Leung v. MNR, 92 DTC 1090, [1992] 1 CTC 2110 (TCC)

Kempo, T.C.CJ.:—The appeals of Miko Leung and of Sit Wa Leung were, on consent application, joined for hearing on common evidence. Counsel for the respondent having conceded that the subsection 163(2) penalties should be removed, two issues remained to be resolved by the Court.

Issues

The first issue concerned rental losses claimed by Miko Leung for the years 1984 to 1986 inclusive. These were disallowed by the respondent on the basis that they were not the result of outlays or expenses incurred for the purposes of gaining or producing income from property within the meaning of paragraph 18(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") as there was no reasonable expectation of profit therefrom.

The second issue was common to both appellants. It pertained to the fair market value of their shares in the capital stock of 259437 B.C. Ltd. upon their sale in 1986 to non-arm's length corporation. The appellants asserted that it was their intention to transfer these shares at their fair market value, that it was nil at that time, and that the value amount of $500,000 fiscally reported by them was erroneous. On reassessment the respondent assumed their value amount at $2.6 million. This value was reduced to no less than $1 million at trial.

Agreed Facts

The following facts extrapolated from the respondent's reply to notice of appeal have been conceded as being accurate.

In 1972 the appellants founded a business in the consumer electronics industry under the name and style of Mona Trading Company which was incorporated in Canada in May 1978 as Mona Trading Company of Canada Ltd. and changed its name in January 1981 to Mona Electronic International Company Ltd., ("MONA"). MONA imported into and distributed in Canada audio and video consumer electronic products under its own trademark, MTC, and also provided products to other customers for their own private label;

At all material times the appellants Miko Leung ("Miko") and his brother Sit Wa Leung ("Sit Wa") each owned 50 percent of the shares of MONA;

Miko holding 500 Class A shares and Sit Wa holding 500 Class B shares;

The appellants incorporated another company in Canada, 259437 B.C. Ltd. (the “Numbered Company”), and on January 27, 1983 the appellants elected under subsection 85(1) of the Income Tax Act (the “Act’’) to transfer to it all their MONA shares at an elected and agreed amount of one dollar and stated the total fair market value of MONA to be one million dollars or $500,000 for each appellants share; At all material times the Numbered Company owned equally by the appellants had one significant asset, that is the shares of MONA; both MONA and the Numbered Company at all material times had a January 31 fiscal year end;

In November 1984 the Vancouver facilities of MONA had a fire which caused property and inventory damage to their offices and warehouse which was a onetime, isolated, and non-recurring event;

By Agreement dated June 25, 1986 the appellants sold their common voting shares in the Numbered Company to Follow Signal Development ("Follow") a Hong Kong Company owned equally by them for a total of $500,000; [it is this transaction that formed the subject matter of these appeals]

The June 25, 1986 Agreement between the appellants as vendors and Follow as purchaser provided, inter alia:

(i) B. The vendors have agreed to sell and the purchaser has agreed to purchase

the shares [of the Numbered Company] for their fair market value;

(ii) 3.0 PURCHASE PRICE

The purchase price for the shares . . . will be the fair market value . . . which . . . is the sum of $500,000.

(iii) 4.0 ADJUSTMENT

4.1 It is the intention of the parties that the purchase price represents the fair market value of the shares;

The aforesaid June 25, 1986 sale of the shares in the Numbered Company to Follow was a non-arm's length transaction;

The adjusted cost base to the appellants of the subject shares of the Numbered Company immediately before their disposition on June 25, 1986 was $100 as reported by them;

As the major, possibly only, asset of the Numbered Company at June 25, 1986 was its ownership of MONA, its shares had a fair market value of at least the fair market value of the shares of MONA on June 25,1986 . . .;

MONA's gross sales for its January 31 fiscal year end were as follows;

1983	$ 5,063,877
1984	$10,607,288
1985	$12,750,604
1986	$16,187,566
1987	$17,854,202

The financial statements of MONA for its January 31st fiscal year end showed its bank debts as follows;

1983	1984	1985	1986	1987
$917,340	1,711,875	4,388,837	5,016,915	4,095,829

From 1984 to 1987 the demand loan portion of the aforesaid bank debt was secured, inter alia, by a postponement of the shareholders’ loan;

The shareholders’ loan account of MONA as at its January 31st fiscal year end was as follows;

		1983 1984 1984 1985 1985 1986* 1986*				1987**
Interest at prime
plus 1 /2%	$	0	508,608	467,894	546,350	491,183
Non-interest bear
ing & no specific

repayment $353,439 797,439 625,878 1,386,879 1,806,110 terms for repayment

$353,439 1,306,047 1,103,772 1,933,229 2,297,293

*The January 31, 1987 financial statements of MONA restated the shareholders’ loans for January 31, 1986 to net 295,205 previously classified as a current loan receivable against amounts due to shareholders;

Interest at prime plus 1 /2%	$ 546,350
Non-interest bearing & no specific terms for repay-	$1,091,674
ment
	$1,638,024

**The January 31, 1987 financial statement of MONA indicates that the shareholders' loans previously recorded as non-interest bearing were advances with no specific terms of repayment bearing interest ranging from nil to prime;

Although the actual shareholder of MONA from January 27, 1983 up to July 1987 was the Numbered company, the shareholders’ loans recorded in the financial statements of MONA from January 31, 1983 up to and including January 31, 1987 represented moneys owing to each of the appellants and each had postponed these loans in order to secure the existing bank debt;

In July 1987 Follow elected under subsection 85(1) of the Act to transfer all the common shares it held in the Numbered Company to MTC Electronic Technologies Company Ltd. a public company listed on the Vancouver Stock Exchange (which company was controlled by the appellants) for a stated fair market value of three million dollars with an adjusted cost base and an elected and agreed amount of $500,000; Follow received five million common shares at a deemed price of 60 cents per share for this transaction.

Counsel for the respondent advised the Court that the fair market value of the appellants' shares in the Numbered Company as at June 25, 1986 was no less than $1 million and is no longer considered by the respondent to be $2.6 million as assumed on assessment.

The Witnesses

Neither of the appellants testified but three witnesses were called on their behalf.

Rebecca Leung, Miko Leung's daughter, testified about the rental property issue.

Mr. Harry Jung, a chartered accountant since 1976, has known the appellants since 1972 and had prepared their personal tax returns for a number of years prior to the years under appeal. He maintained a close relationship with them along with having provided not only professional advice but business and tax advice as well. He was MONA's auditor. He testified about the rental property issue and on some of the matters surrounding the value of the shares.

Mr. Don Selman testified as the appellants' expert respecting the fair market value of the Numbered Company's shares as at 25 June 1986.

Mr. Rogers-Jones testified as the respondent's expert concerning the fair market value of these shares.

As noted earlier, neither of the appellants testified. On both issues the pivotal evidence concerning matters of intent and decision-making came solely through Mr. Jung's involvement and recall. While I accept his statements that he was the appellants’ key adviser respecting both subject matters and that as far as he was concerned they had followed Ris advice, nonetheless, many instances arose during his testimony which he attempted to relate as fact but which were nat of his personal knowledge and were either hearsay or conjecture.

The Rental Losses (Miko Leung)

As undercapitalization contributed significantly to the alleged rental losses, a contextual overview is pertinent.

In January of 1983 the appellants had transferred all of their MONA shares to the Numbered Company under the subsection 85(1) provisions to avoid a forthcoming dividend distribution tax. Mr. Jung said the $1.0 million value had been suggested to him by the appellants, no outside opinion was obtained and that it appeared reasonable to him given the company's operational performance up to then. Dividends amounting to $300,000 were declared clearing out MONA's retained earnings which the appellants then reinvested back into MONA.

Mr. Jung said that by the end of 1983 MONA was doing well, that it was enjoying 20-25 per cent profit margins with its expansion into the Toronto and Ontario market being actively pursued. Sales had doubled from the previous years and profits, before management remuneration, were just under a half a million dollars.

For MONA's fiscal year ending 31 January 1984, its financial statements recorded $296,774 in unpaid management salaries and bonuses which, Mr. Jung said, would be credited to the appellants; respective shareholder loan accounts in due course rather than being actually paid out. The reason for this was that the bank's perception of their net equity in the company and their shareholder loans, share capital and MONA's retained earnings had all been subordinated to its banking arrangements.

Mr. Jung said it was critical to MONA's ongoing growth that it obtain and retain maximum amounts of capital at all times for this purpose. However to qualify for the small business deduction in order to attract the 25 per cent tax rate it also had to reduce its income to $200,000 or less; hence the 1984 decision for management salaries and bonuses of $296,774 which reduced MONA's income to $202,103. He advised the appellants that these unpaid amounts would be taxed in their hands when filing their 1985 tax returns in the spring of 1986 assuming payment was made to them in January of 1985.

It was in December of 1983 that Mr. Jung first became aware of Miko's purchase of a house in Toronto. He said he was told by Miko Leung that it was for personal use and occupancy by himself and his family due to MONA's expansion into Toronto and Ontario which had compelled his frequent attendances there away from his family. Mr. Jung advised him that interest on money borrowed for this purpose would not be deductible. This type of problem was already known to the appellants (see Exhibit R-2) as they had previously sought, unsuccessfully, to deduct interest costs respecting vacant land.

Mr. Jung recommended the house be leased to MONA at $2,500 per month premised on an 8 per cent investment return. No outside advice or opinions as to fair market rental values were sought or obtained; Mr. Jung said he thought that amount was fair. He advised a demand loan be taken for the reasons of then high and fluctuating interest rates and also because this would enable rapid pay down of the principal amount by Miko Leung via his accrued and unpaid salaries and bonuses in MONA. No documents respecting the financing of the house purchase were produced. It was known at the outset that the interest costs of the borrowing would exceed the rental income.

Rebecca Leung testified that her father and her family did not move to Toronto, nor was the house occupied as a principal residence. The house purchase closed in May of 1984.

According to Mr. Jung, Miko Leung's failure to pay down the loan was due to MONA's fire in November 1984, the resultant loss of inventory and business precluding it from being able to pay out any of the salary or bonus accruals.

The contents of the following are relevant to the matter. The Richmond property mentioned in the third paragraph is the vacant land earlier referred to.

Exhibit R-4

March 10, 1985

Memo to: Mona Electronics International Company Ltd.

From: Henry Jung

Re: Meeting with Mr. Michael and Sit Wa Leung,

Thursday, March 7, 1985

The following matters were discussed at the above-noted meeting which should be noted for both corporate and personal tax purposes of the shareholders.

With respect to the insurance recovery to be accrued for financial statement purposes for the fiscal period ended January 31, 1985 it is management's decision that $835,000 shall be accrued as the insurance receivable net of the amount received to date. The company intends to proceed with a claim for $1,000,000 but for financial statement purposes until such time that the claim can be ascertained to be recoverable, the financial statement purposes until such time that the claim can be 2 ascertained to be recoverable, the financial statements should only show $835,000.

With respect to a house acquired by Mr. Michael Leung in Toronto, the present property in Richmond B.C., and a proposed acquisition of a warehouse in Toronto, it is proposed that these properties will be owned by a separate holding company. The holding company will lease all three properties to Mona Electronics International Co. Ltd. and receive rent based on fair market value. This is to insure that all expenses related to these properties are deductible for income tax purposes and any accrued losses will accumulate for carry forward purposes in the corporation. In the future the losses may be accumulated for seven years, can be utilized when the corporation are amalgamated if Mona is subject to a high corporate tax rate. Alternatively, the shareholders will be able to claim an allowable business investment loss should the real estate value prove to be insufficient to repay the funds which they have invested.

With respect to the 1984 financial statement's accrual of bonuses payable of $320,000 it is the intention that these bonuses will not be paid and that section 78(3) of the Income Tax Act will apply. This will be based on the company's inability to pay the bonuses due to the financial reversal suffered in 1984-85 fiscal year. Please note that the bonus amount will be required to be added back to the corporation's income in the appropriate taxation year and subject to tax. For financial statements' purposes the management fee payable of that amount should be left as an accrued liability payable at a future date.

With respect to the house rental arrangements, certain aspects of the evidence were either conflicting or unclear. While a three-year lease had required MONA to pay the rent plus all municipal taxes, public utility and insurance premiums and all repairs, Miko Leung in fact claimed all of these as his own expenses in computing the rental losses for each year. The lease obligations did not appear on MONA's financial statements although its existence was known to Mr. Jung. Mr. Jung was MONA's auditor and also Miko's accounting and tax adviser. While he attempted to give the impression that he was fully knowledgeable about the whole matter, he could not explain why he did not have or seek out a copy of the lease to ensure MONA's compliance, nor could he explain why the expenses were run through Miko's personal account except to infer that all such matters would only have been adjusting entries in any event through Miko's shareholder loan account. In other words to him it would have not made any difference in that the losses claimed by Miko would have merely been reduced. He was uncertain as to whether the rental payments had actually been made or whether there had been recognition of its receipt via shareholder loan adjusting entries.

The above informality of dealings must be considered as well as the reality that MONA's payment out of any accrued salaries or bonuses may have either impacted upon or been precluded by its banking line of credit as earlier described, unless MONA itself had been the lender. No loan documents were produced, and there was no evidence supportive of a finding that at the time interest rates were high and fluctuating as alleged by Mr. Jung. Similarly, no evidence was extant respecting fair market rental rates; only Mr. Jung's subjective percentage opinion was advanced.

What is clear thus far is that at the very outset losses were known and expected because of undercapitalization. MONA was expanding and was heavily dependent on its line of credit, the amount of which in turn was dependent on the appellants’ investment capital remaining in the company.

Those parts of Mr. Jung’s testimony attributable to the intentions of Miko Leung were hearsay which he attempted to justify through his own belief that Miko would have done what he was told or advised to do. Maybe so, but in a non-arm's length situation such as this the taxpayer's own intentions and planning with respect to anticipation of the profitability of his own property are more crucial than what his accounting adviser may have wanted or told him to do. There is no reason to consider Miko Leung as other than an astute and successful businessman in his own right and thus able to understand and answer to his own business affairs. As I see it, there were no special or exceptional circumstances introduced in this case that would support or justify any exception to the hearsay rule. While Mr. Jung may well have been the strategist of Miko Leung's affairs, he is not the taxpayer whose own actions and expectations are under review.

The kernal of Miko Leung's position was that his intentions to inject further capital into the rental property were frustrated by MONA's fire. In my view these intentions have not been persuasively established, nor has it been shown that MONA as a resource of capital was higher than one of mere potential even without the fire.

In weighing the evidence proffered in its entirety, it is my view that Miko Leung has not shown error on the part of the respondent and his appeals on this issue fail.

The Share Value Issue (Both Appellants)

The facts of this aspect of the case are relatively simple and were essentially undisputed. The numbered company was a holding company, its sole asset was the operating company, MONA. The appellants sold their shares in the numbered company to a related company on June 25, 1986. On that date they were also unsecured creditors of MONA in an amount of $381,020 which was interest bearing (upon which interest had been expected annually) and a further amount of $1,661,914 which was non-interest bearing. These related- party loans survived the share transaction; they remained the property of the appellants and continued as a liability to MONA which continued operating thereafter.

As noted earlier, it has been agreed that as MONA was the sole asset of the numbered company, its value would be the value attributed to share value of the numbered company at the transaction date.

Neither of the appellants testified on this aspect of their appeals. Mr. Jung gave accounting evidence on the matter. A gentleman of long and extensive experience in the field of business valuation, Mr. Donald C. Selman ("Selman"), gave expert evidence relating to the valuation of the shares. Mr. Edward Rogers-Jones ("Jones") gave expert evidence for the respondent. His experience in the field was more recently acquired and was not of the broad and long-standing nature of Mr. Selman's. Much of Mr. Jones’ training was of the inhouse kind given by Revenue Canada, and he is in the process of obtaining further outside professional accreditation in addition to his present achievements.

The evidence given by both experts via direct and cross-examination lasted many days. Mr. Selman had been provided with a great deal of informational input from the appellants and from Mr. Jung. While Mr. Jones was without this benefit, he was able to glean much of the information he relied upon from financial statements and from other various sources, some of which he conceded may have been either erroneous or overly optimistic as to their representations.

Suffice it to say that notwithstanding Mr. Selman's futuristic approach to earnings and Mr. Jones’ historical approach to earnings, both agreeing that what a notional purchaser would be acquiring was MONA's income stream, the end result was reasonably close. The major difference between them as to share value was how each had treated the appellants’ non-interest bearing loans in MONA.

Both experts agreed that MONA was unacceptably leveraged at 95:5 debt to equity, and that normalization should occur to bring the ratio to a 60:40 ratio of debt to equity.

Mr. Jones believed Exhibit A-8, infra, prepared by Mr. Selman was reasonably expressive of the approaches and differences between them. It, and the testimony, are supportive of a finding that the multiplier used by each expert valuator against MONA's after-tax profits was reasonable given that 5 times was applied using the futuristic income stream approach (5 x $3.13m according to Selman) and that 6.67 times was applied using the historical income stream approach (6.67 x $3.15m according to Jones). It is notable that the after-tax profit amounts were not significantly dissimilar. Accordingly, the Court finds that the valuation of MONA's capitalized earnings as at the transaction date was in the range of $1,565 million (Selman) to $2.103 (Jones).

The following extract from Exhibit A-8 graphically illustrates the nub of the litigation:

The Appellants disagree with Revenue Canada that shareholder loans can notionally be considered as converted to shares as shareholder loans survived as a claim against assets and were not transferred to Follow Signal Development Ltd. A purchaser would expect to liquidate the shareholder loans on a payment of $435,375 in order to have a 60/40 debt to equity ratio and there would be no value to the shares.

Mr. Jones’ underlying premise was that a notional vendor would not give away its shares but rather would reorganize the companies to convert their non-interest-bearing loans into equity so as to be able to attract some value to shares and to obviate a notional purchaser's difficulty in obtaining long-term borrowing to normalize the debt. He was unable to say how this would be done or whether the appellants had ever considered doing it, and he gave no evidence respecting its overall tax consequences. The Court is at a loss as to whether such a reorganization would have resulted in any adverse tax consequences to the appellants in any event as it would be unlikely that the loans would have lost their inherent characteristics in the process. All of this remains mere speculation. It was made abundantly clear by Mr. Jones, however, that his valuation amount of $1 million was essentially premised on this assumption.

Mr. Selman was of the view that MONA was being propped up by the appellants' non-interest-bearing loans and that, because it was so highly leveraged from a notional purchaser's perspective of what would have to be paid to achieve normalization, the shares would have no value whatsoever. He was consistently adamant that the sole matter for valuation was that which had been disposed of (i.e., the shares) and not the appellants' entire interests, direct and indirect, in MONA. I agree. I also agree with his conclusions that the maximum fair market value amount would not exceed the value of the capitalized earnings, supra, in any event and that once the appropriate amount had been applied to debt normalization, including the non-interest-bearing amounts of the related party loans, there would be nothing in money or money's worth to apply to the shares. His analysis graphically illustrated MONA's viability and dependency upon the appellants’ interest-free loans. MONA's line of credit had been called by its banker, and it had been singularly unsuccessful in gaining alternates.

The thrust of respondent-counsel's submission, as I understand it, was that the appellants' non-interest bearing loans, having no specific terms of repayment, may be equated to debt which by agreement did not have to be paid on an immediate basis thus rendering them treatable as equity. Similarly, these loans were already postponed in favour of MONA's bank financing and therefore had been viewed or treated by its bankers as a form of equity.

While such loans may be treated “like” equity for financing purposes, they do not in my opinion thereby forfeit their substantive characterization as loans. The appellants’ creditor position at all times ranked superior to their position as shareholders. This status is not displaced by the notional market concept nor does it attract the notional “lifting of restrictions" principles as has been jurisprudentially applied to shares which are restricted as to transferability.

Further, and more conclusively, the appellants' non-interest-bearing loans had not been separately valued by either expert. I agree with Mr. Selman that the loans themselves had not been disposed of, nor they had not been the subject of either of the valuator's assignment.

Mr. Jones' theory of loan-to-equity-to-shares remained an exercise in theory only. As noted by appellants’ counsel, any purported conversion of loan to share equity as envisioned by Mr. Jones would result in new shareholders, the appellants, of the capital stock of the numbered company (query as to their adjusted cost base) neither of whom had, even notionally, disposed of them to anyone for price or for any gain.

The facts that the appellant had stated their value to be $500,000 in fiscally reporting the transaction, that it was a non-arm's length transaction and that it was to be financed by an interest-free loan are not in themselves persuasive. No improper motivations underlying the transaction may be imputed to the appellants.

Nothing adverse may be inferred from the report emanating from someone else's indication of value (i.e., the Western Venture Report) for purposes of going public. According to Mr. Selman, in valuation practice the expression “indication of value" used therein imports that an opinion of value was not being expressed; rather, he said it is known as a denial of an option. This report remained hearsay throughout the trial, and no weight is properly assignable thereto.

Counsel for the respondent finally submitted that the price adjustment clause does not assist the appellants because no bona fide efforts be- tweenthem and the purchaser to determine fair market value have been shown: Guilder News Co. (1963) Ltd. v. M.N.R., [1973] C.T.C. 1, 73 D.T.C. 5048. However, the evidence here was that the appellants and Mr. Jung had addressed the matter, had noted the historical sales and earnings of the company, had considered the effects of the 1984 fire and had felt at the time the value amount of $500,000 would be reasonable. This aspect was neither relied upon nor raised in the respondents's pleadings. Therefore the persuasive evidentiary burden respecting this approach remains on the respondent which has not been discharged.

In my opinion, and for all of the reasons above, the appellants have succeeded in proving that the fair market value of the subject shares on the transaction date was nil dollars.

Decision

With respect to the appeals of Miko Leung (a) the appeal for the 1984 taxation year is dismissed; (b) the appeal for his 1985 taxation year is allowed, without costs, and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the penalties levied pursuant to subsection 163(2) of the Income Tax Act are to be removed; and (c) the appeal for his 1986 taxation year is allowed and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the fair market value of his shares in the capital stock of 259437 B.C. Ltd. on June 25, 1986 was nil dollars.

With respect to the appeals of Sit Wa Leung (a) the appeal for his 1985 taxation year is allowed, without costs, and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the penalties levied pursuant to subsection 163(2) of the Income Tax Act are to be removed; and (b) the appeal for his 1986 taxation year is allowed and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the fair market value of his shares in the capital stock of 259437 B.C. Ltd. on June 25, 1986 was nil dollars.

The appeals of both appellants being heard on common evidence, only one set of costs is to be allowed with respect to the 1986 taxation year of each of the appellants.

Appeal allowed.