Millward v. The Queen, 86 DTC 6538, [1986] 2 CTC 423 (FCTD)

The Associate Chief Justice — Jerome, A.C.J.:—This action by way of appeal from a judgment of the Tax Court of Canada dated November 7, 1983 dismissing the plaintiffs appeal from an income tax reassessment with respect to his 1975 taxation year, came on for hearing at Victoria, British Columbia on January 20, 1986. At issue is the inclusion by the defendant of the amount of $10,800 in the plaintiffs income on the basis that that sum was invested under a registered retirement savings plan in a non-qualified investment and is, therefore, to be included in income pursuant to subsection 146(10) of the Income Tax Act.

The plaintiff’s evidence is that he was engaged in the practice of law in the City of Kamloops until July 3, 1975 and during that time became acquainted with another member of the law firm Dennis Coates. The plaintiff owned a registered retirement savings plan (hereafter R.R.S.P.) which was registered under contract #002726 with the Canada Permanent Trust Company. On November 17, 1975 he requested that his R.R.S.P., which had a balance of $11,292.99, be transferred to the National Trust Company, account #08758. Similarly, Mr. Coates requested that his R.R.S.P. balance of $6,879.65 be transferred from the Mutual Life Assurance Company of Canada to the National Trust Company where he had a R.R.S.P., contract #08292, with a previous balance of $4,000.

The plaintiff further testified that he owned a personal investment company, Adam’s Retreat Ltd. which is merely a nominee for himself. Mr. Coates and his wife were equal owners of a personal investment company called Coates Rentals Ltd.

On April 3, 1975, Adams Retreat Ltd. mortgaged property at 614 Lome Street to the “National Trust Company Limited, R.R.S.P. #08292 in trust for Dennis Patrick Coates” for $10,800. On that same date Coates Rentals Ltd. mortgaged property at 1265/1267 Kimberly Crescent to the “National Trust Company Limited, R.R.S.P. #08758 in trust for Peter John Millward”, for $10,800. Both mortgages were for a term of five years and bore interest at eight per cent per annum with no payment on account of principal or interest being due until maturity. Following notification of the registration of these two mortgages, the National Trust Company Limited conducted the following transaction:

Dr. Coates, pay Millward $10,800 Dr. Millward, pay Coates $10,800

[Ex. D-1, Tab 10]

The plaintiff testified that the $10,800 was placed in his personal bank account and used for ordinary purposes.

In 1979 Mr. Coates substituted a condominium property for 1265/1267 Kimberly Crescent, as security for the mortgage. New mortgages were executed and registered, however, the plaintiff retained the mortgage on 614 Lome Street. The new mortgages were for terms of five years and bore interest at ten per cent per annum with no payments on account of principal or interest being due until maturity. The principal amount of each mortgage was $14,428 consisting of the original mortgage amount of $10,800 plus interest accumulated under the old mortgages. When the mortgages matured the plaintiff advised Mr. Coates that he would be paying out the outstanding principal and accumulated interest and that he expected Mr. Coates to do the same. Regrettably, it was not until legal proceedings were instituted against Mr. Coates that he in fact paid the plaintiff the outstanding amount.

During cross-examination by counsel for the Crown, the plaintiff admitted that before accepting the mortgage on 1265/1267 Kimberly Crescent and the substitute property he did not have a valuation done on either of the properties. Rather, he accepted Mr. Coates’ word that the properties were reasonably adequate security. Furthermore, he testified that when discussing the terms of the reciprocal mortgages he did not bargain with Mr. Coates for a higher rate of interest or an improvement of the terms. There were no discussions concerning the possibility of discounting the mortgages.

With the plaintiff's consent, counsel for the Crown entered as evidence appraisals of the properties having municipal addresses of 614 Lome Street (Ex. D-3) and 1265/1267 Kimberly Crescent (Ex. D-4) and an expert witness’ opinion given by George Malcolm Darroch, mortgage broker (Ex. D-5). The salient portions of that opinion are reproduced below:

(1) Do the rates of interest of these mortgages reflect the going market interest rates for first mortgages on the types of properties involved on or about April 3, 1975?

No, they do not. In the case of Lot 13 (Appendix “A”), going rate of interest charged by major lending institutions for improved properties was at the relevant time 10.67%. This rate was for a 5 year term mortgage calling for blended monthly payments for principal and interest. Accordingly, major lending institutions would not have been in a position to entertain an application for a mortgage such as that in Appendix “A”, and smaller lending companies or private investors would have had to be approached. However, mortgage rates charged by smaller lending companies or private investors have historically been higher than the ones charged by major lending institutions, and the situation was no different in April 1975.

In the case of Lot 16 (Appendix “B’’), an unimproved property, the market mortgage interest would have been even higher than in the case of Lot 13 (Appendix “A”), aS mortgage rates charged by lenders on unimproved properties are as a rule always higher than on improved properties. Furthermore, no institutional lender would have found it possible to grant a $10,800 loan on a property valued at $17,000 on the terms contained in Appendix “B”. This is so because the escalation feature of the mortgage, whereby no principal or interest is payable until the end of the mortgage term, raised the loan to value ratio from 63.5% ($10,800 — divided by $17,000) to 88.9% ($15,120 divided by $17,000). Such an 88.9% loan to value ratio is normally unobtainable, except from the most aggressive and expensive lenders. Most institutional lenders are by law prohibited from advancing mortgage loans exceeding 75% of the value of the property mortgaged without the protection of mortgage insurance, such as that offered by Canada Mortgage and Housing Corporation (“C.M.H.C.”) and The Mortgage Insurance Company of Canada (“M.I.C.C.”). However, such protection was not, and is not, available on unimproved properties. In my opinion, a non-institutional or private investor would have had to be offered, and would have been able to obtain, a rate of interest on a mortgage, such as the one on Lot 16, of at least 15% in order to be attracted to such an investment.

(2) Given the types of properties involved and their location and having regard to alternative investment opportunities in the mortgage market, on or about April 3, 1975 would a prudent investor or lender of funds, being a stranger to the mortgagors, acting at arm’s length with them and being motivated solely by investment considerations:

(i) have been able to insist on rates of interest higher than those in the subject mortgages, or

(ii) assuming that the rates of interest in the subject mortgages were for any reason not subject to negotiation and change, have advanced the full face amounts of these mortgages?

(i) Yes; because the going market interest rates were higher than those offered by the subject mortgages, whether such market rates were actual mortgage rates or yields obtained through discounting existing mortgages bought and sold in the secondary mortgage market. A mortgage on Lot 16 (Appendix “B”) would have commanded a higher rate of interest or yield in the market than a mortgage on Lot 13 (Appendix "A”),

(ii) No; because a prudent lender being presented with this situation would have ascertained the market yield of a comparable investment and would have discounted the face value of the mortgage accordingly. This means that such an investor would not have advanced the full value of $10,800, but would rather have advanced a lesser sum to compensate him for the low rate of the mortgages. This sum would have been lower on Lot 16 (Appendix “B’’) than on Lot 13 (Appendix “A”). The amounts which a prudent investor would have advanced on these mortgages would not have exceeded their fair market value: see my answer to Question (3) below, and Appendices “D” and “E”

(3) What was the fair market value of the subject mortgages if they had been offered for sale on or about April 13, 1975?

My answer to this question is contained in two separate appraisals (Appendix “D” for Lot 13 and Appendix “E”’ for Lot 16).

[market value of 614 Lome Street as of April 13, 1975 was $17,000

market value of 1265-1267 Kimberly Crescent as of April 13, 1975 was $46,500]

(4) Are there any features to the subject mortgages, other than their rates of interest, which would likely have affected the decision of an investor described in paragraph (2) above in advancing the full amount of these mortgages, or which would have affected their fair market value, and if so, which features and why?

Yes. The non-payment of interest until maturity feature of the mortgages would have required placing these mortgages with non-institutional lenders whose rates were appreciably higher than those charged by institutional lenders and hence much higher than the rates offered by these mortgages. Alternatively, such non- institutional lenders would not have advanced the full face amounts of these mortgages if faced with a given 8% mortgage interest rate.

Furthermore, in the case of Lot 16 (Appendix “B”), the unimproved nature of the property would have caused an even further increase in the mortgage interest rate or, alternatively, would have resulted in an even lesser sum advanced than in the case of Lot 13 (Appendix “A’’).

The statutory provisions relevant to this appeal are subsection 146(10) of the Act and paragraph 4900(1)(g) of the Income Tax Regulations which at the relevant time read:

146(10) Where in a taxation year a trust governed by a registered retirement savings plan

(a) acquires a non-qualified investment, or

(b) uses or permits to be used any property of the trust as security for a loan,

the cost to the trust of the non-qualified investment or the fair market value, at the time the property is used as security, of the property so used, as the case may be, shall be included in computing the income for the year of the taxpayer who is the annuitant under the plan.

4900(1) Pursuant to subparagraph 146(1)(g)(iv) of the Act, each of the following investments is hereby prescribed to be a qualified investment for a trust (in this subsection referred to as the “savings plan trust”) governed by a registered retirement savings plan:

(g) a mortgage, or interest therein, secured by real property situated in Canada and acquired by the savings plan trust, other than a mortgage in respect of which the mortgagor is the annuitant under the plan governing the savings plan trust or a person with whom the annuitant does not deal at arm’s length;

Counsel for both parties agree that the sole issue before the Court is whether the plaintiff was dealing at arm’s length with Mr. Coates at the time that these reciprocal mortgage transactions occurred.

Counsel for the plaintiff argues that I ought not to find that the transactions are not at arm’s length unless I conclude that one party held an advantage or a special influence over the other. In support of this contention counsel refers to the decision of the Supreme Court of Canada in M.N.R. v. Sheldon’s Engineering, Ltd., [1955] C.T.C. 174; 55 D.T.C. 1110 where at 179- 80 (D.T.C. 1113) Locke, J. considers the expression “dealing at arm’s length” and states:

The expression is one which is usually employed in cases in which transactions between trustees and cestuis que trust, guardians and wards, principals and agents or solicitors and clients are called into question.

Apart altogether from the provisions of that section [The Income Tax Act, s. 127(5)], it could not, in my opinion, be fairly contended that, where depreciable assets were sold by a taxpayer to an entity wholly controlled by him or by a corporation controlled by the taxpayer to another corporation controlled by him, the taxpayer as the controlling shareholder dictating the terms of the bargain, the parties were dealing with each other at arm’s length and that s. 20(2) was inapplicable.

Counsel submits that to clarify the meaning of the term “dealing at arm’s length” resort must be had to cases dealing with bankruptcy. He specifically refers to the case of Re Tremblay et al., 36 C.B.R. 111 (Qué. S.C.) the head- note of which reads in part:

The meaning of “otherwise than at arm’s length” is, however, elusive. The concept has its source in the Income Tax Act, but the jurisprudence, as it relates to bankruptcy, is practically non-existent. The doctrine provides that the court has wide discretion to say whether or not persons who are not related were dealing at arm’s length when a particular transaction took place. In the absence of a better definition, a transaction at arm’s length could be considered to be a transaction between persons between whom there are no bonds of dependence, control or influence, in the sense that neither of the two co-contracting parties has available any moral or psychological leverage sufficient to diminish or possibly influence the free decision-making of the other. Inversely, the transaction is not at arm’s length where one of the co-contracting parties is in a situation where he may exercise a control, influence or moral pressure on the free will of the other. Where one of the co-contracting parties is, by reason of his influence or superiority, in a position to pervert the ordinary rule of supply and demand and force the other to transact for a consideration which is substantially different than adequate, normal or fair market value, the transaction in question is not at arm’s length.

Counsel submits that here, there is no evidence that one party to the transaction had any special influence over the other party. Furthermore, there is no evidence that the consent to enter into this reciprocal mortgage transaction was obtained by the influence, pressure or control of one party over the other. Therefore, it cannot be said that the parties were not dealing at arm's length.

Counsel urged the Court not to consider the aim or purpose of the transaction as determinative of the issue of whether the parties were dealing at arm's length. He argues that the proposition that to have effect under a taxing statute, a transaction must have a bona fide business purpose other than the reduction of tax, was rejected by the Supreme Court of Canada in Stubart Investments Limited v. The Queen, [1984] C.T.C. 294; 84 D.T.C. 6305. I do not have any difficulty with that argument. It is well established that the fact that a transaction has a praiseworthy purpose unrelated to tax does not enter into the determination of its tax consequences. This is further confirmed in the specific legislative provisions under consideration here. Pursuant to subsection 146(10) it is only if the mortgage here is a non-quali- fied investment that the fair market value of the property must be included in income. Under paragraph 4900(1 )(g) of the Regulations this mortgage is a qualified investment for the trust provided that the parties were dealing at arm's length. This applies regardless of the purpose for which the transaction was entered into.

Because these parties were known to each other and in a professional relationship, it was feasible for them to enter into a reciprocal transaction. Because of their association and because the transaction was reciprocal, the relationship to market factors was unimportant. I accept the expert witness's evidence that the eight per cent interest rate incorporated in the mortgage was below the going rate charged by major lending institutions at the relevant time. Based on the value of the subject properties and the terms of the mortgage, that is five years with no principal or interest payable until maturity, it is inconceivable that a mortgagee dealing at arm's length would have accepted a mortgage at less than between 13 and 15 per cent per annum. Furthermore, a prudent investor, dealing at arm’s length would not have advanced the full face value of the mortgage since the market yield of a comparable investment would have been far greater than that from the mortgage.

The question of whether the parties were dealing at arm's length is one of fact. Here, the parties were members of the same law firm and knew each other in a social context. The plaintiff, by his own admission, respected Mr. Coates and placed a great deal of faith in his integrity. Accordingly, when accepting Mr. Coates' properties as security he did not question his assertion that they constituted adequate security for the $10,800 loan and no valuation of the properties was done. At no time did the plaintiff attempt to negotiate a better yield on his investment by improving the terms of the mortgage. Furthermore, the plaintiff's evidence is that no other possible investments of the R.R.S.P. funds were considered.

On the facts, therefore, it is clear that the transaction here did not involve any of the normal market factors which influence investments. The only aspect of it that brings into play any of the normal market factors is the use of an institutional lender and even that result flows from the fact that these are R.R.S.P. funds. The entire transaction was governed by the common interest of the plaintiff and Mr. Coates. Counsel for the plaintiff has not related any facts or jurisprudence that would lead me to conclude that the parties to this transaction were dealing with each other at arm's length. In my opinion, this matter is precisely the type of situation contemplated by Thurlow, J. (as he then was) in Swiss Bank Corporation et al. v. M.N.R., [1971] C.T.C. 427; 71 D.T.C. 5235, (appeal to S.C.C. dismissed, 72 D.T.C. 6470) where at 437 (D.T.C. 5241) he [sic] quotes Locke, J. in M.N.R. v. Sheldon’s Engineering as follows:

In other words where the evidence reveals that the same person was “dictating” the “terms of the bargain” on behalf of both parties, it cannot be said that the parties were dealing at arm’s length.

and adds that:

. . . where several parties — whether natural persons or corporations or a combination of the two — act in concert, and in the same interest, to direct or dictate the conduct of another, in my opinion the “mind” that directs may be that of the combination as a whole acting in concert or that of any one of them in carrying Out particular parts or functions of what the common object involves.

I have no hesitation in concluding that the plaintiff and Mr. Coates were not dealing at arm’s length. I hasten to add, however, that this in no way makes the transaction unlawful or sinister. My only concern is the tax consequences that flow from it.

In view of my disposition of this matter, I do not propose to deal with the Crown's alternative argument under subsection 245(1) of the Act. Accordingly, the appeal is dismissed with costs.

Appeal dismissed.