McLaws v. Minister of National Revenue, 72 DTC 6149, [1972] CTC 165, [1974] S.C.R. 887

Hall, J (all concur):—This is an appeal from the Exchequer Court of Canada wherein Kerr, J dismissed an appeal by appellant from the income tax reassessments in respect of the years 1963, 1964 and 1965. The issue in the appeal is whether the appellant, in computing his income for these three years, is entitled to deduct the sum of $18,750 which he paid in each year to the Royal Bank of Canada in settlement of a guarantee he had given the bank on behalf of Calgary Iron and Engineering Limited, a company of which he was the sole beneficial owner.

A proper consideration of the issues involved requires a somewhat detailed review of the history of Calgary Iron and Engineering Limited and its predecessor, Calgary Iron Works Limited. Kerr, J made such a review in his reason as follows ([1970] CTC 420 at 422-6: 70 DTC 6289 at 6290-92):

The appellant is a barrister and solicitor who has practised law in Calgary continuously since 1940. That is his principal occupation but he had also had other fairly extensive business activities. At relevant times he was an officer and beneficial owner of all the shares of the aforesaid Calgary Iron and Engineering Limited, a company that he caused to be incorporated in 1953, which l shall refer to as “the new company”.

There was an old predecessor company, Calgary Iron Works Limited. The life of this company went back to before 1900 and continued until 1953. The appellant’s father had control of it and owned 90% of its shares. The father died in 1950, at which time the company was a going concern. By his will he gave a fixed income to his widow and left her a life estate with the residue going to the appellant and the appellant’s younger brother, who was practising law with him.

The appellant explained why he caused the new company to be incorporated. He said that his brother had taken no interest in the old company, but he himself had taken an interest in it even while his father was alive and he wanted to keep its business going after his father’s death because he thought it would be a good source of income for himself. The old company was the major asset of his father’s estate. The other assets were not nearly Sufficient to keep his widow in the way she was accustomed to live, and after the father’s death efforts were made to sell the old company for a price sufficient to meet the widow’s needs. But no purchaser was found. The appellant then took steps to serve the dual purpose of providing his father’s estate with capital to meet the widow’s needs and of retaining the old company business for his own benefit. This involved a purchase by him of the assets of the old company from his father’s estate, incorporation of the new company, and a sale by him of the said assets to the new company that he owned and controlled. By an agreement dated January 2, 1952, he purchased the assets of the old company for a consideration which included payment of $225,000 and assumption of debts. In turn, by an agreement dated February 19, 1953, he sold the assets to the new company for a consideration which included a cash payment of $225,000 and issue of shares of the company.

He arranged the financing of the transactions through a bank loan of $150,000 and a second mortgage for $80,000, both of which were repaid by the company by 1958, in part by sale of its real property. After its incorporation the appellant also personally lent $25,000 to the company and it too was subsequently repaid.

The business of the old company was carried on until the incorporation of the new company much as it had been carried on before the father’s death, but when the new company was incorporated the appellant endeavoured to expand its facilities and improve its business. Until 1958 it made modest profits. It paid no dividends but the appellant took sums from it as salary or bonus.

Prior to 1960 the company had a limited line of credit with the bank, for operational purposes, in addition to its loan for purchase of the assets of the old company. The indebtedness varied from time to time. The appellant originally gave his personal guarantee to the bank with respect to the bank loans. However, it was not on that guarantee, but on an extension of it, that he was called upon to pay.

In the period 1958-60 the company was in financial difficulties and was operating at a loss, which the appellant attributed to an over-ambitious expansion program and ineffective management. Its indebtebdness to the bank had increased, it had sold its real property and applied the proceeds towards the bank loan, it had taken a lease-back of the real estate and in that connection gave a chattel mortgage on the company’s equipment to the landlord. In 1960 affairs reached a crisis. Its liabilities exceeded its assets. It was facing bankruptcy. The bank proposed to call its loans, but offered to extend additional credit to keep the company going, provided that the appellant would give a formal personal guarantee and deposit security. He agreed and gave the guarantee, the one which he was later called upon to honour. He also deposited securities worth $70,000, of which $50,000 belonged to his wife. As additional security the company gave an assignment of book debts and accounts receivable to the bank. Thus the company was then able to continue in business and did so for about a year, but in 1961 the bank called its loans and realized on the company’s receivables and inventory and on the securities deposited by the appellant. The landlord who held the chattel mortgage seized the company’s equipment. And the company went out of business. Then the bank required the appellant to honour his guarantee.

As already indicated the company had a line of credit with the bank in the years prior to 1960 in respect of which the appellant had given a limited personal guarantee, but by the time of the 1960 crisis the limit of credit had been reached and additional bank financing was needed. The appellant said that he decided to try to keep the company going rather than have it go into bankruptcy and that he gave the guarantee so that it could continue in business and be, as it formerly had been, a source of income for him. But he was concerned about the additional guarantee and the possibility that he might have to honour it. He consulted income tax experts on the implications, income tax-wise, of being called upon to make payments on the guarantee and the advice he received was that where a guarantee is given for consideration a payment under the guarantee would be deductible from income as a business loss. The result was that the agreement which he entered into with the company provided that in consideration of his guaranteeing its account with the bank it would pay him an annual fee. The terms of the agreement are set forth in a letter (Exhibit A-2), dated March 16, 1960, from the appellant to the company, as follows:

“March 16, 1960.

Calgary Iron and Engineering Limited

Calgary, Alta.

Dear Sirs,

You have represented to me that you have been borrowing money from the Main Branch of the Royal Bank of Canada, Calgary, and I have heretofore guaranteed that account within certain limits.

You are now at the extent of your limits and require additional bank financing, which the bank is not prepared to give to you unless I extend my guarantee of your account and in addition pledge to the bank certain securities as security for my guarantee.

It is hereby agreed between us that if I guarantee your account to the Royal Bank in an amount of $300,000.00 or in excess thereof you will pay me an annual fee of $3,000.00 as consideration therefor, such amounts to be paid to me on the annual dates of this letter agreement.

It is further agreed that if the amount of your indebtedness to the bank and to which my guarantee applies is reduced to $200,000.00, the aforesaid fee will be reduced to $2,000.00 and if the guarantee is reduced to $100,000.00, the fee will be reduced to $1,000.00.

Should your indebtedness be reduced or repaid at any time during the year and the guarantee be reduced or released you will then only be responsible for a pro rata amount of the fee applicable thereto.

Yours truly,

(Sgd.) Donald McLaws

The foregoing is hereby agreed to.

CALGARY IRON AND ENGINEERING LIMITED

Per: (Sad.) W Dixon.”

At the trial the appellant said that when he extended the guarantee he expected that the company would get on its feet and make profits and pay the fee. The following questions and answers from his Examination for Discovery were put in evidence on this aspect of the case:

“Q. And these fees if they had been paid but none were paid, I take it?

A. That is correct.

Q. These fees if they had been paid would have been income? A. Oh, yes.

Q. Now, tell me, was the provision for these fees an afterthought, so to speak, and was your primary and basic intent in making the guarantee to save the company? A. Well, certainly, the only reason for giving the guarantee was so that the company could continue in business. I don’t think the intent was to save the company in the technical — I mean in the words that you used them. The intent was to save a source of income which I enjoyed for the past number of years. And the saving of the company was, of course, the mechanics by which that was done.

Q. In other words, your primary intent in making the guarantee was to protect your source of income? A. That is correct.

Q. Which the company was? A. That is correct.

Q. Or had been, more correctly? A. That is correct.

Q. And the payment of fees to you in connection with the guarantee was incidental and secondary thereto to that primary purpose? A. At that time I began to realize that there was a possibility that the guarantees I might be called on, if the company survived and I had considered what my position was going to be and I had taken advice of some tax people and the result I got was that a guarantee given for consideration, if you had to make a payment under a guarantee given for consideration that the loss would be deduction from income. It would be a business loss and, therefore, that was put in there.”

The appellant’s previous guarantee for a more limited amount had no fee provision. The only loans or credit that he had otherwise guaranteed were a few for friends or companies with which he was associated, and none of them had a fee provision or was for valuable consideration.

Following this review, Kerr, J continued:

The determination of the appeal depends upon a proper appreciation of the true nature of the transaction and payments on the guarantee. In my Opinion the guarantee and the appellant’s outlays in honouring it and his agreement with the new company should not be considered in isolation, but in association with his basic venture to acquire the assets and business of the old company and continue to carry on the business through the new company for revenue earning purposes with the profits to flow through to himself personally as owner of all the shares of the new company. The acquisition of the plant and assets of the old company was of a capital nature, and the appellant gave a guarantee to the bank in that respect, which may properly be regarded as on account of capital, but the issue in this appeal is not on that guarantee but on the guarantee that he gave in 1960.

I accept the appellant’s testimony that he expected that the company would get on its feet and be a source of income for him, as it had been in some prior years. If he had not thought so, it is unlikely that he would have thrown good money after bad, so to speak, and committed himself to the new guarantee for a larger amount, and deposited $70,000 worth of his own and his wife’s securities as collateral. However, I attach little significance to the provision that the Company would pay him an annual fee in consideration of his agreement to guarantee its credit. That was not really why he gave the guarantee. The fee provision was incidental. and was resorted to in the belief that it would give the transaction the character of a business venture in the nature of trade and that a payment under it could qualify as a business loss that could be deducted from his income for income tax purposes. In my opinion, the reason why he gave the guarantee was to keep the company in business and prevent it from going into bankruptcy.

The appellant asserts that the payments made under the guarantee were business losses sustained by him in the course of the carrying on of a business and an adventure in the nature of trade within paragraphs 32(5)(d) and 139(1)(e) of the Income Tax Act. On the other hand, the Minister contends the payments were capital outlays for losses within paragraph 12(1)(b) and were not payments made or incurred by the appellant for the purpose of gaining or procuring income from property or a business of the appellant within the meaning of paragraph 12(1)(a). The paragraphs above referred to read as follows:

32. (5) For the purpose of this section, “earned income” means the aggregate of

minus

(d) business losses sustained in the taxation year in the course of the carrying on of a business either alone or as a partner actively engaged in the business,

139. (1) In this Act,

(e) “business” includes a profession, calling, trade, manufacture or undertaking of any kind whatsoever and includes an adventure or concern in the nature of trade but does not include an office or employment;

12. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part,

Paragraph 12(1 )(b) of the Income Tax Act has been dealt with by this Court in a number of decisions, including MNR v Freud, [1969] 1 SCR 75; [1968] CTC 438; 68 DTC 5279, relied on by the appellant, and MNR v Steer, [1967] SCR 34; [1966] CTC 731; 66 DTC 5481, relied on by the Minister.

In Freud the outlay was to develop a prototype sports car and to sell it. It was a single transaction and Freud had no intention of continuing the undertaking by manufacturing or selling cars. The venture from its inception was not for the purpose of deriving income from an investment but for the purpose of making a profit on a sale of the prototype. This Court held that it was a venture in the nature of trade.

The Steer case was in respect of a deduction claimed for a sum paid by the taxpayer to a bank under a guarantee of the indebtedness of a company which needed money for the drilling of oil wells as a continuing operation. In delivering the judgment of this Court, Judson, J said at page 37 [732, 5482]:

I have no difficulty in defining the character of this transaction. The company needed money for the drilling of three wells. The convenient way of supplying this money was by a bank loan with the respondent’s guarantee to the extent of $62,500. The guarantee meant that at some time the respondent might have to step into he bank’s shoes to this extent. This happened in 1957. He was then subrogated to the bank’s position. He subsequently proved as a creditor in the company’s bankruptcy and received two dividends — one in 1959 for $6,119 and the other in 1961 for $3,200. The transaction was a deferred loan to the company, part of which was recovered in the bankruptcy.

Having considered Freud and Steer and other cases, including MNR v Algoma Central Railway, [1968] SCR 447; [1968] CTC 161: 68 DTC 5096; Farmers Mutual Petroleums Limited v MNR, [1968] SCR 59: [1967] CTC 396; 67 DTC 5277, as well as British Columbia Electric Railway Company v MNR, [1958] SCR 133; [1958] CTC 21; 68 DTC 1022, Kerr, J concluded:

In my opinion the appellant’s outlays were on account of capital, within the meaning of Section 12(1 )(b) and the claimed deductions are prohibited. In my view of the situation, the guarantee was given to protect and preserve the source of income, a business which was in immediate danger of bankruptcy and whose existence was imperilled. The character of the ensuing outlays in honouring the guarantee is quite different from expenditures which fall naturally into the category of income disbursements and business losses. In my opinion, the outlays are of the character of payments on account of capital and are not of the kind of expenditures that the statute contemplated to be allowed as deductions under the language ‘‘made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer”, in Section 12(1)(a), or under the language “business losses sustained . . . in the course of the carrying on of a business”, in Section 32(5)(d).

I agree with this conclusion. See Stewart & Morrison Limited v MNR, [1972] CTC 73; 72 DTC 6049, in this Court. I also agree with Kerr, J’s conclusion that the agreement contained in the letter of March 16, 1960 is of no assistance to appellant for the reasons given as previously quoted.

There remains the appellant’s contention that the interest portions of the $18,750 annual payments to the bank are, in any event, deductible under subparagraph 11 (1 )(c)(i) of the Income Tax-Act which reads:

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt),

The interest paid by the appellant and which he claims should be allowed as a deduction is not, in my view, an amount paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income. The interest paid by the appellant was not an advance made to him but was paid on the principal sum remaining unpaid under his guarantee. As Viscount Dunedin said in Commissioners of Inland Revenue v Sir H C Holder, Bart and J A Holder, 16 TC 540 at 564:

. . . It is true that he pays a sum which pays all interest due by the person to whom the advance is made, but his debt is his debt under the guarantee, not a debt in respect of the advance made to him. . . .

The appeal must, accordingly, be dismissed with costs.