Tax Court of Canada Judgments

Citation: 2006TCC628

Date: 20061129

Docket: 2005-1126(IT)G

BETWEEN:

CLOVERDALE PAINT INC.,

Appellant,

and

HER MAJESTY THE QUEEN,

Counsel for the Appellant: Marjorie E. Brown and Brian J. Wallace

REASONS FOR JUDGMENT

(Delivered orally from the bench on

October 25, 2006, at Vancouver, British Columbia.)

McArthur J.

[1]      This appeal is from an assessment issued by the Minister of National Revenue for the 2001 taxation year of Cloverdale Paint Inc. The issue is whether the Appellant was entitled to deduct a reserve of $4,316,900 as a doubtful debt in 2001. The Appellant submits that it met the requirements of subparagraph 20(1)(l)(i) of the Income Tax Act, and that at the end of 2001, its subsidiary was unable to pay the Appellant the amount owing as reflected in the reserve claimed. And further, that the reserve was reasonable in the circumstances.

[2]      Counsel for the Respondent submitted that the Appellant was not entitled to deduct a reserve as there was no debt that had been established in 2001, and in the alternative, that the Appellant's assumptions in calculating the amount of doubtful debt cannot support the deduction.

[3]      The most relevant legislation is subparagraph 20(1)(l)(i), which reads, in 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 of such part of the following amounts as may reasonably be regarded as applicable thereto:

(a)         ...

(l)          a reserve determined as the total of

(i)          a reasonable amount in respect of doubtful debts that have been included in computing the income of the taxpayer for that year or a preceding year, and

(ii)         ...

[4]      The Appellant is in the business of manufacturing and selling paint and related products in western Canada, having about 50 retail stores and in 2001, it had gross sales in excess of $80 million. In contrast, its subsidiary had gross sales of $6 million to $7 million in the same year, from six or seven outlets.

[5]      In 1994, the Appellant entered the U.S. paint selling market through a wholly owned subsidiary, Cloverdale Paint Corporation (CPC). Previous to opening its own stores in the states of Washington and Oregon, the Appellant tried in 1993 to purchase existing retailers without success. From 1994 to year end 2001, the Appellant sold paint to CPC, which made partial payments, such that the balance outstanding to the Appellant by the end of 2001 was $6,468,489.[1]

[6]      On the Appellant's behalf, two members of its board of directors testified, Charles Alan Mordy and Robert Mair, as well as the Appellant's inside financial administrator, Paul Schmidt, C.A., and Andrew Clark, an outside chartered accountant with PriceWaterhouseCooper. The Appellant is a private corporation owned by the Vogel family. The Respondent called no witnesses.

[7]      The Appellant's first witness, Mr. Mordy, had worked for the Appellant in senior management positions since, I believe, 1976. He testified that the Board was sensitive to CPC's continuing losses, which was discussed at board meetings three to five times annually. In 2001, efforts were made to find a purchaser or merging partner for CPC, without success. A concern in 2001 was the high tech downturn in the Seattle area, together with the economic damper resulting from 9/11. Because of a break-even year in 2000, CPC at first looked to possible expansion in 2001, but reversed the direction later that year as a big loss was apparent.

[8]      The Appellant's Board of Directors chose to continue funding CPC because the alternative would necessitate its closing, or bankruptcy. Mr. Mordy testified further that this was the approach taken successfully with some arm's length debtors, for example Doman, dealing with a much lesser amount, approximately $100,000. Out of necessity and practicality, the term for payment of 30 days with interest at 1½% per month, specified on the invoices to CPC, was ignored.

[9]      Counsel for the Respondent pointed out that the 2001 minutes of directors' meetings of the Appellant did not refer to the high tech downturn or 9/11, and did not refer to the CPC indebtedness. Both directors, Messrs. Mordy and Mair, stated without reservation that this was incorrect in that although it may not have been included in the minutes, it was definitely discussed. I accept the evidence of the four witnesses, keeping in mind, as with most witnesses, they were recalling events of several years ago and that their evidence is given probably in the light of the Appellant's present-day interests.

[10]     The following table contained in Exhibit A-1, Tab 27, is a list of the receivables in respect of the sale of inventory to CPC by the Appellant from year end December 1993 to December 2001:

Date	Receivable re: Inventory	Payment	Year end Balance	Cumulative Balance
Mar 1 - Dec. 31, 1993	21931.74	11964.98	9966.76	0
Jan. 1 - Dec. 31, 1994	238917.52	0	238917.52	248884.28
Jan. 1 - Dec. 31, 1995	1158564.42	0	115856.42	1407448.48
Jan. 1 - Dec. 31, 1996	2012414.14	269954.49	1742459.65	3149908.13
Jan. 1 - Dec. 31, 1997	2722806.18	1104466.51	1618339.67	476824.78
Jan. 1 - Dec. 31, 1998	2858650.32	2120885.09	737765.23	5506013.03
Jan. 1 - Dec. 31, 1999	3623881.82	3541737.73	82144.09	5588157.12
Jan. 1 - Dec. 31, 2000	3833138.03	3761776.77	71361.26[2]	5659518.38
Jan. 1 - Dec. 31, 2001	3678441.16	2990452.00	687989.16	6347507.54[3]

[11]     The auditing services of PriceWaterhouseCooper and specifically, Mr. Clark, were retained in mid-2001. CPC's indebtedness obviously caught his attention. He, together with Mr. Schmidt,[4] prepared an analysis (Exhibit A-1, Tab 26) and they recommended the paragraph 20(1)(l) reserve, which is the subject of this appeal. Paul Schmidt stated that despite his previous optimism, he concluded with Mr. Clark that in late 2001, the debt was at least doubtful and should be so recognized in that year's financial statements. The losses had accumulated since 1994, and CPC's history of losses was such that there was little hope that it could repay the Appellant, and could only continue operating with substantial Appellant subsidization. After careful consideration by the two chartered accountants, the liquidation method of evaluating CPC's assets was adopted and the doubtful debt of $4,316,900 was agreed to as reasonable. There was a difference of opinion as to the methodology, but not as to the amount. CPC had paid the Appellant as high as $3 million in some years for inventory sold to it by the Appellant, but there was a substantial yearly deficit, which totaled in excess of $6 million by the end of 2001.

[12]     After deliberation, particularly between the chartered accountants, liquidation approach was determined the most appropriate for calculating the reserve. The Respondent denies this method was appropriate, but did not offer an alternative, stating that the Appellant had the burden of proof. I find that the Appellant met its burden of proof with the evidence of Messrs. Schmidt and Clark, and the burden then shifted to the Respondent to establish, with evidence, why the liquidation approach was not acceptable, and to advance an alternative one. This was not done.

[13]     As stated, the Appellant management and PriceWaterhouseCooper disagreed with respect to the approach in evaluating CPC's assets, but both arrived at the same amount, or at least approximately the same amount of $2,180,000 as provided in Exhibit A-1, Tab 26, containing these calculations. It is not disputed that by the end of 2001, the balance outstanding was $4,468,489. I accept the Appellant's estimate of the value of CPC's assets at $2,180,000. The Appellant's claim for doubtful reserve is the difference between the value of assets of CPC and the outstanding balance owing to the Appellant, which is $4,288,489. This amount is the calculated shortfall which would result as of December 31, 2001 if CPC liquidated its assets, and paid the Appellant a portion of its debt. The Respondent offered no evidence to the contrary. Paragraph 20(1)(l) allows for a deduction of reasonable amounts in respect of doubtful debts.

[14]     I am satisfied that $4,290,000 is a reasonable amount, given all the circumstances. The question is whether it is a doubtful debt within the meaning of the Act. Both parties referred to The Queen v. Coppley Noyes & Randall Limited,[5] which sets out the following factors to be considered in determining a doubtful debt: the time element, a history of the account, financial position of the customer and the general business condition in the locality where the debtor lives or operates, as well as general economic conditions. Briefly applying these factors to the present facts, I find that (a) the debt had increased annually[6] over a period of seven years; (b) the customer, CPC, was obviously incapable of paying over $4 million; and (c) the debtor was in the U.S. northwest, where the economic conditions were dismal.

[15]     The Appellant continued to claim a reserve in 2002 and 2003. In 2004, the full amount of the reserve was included in income when CPC merged with a much larger competitor, Rodda Paint Company, operating in the Pacific Northwest. Prior to the merger, CPC sold paint and related products through six branches in Washington. Subsequent to the transaction, the company's operations included manufacturing and selling a complete line of paint products. Had the Appellant attempted to collect the debt or stopped its funding, CPC would have had to close its six stores.

[16]     The Respondent relied on the fact that the Appellant and CPC were not dealing with each other at arm's length which, I believe, was considered to be the Respondent's strongest argument. Arm's length is not a necessity, although the non-arm's length transaction must be carefully scrutinized, and I refer to Rich v. The Queen.[7] I have no doubt that CPC was insolvent. The Appellant had conflicting views as to the continuing support to CPC. Mr. Mair, an Appellant director, was on the side of ceasing support. He felt CPC's past history was so dismal that there was no hope of recovery after six or seven years of losses, although as mentioned, it had a $9,000 profit in 2000. Yet in 2001, it had a loss in excess of $600,000.

[17]     The 2001 minutes of the directors' meeting of the Appellant did not reflect the discussion of the huge CPC losses and the economic downturns. This is somewhat of a mystery, but I have no doubt that it was discussed as a priority. To find differently, I would have to disregard evidence of the two reputable directors. When Mr. Clark first viewed the large CPC debt in 2001 and its history, he spoke to management with a recommendation that the bad debt reserve be taken. This was sound accounting practice. It is obvious to the most casual observer that with unpaid invoices in excess of $6 million and growing, with no end in sight, something had to be done.

[18]     The Appellant's four witnesses impressed me as men of integrity, who did not take the decision of claiming a reserve lightly. Messrs. Mordy and Schmidt were active in the managing of the company. Mr. Mair was an outside director,[8] with an impressive history as a director of large corporations, and Mr. Clark is an able outside accountant with a large accounting firm. He took an objective view as an outsider, and together with Mr. Schmidt, objectively and professionally, orchestrated the Appellant's deduction claim. The determination of doubtful debts is to be made with information available only prior to December 31, 2001.

[19]     I do not see the need to discuss the nomenclature in the financial statements, and Mr. Schmidt's treatment of the CPC account as non-current. The reality of the situation is paramount. The Appellant had been funding a losing business for seven years. The debt arose as a result of sales of inventory by the Appellant to CPC. These were made on the same terms as sales to the Appellant's customers, and the debt was a trade receivable. While I do not believe for a minute that the Appellant would carry a $6 million deficit with an arm's length client, that does not negate the true nature of the debt.

[20]     The requirements in paragraph 20(1)(l) are (a) the debt must be owing to the taxpayer at the end of the year; (b) the debt must be included or deemed to have been included in the taxpayer's income for the taxation year or previous taxation year; (c) the collection of the debt must be doubtful at the end of the taxation year; and (d) the amount of the reserve must be reasonable. Items (a) and (b) have been conceded to, and with respect to item (d), I have found as a fact that the reserve is reasonable. It is item (c) which that I choose to discuss more thoroughly.

[21]     In the decision of Highfield Corporation Ltd. v. M.N.R.,[9] the Tax Review Tribunal stated:

... that a bad debt must have gone beyond any reasonable hope of recovery, but a doubtful debt, while possible of collection is not yet sufficiently certain to justify paying tax on it currently. ...

I believe the Appellant did everything it could leading up to its reserve claim. It was well established and highly successful in the Canadian west. It investigated expansion in the U.S. closest to the Canadian operation. It tried to purchase an existing paint sales outlet in northwestern U.S., without success. It started its subsidiary from scratch in 1994, realizing, I am sure, that it would have difficult years ahead. It sold paint inventory to CPC, receiving partial payments for seven years, with the exception of the year 2000. It invoiced its subsidiary as it did its arm's length customers. It kept meticulous records. At the end of 2001, with over $6 million owing and growing, it decided enough was enough. The decision to claim a reserve was not taken lightly, and I do not know what the Appellant could have done more. Its somewhat reluctant strategy of continuing the funding in 2002 and 2003 turned out to be the right one. It was able to include the full amount of the reserve in income after the 2004 merger. The Appellant, as creditor in December 2001, honestly and reasonably determined the debt was doubtful. It ignored the interest and due dates set out in its invoices. This was a practical decision since CPC could not pay the interest or honour the due dates. To demand payment would have brought on the closing of the debtor and liquidation.

[22]     As stated above, the Respondent's argument is based on the fact that the Appellant and CPC were not dealing at arm's length. In the Rich decision, Rothstein J. then of the Federal Court of Appeal, stated:

            Whether the creditor has a non-arm's length relationship with the debtor may also be relevant in some cases. However, the predominant consideration will be the ability of the debtor to repay the debt in whole or in part. The non-arm's length relationship may justify closer scrutiny than in non-arm's length situations. But a non-arm's length relationship alone, without more, cannot lead to a finding that the creditor did not honestly and reasonably determine the debt to be bad.

Justice Décary concurred with this reasoning and Justice Evans dissented. In Rich, the taxpayer claimed an allowable business investment loss, and for a finding of a bad debt between father and son. The Respondent referred to Justice Evans' dissenting comment in Rich, as follows:

            It is admirable that parents help their children to become established in their careers. However, when parents ask other taxpayers to share the burden of assisting the child's struggling business by deducting from their own income part of a loan as a bad debt, they can expect the tax authorities and the courts to examine the claim with care.

The above does not apply to the present case which is not one of a father assisting a son, but a successful Canadian corporation making a determined effort to expand into the U.S..

[23]     To deny the Appellant's appeal in the present case I believe would require a finding that paragraph 20(1)(l) does not apply to an arm's length transaction. Clearly this is not so.

[24]     For these reasons the Appellant is entitled to deduct a reserve of $4,290,000 as a doubtful debt in the 2001 taxation year. The appeal is allowed with costs.

Signed at Ottawa, Canada, this 29th day of November, 2006.

"C.H. McArthur"

CITATION:                                        2006TCC628

COURT FILE NO.:                             2005-1126(IT)G

STYLE OF CAUSE:                           CLOVERDALE PAINT INC.

                                                          AND HER MAJESTY THE QUEEN

PLACE OF HEARING:                      Vancouver, British Columbia

DATE OF HEARING:                        October 23 and 24, 2006

REASONS FOR JUDGMENT BY:     The Honourable Justice C.H. McArthur

DATE OF JUDGMENT:                     November 1, 2006

APPEARANCES:

Counsel for the Appellant:	Marjorie E. Brown and Brian J. Wallace
Counsel for the Respondent:	Raj Grewal

COUNSEL OF RECORD:

       For the Appellant:

                          Name:                       Marjorie E. Brown and Brian J. Wallace

                            Firm:                      Lawson Lundell LLP

       For the Respondent:                     John H. Sims, Q.C.

                                                          Deputy Attorney General of Canada

                                                          Ottawa, Canada

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