Strayer, J:—
Facts and Issues
The plaintiff was first incorporated by a special Act of the Saskatchewan Legislature in 1941, this Act being revised several times, the last occasion being 1979. It is also regulated under the Co-operative Credit Associations Act, RSC 1970, c 29. It is what is commonly referred to as a “Credit Union Central” (it is now authorized to use that term as part of its name) whose principal purpose is stated, in section 5 of the 1979 provincial legislation to be “to provide financial intermediary services for its members”. Its members or shareholders are for the most part credit unions and other co-operative associations. At the end of 1978, the taxation year in question, the plaintiffs members included 239 credit unions and 200 consumer co-operatives. As an intermediary, the plaintiff holds surplus funds from its members and reinvests them, mostly in short-term loans. It is an important source of loans for its member co-operative associations and with this pool of funds it assists individual credit unions with short-term liquidity problems. It also serves as a clearing house for cheques among credit unions.
Canadian Co-operative Implements Limited, generally referred to in the evidence and documents as “CI”, was originally incorporated under Saskatchewan law and now is continued under federal law, the Canada Cooperative Associations Act, SC 1970-71-72, c 6. It is a co-operative association engaged in selling farm machinery, some of which it manufactures. Its market area is mainly the dryland grain farming region including parts of the three Prairie provinces, a small portion of British Columbia, and portions of one or two states of the US immediately adjacent thereto. It is a shareholder of the plaintiff. In November. 1974, CI applied for and obtained from the plaintiff a demand line of credit in the amount of $3 million. This was for the purpose of inventory or “bulge” financing which CI required during winter months when it was building up its inventory to be prepared for the demand for machinery normally expected during the spring, summer, and fall months. CI drew the full amount of its line of credit.
It appears that this $3 million loan was not repaid but was instead refinanced by the 1975 financial arrangements which I shall next describe. It became apparent in 1975 that CI was experiencing financial difficulties, a not unfamiliar phenomenon in the farm machinery business in Canada during the last decade. CI’s difficulties were to some extent related to its particular problems of procuring equipment for sale, and partly to a more general decline in farm-machinery sales. In 1975 a group of co-operative financial institutions, acting through the Canadian Co-operative Credit Society Limited (hereinafter referred to as CCCS) agreed to loan to CI the sum of $17.5 million. Of this amount, the plaintiff was to loan $10 million. (See the agreement among the financial institutions, P-17). Of the $10 million provided by the plaintiff, 1 million was provided in turn by, and at the risk of, the Credit Union Federation of Alberta. (See Exhibit P-16). The result was that the plaintiff provided $9 million of the $17.5 million loan to CI by the co-operatives. At the same time, several agricultural co-operatives (the three prairie Wheat Pools, the United Co-operatives of Ontario Limited, United Farmers of Alberta Limited) and Federated Co-operatives Limited, a major cooperative wholesaler and manufacturer, guaranteed repayment of two-thirds of the 17.5 million dollar loan to CI. (See Exhibit P-18). The net result was that of the $9 million loaned by the plaintiff to CI, repayment of two thirds or $6 million thereof was guaranteed so that its “exposure” or risk was limited to $3 million. The total $17.5 million loan was repayable on demand or by October 31, 1977. At the same time CI borrowed some $15 million from the Mercantile Bank of Canada and this loan was to have priority over the $17.5 million loan provided by the co-operatives.
In early 1977 CCCS provided a further $5 million in “bulge” financing for CI with respect to the usual winter build-up of inventory.
By the fall of 1977, then, there was a total of $22.5 million owing to the CCCS for itself or on behalf of the other co-operative financial institutions for which it was acting as agent. Of this amount, $9 million was owed to the plaintiff of which $6 million was guaranteed by other co-operatives. 1977 was another difficult year for CI and, according to its audited statement of operations for its financial year ended October 31, 1977 it suffered a loss of $9,407,320. (See Exhibit P-20).
The principal on the outstanding loans was not paid by CI by October 31, 1977, although interest payments had been met. Discussions commenced among Cl’s creditors and with the governments of Canada, Manitoba, Saskatchewan and Alberta in September of 1977 and these discussions continued until the spring of 1978. (See Exhibits P-19, P-21 to 23).These meetings culminated in an agreement which was made effective March 31,1978 which will be discussed below. It may be useful to note at this point that, according to Mr Bromberger, chief executive officer of the plaintiff, some consideration was given by at least some of the creditors in the fall of 1977 to putting CI into receivership or bank- ruptcy. After studying the matter, the plaintiff was unwilling to take this route. This was because of the liability that might be incurred under provincial law, in the event of receivership, with respect to wage claims and with respect to the obligation under Saskatchewan law to maintain a supply of parts for farm machinery for at least ten years after that machinery has first been sold. Receivership or bankruptcy would also have had serious consequences for the plaintiffs member credit unions: bankruptcy in particular, if it put CI out of business, would have caused a depreciation in the value of farm machinery previously sold by it and on which in many cases Saskatchewan credit unions held security for loans advanced for purchase. In some cases credit unions also held security on local depots established by CI for distribution and servicing of machinery. Moreover according to Mr Bromberg the creditors and the governments involved felt there was a real prospect that CI could be restored to a viable position. There was considerable feeling that CI suffered from a lack of working capital and that its reliance on loan capital, with the heavy carrying charges associated therewith, was an important factor in the company’s unfavourable financial situation. The governments of Alberta and of Canada were particularly of the view that the creditor co-operatives should write down some or all of their loans. According to the evidence of Mr Dierker, who was the general counsel for the plaintiff during these discussions, the Government of Canada was particularly concerned that more equity capital should be provided to CI by the other co-operatives in lieu of some of the loan capital they had provided.
The agreement of March 31, 1978 (see Exhibit P-24) involved the Government of Canada, the governments of Manitoba, Saskatchewan, and Alberta, CCCS on its own behalf and as agent of the various co-operatives (including the plaintiff) with an interest in the matter (called the “Co-operative Participants”) and CI. By the terms of the agreement, Cl’s debts to the Mercantile Bank were to be paid off with the result that the Co-operative Participants would have priority as creditors. The outstanding obligations to the various co-operative financial institutions in the amount of $22.5 million were to be paid off. In lieu of this previous financing, there were to be the following arrangements:
(i) the Government of Canada would provide a recoverable cash contribution of $8 million for CI;
(ii) CCCS for itself and as agent for the other co-operative financial institutions would grant a long-term loan to CI in the amount of $7 million, with the governments of Manitoba, Saskatchewan, and Alberta to provide a guarantee of repayment of the whole of this amount;
(iii) CCCS, on behalf of itself and its principals, would establish an operating line of credit for CI in the amount of $20 million;
(iv) CCCS would, for itself and its principals, acquire preferred shares in CI at a par value of $8,750,000;
(v) CCCS would undertake to provide to CI working capital as required, up to a maximum of $2.5 million.
In a subsequent agreement among the various co-operatives involved, dated April 28, 1978 (see Exhibit P-26) the obligations assumed by CCCS on their behalf were allocated. Of the $8,750,000 to be invested in preferred shares of CI, the plaintiff was assigned responsibility for $1,414,286 worth. Of the long-term loan of $7 million (guaranteed by the provincial governments) the plaintiff was to provide $3 million. Of the line of operating credit to a maximum of $20 million, the plaintiff was to provide $7 million and of the working capital advances to a maximum of $2.5 million the plaintiff could be required to provide up to 16.16 per cent.
On April 28, 1978 the parties met in Winnipeg for the purpose of “closing” under the agreement of March 31, 1978. At that time the plaintiff provided a cheque for $1,414,286 for the purposes of its allocation of the preferred shares of CI. A total of $8.75 million was provided by the plaintiff and the other purchasers of the shares, the money being turned over to CI. The advance from the Government of Canada in the amount of $8 million was also provided to CI, together with the $7 million representing the long-term loan provided under the agreement. All of this money was deposited to the credit of CI, and almost all of it was used immediately to discharge the debts of 22.5 million owing to the various co-operative financial institutions. Of this, the plaintiff received $10 million representing the $9 million owed to it directly and the $1 million which had been provided through it by the Credit Union Federation of Alberta. As a result of all these transactions, whereas prior to the closing date $10 million had been owed to the plaintiff (for itself or as agent for the Credit Union Federation of Alberta), by May 26, 1978 CI owed it $7 million representing advances it had made pursuant to the new financing agreement of March 31. Apart from this it was the beneficial owner of preference shares of CI for which it had paid $1,414,286. It was agreed by the parties at the trial that at no time in 1978 were these shares worth more than 50 per cent of their par value: that is, their total value was no more than $707,143.
The net result for the plaintiff was that it received payment in full of its previous loan of $9 million to CI, payment which was guaranteed only to the extent of $6 million. It then advanced $3 million for the long-term loan (all of which was guaranteed by the provincial governments) and additional financing for which there would be better security than previously existed with respect to the unguaranteed portion ($3 million) of its previous loan. The security was improved because the Mercantile Bank loan with its priority had been removed, and with respect to the new financing the claims of the creditor co-operatives were subject only to a limited priority of the Government of Canada with respect to its recoverable contribution.
The plaintiff in its 1978 income tax return included in its operating expenses an amount of $707,000 for ‘‘uncollectable loans’’. Its net revenue for 1978 was thereby reduced by that amount. Revenue Canada by a notice of reassessment dated April 3, 1981, disallowed as an operating expense what it described as a “write-off of 50 per cent of the cost of preferred shares of Co-op Implements Limited”, thereby adding the sum of $707,143 to the net income of the plaintiff. The plaintiff appeals against that reassessment. It contends that it can deduct what it regards as its loss in 1978, being the amount by which the cost of the preferred shares in CI exceeded their value. It contends that this is deductible from net income either because it is a normal cost of doing business, or that it is a bad debt under paragraph 20(1 )(p) of the Income Tax Act, or that these shares represent “inventory” of the plaintiff and that under subsection 10(1) such inventory can be valued at the lesser of its cost or its fair market value, in this case the latter being equal to only 50 per cent of the former.
In arguing its position, the plaintiff asserts that the whole of the refinancing arrangements must be seen as a single transaction. It contends that as of March 31, 1978, the effective date of the refinancing agreement, it was a creditor with a claim, inter alia, for $3 million for which there was no guarantee and very poor security otherwise. In its view this claim against CI was for all practical purposes a bad debt. It points to the fact that some of the creditors were considering receivership or bankruptcy for CI. The refinancing agreement came about be- cause of the interests which the various parties had in seeing a continuation of CI, and in particular because of participation of various governments especially the infusion of cash by the Government of Canada. This government participation was available, however, only on the basis that various of the creditor cooperatives would replace some of the loan capital they had provided to CI with equity capital. The plaintiff contends, in effect, that in return for it receiving payment of its unprotected $3 million loan to CI, it was obliged to purchase $707,000 worth of preferred shares for some $1,414,000 with an attendant loss of $707,000 on the whole transaction.
On the other hand, the defendant contends that there were two separate transactions involved here. First, the plaintiff provided a cheque for $1,414,000 for the purchase of preferred shares of CI. Secondly, it received repayment of its loan of $3 million. The loan was not a bad debt in 1978 because it was paid off in full in that year. The purchase of the preferred shares of CI was a capital transaction by way of investment. If the preferred shares are not in fact worth as much as the plaintiff paid for them, the loss is a potential capital loss which cannot be claimed until the shares are disposed of.
Form and Substance
Counsel for the plaintiff cited several cases in which the courts have distinguished between the “form” and the “substance” of a transaction for purposes of assessing taxation. It has been said on numerous occasions that if there is a conflict between the two, the court would base its characterization on the substance of the transaction. On the other hand counsel for the defendant cited various cases where the courts concluded that the form and substance were the same thing and where some emphasis was given to the form in which the transaction was cast. After reviewing these cases it appears to me that characterization in each case must largely depend on the particular facts, and that while in the Canadian cases especially considerable emphasis has properly been given to substance, the form in which taxpayers cast or term the transactions must be given considerable weight in the determination of substance. I shall make further reference to these distinctions in considering the various grounds on which the plaintiff asserts that the amount of $707,000 was properly deductible from its income in 1978.
Business Loss or ‘‘Bad Debt”
The plaintiff contends that, in substance, what transpired here was a single, if somewhat complicated, transaction in which in order to obtain partial repayment of the unguaranteed part, namely, $3 million, of the $9 million debt owed to it by CI, it took shares in CI worth $707,000 less than their par value of $1,414,000 charged to the plaintiff. It contends, then, that this loss arising from the purchase of CI shares at a cost at least twice their real value was either a business loss incurred in the process of earning income as a money lender or was, in substance, a “bad debt” because it represents for all practical purposes that amount of the pre-1978 loan to CI which will never be recovered by the plaintiff.
The plaintiff relies first on the general rules in section 9 of the Income Tax Act to the effect that a taxpayer’s income from a business or property is his profit therefrom for the year, and says that the “loss” of $707,000 should be deducted from income in computing that profit. Further, the plaintiff relies on paragraph 20(1 )(p) of the Act which provides as follows:
20. (1) Notwithstanding paragraphs 18( l)(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 or such part of the following amounts as may reasonably be regarded as applicable thereto:
(p) Bad debts.—the aggregate of debts owing to the taxpayer
(i) that are established by him to have become bad debts in the year, and
(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year.
It also contends, and this I accept, that if the loss is in the nature of a bad debt which does not come within the particular requirements of paragraph 20(1 )(p) it may still be deducted from income if it otherwise meets the requirements of the Act as a loss incurred in the course of earning income. See Associated Investors of Canada Limited v MNR, [1967] 2 Ex CR 96 at 107-8.
I have come to the conclusion, however, that this “loss” of $707,000 cannot be regarded either as a loss incurred in the course of earning income or as a bad debt. There are of course many circumstances in which a creditor might accept, in lieu of payment of a debt, the transfer of shares in the debtor’s company where the shares would not have a current value as great as the outstanding debt, and the resulting loss to the creditor might be regarded as a business loss, particularly if the creditor disposes of the shares shortly thereafter. Such circumstances are, indeed, contemplated by Revenue Canada Interpretation Bulletin IT-442, paragraph 14. But that was not what happened in this case. Here we have a complex set of creditor-debtor-guarantor relationships both preceding and following the refinancing agreement which was made effective March 31, 1978. Prior to that agreement the plaintiff was creditor of CI in the amount of $9 million, $3 million of which was unguaranteed. After March 31, while the previous debt had been paid off, the plaintiff was committed by that agreement and subsequent arrangements with the other cooperatives to lending up to a possible maximum in excess of $10 million, only $3 million of which would be guaranteed by the provincial governments. The security for the remainder of the possible loans would apparently be better than it was before the refinancing agreement, since priority of the Mercantile Bank had been removed. At the same time, the plaintiff had become the owner of preferred shares of CI with a par value of $1,414,000 and a real value now agreed by the parties to this proceeding to have been no more than $707,000 at any time in 1978. There is simply nothing in this elaborate arrangement to identify the repayment to the plaintiff of the $3 million unguaranteed portion of its previous $9 million loan to CI with the acquisition by the plaintiff at an inflated price of Cl’s preferred shares. It may well be that plaintiff would never have purchased the shares had it not been a major creditor of CI but that in my view is not a sufficient nexus to equate the overpayment for the shares with a loss on the loan.
The fact is that the loan which is said to be uncollectable, and thus a business loss, or a bad debt, was paid off on April 28, 1978 as one of several transactions which took place at that time in the “closing” under the refinancing agreement of March 31, 1978. That debt no longer exists and did not exist at the end of 1978. It was replaced by another set of financial relationships under which the debtor, it was hoped, had been put on a more secure financial basis. The debtor was, by its own agreement, under the management of an administrative committee on which the creditors and governments were to be represented. It was provided with more equity capital and more long-term loan capital, together with immediate cash flows, to enable it to function more efficiently.
While I accept that one should attach more importance to the substance rather than to the form of these transactions, it appears to me from the evidence that the substance of the refinancing agreement was to restore and preserve the viability of CI. This was only partly for the purpose of “cutting the losses” of Cl’s creditors. The four governments which participated in the financing agreement had no creditor relationship to protect at that time. They were obviously more concerned about the social, economic, and political impact of any possible bankruptcy of CI. The concerns of producer and other co-ops with respect to the welfare of their members who are also members and patrons of CI can readily be imagined. Mr Bromberger, chief executive officer for the plaintiff, mentioned some of its specific concerns as the Credit Union Central and a major financial institution in the province of Saskatchewan where a large percentage of Cl’s members and patrons were to be found. Among these was the potential impact on its member credit unions which had numerous outstanding loans to farmers secured by CI equipment and loans to CI on the security of local machinery depots. CI would also, if it survived, be a source of more lending business for the plaintiff and its member credit unions. In my view then the real substance of this series of transactions was the salvage of CI and its continued operation on a sounder footing.
In this connection, it appeared from the evidence of Mr Dierker, general counsel for the plaintiff in 1978, that a major concern of some governments, particularly the Government of Canada, was that CI should have more capital in the form of equity instead of loans. The Government of Canada and apparently the government of Alberta were also of the view that the creditor cooperatives should provide that equity capital. The much needed infusion of $8 million cash which came from the Government of Canada by way of a recoverable contribution was only available on condition that creditor cooperatives buy $8.75 million worth of preference shares. While it appears that the figure of $8.75 million was reached as a compromise on the basis that it represented 50 per cent of previously outstanding loans to the cooperative creditors of $17.5 million, the allocation of preferred shares required to be purchased by each of the former creditors was not uniformly effected on the basis that each creditor or guarantor under the previous debt was expected to purchase shares to a par value of 50 per cent of its former potential loss under the loans. Nor of course was this the only commitment expected of most of the former creditors or guarantors since the refinancing agreement contemplated further loans to be advanced by many of them to CI.
It appears to me that the former creditors and guarantors who agreed to buy shares fully expected that they were making a long-term investment in CI and were assisting its continued operation by making available a substantial amount of equity capital. Even recognizing their inherent interest and concern with the ongoing welfare of CI, perhaps they would not readily have made such an investment. But they agreed to do so under some pressure from the Government of Canada and perhaps other governments in return for the essential participation of those governments. They may also have seen some advantage in having the “asset” of the preference shares in CI to show in their annual report to shareholders, instead of the complete write-off of the loans which was initially suggested by one of the provincial governments. Having chosen this route, however, they should not be surprised that it may have different tax consequences.
Further, it must have been obvious to the creditor cooperatives who agreed to buy shares that they were “locking in” their money for the indefinite future. While Mr Bromberger on behalf of the plaintiff testified that the plaintiff would have been quite willing to sell the shares at any time, there is nothing to indicate that the plaintiff or any other purchaser of the preference shares had any real expectation of being able to resell them. The possibility of resale was not an “operating motivation” for their acquisition. See Racine et al v MNR, [1965] CTC 150; 65 DTC 5098 (Ex Ct). Instead, in my view the plaintiff had become an investor — perhaps a reluctant investor — in CI with no foreseeable prospect of liquidating that investment.
Having come to this conclusion, I find it unnecessary to consider the many other interesting points raised by counsel.
In my view the foregoing conclusion is consistent with Revenue Canada’s Interpretation Bulletin IT-483, paragraph 35 of which, in noting that one of the main functions of a Credit Union is to make a return by investment of funds obtained from members, says that any gain or loss on the disposal of a bond, debenture, mortgage, etc, or a loan acquired with such funds is usually regarded as an income gain or loss. To view it as capital property, an investment would have to be shown to represent long-term employment of members’ capital beyond the needs of the credit union’s money-lending business. It goes on to say:
Examples of capital property would include real estate owned by a credit union to provide it with a business premises, shares in a deposit insurance corporation, shares in an affiliated corporation acquired for long term purposes, and a mortgage taken back on the sale of business premises. [Emphasis added. ]
I believe that the preferred CI shares acquired by the plaintiff come within the sort of “capital property” referred to here, particularly in the emphasized phrase. The long-term purposes had to do with the importance of the survival of CI to the cooperative movement generally, and to the business interests of the plaintiff and its member credit unions.
Loss of Inventory
The plaintiff essentially argues here that the shares acquired by a financial institution in furtherance of its ordinary course of business should be regarded as “inventory”. A gain or loss experienced should be treated as such in computing income. More particularly, subsection 10(1) should apply which provides as follows:
10. (1) For the purpose of computing income from a business, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.
It may be that shares held by a company which is in the business of buying and selling shares can be regarded as inventory. Having regard, however, to my conclusion that in substance the CI shares here were acquired as an investment, they cannot be regarded as inventory so as to allow the difference between their cost and fair market value in 1978 to be debited from income.
Conclusion
I therefore conclude that in substance the refinancing agreement was designed inter alia to make the plaintiff an investor in CI as well as continuing its role as a creditor. It may have assumed the role of investor reluctantly, but the arrangement was not without its advantages to the plaintiff. It had good social, economic, and business reasons for wishing to preserve CI as an ongoing business. This was not a situation of a creditor simply cutting its losses by taking an asset of less value as full payment of a debt in order to be rid of a failing debtor. The refinancing was part of an ongoing relationship.
The shares being an investment, they should be treated as such and any possible capital losses will have to be claimed at the time of disposition of the shares.
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