Easton v. R., 97 DTC 5464, [1998] 3 CTC 26 (FCA)

Robertson J.A.:

Narrowly defined, the issue raised on these appeals is whether an amount paid by a shareholder as guarantor on funds borrowed by the shareholder’s corporation is to be treated as an outlay on account of capital or a loss fully deductible from other income sources. The Trial Judge concluded that the loss was of a capital nature, a conclusion with which I am in respectful agreement. That being said it is apparent that there is at least one decision of the Supreme Court of Canada which offers prima facie support to the taxpayers’ argument on appeal: Fraser v. Minister of National Revenue, [1964] S.C.R. 657 (S.C.C.). In the reasons that follow I conclude that the Fraser decision has been overtaken by another: Minister of National Revenue v. Freud (1968), [1969] S.C.R. 75 (S.C.C.). On this point my conclusion is in conflict with the opinion expressed by the Tax Court of Canada in K.J. Beamish Construction Co. v. Minister of National Revenue (1990), 90 D.T.C. 1584 (T.C.C.). The taxpayers also rely on a decision of the Trial Division of this court: Cull v. Canada (1987), 87 D.T.C. 5322 (Fed. T.D.). The correctness of that decision has been questioned in the Tax Court and, subsequently, in this Court. In my respectful view, both the Beamish and Cull decisions can no longer be considered persuasive authorities.

The salient facts leading up to these appeals are straightforward. In 1976 the taxpayers, co-venturers, decided to purchase a parcel of land with a view to subdividing it and then constructing homes for resale. Under the terms of the purchase agreement the contract was conditional on subdivision approval being obtained from the necessary authorities in British Columbia. Ultimately, such approval was obtained and the taxpayers took title in their respective names. In turn, they transferred the lands to their respective holding companies. That real estate became the sole asset of each holding company. In order to finance the project the corporations obtained a $4.1 million credit facility with a local bank. As a condition precedent to the granting of the loan, each taxpayer was required to extend an individual guarantee in the amount of $300,000. The real estate project proceeded during 1979 and 1980 with some of the residences being marketed. In the fall of 1981 the real estate market in British Columbia collapsed and the taxpayers were called on to honour their guarantee. Each taxpayer claimed a noncapital loss of $300,000. The Minister of National Revenue characterized the payment as a capital loss (by way of an “allowable business investment loss” as provided for under paragraph 39(1 )(c) of the Income Tax Act) for the taxation year in which the guarantees were paid.

Aside from the principal finding that the outlay on the guarantee was on capital account, the Trial Judge also concluded that had the taxpayers eventually sold the real estate development at a profit it would have been treated as a capital gain. The inference to be drawn from that conclusion is that the taxpayers were not engaged in a business or an adventure in the nature of trade (hereafter “an adventure”) but rather a capital transaction, prior to conveying the real estate to their holding companies. The taxpayers take exception to the finding because it undermines their argument on appeal. That argument is premised on the understanding that they were engaged in a business venture and that any profit or loss that would have been realized would have been placed on income and not capital account. Moreover, the taxpayers maintain that the fact that they used the corporate vehicle to pursue their profit making activities does not alter the characterization of the resulting profit or loss. In their view, payment on the guarantees constitutes an incidental expense and, therefore, this particular loss should also be on income account. In support of their argument the taxpayers rely on two decisions of the Supreme Court, Fraser and Freud, and the decision rendered in the Trial Division of this court, namely Cull.

The application of conventional tax wisdom might lead some practitioners to reject the taxpayers’ argument out of hand because it is simply anti thetical to the doctrine of corporate personality. But as there is some judicial support for their position, and the case law is not consistent, I am obliged to pursue the matter further. I shall deal first with the Trial Judge’s conclusion that the taxpayers were engaged in a capital transaction.

lam prepared to accept that the Trial Judge erred in concluding that the taxpayers would have incurred either a capital loss or profit had they not conveyed the real estate to their holding companies. The taxpayers acquired the real estate with a view to subdividing it, constructing houses and selling each lot at a profit. Paragraph 13 of the Agreed Statement of Facts incorporates what I regard as critical concessions on the part of the Minister. That paragraph is worth reproducing:

In early 1975 the Plaintiff and Easton conceived the idea to develop certain property located in Secret Cove, British Columbia. Their joint intention was to acquire lands adjacent to the Secret Cove Marina referred to in subparagraphs 11(d) and (h) above, and to subdivide the land, develop and ready it for construction and to construct housing thereon. Part of their intention was to include a portion of the Secret Cove Marina lands in the development project... They planned to market the housing to the general public through private sales, real estate agents and other third parties who might introduce purchasers to the project.

It is patently clear that the development project was not intended to provide the taxpayers with an enduring benefit which would produce an ongoing stream of income. In short, the real estate was not purchased for investment purposes. What the taxpayers did was no different than what a person engaged in the business of land development would do. Accordingly, I am compelled to accept that the Trial Judge erred on this issue and if judicial support for my conclusion were required then I am prepared to invoke Moluch v. Minister of National Revenue, [1966] C.T.C. 712 (Can. Ex. Ct.). In my view, however, this error does not alter the outcome of these appeals. I turn now to the jurisprudence of the Supreme Court in Fraser and Freud which is relevant to the taxpayers’ argument.

In Fraser, the appellant taxpayer and an associate purchased lands which were subsequently transferred to two corporations in return for all the shares in the corporations. Two years later the taxpayers disposed of their shares and then argued that the gain was of a capital nature. The Minister maintained that the profit was taxable as income and the Supreme Court of Canada agreed. Writing for the court, Judson J, held that the taxpayers were two skilled real estate promoters who had made a profit in the ordinary course of their business. The fact that the taxpayers had incorporated companies to hold the real estate was held to make “no difference” (at 661). It was simply an alternative method for achieving the same end - to realize a profit from the sale of the land.

It cannot be denied that the taxpayers’ argument is supported by the Supreme Court’s decision in Fraser. Standing alone that decision justifies the understanding that a person who embarks upon a business or an adventure and, subsequently, pursues that endeavour through a corporate entity will be taxed as if it never existed. It is important to note that in Fraser the Supreme Court gave no consideration to whether the taxpayer had acquired the shares for investment purposes or as trading assets. In my respectful view, Fraser is a clear example of a court ignoring the axiom that a corporation is a legal entity separate and distinct from its shareholders. At the same time, it is equally clear that the destabilizing effect which Fraser could have had on the doctrine of corporate personality was soon recognized by the Supreme Court. In Freud that Court took the opportunity to revisit the reasoning underlying its earlier decision in Fraser.

Writing for the Court in Freud, Pigeon J. reasoned that Fraser was not a case in which the Supreme Court had ignored the fact that the taxpayer had utilized the corporate structure. Rather it was a case in which that Court recognized that had the taxpayer disposed of his shares any profit would have been characterized as a trading profit and not a capital one. That is to say the share were acquired as trading assets and not as an investment and, therefore, the profit arising from the disposition of the shares in Fraser was taxable on income account. [Note that at the time Fraser and Freud were decided capital gains were excluded from the tax base.] This reformulation of the ratio in Fraser is found at pages 80 and 81 of Pigeon J.’s reasons:

On the first question, the decision of this Court in Fraser v. Minister of National Revenue appears to be in point. It was there held that where two real estate operators had incorporated companies to hold real estate, the sale of shares in those companies rather than the sale of the land was merely an alternative method of putting through the real estate transactions and the profit was therefore taxable. This decision does not in my view necessarily imply that the existence of the companies as separate legal entities was disregarded for income tax assessment purposes. On the contrary, it must be presumed that the companies remained liable for taxes on their operations and their title to the land, unchallenged. / must therefore consider that the decision rests on the view that was taken of the nature of the outlay involved in the acquisition of the companies' shares by the promoters.

It is clear that while the acquisition of shares may be an investment Minister of National Revenue v. Foreign Power Securities Corp. Ltd., [1967] S.C.R. 295, [1967] C.T.C. 116, 67 D.T.C. 5084), it may also be a trading operation depending upon circumstances (Osler Hammond and Nanton Ltd. v. Minister of Na- tional Revenue, [1963] S.C.R. 432, [1963] C.T.C. 164, 63 D.T.C. 1119, 38 D.L.R. (2d) 178; Hill-Clarke-Francis Ltd. v. Minister of National Revenue, [1963] S.C.R. 452, [1963] C.T.C. 337, 63 D.T.C. 1211). Due to the definition of business as including an adventure in the nature of trade, it is unnecessary for an acquisition of shares to be a trading operation rather than an investment that there should be a pattern of regular trading operations. In the Fraser case, the basic operation was the acquisition of land with a view to a profit upon resale so that it became a trading asset. The conclusion reached implies that the acquisition of shares in companies incorporated for the purpose of holding such land was of the same nature seeing that upon selling the shares instead of the land itself, the profit was a trading profit not a capital profit on the realization of an investment, [emphasis added]

In my opinion, there can be no doubt that the Supreme Court’s decision in Freud was intended to limit the breadth of its earlier pronouncement in Fraser. It goes without saying that the Supreme Court is free to reformulate the ratio of an earlier decision without expressly overruling it. Indeed, I would go so far as to say that it would introduce “intolerable uncertainty” into tax law and tax planning to apply the ratio in Fraser without regard to the subsequent jurisprudence.

As outlined earlier, the taxpayers seek to convince us that Fraser and Freud stand for the proposition that if, from the outset, an individual taxpayer is engaged in a trading transaction then any subsequent outlay related to that transaction will receive the same tax treatment. That is to say any loss will be on income account even though the taxpayer decided to use the corporate vehicle for purposes of pursuing the business or adventure. The fallacy in this part of the taxpayers’ argument can be traced to the fact that in Freud the taxpayer did not succeed because the outlay was incidental to a business or an adventure. He succeeded because he was able to convince the Supreme court that the outlay (loss) should receive the same tax treatment as would any profit or loss arising on the disposition of his shares. In other words, if a shareholder can establish that his or her shares were acquired as trading assets, and not for investment purposes, then any loss arising from an advance or outlay made by the shareholder to or on behalf of the corporation, including payments on a guarantee, will also be taxed on income account. In my view this is the true import of Freud. This is a convenient place to recite the essential facts of that case.

In Freud, the individual taxpayer incorporated a U.S. company for the purpose of promoting and developing his invention, a prototype sports car. The taxpayer’s intention was to sell the concept to a manufacturer. He had no intention of manufacturing or selling cars. At a time when the company was in financial difficulty the taxpayer advanced it $13,840. Shortly there- after the taxpayer abandoned the project. He then sought to deduct the amount advanced from other income. The Minister conceded that had the taxpayer pursued the venture in his own name the loss would have on income account as it arose in respect of an adventure. Nonetheless, he disallowed the deduction on the ground that it was an outlay on account of capital. Both the Exchequer court and the Supreme Court disagreed with this characterization.

Assuming that the $13,840 advance could be considered a loan, Pigeon J. observed “that a loan made by a person who is not in the business of lending money is ordinarily to be considered as an investment” (at 82). He went on to reason, however, that in “exceptional or unusual circumstances” such loans could be characterized as a trade and not an investment. The facts of Freud were held to be “quite exceptional or unusual” (at 82). As I understand the reasons for judgment, the exceptional circumstances were that the shares were acquired as a trading asset and not as an investment and therefore the advance was not made for the purpose of securing a stream of income. This understanding comes from the observation by Pigeon J. that had the taxpayer been successful in selling the prototype sports car then any profit realized on the disposition of his shares would have been on income and not capital account. At page 81 of his reasons Pigeon J. made this point Clear:

If the respondent and his friends had been successful in selling the prototype sports car, they might well have done it by selling their shares in the company instead of having the company sell the prototype, and there can be no doubt that if they had thus made a profit it would have been taxable.

It would be misleading on my part to suggest that the Supreme Court in Freud did not attach great significance to the fact that the taxpayer was, from the outset, engaged in an adventure. Moreover, it cannot be denied that the Supreme Court failed to consider the taxpayer’s intention at the time the shares were acquired before determining whether their disposition would have been on income as opposed to capital account. It is trite law today that shares acquired for the purpose of generating income are held on capital account and those acquired with the intent of reselling at a profit are on income account. In both Fraser and Freud the Supreme Court seemed to assume that the shares were acquired on income account simply because the taxpayers in those cases had from the outset been involved in a business or adventure. Finally, I cannot help but observe that both Fraser and Freud appear sceptical to the manipulation of the corporate vehicle as a means of achieving tax planning objectives.

Notwithstanding any perceived imprecision on the part of the Supreme Court in Freud, that decision is significant because it establishes an exception to the general legal framework to be applied when assessing the tax treatment of losses incurred by shareholders arising from advances or outlays made to or on behalf of their corporations. This is a convenient opportunity to restate basic precepts underlying the tax treatment of advances and outlays made by shareholders.

Asa general proposition, it is safe to conclude that an advance or outlay made by a shareholder to or on behalf of the corporation will be treated as a loan extended for the purpose of providing that corporation with working capital. In the event the loan is not repaid the loss is deemed to be of a capital nature for one of two reasons. Either the loan was given to generate a stream of income for the taxpayer, as is characteristic of an investment, or it was given to enable the corporation to carry on its business such that the shareholder would secure an enduring benefit in the form of dividends or an increase in share value. As the law presumes that shares are acquired for investment purposes it seems only too reasonable to presume that a loss arising from an advance or outlay made by a shareholder is also on capital account. The same considerations apply to shareholder guarantees for loans made to corporations. In Minister of National Revenue v. Steer (1966), [1967] S.C.R. 34 (S.C.C.), it was held that a guarantee given to a bank for a company’s indebtedness by the taxpayer in consideration for shares in the company was to be treated as a deferred loan to the company and that monies paid to discharge that indebtedness were to be treated as a capital loss. That case, however, does not stand for the proposition that every time a corporation fails to reimburse a shareholder with respect to an advance, outlay or payment on a guarantee that the loss is necessarily on capital account. There is only a rebuttable presumption of such. I turn now to the circumstances in which that presumption can be rebutted.

There are two recognized exceptions to the general proposition that losses of the nature described above are on capital account. First, the taxpayer may be able to establish that the loan was made in the ordinary course of the taxpayer’s business. The classic example is the taxpayer/shareholder who is in the business of lending money or granting guarantees. The exception, however, also extends to cases where the advance or outlay was made for income-producing purposes related to the taxpayer’s own business and not that of the corporation in which he or she holds shares. For example, in Berman & Co. v. Minister of National Revenue, [1961] C.T.C. 237 (Can. Ex. Ct.) the corporate taxpayer made voluntary payments to the suppliers of its subsidiary for the purpose of protecting its own goodwill. The subsidiary had defaulted on its obligations and as the taxpayer had been doing business with the suppliers it wished to continue doing so in future. [Berman was cited with apparent approval in the Supreme Court decision in Stewart & Morrison Ltd. v. Minister of National Revenue, [1974] S.C.R. 477 (S.C.C.) at 479].

The second exception is found in Freud. Where a taxpayer holds shares in a corporation as a trading asset and not as an investment then any loss arising from an incidental outlay, including payment on a guarantee, will be on income account. This exception is applicable in the case of those who are held to be traders in shares. For those who do not fall within this category, it will be necessary to establish that the shares were acquired as an adventure in the nature of trade. I do not perceive this “exceptional circumstance” as constituting a window of opportunity for taxpayers seeking to deduct losses. I say this because there is a rebuttable presumption that shares are acquired as capital assets: see Mandryk v. R. (1992), 92 D.T.C. 6329 (Fed. C.A.) at 6634.

Accordingly, for the taxpayers to succeed on these appeals they had to establish that the payment on the guarantee came within one of the recognized exceptions to the general proposition. As the taxpayers were not in the business of lending money or extending guarantees they could not claim a business loss. Nor did they seek to establish that the guarantee was given in the ordinary course of the taxpayers’ other business endeavours. Alternatively, the taxpayers could have sought to establish that they held the shares in their respective holding companies as trading assets and, therefore, any gain or loss arising from the disposition of those shares would have been on income and not capital account. The taxpayers failed to establish such and it is unlikely that they could have convinced the Trial Judge the guarantee was given at a time when the taxpayers intended to sell the shares in their respective holding companies for a profit. It is for these reasons that I am of the opinion that the taxpayers are unable to succeed on these appeals.

I recognize that in K.J. Beamish Construction Co. v. Minister of National Revenue, supra, the Tax Court rejected the proposition that an advance or outlay, including payments made on guarantees by shareholders, can be described as being on current account based on whether the shareholder acquired his or her shares as trading assets. In the opinion of the Tax Court Judge the exceptional circumstance outlined in Freud by Pigeon J. is obiter. With respect, I do not agree. In my view, the exception articulated in Freud provided the legal basis on which the taxpayer in that case was suc- cessful. Though Beamish can no longer be considered persuasive with respect to its understanding of the significance of the Supreme Court’s decisions in Fraser and Freud, I am not suggesting that Beamish was wrongly decided. On the facts the Tax Court Judge in that case found that the taxpayer had acquired the shares as an investment and, therefore, the exception to the proposition articulated in Freud did not apply in any event. In short, what was said of Fraser and Freud in Beamish is itself obiter. My understanding of what was decided in Freud is reinforced by another decision of the Tax Court: Lachapelle v. Minister of National Revenue (1990), 90 D.T.C. 1876 (T.C.C.) . I do not propose to review all that is clearly set out in those reasons. For purposes of deciding these appeals it is sufficient to note that in Lachapelle, Brulé J.T.C.C. approaches Freud in the manner I have outlined above. Our understanding is consistent with this Court’s decision in Becker v. R. (1983), 83 D.T.C. 5032 (Fed. C.A.).

Finally, the taxpayers rely on a decision of the Trial Division of this Court in support of their argument; namely Cull v. Canada, supra. In Man- dryk this Court noted that in Beamish the Tax Court refused to apply or follow Cull (MacGuigan J.A., writing for the Court in Mandryk, found it unnecessary to decide whether Cull was correctly decided). In Lachapelle the Tax Court Judge observed that Cull is “a difficult decision to explain” (at 1881). There is no question that Cull is problematic. Briefly, the facts are as follows. In 1976 the taxpayer acquired one-third of the shares in a company which was developing land in two subdivisions and gave a guarantee for one-third of the company’s indebtedness. By 1981 the company ran into financial difficulties and the taxpayer ended up advancing monies to cover certain financial obligations with the company’s creditors. The taxpayer then sought to deduct various losses from income.

In Cull, the Trial Judge allowed the appeal on grounds which reflect the tension between the Supreme Court’s decisions in Fraser and Freud. On the one hand, there are passages in the reasons for judgment which suggest that the separate existence of the corporation can be overlooked (at 5325- 26). In this regard the reasoning in Fraser was invoked. On the other hand, the Trial judge relies on Freud to support the finding that losses will be on income account if shares were acquired for resale (as an adventure) and not for investment purposes (at 5325). Admittedly, and with great respect, the reasoning offered in Cull is not entirely clear. Where I have the greatest difficulty is in accepting the finding that the taxpayer in that case acquired the shares for purposes of resale when in fact they were retained for a period of at least five years. In my opinion, Cull is not helpful to the taxpay- ers’ appeals and should not be followed in future. [That being said, I am aware that Cull was cited in Friesen v. R., [1995] 3 S.C.R. 103 (S.C.C.) at 125 in support of the proposition that land can constitute inventory.]

In conclusion, the taxpayers have failed to rebut the presumption that the losses arising from the payment on the guarantees are on capital account. Furthermore, they cannot lay claim to one of the exceptions to that general proposition. First, they failed to establish that the guarantees were given in the course of profit making endeavours unrelated to the real estate development. Second, they failed to establish that the shares in their respective holding companies were held as trading assets and, therefore, that payments on the guarantees were incidental expenses giving rise to losses on income account. Accordingly, the appeals should be dismissed with costs, the respondent being entitled to one set of counsel fees for both appeals.

Appeals dismissed.