Saskatchewan Co-Operative Credit Society Ltd. v. The Queen, 85 DTC 5599, [1986] 1 CTC 53 (FCA)

Mahoney, J.:—In issue is the right claimed by the appellant to deduct from its taxable income otherwise calculated, for its taxation year ended December 31, 1978, an amount of $707,143. During the year, the appellant paid $1,414,286, being the par value thereof, for 1,414,286 preferred shares of The Canadian Co-operative Implements Limited, hereafter “C.l.” At trial, the following statement was put on the record:

. . . the parties agree that the fair market value of these preference shares was no more than 50 cents per share thoughout 1978, and in particular, that the shares were worth not more than 50 cents or /2 their par value from the time they were issued through the end of that year.

The learned trial judge, in a decision now reported, [1984] C.T.C. 628; 84 D.T.C. 6225, concluded that the acquisition of the shares was an investment and that any capital loss would have to be claimed upon their disposition. The facts are undisputed. There is no issue of credibility. All of the entities which will be referred to, except governments and banks, are co-operative associations, not conventional business corporations.

The appellant is a credit union central, whose members are, for the most part, credit unions and other co-operatives and whose principal function is to provide financial services for its members. It receives the surplus funds of its members and lends them to other members, mostly on a demand or short-term basis. C.I. is a member of the appellant. It sells farm machinery, manufacturing some of it. In November 1974, C.I. sought from, and was granted by, the appellant a $3 million demand line of credit, which it fully drew and which was continued until the 1975 refinancing next described.

In 1975, a group of co-operatives, the appellant among them, acting through Canadian Co-operative Credit Society Limited, hereafter “C.C.C.S.," a national credit union central of which the appellant is a member, agreed to loan C.I. $17.5 million, repayable on demand or by October 31, 1977, a deadline later extended. Repayment of two-thirds of that amount was guaranteed by several producers' and consumers' co-operatives, In the result, the appellant provided $9 million, whereof repayment of $6 million was guaranteed. Its exposure was $3 million. C.I., at the same time borrowed $15 million from the Mercantile Bank. Repayment of the bank loan had priority over repayment of the $17.5 million provided through C.C.C.S. Early in 1977, C.C.C.S. provided C.I. a further unsecured loan of $5 million.

C.I.'s net loss for its year ended October 31, 1977, was over $9 million. As at that date, its current assets totalled over $45 million, whereof $39.8 million was represented by its inventories. Current liabilities were almost $43 million, whereof short-term borrowings were about $36 million: $13.5 million owing the bank and $22.5 million owing the co-operatives. C.I. was insolvent. The appellant’s unsecured exposure remained at $3 million.

Discussions had begun among C.I.'s creditors and the governments of Canada, Manitoba, Saskatchewan and Alberta, respecting which the learned trial judge summarized the evidence as follows:

. . . 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 Cl into receivership or bankruptcy. 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 had first been sold. Receivership or bankruptcy would also have had serious consequences for the plaintiff’s member credit unions: bankruptcy in particular, if it put Cl 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 Cl for distribution and servicing of machinery. Moreover according to Mr. Bromberger the creditors and the governments involved felt there was a real prospect that Cl could be restored to a viable position. There was considerable feeling that Cl 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 Cl by the other co-operatives in lieu of some of the loan capital they had provided.

The upshot was, first, an agreement dated March 31, 1978, to which the four governments, C.C.C.S. and C.l. were party and, second, an agreement dated April 28, 1978, among C.C.C.S., the creditor co-operatives, including the appellant, and the guarantor co-operatives.

The preamble to the March 31 agreement, in so far as it pertains particularly or generally to the appellant, provides:

WHEREAS:

6. CCCS on its own behalf and as the agent for the Co-operative Participants, presently provides a major portion of the financing and financial accommodation for Cl and has agreed on its own behalf and as agent for the Co-operative Participants to make the operating and long term loans and purchase the preference shares herein recited;

7. CCCS and the Co-operative Participants that it represents are of the opinion that Cl is a viable organization and fills a need in the Western Canadian Agricultural Sector;

9. The parties hereto are desirous of entering into this agreement to set forth those arrangements which have been settled and agreed upon with respect to the financial assistance herein agreed to be accorded to Cl.

The appellant was, by definition, a "Co-operative Participant.” The preamble identified C.I. as a viable organization and expressed the intention to extend to it “financial assistance?" The substantive provisions of the March 31 agreement were that:

1. Canada provide a recoverable advance of $8 million to Cl;

2. CCCS afford Cl a long term loan of $7 million, repayment whereof was to be severally guaranteed by the provinces;

3. CCCS establish a $20 million operating line of credit to be secured by a demand debenture charging, by way of a first, fixed, specific and floating charge, all Cl’s undertaking, business, property and assets, present and future, subject to specified prior encumbrances;

4. CCCS acquire treasury preferred shares from Cl for $8.75 million;

5. CCCS provide further recoverable cash advances, not exceeding $2.5 million in the aggregate, as might be necessary from time to time to maintain Cl’s working capital at $20 million, also to be secured by the debenture described in paragraph 3 above.

It was stipulated that Saskatchewan’s entire guarantee, limited to $2,625,000, would be given to the appellant in respect of the long-term loan. The rate of interest to be charged C.I. by C.C.C.S. from time to time is fixed at one per cent per annum over the Bank of Montreal’s prime rate.

The advance by Canada is unsecured and interest free. No fixed or minimum repayment schedule is stipulated. It is repayable according to a formula which, while complex, plainly accepts C.l."s ongoing commercial viability as a precondition to repayment. The annual repayment, if any, will be enhanced in direct proportion to C.l."s cash flow, proceeds from the sale of fixed assets and interest paid C.C.C.S. on the long-term debt; it will be reduced in direct proportion to approved capital expenditures, repayments to C.C.C.S. of previous working capital advances and any amount necessary to maintain C.I.’s working capital at $20 million after an otherwise required payment to Canada. Any balance owing Canada after repayments taking account of the period ending October 31, 1987, is to be forgiven.

The rights and powers of C.I.’s board of directors were vested in an administrative committee composed of up to eight members, two appointed by C.I., up to three by C.C.C.S. and up to three by the governments. This committee was to exist as long as any amount of the federal recoverable advance or the long-term loan remained outstanding. Among the continuing covenants of C.l. were:

8.04 C.I. shall acquire a chief executive officer for its operations, being a person acceptable to the administrative committee.

8.05 C.I. shall cause to be implemented such management policies in conjunction with the administrative committee so as to result in an economic operation being achieved.

8.06 C.I. shall develop a 5 year business plan for approval by the administrative committee and shall provide for an annual update of the same.

8.07 C.I. shall annually prepare an operating and capital expenditure budget for approval by the administrative committee.

8.08 C.I. shall develop a program acceptable to the administrative committee for the raising of equity contributions from its members and shall cause the same to be implemented as expeditiously as is practical. A portion of the money so raised by C.I. shall be used to repay the indebtedness of C.I. to the parties hereto in a manner as may be agreed upon by Canada, C.C.C.S. and the provinces.

The April 28 agreement apportioned the obligations assumed by C.C.C.S. on their behalf under the March 31 agreement among the Co-operative Participants as defined in the earlier agreement. Under it, the appellant assumed the obligations to:

a. provide a maximum contribution of $3 million, and a minimum of $2,625,000 (being the amount guaranteed by Saskatchewan), to the $7 million long-term loan;

b. provide a maximum contribution of $7 million to the $20 million operating line of credit;

c. purchase preferred shares for $1,414,286;

d. provide 16.6 per cent of the further working capital advances from time to time.

I attach no significance whatever to the fact that the various transactions contemplated by the two agreements may not have closed simultaneously. Aside from quantifying the Appellant’s obligations, the April 28 agreement is of no relevance. All of the obligations undertaken by C.C.C.S. under the March 31 agreement were undertaken by it as agent for, inter alia, the appellant.

The financing package provided as a result of that agreement entirely replaced C.I.'s previous financing, including the Mercantile Bank loan and the appellant’s unsecured $3 million. In the result, in so far as the appellant was concerned, it replaced a $9 million loan, $6 million of it guaranteed, $3 million unsecured and ranking behind the $13.5 million balance owing to the Mercantile Bank, with a $1,414,286 investment in preferred shares and $10 to $10.4 million in loans, guaranteed as to $3 million and secured as to the balance, ranking in priority to Canada’s $8 million. The $10.4 million assumes the long-term loan, operating line of credit and working capital advances are fully drawn down by C.I. In so far as C.I. was concerned, it had available new capital and credit aggregating between $43.75 and $46.25 million, depending on its need for working capital, in place of $36 million of short-term borrowings.

The appellant argues that, in the circumstances, the $707,143 paid in excess of the fair market value of the preference shares was a non-capital business expense incurred in 1978 to gain income in the ordinary course of its business as a financial intermediary: it was an outlay to cut an existing loss and to provide the opportunity of future earnings. It argues, in the alternative, that it was an amount properly to be regarded as reducing the amount it had received from C.I. in repayment of the prior indebtedness: the unsecured $3 million was a bad debt and the $707,143 an allowance in respect thereof properly to be claimed at year-end. Finally, and in the further alternative, it argues that the preferred shares are inventory, the value of which was properly to be written down by that amount at year- end. The learned trial judge dealt with each of these arguments at some length.

It is reasonable to accept, as the trial judge did, the proposition that the appellant would not have bought the shares at all, much less paid what it did for them, had not C.I. been indebted to it in the unsecured amount of $3 million, had not C.I. been insolvent and had not the purchase been among the things required to permit the appellant to recover the entire $3 million. It is also the proper approach in law, as taken by the trial judge, to have regard to the substance of a transaction rather than only its form in order to characterize that transaction with a view to ascertaining the consequences flowing from it under the Income Tax Act. However, when its form and the substance evidenced by that form disclose an arm's length transaction that makes commercial sense in all the circumstances, persuasive evidence will be required to establish that its substance is other than that defined by its form. There is no such evidence here.

The learned trial judge rejected the appellant's arguments and concluded:

I therefore conclude that in substance the refinancing agreement was designed inter alia to make the plaintiff an investor in Cl 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 Cl 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.

The appellant acknowledges that there were good economic and business reasons for it to wish to preserve C.I. as a going concern but says that there is no evidence to support a conclusion that it had social reasons. Perhaps that conclusion reflects the trial judge's perception of the cooperative movement or his perception of its perception of itself. Be that as it may, the error is inconsequential. The appellant’s business and economic reasons were sufficient.

The conclusions urged as to the first two arguments entail divorcing the subscription for the preferred shares from the entirety of the March 31 agreement. Except to the extent the first hinges on the opportunity of future earnings, both conclusions also entail relating that subscription independently and exclusively to the consequential repayment of the unsecured $3 million. Those approaches are totally unrealistic. An intention to earn income is not conclusive of an outlay’s character as being on account of capital or as an expense incurred to earn income. Most business outlays of either character are, or should be, made with a view to an earning opportunity. Here a capital asset, preferred shares, was acquired and the outlay was, therefore, prima facie a capital outlay. Taken as a whole, the March 31 agreement confirms that characterization.

As to the third argument, there is no evidence upon which it might be found that the appellant was a trader in securities nor is there evidence that the prospect of their resale at a profit was an operating motive in the appellant's acquisition of the preferred shares. While a finding that the appellant was a trader or had otherwise acquired the shares intending to turn them to profit by resale would not necessarily resolve the issue in the appellant’s favour, the absence of such a finding precludes a finding that they were acquired as inventory.

I find myself in complete agreement with the conclusion reached by the learned trial judge. I would dismiss the appeal with costs.

Appeal dismissed.