Tax Court of Canada Judgments

Date: 19980806

Docket: 94-1573-IT-G

BETWEEN:

MAGICUTS INC.,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Rip, J.T.C.C.

[1]The appellant Magicuts Inc.[1] (“Magicuts”) appeals from two series of assessments issued pursuant to the provisions of the Income Tax Act (“Act”). In the first series of assessments the Minister considered losses on advances of money made by Magicuts to a wholly-owned subsidiary corporation resident in the United States of America to be on account of capital and not on income account as claimed by the appellant in its tax returns for 1989, 1990 and 1991. In the second series of assessments, notices of which are dated December 8, 1992, the Minister of National Revenue (“Minister”) assessed Magicuts pursuant to section 212 of the Act on the basis that during its 1989, 1990 and 1991 taxation years Magicuts failed to deduct and remit tax on dividends paid or credited to The Magicuts International S.A. (“International”), a non-resident of Canada.

[2]At all relevant times Magicuts carried on the business of hair cutting through its corporate owned stores and selling franchises to operate the business of hair cutting. Magicuts gains its income through cutting hair, by selling franchises, receiving royalties from franchisees and selling hair grooming products.

[3]The principal witness on behalf of the appellant at trial was Brian Luborsky, chief executive officer and chairman of the Board of Directors of Magicuts at time of trial. Mr. Luborsky is also a chartered accountant who worked for a firm of chartered accountants in 1984 when he and a family member acquired Magicuts franchises in the Maritimes and California. In cross-examination counsel for the respondent questioned whether Mr. Luborsky, who was not an officer of the appellant before 1988, had sufficient knowledge to testify on behalf of the appellant as to prior events. Mr. Luborsky testified that he was a franchisee of Magicuts between 1983 and 1988, when he became president of Magicuts. Mr. Luborsky declared that he gained knowledge of the appellant by working for its firm of accountants and as owner of several franchises. He stated he was in constant touch with the erstwhile officers and directors of Magicuts and at all relevant times, through meetings and discussions with these people, was aware of the appellant’s business activities before 1988. I hold that Mr. Luborsky was a knowledgeable officer of the appellant and was an informed witness.

[4]Two of the three original shareholders in Magicuts Inc. sold their shares in the company in 1986 to a third shareholder and the remaining shareholder incorporated International under the laws of Panama. The shareholder transferred his share in Magicuts to International for shares in International. Mr. Luborsky acquired “some” shares in International in late 1988 or early 1989. In 1990 he caused Sawley Trading Corporation (“Sawley”), an Ontario corporation he controlled, to acquire outstanding debt of $217,710 and “most” of the shares of International.[2]

A) Income or Capital Loss

[5]Mr. Luborsky explained that of the income generated by Magicuts, a limited amount came from the sale of franchises. The bulk of the income comes from royalties based on a percentage of the gross income of a given store, depending on circumstances, and from the sales of product.

[6]Mr. Luborsky stated that he was “involved in the decision to go to the United States”. By 1983, according to him, there were not many large markets left in Canada to sell Magicuts franchises. In 1983 Magicuts opened its first US store in Atlanta. This store was owned by residents of Canada and was franchised by Magicuts Ltd. On the advice of franchise consultants Magicuts Inc. (“USMagicuts”) was incorporated in 1983 in the United States as a wholly-owned subsidiary of Magicuts Ltd. to carry on the business of selling franchises in the United States.

[7]One of the people Magicuts consulted with prior to incorporating USMagicuts was Robert James Harris. Mr. Harris is a graduate of the University of Toronto and the Law School of the University of Syracuse. Upon graduation from the University of Syracuse in 1960, Mr. Harris worked in an advertising agency and with firms in the fast-food industry in the United States. Mr. Harris described these as “tumultuous times with franchising”. There was no specialized franchise legislation in the United States at the time. Mr. Harris also operated a bakery franchise business in Toronto from 1968 to 1974. Later on, he incorporated Robert Harris and Associates Inc. to carry on the business of franchise consultant. This firm later merged with another firm and Mr. Harris became a partner in the new enterprise. His advice to Magicuts was based on his experience with franchising and with law firms he had engaged in Chicago and Washington to advise him on disclosure legislation.

[8]According to Mr. Harris, investors and others in the United States prefer to deal with a domestic corporation as opposed to an “offshore” corporation. This is particularly revealing when a franchisor is to file a uniform franchise operating circular in the United States. Mr. Luborsky had explained in his evidence that the US Federal Trade Commission requires a franchisor to answer in writing 23 basic questions with respect to franchises available for sale. This information is for the benefit and protection of potential franchisees. The document, the uniform franchise operating circular, is given to all prospective franchisees. The respective franchise is not to execute any franchise agreement for a period of ten days from its receipt and the franchisor is prohibited from accepting any money from prospective franchisees during the same ten day period.

[9]In the circular the franchisor, among other things, discloses the names of all other franchisees, the operating of the franchise system and its financial statements. Thirteen states require the disclosure statement to be verified by state authorities. The circular is filed annually.

[10]At the time Magicuts wished to enter the US market, the franchisees[3] were doing well, according to Mr. Luborsky, but the corporate stores were not. Since the corporate stores were owned by a predecessor to Magicuts, a resident of Canada, the results of the corporate stores would not have to be reported in the circular by a corporation resident in the United States carrying on the franchise business in the United States. Some states, such as California and New York, had the ability to impound franchise fees of foreign franchisors; this was another reason to incorporate an entity in the United States. Other problems a Canadian franchisor had in the United States, according to Mr. Luborsky, were that it would be difficult to sue in the United States, American law was more favourable to franchisees, the American legal system promoted litigation (due to contingency fees, for example) and any royalty payments to a Canadian resident were subject to withholding tax. All these problems, said Mr. Luborsky, would not help sell franchises.

[11]According to the circular dated November 14, 1986, the USMagicuts charged a franchise fee in the amount of $18,000. The USMagicuts also charged royalty and service fee equal to 7 percent of gross revenue, as defined.

[12]A potential franchisee was also informed that the franchisor or its affiliate would derive revenue as a result of any purchases by the franchisee directly from them. The franchisee was obligated to sell and display in the store products specified by the franchisor. Mr. Luborsky advised that the only affiliate of the USMagicuts was Magicuts. He also advised that the trademark “Magicuts” was registered with the US patent and trademark office and that the USMagicuts obtained the right to use the trademark from its parent, Magicuts, without cost.

[13]All activities of the appellant, its predecessor Canadian corporations and USMagicuts were controlled from Canada, in particular from the head office of the appellant in Scarborough, Ontario. The accounting records of all corporations were kept in one office and one ledger book was maintained for all the corporations. At the end of each year, Mr. Luborsky explained, the companies’ accountant would make the necessary adjusting entries; what had to be segregated would be segregated and amounts would be allocated to each corporation. Exhibits filed at trial show actual hand written entries made between the two corporations, Magicuts and USMagicuts, in particular advances from the appellant to USMagicuts (Exhibit A-1, tab 68).

[14]All support staff, “purchasing people” and other employees, including employees responsible for building individual stores were located in Canada Mr. Luborsky testified. He said the only employee in the United States answered the telephone. All supplies for stores in Canada and in the United States originated in Canada.

[15]When a franchise was sold the site for the new store was selected by Messrs. Shawn and Welcott, President and Chief Executive Officer and vice-president of the appellant, respectively. These gentlemen were resident of Ontario. Magicuts would obtain the services of a local real estate agent only to recommend sites.

[16]All the negotiations for sales and franchises took place in Toronto, according to Mr. Luborsky. Stores in both Canada and the United States were designed in Toronto. All the equipment and supplies were purchased in Toronto and shipped to the store site in Canada or the United States. The contractors building the store were local people. However, the Manager of the Store Division of Magicuts, Mr. Dickson, would attend at the site to supervise construction and attend to any ongoing negotiations. He would ensure the transfer of a “turnkey” store to the franchisee.

[17]Employees from Scarborough would attend to the store’s opening, Mr. Luborsky explained. They would hire and train the personnel and select the manager and assistant manager for the store. The franchisee was, almost invariably, an absentee owner. The franchisee would take over the store only when it was “up and running”. When a store required additional supplies, the responsible employee would order the supplies by telephone to the Scarborough office of the appellant, according to Mr. Luborsky.

[18]Mr. Luborsky stated that no money was actually directly advanced by the appellant to USMagicuts. The appellant charged USMagicuts for supplies of product and services and the latter failed to make payment. USMagicuts had incurred losses since its first year of operation, according to Mr. Luborsky. The expenses incurred by USMagicuts included substantial amounts for salaries paid for on its behalf by the appellant. For example, as stated earlier, when a new store was to be opened in the United States, the appellant’s employees prepared the store for opening. The salary of these employees would be charged to USMagicuts and shown as an advance from the appellant to USMagicuts. The advances[4] also include money paid by the appellant to USMagicuts’ landlords for rent as well as to other third parties. In some cases the appellant made purchases for USMagicuts that it showed in its financial statements as advances.

[19]The financial statements of Magicuts compliment those of USMagicuts. The amounts in the balance sheet of Magicuts are, of course, in Canadian currency. Both companies’ year ends are February 28. Page 4 of Tab 68 of Exhibit A-1 is a copy of the last page of journal entries recording the advances and payments between Magicuts and USMagicuts during fiscal year 1986. The amount on page 4, in Canadian dollars, coincides with the amount due in US dollars to Magicuts in USMagicuts’ balance sheet as at February 28, 1986.

[20]Tab 68 of Exhibit A-1 includes copies of excerpts from journal entries, general ledger, adjusting entries, among other documents, that record the payments (advances) by Magicuts to USMagicuts and payments by the latter. There is a steady increase in expenses paid on USMagicuts’ behalf by Magicuts. In the balance sheet of USMagicuts, as at February 23, 1985, for example, the latter is indebted to Magicuts in the amount of $115,262 (US). A year later the debt has increased to $670,302 (US). The debt is decreased to $227,967 as at February 28, 1987 but in the 1987 fiscal year $720,302 (US) of debt was capitalized as contributed surplus. In USMagicuts’ balance sheet as at February 29, 1988, the debt to Magicuts is $287,964 (US). In USMagicuts' balance sheet as at February 28, 1989, no amount is owing to Magicuts: an amount of $283,408 (US) was forgiven and was added to contributed surplus.

[21]A note[5] as at February 28, 1987 of the appellant to the balance sheet informs the reader that Magicuts contributed and additional $998,411 to the capital of USMagicuts. The same note states that Magicuts' investment in USMagicuts is $998,412 and that Magicuts advanced to USMagicuts total $349,153.[6] As at February 28, 1987, the amount of debt advanced to USMagicuts is $349,153. In the financial statement of Magicuts for 1989 only note 5 advises that only $30,011 is reflected owing by USMagicuts to Magicuts. In 1989 all of Magicuts' investment in USMagicuts was written down to its realizable value, that is, nil, "as a result of a permanent decline in value" (note 5) The amount so written off, the amount of $1,355,026, was deducted by Magicuts in computing its income for 1989. In Mr. Luborsky’s view it was not prudent to show as an asset $1,300,000 of contributed surplus, which in previous years had been showing as an advance; in its 1989 fiscal year, the appellant “wrote down a portion of the amount of the advances and deducted the amount in computing its income for the year”. Mr. Luborsky recalled that nothing had been sold by the appellant in the US and a “significant portion of royalties was siphoned off”. USMagicuts’ business was terminated in 1988, during the appellant’s 1989 fiscal year.

[22]USMagicuts had twelve franchisees in the United States when it ceased operations. The US franchisees then paid royalties to Magicuts. During the period 1988 to 1997, Magicuts’ net income from royalties from US franchisees, in particular franchisees in California, was $321,916. Total royalties paid (in US currency) by US franchisees during the period 1986 to 1997 were as follows:

Total Royalties Paid by U.S. Franchisees

Y/E	Amount
1986	84,947
1987	102,799
1988	48,711
1989	57,096
1990	36,753
1991	101,386
1992	64,884
1993	29,861
1994	25,595
1995	19,055
1996	27,804
1997	65,456
	664,347

[23]Franchise payments made in 1986 and 1987 by US franchisees were made to USMagicuts. Of the amount of $48,711 paid in 1988, approximately $4,000 was paid to USMagicuts and the balance to Magicuts. Additional amounts were received by USMagicuts in 1989 and 1990 due to “efforts” made to collect, according to Mr. Luborsky. Also, royalties aggregating $134,048 were received by third parties for supporting franchisees in the US. Mr. Luborsky explained that when USMagicuts closed down operations Magicuts required people to source existing US locations of Magicuts and, in return, these people were paid the royalties.

[24]Mr. Luborsky also testified that Magicuts invoiced US franchisees for product it previously sent to them. Any profit from sales of product to US franchisees would normally have been profit to both Magicuts and USMagicuts. The sales had been recorded in a single set of books maintained by Magicuts.

[25]Sources of revenue reported in the Profit and Loss Statements of Magicuts for the period from September 21, 1985 to February 28, 1986 are hair cutting sales, franchise sales, royalties and other. The Profit and Loss Statements for Magicuts’ 1987, 1988, 1989, 1990 and 1991 report the same four sources of revenue. There was no confirmation from any books of account as to what “other” represents. There appears to be no accounting for any sales of supplies to franchisees in the United States. Indeed, USMagicuts’ statements also account only for hair cutting sales, franchise sales, royalties and other.[7]

[26]Since the thrust of the appellant’s attack on the Minister’s position was that it earned income selling product to USMagicuts or the latter’s franchisees and there was no confirmation of such evidence in either company’s financial statements, I arranged for a conference call to take place between counsel for the parties and myself on December 18, 1997.[8] Mr. Luborsky also participated in the conference call. All agreed that Mr. Luborsky would be considered to be under oath for the purposes of providing information during the call. Unfortunately, and for good reason, Mr. Luborsky was unable to confirm that there were sales by Magicuts to USMagicuts or to its US franchisees and that the sales were reflected in financial statements. He simply did not have the material with him. However he undertook to review the working papers of the appellant’s auditors at the time and appellant’s counsel was to advise the trial co-ordinator of the status of Mr. Luborsky’s review by January 9, 1998. If Mr. Luborsky was successful in finding any material I would be amenable to reopening the trial to hear such evidence.[9] I am advised by the trial co-ordinator that as of February 28, 1998 she had not received any information from appellant’s counsel. In the circumstances I thought it would be in the best interest of justice that counsel be contacted by court officials.[10] On April 22, 1998, counsel and myself held a conference call and I fixed a hearing date of June 30, 1998 (changed from the original date of July 2, 1998) in Ottawa for Mr. Luborsky to testify further.

[27]In preparation for the reopening of the hearing Mr. Luborsky produced an affidavit that included documents.[11] The other documents included, among others, copies of invoices to franchises of USMagicuts in 1985 and 1986 for equipment and supplies, working papers and summaries showing portions of royalties the appellant received from the United States in 1985 and 1986 and a summary of deposits in 1988, including bank deposit slips, from US franchisees to Magicuts' bank account after USMagicuts ceased to operate. At the rehearing of the trial Mr. Luborsky was examined on his affidavit. Magicuts arranged with a corporation in the United States, Shavecan Inc. ("Shavecan") to "look after" the franchisees in the United States. The majority shareholder of Shavecan is Mr. Luborsky. Shavecan operated several franchises in the United States and the consideration for administering the franchises was that Shavecan did not have to pay a franchise fee to Magicuts. Shavecan also became a "sub-franchisor" of Magicuts in California. US franchisees paid franchise fees directly to Magicuts. All the while, Magicuts continued to sell equipment to US franchisees.

[28]In cross-examination, Mr. Luborsky explained that US franchisees purchased products from Magicuts and were billed from Canada. He also stated that each time a salon opened, whether in Canada or in the United States, Magicuts would sell the new franchise equipment and leasehold components and earn income from these sales. In the mid-1980s, Mr. Luborsky recalled, US franchises complained they could acquire product cheaper locally and Magicuts permitted them to do so, however, all equipment was supplied by Magicuts.

Argument & Analysis

[29]The appellant, counsel submitted, incurred expenses on behalf of USMagicuts so as to be in a position to earn income from the franchisees of USMagicuts: the appellant sold supplies to the US franchisees of USMagicuts.

[30]In her Reply to the Amended Notice of Appeal the respondent stated that in assessing the appellant, the Minister assumed that by the time USMagicuts ceased operations, Magicuts had invested $998,412 in shares and made advances totalling $356,614. Respondent’s counsel argued that once a creditor converts its debt or advances to capital, i. e., the creditor contributes capital to the debtor by eliminating or reducing the debt, the debt, whether originally on account of income or capital, ceases to exist. Contributed surplus is part of the debtor's capital stock; it is capital in nature. The amount contributed cannot be "written off" or deducted by the creditor in computing its income.[12] The amounts written off by the appellant were not incurred for its own business but to make viable the business carried on by the USMagicuts: therefore, the amount is not deductible in computing income.

[31]Respondent’s counsel argued that the facts of the appeal at bar are not substantially different from those in Morflot Freightliners Limited v. The Queen[13], a decision of Strayer, J., as he then was. The corporate taxpayer acted as agent for a Soviet shipping company (“F Co.”) in respect of the operation of its ships into and out of certain Pacific coast ports in Canada and in the northwestern United States. The taxpayer’s wholly-owned U.S. subsidiary (“M Inc.”) was established to carry out in the United States the taxpayer’s function as F Co.’s agent. As the U.S. Soviet international relationship deteriorated from 1978 onward, easy access by U.S.S.R. ships to U.S. ports began to decline, and by March, 1982, such access had stopped altogether. This, in turn destroyed the business of Mr. Rees, prompting the taxpayer to wind it down in 1982. At the same time, the taxpayer wrote off an amount of $284,854, representing advances which it had made since 1979 to keep M Inc. in funds during the post-1978 decline being experienced by it in its business. The taxpayer sought to deduct the $284,854 in the computation of its income from business for its 1982 taxation year. The Minister disallowed the deduction, alleging that the $284,854 was a capital outlay. The taxpayer appealed to the Federal Court - Trial Division, arguing that the $284,854 had been laid out to earn income by ensuring the continued existence of its subsidiary, without which its Canadian business would have been rendered unprofitable.

[32]The taxpayer’s appeal was dismissed. Strayer, J. held the advances in question were made with a long term objective in mind, the preservation for the indefinite future of the taxpayer’s U.S. subsidiary as an enduring asset, through which its agency responsibilities to F Co. could be carried out in the United States. The money advanced by the taxpayer, noted Strayer, J., appeared not to have been incurred for the purpose of gaining and producing income from its business but rather from the business of the U.S. subsidiary. This made the advances capital in nature, so that the taxpayer was precluded from deducting them as a business expense in respect of its 1982 taxation year.

[33]Strayer, J. held that the Morflot case was within the principle of Stewart & Morrison Limited v. M.N.R.[14] and was similar to the facts in that case and in The Queen v. H. Griffiths Company Limited.[15] In Stewart & Morrison, a company located in Toronto had established a wholly-owned U.S. subsidiary to operate an office in New York. The New York company carried on business in its own name and had its own staff but it was generally directed by the Toronto parent company. Eventually the New York company suffered losses and had to cease operations. It was unable to repay the advances from the Toronto company which sought to deduct these amounts as expenses incurred for the purpose of earning income from its own business. The Supreme Court of Canada rejected this position and treated the advances as “working capital”.

[34]In the Griffiths case the loan to the subsidiary guaranteed and ultimately repaid by the parent company due to the bankruptcy of the subsidiary was an investment of a capital nature. The parent company, a mechanical contractor, required a reliable supply of sheet metal products and incorporated the subsidiary as a supplier of such products. This sum paid by the parent for the subsidiary was said to have been expended to ensure an advantage for the enduring benefit of the parent company and was therefore capital in nature. Strayer, J. at 5185, says in Morflot, supra, that Griffiths, and by implication, Morflot, were not cases where the advances were made for the direct and immediate promotion of sales.

[35]In its Amended Notice of Appeal, Magicuts submitted that USMagicuts operated as its agent in connection with the business carried on by Magicuts in the United States and, therefore, losses incurred by USMagicuts were losses incurred by Magicuts. At trial, appellant’s counsel stated he would not pursue this argument. He would rely on its alternative submission that from 1984 to 1988, when USMagicuts ceased operations, the USMagicuts acquired goods and services from Magicuts for the purpose of its business, and, if I understand counsel’s position, Magicuts earned income from the sale of those goods and services to USMagicuts. The amounts so advanced and written off ought therefore to be deductible in computing income. They are not prohibited by paragraph 18(1)(a) of the Act since the amounts were laid out for the purpose of gaining or producing income from Magicuts’ business. Counsel relied on the reasons set out in The Queen v. F.H. Jones Tobacco Sales Co. Ltd., 73 DTC 5577, among other cases.

[36]In F.H. Jones Tobacco, the corporate taxpayer was a tobacco processor. A third party wanted to buy the shares of a customer (“TTC”) of the taxpayer who was in financial difficulty. The taxpayer undertook to guarantee the loan necessary for the third party to finance the purchase of TTC. In exchange for this guarantee the third party agreed to buy all of its tobacco from the taxpayer through TTC. The third party became insolvent and the taxpayer paid an amount under the guarantee. Noël, J. held that the taxpayer was entitled to deduct the payment made under the guarantee. He noted that the payment was made for commercial reasons in accordance with ordinary business practices. The purpose of the payment was to earn income from the taxpayer’s business through increased sales and therefore came within the exception of paragraph 18(1)(a).

[37]In effect, stated Noël, J.[16], the taxpayer sought through the guarantee to ensure continued growth of its sales to TTC, and at the same time made certain that the latter would be able to proceed with large orders for tobacco. The payments, on behalf of USMagicuts, unlike those in Morflot, supra, were laid out to earn income for the appellant, not to ensure the continued existence of USMagicuts, although one was dependent on the other. So long as USMagicuts carried on business the franchisees would order product from the appellant, thus increasing the appellant’s sales and profits. A great proportion of the appellant’s income over the years came from these sales.

[38]In his reasons for judgment in F.H. Jones Tobacco, Noël, J. referred to the reasons for judgment of the Supreme Court of Canada in M.N.R. v. Henry J. Freud, 68 DTC 5279 at 5283. In Freud, the individual taxpayer made advances to a USMagicuts in which he was a shareholder (“US Co”). US Co was organized for the purpose of developing and promoting a prototype of a sports car. Pigeon, J. (for the Court) held that the taxpayer’s advances were made with the purpose of making a profit from the selling of the prototype car, and not to derive income from an investment and therefore the transaction was characteristic of a venture in the nature of trade. Pigeon, J. emphasized that the transaction could not be considered an investment because it involved pure speculation and that if a profit had been realized it would have been taxable as income. The outlays were therefore deductible.

[39]Counsel also cited Algoma Central Railway v. M.N.R., 67 DTC 5091, 68 DTC 5096 [Exc. Ct], Paco Corporation v. The Queen, 80 DTC 6215 (F.C.T.D.) and Canada Starch Company Limited v. M.N.R., 68 DTC 5320.

[40]As I stated earlier, Mr. Luborsky’s understanding that the appellant sold product to USMagicuts' franchisees, or to USMagicuts itself, may not be clear from an initial examination of the appellant’s financial statements for the years in appeal. On resumption of the appeal, Mr. Luborsky testified that Magicuts sold product to USMagicuts and produced documentation in support of his testimony. The documents are included in his affidavit of April 17, 1998. As a result of Mr. Luborsky's new evidence, the facts in the appeal at bar suggest that they are more similar to those in F.H. Jones Tobacco, supra, than those in the cases exemplified by Stewart & Morrison, supra, H. Griffiths Company Limited, supra, and Morflot, supra. Magicuts sold product and equipment to USMagicuts for a profit. The debt arose as a result of USMagicuts not paying for the product and equipment it acquired from Magicuts. USMagicuts was a trade debtor of the appellant and the amounts owing were accounts receivable by Magicuts. Magicuts, because it was the sole shareholder of USMagicuts, treated the accounts payable as advances to its subsidiary. There were not advances made by Magicuts to preserve USMagicuts as an enduring asset or as "working capital". Magicuts sold product to USMagicuts for value. These debts were incurred in Magicuts' profit making operation and if the trade debtor, USMagicuts, eventually failed to pay the debt, Magicuts ought to be permitted to deduct these debts as a bad debt in the year the debts actually became bad.

[41]However, starting in 1986 or 1987 Magicuts started to reduce the amount of debt owed to it by USMagicuts. For whatever reason - Mr. Luborsky stated it was for the purposes of satisfying California authorities - Magicuts decided to cancel portions of debt owed to USMagicuts. Magicuts contributed portions of the debt to USMagicuts' capital. By the end of its 1989 fiscal year Magicuts had contributed $1,366,026 to USMagicuts' capital and in that year decided to write off the amount of its investment down to its realizable value.

[42]When a person contributes money or other property to a corporation that person invests in the corporation and the investment in 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.[17]

[43]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.

B) Failure to Withhold and Remit

[44]The second issue is dependent on whether as a result of loans between the appellant Magicuts and International, paragraph 15(2)(b) of the Act may be applied to include the amount of any loan or indebtedness in International’s income as a deemed dividend. The Minister assumed International owed Magicuts $77,664 at the end of Magicuts’ 1988 taxation year and that the loan or indebtedness increased to $261,219 at the end of its 1989 taxation year. Further, the Minister alleges that in 1989 and 1990 International received loans or otherwise incurred debts to Magicuts on which no interest was paid,

[45]Accordingly, the Minister concluded that pursuant to paragraph 214(3)(a) of the Act, International’s unpaid shareholder’s loans at the end of Magicuts’ 1989 taxation year pursuant to subsection 15(2) and interest, calculated pursuant to subsection 80.4(2) in respect of the 1990 and 1991 taxation years, were deemed to have been paid as dividends to International for which Magicuts was liable for tax pursuant to Part XIII of the Act of 25% as follows:

[46]Magicuts admits that as of its 1988 year end its shareholder International was indebted to it in the amount of $77,664. However, the appellant submits, this and subsequent indebtedness to it incurred by International during the appellant’s 1989 fiscal year were repaid by the year end, February 28, 1989. The repayment resulted from the netting, at February 28, 1989, of the two general ledger accounts that recorded amounts owing to and from International. Magicuts’ position is that this set-off of amounts owing to and from International reflected the true arrangement between the appellant and its shareholder.

[47] The appellant’s general ledger account recording amounts advanced by it to International is numbered 127 and is named “Magicuts SA”. The account ledger records amounts debited and credited to the account for the period from February 28, 1986 to February 28, 1989. As of February 29, 1988 the ledger balance indicates an amount due from International of $92,663.99. A $15,000 adjustment in International’s favour reduced this figure to the $77,664 amount agreed by the parties as owing by International to Magicuts at the 1988 fiscal year end. As of the 1989 year end the balance of the account showed an amount owing by International to Magicuts of $261,218.99.

[48] The general ledger account recording payments from International to the appellant is numbered 540 and named “Due to Worldwide Trust”. This ledger records two amounts credited to the account as of February 28, 1989. These amounts, $125,000 and $185,145, aggregate $310,145 and appear to represent amounts owed to International by Magicuts.

[49] Counsel for the respondent asked me to find that the payments recorded in the “Due to Worldwide Trust” account ledger were not advanced from World Wide Trust Services Inc. as transfer agent for the benefit of International. The documents adduced by the appellant indicate the contrary and the testimony of its witness, Mr. Luborsky, is credible. I, therefore, accept his evidence that “Due to Worldwide Trust” in the appellant’s books of account represent amounts due to International.

[50] The result of the netting of the two accounts is reflected in the appellant’s audited financial statements for the fiscal period ending February 28, 1989 as a loan from shareholder in the amount of $48,926. In Ozawa v. The Queen, 97 DTC 1500 at 1504, Sarchuk, J.T.C.C. observed that the onus is upon the taxpayer to establish both the right to set-off and the amount of set-off. The appellant’s evidence suggests that set-off occurred and confirms the amounts involved. There is no question that if the accounts are netted at the February 28, 1989 year end, International became a net creditor of Magicuts.

[51] The question I must now decide,then, is whether Magicuts is legally entitled to the set-off claimed. In Austin v. M.N.R., 91 DTC 778 (T.C.C.), the taxpayer argued that any deemed benefit assessed pursuant to subsection 80.4(2) should be reduced to the extent that amounts owing to the taxpayer by the lending company could be set off against his debts to the company. Mogan, J.T.C.C. said at 780 with respect to the taxpayer’s argument for set-off:

[...] If no action is commenced for the payment of a debt, there is nothing in law to prevent the co-existence of mutual debts. In other words, if A owes B $1,000 and B later becomes indebted to A in the amount of $1,400, the debt from A to B is not extinguished. If A or B should commence an action on one debt, the defendant would claim the right to set off the other debt by way of defence. Even if no action were commenced, A and B could agree that their mutual debts be set off leaving B owing A only $400. There would, however, have to be real evidence of such agreement.

[52] On the facts before him, Mogan J.T.C.C. found at 781 that there was no evidence of any agreement between the taxpayer and the company to set off the amounts. In particular, he noted:

In the circumstances of this appeal, one must ask if there was any evidence of an agreement between the Appellant and the Company that the accrued bonuses were to be set off against the Shareholder Receivable account. There was no evidence of a journal entry linking the balance in one account with the balance in the other account. There was no evidence of a long established practice setting off these respective accounts within each fiscal period. There was no evidence as to the manner in which the Company recorded in its books and records the payment of the accrued bonuses when they were actually paid to satisfy the time limit in section 78 of the Act. In summary, there was no evidence of any agreement between the Appellant and the Company to set off these two accounts.

[53] Mogan, J.T.C.C. found support for his decision in the reasons of Bonner, J.T.C.C. in Gannon v. M.N.R., 88 DTC 1282, where the taxpayer shareholder testified that it was his intention that the indebtedness of the company to him be paid before drawings could be considered to be a debt from the taxpayer to the company. Bonner, J.T.C.C. held at 1284:

Nothing in the evidence in the present case suggests the existence of any agreement or contract calling for the liquidation of the indebtedness on the note by means of the payments made to the Appellant. An agreement between a company and its shareholder is not formed by a mere fleeting thought in the mind of the individual who controls it. The accounts in question here are not connected in any way. This is simply a case in which the company and the Appellant each owe the other money. There is no authority for the proposition advanced by the Appellant which is, in effect, that mutual debts cannot coexist and that in all cases where they might arise a set-off is automatically effected.[18]

[54] In so concluding, Bonner, J.T.C.C. mentioned Bank of Montreal v. Tudhope, (1911) 21 Man. R. 380 where Robson, J. referred at page 386 to Watson v. Mid-Wales Railway Company, 36 L.J.C.P. 285 and said:

Willes, J., points out that mere cross-claims do not necessarily give an equity to set off, much less so when they are in futuro. He says: "It is necessary to shew mutual credit: I do not mean in the sense of mutual credit under the statutory provisions of the Bankrupt Law, but in the sense of there being an agreement or contract made or to be inferred that one debt was to liquidate the other. Where the balance only is to be the debt, there is a clear equity that one of the parties is not to have any detriment by the act of the other. But here the debts are payable at different times. There is nothing from which we can infer that one liability was to liquidate the other, or that the balance only was to be considered due".

[55] In the appeal at bar, there is no evidence of a formal agreement or contract between Magicuts and International to set-off their mutual debts. In The Queen v. Peter Neudorf, 75 DTC 5213, Heald, J. stated at 5215:

It is my further view that since one of the parties to the arrangement was a corporation, there is more formality required (such as corporate resolutions, for example) than in the case of individuals and particularly where the details of a relationship are important as against third persons such as the Revenue.

[56] On the facts before me, I would not necessarily hold the appellant to the high degree of formality if there were some extrinsic evidence that Magicuts and its shareholder intended that their mutual debts be set off. None of the appellant’s corporate resolutions introduced as evidence indicates an intention to set-off its indebtedness with International. The minutes of a special and general meeting of shareholders of the appellant, held on September 21, 1988, indicate that a demand debenture in the amount of $750,000 was executed by Mr. Luborsky on behalf of the appellant and in favour of World Wide Trust Services Inc. to secure “present and future advances” by World Wide Trust Services Inc. to the appellant. These minutes, however, do not evidence an agreement between the appellant and SA to set-off their mutual debts.

[57] The appellant’s ledgers for the “Magicuts SA” and “Worldwide Trust” accounts were introduced as evidence in handwritten form in Exhibit A-1 and in computer generated form in Exhibits A-7 through A-9. The account balances for these accounts are not linked to one another in the ledgers at the February 28, 1989 year end.

[58] The balance sheet of Magicuts as of February 28, 1986 records an amount due from International of $25,000. In the balance sheet as of February 28, 1987 the amount due from International increased to $110,711 and is described as having no set terms of repayment. The balance sheet of Magicuts as of February 28, 1988 records an amount of $77,664 due from International with no set terms of repayment.

[59] There is no evidence that any of the amounts recorded in the appellant’s financial statements as due from International resulted from a setting-off of mutual indebtedness. Set-off would not have been necessary earlier as Magicuts does not appear to have incurred indebtedness to International before May 1988. The appellant’s financial statements therefore do not reveal the kind of long established practice of set-off that might have evidenced an intention on the part of the parties to set-off their mutual indebtedness as of the year end.

[60] Subsequent events are of no assistance either. Magicuts’ balance sheet as of February 28, 1989 records a receivable of $126,074 from International with no set terms of repayment. Following International’s sale of control in the appellant in October 1990, the November 30, 1990 year end balance sheet records an amount of $300,000 due from “related party”.[19] In the absence, however, of accounting evidence regarding the calculation of these figures I cannot conclude that these financial statements evidence the setting-off of the underlying accounts of indebtedness.

[61] I am unconvinced that at the time the debts were incurred there existed between Magicuts and International an intention to set-off the debts against one another. The evidence is simply not sufficient to establish that an agreed intention to set-off existed.

[62] The Minister assessed the appellant on the basis of indebtedness incurred by International in the 1989 taxation year of $183,555. The Minister appears to have arrived at this figure by subtracting the balance of $261,219 in the “Magicuts SA” account at the 1989 fiscal year end from the balance of $77,664 in the same account at the 1988 fiscal year end. Paragraph 15(2)(b) provides that to be excepted from inclusion the borrower must repay its indebtedness within one year after the end of the taxation year of the lender in which the indebtedness arose. International incurred the $183,555 of indebtedness to the appellant in the appellant’s 1989 taxation year. International therefore had within one year after the appellant’s 1989 year end to repay its debt without attracting the 15(2)(b) inclusion.

[63] No evidence was presented at trial to establish that the $183,555 was repaid within the time limitations imposed by paragraph 15(2)(b). The “Magicuts SA” and “Due to Worldwide Trust” account ledgers submitted as evidence do not record debit and credit items beyond February 28, 1989. An amount of $126,074 is recorded in the appellant’s February 28, 1990 financial as due from the “parent”, International.

[64] Pursuant to subsection 80.4(2), where there has been a debt or loan outstanding at any point in the year then a taxable benefit will be imputed to the shareholder debtor in the amount of the interest computed at the prescribed rate[20] in effect during the period less the interest actually paid not later than 30 days after the end of the year:

Where a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) was

(a) a shareholder of a corporation,

[...]

and by virtue of that shareholding that person or partnership received a loan from, or otherwise incurred a debt to, that corporation, any other corporation related thereto or a partnership of which that corporation or any corporation related thereto was a member, the person or partnership shall be deemed to have received a benefit in a taxation year equal to the amount, if any, by which

[...]

(d) all interest on all such loans and debts computed at the prescribed rate on each such loan and debt for the period in the year during which it was outstanding

exceeds

(e) the amount of interest for the year paid on all such loans and debts not later than 30 days after the later of the end of the year and December 31, 1982

[65] To succeed on this ground the appellant has to establish that at no time during the 1990 and 1991 taxation years were there any amounts owing by International to it, or in the alternative, that if there were amounts owing to it by International, then interest was paid by International on the amounts at a rate equal to or greater than the prescribed rates. It is not sufficient for the appellant to merely establish that International paid back to it any indebtedness for which International was potentially liable under subsection 15(2). So long as the loan or debt was outstanding, subsection 80.4(2) applies.

[66] There is no evidence that International paid interest at the prescribed rate on the amount of its indebtedness to the appellant.

[67] The next question to be considered is whether the resulting benefits are subject to Part XIII tax and, if so, is the appellant liable for any Part XIII tax owing by International. The relevant statutory provisions are paragraph 214(3)(a) and subsections 15(9), 215(1) and (6), [21] contained in Part XIII of the Act:[22]

[68] Pursuant to paragraph 214(3)(a), if International received an amount that falls within the provisions of section 15, then the amount would be deemed a dividend and International would be liable for tax under Part XIII in respect of the amount. In turn, subsection 215(1) imposes the obligation on the Canadian resident payer to deduct and remit the tax at the appropriate rate before paying the non-resident. Under subsection 215(6), the person who is obliged under section 215 to deduct or withhold the amount of the tax and fails to do so is made personally liable for the amount of the tax.

[69]Internationalincurred an indebtedness that was not repaid within one year from the year end of the year in which the indebtedness was incurred. The unpaid amount of indebtedness is included in International’s income pursuant to subsection 15(2). International is also deemed to have received a benefit under section 80.4. That benefit is deemed by subsection 15(9) to be a benefit conferred on a shareholder for the year for the purposes of subsection 15(1). Accordingly, the provisions of subsection 214(3) apply and International is deemed to have received a dividend from Magicuts. Magicuts was required to deduct the appropriate taxes upon payment of the deemed dividends to International. Obviously the appellant did not deduct and remit the required taxes; it is liable for these amounts.

[70] Accordingly, the Minister’s assessment must stand. International is deemed to have received a shareholder benefit in the 1989 year in the amount of $183,555 and the appellant is liable for failing to withhold taxes of $45,889 on this amount.

Decision

The appeals from the assessments for the appellant’s 1989,1990 and 1991 taxation years are dismissed. Similarly, the appeals from assessments made pursuant to section 212 of the Act are also dismissed. There will be one set of costs in favour of the respondent.

Ottawa, Canada, August 6, 1998.

"Gerald J. Rip"

J.T.C.C.

---