W.F. Botkin Construction Ltd. v. The Queen, 93 DTC 448, [1993] 1 CTC 2765 (TCC)

Teskey, T.C.C.J.:—The appellant appeals from a reassessment for taxation years 1988 and 1989.

Issues

Originally, there were two issues; namely, the question of a "capital loss” and whether certain assets and labour were qualifying manufacturing and processing as defined by section 125.1 of the Income Tax Act, R.S.C. 1952,

c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). This second issue has been settled. Thus, the only issue before me is whether the appellant suffered a capital loss in 1988 as a result of a disposition of a debt owed to it by Provincial Bandag Retreaders Inc. and, if so, whether the guarantee giving rise to the debt was given by the appellant for the purpose of earning income for a business.

Facts

Since the two companies that entered into this transaction under review have identical names except for the last name being Ltd. in one and Inc. in the other, I prefer to refer to them as the “selling company” and the "purchasing company". The selling company, through an amalgamation in 1987, became known as W.F. Botkin Construction Ltd. (the"appellant" herein).

The selling company for a number of years operated a very successful tire retreading business in Regina, Saskatchewan. It was owned by Gordon Harvey Dohlen ("Dohlen") and Walter Franklin Botkin (“Botkin”). Each held one common share, Dohlen held 750,000 class A preferred shares and Botkin held 750,000 class B preferred shares.

The selling company had a net profit after income tax for the years 1980, 1981, 1982, and 1983 of $116,796, $168,542, $105,944 and $160,632 respectively. Over and above, the partners each took out in salary in those years, approximately $174,000, $180,000, $190,000 and $40,000 respectively. There was no explanation why management salaries were kept so low in 1983.

Apparently Dohlen wanted the arrangement terminated. Between Dohlen and Botkin, it was agreed that the total equity value of the selling company was approximately $1,500,000. They were not sure what the value of land and building was actually worth. It was agreed that if the selling company redeemed the 750,000 class A shares held by Dohlen, he would terminate his employment with the selling company. It being understood that eventually Botkin would have his 750,000 class B preferred shares redeemed and if there was any surplus thereafter, it would be shared equally as Dohlen retained ownership of his one common share.

At this time, the selling company had $400,000 cash on hand and accounts receivable of $382,000. Botkin then arranged for Dohlen's Class A shares to be redeemed, thus making Botkin to sole owner of the selling business for all practical purposes.

Botkin then decided that he would sell off the operating business but not the realty.

The business assets; namely, vehicle machinery, accounts receivable and goodwill had a market value of $936,026.55.

Botkin now had two alternatives, firstly to sell these business assets to Crown Tire ("Crown"), a large corporation with substantial assets, or secondly to sell these assets in a non arm's-length transaction to his children. It was this second choice he took as he felt he had more to gain by doing this than by selling the business to Crown.

Botkin (whose children ranged in ages from 16 to 23 at the time), incorporated the purchasing company. This company had no assets and no money. To make up the purchase price, it borrowed a total of $450,000 from the Bank of Nova Scotia (the"bank").

The sale was structured as follows:

It was agreed that the purchasing company would assume a liability of the selling company in the amount of $148,784.37 thus, it only had to pay $787,242.18 to complete the transaction.

The transfer took place on April 1, 1984 with no money changing hands. Four hundred and fifty thousand dollars were paid on April 30, 1984 and the balance of $337,242.18 on May 31, 1989. Botkin, on May 23, 1988 loaned $50,000 to the purchasing company.

The selling company had to give a guarantee to the Bank of Nova Scotia for the sum of $450,000 and to back up this guarantee it had to mortgage its land and building and execute a demand debenture in favour of the bank. Over and above this, Botkin had to give an unlimited personal guarantee to the bank.

The purchasing company agreed to rent the land and buildings of the selling company for one year to March 31, 1985 at a monthly rental of $2,500 and thereafter from year to year with either party having the right to terminate the lease on three month's notice.

Shortly after the conclusion of the sale of the business, Botkin had to loan a further sum of $210,000 to the purchasing company. In 1986, the purchasing company was insolvent and it sold the business to Crown who took over the leased premises. The purchasing company was now a dormant shell owing money to the bank with its only assets being a few accounts receivable. For all intents and purposes, the purchasing company was bankrupt.

In 1987, the bank called on the appellant to honour its guarantee. The appellant paid the bank $260,000 and was subrogated into its position. The appellant was able to collect on the accounts receivable $19,443.53. Thus, the loss on honouring the 1984 guarantee was $240,556.47 being the amount in question.

It was common ground that I should look at the circumstances surrounding the giving of the guarantee, notwithstanding the restrictive words of subparagraph 40(2)(g)(ii) of the Act which reads:

(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.

Dubé, J. of the F.C.T.D. in Easton v. Canada, [1992] 1 C.T.C. 334, 92 D.T.C. 6218 at page 340 (D.T.C. 6222) said:

Where a taxpayer has sustained a loss on a guarantee for a loan, the courts must look at the practical and commercial aspects of the transaction.

I find that the primary reason behind the sale once Botkin decided not to sell to Crown was to set up five of his children in a profit-making business that should benefit him and them substantially as time went on. The guarantees given by the appellant were not given for the purpose of earning income from a business or property.

The business could have been sold to Crown without risk, but the potential large future profits, if they occurred, would be lost. Botkin said at page 30 of his discovery "I figured I had more to gain by the restructuring of it, than by selling it to Crown.” There was no commercial reality to the transaction as structured other than to benefit his children by distributing to them the potential large annual profits the company was expected to produce in light of its past history. There was no valid business reason for the selling company (the appellant) to do what it did.

Botkin never contemplated that the selling company might have to honour its guarantee to the bank.

The only reason for the selling company's guarantee was to facilitate the highly leveraged transfer of the business to the five children. The gain on the transfer and the future rental were there on a sale to Crown without risk. The guarantee by the selling company was "not" given for the purpose of gaining or producing income from a business or property, which is a requirement to escape the" nil" valuation provided for in subparagraph 40(2)(g)(ii) of the Act. It was given so that the five children and possibly Botkin personally might reap the anticipated future profits from the business. The transaction was badly structured. The appellant has to live with how it was structured.

For these reasons, this portion of the appeal is dismissed.

Appeal dismissed.