When is a Debt Bad for Tax Purposes?

In Coveley v. The Queen the Tax Court of Canada (TCC) had to decide whether certain allowable business investment losses (ABILs) claimed in the 2005 and 2006 taxation years by a couple who owned a business were correct. 

Justice D'Auray did a comprehensive review of the case law pertaining to ABILS in making her determination. The case provides great insight to the validity of ABIL claims, as well as when debts are considered bad for the purposes of a claim under Subsection 50(1) of the Income Tax Act.

The taxpayers were husband and wife and the co-founders of cStar Technologies Inc. (“cStar”), a company focused on wireless communications. The taxpayers did not receive cash remuneration from cStar, but made loans to the company of their unpaid remuneration, cash advances and corporate expenses. Those expenses were paid on behalf of cStar with their own credit cards.

They claimed large ABILs on their income tax returns for the 2005 taxation year, and a non-capital loss carry-forward arising from their ABIL claims in 2005 against their income in 2006; claims that were promptly denied by CRA.

The parties looked both to the Income Tax Act and prior legal tests to determine the outcome of the case.

First, according to paragraph 38(c) of the Income Tax Act, a taxpayer's ABIL for a taxation year from the disposition of any property is one half of the taxpayer's business investment loss for the year from the disposition of that property.

Paragraph 39(1)(c) partially defines a business investment loss and links to subsection 50(1), which defines debts established to be bad debts and shares of bankrupt corporations.

Subparagraph 40(2)(g)(ii) of the Act was also reviewed for its significance – that debts incurred must be for the purposes of producing income from a business or property.

Both parties next agreed that the test to determine whether an ABIL is validly claimed under the Act remains the test established by the Federal Court of Appeal in Rich v. Canada (2003). Consequently, all of the following had to be established in order for the claims of these taxpayers to be allowed: 

• The debts were owed by cStar to the taxpayers, pursuant to subsection 50(1).
• The debts were incurred for the purpose of gaining or producing income from a business or property under subparagraph 40(2)(g)(ii).
• In 2005, cStar was a small business corporation as defined in subsection 248(1) of the Act, pursuant to paragraph 39(1)(c).
• Their debts became bad in 2005, pursuant to subsection 50(1).

Justice D’Auray found that cStar did owe a debt to the appellants with regard to the payment of the corporate expenses. The absence of a negotiable instrument, such as a cheque, was not consequential in her determination.

Justice D’Auray reasoned that a debt was owed by cStar to at least one of the appellants because the debt was incurred for the purpose of gaining or producing income from a business or property. The appellants had the burden of establishing that they had a genuine intention to earn income from a business or property and D’Auray felt that only one of them, Mrs. Coveley, had satisfactorily done so.

The appellants stated in their written submissions that Mr. Coveley’s advances were made “not only to earn interest on his promissory note, but also to earn employment income for himself”. For that reason D’Auray held that the debt was incurred for the purpose of gaining or producing income from a business or property for Mrs. Coveley, but not for Mr. Coveley.

And so, the success of the appellants, ended there. For both Mr. and Mrs. Coveley, the ultimate success of their appeals rested on the interpretation of Subsection 50(1) of the Act and the meaning of “bad debt”. 

And that is the subject of the continuation of this case, next time.

Next Time: The Meaning of Bad Debt

Greer Jacks is updating jurisprudence in EverGreen Explanatory Notes, an online research library of assistance to tax and financial professionals in working with their clients.