Date: 20011031
Docket: A-494-98
Neutral citation: 2001 FCA 332
CORAM: ROTHSTEIN J.A.
BETWEEN:
MAGICUTS INC.
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
Heard at Toronto, Ontario, on October 31, 2001.
Judgment delivered from the Bench at Toronto, Ontario, on October 31, 2001.
REASONS FOR JUDGMENT OF THE COURT DELIVERED BY: ROTHSTEIN J.A.
Date: 20011031
Docket: A-494-98
Neutral citation: 2001 FCA 332
CORAM: ROTHSTEIN J.A.
BETWEEN:
MAGICUTS INC.
Appellant
- and -
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT OF THE COURT
(Delivered from the Bench at Toronto, Ontario
on Wednesday, October 31, 2001)
[1] There are two issues in this appeal from an August 6, 1998 judgment of the Tax Court of Canada:
(i) Is the Appellant entitled to deduct from its income for the taxation year 1989 the sum of $1,355,026 which it claims is a bad debt from its U.S. subsidiary?
(ii) Is the Appellant liable for withholding tax on the amount of $183,555 for the same taxation year which the Minister says is deemed to have been paid as a dividend to the Appellant's non-resident parent company?
[2] As to the first issue, the learned Tax Court Judge found that the amount in question, $1,355,026, was a trade debt from the Appellant's U.S. subsidiary to the Appellant and that it was not paid. He found that the receivable arose in the Appellant's profit-making operations. He concluded that since the amount was not paid, the Appellant ought to have been permitted a bad debt deduction in the year the debt actually became bad.
[3] However, the Tax Court Judge noted that the Appellant and the U.S. subsidiary actually converted the receivable to equity capital in the U.S. subsidiary. Indeed, by Unanimous Written Consent of the Sole Director of the Appellant dated November 14th , 1986, the sum of U.S. $720,302 (Cdn. $998,411) was converted from "debt to capital" and was to be treated as "paid in surplus". In the February 28, 1989 financial statements of the U.S. subsidiary, the sum of U.S. $283,408 (Cdn. $356,615) is shown as being "forgiven" by the Appellant and is added to contributed surplus. The sum of $998,411 and $356,615 total the amount of $1,355,026 which is at issue. The Tax Court Judge's reasons on this point are succinct:
When a person contributes money or other property to a corporation that person invests in the corporation and the investment is on capital account. Magicuts owned an asset, an account receivable, and contributed this property to USMagicuts as an investment. Magicuts' financial statements describe the contributed surplus as an investment because that is what it was. That the contributed money was derived from Magicuts' own revenue account does not matter. Once the amount was contributed to USMagicuts the nature of the transaction was changed. There was a change of use of the money from a trade debt to capital. USMagicuts was no longer a debtor and Magicuts was no longer a creditor. The amounts were contributed to preserve USMagicuts' long-term viability and the principles set out in Stewart & Morrison, supra, H. Griffiths Company Limited, supra and Morflot, supra apply. Magicuts' loss was on capital account.
We are in agreement with this conclusion of the Tax Court Judge.
[4] The Appellant argued that entries in financial statements are not conclusive of the reality of the circumstances and that the Appellant has not been paid. However, the reality in this case is that the Appellant and its subsidiary entered into transactions by which the debt owing to the Appellant was converted to equity. The debt was discharged by that conversion. Once the conversion took place, there was no outstanding account receivable that could be considered a bad debt.
[5] There was a reason for the conversion of debt to equity. Apparently it was necessary to demonstrate a more solvent balance sheet to franchising authorities in the United States. We accept that financial statements may have different purposes and that financial results for tax purposes may be different from financial results for regulatory or other purposes. However, here, there were actual transactions converting debt to equity. The purpose may have been to satisfy U.S. regulatory authorities, but whatever the purpose, debt was converted to equity and, for tax purposes, there was no outstanding debt that could be considered a bad debt to be written off.
[6] As indicated above, the Tax Court Judge found that the amount in question arose initially as a trade debt and by implication was included in the Appellant's revenue and income for income tax purposes. It is not necessary to interfere with that finding of the Tax Court Judge. However, we would observe that it is not at all clear to us, on the basis of the documents in the record, that the amount in question was, in fact, taken into the Appellant's income for tax purposes. The financial statements are not helpful and it is by no means apparent that the amounts were treated as revenue by the Appellant.
[7] As to the second issue, involving withholding tax, the question is whether the Appellant may treat amounts owing between it and its parent company on a net basis. If so, as at February 28th, 1989, the Appellant was indebted to its parent company in the sum of $48,926 and there was no net amount owing from the non-resident parent, no deemed dividend and no requirement to pay withholding tax. On the other hand, if no set off of accounts can be made, then the Appellant was owed at least $183,555 by its parent and, prima facie, a dividend was deemed and withholding tax was required to be paid.
[8] The Tax Court Judge acknowledged that if the accounts between the Appellant and its parent were netted, the Appellant was indebted to its parent. However, the learned Judge was not satisfied that there was sufficient evidence to establish an intent or agreement to set off. He cited a number of authorities to the effect that for a set off to be established, there must be some evidence of an intent or agreement between the parties to set off.
[9] In the present case, the balance sheet of the Appellant as at February 28th, 1989 shows the set off. No amount is shown as owing from the parent to the Appellant. Rather, the accounts between the parent and the Appellant were netted and the amount of $48,926 is shown as a liability of the Appellant to its parent. On the balance sheet of the parent the equivalent net amount is shown as "due by subsidiary". In prior years there appears never to have been an occasion to net out liabilities between the Appellant and its parent. However, in subsequent years the same netting process was followed as in 1989. In our respectful opinion, the balance sheet entries are some evidence of an intention and agreement between the Appellant and its parent to net their intercorporate liabilities and that is sufficient to validate the Appellant's position on this point. Accordingly, as of February 28th, 1989 there was no net amount owing from the Appellant's non-resident parent to the Appellant, no deemed dividend, and therefore no requirement to pay withholding tax.
[10] We would allow the appeal in respect of the withholding tax issue and remit the matter to the Minister of National Revenue to reassess in accordance with these reasons. In all other respects we would dismiss the appeal. In view of divided success, there will be no order as to costs.
"Marshall Rothstein"
J.A.