Anglemont Estates Ltd. v. MNR, 88 DTC 1770, [1989] 1 CTC 2004 (TCC)

Brulé, T.C.J.: —The appeal of Anglement Estates Ltd. is in respect of the 1978 and 1979 taxation years. There are two issues involved: (1) the deductibility of a "loss" on the disposition of accounts receivable, for the 1978 taxation year in the amount of $60,270; and (2) the deductibility of of interest on a loan incurred by the appellant, said interest amounting to, respectively for the 1978 and 1979 taxation years, $9,769.61 and $61,860.83.

Facts

The facts which are not in dispute and as put forth in the appellant's notice of appeal are a follows:

1. The Appellant is a corporation incorporated under the laws of the Province of British Columbia which carries on business which includes:

(a) the development and sale of real property;

and

(b) the sale of accounts receivable.

2. The Appellant is a wholly-owned subsidiary of Anglemont Holdings Ltd. (“Holdings”).

3. In 1978 the Appellant agreed to advance to Holdings the sum of $639,730 by a transfer of the following amounts (the "Advance"):

(a) the proceeds of a bank loan to the Appellant in the amount of $400,000 (the "Loan") in respect of which the Appellant paid interest; and

(b) accounts receivable having a face value of $300,00 and a fair market value of $239,730 (the "Receivables") that were acquired by the Appellant in the course of carrying on its business.

4. Following the making of the Advance, the Appellant declared a dividend in favour of Holdings in the amount of $639,730 (the "Dividend").

5. Holdings applied the Dividend to repay the Advance from the Appellant.

6. In reporting its income for the 1978 and 1979 taxation years the Appellant deducted interest expense incurred in respect of the Loan.

7. In reporting its income for the 1978 taxation year the Appellant also claimed a deduction in the amount of $60,270 as a "discount expense" incurred in respect of the disposition of the receivables for proceeds of disposition less than the face value thereof.

The respondent in his reply to notice of appeal made the following assumptions:

(a) that the Appellant borrowed the amount of $400,000 from the Royal Bank of Canada in September 1978;

(b) that at that time the funds were fully committed for non-income producing purposes;

(c) that the loan was not repaid during the 1978 and 1979 taxation years;

(d) that the mortgages were transferred by the Appellant at a face value of at least $300,000.

I-Loss from Disposition of Accounts ReceivableAppellant's Position

Counsel for the appellant argued that the proceeds should be in an amount of $239,730 as this represents the fair market value of the transferred receivables. It was argued that this amount is less than the face value of $300,000. It was contended that the consideration received by the appellant from Holdings was in the form of a payable, in the amount of $239,730, which was settled (or offset) through the declaration of a dividend.

There was testimony by witnesses, called by the appellant, to the effect that discounts such as arose in this case (approximately 20 per cent) on the sale of accounts receivable are commercially common, and reasonable given the circumstances. It was also pointed out in evidence that the sale of mortgages by the Appellant at discounted amounts took place frequently.

Minister's Position

Counsel for the respondent agreed that discounts are commercially normal, but took the position that such was not the case here. The respondent relied heavily on the case of Rosevale Apartments Ltd. v. M.N.R., 29 Tax A.B.C. 393; 62 D.T.C. 411 (T.A.B.).

Analysis

The only authority put forth by either party on this issue was the case of Rosevale Apartments, supra. In that case, the appellant held a mortgage on real estate, which it decided to sell to shareholders at an amount discounted by 40 per cent. The appellant then sought to deduct the difference between the face value of the mortgage, and the amount which was paid for this mortgage by the shareholders. It must be noted that in the Rosevale Apartments case, the issue was whether or not the said loss was of a "business" or “capital” nature. The fact that it was a loss was not in question.

That case is distinguishable from the present case (as argued by counsel for the appellant) on the basis that counsel for the Minister argued here that there was no loss at all; no argument, however, was made as to quantum and therefore this is not in dispute.

The sole question as regards the disposition of the accounts receivable is whether or not the transfer occurred at fair market value (“FMV”), as required by paragraph 69(1)(b) of the Income Tax Act which reads:

(b) where a taxpayer has disposed of anything

(i) to a person with whom he was not dealing at arm's length for no proceeds or for proceeds less than the fair market value thereof at the time he so disposed of it, or

(ii) to any person by way of gift inter vivos,

he shall be deemed to have received proceeds of disposition therefor equal to that fair market value; and.

If counsel for the respondent is correct, i.e. that the FMV of the accounts receivable in question is, in fact, equivalent to its face value ($300,000), then paragraph 69(1)(b)(i) would deem the appellant to have received proceeds of disposition equivalent to the FMV.

The term “fair market value” was clearly and succinctly defined by Mr. Justice Mahoney of the Trial Division of the Federal Court in the case of Connor v. The Queen, [1978] C.T.C. 669 at 677; 78 D.T.C. 6497 at 6503; aff'd [1979] C.T.C. 365; 79 D.T.C. 5256 (F.C.A.):

the highest price available in an open and unrestricted market between informed, prudent parties acting at arm's length and under no compulsion to act, expressed in terms of money or money's worth.

The question is: Would a reasonable and prudent businessman pay $300,000 for $300,000 worth of accounts receivables secured by mortgages which are not immediately due and with interest rates lower than those of the current market? I would say not. Thus, some amount less than $300,000 should be the FMV in this case. Counsel for the respondent made no representations as to quantum in this case, whereas counsel for the appellant called a witness, Mr. Osborne, who although not accepted at trial as an expert was recognized as very knowledgeable in the field. Mr. Osborne's testimony was that selling accounts receivable at a discount is commercially common and reasonable.

There is further authority for this finding in the field of accounting. The following is stated, as a general accounting principle, in the Canadian Institute of Chartered Accountants' Handbook (at subsection 1580.45, last paragraph):

Discounting may be considered to be an aid in valuation where an asset would not be realized or an obligation would not be discharged in the current operating cycle.

And at subsection 1580.46:

Any assets, including cash, which are subject to particular restrictions would be valued with consideration given to those restrictions.

As well, in Intermediate Accounting (4th Cdn Ed.) by Welsch, Zlatkovich, Harrison, Nelson and Zin, the authors state, at page 202:

Many companies utilize receivables to secure immediate cash prior to their regular collection dates.

And at page 204:

Occasionally accounts receivable are sold outright to a third party . . . Outright sale often involves a high discount rate, varying as high as 50 per cent, depending upon interest rates and other circumstances.

I appreciate that in the recent decision of the Federal Court of Appeal in the case of Moore v. R., [1987] 1 C.T.C. 377; 87 D.T.C. 5215, Mahoney, J. stated at page 377 (D.T.C. 5216):

That said, we do not think it was proper for the trial judge to have had recourse to an accounting textbook and the Handbook of the Canadian Institute of Chartered Accountants, neither of which were in evidence. The statements therein which he accepted are not matters for judicial notice.

These remarks were prompted by the judgment of Rouleau, J. in that case in the Federal Court-Trial Division wherein he referred extensively to the CICA Handbook and an accounting text. I do not take the accounting authorities referred to above as "matters for judicial notice.” I see them simply as additional authority on the subject of what is considered reasonable and prudent in a business context.

From this I believe that some discount was reasonable in the circumstances and therefore, the FMV of the accounts receivable is something less than their face value. The appeal on this issue is therefore allowed.

Il-Deductibility of Interest Appellant's Position

The appellant submitted, firstly, that the effect of the transactions was a repayment by Holdings to the appellant of the $400,000 liability which had previously arisen between the two as a result of the transfer of cash that was provided by the appellant to Holdings. In support of this position the Court was referred to the cases of Mary Ada Cox and Montreal Trust Company Executor of the Will of Harris Cox v. M.N.R., [1969] C.T.C. 606; 69 D.T.C. 5400 (Ex. Ct.), and The Queen v. Norman Kenneth Ans, [1983] C.T.C. 8; 83 D.T.C. 5038 (F.C.T.D.).

It was also submitted on behalf of the appellant that it is the current use, and not the original use of funds which must be considered in determining the deductibility of interest. On this point, the appellant relied upon the case of The Queen v. Phyllis Barbara Bronfman Trust, [1987] 1 C.T.C. 117; 87 D.T.C. 5059 (S.C.C.)

Finally, the appellant argued that as a result of the transactions in question when the $400,000 was repaid to the appellant it became part of its working capital. In support of this argument he cited the case of Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537; 70 D.T.C. 6351, (Ex. Ct.).

Minister's Position

Counsel for the respondent argued, firstly, that the courts must deal with what was done, and not what might have been done. In other words, to quote counsel for the respondent, the appellant should have “left the appropriate paper trail.” The Bronfman Trust case, supra, was cited in support of this contention.

It was further submitted that the money borrowed by the appellant was originally used for an ineligible purpose, and that purpose did not subsequently change. It was suggested that there was, in fact, no repayment of the loan by Holdings to the appellant, thus rendering it impossible that the said amount ever became part of the appellant's working capital.

Analysis

It should be noted that although not mentioned at trial the Estate of Harris Cox case, supra cited by counsel for the appellant and heard in the Exchequer Court, was appealed by the Minister to the Supreme Court of Canada: M.N.R. v. Cox Estate, [1971] C.T.C. 227; 71 D.T.C. 5150. The appeal was allowed in a judgment by Mr. Justice Judson. However, it is my opinion that the Cox Estate case is distinguishable on the facts. In that case, a husband transferred a cheque to his spouse, who in turn wrote her husband a cheque in payment of a life insurance policy. The Supreme Court's decision turned on the fact that neither cheque would have been honoured because of insufficient funds. That is not the case here. The appellant was in a position to justify the dividend declared because during the period when the declaration of the dividend was made the retained earnings of the Company were greater than the amount of the dividend.

In order for interest to be deductible pursuant to paragraph 20(1)(c) of the Income Tax Act, the funds borrowed must have been used to gain or produce income from business or property. It was admitted by counsel for the appellant that the original use to which the $400,000 was put was to make a non-interest bearing loan to Holdings. It was also conceded by counsel that the declaration of dividends could not be proven, at trial, to have occurred prior to December 30, 1978, the date of the audited financial statements of the appellant. While there should have been produced evidence of the actual date of the dividend I accept that it did take place at some unknown time prior to December 30, 1978, but without proper evidence this is the only date which can be accepted. Thus, the appeal on this issue with respect to the 1978 taxation year must be and is dismissed.

As of December 30, 1978, the dividend was in fact declared and because of this, the appeal regarding the 1979 taxation year is allowed.

The authorities cited by counsel for the appellant on the “offsetting” of liabilities satisfy me that what is reflected in the financial statements actually did take place even though "no paper trail" is in evidence.

Furthermore, it would seem to me that the Trans-Prairie Pipelines Ltd., supra case is good authority for the proposition that borrowed moneys which become part of the working capital of a company may be said to be used for the purpose of earning income.

This proposition was clearly supported by Chief Justice Dickson in the Brontman Trust case, supra at page 125 (D.T.C. 5064) when he said:

The cases are consistent with the proposition that it is the current use rather than the original use of borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments.

And at page 125 (D.T.C. 5065):

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current eligible use. . . . For example, if a taxpayer borrows to buy personal property which he or she subsequently sells, the interest payments will become prospec tively deductible if the proceeds of sale are used to purchase eligible incomeearning property.

Counsel for the appellant also cited Interpretation Bulletin IT-80 entitled "Interest on Money Borrowed to Redeem Shares, or to Pay Dividends" wherein the Department of National Revenue states at paragraph 5:

It is not the Department's policy to disallow interest on money borrowed to pay dividends unless a substantial portion of the accumulated profits of a corporation immediately before the payment of the dividend has

(a) not been used for the purpose of earning income,

(b) been used to acquire property the income from which is exempt, or

(c) been used to acquire a life insurance policy.

Interpretation Bulletin IT-80 was cancelled as of January 29, 1987 by way of a News Release by Revenue Canada, Taxation. The Bulletin in question was in force during the 1979 taxation year, which is the taxation year under appeal. Although Interpretation Bulletins do not represent law, it has been stated that opinions of the Department of National Revenue are admissible in such a form: J. Harel v. The Deputy Minister of Revenue of the Province of Quebec, [1978] 1 S.C.R. 851 at 859; [1977] C.T.C. 441 at 447; Gene A. Nowegi- jick v. The Queen, [1983] C.T.C. 20 at 24; 83 D.T.C. 5041 at 5044 (S.C.C.); and The Queen v. Royal Trust Corp. of Canada, [1983] C.T.C. 159 at 166; 83 D.T.C. 5172 at 5177 (F.C.A.).

While the original purpose of the borrowed funds was to make a loan to Holdings, this loan was cancelled by the dividend and thus ended up in the form of working capital for the appellant. Therefore the interest payable by the appellant became eligible for deduction after the dividend was declared. There being no actual date proven for the dividend it must be taken as December 30, 1978, the date of the audited financial statements wherein the dividend was recorded.

Conclusion

The appeal therefore will be allowed on the basis that a loss was incurred on the disposition of accounts receivable in 1978 of $60,270, and interest may be deducted in the 1979 taxation year by the appellant of $61,860.83. In all other respects the appeal is dismissed. The matter will be returned to the Minister for reconsideration and reassessment. The appellant is entitled to party-and-party costs.

Appeal allowed in part.