
In addition to the above - it doesn't matter whether YOU think you are running a business, the inland revenue will decide that and you need to declare ALL your earnings, not just the ones you think count.
So yes, you are using your dog to make money, you haven't done the basics required to be even vaguely responsible because you didn't fancy the financial outlay for health testing so it would be safe to say you neither know, nor CARE if your dog is producing pups with health problems...
I do agree the other woman sounds nuts, but then, no more nuts nor irresponsible than you.
From here on in you have a choice - you can hope fervently that this womans bitch misses and no pups are produced, get your dog neutered and quit adding to the worlds irresponsibly bred dog population, OR if you want to continue breeding you can get your dog tested, show him and/or work him and make sure he HAS something to add to the gene pool worth having.
I guess the third option is to decide we are all mean and evil and leave in a huff and carry on as you are...