Freeway Properties Inc. v The Queen, 85 DTC 5183, [1985] 1 CTC 222 (FCTD)

Addy, J:—The plaintiff (hereinafter referred to as Freeway) is appealing its assessment for income tax purposes for the 1980 taxation year. It received, during that year, a total of $150,000 in interest on a realty mortgage secured on a property which it sold in 1979. $20,000 of that amount was admittedly due, payable and received in that year. The dispute arises out of the remaining $130,000 which consisted of prepaid interest and revolves around the question whether that amount should be considered as income for 1980 or considered as income attributable to the entire term of the mortgage, that is, up to the 31st of December 1984, when the whole of the principal of $300,000 became payable in one lump sum.

Freeway was incorporated as a private corporation in 1977 in the province of British Columbia. Pursuant to the legislation in force in this province there is no requirement for a company to indicate any of the objects for which it is incorporated nor is there any restriction on the type of business in which a company may engage. The evidence establishes, however, that it was in fact incorporated for the purpose of engaging in the business of land development and resale. This also included land assembly, construction and management. The more immediate and important object of incorporation, however, was to purchase a specific piece of property, to develop it for rental to an auditing firm and other tenants and then to dispose of the developed real estate by sale when the time was propitious. The company purchased the property in question, that is, one acre of raw land in 1977 for the sum of $275,000. As it had no assets the entire purchase price was financed by loans. The company acquired no other lands.

An architect was hired and negotiations were entered into with the municipal authorities in order to obtain a change of zoning to suit the proposed use. Plans were prepared by the architect for that purpose. An attempt was also made to arrive at a mutually satisfactory price for the payment of municipal services and for changes to the adjacent highway overpass. Rental agents were engaged and charged with obtaining undertakings for leases from prospective tenants for at least a 50 per cent occupancy in order to facilitate the obtaining of mortgage financing of the building and to minimize the financial risk once the building was erected. The rental agency was unsuccessful in obtaining tenants and another agency was subsequently engaged. It also was unable to obtain any commitments to lease from any persons or firms except from the accounting firm of which parties interested in the plaintiff were members.

The manager of the plaintiff, who had been a member of the accounting firm, also had extensive experience in land development. He, as well as the rental agents, attempted, unsuccessfully, to obtain future tenants. It appears that the main reason why any prospective tenants were reluctant to commit themselves to renting any portion of the proposed building was that, at that particular time, the land was considered to be too far from the business areas of central Vancouver. As a result, attempts by Freeway at obtaining financing for the building failed. The only improvement to the property was a certain amount of clearing and levelling done with a bulldozer.

Following these attempts at financing and renting the property, it was sold in July 1979 for $350,000 to a syndicate composed mainly of partners and clients of the accounting firm. Some of the shareholders of the plaintiff Freeway were wives of the partners of the accounting firm. The purchase price of the property was payable $50,000 cash with the balance secured by a 4 /z-year $300,000 mortgage back to Freeway with interest at 14% per cent per annum calculated half yearly. None of the capital of the mortgage was repayable until the 31st of December 1984 at which time the entire capital sum became due and payable. Meanwhile the interest was prepayable in its entirety by the 31st of March 1980. The repayment terms of the mortgage were as follows:

PROVIDED this mortgage to be void on payment of three hundred thousand dollars ($300,000.00) of lawful money of Canada, with interest at fourteen per cent (14.0%) per annum, both before and after maturity, as follows:

computed from June 30, 1979, calculated semi-annually, not in advance, payable as well after as before maturity as follows:

AS TO INTEREST: Interest accruing hereunder shall be due and be payable as follows:

(a) by monthly payments commencing July 31st, 1979 up to and including December 31, 1979;

(b) prepayment of interest due for the balance of the term hereof to be calculated on the present value of the interest at the interest rate aforesaid and payable in equal lump sum instalments of $50,000 on September 30, 1979, December 31, 1979, and a final payment on March 31st, 1980. The prepayment of lump sum interest as aforesaid shall represent full and final payment of all interest owing hereunder during the term of this mortgage.

AS TO PRINCIPAL: All monies due and owing hereunder including principal and interest shall become due and be paid on December 31, 1984.

Had the interest been payable and paid half-yearly throughout the term Freeway would have received a total of $210,000. Having regard to the prepayment clause, however, the true discounted value of the interest amounted to approximately $150,000 which was repayable as above indicated in paragraph (b) of the interest payment clause by three equal $50,000 instalments.

At the same time as the sale and as part of the terms thereof, Freeway, together with another company specializing in property management, entered into a management agreement with the purchasers under the terms of which Freeway and its partner company would, for a fee, attend to the management aspects of the construction and also manage the property after the construction was terminated. Freeway also searched for and found take-out financing for the construction. It received a $12,500 finding fee for this service from the purchasers. It also rendered certain management services such as liaison with a construction management firm during the construction and received in 1980 a total of $72,500 which included the finding fee of $12,500 above-mentioned plus $5,500 for its other services and $55,000 in disbursements paid to a construction management firm. Freeway itself, although its manager was quite active, had no salaried employees. The manager was never remunerated for his services. His wife, however, was one of the four shareholders of Freeway. The incidence of taxability and the amount of tax payable on the prepaid interest of $130,000 depends on the following two issues:

1. Whether the interest income from the mortgage constituted “active business income” pursuant to subsection 125(1) of the Income Tax Act as opposed to “investment income” pursuant to subsection 129(4).

2. Whether the $130,000 in interest received in 1980 constitutes income for that year for taxation purposes or whether, since Freeway was accounting for its income on an accrual basis, it should only be credited as taxable profits from year to year throughout the remainder of the mortgage.

Regarding the first issue the relevant portion of subsection 125(1) of the Act reads as follows:

125. (1) There may be deducted from the tax otherwise payable under this Part for a taxation year by a corporation that was, throughout the year, a Canadian-controlled private corporation, an amount equal to 21% of the least of:

(a) the amount, if any, by which

(i) the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada,

exceeds

(ii) the aggregate of all amounts each of which is a loss of the corporation for the year from an active business carried on in Canada.

[Emphasis added.]

Although the term “active business” is now defined in the Act, there was no statutory definition of the term for the period relevant to the present case.

There are, however, numerous cases where the term has been judicially interpreted. The question of whether a business is an active one 1s, above all, a question of fact. In the case King George Hotels Ltd v The Queen, [1981] CTC 87; 81 DTC 5082, Urie, J, in expressing the unanimous opinion of the Court of Appeal, stated at 90 [5084] of the above-mentioned report:

Before disposing of the appeal I think that it should be stressed that whether a business is an active or inactive one is, as earlier pointed out on the authority of the Rockmore case, supra, one of fact dependent on the circumstances of each case. That being so, it is neither possible nor desirable to lay down any rule or principle applicable in every case. It cannot be said, therefore, in my view, that income from “other than an active business” necessarily means that derived from a business that “is in an absolute state of suspension” or one ‘‘devoid of any quantum of business activity” as has been said in earlier decisions in the Trial Division. In any given case, the business may be of that kind but whether or not it is, is not necessarily determinative of the issue, the resolution of which depends on the fact finder’s view of the true nature of the business based on the facts in the particular case. The quantum of activity may well vary from case to case but still it is necessary for the Court to weigh all of the evidence to characterize the quality of the particular business.

The following statement by Sweet, DJ in the case Birmount Holdings Ltd v The Queen, [1977] CTC 34; 77 DTC 5031 at page 46 [5039] is quite helpful:

Here, the situation is quite different. This is not a situation where the realty was acquired with funds awaiting use in connection with some other business of the company. Here, the plaintiff had no business other than business associated with the realty. Neither is it the case of a company, having surplus funds acquired in the conduct of its business, seeking an investment for those funds in a field other than that in which the company usually operated. Here, the evidence does not disclose any asset of the plaintiff except the realty out of which the assessment arose and possibly some increment from it. The funds with which the realty was acquired were not generated by the business of the plaintiff. They were supplied by Mr Mentzelopoulos and were so supplied only for the purchase of the realty.

According to the wording of the letters patent of the plaintiff its only stated object was “to acquire by purchase” the lands in question. So far as the wording of the “objects” of the corporation is concerned the plaintiff had no function to perform, no business to pursue and nothing to do except in connection with the realty. The business of the plaintiff was dealing in and with the realty and that was the plaintiffs only business.

In my opinion, the result is that the plaintiff did more than just engage in an adventure in the nature of trade. It carried on business in and with the land. In doing so, it performed the very business function anticipated by the wording of its letters patent.

In the case at bar, the object of the incorporation of the company was quite clearly to acquire land with the intention of selling it when it became advantageous to do so. In Riviera Hotel Co Ltd v The Queen, [1982] CTC 30; 82 DTC 6045, I held that the acquisition of real property for profit and resale constituted an active business operation in the circumstances of that case, although the taxpayer was primarily engaged in the hotel business. Where the income under consideration is part of the normal business activity of a company and it is inextricably linked with an active business it is considered active business income. (See Supreme Theatres Ltd v The Queen, [1981] CTC 190; 81 DTC 5136). The same principle of interdependence between what might otherwise be considered passive income and active business operations was recognized by the Court of Appeal in the case of The Queen v Marsh & McLennan Ltd, [1983] CTC 231; 83 DTC 5180 where we find the following statement at 242 [5189]:

To use the words employed by Rowlatt J in Scales v George Thompson and Company Limited, [1927] 13 TC 83, on the facts of this case there was between the broker’s business and the investments an inter-connection, an interlacing, an interdependence, a unity embracing the investments and the business. I conclude that the income from the investments is excluded as Canadian investment income under subparagraph (4)(l)(ii). These facts would also, on authority I have cited, serve to exclude it under subparagraph (4)(a)(iii).

For taxation purposes, the characterization of income received from property, including mortgages, depends upon the purpose for which the initial investment was made (See The Queen v Rockmore Investments Ltd, [1976] CTC 291; 76 DTC 6156.).

I also held in the Riviera Hotel case, supra, that, where the sale of property constitutes an active business, then the income and interest derived therefrom constitute active business income.

The defendant had conceded that the sale of the land by Freeway constitutes an adventure in the nature of trade and, although the Crown does not concede that the mortgage interest constituted income from an active business, the Crown does admit that Freeway’s management income does.

Having regard to the facts which I have enumerated previously regarding the purpose of incorporation of Freeway, its activities subsequent thereto, leading to and including the sale, I find no difficulty in concluding that the sale of the property which was effected in direct pursuance of the objects for which it was incorporated, constituted an active business enterprise. The mortgage, as stated by the witness Barr and Willoughby, was negotiated and entered into for the purpose of facilitating the sale of the property. Without that morgage, the sale would probably not have taken place. It was therefore inextricably linked with the sale. There was a close interdependence between the sale and the mortgage. Therefore, according with the principles which I have mentioned, the mortgage and the interest payable thereunder are to be considered as part and parcel of the active business of the taxpayer. The facts of this case are clearly distinguishable from those considered by the Court of Appeal in Canadian Marconi Co v The Queen, [1984] CTC 319; 84 DTC 6267, where the taxpayer, a manufacturer of electronic equipment, invested the proceeds of a sale in short-term interest bearing securities for three years while looking for a business in which to invest.

On the second issue, namely whether the $130,000 of prepaid interest received in 1980 constituted income for that year, counsel for Freeway argued that, in the absence of any express provisions to the contrary in the Act, because the company had always computed its income on the accrual method and because the prepaid interest represented the profit earned by reason of the use by the borrower of the money lent for the entire period between January 1, 1980 and December 31, 1984, that profit, in accordance with normal business accounting practices, had to be accounted for as a profit over the whole period, as and when the interest became attributable to each accounting period.

Section 9 of the Income Tax Act indeed states that profit must be accounted for in accordance with normal business practices unless the Act otherwise provides. Several cases were relied upon by counsel for Freeway including Ken Sleeves Sales Ltd v MNR, [1955] CTC 47; 55 DTC 1044, Industrial Mortgage and Trust Co v MNR, [1958] CTC 106; 58 DTC 6185, to emphasize the importance of relying on normal business practices. I find no difficulty in concluding and indeed it was admitted by the Crown, that Freeway was justified in accounting for its operations on an accrual as opposed to a cash basis. It was in fact obliged to do so. The Crown also conceded and I so find, that the method of accounting by Freeway was in accordance with generally accepted accounting principles. Counsel for the Crown, however, argued that in the circumstances of this case, because of the specific provisions of paragraph 12( l)(c) of the Act all of the interest paid during the year in question had to be accounted for as profit in that year, notwithstanding that, from the standpoint of generally accepted accounting principles, it might well be proper to only credit as profit that portion of the interest earned in each year of the term of the mortgage. It was argued, in other words, that, where the provisions of the Act override or render inapplicable in any particular manner generally accepted accounting principles, the provisions of the Act must prevail. This, in my view, is obviously good law. The question remains, however, whether it applies to the facts of the case at bar.

Paragraph 12(l)(c) of the Income Tax Act reads as follows:

(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(c) Interest: Any amount received by the taxpayer in the year or receivable by him in the year (depending upon the method regularly followed by the taxpayer in computing his profit) as, on account or in lieu of payment of, or in satisfication of, interests;

It appears clear from the above text that interest for taxation purposes can and must be taken into account as income in only two ways: when the taxpayer is entitled to account for income on a cash basis, interest is to be considered in computing income during the year of receipt; where the taxpayer, on the other hand, is accounting for income under the accrual method, interest must be taken into account when it is receivable. This section allows for no other alternative. For instance, it does not say that if it is receivable in any one year it is not to be taken into account in that year where it is interest in respect of a period previous to or subsequent to the time when it is receivable.

The payment clause in the mortgage which I have quoted in these reasons cannot, in my view, be interpreted in any other way but to lead to the conclusion that it imposes on the mortgagees the strict obligation to pay to Freeway and grants to Freeway the strict legal right to receive in the 1980 taxation year the whole of the interest mentioned therein. The interest, in my view, must be considered as “receivable” in that year, by whatever dictionary or technical accounting definition one might attribute to the word “receivable”. It seems clear that if any payment stipulated to be made by the mortgagee in that year is not in fact made, Freeway would have an immediate, absolute and unconditional right to sue for the amount and arrears. As stated by our Court of Appeal in the case of Commonwealth Construction Company Limited v The Queen, [1984] CTC 338; 84 DTC 6420, the amounts had “the quality of income” because the taxpayer’s right to receive them were absolute and under no restriction as to their disposition, use or enjoyment. In delivering reasons which were concurred in by the other members of the Court, Urie, J stated at 343 [6425] of the above report:

The test for determining the proper year for the inclusion of receivables in taxable income enunciated by Kearney J received the approval of the Supreme Court of Canada in Maple Leaf Mills Limited v Minister of National Revenue (1976), 76 DTC 6182. At page 6186 of the report de Grandpré J, speaking for the Court, had this to say:

“. . . I accept without question the test expressed by Kearney, J in The Minister of National Revenue v John Coif ord Contracting Company Limited [60 DTC 1131] (1960) Ex CR 433, at pages 440 and 441. An appeal to this Court from this judgment was dismissed without written reasons [62 DTC 1338] (1962) SCR viii.

This test is the one this court has applied in income tax cases resulting from expropriations: for an amount to become receivable in any taxation years, two conditions must coexist:

(1) a right to receive compensation;

(2) a binding agreement between the parties or a judgment fixing the amount. [Emphasis mine.]”

(See also The Queen v Terra Mining & Exploration Limited (NPL), [1984] CTC 176; 84 DTC 6185 and MNR v Mid-West Abrasive Company of Canada Limited, [1973] CTC 548; 73 DTC 5429.)

Counsel for Freeway argues on the other hand that clause 15 of the mortgage changes the situation. That clause gives the mortgagee, Freeway, in the event of default, the right to claim three months’ interest by way of indemnity. Counsel alleges that, should default occur say after six months, then the mortgagor would not be entitled to claim the interest for the full term but only up to the time of default plus a three months indemnity and that, as a consequence, the remainder of the interest would not be a “receivable”.

That reasoning must be rejected for the clause is but a privilege of the mortgagee which the latter may or may not choose to exercise. It does not in fact or in law change the character of all the interest payments due in 1980 unless the mortgagee chooses to avail itself of the acceleration clause on default (clause 5) and claims payment in full of the mortgage including principal and interest to date. Unless and until the mortgagee chooses to exercise that right (having regard to the terms of repayment of interest he would in all probability be very ill-advised to do so) the obligation to pay the interest in 1980 and the right to receive it, retain it and use it remain absolute and unaffected by clause 15.

Counsel for Freeway also relied on the recent decision of a Court of Appeal in The Queen v Imperial General Properties Ltd, [1985] CTC 40; 85 DTC 5045. The decision is clearly distinguishable since it turned entirely on a finding that the agreement for sale of land which was in issue provided that the purchase price was not truly receivable until a condition precedent had been complied with. There is no question of any condition precedent existing in the case at bar.

The taxpayer in the Imperial General Properties case was claiming that the amount was taxable in 1968 since that was when the agreement was executed. The Crown argued on the contrary that it was only taxable in 1970, which was the year when the condition precedent was finally fulfilled and the moneys truly became receivable. In delivering judgment, in which his two brother judges concurred, MacGuigan, J at 48 [5051] of the above-mentioned report stated:

In summation, as I see it, the balance of the purchase price neither was received nor did it become receivable until the 1970 taxation year of the respondent when the condition relating to compliance with the Planning Act was fulfilled, at which time it was properly included in the computation of the respondent’s income for that year pursuant to subparagraph 85B(1)(b) of the Income Tax Act.

And further on, in the same page:

The Supreme Court of Canada came to a similar conclusion in the cases of Diamond Taxicab Association Ltd v Minister of National Revenue [53 DTC 1111], [1952] CTC 229, and Dominion Taxicab Association v MNR, [54 DTC 1020], [1954] CTC 34, where it held that the test of income was whether it had become the absolute property of the taxpayer rather than a deposit contingently received.

I have held that the interest was entirely receivable in 1980 and therefore following the principles of the above-mentioned cases it must be taxable in that year.

For the above reasons, the plaintiff does not succeed on this second ground of appeal and the interest in the amount of $130,000 which is in dispute must be considered as income of the taxpayer for the year 1980 when it was receivable.

Judgment will issue in accordance with these reasons. Since the plaintiff was partially successful, it will be entitled to its costs.