Carma Developers Ltd. v. The Queen, 96 DTC 1798, [1996] 3 CTC 2029 (TCC), briefly aff'd 96 DTC 6569 (FCA)

Bowman J.T.C.C.: — This appeal is from an assessment for 1988. It involves the application of section 80 of the Income Tax Act. That section provides in essence that where a debt is “settled or extinguished” there is a reduction, in a specified order of, inter alia, a taxpayer’s capital losses, non-capital losses and the cost of different types of property. The Minister of National Revenue applied that section and reduced the appellant’s non-capital losses, net capital losses, its capital cost of depreciable property and its adjusted cost base of non-depreciable capital property by a total of $163,884,366. The respondent’s position is that the debts were settled or extinguished in the course of a debt restructuring under which the amounts owing by the appellant to lenders were assigned to its parent company in exchange for shares.

Subsection 80(1) of the Income Tax Act reads:

Where at any time in a taxation year a debt or other obligation of a taxpayer to pay an amount is settled or extinguished after 1971 without any payment by him or by the payment of an amount less than the principal amount of the debt or obligation, as the case may be, the amount by which the lesser of the principal amount thereof and the amount for which the obligation was issued by the taxpayer exceeds the amount so paid, if any, shall be applied

(a) to reduce, in the following order, the taxpayer’s (i) non-capital losses,

(1.1) farm losses,

(ii) net capital losses, and

(iii) restricted farm losses,

for preceding taxation years, to the extent of the amount of those losses that would otherwise be deductible in computing the taxpayer’s taxable income for the year or a subsequent year, and

(b) to the extent that the excess exceeds the portion thereof required to be applied as provided in paragraph (a), to reduce in prescribed manner the capital cost to the taxpayer of any depreciable property and the adjusted cost base to him of any capital property,

unless ...

FACTS

The appellant, Carma Developers Ltd., (“CDL”) is a wholly owned subsidiary of Carma Corporation, formerly Carma Limited, (“CL”). Both companies are continuing corporations resulting from prior amalgamations and were formed under the laws of Alberta. CL’s shares are publicly traded. CDL was described in the evidence as CL’s “principal operating arm” in Canada and its business consisted of the development and sale of residential and commercial real estate.

In the early 1980’s, CDL was heavily indebted to several classes of creditors, particularly operating lenders (the Bank of Nova Scotia, the Canadian Imperial Bank of Commerce and the Toronto Dominion Bank, of which the largest lender and the lead bank was the Bank of Nova Scotia) project lenders and debenture holders. The operating lenders had a floating charge, and, in some cases, specific charges, on CL’s property. The project lenders, who in some cases were unpaid vendors, had charges on specific properties of the appellant. The debenture holders, of which Montreal Trust Company was the trustee, evidently were secured as well, presumably with some form of floating charge.

In the early 1980’s CDL was suffering severe financial difficulties. High interest rates, falling property values and declining demand for building lots created cash flow problems that rendered it difficult, if not impossible, for it to service its heavy debt load. It was in danger of being put in receivership and its survival was at stake. It entered into discussions with some of its creditors and proposals were made that included quit claiming some of its properties and converting some of its debt into equity of CL, its publicly traded parent. These proposals were initially rejected, particularly by the operating lenders who appear to have been of the view that their security on the principal amount of their debts was adequate, although their security, if any, for the unpaid interest was more precarious.

The problem became more serious however when one of CDL’s creditors, Crédit Suisse, took foreclosure action. Had judgment been obtained, other creditors might have followed suit and CDL could have been forced into receivership. Therefore CDL sought protection under the Companies’ Creditors Arrangement Act and a plan (the “CDL Plan”) was worked out and filed with the Court of Queen’s Bench of Alberta.

The essential elements of the plan, to which CL, CDL and the creditors were parties, were as follows:

(a) an operating loan agreement was entered into between CDL and the operating lenders, under which CDL was to make minimum repayments on its operating loans over a period of three years;

(b) CDL was to quit claim certain of its properties to the project lenders;

(c) the debenture holders would receive a cash payment and in addition would assign the debentures to CL in return for shares of CL;

(d) the operating lenders would assign to CL the unsecured portion of CDL’s indebtedness to them (essentially the unpaid interest) in return for shares of CL;

(e) the project lenders, to the extent that CDL’s indebtedness was not satisfied by the value of the property quit claimed to them, would assign to CL their indebtedness in return for shares of CL.

Clause 2.1 of the CDL Plan read in part as follows:

The Plan is designed to permit CDL to continue in business so that CDL and the Creditors can equitably share in the benefit of improvements in the economy and increases in asset values. It is intended that the Creditors’ recovery will be greater under the Plan than under the alternative of a forced liquidation.

Clause 3.16 of the CDL Plan provided that:

Any and all claims assigned to Carma [1.e. CL] by any Creditor pursuant to the Plan shall not be extinguished.

The plan was presented to the Court of Queen’s Bench of Alberta. It had been approved by the requisite majority of creditors and shareholders in accordance with the Companies’ Creditors Arrangement Act, and by an order dated January 31, 1986 Mr. Justice A.H. Wachowich approved the plan. Not all of the creditors approved of the plan.

A base price for the shares to be issued for the debts was determined at $2.80 per share, but this was adjusted upwards or downwards in respect of the three classes of creditors. For example, for each $2.80 of indebtedness assigned by the operating lenders to CL, one share of CL was issued. The debenture holders received $11,400,000 on account of their indebtedness and were to sell the debentures to CL for shares on the basis of one share of CL for each $1.70 of assigned debt. The project lenders were to assign the “deficiency” portion of their indebtedness (i.e. the part not satisfied by the quit claims given by CDL) on the basis of one share for each $3.50 of assigned debt. The operating lenders retained the secured principal portion of their indebtedness.

These figures were the result of negotiations among the various classes of creditors. They bore no relation to the value of the shares of CDL, which were at that time trading at about 20¢. As Mr. Norris, the president of the appellant testified, the figures used were irrelevant and were simply a means of determining what percentage of the issued shares of CDL would be obtained by each class of creditors. In the result the creditors obtained about 75 per cent of the issued voting Class A shares of CDL, and the previous shareholders retained about 25 per cent. The Bank of Nova Scotia obtained about 22 per cent, and the three banks together obtained between 45 per cent and 50 per cent.

In summary then, the three classes of creditors assigned to CL the unsecured portion of the indebtedness owed to them by CDL and obtained shares in CL. After the implementation of the CDL plan the creditors owned about 75 per cent of the shares of CL which in turn owned the debts of CDL assigned to it by the creditors.

The Minister assessed CDL for 1988 on the basis that the debts of CDL were “settled or extinguished”, and applied section 80 accordingly to reduce CDL’s capital and non-capital loss carry-forwards, the capital cost of its depreciable property and the adjusted cost base of its nondepreciable capital property, as follows:

Debenture holders: $96,890,429

Project lenders: $96,705,775

Operating lenders: $19,549,084

Total: $213,145,288

Less payments received [i.e. the $11,400,000 paid to the debenture holders plus the value of the property quit claimed to the project lenders and 20 (an assumed value) for each share issued in exchange for the assigned debts]:

$49,260,922

Amount applied under section 80: $163,884,366

The basic premise of the assessment is that this amount of $213,145,288 was “settled or extinguished” by the implementation of the CDL plan by the payment of $49,260,922. I hope that I Ido no disservice to Mr. Chambers’ thorough and able argument in my attempt to summarize its salient points. Essentially he bases his case on three propositions:

(a) that the debts were, as a matter of legal substance, extinguished in June 1986;

(b) that the debts were extinguished by novation in June 1986; and

(c) the debts, if not extinguished, were “settled” within the meaning of subsection 80(1) in June 1986.

(a) Extinguishment in substance

Mr. Chambers reviewed many of authorities on the doctrine of substance over form. It is not necessary for me to do so again. That has been done elsewhere. The principle to be deduced from the authorities is this: the essential nature of a transaction cannot be altered for income tax purposes by calling it by a different name. It is the true legal relationship, not the nomenclature that governs. The Minister, conversely, may not say to the taxpayer: “You used one legal structure but you achieved the same economic result as that which you would have had if you used a different one. Therefore I shall ignore the structure you used and treat you as if you had used the other one”.

Here we have arm’s length parties entering into binding legal relationships and I cannot conclude that these legal relationships, under which the debts were legally assigned and the obligations of CDL continued to exist, as contemplated by a plan approved by the Court of Queen’s Bench of Alberta, were simply a masquerade for a forgiveness of debt. Indeed the assignment of the debts, the issuance of shares and the continued enforceability of the debts by CL against CDL were integral and essential components in the efficacy of the plan and in its acceptability to the creditors. Mr. Chambers withdrew an admission made on discovery by the officer of the Department of National Revenue that the legal relations were valid and binding. He was entitled to do so, since the admission was one of law, but there is nothing before me to demonstrate that the admission was wrong as a matter of law.

Mr. Chambers also contended that the assignment of the debts to CL was purely tax motivated, and was done only as a device to avoid the application of section 80. I should be surprised if the tax implications of a transaction of this magnitude were not considered but I do not see the plan as a tax avoidance scheme. Even if the motivation for the assignment were primarily tax, this does not affect its legal validity. I view this entire arrangement as a commercially motivated one, structured in a manner that would attract the least unfavourable tax consequences. I do not see it, as evidently the respondent does, as a case of the tax tail wagging the commercial dog. Mr. Chambers argued that in substance the assignment was a release of the debts. The doctrine of substance over form does not permit me to take that leap. Even if the ambit of the doctrine were broadened to the extent necessary to accommodate a major recharacterization of the legal relations between the parties it would not go far enough to support the respondent’s position. If we are to speak of “substance” in some broad economic sense that ignores arm’s length legal relationships and corporate entities, it will be apparent that there is a fundamental difference between a simple forgiveness of debts and what we have here. A simple forgiveness of the debts would involve the complete withdrawal of the creditors and the termination of their legal rights against CDL. Instead, we have here the creditors owning 75 per cent of CL, which owns the debts. In substance, if one must use that amorphous and elastic term, one could say they still control the debts, through their 75 per cent ownership of CL.

It was contended further, in support of the allegation that the assigned debts were in substance extinguished rather than assigned, that it was not intended that the debts were to be paid by CDL. To support this position, Mr. Chambers observed that CDL did not pay interest or principal on the assigned debts, that it could not do so and that in fact the CDL Plan prohibited such payment until 1989. This appears to be so until 1988. There is no evidence of what may have happened after 1988. I do not think that these facts justify the inference that it was not intended that the debts be paid. All of the witnesses testified that it was intended that they be paid, including Mr. Belcher, a vice president of the Bank of Nova Scotia whom the respondent called as a witness. I see no reason to disbelieve them nor indeed do I see any commercial reason for the creditors to be willing to forego payment of the debts to a company of which they were 75 per cent owners.

(b) Novation

Mr. Chambers argued that the debts were extinguished by novation. He based this argument on a provision in the assignment and subscription agreements whereby the creditors acknowledged to CDL that having assigned, transferred and set over the claims on the covenants to pay the assigned indebtedness to CL, no further payment or consideration of any kind whatsoever was owed by CDL or CL or either of them to the creditors in respect of the assigned indebtedness.

From this, it is contended that the creditors released CDL and a new contract arose between CDL and CL. I do not read the provision in that way. The debt continued to exist, as contemplated by clause 3.16 of the CDL Plan. It is obvious that by operation of law the assignor of a debt to an assignee no longer has any rights against the principal debtor. The “release” of CDL by the creditors is not a release followed by a new agreement with CL. If the creditors released the debts of CDL there would be nothing to assign and the issuance of the shares to them by CL would be unsupported by any consideration. Moreover, there would be no legal basis upon which CDL would need to enter into a novation agreement with CL. The only conclusion possible is that the legal arrangement was precisely what it purported to be - an assignment of the CDL debts in consideration of the issuance of shares. A novation involves the creation of a new contractual relationship, generally where a debtor is released from its obligation to an obligee with the consent of the obligee and the assumption of the obligation by a third party so that a new obligation arises between the obligee and the third party. Here there is no new contract. The same debt of CDL continues to exist. Only the creditor has changed as the result of the assignment.

In light of this conclusion it is not necessary for me to consider whether section 80 would apply if in law there were a novation. Here the obligation of CDL continued after the assignment to CL.

(c) Settlement

Mr. Chambers also argued that the debts were “settled” within the meaning of subsection 80(1). The term “settle” has a variety of meanings, some of which are colloquial, in the sense that a problem is resolved one way or another. The terms “settle” or “compromise” are used in some of the documents. In the context of section 80, however, “settle” connotes a final and legal resolution of a taxpayer’s obligation whereby that obligation is reduced or brought to an end. It must be considered from the point of view of the taxpayer who would be affected by section 80, not the creditor. Moreover, it must be a final and legally binding termination or reduction of the debtor’s obligations. That did not, as a matter of law, occur here. It is understandable that both the creditors and the CL group would view the implementation of the plan as a resolution of the immediate debt and cash flow problem confronting CDL, and in that sense the term “settlement” might loosely and colloquially be used. Its use by business persons does not imply that as a matter of law the debts have been settled. The effect of section 80 is to ascribe certain specific tax consequences to a formal and binding forgiveness or reduction of debt. It may be the legislative reaction to the decision of the House of Lords in The British Mexican Petroleum Co. v. Jackson (1932), 16 T.C. 570, although the effect of that decision has been partially modified by such cases as Oxford Motors Ltd. v. Minister of National Revenue, [1959] S.C.R. 548, [1959] C.T.C. 195, 59 D.T.C. 1119 and Minister of National Revenue v. Enjay Chemical Co., [1971] C.T.C. 535, 71 D.T.C. 5293 (F.C.T.D.). It is presumably based on the rather sensible assumption that business indebtedness is incurred to pay expenses laid out in the computation of losses or to pay for depreciable or other property used in the business and when those debts are forgiven or reduced this fact should be reflected in some manner in the computation of income or taxable income by the reduction of such losses or the cost of capital properties. If the obligations subsist, there can be no basis in principle for such a reduction even though the continuing creditor is the parent of the debtor. There can be no justification for ascribing such an effect to the assignment of a debt in the absence of a specific statutory provision, so long as the obligations remain enforceable and there is a possibility that they may be paid in accordance with their terms. [1]

It was contended that the debt restructuring resulted in a major debt reduction of the Carma group as a whole. In the sense that the debts of CDL were, after the implementation of the plan, owed to its parent CL, this was no doubt so simply because in the consolidated financial statements of CL intercorporate debt and shareholdings disappear on consolidation. We are concerned here with CDL, not with the consolidated entity CL. CDL continued to show the debt to CL on its financial statements. If consolidated corporate tax reporting were permitted or required in Canada it would have implications that far transcend section 80 and would undoubtedly require a rewriting of large portions of the Income Tax Act.

The appeal is allowed with costs and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the debts of $163,884,366 were not settled or extinguished in 1986 within the meaning of subsection 80(1) of the Income Tax Act.

Appeal allowed.