Date: 20011102
Docket: 1999-1928-IT-G
BETWEEN:
LARRY W. RICH,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor Judgment
Miller, J.T.C.C.
[1] Mr. Larry Rich claimed a business investment loss of $125,000 in his 1995 income tax return. The loss arose, according to Mr. Rich, from an unpaid debt owed to him from D.S.M. Foods Inc. ("DSM"), a company operated by Mr. Rich's son Michael. This matter turns entirely on its facts. If Mr. Rich establishes:
(1) There was a debt of $125,000 owed to him by DSM;
(2) The debt was incurred for the purpose of gaining or producing income in accordance with subparagraph 40(2)(g)(ii) of the Income Tax Act ("Act");
(3) DSM was an eligible small business corporation in 1995 (this fact was agreed upon by the parties); and
(4) The debt became a bad debt in 1995;
then Mr. Rich is entitled to claim an allowable business investment loss of $93,750 in his 1995 tax return. The Crown contends:
(1) If there was a debt owing to Mr. Rich, the debt was not incurred for the purpose of gaining or producing income from a business or property;
(2) If there was a debt incurred for the purpose of gaining or producing income from a business or property then it had not become a bad debt in 1995; and
(3) In any event the Appellant has not established there was a debt of $125,000 owing to him from DSM in 1995.
[2] The Appellant's son Michael Rich ("Michael") and two associates commenced the operation of DSM in 1987. In 1989 Michael's two associates left the business and the Appellant and the Appellant's father-in-law's company acquired a 25 percent and 50 percent interest respectively in DSM. Michael explained that his father and his grandfather's company got shares at this time as they had previously lent some money to DSM. It was agreed by the Respondent that the Appellant has been a 25 percent shareholder of DSM from October 31, 1989 to the present. Michael retained a 25 percent interest.
[3] DSM was in the food distribution business. As president of DSM Michael was responsible for purchasing, distribution, sales, accounts payable and accounts receivable. Three of DSM's major customers were Loblaws, Mr. Sub and Costco, the latter accounting for two-thirds of DSM's business in 1995. The Costco business was retained at some considerable cost to DSM due to Costco's demands for a low sale price plus their ongoing requirements for demonstrations. DSM's major supplier was Select Food Products Ltd. ("Select Foods"). DSM owed Select Foods approximately $184,000 in 1995 and approximately $241,000 in 1996.
[4] The financial statements of DSM show loans outstanding to the Appellant and Harry L. Barkin Investments Limited for the years 1988 to 1995 as follows:
|
Year |
Appellant |
Harry L. Barkin Investments Limited |
|
1988 |
$56,208 |
$0 |
|
1989 |
$85,515 |
$0 |
|
1990 |
$125,215 |
$52,500 |
|
1991 |
$120,065 |
$77,000 |
|
1992 |
$127,565 |
$87,000 |
|
1993 |
$128,765 |
$87,000 |
|
1994 |
$125,515 |
$87,000 |
|
1995 |
$125,515 |
$87,000 |
[5] The financial statements were prepared by the Appellant's C.A. firm, though no charge was rendered to DSM for this work.
[6] Before going over the records introduced as evidence to determine the amount of the loan outstanding at the end of 1995, I will address the evidence regarding the circumstances of the advances made by the Appellant to DSM. Michael testified that in the early stages of the business, being the late 80's and early 90's, the company was operating at a loss, so he approached his father about financial help to "help turn things around". He further indicated that the money was to help develop new lines of products though there was no evidence of such new lines. The Appellant described his reason for investing in DSM was to provide working capital so the company would be on solid financial footing. He also indicated that he was an investor and he expected interest, and as a shareholder, (after October 31, 1989), he would receive dividends. The Appellant acknowledged that he was not in the money lending business, though he did invest in the stock market and another private company, but his testimony was not convincing in regards to the latter.
[7] The following is a chart illustrating the financial position of DSM for the years 1989 to 1995:
|
1989 |
1990 |
1991 |
1992 |
1993 |
1994 |
1995 |
|
|
Gross sales |
324,983 |
373,090 |
384,916 |
410,897 |
648,084 |
937,455 |
732,917 |
|
Cost of goods sold |
239,000 |
282,607 |
276,492 |
300,601 |
497,283 |
634,810 |
533,633 |
|
Expenses |
155,867 |
128,338 |
112,591 |
108,645 |
154,764 |
269,431 |
264,881 |
|
Profit (loss) |
(69,884) |
(37,855) |
(4,167) |
1,651 |
(3,963) |
33,214 |
(65,627) |
|
Current assets |
52,646 |
72,955 |
67,585 |
112,062 |
110,622 |
155,012 |
132,643 |
|
Current liabilities |
175,970 |
170,077 |
153,006 |
204,898 |
231,145 |
274,477 |
198,905 |
|
Deficit |
(187,324) |
(256,236) |
(261,403) |
(259,752) |
(292,207) |
(258,793) |
(324,420) |
[8] Michael Rich testified that the loans from his father to DSM were generally in smaller amounts, based on Michael's description of DSM's needs. As Michael put it, he would talk about the direction of the business and the Appellant would write a cheque. According to Michael no terms of repayment were discussed but there was an understanding that the Appellant would be repaid. The Appellant indicated that in 1990, 1991 and 1992 there was some considerable activity in his shareholder loan account. I would describe the arrangement as akin to an operating line provided by the Appellant to DSM. There would be both payments to the Appellant from DSM and repayments from DSM to the Appellant in small amounts.
[9] The Appellant pointed to the notes to the financial statements as evidence of the terms of the loan. The notes indicated in all years the loans were on demand but interest varied from 10% in one year, to prime in another and prime plus 1% in another. As well, in 1994 the Appellant and L. Barkin Investments Limited insisted upon and received a general security agreement from DSM securing their position as creditors of DSM. Both the General Security Agreement itself and the report letter from the law firm of Torkin Maines Cohen & Arbus were produced as evidence. Section 16 of the General Security Agreement identified the debt to the Appellant as being $130,000, though the General Security Agreement was clearly intended to cover future debts as well. It also gave a priority to Harry L. Barkin Investments Limited over the Appellant.
[10] Turning back now to the determination of the amount of debt, the accounting records provided by the Appellant did not provide a complete picture of how the loan amount ended up as $125,515 in 1995. The Appellant relied on the DSM financial statements, which his firm prepared, although initially those 1995 statements indicated in error that the loan had been written off. The Appellant subsequently corrected this. The Appellant also relied on a computer generated general ledger for the periods November 1, 1989 to May 31, 1990, November 1, 1990 to October 31, 1991 and November 1, 1991 to August 18, 1992. The first period showed an opening balance of the Appellant's loan account of $112,015. It goes on to indicate repayments of $86,500 in nine different repayments. It then indicates a further investment by Mr. Rich of $82,500. This investment is not entirely clear as it appears to be a transfer from an erroneous posting to the sales account. In the next period from November, 1990 to October, 1991, the ledger indicates additions to the loan account of $12,000 but does not appear to indicate any repayments. At the end of that period the balance in the loan account is shown as $137,215, which is picked up as the opening balance in the third period (November, 1991 to August 18, 1992). In that third period there appears to be an adjusting entry that takes the balance of $137,215 to $120,065. The period then goes on to indicate certain additions and repayments leaving a balance at year end of $128,765. There are no further records to indicate how the balance of $128,765 in 1993 got to $125,515 in 1994 where it remained through to the end of 1995. From this review it appears that at some point in the 1989-90 fiscal year the loan may have been reduced to as little as approximately $26,000. The bulk therefore of the debt would have arisen subsequent to that time. This would have been in the early 90's when the company appeared to be in a break-even position.
[11] In support of the 1991 loan amounts the Appellant also provided deposit slips hand-written by Donna Pavlovich, the Appellant's daughter-in-law, along with the Royal Bank deposit slips showing a total amount, without identifying the specific source of the deposit. No cancelled cheques were provided by the Appellant. He stated that in a house move in September, 1997 all such cancelled cheques must have been discarded, presumably by his wife. The Appellant was dealing with the Appeals Department of Revenue Canada at that point in time in connection with his allowable business investment loss.
[12] The questionable areas in an attempted reconstruction of the loan are firstly, the $82,500 which the Appellant claimed was recorded by the company in error as sales income. An adjusting entry was required to transfer that amount from sales revenue to the Appellant's shareholder's loan account. Secondly, an adjusting entry to take the balance from $137,000 to $125,000 had little support. The Appellant offered an explanation and provided a working paper to show how the account went from $128,000 to $120,000 but no acceptable explanation was given for the difference.
[13] DSM appears to have operated on a rather tight financial basis throughout the early 90's, with a reliance on the family loans. From 1991 to 1993 the company appeared to be in a break-even position although little in the way of wages appear to have been paid to the Rich family. Through 1993 to 1995 sales increased considerably, but this appears to have been due to the Costco account, which did not result in profits, just increased cash flow. This problem appears to have become acute in 1995. Normal margins for the business were 30 to 38 percent, according to Michael, but Costco was down to 20 percent. By the end of 1995 DSM was operating on a negative cash flow. It also owed its major supplier, Select Foods, approximately $184,000, and it was critical that some arrangement had to be made to ensure a continued supply. Then Costco pulled out. Although it appears that DSM was losing money with Costco, according to Michael, that contract did provide two-thirds of their cash flow. The company ended up losing approximately $65,000 in 1995.
[14] On September 21, 1995 the Appellant wrote the following letter to his son at DSM.
Larry W. Rich, FCA
September 21, 1995
DSM Foods Inc.
910 Rowntree Dairy Road
Unit 31
Woodbridge, Ontario
L4L 5W6
Attention: Michael B. Rich
SUBJECT: LOAN PAYABLE - LARRY W. RICH
It appears that your loan payable to me is in default, as you have not been making payments in accordance with the terms previously negotiated, and as per the registered general security agreement covering all the assets of the company.
Please advise me when these arrears will be made up.
Yours very truly,
"signature"
Larry W. Rich, FCA
LWR/dt
[15] The Appellant claims that he wrote this letter because he had not received any repayment for some period of time, and he wanted to "bring Michael to the table". Michael's response was equally brief:
D S M
Foods Inc.
______________________________________________
The DAVID
Gourmet & MICHAEL's
Club (U.S.A.)
(Canada)
September 30, 1995
Larry W. Rich, FCA
Rich Rotstein Chartered Accountants
50 Richmond Street East
3rd Floor
Toronto, Ontario
M5C 1N7
Attention: Larry W. Rich
Dear Larry,
I am in receipt of your letter dated September 21, 1995. Unfortunately the company is having financial difficulties and cannot pay your arrears on the loan.
Due to continuing loss of business at DSM Foods Inc., I doubt if "DSM" will ever been in a position to repay any or all of the outstanding debt owed to you. Profits are just not there.
Yours very truly,
"signature"
DSM FOODS INC.
per: Michael B. Rich
[16] There was no further written communication between them on this subject.
[17] The Appellant testified he assessed his investment as at December 31, 1995 and reached, in his professional opinion, a conclusion that he was not going to be repaid the debt. He based this on his son's letter, the cancellation of the Costco account and the debt due to Select Foods. Further, he believed that had he taken any collection steps it would have forced DSM into bankruptcy with no chance of survival and ever seeing his money back.
[18] It is difficult to accurately assess the company's fortunes in 1996 and following as no reliable statements or accounting records were provided. Michael Rich provided a copy of property tax assessment indicating arrears owing in 1996. He also produced a letter from the Royal Bank shutting down the relationship with DSM, though it was established that the Royal Bank was in fact paid everything it was owed. He also produced a letter from Select Foods on September 19, 1996 setting out an arrangement for monthly payments. While the net amount owed to Select Foods increased from $184,000 to approximately $240,000 in 1996, the statement from Select Foods dated November 19, 1996 showed that no amounts were still owing from 1995; that is, all $184,000 had been paid throughout 1996. While it is clear finances were tight, the company continued to operate and does so today. The representative from Canada Customs and Revenue Agency who testified indicated that DSM claimed Goods and Services Tax input tax credits and was receiving $1,000 to $1,500 in monthly refunds.
[19] What troubles me about the Appellant's testimony is the contradiction I find with a reputable accountant such as the Appellant, a Fellow of the Institution of Chartered Accountants, accepting what I would describe as some rather sloppy accounting and bookkeeping in regards to DSM. He acknowledged that he was frustrated with the level of expertise with the bookkeeping, yet his firm does not appear to have recommended any improved systems. Further, he appears to rely on DSM's questionable practices for support of the thousands of dollars of loans he made over the years, rather than keeping any personal record, not even the cancelled cheques. This may be a case of being blinded by familial ties, but it leaves me with some question as to the reliability of the numbers. This uneasy feeling was not pacified by the presentation of computer generated financial statements for the years 1996 to 1999. The Appellant presented these statements to prove that his loan with DSM was still showing up as a liability of DSM. He denied however the accuracy of every single number on those statements other than the ones supporting his and his father-in-law's company's loans. This is not perhaps surprising given that the statements showed that hundreds of thousands of dollars had been paid out to Michael. Mr. Rich's explanation was unsatisfactory. I attach no weight to the veracity of these statements, simply raising them to support my concern with the Appellant's apparent lack of scrutiny when dealing with DSM.
[20] What can be gleaned from the relevant sections of the Act, being paragraphs 39(1)(c), 50(1)(a) and subparagraph 40(2)(g)(ii) is that four elements are required in determining the Appellant's claim for an allowable business investment loss. As the Appellant and Respondent agreed that DSM was a Canadian controlled private corporation qualifying as a small business corporation as at December 31, 1995, there are just the following three elements to review in the determination of the claim for an allowable business investment loss:
(1) Was there a debt of $125,000 owing by DSM by the Appellant at December 31, 1995?
(2) Had the debt become a bad debt by December 31, 1995?
(3) Was the debt incurred for the purpose of gaining or producing income?
[21] Existence of Debt
The Appellant relied on the evidence of Michael Rich, Donna Pavlovich and himself in proving the existence of the debt. He further pointed to the financial statements from 1988 to 1995, excerpts from computer printed general ledgers, handwritten deposit slips, bank deposit slips, the 1994 General Security Agreement and the accompanying reporting letter of the law firm. The Crown contended that such evidence was not sufficient to establish a debt of $125,000 at December 31, 1995. He suggested, relying on the case of Taylor v. Her Majesty The Queen [1996] 3 C.T.C. 2942 (T.C.C.) that when a situation is tinged with non-arms length circumstances, parties must be doubly vigilant in recording events to ensure the record can support claims under the Act. He maintained that the lack of any personal records kept by the Appellant to substantiate the thousands of dollars lent to his son's business, combined with the reliance on his daughter-in-law's handwritten deposit slips falls well short of the required corroborating source documents. The accounting entries showing adjustments to the loan account of $82,500 moved from sales and to move the loan account balance from $137,000 to $120,000 further cast doubt on any accurate determination of a debt.
[22] I have no doubt the Appellant advanced monies to DSM on a frequent basis from 1989 to 1992. I also find that such advances were loans, not gifts. I find that DSM repaid monies to the Appellant on an irregular basis until some time in 1993 or 1994. What I cannot find on a definitive basis is the actual amount of the loan outstanding at December 31, 1995. I do believe the Appellant that some amount was still owing to him from DSM at that time, but he has not convinced me what that amount truly is. I am not prepared to rely solely on the financial statements, as I see too many adjustments in the records presented in support of those statements. Even the statements themselves contained a basic error in indicating the preparer of the statements was related to a shareholder rather than revealing that the preparer (the Appellant) was in fact a shareholder himself. Michael Rich clearly could not indicate with any certainty the amount of the loan. The Appellant suggested he could trace the balance over the years but did not have the material with him to do so. While I am not prepared to impose a standard of double vigilance (as I am not certain exactly what that entails) on an Appellant such as Mr. Larry Rich, who invests in his son's business, I do require evidence of solid, competent, professional accounting records in support of the financial statements before I accept them, as Judge Bowman did in Gamus v. Her Majesty The Queen, [2001] 3 C.T.C. 2342 (T.C.C.) as prima facie evidence of an indebtedness. This is especially so when the financial statements are prepared by the Appellant himself.
[23] That I cannot determine the exact amount of the debt does not mean no debt existed. The granting of a general security agreement prepared and reported upon by a reputable law firm satisfies me that a debt did exist in 1994. The accounting records simply do not satisfy me as to quantum of that debt at December 31, 1995. Given my finding on the next point, I need not grapple further with the determination of the amount of the loan.
[24] Did the debt became bad in 1995?
The Appellant's counsel referred me to the case of Granby Construction & Equipment Ltd. v. The Minister of National Revenue, [1989] 2 C.T.C. 2239 (T.C.C.) which cited Hogan v. The Minister of National Revenue, 56 DTC 183 (Tax Appeal Board) and No. 81 v. The Minister of National Revenue, 53 DTC 98 to set forth the following tests for the determination of a bad debt:
Among the factors which may be taking into consideration by a taxpayer who claims a deduction "as a bad debt" would be: the time element, the history of the account; the financial position of the client, the past experience of the taxpayer with the writing off of his bad debts, the general business condition in the country in a case like in the present one where the taxpayer is doing business all over Canada, the business condition in the locality where the client lives, the increase or decrease in the total sales and accounts receivable at the end of the year for which the deduction is claimed, as compared with previous years.
Later on he went to say at page 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 uncollectible 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.
These words have been agreed upon and cited in most relevant cases and may apply to the case at bar as well. It appeared to me from the evidence that the appellant had acted on sound grounds, and to use my colleague Judge Sarchuk's words in the Berretti case, supra, page 2298 (D.T.C. 1723), the appellant had acted in a "pragmatic businesslike manner" when it determined the debts to be bad debts.
[25] The Appellant's counsel argued that the Appellant had indeed made an honest and reasonable determination based on the 1995 financial statements which showed DSM to be insolvent, Michael Rich's response to his demand letter and the loss of the Costco account. Further, he emphasized the Appellant's testimony that further steps would bankrupt DSM and simply that he was not prepared to do that. Finally he argued that subsequent events in 1996 illustrate that DSM's financial position was dire.
[26] The Crown suggested that the Appellant's letter was not so much a demand but an overture to discuss the financial arrangement with his son. Taking no further steps after receipt of Michael's letter is not sufficient, according to the Crown, to justify the debt being treated as bad. In looking at events subsequent to 1995, the Crown maintained that the finances were not as grim as the Appellant would have us believe, as the Royal Bank was paid in full and arrangements were made for the overdue payments of Select Foods.
[27] While the Crown made an argument that the Appellant must exhaust all legal remedies to satisfy the debt prior to treating it as bad, no case support was provided for the proposition. I accept more readily the test is one of an honest and reasonable determination at the end of the fiscal year, in this case, being December 31, 1995. I also accept that little emphasis need be put on subsequent events: it is the circumstances at December 31, 1995 that are most relevant to the determination, not the good or bad fortunes of the debtor subsequently.
[28] Was the Appellant's assessment at December 31, 1995 honest and reasonable and conducted in a pragmatic businesslike approach? Firstly, the Appellant could not have relied on the October 31, 1995 statements as it appears the first version of those were not released until July, 1996. Those statements showed a net loss of approximately $65,000, but also showed the write off of the $125,000 shareholder loan. These are subsequently revised by the Appellant to indicate that the loan had not in fact been written off. Reliance on the loss of the Costco contract is also somewhat suspect, as Michael Rich's testimony was that that particular contract was too costly to maintain in any event. So what we really have is a lack of repayments from DSM triggering the Appellant's request to his son and his son's response. There was no further communication between the Appellant and his son thereafter. There was no evidence of the Appellant, in his capacity as owner of DSM or as the professional accounting advisor to DSM in exploring possible workouts, in assisting with finding other refinancing options, in projecting future cash flow or doing anything at all to assist DSM with it's financial problems. By this I do not mean exhausting all legal recourses of collection; I mean more proactive positive action to assist DSM than negative enforcement action against DSM. In fact there was none of either.
[29] Both the Appellant and his son used the same language that any action by the Appellant against DSM would bankrupt the company. They testified however that they did not even discuss any action, positive or negative. I conclude the Appellant, rather than approaching this in a truly businesslike manner, took an early opportunity to write-off this debt, an opportunity which on balance I find not to be reasonable. This is not a case of an arm's length loan. The Appellant was the 25 percent owner of a family-owned business operated by his son. The Appellant's chartered accountant firm was also the accounting firm for the business. In such circumstances I expect some concrete effort from the Appellant to deal with the debt prior to declaring it bad. His letter of September 17, 1995 with no follow up was not sufficient. I find that in December, 1995 the Appellant's assessment of the debt falls short of an honest and reasonable determination the debt had become bad.
[30] Was the debt incurred for the purpose of gaining or producing income?
While it is unnecessary for me to consider the third factor of whether the debt was incurred for the purpose of gaining or producing income from a business or property, for the sake of completeness I wish to comment. Prima facie when a shareholder lends funds to the corporation in which he holds an interest, there is a sufficient nexus between the shareholder and potential future income to satisfy the requirements of subparagraph 40(2)(g)(ii). This is a conclusion reached by the Federal Court of Appeal in Her Majesty the Queen v. Edwin J. Byram, 99 DTC 5117 (F.C.A.) at 5120:
The shareholders of a company are directly linked to that corporation's future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income.9 Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).
[31] This must still depend on the circumstances of the actual advances. In this case, the Appellant had commenced his string of loans before he actually became a shareholder, at a time when the only income that could be produced would be interest. There was no documentary evidence of any interest ever having been paid. The nature of the advances were similar to an operating line, small amounts on a regular basis as required by Michael, with equally small payments as cash flow permitted. This revolving line does not smack of a shareholder intent on dividends. I would categorize the Appellant more as a generous, helpful father than an astute investor. I find most telling Michael Rich's testimony that nothing was written in connection with the advances from his father because it was their understanding the monies would be repaid. There was no mention that it was the understanding the Appellant would be repaid with interest or would profit handsomely from his ownership interest, simply that he would be repaid. Dad was helping his son and his son's company with an expectation to be repaid. This I find was the predominant purpose, while the normal purpose of a bona fide commercial investor to reap interest and dividends was, in this situation, a faint hope.
[32] I dismiss the appeal on the basis the Appellant has not proven the debt had become bad by December 31, 1995.
Signed at Ottawa, Canada, this 2nd day of November, 2001.
"Campbell J. Miller"
J.T.C.C.
COURT FILE NO.: 1999-1928(IT)G
STYLE OF CAUSE: Larry W. Rich v. Her Majesty The Queen
PLACE OF HEARING: Toronto, Ontario
DATE OF HEARING: October 22, 2001
REASONS FOR JUDGMENT BY: The Honourable Judge Campbell J. Miller
DATE OF JUDGMENT: November 2, 2001
APPEARANCES:
Counsel for the Appellant: David Rotfleisch
Counsel for the Respondent: Bobby Sood
COUNSEL OF RECORD:
For the Appellant:
Name:
Firm:
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
1999-1928(IT)G
BETWEEN:
LARRY W. RICH,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on October 22, 2001 at Toronto, Ontario
by the Honourable Judge Campbell J. Miller
Appearances
Counsel for the Appellant: David Rotfleisch
Counsel for the Respondent: Bobby Sood
JUDGMENT
The appeal from the assessment made under the Income Tax Act for the 1995 taxation year is dismissed in accordance with the attached Reasons for Judgment.
Signed at Ottawa, Canada this 2nd day of November, 2001.
|
"Campbell J. Miller" |
J.T.C.C.