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Citation: 2007TCC179
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Date: 20070523
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Docket: 97-3731(IT)G
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BETWEEN:
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JOHN H. DANIELS,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Hershfield
J.
[1] The Appellant appeals reassessments
of his 1992, 1993 and 1995 taxation years whereby the Minister of National
Revenue (the “Minister”) denied the Appellant an allowable business investment
loss (“ABIL”) deduction of $3,000,000 in computing his income for 1992. The
appeals in respect of the 1993 and 1995 taxation years turn on whether there is
an ABIL carry forward deduction available from the 1992 taxation year.
[2] The
loss claimed by the Appellant arose in respect of a $4,000,000 debenture of
Shoppers Trust Company (“Shoppers Trust Co”) which had been pledged by the
Appellant’s brother (Phillip) as security for a bank loan. That debenture (“Debenture”
or “Phillip’s Debenture”) was eventually acquired by the Appellant as a
consequence of a series of events that followed Shoppers Trust Co being put
into receivership. After acquiring the Debenture, the Appellant elected in
respect of his 1992 taxation year to have subsection 50(1) of the Income Tax
Act (“Act”)
apply. That subsection deems the taxpayer to have disposed of the Debenture for
nil proceeds. It is the application of this subsection, in part at least, that
gave rise to the $4,000,000 loss.
[3] The
sole issue is whether subparagraph 40(2)(g)(ii) of the Act applies to
deny the loss claimed by the Appellant when he elected under subsection 50(1)
of the Act to treat the Debenture as having been disposed of for nil
proceeds. Subparagraph 40(2)(g)(ii) denies that loss unless the asset giving
rise to the loss (the Debenture) was acquired for the purpose of gaining or
producing income. The Respondent asserts that the Appellant failed to meet this
requirement when the Debenture was acquired from his brother.
[4] The
relevant facts are set out in the Statement of Agreed Facts attached to these
Reasons as Appendix “A”.
[5] Briefly,
background facts to the end of 1991 may be summarized as follows:
a) The
Appellant and his brother Phillip invested in Shoppers Trust Co in the early
1980’s. It was engaged in the mortgage lending business and at all relevant
times qualified as a Canadian controlled private corporation (CCPC) and as a small
business corporation (SBC) as those terms are defined in the Act. Phillip
held 75% of the shares of Shoppers Trust Co directly and the Appellant held the
remaining 25% share interest through a holding company controlled by him;
b) Prior to 1988, each of the Appellant and Phillip also owned Shoppers
Trust Co debentures with a face amount of $1,500,000 and Phillip was
indebted to the Toronto Dominion Bank (the “TD Bank”) in the amount of
$3,000,000 (the “TD Debt”);
c) In 1988, the
Appellant and Phillip borrowed $8,000,000.00 from the Royal Bank of Canada on a
joint and several basis (the “RBC Loans”). The loan to Phillip was in the
amount of $5,500,000 and the loan to the Appellant was in the amount of $2,500,000. Phillip used his loan
proceeds to repay the TD Debt and the balance ($2,500,000) to acquire a further
debenture from Shoppers Trust Co.
The Appellant used his proceeds from the RBC Loan ($2,500,000) to purchase a
further debenture from Shoppers Trust Co. Thereafter, the Appellant and his
brother each owned $4,000,000 of Shoppers Trust Co debentures. The debentures
bore interest at a rate of 12 per cent;
d) It is admitted that the Appellant had an income
earning purpose when he became jointly and severally liable to the Royal Bank
in respect of the RBC Loans made to him and Phillip;
e) The Appellant
and Phillip each pledged their respective $4,000,000 Shoppers Trust Co Debentures
and common shares in Shoppers Trust Co (collectively, the “Shoppers’
Securities”) as security for the RBC Loan; and,
f) As a result of a regulatory audit by the Office of Financial Savings
Institutions in December 1991, Shoppers Trust Co was put into receivership
in March of 1992.
[6] In
computing his income for his 1991 taxation year, both the Appellant and Phillip
determined that at December 31, 1991, the Shoppers’ Securities had become
worthless. This gave rise to a business investment loss of $4,000,000 to each
of the Appellant and his brother in respect of the debentures. Accordingly,
they each claimed an ABIL of $3,000,000. These deductions were allowed by the
Minister in computing income for the 1991 taxation year.
[7] In
January of 1992, after some payments by each of the Appellant and his brother
toward their respective obligations under the RBC Loans, Royal Bank was owed
$4,500,000 by Phillip ($1,000,000 having been repaid by Phillip) and $750,000
by the Appellant ($1,750,000) having been repaid by the Appellant). As noted, both
the Appellant and Phillip were jointly and severally liable in respect of the
entire remaining indebtedness of $5,250,000 – a liability admitted to have been
incurred by the Appellant for an income earning purpose at the time the RBC
Loans were made.
[8] The
Royal Bank then called for repayment of the RBC Loans. Phillip was unable to
repay any part of the outstanding balance of the RBC Loans. Consequently, the
Appellant was required to repay the full amount of $5,250,000 owing to the
Royal Bank pursuant to his joint and several obligation. Such amount was paid
in June 1992.
[9] In
the aggregate, the Appellant repaid $7,000,000 of the $8,000,000 RBC Loan
($2,500,000 to pay off his loan and $4,500,000 on account of his brother’s
loan).
[10] In a
letter addressed to Phillip dated November 18, 1992, the Appellant demanded
that Phillip pay him the $4,500,000 that the Appellant was required to pay the Royal
Bank in respect of Phillip’s loan. Failing such payment the Appellant stated he
would obtain an assignment of the Shoppers’ Securities from the Royal Bank and would
take steps to recover payment of the $4,500,000 amount in full.
[11] The
Appellant obtained an assignment of Phillip’s Debenture on December 1, 1992. On
December 4, 1992, the Appellant gave Phillip written notice pursuant to The
Personal Property Security Act of Ontario (PPSA) that the Appellant
intended to dispose of Phillip’s Debenture unless Phillip paid the Appellant
$4,500,000, but if that amount was not paid, the Appellant accepted Phillip’s
Debenture in satisfaction of Phillip’s obligation to the Appellant.
[12] Phillip
was unable to repay any amount to the Appellant due to serious financial
difficulties. The Appellant therefore acquired Phillip’s Debenture (and common
shares) without attempting to collect the $4,500,000 from Phillip.
[13] Shoppers
Trust Co remains in receivership to this day. It is agreed that on December 31,
1992, the Debenture acquired by the Appellant from his brother had no value. As
the owner of this newly acquired Debenture and electing under subsection 50(1),
the Appellant claimed a $4,000,000 business investment loss and an ABIL of
$3,000,000. This loss was denied by the Respondent.
[14] The loss
claimed relies on the Appellant having an adjusted cost base of $4,000,000 in
respect of the Debenture acquired from his brother. The Appellant relies on
section 79 as it read at the relevant time in 1992 to support his assertion in this
regard. Respondent’s counsel conceded this at trial and made no argument as to
a different construction of section 79. Accordingly, having a $4,000,000
adjusted cost base and nil proceeds of disposition under subsection 50(1), the
Appellant had a capital loss of $4,000,000 and claimed an ABIL of $3,000,000.
[15] Subject to
the application of subparagraph 40(2)(g)(ii), the Respondent agreed at the
hearing that paragraphs 79(f) and (g), subsection 50(1), and paragraphs
39(1)(c) and 38(c) of the Act, permitted the Appellant to deduct the
ABIL claimed in respect of the Debenture acquired from Phillip. Therefore, the
only matter to be decided is whether the Appellant acquired Phillip’s Debenture
for the purpose of gaining or producing income from a business or property
within the meaning of subparagraph 40(2)(g)(ii) of the Act.
[16] Before
turning to consider that question, I note that in addition to the Statement of Agreed
Facts, the Appellant gave evidence at the hearing. He testified that when
he seized Phillip’s Debenture, he believed in its eventual value and did not
sue his brother for contribution because Phillip already had severe financial
troubles and no assets. While reluctant to acknowledge knowledge of certain
correspondence from tax advisers relating to his acquiring his brother’s Debenture,
he did acknowledge that he knew of the tax advantage and followed the advice of
his advisers to best ensure his loss position in respect of his obligations
under the joint and several RBC Loans.
[17] I turn now to the arguments made by the
parties.
ARGUMENT
Appellant
[18] The
Appellant’s principal argument is that I must accept the uncontradicted
testimony of the Appellant that he had in mind that the ownership of Phillip’s
Debenture might one day have value. That that may only have been a faint hope
and not the predominant reason for acquiring the Debenture, cannot dissuade me
of accepting his income producing purpose. The Appellant relies on Larry W. Rich
v. Her Majesty the Queen.
[19] The
Appellant’s alternative argument is that the time to consider the purpose of
acquiring Phillip’s Debenture is not the time of acquisition of the worthless
subrogated debt, but rather the time to consider purpose should be determined
by looking to the event that eventually gave rise to the acquisition. It
is the Appellant’s position that his seizure of Phillip’s Debenture is a direct
result of the income earning purpose that motivated him to effectively guarantee
Phillip’s debt and invest in Shoppers Trust Co originally.
[20] The
Appellant relies on the Reasons for Judgment of Justice Bowman of this Court
(now Chief Justice) in The Cadillac Fairview Corporation Limited v. Her
Majesty the Queen,
where he states, at pages 406-407:
To arrive at the conclusion that a
capital loss has been sustained for the purposes of the Act it is clear from
sections 3, 38 and 39 that there must have been an actual or deemed
disposition of property. The mere making of a capital payment does not, of
itself, give rise to a capital loss. Where a guarantee of a primary debtor’s
obligation is given and the guarantor is required under the guarantee to pay
and does pay to the creditor the primary debtor’s obligation, the guarantor
is in the normal course subrogated to the position of the creditor unless it
has explicitly or implicitly waived those rights of subrogation or other
circumstances prevent such rights from arising. Absent such a factual or legal
impediment, by operation of law a debtor-creditor relationship arises between
the guarantor and the primary debtor. The guarantor’s cost of the debt would
normally be the amount that it paid under the guarantee. (emphasis added)
If, as is frequently the case, the
principal debtor cannot pay, the debt may be regarded as having become bad.
Section 50 of the Act deems the debt to have been disposed of by the guarantor
at the end of the taxation year in which it became bad and to have been
reacquired at a cost of nil immediately thereafter. Thus, through the combined
operation of the law of subrogation and section 50 of the Act the disposition
necessary to support the claim for a capital loss is achieved.
[21] Chief
Justice Bowman then dealt specifically with how subparagraph 40(2)(g)(ii)
should be interpreted and stated as follows at page 407:
In many cases if a guarantor is
obliged to make good under a guarantee it is because the principal debtor is
unable to pay the obligation. From this, it follows that the guarantor’s right
of subrogation against the principal debtor is, at the time of acquisition,
likely to be, in many instances, worthless or virtually worthless. A narrow
and mechanical reading of subparagraph 40(2)(g)(ii) would lead one to
conclude that on the payment of the guaranteed amount the guarantor’s
acquisition of the worthless subrogated debt could not possibly have as its
purpose the gaining or producing of income from a business or property. Such
an interpretation in my view lacks commercial sense. A functional and more
commercially realistic interpretation would subsume in the purpose of the
acquisition of the subrogated debt the purpose for which the guarantee was
originally given. (emphasis added)
[22] Relying on
this passage, the Appellant argues that it is clear that the Court would not accept a “narrow and mechanical
reading” of subparagraph 40(2)(g)(ii) and insist that a taxpayer satisfy a
condition that could likely not be satisfied in most cases once a debt has gone
into default. If it is only after the default that the purpose of acquiring the
worthless subrogated debt is examined, the test of gaining or producing income
from a business or property could, in almost every case not be satisfied.
[23] In Harry
Gordon v. Her Majesty the Queen, Justice
McArthur applied Chief Justice Bowman’s test in Cadillac Fairview and
said at page 1558:
Common sense and commercial reality
leads to the obvious conclusion that the appropriate time to consider whether
the Appellant had an income earning purpose was at the time that the guarantee
was given, and not at the time the guaranteed debt was in fact paid. (emphasis
added)
[24] In National
Developments Ltd. v. Her Majesty the Queen, Justice Bell held that the taxpayer’s right to
receive an amount from a subsidiary by way of subrogation (following the
taxpayer’s payment of that amount to the subsidiary’s creditor) related back to
the time when the amount was pledged to the creditor.
At page 1067 he found:
(b) the debt or right
to receive the sum of $951,177 from K-Tel arising on the banks’ calling on the
Appellant’s pledge related back to the time when the amount of that pledge
was deposited in a collateral account as security for payment to the banks of
K-Tel’s obligations. Although it may be suggested that technically the
reference to “debt or other right to receive an amount” being acquired must
refer only to the date upon which the banks called K-Tel’s loan and applied the
monies in the Collateral Accounts to K-Tel’s obligation to the banks, such
construction, in my opinion would be inconsistent with the object and spirit of
subparagraph 40(2)(g)(ii), would not be in harmony with the evident purpose of
that provision, would lack common sense and would cast a blind eye to the
commercial and economic realities of business transactions; (emphasis
added)
[25] In Estate
of the Late Fabian Aylward v. Her Majesty the Queen,
Justice Mogan referred to the National Developments and said, at page
643:
By parallel reasoning, I conclude
that the payments to General Tire and Toyo Tire, made by Mr. Aylward in 1994,
relate back to the time when two guarantees were first given and the later time
when those two creditors demanded payment from Provincial Tire (as debtor) and
from Aylward’s Limited (as guarantor). The capital loss incurred by Mr. Aylward
in 1994 upon his payment of the $305,000 was not reduced to nil by subparagraph
40(2)(g)(ii).
[26] In Xavier
v. Fernandez v. M.N.R.,
Mogan, J. said at page 184:
In my oral Reasons for Judgment, I
erred in looking at the retaining of the net proceeds of sale by the financial
institutions as an investment by the Appellant and his co-owners at the time of
the forced sale. Instead, I should have related the investment of those
proceeds back to the date when the property was pledged. I regret that I have
not had the benefit of hearing legal argument on this issue of “relating back”.
[27] All these
authorities are argued to support the Appellant’s position that the test of whether a debt or security was acquired
for the purpose of gaining or producing income from a business or property must
be applied at the time the guarantee or, in this case, the obligation to pay,
was originally given or created, not at the time when the debt or the security
are likely worthless.
Respondent
[28] The
Respondent challenges the Appellant’s testimony that he thought Phillip’s
Debenture might have value one day and argues that releasing his brother
from his indebtedness and acquiring an admittedly worthless Debenture is not
consistent with a reasonable objective conclusion that the Debenture was
acquired for the purpose of gaining or producing income. The Debenture had been
worthless for a year when he acquired it; it was unsecured; and had no prospect
of having any value. Discharging Phillip was forgoing a better prospect for
financial recovery and all documentary evidence shows that the only
considerations for the acquisition and discharge were income tax
considerations.
[29] With
respect to the Appellant’s alternative argument, the Respondent does not
take issue with the Appellant taking an assignment of Phillip’s Debenture from
the Royal Bank which gave the Appellant a security interest in the Debenture. The
Respondent recognizes that under the law of guaranty as set out in the province
of Ontario under the scheme of the Mercantile Law Amendment Act (“MLAA”)
and the PPSA, upon assignment from the creditor, the surety for a debt is
entitled to stand in place of the creditor and use all the remedies available
to the creditor to recover the loss from the original debtor. However, the
Respondent contends that the Appellant therefore had three possible recourses
for recovery of his payment for Phillip’s liability to the Royal Bank:
a. He could have pursued Phillip
on his liability;
b. He could have sold the Debentures
and pursued Phillip for the deficiency pursuant to subsection 64(3) of the
PPSA; or
c. He could have accepted the Debentures in satisfaction
of Phillip’s indebtedness to him.
[30] The
Respondent argues then that the acquisition of the ownership interest in the
Debenture was not a necessary consequence of holding the security interest. It
was the consequence of a choice made by the Appellant. By choosing to seize
Phillip’s Debenture, the Appellant entered into a fresh transaction, distinct
and separate from the guarantee. It had legal
effect as a separate transaction. New rights came into existence (he became
beneficial owner of the Debenture) and obligations were extinguished. This was
a substantive transaction that must, according to the principle laid down by
the Supreme Court of Canada in Her Majesty the Queen v. John R.
Singleton,
be viewed independently - not as part of a chain of related interdependent
transactions.
[31] In Singleton
the issue was to determine if the use of borrowed funds by the taxpayer was an
eligible use. In that case the taxpayer essentially refinanced a partnership
interest (in the sense that financing from a borrowed source replaced the
taxpayer’s own investment in an income earning partnership) and used his freed
up equity to acquire a personal residence. The transactions were clearly related
and were part of an uninterrupted interdependent chain of transactions that
were completed with each step done in contemplation of the preceding step.
[32]
Even with such a direct connection between the transactions, the majority
judgment in Singleton found that each transaction should be viewed as a
separate transaction. At the point in time that the money was borrowed by the
taxpayer, it was borrowed to finance a capital contribution to his partnership
- a contribution made necessary by a prior withdrawal from his capital account.
The loan was applied to an income producing asset which was held for that
purpose. Accordingly, the money was used for the purpose of earning income, and
this was an eligible use of the borrowed money.
[33] The
Respondent argues that the reasoning in Singleton is clear authority
requiring that the seizure of Phillip’s Debenture be isolated as a separate
step, the purpose of which could not objectively be found to have been an
acquisition made for the purpose of earning income. That a related
earlier transaction – the incurrence of a debt under a joint and several
liability covenant made for the purpose of earning income – had a qualifying
purpose, is not relevant in determining the purpose of the ultimate
acquisition. Even if the chain between these events was unbroken – as were the
events in Singleton – the acquisition itself is a separate step, the
purpose of which must be determined in isolation of earlier connected
transactions. If the chain between these events can be broken, then the argument
to treat the acquisition of the Debenture as a separate transaction, in terms
of determining its purpose, is all the more compelling. The Respondent argues
that the Appellant had a choice as to what action he could take after acquiring
the security interest in Phillip’s Debenture. The exercise of that choice is a
break in the chain of events. Such a break makes it all the more clear that the
acquisition of the Debenture was a distinct step, the purpose of which must be
determined in isolation of prior events.
[34] I also note
that Respondent’s counsel saw a lack of symmetry in the operation of the
provisions of the Act, or tax
slippage in this case, that might warrant my attention. The same Debenture was
claimed as an ABIL by two taxpayers (by Phillip in 1991 and by the Appellant in
1992) and that the total amount of business loss claimed between the two
brothers was $12,000,000 in respect of an $8,000,000 debt issue.
[35] While this
is the result, I note that any tax slippage flows from the provisions of the Act.
The operation of section 79 ensures that Phillip, who has properly taken
his ABIL, is deemed to have a $4,000,000 gain in 1992 on the disposition of the
Debenture. As to the symmetry that one might expect, one can see that gain
as offsetting the loss claimed in 1992 by Phillip. That the loss was an ABIL
and the gain is an ordinary capital gain is irrelevant. That Phillip may have
had capital losses to consume this gain is also irrelevant. From this
perspective, there has been $12,000,000 of losses claimed, $4,000,000 of gains
declared – leaving $8,000,000 of losses to be declared. That is what has
occurred. There is no need for me to give this argument my further attention.
ANALYSIS
[36] As
acknowledged by the Respondent, subject to subparagraph 40(2)(g)(ii),
the requirements of paragraph 39(1)(c) have been satisfied to permit the
Appellant to realize an ABIL of $3,000,000 upon the deemed disposition, by the
Appellant, of the Debenture at December 31, 1992, pursuant to subsection 50(1).
Subparagraph 40(2)(g)(ii) reads as follows:
(2) Limitations - Notwithstanding
subsection (1),
…
(g) a taxpayer's loss, if any, from
the disposition of a property, to the extent that it is
…
(ii) a loss from the disposition of
a debt or other right to receive an amount, unless the debt or right, as the
case may be, was acquired by the taxpayer for the purpose of gaining or
producing income from a business or property (other than exempt income) or as
consideration for the disposition of capital property to a person with whom the
taxpayer was dealing at arm's length,
…
is nil;
[37] I will deal
firstly with the threshold issue as to the Appellant’s purpose for seizing
Phillip’s Debenture as an isolated event.
[38] It might be
helpful to re-state the context in which the Appellant’s acquisition of Phillip’s
Debenture occurred. The Debenture (and shares) replaced the $4,500,000
debt that Phillip owed the Appellant by operation of the law of guaranty and
the right of contribution. Having repaid $4,500,000 of Phillip’s indebtedness
to the Royal Bank, the Appellant obtained a right of contribution for that
amount from Phillip. As well, the Appellant had a right to an assignment of the
Royal Bank’s security interest in the Debenture - a right he exercised. He then
seized or took ownership of the Debenture in satisfaction of his brother’s
indebtedness to him.
[39] The
Appellant contends that he seized the $4,000,000 Debenture from Phillip in
satisfaction of Phillip’s debt, instead of pursuing Phillip on the debt for
three reasons:
a. It was unlikely that any amount
could be recovered in a claim against Phillip;
b. The Appellant believed the
Debentures could have value in the future; and
c. The Appellant had been advised of a
tax advantage in seizing Phillip’s Debentures rather than pursuing Phillip.
[40] If I believe that the Appellant seized the Debenture
because he believed it could have value in the future, that would be sufficient
to dispose of the appeal in favour of the Appellant. In such case, applying the
reasons in Rich, there would be no need to question the weight of the
income-earning purpose, even if his belief in the future value of the Debenture
was only a faint hope and subordinate to the tax advantage he sought. While
every case must be considered in its overall context, I see no reason in the
case at bar to distinguish it from the Federal Court of Appeal decision
in Rich.
[41] Rich was also a case involving the taxpayer’s
claim for an ABIL. The trial judge had found that the predominant purpose of
the share purchase that gave rise to the ABIL claim was to assist the
taxpayer’s son and that the commercial purpose normally associated with such
purchase, namely to earn dividends, was a faint hope. While the trial judge
found that fact to be fatal, the Federal Court of Appeal did not agree. The
Court of Appeal allowed that the purpose test in subparagraph 40(2)(g)(ii) had
been met, accepting that even a faint hope of income as a subordinate reason to
acquire shares was sufficient.
[42] Recalling that the purpose of the ABIL is to encourage
investment in small Canadian businesses, it is little wonder to me that a Court
would accept a faint hope as sufficient to meet the requisite purpose test. When
a family business experiences financial difficulty, the objective rationality
of rescue motives might always be questionable with hindsight. Considerable tolerance
seems essential. In my view Rich stands for such principle.
[43] Still, the Respondent relies on the difference between
a faint hope and the assertion that the Appellant’s testimony, when viewed
objectively, is not credible. The Respondent essentially wants me to find that
on a balance of probability, the Appellant never considered that the worthless
Debenture might someday yield a return. His self-interested testimony should be
disregarded.
[44] Objectively, the Respondent’s
position is not without merit. The Appellant need not have released Phillip to
maintain a faint hope of recovery under his security interest in Phillip’s Debenture.
The acquisition was not necessary for him to claim a loss on the bad debt. It
was only necessary to obtain ABIL treatment.
[45] It is hard not to
accept on a balance of probability that the Respondent’s assertions are true in
this case in spite of the Appellant’s testimony. Self-interested recollections
of doubtful thought processes going through one’s mind years ago are not
reliable. While corroborative evidence of intent or purpose may be difficult to
find in cases such as this, there is a greater likelihood that such evidence might
exist if the stated purpose was genuinely present. For example, evidence that
he did an analysis of the Receiver’s report might have warranted an inference of
some faint hope being present. The absence of anything corroborative leads to
an opposite inference. The only evidence the Appellant gave was that the
Receiver was not patient enough to make the best of real estate cycles and that
some of Shoppers Trust Co’s property interests escalated in value sufficiently
in recent years to give more than faint hope of recovery, had such property
interests been kept. But that evidence seems only to underline that he
understood that Receivers liquidate and in that environment at that time, his
tax motivation for exchanging his right of contribution for the Debenture objectively
appears not only to be his predominant reason for the exchange but seems likely
to be the only reason. That is, the evidence tends to support a finding that
the release of one debt in exchange for another was nothing other than a step
taken on the advice of tax advisers in order to secure not only a capital loss
for tax purposes but an ABIL.
[46] On the other hand, taking the assignment of Phillip’s Debenture
from the Royal Bank strikes me as a routine step anchored, objectively, in the
hope of recovery. Collection of Phillip’s indebtedness to the Appellant would
only be enhanced by the Appellant taking any security interest in any asset as
per his entitlements. Even the Respondent
does not take issue with that.
[47] If the Respondent
does not take issue with the fact or likelihood that the Appellant had recovery
options in mind when he took the security interest, it seems to me that the
Respondent is hard pressed to attack the Appellant’s oral testimony that he
thought the Debenture may have potential value. Taking action to gain recovery
options necessarily implies a belief that the Debenture itself had potential
value. The Respondent’s own argument focuses on the recovery options afforded
by the assignment of the security interest in the Debenture without condemning
the motive for obtaining the assignment. The Respondent just condemns the
option chosen once the assignment was made and in doing so reliance is placed
on the fact that the security interest assigned to the Appellant by the bank
gave the Appellant a right to realize any value the Debenture might have
without actually owning the Debenture and on the fact that the Appellant lost
an additional avenue for recovery by discharging his brother without gaining
any advantage.
[48] These objective realities do not, in my view, entirely
distract from the corroborative inference that might properly be drawn if one
accepts that the security interest assigned to the Appellant by the bank could
reasonably be considered as having been acquired because it represented some
potential value as a security interest. Any value perceived in a security
interest in the Debenture reflects value perceived in the Debenture. On this
basis, I might be inclined to give the Appellant the benefit of the doubt as to
his purpose. However, such finding is not
necessary as the Appellant’s alternative argument prevails in any event.
[49] The
Appellant’s alternative argument is that the time to consider purpose is not
the time of acquiring (seizing) the Debenture. If that was the time to apply
the test of a purpose to gain or produce income, the test could never be
satisfied. It is the Appellant’s position that his seizing Phillip’s Debenture was
a direct result of the income earning purpose that motivated him to effectively
guarantee Phillip’s debt and invest in Shoppers Trust Co originally. The
Appellant relies on the Cadillac Fairview line of authorities that
rejects a narrow and mechanical reading of subparagraph 40(2)(g)(ii). As Chief
Justice Bowman said in his Reasons for Judgment in Cadillac Fairview:
A functional and more commercially realistic
interpretation would subsume in the purpose of the acquisition of the
subrogated debt the purpose for which the guarantee was originally given.
[50] However, in
that case and the other cases relied on by the Appellant, the debt referred to is
the debt arising as a consequence of the right of contribution. In the case at
bar that debt is Phillip’s personal debt to the Appellant. That personal
indebtedness of Phillip was acquired at law when the Appellant paid Phillip’s
debt to the Royal Bank. If the indebtedness to the Appellant remained Phillip’s,
the authorities relied on would be on all fours and I would not hesitate to apply
them and relate back to the earlier transaction in determining the Appellant’s
purpose in respect of his acquiring the debt that arose from his right of
contribution. However, in the case at bar the relevant indebtedness to the Appellant
did not remain Phillip’s; instead it was replaced with the indebtedness of
Shoppers Trust Co in the form of the Debenture.
[51] Without
this “exchange”, the Appellant would be entitled to a capital loss in respect
of the bad debt owed to him by his brother. It was a bad debt to which section
50 would apply. This would be the case even though the debt was created well
after the transactions that led up to and eventually gave rise to its creation.
However, in that case he would not be entitled to an ABIL. The Respondent sees
this extra “exchange” step, affected by seizing Phillip’s ownership interest in
the Debenture and releasing Phillip, as a step that distinguishes the line of
cases relied on by the Appellant. That step, as an isolated step that affords
the Appellant better tax treatment, is argued by the Respondent not to be
governed by the authorities relied on by the Appellant but rather is one that
must be governed by the principles set out by the Supreme Court of Canada in Singleton.
[52] In
considering how this extra step fits into the analysis, it is necessary to
consider the provisions of the Act that govern it. The governing
provision is section 79 of the Act. At
the relevant time that section provided that where beneficial ownership of a
property (the Debenture) is acquired by a person (the Appellant) from a debtor
(Phillip) as a consequence of the failure of the debtor (Phillip) to pay the
debt owed (Phillip’s debt arising from the Appellant’s right to contribution),
the creditor’s (the Appellant’s) adjusted cost base of the debt owed is deemed
to be nil. Since the value of the extinguished unpaid debt is nil, no gain or
loss is triggered on its extinguishment. The cost of the property (the
Debenture) acquired by the creditor (the Appellant) in satisfaction of the debt
is then deemed to be the cost of the debt extinguished on the acquisition
($4,000,000).
[53] In more
general terms, section 79 transfers the loss associated with the bad
debt to the newly acquired property. No immediate tax consequence is triggered
in relation to the loss incurred as a result of the debtor’s failure to pay.
The loss is deferred and recalculated based on future events such as on the disposition
of the newly acquired property. Where the newly acquired property is a debt
instrument such as the Debenture in this case, such a future event would
include the application of section 50 if the requirements of that section are
met. In the case at bar, section 50 applies and the Appellant’s loss is
recognized unless, as argued by the Respondent, subparagraph 40(2)(g)(ii)
applies to deny the loss.
[54] The
Appellant argues, in effect, that the Act should not be read in a manner
that would eliminate the loss that section 79 is intended to preserve. I agree.
To preserve the loss, which is the purpose of section 79, an income earning
intention acknowledged in respect of the original debt must flow through to the
newly acquired property as worthless as it may be. Otherwise such an exchange
of indebtedness involving a worthless Debenture in a non-SBC could result in
the denial of a capital loss in respect of which an ABIL was not being sought.
Even the Respondent has not suggested such a construction of the Act.
The Respondent just objects to the effectiveness of a tax plan when the
exchange of debt results in an ABIL. However, it is well established that
taking advantage of sections of the Act that give rise to preferred tax
treatment is not a reason to deny the advantage sought. That the newly acquired
property, the Debenture, might afford the creditor a less restricted use of the
loss is in this sense circumstantial and in any event, in respect of the tax
advantage sought, there is a direct connection between the property acquired by
the Appellant under section 79 (a debt instrument of a SBC) and the original indebtedness
that arouse as a consequence of a guarantee given by the same taxpayer (the
Appellant) to re-finance that same SBC. On that basis it follows that a
functional and more commercially realistic interpretation of section 79 would be
to subsume in the purpose of the acquisition, to which that section applies, the
purpose for which the guarantee was originally given.
[55] As to the
Respondent’s reliance on Singleton, in my view, that case can readily be
distinguished. It dealt with whether borrowed money was used for the purpose of
earning income as required by paragraph 20(1)(c) of the Act to allow an
interest deduction. No other provisions of the Act had to be considered in
terms of aiding or dictating a particular construction of that provision in the
circumstances of that case. That being the case, the Court found in favour of
the taxpayer, relying on the direct link from the borrowed money to an eligible
use. The loan proceeds were in that case found to be used for an income
earning purpose because they were directly applied to an income producing asset
which was held (already held) for that purpose.
[56] The test in
the case at bar is very different. Subparagraph 40(2)(g)(ii) looks to the
purpose of the acquisition of the debt not the use to which money is put. The
“purpose of acquisition” test has already been held by a strong line of thoughtful
and compelling cases to relate back to the purpose of the transaction that ultimately
gave rise to the acquisition of the debt where the acquisition occurs by virtue
of a right of contribution. That is, the proper construction of the purpose
test in such cases is impacted by its interaction with such related events. The
acquisition of the Debenture is such a related event and that event calls even
more for the purpose test to be related back. Otherwise section 79 will fail to
accomplish its objective in a very penalizing way. Accordingly, I am satisfied
that the reasoning in the Cadillac Fairview line of cases must
apply equally to the case at bar. Section 79 deals with the acquisition of property
(the Debenture) on the basis that the loss denied by that provision (in respect
of the extinguishment of the contribution debt owed by Phillip) will be
accounted for when a taxable event occurs in respect of that property. In such
case one must subsume in the purpose of the acquisition governed by section 79,
the purpose that relates back to the extinguished debt, which in turn relates
back to the purpose of providing the guarantee in the first place.
[57] The debt in
this case arose in respect of a financing arrangement made for a SBC. As a
result of that arrangement the Appellant has incurred a loss. That that loss
can only be categorized as an ABIL by taking an extra tax planned step is no
reason to view that step, and the provisions of the Act applicable to
it, in a way that leaves the Appellant on the outside of the tax expenditure provisions
put in the Act to assist in the financing of SBCs. In these
circumstances a functional and more commercially realistic interpretation of the
subject provisions would be to subsume in the purpose of the acquisition to
which section 79 applies, the purpose for which the guarantee in this case was
originally given. Such construction, in my
view is consistent with the object and spirit of the subject provisions. To
find otherwise would not be in harmony with their evident purpose, would
lack common sense and would cast a blind eye to the commercial and economic
realities of business transactions. These were the comments of Justice
Bell in National Developments at page 1067. While they referred
singularly to subparagraph 40(2)(g)(ii), they
apply equally in my view to the interaction among section 79, subparagraph
40(2)(g)(ii) and the provisions of the Act affording ABIL treatment to
debt instruments of SBCs.
[58] For all
these reasons the appeals are allowed.
Signed at Ottawa, Canada this 23rd day of May 2007.
Hershfield J.
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COURT FILE NO.:
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97-3731(IT)G
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STYLE OF CAUSE:
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John H. Daniels and Her
Majesty the Queen
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DATE AND PLACE OF
HEARING:
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March 6, 2007 - Toronto, Ontario
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REASONS FOR JUDGMENT
BY:
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The Honourable
Justice J.E. Hershfield
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DATE OF JUDGMENT:
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May 23, 2007
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Counsel for the
Appellant:
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Sheldon Silver,
Q.C.
Glenn Ernst
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Counsel for the
Respondent:
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Luther P.
Chambers
Pascal Tétrault
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Name:
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Sheldon Silver,
Q.C.
Glenn Ernst
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For the
Respondent:
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John H. Sims, Q.C.
Deputy Attorney
General of Canada
Ottawa, Canada
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