King Rentals Ltd. v. The Queen, 96 DTC 1132, [1995] 2 CTC 2612 (TCC)

Lamarre J.T.C.C.:-This appeal arises out of a disallowance by the Minister of National Revenue (the "Minister”) of the deduction of noncapital losses in the amounts of $110,350 and $104,561 claimed by the appellant for the 1987 and 1988 taxation years respectively. The Minister so assessed the appellant on the basis that the debts owed by the latter to its shareholders and to an associated company were settled or extinguished by the payment of an amount less than the principal amount of the debts and therefore, the appellant’s non-capital losses were consequently reduced pursuant to subsection 80(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the ’’Act”).

Facts

The relevant facts admitted by the parties may be summarized as follows:

-The appellant is a body corporate duly constituted under the New Brunswick Business Corporations Act, S.N.B. 1981, c. B-9.1 (the "N.B. Act").

-At the beginning of 1987, the sole beneficial shareholders of the appellant were John Whalen and Bettina Whalen (the "Whalens").

—In the 1987 year end financial statements, the appellant reported, among others, the following liabilities:

Loan from shareholders $615,098

Loan from associated company $ 63,155

—By the beginning of its 1987 taxation year the appellant had accumulated non-capital losses in the amount of $478,018 and undepreciated capital cost in the amount of $141,593.

-On August 7, 1987, the Whalens entered into an Agreement with R. Lloyd Galbraith ("Galbraith") which provided, in part, the following:

I. Galbraith shall forthwith loan to the appellant the sum of $95,000 so that the funds can be used to pay off the appellant’s outstanding liabilities other than its liabilities to its shareholders and associated corporation;

II. The Whalens shall sell 40 per cent of the appellant’s issued and outstanding common shares (80 common shares) to Galbraith for a price of $20 per share;

III. The Whalens shall cause the appellant to create a series of redeemable/retractable non-voting shares (the "preferred shares") of a par value of $100 each in the capital of the appellant.

The agreement further provided in section 4, inter alia, that:

-[The preferred shares] be redeemable at a price per share equivalent to the lesser of the par value thereof or the profit earned by [the appellant] subsequent to the issue date of the new shares divided by the number of such shares outstanding at the redemption date. Such shares may be issued by [the appellant] in full satisfaction of liabilities to its shareholders and to companies or corporations associated with [the appellant].

—"In consideration of the aforesaid loan", the Whalens were then to "transfer to Galbraith free from encumbrances all the preferred shares issued pursuant to section 4", as stated in section 5 of the Agreement.

-The preferred shares were to be issued by the appellant at the time of transfer to Galbraith (section 7 of the Agreement) and the transfer and delivery of the new shares were to be effected at the time of closing (section 10) which was determined to be August 28, 1987 (section 9).

-Section 8 of the Agreement provided that "the obligation of Galbraith to make the loan and to purchase shares hereunder shall be subject to the satisfaction of or compliance with at or before the Time of Closing, as a condition precedent thereto, that all of the representations and warranties of the Whalens made in or pursuant to this Agreement shall be true and correct in all material respects as at the Time of Closing and with the same effect as if made as at the Time of Closing".

-On August 7, 1987 Galbraith acquired an option to purchase the remaining 60 per cent of the common shares from the Whalens at a time up to one year after their death for the amount of $2,400.

-The preferred shares became part of the authorized capital of the appellant by Articles of Amendment under the N.B. Act dated August 27, 1987.

-An aggregate of 7,000 new preferred shares of a par value of $100 each were subscribed for and issued to the Whalens and to Whalen Brothers Construction Ltd., the latter being a body corporate associated with the appellant, at the par value by resolutions of the directors of the appellant dated November 9, 1988.! [1] By the same resolutions, the subscription price of $100 per share for the new shares was accepted as being satisfied by the application of amounts previously advanced to the appellant by the Whalens and by Whalen Brothers Construction Ltd. in an aggregate principal amount of not less than the redemption price of $100 per share. It was further provided by the resolutions that the 7,000 new shares were authorized to be transferred to Galbraith’s sons, Gary Galbraith and David Galbraith.

—The actual transactions which took place are as follows:

(i) On August 7, 1987 Galbraith loaned the appellant the amount of $95,000;

(ii) On August 28, 1987 the Whalens sold 40 per cent of the appellant’s common shares to Gary and David Galbraith;

(iii) Preferred shares were issued on November 9, 1988 by the appellant as follows in exchange for the debts owed to them:

John Whalen	3,438 shares
Bettina Whalen	2,930 shares

Whalen Brothers Construction Ltd. 632 shares

7,000 shares

—The Whalens and Whalen Brothers Construction Ltd. subsequently transferred the preferred shares to Gary and David Galbraith.

Issue

The issue to be decided is whether the debts owed by the appellant to the Whalens and Whalen Brothers Construction Ltd. were settled by the payment of an amount less than the principal amount of the debts. If the answer to this first question is affirmative, then I have to decide whether the settlement of the debts occurred in the appellant’s 1987 or 1988 taxation year. In the proceedings, both parties put as a third issue the question of whether the appellant had the right to claim deductions both for capital cost allowances in each of the taxation years referred above and for investment tax credits in the 1987 taxation year. I understand from the oral argument of both counsel that I do not have to answer this last question as the answer to the first two questions will automatically resolve this matter.

Analysis

Pursuant to section 80 of the Act, as it read for the years 1987 and 1988, where at any time in a taxation year a debt or other obligation of a taxpayer to pay an amount is settled or extinguished without any payment by the taxpayer or by the payment of an amount less than the principal amount of the debt or obligation, as the case may be, the amount by which the lesser of the principal amount and the amount for which the obligation was issued by the taxpayer exceeds the amount so paid, if any, shall be applied to reduce non-capital losses for preceding taxation years, to the extent that those losses would otherwise be deductible in computing the taxpayer’s taxable income for the year or a subsequent year. To the extent that the excess exceeds the non- capital losses (and other losses that are not applicable in the present instance), the excess shall reduce in prescribed manner the capital cost to the taxpayer of any depreciable property, and the adjusted cost base to the taxpayer of any capital property.

The argument of both counsel is centred on the meaning to be given to the word "amount" found in section 80. A definition of this word is given in section 248 of the Act and reads as follows:

"amount" means money, rights or things expressed in terms of the amount of money or the value in terms of money of the right or thing....

According to counsel for the appellant, when the consideration paid is something other than money, as in the present case where the appellant issued 7,000 new preferred shares with a par value of $100 each to its shareholders and an associated company, in full satisfaction of its liability to them, the fair market value of the shares is not a relevant consideration in determining whether any forgiveness has occurred. Relying on the definition of the word "amount" found in section 248, counsel argued that shares are rights or things expressed in terms of an amount of money. In the present case, the shares were issued and they had an amount of money attached to them, the $700,000 par value. He said that if the word "amount" found in sections 80 and 248 was intended to include the fair market value, it would have said so. Indeed, section 80 was amended for the taxation years ending after February 21, 1994, to provide that upon a conversion of debt to equity the debt will be regarded as having been settled for an amount equal to the fair market value of the shares received. [2] Counsel for the appellant then relied on subsection 23(2) of the N.B. Act which states that:

a share with par value shall not be issued except for a consideration at least equal to the par value thereof.

According to him, the value for the appellant of the shares issued to its shareholders could not be less on a corporate law point of view than the par value attached to them. On that point he relied on a decision of the Federal Court- Trial Division, Praxair Canada Inc. v. The Queen, [1993] 1 C.T.C. 130, 93 D.T.C. 5100. In that case, Justice Walsh analyzed a similar statutory provision found in the Ontario Business Corporation Act, R.S.O. 1970, c. 53, subsection 44(2), as it then read, and concluded that "from the issuer’s point of view the release of indebtedness as a result of the share issue was worth [the par value] but this is regardless of the value of the claim to the creditor." (p. 5106). Counsel for the appellant therefore concluded that section 80 of the Act has no application on the present case as the appellant’s debts to its shareholders and associated company were not extinguished by the payment of an amount less than the principal amount of the debts.

According to respondent’s counsel, the word "value" appears in the definition of "amount" in section 248 of the Act. The purpose of the definition is to reduce or quantify the right or thing to some monetary amount by assessing the value of that right or thing. According to him, the most objective way to determine the value is the fair market value. He based his argument on a decision of the Federal Court of Appeal, in Kettle River Sawmills Ltd. v. Canada [1994] 1 C.T.C. 182, 94 D.T.C. 6086, where the Court considered the concept of value as opposed to cost. In this decision, it was said that the term "value" contains a far higher component of subjectivity and judgment than the term "cost". "Cost" means the money or money’s worth that is given up by somebody to get something and is generally viewed as an objectively determined historical fact. Counsel for the respondent then went on to say that objectivity in terms of ascertaining value is only achieved to the extent that the value is determined in a manner consistent with fair market value. Furthermore, he urged this Court not to follow the principle of corporate law, that the consideration must be whatever the par value was, as the appellant and its shareholders to whom it issued the new shares were not dealing at arm’s length. Indeed, the Whalens were virtually controlling the appellant (they owed 60 per cent of the common shares when the preferred shares were issued). He contended that the purpose of section 80 of the Act is to prevent the debtor from claiming expenses with respect to the debt and then benefiting tax-wise from the fact that the debtor does not have to pay the debt because it has been settled. According to respondent’s counsel the fair market value of the shares issued is nil. However, no expert evidence was brought on this point. His arguments were simply that the appellant was in poor financial condition in 1987 as per the financial statements filed in evidence, that 40 per cent of the common shares were bought by the Galbraiths’ for only $1,600 and that the redemption price of the preferred shares was the lesser of the par value and the profit earned by the appellant to the date of redemption. From there he concluded that the fair market value of the preferred shares was nil.

The impact of section 80 of the Act has been analyzed in the cases of equity-for-debt refinancing and conversion of debt to equity by two authors that were referred to me by counsel for the appellant. [3] Among others, the question of the extinguishment of a debt by the payment in shares was treated. At this stage, it is interesting to point out a statement made by R. Couzin, [4] where he said this:

As a matter of law (real law, not tax law), where a presently payable debt is satisfied by the issuance of fully paid shares of the debtor having the same nominal amount, the issue of shares is treated as if it had been made for cash in that same amount.... Modern Canadian company law statutes usually permit the issuance of shares for a consideration payable in property. For these purposes, "property" does not include a promissory note or a promise to pay. [5] The old cases still seem to apply to treat the issuance of shares in payment of a present debt as an issue for cash. [6]

And further, he goes on:

Normally, the amount paid [for the satisfaction of the debt] is the value of the right or thing given up by the debtor, which in the case of a share subscription is the par value or stated capital of the shares. If the company law of the jurisdiction permits the capital to be equal to the principal amount of the debt, it is not clear why the fair market value of the shares should be relevant. [7]

The author explained that, from the debtor’s point of view, the value of shares should be irrelevant. According to him,

the logic is the same as that in a debt-for-debt refinancing. If the debtor replaces one debt obligation with another in the same principal amount, one does not expect section 80 to apply. If the debtor replaces a debt obligation with share capital, and the stated value of the shares is the same as the principal amount of the debt, again one does not expect section 80 to apply. [8]

The leading Canadian tax decisions have adopted a similar approach where the question has arisen as to the cost of property given to a corpora tion in consideration for shares. In Tuxedo Holding Co. v. M.N.R., [1959] C.T.C. 172, 59 D.T.C. 1102 (Ex. Ct.), it was determined that the price paid or the consideration given for the property (in that case land) by the appellant’s company was the par value of the shares issued and not the agreed market value of the land at the time of purchase. This was based on the proposition that the cost to a company of any property is what it has given up to get the property, [9] and in this case what the company gave up was its right to claim from the subscriber payment of the par value of the shares. The Exchequer Court referred to an English case, Osborne v. Steel Barrel Co., [1942] 1 All E.R. 634, 24 T.C. 293 (U.K. C.A.), where Lord Greene, M.R., delivering the judgment for the Court, said at page 638:

Accordingly, when fully-paid shares are properly issued for a consideration other than cash, the consideration moving from the company must be at the least equal in value to the par value of the shares and must be based on an honest estimate by the directors of the value of the assets acquired.

The Tuxedo Holding Co., supra, case is authority for the proposition that the par value of shares issued as consideration for property purchased by a company establishes the cost of that property in the hands of the purchasing company only.

On the other hand, it is well established that the value for the person receiving the shares is not necessarily the par value of the shares. [10] This proposition has been considered again in the case of Praxair Canada Inc., supra, raised by counsel for the appellant. In that case, the issue involved the valuation to be given to preferred shares held by the plaintiff at the time of their issue in consideration of the surrender of subordinated debentures and interest thereon of an equivalent face value. The Court had to determine what amount was to be included by the plaintiff in its income as interest under paragraph 12(l)(c) of the Act. The plaintiff argued that a right or thing cannot be expressed in terms of an "amount of money", but only in terms of its value in money. The plaintiff, therefore, wanted the value in terms of money of the right or thing to be included for tax purposes and, since the shares issued in payment of interest were valueless, the interest could not be considered as having been paid. It was also argued by the plaintiff that often par value does not reflect the actual value of shares; rather, par value is merely a means to fix a minimum subscription price for the original issue of shares. If such shares are received in payment of an obligation to pay interest, the amount received is the value in terms of money of the said shares; thus, it is the real value rather than the par value which must be determined. Justice Walsh agreed with this statement in order to establish the value of the shares for their holder. From the issuer’s point of view, however, he recognized that the release of indebtedness as a result of the share issue was worth the par value. As well, this was not an illegal way to proceed since it was permitted by the Ontario Statute. On this point, reference was made to the case of Australian Machinery & Investment Co.,^ [11] where Atkinson J. commented on the case of Craddock (Inspector of Taxes) v. Zevo Finance Co., [1946] 27 T.C. 267, 1 All E.R. 566 (U.K. H.L.) and stated at page 254:

The Zevo case merely laid down this proposition, that an investment company which has bought investments for fully paid shares by transactions which were not illusory is entitled to treat the par value of the shares as the cost to the company of the investments purchased by the company for fully paid shares.

In the Zevo, supra, case, it was pointed out that although the price paid by the company was prima facie the nominal value of the shares, the contrary could be established in appropriate cases. In particular, the Court reserved its judgment in cases where the transaction might be illusory, colourable or fraudulent.

The House of Lords reviewed the Osborne and Zevo, supra, decisions, in Stanton v. Drayton Commercial Investment Co., [1982] 2 All E.R. 942, [1983] 1 A.C. 501 (U.K. H.L.) and came to the following conclusions at page 946-47 (A.C. 511):

From these judgments I extract the following propositions relevant to the present appeal. (1) A company can issue its own shares "as consideration for the acquisition of property", as Lord Greene MR said. (2) The value of consideration given in the form of fully paid shares allotted by a company is not the value of the shares allotted but, in the case of an honest and straightforward transaction, is the price on which the parties agreed, as Lord Simonds said.

His Lordship continued at page 947 (A.C. 512-13):

Second, Osborne and Craddock are ample authority for saying, in the words of Lord Wright in the latter case, that the Revenue is not entitled to go behind the agreed consideration in a case where, as in the present case, the transaction is not alleged to be dishonest or otherwise not straightforward.

I conclude from this jurisprudence that, provided there is no abuse, the amount agreed upon between the subscriber and the corporation and added to the paid-up capital of the shares is conclusive of the amount paid by the corporate debtor to retire the debt.

In the present case, the N.B. Act allows the issuance of shares only if the shares are fully paid in money or in property that is the fair equivalent of the money that the corporation would have received if the shares had been issued for money [subsection 23(5)]. Here, by issuing the shares in full satisfaction of its liabilities to its shareholders and an associated company (which assumption was not challenged by the respondent), the appellant gave up its right to claim from the subscriber the price that it would have been entitled to receive on this share subscription, which is the par value of the new shares. The appellant therefore acted in conformity with the statute as the shares were paid in property (forgiveness of the debt) that was the fair equivalent of the money that the appellant would have received if the shares had been issued for money. Furthermore, under the same N.B. Act, a corporation shall add to the appropriate stated capital account the full amount of the total of the product of the number of shares of each class issued with par value multiplied by the par value thereof [paragraph 25(2)(b)]. This was properly done by the appellant as shown by the Resolution of shareholders dated July 20, 1987 authorizing the creation of preferred shares of a par value of $100, the Articles of Amendment dated August 27, 1987, the resolution of the board of directors adopted on November 9, 1988 by which the Whalens and Whalen Brothers Construction Ltd. subscribed for 7,000 preferred shares in consideration of the release of the debts, the shares certificates issued to each subscriber on November 9, 1988, and finally the balance sheet of the appellant on December 31, 1988 showing that 7,000 preferred shares of a par value of $100 had been issued during the year (that is $700,000 in the capital stock), the consideration of which was the conversion of $700,000 in liabilities to shareholders and to an associated company.

I do not see anything in the evidence that would lead me to believe that the appellant and its shareholders and associated company acted in a fraudulent manner or that the whole transaction was illusory. It is not uncommon for a company to convert its debt into equity and for the shareholders to accept shares in repayment of their loan to the company, particularly when the company is in a bad financial situation. This does not mean, however, that the transaction is "dishonest or otherwise not straightforward", as long as the parties complied with the law, which I believe is the case here.

Considering section 80 as it read in the taxation years under issue, before the amendment brought in the Act for taxation years ending after February 21, 1994, and considering the doctrine and the jurisprudence cited above, I find that the corporate law should prevail in the interpretation of a taxing statute when nothing in the legislation dictates otherwise. I therefore agree with the appellant that the fair market value of the preferred shares should not be taken into account in determining the amount that was paid by the appellant in consideration for the settlement of the debt for the taxation years under issue. [12] I am of the opinion that objectivity in terms of ascertaining value can be achieved in a manner which is consistent with corporate law, that is to the extent that the value is determined as being the cost for the debtor corporation of the property acquired (that is the release of indebtedness) in consideration for the issuance of the shares, that is the par value of the shares in the present instance. I am aware though that this reasoning will not apply for the year 1994 and following years as the Act has been changed.

Considering my conclusion on this first issue, it is not necessary for me to analyze the second issue with respect to the year in which the debts were settled. However, I would like to point out that it seems obvious that the settlement occurred only in the appellant’s 1988 taxation year. The Agreement of August 7, 1987 clearly stated in section 4 that "the shares may be issued by the corporation in full satisfaction of liabilities to its shareholders". The resolution of the board of directors authorizing the issuance of the new shares as well as the share certificates were dated November 9, 1988. The same resolution specifically provided that the subscription price of $100 per share for the preferred shares was accepted as being satisfied by the application of amounts advanced to the appellant by the shareholders and the associated company. The 1987 financial statements showed the existence of the shareholders and associated company’s debt; it was only in the 1988 financial statements that these debts were converted into capital stock indicating that $700,000 in preferred shares had been issued. I can only conclude from this information that the debts were settled in the appellant’s 1988 taxation year.

I therefore conclude that section 80 of the Act has no application and that the appellant is allowed to deduct the non-capital losses it claimed in its 1987 and 1988 taxation years.

The appeals are allowed with costs.

Appeals allowed with costs.