debit position, may loan or borrow funds is an incident of its business. The appellant's argument equates the words "whose ordinary business includes the lending of money" to the words "in whose business the lending of money is an incident". I do not think the two expressions cover the same territory.

This conclusion is reinforced by the concluding words of clause 20(1)(p)(ii)(A):

... made or acquired in the ordinary course of the taxpayer's business of ... the lending of money.

[27] Clearly, from the evidence, the Appellant was not in the business of lending money. The advances may have been "in the ordinary course of business" in the sense that supporting Fremont and keeping Adagio afloat was an incident of the Appellant's business, but it cannot be said that it was made in the ordinary course of a lending business.

[28] The appeals are dismissed, with costs.

Signed at Ottawa, Canada, this 28th day of March, 2000.

"C.H. McArthur"

J.T.C.C.

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