Hallbauer v. R., 98 DTC 6275, [1998] 3 CTC 115 (FCA)

Robertson J.A. .

This appeal focuses on whether the appellant taxpayer is obligated to pay what is colloquially referred to as the “alternative minimum tax”, imposed under s. 127.5 of the Income Tax Act. If applicable, that provision claws back into taxable income the non-taxable portion of a capital gain. The taxpayer seeks to avoid that result by one of two routes. First, he argues that conveyances to two unsecured creditors amounting to a 40% interest in a commercial building did not give rise to a capital gain. This argument hinges on the premise that the conveyances were effected solely for the purpose of securing pre-existing debts. Therefore, the conveyances do not constitute “dispositions” within the meaning of s. 54 so as to give rise to a capital gain. Alternatively, the taxpayer submits that if they qualify as “dispositions” then they fall within s. 79. Pursuant to ss. 127.52(l)(d) a disposition to which s. 79 applies is not included in the computation of a person’s adjusted taxable income for purposes of calculating the minimum tax. In a decision now reported at (1996), 97 D.T.C. 767 (T.C.C.) , the Tax Court of Canada rejected the taxpayer’s arguments. In the reasons that follow I reach the same conclusion, albeit for slightly different reasons. My analysis begins with a recitation of relevant facts.

Between 1979 and 1982 the taxpayer acquired several properties, including the “Liberty” building. [The transfer relating to the “Weiler” building is not in issue on this appeal.] Partial financing for the purchases came from monies borrowed from the taxpayer’s sister, Renata Doerre and his former wife, Monika Hallbauer. Both loans were undocumented and unsecured. By 1985, the taxpayer’s financial circumstances suffered adversely because of the decline in real estate values and the downturn in the economy of Western Canada. In 1986, both Renata and Monika demanded repayment of their respective loans. Renata was owed approximately $2.3 million, while the taxpayer’s indebtedness to Monika totalled $600,000. By this date the taxpayer had invested approximately $5 million in the Liberty building, which building was subject to a first mortgage for $2.4 million.

To placate the financial concerns of his unsecured creditors, the taxpayer agreed to convey to Renata a 25% interest in the Liberty building to offset $1 million of the $2.3 million she was owed. Monika would obtain a 15% interest in the same building to offset the $600,000 she was owed. At the same time, the taxpayer agreed that if the Liberty building sold for less than $3.75 million the taxpayer’s debt to each would not be considered to have been repaid.

Under the agreement Renata was to assume $250,000 of the existing mortgage for a total purchase price of $1.25 million. Monika was to assume $150,000 for a total purchase price of $750,000. Apparently, the taxpayer insisted on this arrangement in order to ensure that in the event the Liberty building were to sell for $5 million, the amount the taxpayer had invested in the building, Renata and Monika would not realize more than $1 million ($5 million x 25% - $250,000) and $600,000 ($5 million x 15% - $150,000) respectively.

In order to effect their agreement, the taxpayer instructed a lawyer in Calgary to prepare the necessary contracts. The lawyer drafted the two agreements in the form of an “Offer to Purchase and Sell”. Each agreement provided that as a part owner in the Liberty building, Renata and Monika would be guaranteed a minimum income of 6% based on the amount each paid for their respective interests. From that amount would be deducted principal and interest relating to the assumption of their proportionate share of the existing mortgage. As well, the agreements provided that if net revenues fell short of the guaranteed minimum income the taxpayer was obligated to pay the difference. The taxpayer made no such payments.

On December 22, 1986 Renata and Monika registered caveats on title to the Liberty building. On reflection, I assume that the caveats were registered on title to protect their interests against the possibility of intervening third parties pending the closing of the transactions and registration of their respective interests in the building. On January 14, 1987 Renata and Monika became registered as two of the co-owners of the Liberty building. The taxpayer never received any cash on the closing of the transaction for the obvious reason that the purchase monies took the form of a pre-existing indebtedness. Neither creditor made payments against the mortgage which they purported to assume because of the “minimum income clause” set out in each of the agreements of purchase and sale.

The Liberty building was foreclosed by the mortgagee in October 1991 at a time when the balancing owing under the mortgage exceeded its fair market value of $2 million. Consequently, neither Renata nor Monika received any funds as a result of the foreclosure.

In his 1986 tax return, the taxpayer reported, inter alia, a “disposition” of a 40% interest in the Liberty building for proceeds of $2 million ($1.6 for the 40% interest and $400,000 pertaining to the assumption of the existing mortgage). In assessing the taxpayer for the 1986 taxation year, the Minister added back the untaxed portion of the capital gain realized by the taxpayer on the disposition. This was done solely for the purpose of calculating the minimum tax payable under s. 127.5. The taxpayer appealed to the Tax Court.

Two issues were pursued before the Tax Court Judge. First, it was argued that the transfers of the interests in the Liberty building were made for the purpose of securing debts and, therefore, were not “dispositions” within the meaning of s.54. Paragraph 54(c)(iv) expressly excludes transfers made for such purposes. The relevant portions of s. 54 read as follows:

54 Definitions - In this subdivision,

(c) “disposition” of any property, except as expressly otherwise provided, includes

(i) any transaction or event entitling a taxpayer to proceeds of disposition or property,

(ii) any transaction or event by which

B) any debt owing to a taxpayer or any other right of a taxpayer to receive an amount is settled or cancelled

but, for greater certainty, does not include...

(iv) any transfer of property for the purpose only of securing a debt or a loan, or any transfer by a creditor for the purpose only of returning property that had been used as security for a debt or a loan,...

(h) “proceeds of disposition” of property includes,

(i) the sale price of property that has been sold,

(viii) any amount included in computing a taxpayer’s proceeds of disposition of the property by virtue of paragraph 79(c), and...

The Tax Court judge ruled that the transfers were not made for the purpose of securing pre-existing debts, a finding with which I am in complete agreement. The quintessential feature of any secured transaction is the right of the debtor to obtain a reconveyance of the property given as security upon repayment of the underlying indebtedness. In the present case, both Renata and Monika obtained an indefeasible or beneficial right of co-ownership; a right which is incompatible with the concept of a secured transaction. In short, there is no evidence to support the understanding that if the indebtedness to these creditors was repaid the taxpayer would be entitled to a reconveyance of the 40% interest in the Liberty building. More importantly, the documentary evidence contradicts such an understanding, as does the taxpayer’s own income return for the taxation year in question. On this particular point, I need only refer to two decisions of this Court: Friedberg v. R. (1991), 92 D.T.C. 6031 (Fed. C.A.), per Linden J.A. at 6032 and Paxton v. R. (1996), 97 D.T.C. 5012 (Fed. C.A.) (leave to S.C.C. refused (June 26, 1997), Doc. 25816 (S.C.C.)), per Robertson J.A. at 5018.

The second issue addressed by the Tax Court Judge was whether the disposition of the 40% interest in the Liberty building falls within s. 79. This argument rests on the realization that ss. 127.52(l)(d) provides an exception for dispositions which meet the criteria set out in s. 79 which reads in part:

79 Where, at any time in a taxation year, a taxpayer who

(a) was a mortgagee or other creditor of another person who had previously acquired property,...

has acquired or reacquired the beneficial ownership of the property in consequence of the other person’s failure to pay all or any part of an amount (in this section referred to as the “taxpayer’s claim”) owing by him to the taxpayer, the following rules apply:

(c) there shall be included, in computing the other person’s proceeds of disposition of the property, the principal amount of the taxpayer’s claim plus all amounts each of which is the principal amount of any debt that had been owing by the other person, to the extent that it has been extinguished by virtue of the acquisition or reacquisition, as the case may be;

(d) any amount paid by the other person after the acquisition or reacquisition, as the case may be, as, on account of or in satisfaction of the taxpayer’s claim shall be deemed to be a loss of that person, for his taxation year in which payment of that amount was made, from the disposition of the property;...

The Tax Court Judge acknowledged that s. 79 applies equally to cases where an unsecured creditor subsequently acquires the beneficial ownership of property “in consequence of” the debtor’s failure to pay monies owing. He reasoned that there must be a strong causal relation between the acquisition of beneficial ownership of a property and the debtor’s failure to pay his or her creditor. As to the scope of that causal connection the Tax Court Judge held at page 776 of his reasons:

It is not enough that the debtor’s failure gives rise to, or provides opportunity for, the creditor to acquire ownership of the property. The debtor must realize that if he or she fails to pay the debt when required to do so, the creditor has, as a remedy, the right to acquire the property. The creditor’s right to acquire the property is caused by the debtor’s default, [emphasis mine]

The above passage establishes the proposition that a creditor can only acquire beneficial ownership of property “in consequence of” a debtor’s default where the creditor has “the right to acquire the property”. In my respectful view, this is where the Tax Court Judge fell into error. Such a criterion would have the legal effect of rendering s. 79 inapplicable to cases involving unsecured creditors. I say this for the reason that no unsecured creditor has the right to insist on a conveyance of a debtor’s property simply because there has been default on a loan. To accept the Tax Court Judges’s reasoning would mean that s. 79 would never apply in cases where an unsecured creditor negotiated the acquisition of the debtor’s property following default on a loan. That being said, it is common ground that s. 79 applies equally to secured and unsecured creditors and, therefore, the term “in consequence of’ cannot be construed narrowly. Even counsel for the Minister of National Revenue declined the taxpayer’s invitation to argue in support of the Tax Court Judge’s reasoning on this issue.

Accepting that s. 79 applies to cases where land is transferred to an unsecured creditor following a debtor’s default on a loan, it remains to be decided whether the transfers of a percentage interest in the Liberty building fall within that section. Both the taxpayer and the Minister invoke Brill v. R. (1996), 96 D.T.C. 6572 (Fed. C.A.) in support of their respective positions. In fairness to the Tax Court Judge it must be acknowledged that Brill was decided after the present case. Before turning to the specifics of that case it may be helpful to outline my understanding of the purpose underlying s.79 and the circumstances in which it was intended to apply: see generally R.B. Goodwin, “Tax Consequences of Repossessions, Foreclosures, Forced Sales, and Defaults” Income Tax Aspects of Real Estate Transactions, Corporate Management Tax Conference, 1983 at 111; M.J. Beninger, “The Scope and Application of section 79 of the Income Tax Act” Canadian Tax Journal, vol. 33, no. 4 at 928; R. Couzin, “Income Tax Considerations in Corporate Financing” Canadian Tax Foundation, Corporate Management Tax Conference, 1986; G.W. Flynn, “Restructuring Financially Troubled Corporations” Canadian Tax Foundation, 1989 Conference Report.

In the 1966 Report of the Royal Commission on Taxation (vol. 3, Taxation of Income)(hereinafter referred to as the “Carter Report”), the view was expressed that when a debt is cancelled the debtor has in effect received income in the sense that cancellation of a liability increases a person’s net assets (at 528-30). This is particularly apt in cases where a business debt is cancelled and the debtor may have claimed expenses or recorded assets which in fact will have cost him or her nothing. At the same time, it was acknowledged that there was a problem in determining when “cancellation” should give rise to a deemed receipt of income. There was also the problem of how to deal with the insolvent debtor who by definition would not be in a position to pay tax.

Both s. 79 and s. 80 address the concerns raised in the Carter Report. Section 79 is directed at cases where a debtor conveys property to a creditor in regard to an unsatisfied debt. It applies to secured creditors, such as mortgagees or vendors under a conditional sales contract, as well as unsecured creditors who obtain title to a debtor’s property. With the inclusion of the latter group of creditors it follows that it makes no difference to the application of s. 79 whether the transfer of property comes about as a result of a voluntary or involuntary act of the debtor. What is common to all three categories is that a creditor has received payment in kind and not cash. What s. 79 seeks to ensure is that the debtor realizes proceeds of disposition equal to the amount of the creditor’s claim. In circumstances where the value of the debtor’s property is less than the amount owed the creditor, the debtor is forced to bring into income any benefit that arises from the cancellation or settlement of the underlying debt. At the same time, it must be recognized that s. 79 is not restricted to cases where creditors accept title to property in full settlement of an outstanding indebtedness. On the contrary, ss. 79(d) embraces the possibility of a creditor obtaining title to the debtor’s property while retaining the right to sue for the indebtedness. Specifically, that subsection provides that if a debtor subsequently makes payment on the debt for which the land was conveyed, such payments are deemed to be a loss from the disposition of the property for the year in which the payment was made.

It is not difficult to appreciate why s. 79 does not insist that the underlying debt be extinguished before it comes into play. The antiquated remedy of “foreclosure absolute” illustrates the draftsperson’s appreciation of elementary rules of mortgage law. At common law the failure of a mortgagor to pay on the “law day” resulted in the mortgagee obtaining title to the property given as security upon obtaining a decree of foreclosure absolute. Moreover, a mortgagee retained the right to sue for the amount of the outstanding indebtedness without being under a corresponding obligation to reconvey the property. In short, a decree of foreclosure absolute did not extinguish the underlying debt. Because of the potential for double recovery, or what we now term “unjust enrichment”, courts of equity denied mortgagees the right to sue “on the covenant” unless in a position to reconvey the property to the mortgagor.

Though the common law and equitable rules governing mortgage foreclosure have been superseded by legislative developments in many of the provinces, s. 79 reflects Parliament’s concern that a benefit may accrue to a taxpayer even though a debt may have not been legally extinguished or fully settled. It is for this reason that a debtor is required under ss. 79(c) to calculate the proceeds of disposition by including the principal amount of the creditor’s claim. In effect, as there is no correlation between the value of the property being conveyed and the amount of the indebtedness owing to the creditor, s. 79 deems a sale to have taken place for an amount equal to the amount of the creditor’s claim. In this way, any benefit arising from the possible cancellation or settlement of a debt is brought into income as proceeds of disposition. With respect to the Carter Report’s concern over the plight of insolvent debtors, it is interesting to observe that the minimum tax provisions are inapplicable to s. 79 dispositions. These are cases where debtors are more likely to be insolvent.

It is trite to observe that s. 79 does not apply to cases where a debtor’s property is sold to a third party. Thus, for example, in cases where a mortgagee effects a “judicial sale” to a third party, following default under the terms of the mortgage, s. 79 is not applicable. And the same holds true where the property is sold to a secured creditor such as a mortgagee. This is the effect of the ruling in Brill. In that case the taxpayer had defaulted on a mortgage and in response the mortgagee initiated foreclosure proceedings under the laws of Alberta. The mortgagee sought and was granted a “Rice Order”. That order permitted the mortgagee to purchase the property at a price fixed by the court. Presumably that price reflected the property’s “fair market value”. The mortgagee paid $49,000 for the property and, at the same time, obtained a deficiency judgment for the balance owing under the mortgage.

The taxpayer in Brill claimed proceeds of disposition equal to $49,000 while the Minister reassessed on the basis of the amount outstanding on the mortgage at the time of default by invoking s. 79. On appeal to this Court the mortgagor was successful. Justice Linden held that s. 79 applies only to acquisitions “...where no fixed price is paid...”. In Brill the price was fixed, not by the mortgagor and mortgagee, but by the Alberta court. In my respectful view, this conclusion is unassailable. Where a creditor pays what a court deems to be a fair market value for a debtor’s property it cannot be argued that a benefit of the kind anticipated in s. 79 has accrued to the debtor. Such sales are, at least in theory, no different than a sale to a third party and, therefore, s. 79 has no application. [The problem of mortgagees buying in under their own power of sale, and at a nominal price, raises other considerations: see generally J.T. Robertson, “The Problem of Price Adequacy in Foreclosure Sales” (1987) 66 Can. Bar. Rev. 671]

Brill involved a forced sale of property to a secured creditor at a fixed price. In the present case, we are dealing with a voluntary disposition to an unsecured creditor. What counsel for the taxpayer seeks to establish that is that the voluntary disposition was not at a “fixed price” as required under the reasoning in Brill. Specifically, the taxpayer seizes on the fact that no monies were exchanged by the parties to the contracts of purchase and sale and that the transfer did not result in the extinguishment or settlement of the two debts. Renata and Monika had to wait until the Liberty building was sold before they would know whether their respective debts would be satisfied.

In my view, the argument outlined above cannot succeed. In the circumstances of this case, the fact that no monies exchanged hands is explained by the fact that the purchase monies took the form of a preexisting indebtedness. The fact that the transfers to Renata and Monika did not result in a settlement of their debts does not lead to the conclusion that there was no sale at a fixed price. Take for example the bargain negotiated with Renata. In return for $1 million of the $2.3 she was owed by the taxpayer, Renata received: (1) a 25% interest in the Liberty building; (2) a guaranteed minimum income of 6% of $1 million less principal and interest relating to $250,000 of the amount outstanding on the first mortgage; and

(3) a guarantee that she would receive nearly a $1 million on the sale of the Liberty building. If that property had sold for more than $5 million she would have been legally entitled to her proportionate share of the excess. In my opinion, this is a sale at a fixed price in the sense contemplated by Brill and the same holds true in regard to Monika’s purchase of her 15% interest in the Liberty building.

Admittedly, this case differs from the conventional sale because the purchasers bargained not only for a percentage interest in a property, but also for certain minimum guarantees respecting rental income and ultimate sale price. Such novel contractual obligations, however, do not make the transfer any less a sale. The only matter which was not “fixed” was whether Renata and Monika would ultimately receive more than the amounts which they had paid for their respective interests. Above all this is not a case where it can be argued that the taxpayer has received a benefit of the kind which s. 79 seeks to bring into income as proceeds of disposition. This is not a case where there is no correlation between the value of the property being conveyed, the Liberty building, and the amounts owing to Renata and Monika. In my respectful view, s. 79 is inapplicable to the dispositions in question.

I would dismiss the appeal with costs.

Appeal dismissed.