Reeson Investments Ltd. v. The Queen, 90 DTC 6420, [1990] 2 CTC 190 (FCTD)

Reed, J.:—The issue in this case is a narrow one. It involves the correct interpretation of subparagraph 39(1)(c)(v) of the Income Tax Act’ [1] and, in particular, how that subparagraph relates to subsection 85(4) of the Act.

Legislative History

It is useful, first of all to put these provisions in the context of their legislative history. In 1971, as is well known, the taxation of capital gains first became part of Canadian income tax law. Section 39 of S.C. 1970-71-72, c. 63 provided, amongst other things:

39. (1)(b) a taxpayer's capital loss for a taxation year from the disposition of any property is his loss for the year determined under this subdivision (to the extent of the amount thereof that would not, if section 3 were read in the manner described in paragraph (a) of this subsection, be deductible in computing his income for the year or any other taxation year) from the disposition of any property of the taxpayer other than

(i) depreciable property, or

(ii) property described in subparagraph (a)(i), (ii) or (iii).

Paragraph 40(2)(e) provided:

40. (2)(c) where the taxpayer is a corporation, its loss otherwise determined from the disposition of any property disposed of by it to

(i) a person by whom it was controlled or

(ii) a corporation that was controlled by a person described in subparagraph (i),

is nil;

And subsection 85(4):

85.(4) Where a taxpayer has, after 1971, disposed of any capital property of the taxpayer to a corporation that, immediately after the disposition, was controlled, directly or indirectly in any manner whatever, by the taxpayer or by a person or group of persons by whom the taxpayer was controlled directly or indirectly in any manner whatever, and but for this subsection, the taxpayer would have had a capital loss therefrom, the following rules apply:

(a) his capital loss therefrom otherwise determined shall be deemed to be nil;

(b) where, immediately after the disposition, the taxpayer owned any common shares of any class of the capital stock of the corporation, in computing the adjusted cost base to him of all common shares of that class owned by him amount, if any, by which the adjusted cost base to him, immediately before the disposition, of the property so disposed of exceeds his proceeds of the disposition, that

(i) the fair market value, immediately after the disposition, of all common shares of that class so owned by him,

is of

(ii) the fair market value, immediately after the disposition, of all common shares of the capital stock of the corporation owned by him immediately after the disposition; and

(c) where, immediately after the disposition, the taxpayer owned no common shares of any class of the capital stock of the corporation, in computing the adjusted cost base to him of all preferred shares of any class of the capital stock of the corporation owned by him at that time, there shall be added that proportion of the amount, if any, by which the adjusted cost base to him, immediately before the disposition, of the property so disposed of exceeds his proceeds of the disposition, that

(i) the fair market value, immediately after the disposition, of all preferred shares of that class so owned by him,

is of

(ii) the fair market value, immediately after the disposition, of all preferred shares of the capital stock of the corporation owned by him immediately after the disposition.

Thus, if a corporation had a capital loss which was transferred to what I will call, for the purpose of these reasons, a member of a "controlled group" [2] then, the loss was deemed nil. That is, the loss was lost and could never be realized for tax purposes. If, however, the property to which the loss related was transferred by a taxpayer to a corporation which, immediately after the transfer, was controlled by the taxpayer or by a person or group of persons who controlled the taxpayer, then, the loss was not lost but was preserved by being added to the adjusted cost base of the taxpayer's shares in the purchasing corporation. This was so providing the taxpayer vendor after the purchase held shares in the purchasing corporation. This effect occurred through the operation of subsection 85(4). Subsection 85(4) is part of what are referred to as the rollover provisions, provisions designed to allow corporate reorganizations or to allow individuals to incorporate their businesses without tax penalty. Subsection 85(4), in 1971, only applied where "but for this subsection the taxpayer would have a capital loss". That is, if the taxpayer by operation of other sections of the Act had no capital loss, or a capital loss that was deemed nil (for example, by operation of paragraph 40(2)(e)) then, subsection 85(4) would not apply. In those situations there would be no existing capital loss upon which subsection 85(4) could operate.

In 1975, subsection 85(4) was amended by S.C. 1974-75-76, c. 26, s. 48(5) so that the preserving provisions of 85(4), which were to apply in the case of the denial of a capital loss pursuant to 85(4), also applied if the capital loss was denied by reason of paragraph 40(2)(e):

(5) Subsection 85(4) of the said Act is repealed and the following substituted therefor:

(4) Where a taxpayer or a partnership (hereinafter referred to as the taxpayer) has, after May 6, 1974, disposed of any capital property or eligible capital property of the taxpayer to a corporation that, immediately after the disposition, was controlled, directly or indirectly in any manner whatever, by the taxpayer, by the spouse of the taxpayer or by a person or group of persons by whom the taxpayer was controlled, directly or indirectly in any manner whatever, and, but for this subsection, subsection 24(2) and paragraphs 40(2)(e) and (g), the taxpayer would have had a capital loss therefrom or a deduction pursuant to paragraph 24(1)(a) in computing his income for the taxation year in which he ceased to carry on a business, as the case may be, the following rules apply:

(a) notwithstanding section 24 and paragraphs 40(2)(e) and (g), his capital loss therefrom, or his deduction pursuant to paragraph 24(1)(a) in computing his income for the taxation year in which he ceased to carry on the business, as the case may be, otherwise determined shall be deemed to be nil; and

(b) (where immediately after the disposition, the taxpayer owned any common shares of any class of capital stock of the corporation) in computing the adjusted cost base to the taxpayer of all shares of any particular class of the capital stock of the corporation owned by him immediately after the disposition, there shall be added, in the case of capital property, the amount that is equal to, and in the case of eligible capital property, twice the amount that is equal to, that proportion of the amount, if any, by which

(i) the cost amount to him immediately before the disposition of the property so disposed of,

exceeds

(ii) his proceeds of disposition of the property or where theproperty was an eligible capital property, his eligible capital amount, within the meaning assigned by section 14, as a result of the disposition of that property

that

(iii) the fair market value, immediately after the disposition, of all shares of that class so owned by him,

is of

(iv) the fair market value, immediately after the disposition, of all shares

of the capital stock of the corporation so owned by him.

[Emphasis added.]

A description of the purpose of this amendment can be found in Stikeman, Canada Tax Service, Vol. 5 (Richard De Boo) at 85-148 —85-149:

Dispositions Prior to May 7, 1974

Subsection 85(4) was amended in a number of respects with application to transfers after May 6, 1974. Therefore, in respect of dispositions prior to May 7, 1974, reference should be had to the provision as it then read. The following more pertinent differences should be noted:

1. Subsection 85(4) only applied in respect of dispositions of capital property.

2. No reference was made to dispositions by a partnership.

3. No reference was made to control of the transferee corporation by the taxpayer's spouse.

4. No reference was made to paragraphs 40(2)(e) and (g) and section 24.

5. Recognition for the disallowed capital loss was given in computing the adjusted cost base of common shares and, if no common shares were owned, then to preferred shares.

Prior to May 7, 1974, difficulties arose in connection with the application of subsection 85(4) due to the fact that, on its terms, it applied only if a capital loss would otherwise result from the disposition. Other provisions of the Act could prevent such a loss, notably paragraph 40(2)(e). There was some question in these circumstances as to whether subsection 85(4) would apply so as to permit an increase in computing the adjusted cost base of the transferor's shares. However, as stated in the bulletin reproduced below, the Department did not apply para- graph 40(2)(e) to prevent this adjustment of the cost base of the vendor's shares in the purchasing corporation in these circumstances.

The position the department took, as a matter of practice, prior to the 1975 amendment and which position the amendment was designed to establish in statutory form was described in InterpretationBulletin IT-162 (referred to in the Stikeman text above):

Interpretation Bulletin IT-162

Capital Loss on Disposition of Property to a Controlled Corporation

Paragraph 40(2)(e) deems a corporation's capital loss to be nil on the disposition of property to a person who controls the corporation or a corporation controlled by that person. In circumstances where subsection 85(4) would otherwise apply, the Department will not apply paragraph 40(2)(e) to prevent the addition of the capital loss of the corporation to the adjusted cost base of the shares held by it.

Then, in 1977, the policy respecting transfers of capital losses between members of a controlled group of corporations changed. Amendments were enacted to allow such corporations to transfer capital losses from one to another without the loss being lost. The loss could only be realized for tax purposes, however, when the property in question was disposed of to an arm's length purchaser outside the controlled group. This change was accomplished by an amendment to section 53(1) of the Act, as amended by S.C. 1977-78, c. 1, s. 21(3).

53.(1) In computing the adjusted cost base to a taxpayer of property at any time, there shall be added to the cost to him of the property such of the following amounts in respect of the property as are applicable:

(f.1) where the property has been disposed of by a corporation to the taxpayer in circumstances such that subsection 85(4) does not apply in respect of the disposition, and the corporation's loss from the disposition has been deemed by paragraph 40(2)(e) to be nil, the amount that, but for that paragraph, would have been the corporation's loss from the disposition;

Thus, as of 1977, in the case of an ordinary capital loss, it could be transferred as between members of a controlled group and realized for tax purposes when the capital property to which the loss related was sold to an arm's length purchaser outside the group. The rollover provisions continued to also apply, however, so that if the purchaser, after the transaction, was one in which the taxpayer vendor held shares, the vendor would retain the loss by having it added to the adjusted cost base of the shares held in the purchasing corporation.

In 1978, sections 38 and 39 of the Act were amended so as to provide that certain kinds of capital losses would be categorized as business investment losses. [3] These were to be treated as losses which could be set off against income from all sources in a taxation year rather than being confined to a set off against capital gains only. (It is not necessary to describe the differences in treatment in detail.) The capital losses which were to be given this special treatment were those arising from the sale of shares of a Canadian-controlled private corporation (CCPC). [4] The purpose of the amendment was to encourage investment in small-and medium-sized Canadian corporations by giving losses, which might arise as a result of the purchase of shares in those corporations, a more generous tax treatment than that available for capital losses generally.

2. (1) Section 38 of the said Act is amended . . . adding thereto the following paragraph:

(c) a taxpayer's allowable business investment loss for a taxation year from the disposition of any property is /z of his business investment loss for the year from the disposition of that property.

(2) This section is applicable to the 1978 and subsequent taxation years.

3. (1) Subsection 39(1) of the said Act is amended by adding thereto the following paragraph:

(c) a taxpayer's business investment loss for a taxation year from the disposition of any property is the amount, if any, by which

(i) his loss for the year determined under this subdivision (to the extent of the amount thereof that would not, if section 3 were read in the manner described in paragraph (a) of this subsection, be deductible in computing his income for the year or any other taxation year) from the disposition after 1977 of any property that is

(A) a share of the capital stock of a Canadian-controlled private corporation, or

(B) a debt owing to the taxpayer by a Canadian-controlled private corporation (other than, where the taxpayer is a corporation, a debt owed to it by another corporation with which it does not deal at arm's length)

and, except where subsection 50(1) applies, that has been disposed of to a person other than a person who does not deal at arm's length with the taxpayer

exceeds

(ii) the amount, if any, of the increase after 1977 in the adjusted cost base to the taxpayer of the property by virtue of the application of subsection 85(4).

(2) This section is applicable to the 1978 and subsequent taxation years.

[Emphasis added.]

Then, in 1979, paragraph 53(1)(f.1) was amended to clarify its operation: paragraph 53(1)(f.1) was amended to relate to situations where 85(4)(b) does not apply and paragraph 53(1)(f.2) was added to cover circumstances in which 85(4)(b) does apply. [5]

Facts

There is no dispute about the relevant facts. On November 25, 1986 control of the plaintiff was acquired indirectly by Bruce Campbell, who at the time also controlled indirectly Quasar Helicopters Ltd. ("Quasar") and Sunburst Industries Ltd. ("Sunburst"). At the time, Quasar held shares in Sunburst which shares carried an adjusted cost base of $7,385,255. On November 26, 1986 the plaintiff purchased the Sunburst shares from Quasar for $950. On November 27, 1986 the plaintiff sold the shares to an arm's length purchaser for $950. The parties have agreed that, but for paragraphs 40(2)(e) or 85(4)(a) of the Act, Quasar would have realized a capital loss for tax purposes on its sale of the shares to the plaintiff in the amount of $7,384,305. The parties have agreed that paragraph 53(1)(f.1) of the Act required the plaintiff to add to the adjusted cost base of the Sunburst shares, in its hands, the amount of the $7,384,305 loss denied to Quasar and, as a consequence, the plaintiff's adjusted cost base of those shares was $7,385,255. The parties are agreed that, as a result of the sale of the shares by the plaintiff to an arm's length purchaser, the plaintiff became entitled to claim a loss of $7,385,255. The issue between the parties is whether this loss is a business investment loss or merely an ordinary capital loss. Sunburst was a small business corporation (CCPC) within the meaning of subsection 248(1) of the Act and at no time did Quasar own shares in the capital stock of the plaintiff.

Possible Interpretations of 39(1) (c)(v)

The defendant argues that the sale of the Sunburst shares by the plaintiff does not qualify as a business investment loss because subsection 85(4) applies by operation of subparagraph 39(1)(c)(v) so as to reduce that loss to nil. The notice of assessment which was sent to the plaintiff disentitled it to the loss on the ground that paragraph 85(4)(b) applied. This has subsequently been agreed to have been an error. The Minister, in fact, now relies on paragraph 85(4)(a).

As I understand the defendant's argument, it is that paragraph 85(4)(a) applies to the sale of the shares from Quasar to the plaintiff so as to reduce the business investment loss to nil. The loss thereby becomes an ordinary capital loss in the hands of the plaintiff which it can set off as such against capital gains pursuant to paragraph 53(1)(f.1) but which it cannot treat as a business investment loss. With respect to whether or not paragraph 40(2)(e) or paragraph 85(4)(a) is the source of the denial of the capital loss to Quasar, on the sale to the plaintiff, it is argued that paragraph 85(4)(a) takes precedence over 40(2)(e) because 85(4)(a) is expressed to operate "notwithstanding" 40(2)(e). [6] Thus, when the "deeming nil” of a loss might occur under one or other of the two paragraphs, then, paragraph 85(4)(a) should be found to be the applicable section.

In response, the plaintiff argues that the increase in the adjusted cost base of the Sunburst shares in the hands of the plaintiff did not occur by reason of subsection 85(4). At no time did the plaintiff own shares in the capital stock of the vendor Quasar. Rather, counsel argues that that increase occurred as a result of the deeming nil of the loss by paragraph 40(2)(e) and then the addition to the adjusted cost base given by 53(1)(f.1). And in any event, the plaintiff argues, that, even if the loss was deemed nil by operation of paragraph 85(4)(a), then the increase in the adjusted cost base which subsequently occurred was still effected by operation of 53(1)(f.1) and not subsection 85(4).

I find that argument very compelling. In my view, it is doubtful that subsection 85(4) applies at all to the present transaction. Subparagraph 39(1)(c)(v) provides that "a taxpayer's business investment loss . . . is the amount. . . by which his loss for the year. . . exceeds the amount. . ., of the increase . . . in the adjusted cost base to the taxpayer by virtue of the application of subsection 85(4)". There has never been an increase in the adjusted cost base to the taxpayer with respect to the shares in issue by virtue of subsection 85(4).

Also, I accept counsel for the plaintiff's argument that the limitation in subparagraph 39(1)(c)(v) requiring a decrease in a business investment loss, in proportion to any increase occurring as a result of 85(4), was included in order to prevent the conversion of an ordinary capital loss into a business investment loss (an ABIL) and has nothing to do with the prevention of transfers of ABILs as between members of a controlled group. With respect to this purpose, a person with an ordinary capital loss, for example, arising out of a decrease in the value of an apartment building, might sell that building to a corporation and take back shares. In the absence of the limitation imposed by reference to subsection 85(4), assuming the corporation was a small business corporation (CPPC), the taxpayer would thereby have converted the capital loss which arose on the apartment building into an ABIL. The shares could then be sold and the loss applied as a business investment loss. This would clearly be an abuse of the business investment loss provisions. [7] If that is the purpose of the limitation based on subsection 85(4) found in subparagraph 39(1)(c)(v) then it would clearly not have been intended that that limitation would include increases arising by operation of paragraph 53(1)(f.1) as applicable when 85(4)(b) does not apply.

Counsel for the defendant agrees that one purpose of the limiting effect of the reference to 85(4) in subparagraph 39(1)(c)(v) is to prevent the conversion of an ordinary capital loss into a business investment loss. But she argues that it has another purpose as well and that is to prevent the transfer of business investment losses between members of a controlled group. It is argued that the amendment to paragraph 53(1)(f.1), in 1979, to refer to paragraph 85(4)(b) instead of subsection 85(4) makes it clear that an ABIL was not meant to be transferrable within a controlled group. This, it is argued follows from the fact that in making paragraph 53(1)(f.1) more explicit and adding paragraph 53(1)(f.2), the draftsman would have had to turn his or her mind to the provisions of subparagraph 39(1)(c)(v) and to whether the reference to subsection 85(4) therein was intended to encompass increases occurring both as a result of subsection 85(4)(b) and increases occurring as a result of 53(1)(f.1) through subsection 85(4)(a). In addition, it is argued that if the plaintiff's interpretation of the 85(4) reference in subparagraph 39(1)(c)(v) is correct, then, an anomalous situation arises: a taxpayer in the position of the plaintiff who holds no shares in the related corporation (Quasar) from whom the shares were purchased, retains the benefits of the ABIL which is transferred while a taxpayer who acquires shares in a similar situation but from a related corporation in which shares are held, would lose the benefits of the ABIL. And, lastly, it is argued that an interpretation which would deny transferability of ABILs, as between members of a controlled group, is consonant with the purpose of the Income Tax Act given: (1) the Act's history of originally not allowing for the transfer of any capital losses between members of a controlled group of companies; (2) the concept that each person is a separate entity for taxation purposes; and (3) the fact that ABILs are accorded a more generous treatment for tax purposes than ordinary capital losses.

With respect to the 1979 amendment to paragraph 53(1)(f.1), I cannot draw the conclusion therefrom which counsel for the defendant would have me make. It is too remote a speculation to assume that in redrafting paragraph 53(1)(f.1) to make it abundantly clear that the increase occurring as a result of 85(4)(b) was added to the taxpayer's adjusted cost base, that any consideration was given to the interaction of subparagraph 39(1)(c)(v) and subsection 85(4). With respect to the argument that the plaintiff's position leads to an anomalous situation as between taxpayers who hold shares in the vendor corporation and those who do not, it is sufficient to note that many such anomalous situations exist under the Income Tax Act. With respect to the arguments that the various purposes, or perhaps more accurately principles upon which the Income Tax Act has proceeded, suggest that business investment losses were intended to be non-transferable as between members of a controlled group, I do not find those arguments convincing. The history of not allowing transfers of capital losses is not relevant because it is no longer a tenet on which the Act is based. The general principle that each person is a separate entity for tax purposes is one which is departed from on numerous occasions in the Act. The third (that the provisions relating to ABILs should be strictly construed because they constitute a more generous treatment for capital losses than is usual under the Act) is not one that can override the specific language and general context of the provisions. Also, in this case the purpose of the creation of ABILs was to benefit small and medium-sized Canadian corporations. It is equally consonant with that purpose, indeed, perhaps more consonant therewith that ABILs should be transferable between members of a controlled group than that they should not.

In my view, the defendant's position does seem a rather strained interpretation of the cross-reference to subsection 85(4) which is found in subparagraph 39(1)(c)(v). If it had been Parliament's intention to prohibit transfers between members of a controlled group, it seems likely that a more straightforward way of accomplishing that purpose would have been adopted. As counsel for the plaintiff argues, this could easily have been accomplished, for instance, by way of an explicit cross-reference to paragraph 53(1)(f.1). Given the very specific drafting terms (references and cross-references to various sections) in which the provisions of the Act are usually couched, it seems difficult to understand why, if it had been intended to prevent the transfer of ABILs as between members of a controlled group, this was not explicitly articulated in the provisions.

Counsel for the plaintiff argues that 85(4) does not apply to the present situation and I agree. The increase in the accumulated cost base of the shares did not occur by operation of subsection 85(4). In my view, the interpretation which the defendant argues is too strained and does not fit with the overall scheme of the respective provisions of the Act.

For the reasons given the plaintiff's claim is allowed. The plaintiff will be entitled to recover its costs of the action.

Appeal allowed.