Business Art Inc. v. MNR, 86 DTC 1842, [1987] 1 CTC 2001 (TCC)

Rip, T.C.J.:—Business Art Inc. appeals from notices of reassessment for income tax issued by the Minister of National Revenue, Taxation, the respondent, in respect of its 1979 and 1980 taxation years. In computing its income for 1979 and 1980 the appellant deducted the amounts of $109,187.50 and $204,026.40 respectively, pursuant to paragraph 18(1 )(a) of the Income Tax Act (“Act”) on the basis that these amounts, which were advanced to an affiliated corporation in the United Kingdom, were incurred by the appellant for the purpose of earning income from a business; in the respondent's view these amounts represented non-deductible advances made by the appellant to an affiliated corporation and are not deductible in computing income. The respondent however did allow the appellant to deduct for 1979 an allowable capital loss of $37,500, (being one-half of $75,000 which was included in the amount of $109,187.50 claimed as an expense) which the appellant advanced to the affiliated corporation. The appellant alternatively asks that if he is precluded by paragraph 18(1)(a) of the Act from deducting these amounts, one-half of the losses be recognized as an allowable capital loss.

The appellant changed its corporate name in 1980; previously it was known as Dixie Lee Company Limited. The name “Dixie” was used by witnesses when referring to the appellant in their evidence and I shall do so in these reasons.

In the early 1960s Dixie started to carry on the business of franchising chicken restaurants; it earned its income from operating restaurants, royalties from franchises based on sales turnover and the sales of paper goods to the franchised restaurants; it also sold franchises.

Mr. Ramon Walmsley, Dixie’s general manager, went to the United Kingdom in 1974 for an intended stay of two years. Once in the United Kingdom, he started looking for a new business for Dixie which would lend itself to franchising, but have more regular hours than a restaurant and sell a non-perishable product.

Mr. Claude William Hunt, an employee of Dixie replaced Mr. Walmsley at Dixie while the latter was in the United Kingdom. He met with Mr. Walmsley in London late in 1974 and they agreed that Dixie should enter into the business of franchising retail outlets to sell pictures, picture frames and custom frames throughout Canada. The source of supply of the pictures, it was thought, would be New York, Paris and London; the source of the frames would be the United Kingdom.

On the advice of an accountant in the United Kingdom, Dixie incorporated a company in the United Kingdom called Noonday Graphics U.K. Limited (“Noonday U.K.”) and subscribed for 48 per cent of the capital stock in the new corporation. Franchise Consultants Ltd., a company owned or controlled by Mr. Walmsley, also subscribed for 48 per cent of the issued and outstanding stock of Noonday U.K.; a solicitor in England subscribed for the balance of the shares.

In the meantime, Dixie started a picture and frame franchise business in Canada under the firm name and style of Noonday Graphics. Plans called for 100 franchised shares in Canada. A store was opened in Peterborough, Ontario during the winter of 1974 and 1975. Dixie granted franchises during 1975 and 1976 to persons in Windsor, Ontario, St. John's, Newfoundland and Halifax, Nova Scotia. It also opened its own stores in Kingston, Ontario, and Toronto. In 1975 frames were purchased from a supplier in New Jersey; a temporary framing centre was set up in Belleville, Ontario. During spring 1976, supplies started to arrive from the United Kingdom and the Belleville operation was closed. Noonday U.K., in addition to its primary function to supply Dixie’s Noonday Graphics division, operated two retail outlets in the United Kingdom.

Mr. Walmsley testified that the intention of Dixie was to have a branch office of the Canadian business in the United Kingdom rather than incorporating Noonday U.K. However their English accountants advised them that exchange control restrictions in the United Kingdom at the time made it easier to export funds from a limited corporation than from a branch office; also the accountant advised it would be easier to operate in the United Kingdom with a corporation incorporated domestically.

In 1976 permission was obtained from the Chief of Exchange Control of the Bank of England for Dixie to make loans to Noonday U.K. not exceeding $75,000, with interest at the rate of 14 per cent per annum. Mr. Walmsley stated he was advised by Noonday U.K.’s accountant to request permission to lend $75,000, since this was a low amount and permission would be obtained easily. He understood that if additional funds had to be advanced in the future the money would be loaned at the same rate of interest. Dixie actually loaned Noonday U.K. amounts in excess of $75,000 and in Dixie’s balance sheet as at December 31, 1978, $109,187.50 was shown as an asset, to wit, an “Investment in & advances to Noonday Graphics (U.K.) Ltd.”

Noonday U.K.’s raison d'être was to supply the franchise business in Canada with pictures and frames, according to Messrs. Walmsley and Hunt. Noonday U.K. was not to make any profit on its sales to Dixie, they revealed in evidence. Mr. Hunt stated that his salary was based on Dixie’s profits for the year and he did not want profits artificially reduced by increased costs to Noonday U.K. Mr. Walmsley had determined that even with shipping and related costs, the cost of acquiring the frames and pictures from the United Kingdom would be substantially less than if they were acquired in Canada. This reduced cost to Dixie would place it in a favourable competitive position in Canada.

Mr. Walmsley stated Noonday U.K. operated on instructions of Dixie. Noonday U.K. had no assets, no liabilities of value and no goodwill, according to Mr. Walmsley. No balance sheet for Noonday U.K. was submitted into evidence. During the first four years, according to Mr. Walmsley, the business of Noonday U.K. did well, but then, in 1977 became “static” as the company had trouble obtaining sufficient supplies.

Dixie then decided to hire a Mr. Serge Ollu to work at Noonday U.K. to ensure product availability and protect its investment. Mr. Ollu’s salary was paid by Dixie and he was considered to be an employee of Dixie. Mr. Ollu worked for Noonday UK. during 1978. Mr. Walmsley described Mr. Ollu as “a disaster to the corporation”. According to the evidence Mr. Ollu misappropriated over $50,000 and stole over $50,000 worth of material from Noonday U.K. resulting in Noonday U.K. incurring losses of over $100,000. Mr. Walmsley did not realize the poor financial condition of Noonday U.K. until 1979.

As a result of Mr. Ollu’s actions Dixie was forced to borrow funds from its banker for the purpose of advancing to Noonday U.K. $151,810.58 and $52,215.82 in 1979 and 1980, respectively. The sum of $151.810.58 was shown as an asset in Dixie’s balance sheet as at December 31, 1979 as an investment in and advance to Noonday U.K. These advances were in addition to the $75,000 agreed to by Dixie and the Chief of Exchange Control. Mr. Walms- ley explained that exchange controls were reduced in 1979 and abolished in 1980.

Mr. Walmsley testified that it was the intention of Dixie and Noonday U.K. that the additional loans be on the same terms as that agreed to with the Chief of Exchange Control; that is, there was to be interest on the principal amount at the rate of 14 per cent per year. At the time the advances were made it was expected they would be for the short term. No interest was paid by Noonday U.K. to Dixie; the unpaid interest was not accrued by Dixie, Mr. Walmsley said, since Dixie reported interest on a cash basis. Mr. Walmsley said he “thinks”, Noonday U.K. accrued the unpaid interest in its books.

Mr. Walmsley testified that eventually Noonday U.K. was wound up. A note to the financial statements of Dixie for fiscal year 1979 states, and the respondent has pleaded, that Noonday U.K. made an assignment in bankruptcy in October 1980. Noonday U.K. did not repay the loans to Dixie.

Noonday U.K.'s position was that since its losses were caused by Mr. Ollu, an employee of Dixie, the losses ought to be charged to Dixie. Mr. Walmsley testified that “our man caused the damage”; he stated that by investing additional funds in Noonday U.K. “we thought we could solve the problems”. Dixie was willing to borrow from its banker to advance funds to Noonday U.K., stated Mr. Walmsley, because the Canadian operations would be more profitable if it could continue to secure supplies from the United Kingdom, and Noonday U.K. was the source of supply.

Dixie’s accountant during the years of Noonday U.K.’s activities, Mr. Lawrence Soden, a chartered accountant, also testified. Mr. Soden is now associated with a real estate firm in Toronto. Mr. Soden's testimony served to corroborate the evidence of Messrs. Walmsley and Hunt that Noonday U.K. was incorporated for the purpose of supplying Dixie's Noonday Graphics division. Mr. Soden also testified that Mr. Walmsley directed the operation of the United Kingdom company whether he was in the United Kingdom or Canada. He also stated that interest charged to Noonday U.K. on the various loans made in 1979 and 1980 was always in excess of interest charged to Dixie by its banker when Dixie borrowed the funds. Mr. Soden produced photostatic copies of general ledger sheets of Dixie reflecting monthly postings to the loan receivable from Noonday U.K. account, a running balance of payments and year-end adjustments. A photostat of a document prepared by Mr. Soden entitled “Loans — Dixie Lee to Noonday U.K.” reflects advances and repayments of loans from 1975 to December 1977 and provides for interest at the rate of 14 per cent per year; the principal balance shown for December 31, 1977 is $109,187.50; total interest accrued is $14,557.

Mr. Soden testified that in preparing the financial statements of Dixie for 1979 and 1980 he treated the advances as a business loss since the Noonday U.K. losses were related to an employee of Dixie and then offset the losses from the advances. He stated that any loss incurred by Dixie “technically was a loss on loan advances; (however) in a business sense the loss was on money paid for the U.K. operation which was the source of supply.”

Dixie claims that in accordance with paragraph 18(1 )(a) of the Act it ought to be permitted to deduct, in computing its income for 1979 and 1980, the amount of the loans it made to Noonday U.K. since the loans were expenses made or incurred for the purpose of gaining or producing income from its business, that is, the business carried on by Noonday U.K. was the business of Dixie.

The Minister of National Revenue disallowed the deduction of advances of $109,188 claimed by Dixie in its 1979 income tax return on the basis the loans were not made or incurred to produce income from Dixie's business, but permitted the deduction of an allowable capital loss of $37,500, being one-half of $75,000, the amount of loan to Noonday U.K. agreed by Dixie and the Chief of Exchange Control and on which there was evidence of interest being charged on the loan. the deduction by Dixie of $204,027 in computing income in respect of further advances of $151,810.58 and $52,215.82 made to Noonday U.K. in 1979 and 1980 respectively, were disallowed by the Minister since these amounts did not constitute outlays or expenses made or incurred for the purpose of gaining or producing income from the business of Dixie and were outlays of capital other than for the purpose of gaining or producing income from a business or property.

Counsel for the appellant argued that the commercial purpose of Noonday U.K. was to be the branch operation of Dixie and the loans from Dixie to Noonday U.K. represented payments by Dixie in its business. Counsel asks the Court not only to lift the corporate veil of Noonday U.K. but to ignore the existence of that corporation. In support of his position counsel referred the Court to the following cases: M.N.R. v. Freud, [1969] S.C.R. 75; [1968] C.T.C. 438; 68 D.T.C. 5279; Stewart & Morrison Limited v. M.N.R., [1972] C.T.C. 73; 72 D.T.C. 6049 and Paco Corporation v. The Queen, [1980] C.T.C. 409; 80 D.T.C. 6215 and 6328. The headnote in Freud (supra) is as follows:

In 1958 the taxpayer, practising law in Detroit and residing in Windsor, conceived, with an associate, the idea of designing and developing a prototype of a sports car with the intention of selling their concept, embodied in the prototype, to a manufacturer of cars who could be interested in putting it into production. A corporation was formed to carry out the project and shares were issued to the two associates and others who put money in the undertaking. In 1960, the taxpayer advanced to the corporation a sum of $13,840.47 in a final attempt to sell the idea to a manufacturer. Part of this money was paid to the corporation and part consisted of direct payments for labour, materials and expenses. When the venture became a total loss in 1960, the taxpayer sought to deduct the $13,840.47 from his other income for that year.

The Supreme Court of Canada dismissed the Minister’s appeal. The head- note continues:

The amount in question must be considered as an outlay for gaining income from an adventure in the nature of trade and not as an outlay or loss on account of capital. It could not be considered as an investment. From its inception, the venture was not for the purpose of deriving income from an investment but for the purpose of making a profit on the sale of the prototype. The payments made by the taxpayer were purely speculative. If a profit had been obtained it would have been taxable irrespective of the method adopted for realizing it. The fact that a corporation was formed to carry out the venture did not affect the matter. If the taxpayer and his friends had been successful in selling the prototype, they might well have done it by selling their shares in the company instead of having the corporation sell the prototype. There can be no doubt that if they had thus made a profit it would have been taxable. The same rule must be followed when a loss is suffered. The payments made by the taxpayer could not be considered as a separate operation isolated from the initial venture and had none of the characteristics of a regular loan. In the circumstances, the loss should be deducted from the other income of the taxpayer in the year in which it was sustained, namely 1960.

In Paco (supra), the taxpayer corporation, resident of Canada, made and sold equipment and machinery to manufacture cement blocks. It decided to explore the European market. The taxpayer corporation and a small group of businessmen in France joined together to establish a demonstration plant close to Paris. The plant was owned by a French corporation in which the taxpayer held 60 per cent of the shares. The taxpayer was not interested in becoming a block manufacturer; its primary concern was to launch a local company which could later serve as a demonstrator and enable the equipment and machinery to be sold. Once the plan was in operation the taxpayer would sell its shares to the French shareholders, reserving the right for potential visitors to visit the plant. The venture was not successful and it was sold at a loss to the taxpayer. The Federal Court, per Dubé, J., found that the loss was a fully deductible operating expense; the intention of the taxpayer was to establish a demonstration plant to explore the market.

In the Stewart & Morrison (supra) appeal, the taxpayer deducted losses incurred on the write off of advances it made to a wholly owned United States subsidiary company formed to operate an office in New York. The subsidiary solicited clients in its own name and billed them accordingly. The subsidiary was “mastermined" from the taxpayer's office in Toronto. The taxpayer made direct advances to and guaranteed loans for the subsdiary. The advances were treated by both companies and by their auditors as loans from the taxpayer. The business in New York was not successful and ceased operations. At the time it ceased operations it owed the taxpayer $72,000 spent for operating expenses and not for capital investment. The Supreme Court of Canada confirmed the finding of the Exchequer Court ([1970] C.T.C. 431; 70 D.T.C. 6295) that the taxpayer provided working capital to its subsidiary by way of loans. The money was lost, and the losses were capital losses to the appellant, the deduction of any amount of which was prohibited by the Income Tax Act at the time. Mr. Justice Judson wrote that the Court was "not concerned in this appeal with what the result would have been if the appellant taxpayer had chosen to open its own branch office in New York” (page 74; D.T.C. 6051).

None of these cases are, in my opinion, on point. In Freud the development of the prototype sports car and the incorporation of a company constituted at the very outset a venture in the nature of trade, a business; the loss incurred in that business was deductible. The advances made to the corporation by Mr. Freud were outlays made in the hope of making a profit on the whole transaction; the shares of the corporation were not an investment since if they had been sold by the taxpayer at a gain the profits realized would have been taxable as income from a business.

The intention of the taxpayer in Paco (supra) was to establish a demonstration plant which could be used to promote sales, and as such the costs incurred in building the plant were expenses incurred in a business. The appellant argued that, by analogy, it set up a plant in the United Kingdom in incorporating and funding Noonday U.K.

I accept that Noonday U.K. was incorporated for the purpose of supplying the taxpayer with material at favourable prices. I also find that the purpose for the incorporation of Noonday U.K. was to bring into existence an asset of an enduring benefit for Dixie. There was no evidence the incorporation of Noonday U.K. was part of a venture in the nature of trade, as in Freud (supra), or a means to promote sales as in Paco (supra). In both Freud and Paco the taxpayer's interest in owning the asset created, the car and plant, was only temporary. I infer from the evidence at trial that Noonday U.K. would continue to exist so long as the taxpayer carried on the picture and frame franchise business. Dixie owned 48 per cent of the issued and outstanding shares of Noonday U.K.: there is absolutely no evidence that Dixie's intention was to sell these shares at a given point in time and in fact the evidence is completely contrary to such a finding.

Counsel for the appellant sought to distinguish the facts in the Stewart & Morrison, (supra) on the basis that in that case the taxpayer's intent was to have a business in New York. The intent of Dixie, he submitted, was not for Noonday U.K. to carry on a business in the United Kingdom, but to secure supplies for Dixie. In fact Noonday U.K. carried on more than one business: it was a retailer of pictures and frames in the United Kingdom and sold supplies to Dixie.

There was no evidence, and it was not argued, that Noonday U.K. was carrying on business as agent for Dixie. Although Mr. Walmsley suggested Dixie advanced funds to Noonday U.K. since it felt responsible for the misappropriation of funds and property by Mr. Ollu, it was not argued that the payment of such amounts would be deductible by Dixie as an expense in the carrying on of a business.

In my opinion any business carried on by Noonday U.K. was for its own account and its activities could not be interpreted as a “branch plant” of Dixie. There is not a scintilla of evidence that Dixie considered the business of Noonday U.K., or its assets or liabilities, as its own. Nowhere is it even suggested that Dixie's assets were made available to the creditors of Noonday U.K. when it made an assignment in bankruptcy. How then can one contemplate that the business of Noonday U.K. was a "branch plant operation" of Dixie? Dixie owned 48 per cent of the issued and outstanding shares of Noonday U.K. Dixie’s financial statements for 1979 refer to Noonday U.K. as an affiliated company. There was no explanation at trial why, if a so-called branch operation was contemplated, Dixie held only a minority position in Noonday U.K. There is no doubt Dixie made the advances to Noonday U.K. because Dixie hoped Noonday U.K. would be a source of income. Noonday U.K. carried on business in its own name and manufactured material for sale to Dixie. Dixie ran Noonday U.K.'s affairs and the companies were closely related and managed. Noonday U.K. needed capital, but had none. Capital was supplied by Dixie. The funds loaned were described in the financial statements of Dixie as "investment in advances to" Noonday U.K. and in my view this correctly describes the nature of the loans. "The fact that the money so provided was used by the subsidiary to pay its operating expenses, and was lost in a losing cause, does not determine or change its nature of money lent by the respondent to the subsidiary." See reasons for judgment of the Exchequer Court, per Kerr, J., in Stewart & Morrison, (supra) at 439 (D.T.C. 6299-300).

In my view, therefore, the advances in issue were capital in nature and, in accordance with paragraph 18(1)(b) of the Act, cannot be deducted in computing the income of the appellant’s business for 1979 and 1980.

The appellant's alternate submission is that one-half of the capital loss be permitted as an allowable capital loss. The appellant says that interest was chargeable on the funds advanced in excess of $75,000. Counsel said that it was understood by Dixie and Noonday U.K. that the additional funds were being advanced with interest at the rate of 14 per cent per year. Mr. Soden, Dixie’s erstwhile accountant, produced papers in his handwriting which show interest accruing on the unpaid balance. This, argued counsel for the appellant, confirmed that the advances were made for the purpose of earning income from a business or property.

Respondent was of the view no interest was chargeable on the loans in issue since he found no evidence of interest being charged in the books or records of Dixie. Therefore, he concluded that, pursuant to subparagraph 40(2)(g)(ii) of the Act, the taxpayer’s loss for tax purposes was nil. Subparagraph 40(2)(g)(ii) reads as follows:

40(2) Notwithstanding subsection (1),

(g) a taxpayer’s loss, if any, from the disposition of a property, to the extent that it is

(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length,

is nil;

For the purpose of subparagraph 40(2)(g)(ii) a taxpayer is deemed to have disposed of a debt owing to him at the end of a taxation year in which the debt is established by him to have become a bad debt: subsection 50(1). It was not argued by the respondent that the debt did not become bad until after 1979; in fact the respondent confirmed Dixie’s view that part of the debt became bad in 1979 by allowing Dixie an allowable capital loss for 1979. In any event I was not asked to make a finding on this issue. Evidence produced through Mr. Soden indicates he calculated interest on the principal balance of loans outstanding by Noonday U.K. to Dixie from 1975 to December 31, 1977. The evidence is silent as to when Mr. Soden prepared the calcualtions. No book of account of the appellant produced in evidence indicates any interest, although it is quite clear interest was chargeable on advances of the initial $75,000. I would have preferred to have had the opportunity of reviewing all the financial statements of Noonday U.K. for 1979 or earlier years to determine with certainty that it accrued interest and to what extent, rather than relying on what Mr. Walmsley thought the U.K. corporation did. Also, while some schedules to the financial statements of the appellant for 1975, 1976 and 1977 were produced, no financial statement for those years was submitted to assist me: notes to the statements may have indicated the terms of the loans. No resolution of directors of Dixie authorizing the increased loan and its terms was before me. I mention these omissions from the evidence because the following comments are made by

F. W. Stephens & Co., chartered accountants, of London, England, to Mr. Walmsley in a letter of February 11, 1985:

The amount of Can. $75,000 would have been ascertained at that time from the best estimates of the parties involved as to the amount required by Noonday Graphics (U.K.) Ltd. It is not unusual for such companies to require additional loan amounts subsequently and, in such circumstances, the most common method of completing the legal documentation is simply to record the additional loan as an addendum to the original loan agreement. Thus the basic terms of the original loan would apply to subsequent loans.

For subsequent loans dealt with in the above manner, it was always recommended that exchange control consent be saught (sic) because it facilitated firstly the payment of interest in foreign currency and secondly the repayment of the loan principal in foreign currency . ..

There was no evidence before me of any documentation recording the additional loans and their terms nor any further exchange control assent.

However even if no interest was chargeable I do not believe that would be fatal to the appellant’s alternate submission. The fact that there may have been no interest attached to the debts in question is not relevant in decid- ing whether they were acquired for the purpose of gaining or producing income. See The Queen v. Lalande and Watelle, [1983] C.T.C. 311 at 318; 84 D.T.C. 6159 at 6164. It is not uncommon for a shareholder to lend money without interest and without security to the corporation since he anticipates that the loans will assist the corporation to earn income and to pay to him income by way of dividends; the loan is made for the purpose of earning income from a property. Although the shareholder is a creditor of the corporation when he advances money to the corporation the shareholder does not see his advance of money to the corporation and his subscription for shares of the corporation as separate investments in two watertight compartments; rather he sees his money entering two compartments which open up into a single compartment for the use of the corporation. Purchasing shares and advancing money to a corporation are two ways of making an investment in the corporation. This is a sensible interpretation.

Similarly a shareholder of a corporation who may have incorporated a corporation for the purpose of acquiring product at a low cost and so reduce its own costs may advance money without interest to the corporation to enable the corporation to operate as intended; in this example even if the shareholder is not making loans for the purpose of producing income from its business, by having reduced costs, the loan is being made to earn income from property, that is, to receive dividends on the shares it owns in the corporation. It is not unusual for a person to invest in a corporation by subscribing for share capital and lending money without interest; as far as he is concerned the shares and his loans constitute a single investment and if later on, he is called on to advance further loans without interest he is only increasing his investment. I cannot subscribe to the theory that in such an example the non-interest bearing loans were not incurred for the purpose of earning income from property; if the loans were not advanced the corporation may have become bankrupt and the shares may have become worthless. Clearly the loans were made to earn income from property, that is, to place the corporation in a position where it will be successful and pay dividends.

The appeal will therefore be allowed in part and the assessment referred back to the respondent for reconsideration and reassessment in accordance with these reasons. The appellant shall be entitled to its party and party costs.

Appeal allowed in part.