Tax Court of Canada Judgments

Date: 20000114

Docket: 96-4709-IT-G

BETWEEN:

WILLIAMS GOLD REFINING CO. OF CANADA LTD.,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Bowie J.T.C.C.

[1] In filing its income tax returns for the 1992 and 1993 taxation years the Appellant (Williams) claimed to be entitled to deductions of $560,529 and $67,619 respectively as bad debts owed to it by a related company, W.G.R. Hollowforms Ltd. (Hollowforms). These amounts remained unpaid at the end of the years in question, and were considered by the Appellant to be uncollectible. It claims to deduct the amounts in computing its income for the 1992 and 1993 taxation years, either as bad debts, pursuant to paragraph 20(1)(p) of the Income Tax Act (the Act), or as outlays or expenses incurred for the purpose of producing income. The Minister of National Revenue (the Minister) allowed the deduction to the extent of $19,815 for 1992, and not at all for 1993. The subject of these appeals, therefore, is the Appellant's claim to deduct the balance of $540,714 for the 1992 taxation year, and the full amount of $67,619 for the 1993 taxation year.

[2] In 1989 Richard Dimberio acquired all the shares of 842700 Ontario Ltd., which carries on business as W.G.R. Holdings (WGR). It, in turn, holds all the shares of Williams. WGR also owns the three buildings, and appurtenant land, on Courtwright Street in Fort Erie, Ontario, where Williams carries on its operations. During the relevant time period, the business of Williams consisted of formulating alloys of gold, silver and platinum for use by dentists and dental laboratories, and precious metal alloys for use in the jewellery business. It also refined scrap precious metals, separating them into their various elements for reuse.

[3] In 1989, Mr. Dimberio hired a Mr. Nicholson as his sales manager. Soon after, he and Mr. Nicholson looked into the possibility of entering the business of producing hollow form jewellery. After some investigation, they obtained the rights to the use of a German process for producing hollow jewellery. This process involved plating wax forms, which were then melted, to leave a hollow jewellery item. Hollowforms was created to carry on this business. Initially, WGR and Mr. Nicholson each owned 50% of the shares.[1] Hollowforms obtained the specialized equipment which the process required by way of lease. A Mr. Fortin was hired as a jewellery designer, and a Mr. Lewicki was hired as a technician to manufacture it. Both of them were employees of Williams, although their work was entirely related to the production of jewellery for Hollowforms. The jewellery manufacturing operations began in September 1990.

[4] According to the evidence of Richard Dimberio, which I have no reason to doubt, his objectives in creating Hollowforms and entering into the jewellery business were two-fold. One was to improve the profitability of Williams by devoting some of the space in the three buildings it occupied, and some of the time of its employees, to the new business. With surplus space, and employees who were not fully occupied, Williams had unnecessarily high overheads. It was Mr. Dimberio's intention to redeploy some of that overhead to the work of the Hollowforms company. His other objective was to create an additional precious metals market for Williams, and it did in fact supply the precious metals and alloys which Hollowforms used in its manufacturing business. Hollowforms itself had no employees, and Mr. Fortin and Mr. Lewicki were added to the payroll of Williams. The existing Williams staff handled all the necessary administrative, financial and secretarial work for Hollowforms.

[5] On March 1, 1991 WGR entered into two leases in respect of the Courtwright street property where Williams carried on its business. The first of these was with Williams, and it covered all the property except the upper floor. The lease was for one year, at a rent of $3,000 per month. The second lease covered the upper floor, which was leased to Hollowforms, also for one year, at a monthly rent of $2,375. During the years under appeal, the Appellant paid the rent under both leases, and then invoiced Hollowforms for the amount of the rent paid on its behalf under its lease.

[6] Williams remitted invoices to Hollowforms for the raw materials at prices equal to the current value of the metal, plus overhead, but with no profit factor. Similarly, the time of employees devoted to the work of Hollowforms was invoiced by Williams to Hollowforms, at cost, including the cost of related employee benefits. To the extent that Hollowforms required raw materials and supplies that were not produced by Williams, these were purchased for it by Williams, paid for by Williams, and invoiced to Hollowforms at cost. The proportion of employees' time invoiced by Williams to Hollowforms appears to have been arrived at by an estimate made by Mr. Dimberio, or perhaps by his son David Dimberio, who was the vice-president and general manager of Williams.

[7] The business of Hollowforms did not go well. Sales figures did not meet expectations, and significant losses resulted. In September, 1991, WGR purchased Mr. Nicholson's 50% shareholding, thus becoming the sole owner of Hollowforms. By September, 1992 it was apparent that the business of Hollowforms was a failure. Mr. Fortin's employment with the Appellant was terminated in October 1992; Mr. Nicholson was let go in December. Mr. Lewicki remained on the Appellant's payroll until August 1993, only because he was Mr. Dimberio's son-in-law.

[8] As a result of its poor sales performance, by the end of 1991 Hollowforms owed Williams $407,000. By August 31, 1992, which was the 1992 year-end, this debt had risen to $626,686. During its 1993 fiscal year, Williams forgave debts of Hollowforms totalling $694,305. Nevertheless, at August 31, 1993, there remained $68,012 payable by Hollowforms to Williams. Hollowforms was clearly insolvent at that time, having assets substantially less than its liabilities. In 1994, Hollowforms underwent a change of name and became known as Canada Ventures Dental Supplies Limited. It took up a new line of business, selling dental products purchased from a U.S. manufacturer. It continued to incur operating losses in this new business each year until 1997, when it became dormant.

[9] The amounts which comprise the indebtedness on the books between Hollowforms and Williams, and which are claimed by Williams as a bad debt expense, may be divided into three categories. The first relates to the supply by Williams to Hollowforms of materials to be formed into jewellery. This amount was $19,815, and was allowed by the Minister in assessing the Appellant, as it was a debt which came into existence as the result of sales of product by Williams to Hollowforms. The second consists of amounts which were billed by Williams to Hollowforms as Hollowforms' share of the salaries and benefits of employees, and as its share of other expenses which were incurred by the Appellant on behalf of both companies. The third is comprised of the rent payable by Hollowforms to WGR under its lease, and other amounts for materials, supplies and services obtained by the Appellant for Hollowforms, all of which were initially paid by the Appellant, and then invoiced to Hollowforms. The second and third categories are the subject matter of these appeals. Particulars of the items making up the second and third categories are set out in an appendix to the Reply filed by the Respondent. There is no dispute as to the accuracy of that document, and it is included as Appendix "A" to these Reasons for Judgment.

[10] The Appellant claims to be entitled to deduct the amounts in issue on either of two independent bases. The first is that they are bad debts whose deduction from income is specifically permitted by paragraph 20(1)(p) of the Act. The second is that they are outlays or expenses incurred by the Appellant for the purpose of gaining or producing income from its business, and are therefore proper deductions in the computation of profit from that business.

[11] The relevant parts of the provisions of the Act invoked are:

9(1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

...

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

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

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

...

[12] I shall deal first with the claim that these amounts fall within paragraph 20(1)(p) of the Act. The evidence establishes to my satisfaction that the amounts here in question had become bad debts by the time they were so treated by the Appellant. The more difficult question is whether they had been included by the taxpayer in the computation of its income for the year, or for a preceding year. The Respondent takes the position that they had not, and that this is definitively established by the undisputed fact that the Appellant recorded the amounts in question in its accounts as reductions to its expenses, and not as sales. Counsel for the Appellant responds that the amounts could as well have been treated as sales for accounting purposes, and that, in any event, the effect on the computation of profit from the business would be exactly the same whether they were treated as revenues, or as reductions to expenses.

[13] The question whether an amount has been included in computing a taxpayer's income is not resolved simply by whether it has been credited in the books to a revenue account. What I must look at is the true nature of the transactions giving rise to the amounts, and not simply the treatment given to them by the bookkeeper: see L. Berman & Co. Ltd. v. M.N.R.,[2] and Associated Investors of Canada Ltd. v. M.N.R.[3]The evidence before me establishes that the employees were employees of the Appellant company. They had no contractual relationship with Hollowforms. I am driven to the conclusion that the Appellant was their employer, and that it supplied their labour to Hollowforms in return for the debt represented by the account receivable. This is true of the shared employees, and it is equally true of Mr. Lewicki and Mr. Fortin, even though all the work that they did was done for the benefit of Hollowforms. The amounts due to the Appellant for the services of these employees is no less revenue because it was recorded, in my view inappropriately, as a reduction of the Appellant's wage expense for the year, rather than as revenue from the supply of services.

[14] The evidence as to the other items in the second category was sparse. However, I see no reason to treat them differently than the wages and related costs. I did not understand counsel for the Respondent to be asserting that there was any reason to do so. The amounts falling into category two, therefore, should properly be considered charges for supplies and services furnished by the Appellant to Hollowforms, and are to be treated as being on revenue account. The fact that the sales were made at cost does not affect the appropriate treatment of them: see Greenfield Industries Ltd. v. M.N.R.[4]The amounts in the second category therefore qualify as bad debts under paragraph 20(1)(p), and are deductible in the years in which they were written off.

[15] The third category consists of amounts which were owed to the Appellant by Hollowforms as the result of transactions between Hollowforms and third parties, for which payment was made to those third parties by the Appellant on behalf of Hollowforms. These amounts are set out in the lower half of Appendix "A". It is not at all clear from the evidence whether these liabilities of Hollowforms arose from contracts entered into on its behalf by the Appellant as its agent, or by the employees of the Appellant while they were serving Hollowforms. I doubt that any of the people involved ever gave a thought to that question. In either event, however, the debt to the third party supplier is the debt of Hollowforms, and the discharge of those debts by the Appellant is properly characterized as a loan from the Appellant to Hollowforms, and not as a supply of goods or services. The amounts making up this category cannot therefore be charaterized as revenues, and have not been included in the computation of the Appellant's income. They do not qualify for the deduction under paragraph 20(1)(p).

[16] I turn now to the Appellant's subsidiary argument, which is that the amounts in question may be deducted by the Appellant in the years in which it recognized them as having become uncollectible, pursuant to the ordinary principles governing the computation of profit. Those principles were recently reconsidered by the Supreme Court of Canada in Canderel Limited v. Canada.[5] Iacobucci J. summarized them at pages 174-5:

(1) The determination of profit is a question of law.

(2) The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income: M.N.R. v. Irwin, supra, Associated Investors, supra.

(3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year.

(4) In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with

(a) the provisions of the Income Tax Act;

(b) established case law principles or "rules of law"; and

(c) well-accepted business principles.

(5) Well-accepted business principles, which include but are not limited to the formal codification found in GAAP, are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer's financial situation.

(6) On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.

[17] It is well established that a taxpayer may, in the computation of profit, deduct amounts that it has paid gratuitously to, or for the benefit of, another, where the payment has been made for the purpose of increasing the profitability of the taxpayer's own business, by creating or preserving a market for its product, for example. This may be seen in such cases as The Queen v. F. H. Jones Tobacco Sales Co. Ltd.,[6] where the taxpayer, Jones, guaranteed certain loans for a customer in return for the customer's undertaking to continue buying its raw materials from Jones in the future. The customer became insolvent, and Jones was required to honour the guarantees. Noël A.C.J. held that the amount that Jones was required to pay was not deductible under the predecessor of paragraph 20(1)(p) of the Act, but that it was nevertheless deductible as an amount expended by Jones for the purpose of gaining or producing income from its own business. The Queen v. Lavigueur[7] and Paco Corporation v. The Queen[8] are other examples of the application of this principal.

[18] Counsel for the Respondent argued that the deductions in question should not be allowed because they were capital in nature, representing the Appellant's investment in the new business. As capital outlays, their deduction would be precluded by paragraph 18(1)(b) of the Act. In Stewart & Morrison Ltd. v. M.N.R.,[9] the Supreme Court of Canada found that an amount advanced by the taxpayer to its subsidiary as working capital, and later written off as a bad debt, could not be deducted as it was a capital outlay, the purpose of which was to finance the start-up of the subsidiary. A similar result was reached by Strayer J. in Morflot Freightliners Limited v. The Queen.[10] In both these cases the result was driven by the factual finding that the payments were made for the purpose of bringing a capital asset into existence for the enduring benefit of the taxpayer, and not to produce income from the taxpayer's existing business.

[19] Hollowforms was not a subsidiary of the Appellant, but during the years under appeal they were both wholly owned by Mr. Dimberio's holding company, WGR. The question, then, is whether the purpose of the loans was, as in Stewart & Morrison and Morflot Freightliners, to capitalize a new business venture through loans from the existing subsidiary to the new one. If it was, then the deduction is precluded by paragraph 18(1)(b) of the Act.

[20] Mr. Dimberio's evidence was to the effect that his purpose in creating Hollowforms was to improve the profitability of the Appellant, both by providing an expanded market for its products, and by reducing its overhead costs. He was not cross-examined as to this aspect of his evidence, and I accept it. The conclusion that the loans in question were not simply an alternate way of capitalizing the Hollowforms business is reinforced by an examination of the balance sheets of Hollowforms throughout the period from its year-end on August 31, 1990 to August 31, 1993. During all of that period it had paid up capital of $100,200.00, consisting of two preferred shares issued for $50,000.00 each, and 200 common shares issued for $1.00 each. There were also loans from shareholders in excess of $80,000.00 on the balance sheet throughout the period.

[21] I conclude that deduction of the amounts making up the third category is consistent with both established case law principles and well-accepted business principles, and that it is not inconsistent with paragraph 18(1)(b), or any other provision of the Act. The appeals are therefore allowed, with costs.

Signed at Ottawa, Canada, this 14th day of January, 2000.

"E.A. Bowie"

J.T.C.C.

Appendix "A"

Williams Gold Refining Co. of Canada Limited v. Her Majesty the Queen

The accumulated intercompany Liability for years ended 8/31/90, 91, 92, 93 is as follows:

1.) Expenses incurred by the Appellant and rebilled to Hollowforms:

Wages and Benefits	$234,708.08
Building and Equipment Repairs	10,425.85
Small Tools	17,180.31
Utilities and Telephone	22,866.12
Insurance	6,425.40
Convention Booths and costs	1,913.27
Travel	1,771.06
Office Equipment Rent	1,883.44
Total	$297,173.53

2.) Costs paid by the Appellant on behalf of Hollowforms:

Raw Materials	$208,016.66
Supplies	53,331.67
Advertising and Promotion	14,376.23
Supplier Carrying Costs	1,244.37
Sales Commissions	373.28
Association/Professional Fees	4,565.33
Third Party Rent	2,300.00
Provincial Sales and Federal Excise Tax	6,700.81
Capital Assets	22,666.66
Cash Repayments	(2,415.50)
Total:	$311,159.51

Total Amounts Included in Bad Debt Expense $608,333.04

---