West Hill Redevelopment Co. Ltd. v. The Queen, 91 DTC 5430, [1991] 2 CTC 83 (FCTD)

Cullen, J.:—This is an appeal from a judgment of the Tax Court of Canada dismissing the plaintiff's appeal from income tax assessments for the 1977 to 1979 taxation years. The appeal concerns various low-interest mortgages taken back by the plaintiff from purchasers of its condominiums. The issue is whether the plaintiff, in computing its income from its condominium business, is entitled to include in its income the fair market value of these mortgages rather than their higher face value.

Facts

The plaintiff is in the business of the construction and sale of condominiums. During the taxation years in question, the condominium market was very competitive. A common marketing device in the condominium industry to induce sales was to provide prospective purchasers with mortgage financing at rates below those available from lending institutions. These discount mortgages make the builder's condominiums more attractive to purchasers by reducing both the monthly payments on the mortgage, and the amount of income needed by the purchaser to qualify for financing.

There are two ways in which a builder like the plaintiff can offer such discount mortgages. First, the builder makes a payment directly to the lending institution which will hold the mortgage. In consideration of this payment, the lending institution will reduce the interest rate on the mortgage for a fixed term. This is known as “paying down" the mortgage, or a "bought-down" mortgage. However, lending institutions impose limits on the extent to which they will permit the rate to be discounted below the prevailing market rate. The lending institutions do this because of the risk of default when the term ends, and the mortgage must be refinanced at market rates which could be very much higher than the original mortgage subsidized by the builder. In this case, the lending institutions would not permit discounts greater than two per cent.

In order to undercut its competitors, the plaintiff wished to offer mortgages at a greater discount than the two per cent permitted by lending institutions. It therefore turned to the second way a builder may do so, taking back mortgages from the purchasers. In 1977, the plaintiff adopted the practice of taking □ack low-interest mortgages on some of the units in its Woodland condominium project as a sales incentive. Some of these mortgages were taken back at the same reduced rate available from the banks for a "bought-down" mortgage, and some at an even lower rate, depending on market conditions. These mortgages generally had a term of three to five years. The mortgages which were renewed at the expiration of the initial term were renewed at the market rate, without further discounting.

In 1978 and 1979, the plaintiff also decided to take back rather than pay down mortgages in a joint venture condominium project with Gaza Investments called Camargue I. The plaintiff held a 62 per cent interest in the project, With Gaza holding a 38 per cent interest. The plaintiff decided to take back the mortgages in the Camargue project because of the complications involved in having the prospective purchasers qualified through the holder of the mortgage on Camargue I. The plaintiff therefore paid off its mortgage, and took back the purchasers' mortgages at an interest rate below the prevailing market rate. Gaza subsequently sold its 38 per cent share in the taken-bac mortgages to the plaintiff at a discount based on the difference between the interest rate on the mortgages and the prevailing market rate for first mortgages.

When builders take back mortgages, they often immediately resell them at a discount in order to obtain capital. In this case, however, the plaintiff did not sell any of the mortgages, but held onto them until they matured. The plaintiff stated that it did not sell any of the mortgages because the discount demanded by purchasers of the mortgages would nave been too steep. This was because of the combination of the below market interest rate, and the fact that purchasers would seek a further discount because of some of the credit risks the plaintiff had been prepared to assume in taking back some of the mortgages.

In computing its income for each of the relevant taxation years, the taxpayer based its calculations on the purported fair market value of its portfolio of discounted mortgages as reflected by market interest rates prevailing at the time, rather than including them in income in the year the mortgages were made at their principal amount. For example, if a condominium was sold for $45,000 in 1977, with a down payment of $10,000, the face value of the discounted mortgage would be $35,000. A hypothetical fair market value for the mortgage in 1977 might be $32,000, depending upon prevailing interest rates. The plaintiff would then include $42,000 in its income for 1977, rather than $45,000. It would then revalue each discount mortgage held in its portfolio each year based on market rates.

This accounting approach resulted in the plaintiff deducting from its income the following amounts in respect of its discount mortgage portfolio:

The Minister of National Revenue reassessed the plaintiff for the 1977 to 1979 taxation years. The plaintiff filed a notice of objection in response. An appeal to the Tax Court by the plaintiff followed, and by judgment dated September 12, 1986, the Tax Court dismissed the appeal of the plaintiff in respect of the mortgage discount issue. The plaintiff appeals the decision of the Tax Court to this Court.

Position of the Plaintiff

The plaintiff states that in calculating its income in accordance with subsection 9(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), each discount mortgage should be brought into income at its fair market value in the year of sale of the property to which it relates, and not at the principal amount. In addition, the plaintiff's portfolio of discount mortgages should be revalued at the end of each year they are held by reference to market rates, pursuant to subsection 10(1) of the Act, Part XVIII of the Income Tax Regulations, and generally accepted accounting principles, because the mortgages are "inventory" as that term is defined in subsection 248(1) of the Act.

The taxpayer also submits that subsection 16(1) of the Act applies in this situation. The plaintiff states that the subsection provides that where an amount can reasonably be regarded as being in part interest and in part capital, the interest part shall be deemed to be interest on a debt obligation held by the person to whom the amount is paid or payable. The plaintiff submits that the part of each discount mortgage in excess of the fair market value can be reasonably considered interest, and is therefore deemed to be interest on a debt obligation held by the plaintiff, and not part of the price of the sold property. Therefore the balance of the fair market value is a capital amount, which should be included in computing the plaintiff's income as the sale price of the property.

Position of the Defendant

The defendant submits that the mortgage discount and revaluations are not deductible. It states that pursuant to paragraph 12(1)(b) of the Act, the amounts receivable by the plaintiff for sales of condominiums in a given taxation year are to be included in computing its income for that taxation year. It also submits that the mortgages are not inventory in the circumstances.

Decision of the Tax Court

Bonner, T.C.J. held that the taxpayer must bring the face value of the mortgages into income, and not the fair market value. At the trial, the plaintiff had led expert accounting evidence to the effect that the discount on the mortgage should be deducted from the face value of the mortgage as part of the calculation of profit. The plaintiff's expert stated that this approach to calculating profit is in accordance with the economic realities of the situation:

One has, obviously in this case, sold a property at a price which in effect takes into consideration the discount allowed in the mortgage and if one was not to discount the mortgage for accounting purposes, you would end up with inflated income, because that income has not been realized in that period.

The Court observed that the discount referred to by the plaintiff would in all likelihood have been made if the plaintiff had sold the mortgages. However, in this case, the plaintiff had not sold the mortgages, but either held them until maturity when they were paid off, or it refinanced the remaining principal at market rates. Bonner, T.C.J. held that the determination of income must be based on what actually happened, and not on hypothetical transactions. He held the issue in this case was income from the sale of condominiums, not the sale of condominiums followed by a further sale of the mortgages.

Bonner, T.C.J. held that his interpretation was supported by reference to paragraph 12(1)(b) of the Act:

Counsel for the appellant argued that the Court should take a “realistic approach" to the determination of the “true profit" of the appellant and consider the real substance of the transactions entered into. This, he submitted,

. . . requires a recognition that the low-interest mortgages taken back were clearly not worth their face amount, and only the value of such mortgages should be included in income.

In support of his position he relied on a number of authorities including John Cronk and Sons Ltd. v. Harrison, 20 T.C. 612 and Absalom v. Talbot, 26 T.C. 166; [1944] 1 All E.R. 642.

In my view the central fact in this case is that the mortgages taken back on sale and held by the appellant were held as security for the promise of the purchaser of each unit to pay the deferred balance of the purchase price. Paragraph 12(1)(b) of the Act provides:

12. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(b). any amount receivable by a taxpayer in respect of property sold . . . in the course of a business in the year, notwithstanding that the amount or any part thereof is not due until a subsequent year . . .

The promise to pay which is secured by a mortgage given back to the appellant as vendor is without question an amount receivable by the appellant in respect of property sold in the course of its business. The statutory language of paragraph 12(1)(b) is plain and unambiguous. It requires the inclusion of the full amount of the receivable. It matters not that such inclusion may be contrary to accounting principles which would otherwise govern the computation of profit for purposes of section 9 of the Act. The position is laid down by the Supreme Court of Canada in Dominion Taxicab Association v. M.N.R., [1954] C.T.C. 34 at 37; 54 D.T.C. 1020 at 1026 per Cartwright, J.:

The expression profit is not defined in the Act. It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.

[Emphasis added.]

Cases decided under a statute which does not contain an overriding direction equivalent to paragraph 12(1)(b) are of little assistance here.

Analysis

At trial, the plaintiff led expert accounting evidence concerning accounting practice in the land development industry, and in particular in the context of a land development business that takes back low interest loans. The plaintiff's expert stated that specific accounting practices have been developed to deal with financial circumstances unique to the development of real estate. These circumstances include

(1) the relatively long periods required to assemble land;

(2) the high degree of "paper" proceeds that usually accompany an initial sale;

(3) the variation of the terms of a sale agreement to provide greater consumer acceptance of the terms without changing the economic substance of the transaction, i.e., sales proceeds involving mortgages with high principal amounts, but with low interest rates;

(4) long collection and warranty periods, which increase the uncertainty as to the long-term value of the sale proceeds.

The expert's evidence was that in order to account for these circumstances, generally accepted accounting practice (GAAP) in the industry was to reflect the substance of these transactions, rather than their form, and that the accounting policies of the plaintiff reflected GAAP. For example, if the vendor wished to create the impression that a purchaser is receiving a good value, he may either take back a high-ratio/low interest mortgage, or buy down the interest with a bank by a cash payment. If the seller takes back the mortgage, as in this case, it may sell the mortgage at a discount, or keep it with its low yield. Since neither option provides the seller with any greater economic benefit, the amount recorded as revenue would not be the face value of the mortgage, but the discounted amount, which is computed based on the difference between the market rate of interest and the mortgage rate.

Furthermore, according to the expert evidence, these mortgages carried by the plaintiff should be revalued each year at an amount reflecting their present discount value as determined by market interest rates, in accordance with GAAP applied to accounts receivable in general.

Paragraph 12(1)(b)

In my opinion, while the approach put forward by the plaintiff concerning the computation of income may be in accordance with generally accepted accounting principles, it is not in accordance with the clear language of the Act. It is true that it is likely that the market value of the mortgages was lower than their principal amount. In support of its position that the market value of the mortgages be recognized for the purpose of computing its income rather than their face value, the plaintiff cited numerous cases in which it was held that the courts should take a realistic approach when computing income for income tax purposes. However, in all of the cases cited by counsel, this principle was made subject to the caveat that this approach only applies unless there is something in the Income Tax Act which specifically requires different treatment. Representative of the thrust of these cases is the decision in Maritime Telegraph and Telephone Co. v. Canada, [1991] 1 C.T.C. 28; 91 D.T.C. 5038 (F.C.T.D.), per Reed, J., at 31 (D.T.C. 5040):

It is well settled in the jurisprudence that the computation of a taxpayer's profit for the year is to be determined in accordance with ordinary commercial principles and practices. In addition, the method of accounting for tax purposes should be that which best reflects the taxpayer's true income position for the year unless the Income Tax Act dictates otherwise.

[Emphasis added.]

In my opinion, paragraph 12(1)(b) of the Act governs this situation, and therefore precludes the application of arguments based on GAAP. This paragraph provides that any amount receivable by a taxpayer in respect of property sold or services rendered in the course of business in the year be included in income, notwithstanding the fact that the amount or any part thereof is not due until a subsequent year:

12. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(b) any amount receivable by the taxpayer in respect of property sold . . . in the course of a business in the year, notwithstanding that the amount or any part thereof is not due until a subsequent year, . . .

Clearly, the mortgages are “receivable” within the meaning of the subsection, as "receivable" has been interpreted to mean that a taxpayer has an unconditional legal, though not necessarily immediate, right to receive an amount in question: The Queen v. Imperial General Properties Ltd., [1985] 1 C.T.C. 40; 85 D.T.C. 5045 (F.C.A.), and M.N.R. v. Colford, [1960] C.T.C. 178; 60 D. T.C. 1131 (Ex. Ct.). There was no contention by the plaintiff that the mortgages in question were in any way conditional.

In my opinion, the decision in M.N.R. v. Burns, [1958] C.T.C. 51; 58 D.T.C. 1028 (Ex. Ct.) is essentially indistinguishable from the case at hand. In that case, a builder in 1953 took back second mortgages from purchasers of his houses for the balance of the purchase price after the purchaser had arranged a first mortgage with a third party. The builder sought a deduction of an amount equal to the difference between the Principal amount of the mortgages and their market value. Cameron, J. held that under paragraph 85B(1)(b) of the former Act, (the predecessor to the present paragraph 12(1)(b)), the builder was required to include the amounts receivable from the second mortgages in his income for 1953 without allowance for any discount.

In addition, as the defendant points out, there is within the Act a self- contained system of debts and reserves pursuant to paragraph 20(1)(m) that may result in the deductibility of amounts that have not yet been earned. The approach of the plaintiff in this case seeks to in effect circumvent this statutory scheme.

Inventory

With respect to the argument that the mortgages represent inventory to the plaintiff, in my opinion this position is without merit. There is no evidence that the mortgages were held in the ordinary course of business for sale, and no sales of the mortgages were ever made. The plaintiff sells condominiums, not mortgages, and therefore it could not be said to be in the business of money lending: cf. M.N.R. v. Curlett, [1967] C.T.C. 62; 67 D.T.C. 5058 (S.C.C.), at 64 (D.T.C. 5059-60). The mortgages were simply security for the balance of the. purchase price, and not the stock in trade of the plaintiff. Indeed, the evidence at trial indicated that at the end of the initial discounted term of the mortgages, the plaintiff would either be paid in full when a purchaser obtained a new mortgage on the property from a third party, or the plaintiff would refinance the mortgage at market rates. There was no evidence of any efforts to sell the mortgages. Therefore, in my opinion, the value of the mortgages is not “relevant in computing a taxpayer's income from a business for a taxation year", as required by the definition of inventory in subsection 248(1). Consequently, as the mortgages are not inventory, the plaintiff is not able to rely on the provisions for inventory valuation in subsection 10(1) of the Act with respect to the mortgages.

Subsection 16(1)

The plaintiff finally argues that subsection 16(1) of the Act applies to the case at hand. At the relevant time, subsection 16(1) read as follows:

16. (1) Where a payment under a contract or other arrangement can reasonably be regarded as being in part a payment of interest or other payment of an income nature and in part a payment of a capital nature, the part of the payment that can reasonably be regarded as a payment of interest or other payment of an income nature shall, irrespective of when the contract or arrangement was made or the form or legal effect thereof, be included in computing the recipient’s income from that property.

The plaintiff submits that the part of the face value or principal amount of the discount mortgages held by the plaintiff in excess of its fair market value can reasonably be regarded as interest, and therefore is deemed to be interest on a debt obligation held by the plaintiff and not part of the price of the property sold. It follows, in its submission, that the remaining part of the face amount of the discount mortgage, (i.e., its fair market value) is an amount of a capital nature, which is the amount properly includable in computing the plaintiff's income as the sale price of the property.

I cannot accept that subsection 16(1) was meant to apply in this situation as submitted by the plaintiff. In my opinion, the principal amount of the mortgages is a payment in the nature of income to the plaintiff, in that it is the proceeds of the sale of the property by the plaintiff in the course of business. I do not see it as a blended payment of income and capital combined, which is the situation with which subsection 16(1) is designed to deal. I find it difficult to accept the plaintiff's characterization of the difference between the face value of the mortgage principal and the fair market value of the mortgage as interest within the meaning or subsection 16(1). Similarly, I cannot equate a payment made on account of principal with a payment made on account of capital, which is in effect the interpretation urged on me by the plaintiff.

Conclusion

This action is dismissed with costs to the defendant.

Appeal dismissed.