The Queen v. Mandryk, 92 DTC 6329, [1992] 1 CTC 317 (FCA)

MacGuigan, J.A. (Huggessen and Stone, J.J.A. concurring:—The principal issue in this appeal is the question of whether the respondent's losses for his 1980 through 1984 tax years are properly characterized as business losses, as the trial judge held, or investment losses, as the appellant contends. There is also a secondary issue as to interest expenses incurred by the respondent.

The respondent, a lawyer engaged in active legal practice, was a shareholder in two corporations—315826 Ontario Ltd. (“the numbered corporation" or "the laundromat business") and Stoney Court Ltd. ("Stoney Court” or the “land development business"). The losses were suffered and the interest expenses incurred as a result of certain guarantees of bank loans to each of the numbered corporation and Stoney Court.

The issues to be decided on the appeal are as follows: (1) were the losses realized by the respondent with respect to certain guarantees honoured by him capital losses the deduction of which is prohibited pursuant to paragraph 18(1)(b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), or on income account the deduction of which would not be prohibited by paragraph 18(1)(a) of the Act?; and (2) were the interest expenses incurred by the respondent in honouring his guarantee of the indebtedness of Stoney Court Ltd. to a bank deductible pursuant to paragraph 20(1)(c) of the Act?

The relevant provisions of the Act are as follows:

3. Income for taxation year

The income of a taxpayer for a taxation year for the purposes of this Part is his income for the year determined by the following rules:

(a) determine the aggregate of amounts each of which is the taxpayer's income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, his income for the year from each office, employment, business and property;

(b) determine the amount, if any, by which

(i) the aggregate of his taxable capital gains for the year from dispositions of property other than listed personal property, and his taxable net gain for the year from dispositions of listed personal property,

exceeds

(ii) the amount, if any, by which his allowable capital losses for the year from dispositions of property other than listed personal property exceed his allowable business investment losses for the year;

(c) determine the amount, if any, by which the aggregate determined under paragraph (a) plus the amount determined under paragraph (b) exceeds the aggregate of the deductions permitted by subdivision e in computing the taxpayer's income for the year (except such of or such part of those deductions, if any, as have been taken into account in determining the aggregate referred to in paragraph (a));

(d) determine the amount, if any, by which the remainder determined under paragraph (c) exceeds the aggregate of amounts each of which is his loss for the year from an office, employment, business or property or his allowable business investment loss for the year; and

(e) determine the amount, if any, by which the remainder determined under paragraph (d) exceeds the lesser of

(i) the amount, if any, by which the amount determined under subparagraph (b)(ii) exceeds the aggregate determined under subparagraph (b)(i),

and

(ii) $2,000, or if the taxpayer is a corporation, nil;

and the remainder, if any, obtained under paragraph (e) is the taxpayer's income for the year for the purposes of this Part.

18. General limitations.

(1) in computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation.—an outlay or expense to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) Capital outlay or loss.—an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

20. Deductions permitted in computing income from business or property.

(1) Notwithstanding paragraphs 18(1)(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:

(c) Interest.—an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy), or

(iii) an amount paid to the taxpayer under

(A) an Appropriation Act and on terms and conditions approved by the Treasury Board for the purpose of advancing or sustaining the technological capability of Canadian manufacturing or other industry, or

(B) the Northern Mineral Exploration Assistance Regulations made under an Appropriation Act that provides for payments in respect of the Northern Mineral Grants Program,

or a reasonable amount in respect thereof, whichever is the lesser;

(3) For greater certainty, it is hereby declared that where a taxpayer has used borrowed money

(a) to repay money previously borrowed, or

(b) to pay an amount payable for property described in subparagraph (1)(c)(ii) previously acquired,

the borrowed money shall, for the purposes of section 21 and paragraph (1)(c) or (k), be deemed to have been used for the purpose for which the money previously borrowed was used or was deemed by this subsection to have been used, or to acquire the property in respect of which the said amount was so payable, as the case may be.

Section 3 and subsection 20(1) were both amended in non-relevant ways as of the 1983 taxation year.

I

The numbered corporation was incorporated on December 8, 1975, by the respondent and two others, each holding one-third of the shares, for the purpose of carrying on a coin laundry business, and was the respondent's first involvement in such a business. The corporation purchased equipment and entered into a five-year lease of premises.

The investors personally and severally guaranteed the bank loan, and in 1980, following financial difficulties with the laundromat business, the respondent was required to pay his share of the outstanding bank loan guaranteed by him personally in the amount of $9,636, the corporate assets were liquidated, and the numbered corporation was voluntarily dissolved. The respondent deducted the full amount of this debt from his income in 1980 as a bad debt.

Stoney Court was incorporated, with one of the same investors, on March 18, 1975, with each shareholder being issued one common share, to carry on the business of building and selling residential housing. During the period 1975-80 the corporation purchased lots with bank loans, built houses, and sold some of the houses. Once the houses were sold, the proceeds were used to pay the bank loans, which had been guaranteed to the bank by the two shareholders.

During the same period the respondent also owned other vacant land in which he traded, but it was always sold for a profit in an undeveloped state.

Following corporate financial difficulties in 1980, the bank called on the respondent's guarantee, and he was required to pay his share of the bank loan in the amount of $245,700. He paid off $15,000 with his own funds, and refinanced the remaining $230,700, which he paid over a period of time, together with interest. The other shareholder having left the Province and gone into bankruptcy, the bank also assigned to the respondent all of the indebtedness and liabilities owing by Stoney Court to the bank and, in addition, all security for repayment.

The respondent wrote off the entire amount of the loan to Stoney Court in his books on December 31, 1980, and also deducted the full amount of $245,700 from his income for 1980 as a bad debt.

During the taxation years 1981-4, the respondent continued to deduct the interest expenses incurred on the loan from the bank in order to preserve his own assets and the assets of Stoney Court, the corporate status of which was maintained, though it ceased to earn income or carry on active business.

For completeness, it should be added that the respondent had been actively engaged in running the laundromat and had also taken a personal role in the running of Stoney Court.

The Minister of National Revenue ("the Minister") admitted that the respondent was trading in real estate in the period 1980-4 with regard to his other real estate interests, but took the position that the ventures in the case at bar were of a different nature and represented a capital investment.

II

The salient parts of the trial judge's reasons for decision are as follows (Appeal Book, III at pages 464-70):

I must say at the outset that I was surprised that the Minister conceded that the plaintiff was a trader in respect of some of the real estate ventures in which he was involved but would make no such concession with respect to the balance of his transactions. The jurisprudence reveals that the Minister is generally quite unsympathetic to the taxpayer who attempts to show that some of his transactions entered into in either the same or successive taxation years had the character of capital investments whereas others were business ventures. The slogan "once a trader, always a trader" immediately comes to mind. I further question what the Minister may have done if Stoney Court had been successful and the plaintiff was able to realize a considerable gain on the shares. Would he have allowed the gain to be treated as capital? I have my doubts. . . .

After having heard the testimony of Mr. Mandryk, I was satisfied that there were cogent business reasons for this choice [of incorporated companies as the vehicle for his business] and I did not hear anything more persuasive than Mr. Mandryk's explanations. I did not see any substantive differences between Mr. Mandryk's approach to the Stoney Court and numbered company ventures and the rest of his real estate projects.

In the first place, Stoney Court was a more ambitious project than any of the others and its financial and planning needs were more complex. More significantly, there was the need for a constant flow of funds. It was contemplated that a significant number of mortgages would be entered into at any one time and as builders, it made perfect sense that the parties would attempt to limit their liability by using a corporate structure. With respect to the laundry business, it is clear that the establishment of this venture was purely a business enterprise, and in fact the defendant did not address very much argument to the contrary.

The Minister's other fundamental objection with respect to the taxpayer's situation was that the investment of money in shares, as was decided by the Supreme Court of Canada in Irrigation Industries Ltd. v. M.N.R., [1962] C.T.C. 215, 62 D.T.C. 1131, is prima facie a capital investment. This may well be so, but the decision of the Supreme Court also reveals that the particular circumstances of each taxpayer are relevant to a final determination and that the treatment of shares as a capital investment is by no means an invariable rule. It is apparent that it is always open to the taxpayer to establish that the purchase of shares was other than a capital investment, for example M.N.R. v. H.J. Freud, [1968] C.T.C. 438, 68 D.T.C. 5279, M.N.R. v. J.M. Fraser, [1967] Tax A.B.C. 418, 68 D.T.C. 5279, and P.]. Cull v. The Queen, [1987] 2 C.T.C. 63, 87 D.T.C. 5322.

In my view, the case turns upon the fact that the plaintiff was a trader in real estate during the taxation years in question. All the moneys advanced by him, (whether by way of cash infusion or by the signing of a note) flowed into the plaintiff's various ventures for the purpose of earning income from real estate. I believe that the distinction proposed by the Minister in this case is an artificial one. Can it be truly said that the plaintiff's involvement in the Stoney Court project was not in respect of real estate, but that instead, the plaintiff was in the business of giving guarantees and therefore would not be entitled to treat this loss as a business loss? I do not think so.

The plaintiff was clearly actively involved in developing the housing projects undertaken by Stoney Court. Every advance that was made to the company on the strength of the notes the taxpayer provided to the Bank of Montreal was money forwarded in expectation of earning income. The funds were advanced for the purposes of purchasing additional properties and continuing the company's construction plans. They were not merely for the provision of working capital by a lender who himself was a trader in real estate but had chosen to set up separate corporate bodies when the ventures were speculative and in which they intended to limit their exposure, as was the case in Isaac Meisels Investments Ltd. v. The Queen, [1985] 1 C.T.C. 9, 85 D.T.C. 5029. The various notes were not isolated transactions advanced speculatively but were in fact continuing advances to pursue the ongoing activities of the company.

When the taxpayer was ultimately forced to sign the final consolidating note to avoid the Bank's possible seizure of all his meaningful real estate assets and other ventures, he received an assignment of the assets of Stoney Court previously pledged to the Bank, in return for the consolidated note; he held a very real expectation of salvaging something from the properties and mortgages held in the inventory of Stoney Court. He also had the very important motive of protecting the balance of his income generating assets from the reach of the Bank. . . .

In coming to this conclusion, I am very much influenced by the decision of Madam Justice Reed in the case of Cull, supra. The similarities between the plaintiff's case and that of the taxpayer in the Cull case are striking. In that case, a partnership consisting of several lawyers was a shareholder in a company formed to take advantage of a real estate development project. The lawyers gave personal guarantees for a share of the debt incurred by the corporation as well as interest thereon. After the project failed, and the partners were called upon to honour the amount of the guarantees, the partnership recorded a loss for the full amount and this was contested by the Minister of National Revenue.. . .

There is very little in the case before me that can be distinguished from the Cull case, supra. In fact, it is clear that the plaintiff Mandryk, as a 50% shareholder in Stoney Court was in an even stronger position to exercise control over the assets of Stoney Court than was the Cull partnership which held a one-third interest in the underlying company. Furthermore, in the case before me, I have the Department's admission that the plaintiff was trading in real estate during the taxation years in question, whereas in the Cull case, the partnership was required to establish based on an isolated transaction, that it was involved in the trading of real estate.

If the taxpayer in the Cull case is entitled to deduct the amount of its business losses, as a person who is engaged in only a single venture in the nature of trade, then Mr. Mandryk, who has shown a long history of engaging in business ventures which was well documented before the Court, must be entitled to the same treatment.

As to the deductibility of the interest payments made by the taxpayer during the 1980 to 1984 taxation years, the plaintiff argues that he signed the note and agreed to additional interest payments to the bank in order to protect his real estate holdings from seizure; that these holdings generated income for the plaintiff and that hence section 20(1)(c) of the Act provides that they can be deducted from income.

The defendant argues that as Stoney Court had essentially stopped its operations, there was no active source of business income to which the plaintiff could relate the cost of borrowing the money. In advancing this proposition, the defendant relies on the case of Russell I. Emerson v. The Queen, [1986] 1 C.T.C. 422, 86 D.T.C. 6184. This does not answer the plaintiff's argument that the purpose of the borrowed funds was to protect the balance of the real estate interests of the plaintiff. As distinguishable from the Emerson case, supra, the plaintiff is still the holder of shares in Stoney Court and it is not up to the Court to speculate as to whether or not they may or may not generate income

The interest payments are hence deductible.

Virtually every other authority discussed by the defendant was addressed at length by Madam Justice Reed in Cull. As the Minister is unable to distinguish this taxpayer's situation from the one laid out in Cull, I believe that in the interests of maintaining consistent jurisprudence from this Court, Mr. Mandryk is entitled to the remedy he seeks.

The Minister is directed to issue reassessments with respect to the taxation years in question reflecting the fact that the amounts claimed as losses on both the Stoney Court project and 315826 Ontario Ltd. are to be treated as business losses. Furthermore, the amounts attributable to interest on the loan taken out from the Bank of Montreal in December 1980 are deductible in each of the taxation years in question pursuant to section 20(1)(c) of the Income Tax Act. The plaintiff is entitled to his costs.

Ill

Leading authorities cited to us by the parties were as follows: Irrigation Industries Ltd. v. M.N.R., [1962] C.T.C. 215, 62 D.T.C. 1131 (S.C.C.); Fraser v. M.N.R., [1964] C.T.C. 372, 64 D.T.C. 5224 (S.C.C.); M.N.R. v. Freud, [1968] C.T.C. 438, 68 D.T.C. 5279 (S.C.C.); M.N.R. v. Sissons, [1969] C.T.C. 184, 69 D.T.C. 5152 (S.C.C.); McKinley v. M.N.R., [1974] C.T.C. 170, 74 D.T.C. 6138 (F.C.A.); Becker v. The Queen, [1983] C.T.C. 11, 83 D.T.C. 5032 (F.C.A.); P.J. Cull v. The Queen, [1987] 2 C.T.C. 63, 87 D.T.C. 5322 (F.C.T.D.); K.J. Beamish Construction Co. Ltd. v. M.N.R., [1990] 2 C.T.C. 2199, 90 D.T.C. 1584 (T.C.C.). They might also have cited G.R. Dumas v. M.N.R., [1989] 2 F.C. 58, [1989] 1 C.T.C. 52, 89 D.T.C. 5005 (F.C.A.), the case which to my mind is most like the present one.

The governing principle appears to me to be that set out by the Supreme Court majority in Irrigation Industries Ltd., where Martland, J. wrote at page 221 (D.T.C. 1133-34):

Corporate shares. . .constitute something the purchase of which is in itself, an investment. They are not, in themselves articles of commerce, but represent an interest in a corporation which is itself created for the purpose of doing business. Their acquisition is a well recognized method of investing capital in a business enterprise.

There is thus a presumption that such a transaction is of a capital nature, though it may be rebutted by the taxpayer. The same Court both in Fraser and Freud, in finding that the funds in question there were income, allowed this presumption to be rebutted by the evidence. In Freud Pigeon, J. said for the Court at page 442 (D.T.C. 5282) that“ the decision rests on the view. . .taken of the nature of the outlay involved in the acquisition of the companies' shares".

It is clear from the decisions of this Court in Becker and Dumas that it is the intention of the taxpayer at the time of acquiring the shares that is determinative. These cases were decided in opposite ways, but precisely on the basis of the intention discovered. Becker, at page 14 (D.T.C. 5035), held that "there is only one conclusion that can properly be drawn from it [the appellant's testimony, which was taken as credible by the trial judge], and that is, that it was the appellant's intention upon changing the nature of [the] business and making it profitable, to sell it as soon as possible for a profit." Dumas, at page 54 (D.T.C. 61-62), decided that the transaction was a capital one because "the appellant had no intention of selling his shares. . .at the time he acquired them; he simply wanted to carry on his business."

In the case at bar the trial judge appears to have been overly influenced by the appellant's admission that the respondent was, in relation to some of his business ventures, a trader in real estate. With respect, I believe the respondent's use of the corporate structure for the two ventures here requires that they be considered independently, and not simply be assumed to be of a piece with his other activities. What must be determinative is his intention in relation to these two businesses. The trial judge does not explicitly draw a factual conclusion as to the respondent's intention, but appears to do so implicitly on the basis of an analogy with the facts in Cull, where Reed, J. found at 68 (D.T.C. 5325) that the shares "were not. . .merely of the usual and normal investment character."

Even if Cull is correctly decided, [1] in the light of the factual variations between cases in my view proceeding by analogy is not an adequate method of fact-finding, particularly in the face of a factual presumption, as here. In such a situation I believe a clear and strong finding is necessary.

Supporting the trial judge's implicit finding was the respondent's own testimony (Transcript of Testimony at pages 16 and 64) that both businesses were entered upon with the intention of selling them at a profit and that he was actively involved in the running of both businesses. But this after-the-event testimony is at odds with the facts that the coin laundry business was carried on for some five years and that the land development business was run even longer, with continual purchases of new lots for development as retail housing units and continual placing of additional mortgages on houses constructed.

These factors lead me to take a different view of the facts from that implicitly taken by the trial judge. To my eye both ventures have the character of genuine investments with a view to the making of profits, in the laundry case by selling services, in the development case by selling built-on lots. They were not ventures in trade for the purpose of profit on resale. Both the duration of the ventures, which tend to negative adventures in the nature of trade, and particularly in the land case the continual reselling over a number of years of individual lots after development, provide insufficient foundation for the clear intention to the contrary required to offset the presumption arising from the investment in shares, and indeed rather suggest the carrying on of ordinary business by both corporations. Moreover, the losses suffered by the respondent in honouring guarantees to the bank were on account of capital, since he was not in the business of lending money.

If the trial judge had made explicit findings of fact, I should have had to find them to be "palpable and overriding errors" as required by Stein v. The Ship "Kathy K.”, [1976] 2 S.C.R. 802 at 808 (S.C.C.). In the circumstances here, I have merely to obey the dictates of paragraph 52(b)(i) of the Federal Court Act and make the findings he should have made. In my view the facts do not reverse the presumption that the transaction was a capital one, because they are not consistent with an intention of selling out for a profit as soon as possible, but rather point to a simple intention to carry on business.

Since the losses must be considered to have been incurred on capital account, the appeal must be allowed in this respect.

IV

In relation to the interest payments in question, in the words of Rand, J. in Canada Safeway Ltd. v. M.N.R., [1957] C.T.C. 335, 57 D.T.C. 1239, at page 344 (D.T.C. 1244) "in the absence of an expense statutory allowance, interest payable on capital indebtedness is not deductible as an income expense."

The leading authority on the meaning of paragraph 20(1)(c) of the Act is the Supreme Court decision in The Queen v. Phyllis Barbara Bronfman Trust, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. Dickson, C.J.C. first posed the question to be answered at page 119 (D.T.C. 5060):

The issue is whether the interest paid to the bank by the Trust on the borrowings is deductible for tax purposes; more particularly, is an interest deduction only available where the loan is used directly to produce income or is a deduction also available when, although its direct use may not produce income, the loan can be seen as preserving income-producing assets which might otherwise have been liquidated.

He then declared for the Court at page 129 (D.T.C. 5067):

In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve income-earning property but which are not directly "used for the purpose of earning income from. . .property".

The Court therefore held in that case that the purpose of preserving income-producing assets was an indirect one which did not qualify interest payments as used directly to produce income.

That holding it seems to me, is fatal to the deductibility of the respondent's interest payments in the case at bar, which were found by the Trial Judge to be payment on borrowed funds to protect the balance of his personal real estate interests. There could be no expectation of income from the loan advancement to Stoney Court, since the loan was written off as a bad debt the day it was advanced. Stoney Court with no income and no active business is only nominally alive, and is more analogous than not to the property in Emerson v. The Queen, [1986] C.T.C. 422, 86 D.T.C. 6184, which, no longer being in existence, could not support deductions for interest.

As indicated by the Bronfman case at page 126 (D.T.C. 5065), subsection 20(3) of the Act is not to be interpreted as extending the meaning of subsection 20(1). In fact, borrowings used to preserve assets cannot be borrowings to earn income.

The appeal must therefore be allowed in this respect as well.

Accordingly the appeal must be allowed with costs, the decision of the trial judge set aside, and the action dismissed with costs.

Appeal allowed.