ABILs: Understanding the Meaning of Bad Debt

Last week, we discussed the partial success of the Coveleys, a couple whose claim for an ABIL in 2005 was challenged by CRA.

In Coveley v. The Queen, the Tax Court of Canada's (TCC) Justice D’Auray used a test established by the Federal Court of Appeal in Rich v. Canada (2003) for guidance in establishing whether their debt had gone bad.

Both the appellants and the Minister agreed that the following non-exhaustive list of factors from Justice Rothstein’s judgment in Rich should be considered in determining whether the debt had gone bad:

• The history and age of the debt.
• The financial position of the debtor, its revenues and expenses, whether it is earning income or incurring losses, its cash flow and its assets, liabilities and liquidity.
• Changes in total sales as compared with prior years.
• The debtor's cash, accounts receivable, and other current assets at the relevant time and as compared with prior years.
• The debtor's accounts payable and other current liabilities at the relevant time and as compared with prior years.
• The general business conditions in the country, the community of the debtor, and in the debtor's line of business.
• The past experience of the taxpayer with writing off bad debts.

Mrs. Coveley was asked why she continued to work for cStar without being paid after 2005. Her response was:

“...we have great assets, intellectual property, solutions, innovative solutions but a little bit too advanced for the market, and we know someday we will be there. Hope is there, but we know clearly this amount [of debt] we cannot collect.”

This response was crucial to Justice D’Auray’s determination that the debt was not bad in 2005. D’Auray cited Judge Mogan in the 2001 decision of Giahinejad v. Canada for the following proposition, which essentially became the crux of her determination:

“Making advances implicitly suggests something positive in the future which contradicts a bad debt determination at the time of the advance. Following that rationale, a loan not due for some time cannot reasonably be found to be bad today, where the prospects of collection when due are promising as shown by recent advances and by the commitment and drive and ongoing work of the debtor whose actions reflect no sign of an imminent failure of the business.”

This case provides great insights into the tax law surrounding the establishment of when a debt is in fact bad, so that an ABIL is claimable. It also underscores why it is always prudent to speak with an experienced tax, financial and legal advisor before structuring any investment or tax plans, personally and for the business.

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.