Rostland Corp. v. The Queen, [1995] 2 CTC 2276, 96 DTC 1973 (TCC)

Mogan J.T.C.C.:—The appellant is a corporation existing under the laws of the Province of Ontario. Its principal business is the development and operation of commercial office buildings in Canada. The appellant has a number of subsidiary corporations in the United States of America which are also engaged in the development and operation of commercial real estate. The appeals for the taxation years 1986, 1987, 1988 and 1989 were heard together on common evidence. For the years 1986, 1987 and 1988, the Minister of National Revenue ("M.N.R.") included in the computation of the appellant’s income the following amounts which were identified as ’’foreign accrual property income’’ (”FAPI") within the meaning of paragraph 95(1 )(b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the ’’Act”):

1986: $1,493,995

1987: 5,333,076

1988: 3,296,150

Although these amounts were reduced by certain reserves and other allowances deducted by the M.N.R., the primary issue in these appeals is whether the above amounts are FAPI or whether such amounts are income from an active business of a controlled foreign affiliate of the appellant within the meaning of paragraph 95(1 )(b) of the Act. There are other secondary issues which will be referred to below.

It is necessary to describe briefly the corporate chain of the appellant’s relevant subsidiaries. Rostland America Inc. ("America") was incorporated in Arizona in 1977 to be the holding company for the appellant’s U.S. subsidiaries. From its incorporation until February 1984, all of the issued and outstanding shares of America were held by the appellant. In 1984, Rostland B.V. ("BV”) was incorporated in the Netherlands to become the holding company for the appellant’s U.S. subsidiaries and to facilitate financing of the appellant from European sources. At all relevant times, all of the issued and outstanding shares of BV have been held by the appellant. On February 24, 1984 all of the outstanding shares of America were transferred by the appellant to BV.

Rostland Arizona Inc. (’’Arizona") was incorporated in Arizona in 1977. At all relevant times, all of the issued and outstanding shares of Arizona have been held by America. Rostland Texas Inc. ("Texas") was incorporated in Texas in 1978 to acquire and develop real estate properties. Texas has carried on an active real estate business since its incorporation. In addition to developing real estate held directly by it or through joint ventures, Texas also invested in subsidiary or affiliate corporations which carried on real estate development activities and acted as financier for certain of such corporations.

Since its incorporation, all of the shares of Texas have been held by Arizona.

In 1977, Arizona acquired and commenced to operate the Arizona Biltmore Hotel (usually referred to herein as the "hotel") located on 34 acres of land in Phoenix, Arizona. In 1980, a new corporation named "Arizona Biltmore Hotel Inc." ("Biltmore") was incorporated in Arizona. From 1980 to February 1984, all of the issued and outstanding shares of Biltmore were held by Arizona. In 1980, Arizona transferred the hotel itself (land, building and hotel operation) to Biltmore.

The hotel was built in 1929. It was designed by Frank Lloyd Wright. When Arizona purchased it in 1977, it had 300 rooms. Arizona entered into a management agreement (Exhibit A-2) with Western International Hotels Company (later known as the ’’Westin Hotel Company" or simply "Westin") dated August 9, 1977 under which Westin was engaged to manage the hotel. Westin continued to manage the hotel after it was transferred to Biltmore in 1980 and after it was sold at arm’s length in 1984. Between 1977 and 1984, Arizona and Biltmore as successive owners of the hotel added 200 rooms plus a large convention facility. Although Westin was responsible for the day-to-day operation of the hotel, it was necessary and important for the owner to supervise Westin’s management.

At all relevant times, each of America, BV, Arizona, Texas and Biltmore was a "controlled foreign affiliate" of the appellant for purposes of the Income Tax Act, and did not act at arm’s length with the appellant. In February 1984, Arizona transferred all of the issued and outstanding shares of Biltmore to America; and America transferred 79 per cent of such shares of Biltmore to BV. To summarize the above corporate chain at the end of February 1984, the issued and outstanding shares of the above subsidiaries were held as follows:

The appellant held the shares of BV. BV held the shares of America. America held the shares of Arizona. Arizona held the shares of Texas. The shares of Biltmore were held as to 21 per cent by America and as to 79 per cent by BV.

With the above shareholdings in place, there occurred in the last two months of 1984 a significant commercial transaction which is at the heart of these appeals.

Pursuant to the terms of a 90-page agreement dated November 9, 1984 (Exhibit A-1 usually referred to herein as the "sale agreement"), America and BV sold their interest in the hotel by selling 100 per cent of the shares of Biltmore to DBL/Lepercq Limited Partnership (referred to herein as the "partnership"). The sale price was $125,500,000 and all amounts referable to the sale agreement and payments arising thereunder are expressed in U.S. dollars. The transaction closed on December 14, 1984. According to the terms of Exhibit A-1, the sale price was to be paid as to $33,500,000 by the delivery of two promissory notes of the partnership payable to America and BV respectively, and as to $92,000,000 by the payment of cash. Immediately following the acquisition of the shares of Biltmore, the partnership caused Biltmore to be liquidated and the hotel itself (land, building and hotel operation) became the property of the partnership.

P.M. & L. Inc. (”PML) was incorporated in Delaware in 1970. At all relevant times, the shares of PML were held by Arizona. On November 9, 1984 (the same date as the sale agreement), the partnership entered into a 45-page supervisory management agreement (Exhibit A-3) with PML under which PML was appointed as "supervisory managing agent" of the hotel. Exhibit A-3 refers to the prior 1977 agreement between Arizona and Westin. The purpose of Exhibit A-3 was to appoint PML (with the accumulated experience of the appellant and its subsidiary companies in the management of the hotel) as agent for the partnership to supervise the management of the hotel by Westin. PML did not have any employees of its own but Arizona provided the personnel (about five persons) who permitted PML to discharge its obligation as agent/supervisor for the owner.

In the pleadings, it is alleged by the appellant and admitted by the respondent that the $92,000,000 portion of the sale price was satisfied in part by the assumption of a first mortgage secured on the hotel and held by a third party and in part by the payment of cash. The two promissory notes payable to America and BV respectively are both secured by a second deed of trust on substantially all of the assets of the partnership. Those same assets of the partnership are subject to a first deed of trust which secures a note in the amount of $70,000,000 payable to The Equitable Life Assurance Society of the United States. The $70,000,000 secured note held by Equitable Life is the first mortgage "held by a third party" referred to in the pleadings.

The two promissory notes of the partnership payable to America and BV respectively in the aggregate amount of $33,500,000 are both dated December 14, 1984 and have identical terms covering 42 typed pages. They are significant commercial documents. In the pleadings, the appellant refers to the aggregate amount of the promissory notes as "mortgage debt" and refers to the

notes themselves as "mortgages". This nomenclature is disputed by the respondent who denies any implication that the promissory notes were mortgages. The name given to a document is not as important as its substance. In the sale agreement, the documents delivered as evidence of the $33,500,000 debt are called "promissory notes". (See article 1.02(b) in Exhibit A-1.) Exhibit A-4 is a 42-page promissory note in the amount of $8,145,000 payable to BV. Exhibit A-5 is a 42-page promissory note in the amount of $25,355,000 payable to America.

A promissory note does not ordinarily represent security by itself but is only evidence of an unsecured debt. In these appeals, the two promissory notes issued to America and BV respectively were secured by a second deed of trust on substantially all of the assets of the partnership. (See page 10 of each note.) The principal amounts were not payable in full until December 31, 1999. There were extensive and complicated provisions for the accruing of interest, for the required payment prior to 1990 of certain minimum annual amounts with respect to interest, for changing the rate of interest after 1989, and for the possible payment of additional amounts after 1989 depending upon annual gross revenues of the hotel and an increase in the value of the hotel before December 1999. When deciding these appeals, I will be governed by the rights and obligations created by the promissory notes issued to America and BV respectively and not by the name given to those documents. I will, however, refer to them as "promissory notes" because that is what they are called in the sale agreement.

The promissory notes were "non-recourse" in nature in that neither America nor BV had any legal right to proceed against the partnership or its members or any other person to recover any portion of the principal (including unpaid and capitalized deferred interest) or unpaid interest, but had recourse for payment of principal and interest only to the hotel property. The term of the notes expired on December 31, 1999 at which time the principal amount, including deferred interest, became due and payable under most circumstances.

The notes were assignable. In October 1985, ten months after the sale of the hotel, America transferred its note in the original amount of $25,355,000 to Texas as a contribution of capital. Thereafter, at all relevant times the two notes were held by Texas and BV respectively.

The terms of the notes provided that interest accrued until December 31, 1989 at the rate of 13 per cent per annum but such interest was payable only to the extent of "cash flow" (as defined in the notes) from the operation of the hotel, subject to the payment of certain minimum annual amounts in respect of interest. The principal amount of each note was increased by the amount of accrued but unpaid interest. After January 1, 1990, interest was payable on the notes at a base rate of 9 per cent per annum. Other amounts could become payable depending upon the gross revenues of the hotel or a valuation of the hotel above a certain level.

During the 1985 calendar year, the cash flow from the hotel was sufficient to pay only the minimum amount in respect of interest on the notes plus a portion of the difference between that minimum amount and 13 per cent. During 1986 and 1987, the cash flow from the hotel was not sufficient to pay even the minimum amounts in respect of interest on the notes but those minimum amounts were in fact paid. During 1988, no amount in respect of interest was paid on the notes. I shall refer to any amount in respect of interest paid to and received by Texas or BV as "cash interest"; and the difference between total interest accruing on the notes and cash interest will be referred to as "deferred interest".

Interest was payable on the two notes at June 30 and December 31 of each year commencing June 30, 1985. The taxation years of the appellant and of each controlled foreign affiliate relevant to this appeal ended on February 28 of each year. Therefore, the fiscal period ending February 28, 1986 would include any amount of interest paid or payable as at June 30 and December 31, 1985. The same would apply to each subsequent year. For the taxation years 1986, 1987 and 1988, the table below shows for each promissory note the accrued interest, the cash interest and the deferred interest (remembering that the note originally issued to America was transferred to Texas in 1985):

When issuing reassessments for the 1986 and 1987 taxation years, the M.N.R. regarded the cash interest and the deferred interest on the notes as FAPI of Texas and BV. For 1986, the MNR did not include in the appellant’s income any amount with respect to FAPI of Texas because the time for making a reassessment with respect to Texas as set out in subsection 152(4) of the Act had expired. Therefore, for 1986, the M.N.R. included in the appellant’s income as FAPI only interest received by or accrued in BV. When issuing the reassessment for 1988, the MNR included in the appellant’s income the amount of $3,296,150 (U.S. dollars) as FAPI with respect to interest received by or accrued in Texas on account of its promissory note. The issues to be decided are as follows:

1. whether either or both the cash interest and deferred interest in respect of the notes is FAPI of Texas and BV;

2. if either or both the cash interest and deferred interest on the notes is found to be FAPI of Texas, whether and in what amount Texas had a "deductible loss" within the meaning of section 5903 of the Income Tax Regulations deductible in its 1987 or 1988 taxation year in computing FAPI;

3. if deferred interest on the note held by Texas is found to be FAPI, whether Texas or the appellant was entitled to deduct in 1987 a reserve in respect of doubtful debts under paragraph 20( 1 )(1) of the Act in respect of deferred interest on the note held by Texas which arose in 1986; and

4. the amount of non-capital losses available to be deducted by the appellant in computing taxable income in its 1988 and 1989 taxation years.

The primary issue therefore is whether cash interest or deferred interest in respect of the notes is FAPI. The provisions of the Income Tax Act relevant to this primary issue are:

91(1) In computing the income for a taxation year of a taxpayer resident in Canada, there shall be included, in respect of each share owned by him of the capital stock of a controlled foreign affiliate of the taxpayer, as income from the share, the percentage of the foreign accrual property income of any controlled foreign affiliate of the taxpayer, for each taxation year of the affiliate ending in the taxation year of the taxpayer, equal to that share’s participating percentage in respect of the affiliate, determined at the end of each such taxation year of the affiliate.

95(1) In this subdivision,

(b) "foreign accrual property income" of a foreign affiliate of a taxpayer, for any taxation year of the affiliate, means the amount, if any, by which the aggregate of

(i) the affiliate’s incomes for the year from property and businesses other than active businesses, other than…

95(2)For the purposes of this subdivision,

(a) in computing the income from an active business of a foreign affiliate of a taxpayer there shall be included

(i) any income from sources in a country other than Canada that would otherwise be income from property or a business other than an active business, to the extent that it pertains to or is incident to an active business carried on in a country other than Canada by the affiliate or any other non-resident corporation with which the taxpayer does not deal at arm’s length, and

The primary issue comes down to the question of whether any amount received or accrued with respect to interest on the notes is "income from property” or "income from an active business" as those words are used in subparagraph 95( 1 )(b)(i) of the Act. The appellant claims that any amount paid or payable in respect of interest on the notes is income from an active business. The respondent claims that any such amount is income from property.

The appellant puts forward two basic arguments. Firstly, the operation of the hotel was an active business; the notes were non-recourse because they were secured on the assets of the partnership (primarily the hotel) and there was no covenant by any member of the partnership or any other person to pay the interest; the notes were participating in the sense that payments in respect of interest depended upon the cash flow from the hotel; and therefore, the source of any amounts paid in respect of interest on the notes was the active business of the hotel. Secondly, the interest income of Texas and BV from the notes pertains to or is incident to the active management business carried on by PML (within the meaning of subparagraph 95(2)(a)(i) of the Act) because the cash flow from the hotel was affected, at least in part, by the management and other supervisory services rendered by PML.

The respondent argues that the sale of the shares of Biltmore by America and BV was the sale of a capital property resulting in a capital gain to the vendors; the notes were accepted by the vendors as part of the consideration for the sale of the shares of Biltmore; the notes had the same character in the hands of the vendors (i.e., capital property) as the shares of Biltmore for which the notes represented part consideration; neither Texas (assignee of America’s note) nor BV was carrying on an active business concerned with acquiring or otherwise dealing in property like the notes in question; the relationship between the partnership and the holders of the notes was a debtor-creditor relationship; and therefore, interest on the notes was income from property. The Respondent also argued with respect to subparagraph 95(2)(a)(i) that the words "pertains to or is incident to" refer to a subordinate role as against a principal function. The principal function of Texas and BV (as holders of the notes) was to collect on the notes. The role of PML was subordinate because its supervision of the hotel management was intended to ensure payment of the notes. The notes were not held by Texas and BV for the purpose of helping PML to operate its management business.

The arguments of both parties are persuasive. One would ordinarily conclude that any amount received or accrued with respect to interest on a secured debt like a mortgage is passive income from property and not income from an active business. In the extraordinary circumstances of these appeals, however, I have concluded for the reasons set out below that the appellant should succeed on the proposition that all amounts in respect of interest derived from these two promissory notes are income from an active business. My conclusion is based on the rights conferred on the holders of the promissory notes, on the role played by the appellant and its subsidiaries in the operation of the hotel from 1985 to 1988, and on the passive character of the partnership as legal owner of the hotel after the 1984 transaction.

When the partnership purchased the hotel on December 14, 1984, the purchase price of $125,500,000 was financed as follows:

Capital from Partnership 22, 000,000

$125,500,000

The partnership as new owner had invested less than 20 per cent of the cost. The vendors as holders of the promissory notes had a greater equity in the hotel than the partnership. Under Article IX of the sale agreement (entitled ’’post closing reduction in purchase price"), the vendors were required to remit to the partnership cash amounts not exceeding $5,000,000 in the aggregate in the period up to December 31, 1989 if the net cash flow from the hotel did not achieve certain annual targets. If the vendors defaulted in their obligation to remit such cash amounts, the partnership was entitled to enforce such obligation against the notes. (See section 5.3 of each note.) Those net cash flow targets were not achieved. By December 31, 1988, the vendors had remitted the $5,000,000 to the partnership reducing the sale price to $120,500,000 and reducing the partnership’s equity to $17,000,000 or approximately 14 per cent of cost. In the business language of the 1980s, the purchase of the hotel by the partnership was heavily leveraged.

Approximately five employees of Arizona had played an active role in supervising Westin’s management in the period 1977 to 1984. When the partnership purchased the hotel, it had no experience in the ownership, management or operation of a 500-room hotel. The partnership needed help to supervise the day-to-day management of the hotel by Westin. The vendors had the experience and the expertise to supervise that day-to-day management because they had worked with Westin for seven years. Also, the vendors were anxious to continue the supervision of Westin because of their significant equity in the hotel through the notes, and their desire to ensure that revenues and cash flow would be adequate to service the required annual payments on the first mortgage and the notes.

John W. McCool, the president and chief executive officer of the appellant, testified at the hearing of these appeals. He gave lengthy and detailed evidence with many examples of the role played by the appellant’s personnel, through PML, in supervising the management of the hotel from December 1984 through to its troubled financial state in 1988-1989. Mr. McCool was an impressive witness with very broad experience in the ownership, development and management of commercial real estate. In particular, he is familiar with the agreements under which certain hotel organizations like Westin and Hilton will manage a particular hotel for its owner. He has a good knowledge of those sensitive areas where the interests of the manager/operator are in conflict with the interests of the owner. The manager is paid a fee based upon gross revenues minus pure operating expenses; but the owner receives only the remainder from gross revenues minus operating expenses, minus fixed expenses (property taxes, financing costs, insurance and manager’s fee), minus capital improvements. The manager will want to push certain items from operating expenses over into capital improvements in order to increase its fee, whereas the owner may want to move certain capital outlays into operating expenses to effect an overall reduction in costs.

Mr. McCool offered a number of examples of this conflict between owner and manager and described how the appellant worked with Westin to achieve satisfactory results. I shall describe only two of Mr. McCool’s examples in the period after 1984 when the hotel was owned by the partnership. PML persuaded Westin to revive the old laundry which was in the hotel but had not been used for many years. All of the sheets and towels and guest clothing were sent out for cleaning. By restoring the hotel’s laundry, they were able to do the work "in-house". Restoring the laundry required the employment of more people (resisted by Westin) but reduced laundry and valet cost by $80,000 in one year. PML also persuaded Westin to install a new phone system which was leased rather than purchased. The leasing costs were operating expenses (above the line and adversely affecting Westin’s management fee) whereas the purchase of new telephone equipment would have been a capital improvement and not an operating expense. PML were able to persuade Westin to make this telephone change because the overall result was a saving of $100,000 in telephone bills in one year. It was only the experience of the personnel within the appellant’s group of companies which permitted these savings to be effected after 1984 when the hotel was owned, at least in name, by the partnership.

In 1986-1987, upon the recommendation of PML, $5,000,000 was expended on renovations and construction of new facilities at the hotel. The amount of $5,000,000 was not advanced by the partnership as owner but by PML on condition that it supervise the design and construction of the new restaurant and all other renovations. PML took back a third mortgage as security for the $5,000,000 loan to the partnership but the third mortgage was never paid. Mr. McCool stated that he reported to his directors at the time that there was a good likelihood that "we would never see the $5 million", but it was thought to be a good business decision at the time to keep the hotel competitive with new hotels opening nearby.

Westin was owned by United Airlines. Westin went through a difficult time around 1986-1987 when it was put up for sale by United Airlines and purchased by a Japanese corporation. The new owners of Westin replaced the executive vice-president, and then Mr. Ravenswood (who had been the Westin manager of the hotel since 1977) resigned because he could not work with his new boss. Mr. Ravenswood was replaced in 1987 with two successive hotel managers from Westin who were in Mr. McCool’s words "a disaster". Mr. McCool said that there were times in 1987 when his Arizona personnel were running the hotel on a day-to-day basis because the interim managers provided by Westin were so hopeless.

Interest accrued on the promissory notes at the basic rate of 13 per cent per annum in the period from December 14, 1984 to December 31, 1989 but it was payable above certain minimum annual amounts only if the net cash flow from the hotel was adequate. Interest was payable on June 30 and December 31 in each year. For 1985, the net cash flow from the hotel permitted the payment of amounts above the minimum required level (approximately 4.8 per cent) but not at the rate of 13 per cent. For 1986 and 1987, the net cash flow did not exceed its defined targets and so only the minimum amounts in respect of interest (approximately 6.2 per cent and 7.9 per cent respectively) were paid. No amounts in respect of interest were paid after December 31, 1987. When the partnership defaulted on the payment due June 30, 1988, Texas and BV commenced foreclosure action with respect to their secured notes. Equitable Life also commenced foreclosure action to protect its position as first mortgagee. Before the foreclosure actions could be concluded, the partnership sought protection under Chapter 11 of the U.S. Bankruptcy Code. The parties could not agree on a plan of reorganization and the Bankruptcy Court finally ordered that the hotel be sold by auction. There were no bidders at the auction and Equitable Life took the hotel by default in 1990 in satisfaction of its first mortgage.

As a result of the foreclosure actions and court-ordered sale, Texas and BV recovered nothing. They lost the principal amounts of the notes ($33,500,000) plus all accrued but unpaid interest; and PML lost the third mortgage for $5,000,000 referred to above. According to Mr. McCool’s evidence, the two main reasons for the failure of the hotel were competition and the inability of the partnership to invest more capital. Competition was significant. During 1986 and 1987, three new hotels comprising 1,600 directly competitive rooms opened for business in the vicinity of the Arizona Biltmore Hotel. One of those new hotels (The Phoenician) went bankrupt almost immediately. A mortgagee took over The Phoenician and slashed room rates. The final result was that the Arizona Biltmore Hotel was unable to maintain its occupancy rate (the percentage of rooms occupied on average through the year) or its room rates.

The promissory notes are extraordinary as notes and as commercial documents. After December 31, 1989, the basic interest rate dropped from 13 per cent to 9 per cent per annum but an additional amount described as "supplemental interest" could be payable. The supplemental interest for any year was to be the sum of (i) 10 per cent of gross revenues (as defined) in excess of $55,000,000 but not exceeding $70,000,000; plus (ii) 3 per cent of gross revenues in excess of $70,000,000. The basic interest at 9 per cent and the supplemental interest were payable on June 30 and December 31 of each year after 1989 but only to the extent that net cash flow (as defined) was sufficient to permit such payments. Otherwise, those amounts would accrue and be added to the unpaid principal amount.

There was a separate provision in the notes which permitted the holders to participate in the value of the hotel above the level of $187,000,000. If the hotel were to be sold prior to December 31, 1999, the partnership was required to pay an amount described as ’’additional interest” equal to the sum of (i) 35 per cent of net sales proceeds (as defined) in excess of $187,000,000 but not exceeding $250,000,000; plus (ii) 46 per cent of net sales proceeds in excess of $250,000,000. If the hotel were not sold prior to December 31, 1999, then it was to be appraised as of that date and, if the appraisal value (as defined) exceeded $187,000,000, then the partnership was required to pay an amount also described as "additional interest” equal to the sum of (i) 35 per cent of the appraised value in excess of $187,000,000, but not exceeding $250,000,000; plus (ii) 46 per cent of the appraised value in excess of $250,000,000.

It appears to me that, when negotiating the terms of the notes, the bargaining position of the vendors was stronger than that of the partnership. In the buoyant, economic climate of the mid-1980s, the vendors must have decided that, if the hotel prospered, they should enjoy part of the fruits of their supervision of Westin by earning after 1989 amounts which were dependent upon annual gross revenues in excess of $55,000,000 and a further amount dependent upon an increase in value of the hotel above $187,000,000.

Notwithstanding the extensive terms of each note providing for a base rate interest (9 per cent) after 1989, supplemental interest dependent upon gross revenues of the hotel, and additional interest dependent upon the sale price or appraised value of the hotel, there was an all-embracing cap on the yield from each note which provided that in no event could the payment of these items exceed a semi-annual bond-equivalent yield to maturity in excess of 19.5 per cent. Although the notes are to be construed in accordance with the laws of the State of Arizona, I will for comparison purposes set out the definition of a ’’promissory note" in the Bills of Exchange Act, S.C., c. B-4, section 176:

176(1) A promissory note is an unconditional promise in writing made by one person to another person, signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money to, or to the order of, a specified person or to bearer.

Consistent with the simplicity of the above definition, it is common in Canada to see a promissory note comprising less than ten lines. By comparison then, I would conclude without hesitation that the two notes in question are not the common garden variety type of promissory note. As stated above, they are extraordinary commercial documents.

The sale of the hotel was negotiated in the fall of 1984 when the conventional wisdom of the business community in North America was based on the assumption that real estate values would increase without limits in the foreseeable future. The newspapers have described many real estate empires which later crashed because this assumption proved to be wrong. A number of large banks were required to write-off significant loans to those real estate empires. These two promissory notes are a reflection of that conventional wisdom because the amount described as "additional ilnterest" was not "interest" within the ordinary meaning of that word but was dependent upon a possible sale or actual appraisal of the hotel within 15 years at values exceeding $187,000,000 and $250,000,000 compared with the arm’s length sale price of $125,500,000 in 1984. Against the background of those possible values, it is interesting to recall that in 1990 (within six years after the sale to the partnership) Equitable Life took over the hotel by default when, at the court-ordered sale, no buyer came forward to pay even the amount of the first mortgage which would have been less than $70,000,000.

The notes also reflect the fact that the partnership had limited capital because the vendors were required to retain an equity in the hotel which was much greater than the equity of the new owner. After the $5,000,000 refund of purchase price to the partnership, when Equitable Life as first mortgagee took over the hotel by default in 1990, the vendors lost the face value of their promissory notes ($33,500,000) plus accrued interest whereas the partnership, as owner, lost only its net invested capital of $17,000,000 or 14 per cent of its purchase price. There is an old western saying "He has a big hat but no cattle". That saying apparently applied to the partnership.

With the benefit of hindsight, it can be said that the principal amount of the notes was always at a significant risk. The hotel appears to have been over- priced when it was sold to the partnership in a buoyant market. The partnership’s net investment was only 14 per cent of the reduced purchase price. The notes were secured by a second mortgage on the hotel ranking behind a first mortgage of $70,000,000 to Equitable Life. And the notes were non-recourse. If the fair market value of the hotel were to fall below the amount $103,500,000 ($70,000,000 plus $33,500,000), then the total equity of the partnership would disappear and at least part of the principal amount of the notes would be gone. The vendors must have recognized the risk to their notes in 1984 when they negotiated the right to supervise the management of the hotel during the 15-year term of those notes.

Mr. McCool described the constant ongoing involvement of the Rostland personnel (primarily employees of Arizona actually living in Phoenix but seconded to PML, plus senior executives from Toronto including Mr. McCool himself) with Westin in the management and operation of the hotel after 1984. That involvement was based on the supervisory management agreement (Exhibit A-3) which was dated and signed simultaneously with the sale agreement. Therefore, the supervision by PML is linked with the holding of the two notes which represented 26.7 per cent of the sale price. That involvement of the Rostland personnel through PML was intensified in 1987 when Westin had its own problems resulting in the resignation of its ten-year manager at the hotel. Mr. McCool and other senior officers within the Rostland group of companies spent many days each year from 1986 through 1988 trying to assist the hotel in its troubled times before it defaulted on its secured debt. According to Mr. McCool’s evidence, there was limited involvement by and no competent assistance from the partnership in the troubles of the hotel from 1986 through 1988. In a practical sense, the partnership was an absentee owner.

Each of the promissory notes contained the following provision as paragraph 5.10 on page 41 (the second last page):

5.10 Certain Relationships. The relationship between the partnership and the holders of the notes is a debtor-creditor relationship and is not intended to, shall not be deemed to be, and shall not constitute a partnership or joint venture.

The respondent relies on paragraph 5.10 to argue that any consideration payable by the debtor to the creditor with respect to the principal amount of the debt is in the nature of interest and therefore is income from property.

I regard the presence of paragraph 5.10 in each note as providing a stronger argument in support of the appellant. Why would such a statement be in a promissory note? A debtor and creditor when negotiating the terms of a promissory note do not ordinarily declare within the note that their relationship is debtor-creditor and not partnership or joint venture. Such a declaration would ordinarily be redundant. In my opinion, the vendors had negotiated such an aggressive and intrusive participation in the financial results of the hotel’s operation that they needed paragraph 5.10 to try to save them from being regarded as partners or joint venturers with the new owner.

That aggressive and intrusive participation by the vendors is exemplified in three ways. Firstly, in the five-year period to December 31, 1989, interest at the rate of 13 per cent per annum was payable only to the extent of "net cash flow" subject to the required payment of certain minimum amounts which for the calendar years 1985, 1986 and 1987 were respectively 4.8 per cent, 6.2 per cent and 7.9 per cent of the original principal amount. No amount in respect of interest was paid after 1987 because the partnership defaulted on the payments which were due June 30, 1988. Net cash flow was defined in paragraph 1.4 of each note and was dependent upon the revenues and expenses of the hotel, as was any profit which the new owner might hope to earn.

Secondly, in the ten-year period from January 1, 1990 to December 31, 1999, the partnership was required to pay "base rate interest" at 9 per cent per annum. The partnership could also be required to pay an additional annual amount called "supplemental interest" dependent upon the "gross revenues" of the hotel. Base rate interest and supplemental interest were payable each year only to the extent that "net cash flow" was sufficient to make such payments. Otherwise, those items were added to the principal amounts of the notes.

And thirdly, the partnership was required to pay an amount called "additional interest" if the hotel were sold at any time prior to December 31, 1999 for a price exceeding $187,000,000. If the hotel were not sold prior to December 31, 1999, it was to be appraised as at that date and, if the ’’appraised value" exceeded $187,000,000, then the partnership was required to pay an amount also called "additional interest".

The amounts which are called "supplemental interest" and "additional interest" in the notes are not interest in the ordinary sense because they do not depend upon a fixed or floating percentage applied to a particular principal amount. Those amounts have more of the attributes of owner than creditor because they depend upon gross revenues and increased property value respectively. Similarly, the right to receive 13 per cent each year in the first five years is not absolute like an ordinary creditor would expect but is dependent upon net cash flow, accepting some of the uncertainties which are incidental to ownership. And lastly, the right to receive in each year after 1989 the amounts called base rate interest (9 per cent) and supplemental interest is also not an absolute right but is dependent upon net cash flow, again accepting some of the uncertainties of ownership.

The amounts which the M.N.R. has included in the appellant’s income as FAPI for the taxation years 1986, 1987 and 1988 are amounts which were received or accrued in the calendar years 1985, 1986 and 1987 respectively, the only years in which Texas and BV received any amounts in respect of interest on the notes. In none of those years was the partnership able to pay the full 13 per cent rate of interest on the notes. In the table below, I have set out the principal amount of each note, the minimum required payment each calendar year with its corresponding percentage of the original principal amount, and the amounts actually received in each year as a percentage of the original principal amount:

It is apparent from the above table that in the calendar years 1985, 1986 and 1987, the net cash flow from the hotel was not adequate to pay anything close to the 13 per cent interest provided in the notes. Although there is an obvious difference between cash flow and profit, I assume it is equally true that there was no profit from the hotel earned by the partnership as owner in those same three years. If the net cash flow from the hotel had doubled in 1985 and 1986, all of the excess would have been paid to Texas and BV in respect of interest on the notes. And in 1987, any increase in net cash flow up to at least 5.13 per cent (13 per cent minus 7.87 per cent) of the principal amount would have been paid to Texas and BV in respect of interest on the notes. In a practical sense, the hotel was operated in 1985, 1986 and 1987 for the benefit of Texas and BV as holders of the notes. It appears that the hotel did not produce any profit for the partnership from December 1984 until it was taken over in 1990 by Equitable Life as first mortgagee.

Why should I then conclude that all amounts received or accrued by Texas and BV in respect of interest on the notes are income from an active business? After December 1984, the appellant (through its subsidiaries) continued to operate as de facto owner of the hotel. Set out below are some examples of the appellant’s de facto ownership:

1. PML continued to supervise the management of the hotel by Westin after 1984 just as Arizona and Biltmore had done successively from 1977 to 1984 during their respective periods of ownership.

2. PML invested an additional $5,000,000 in hotel renovations in 1986 when that amount of capital should have come from the partnership as the legal owner.

3. It was the experience of the appellant’s personnel (mainly employees of Arizona seconded to PML plus senior executives from Toronto including Mr. McCool) which permitted the hotel to operate as long as it did after 1984 and service its secured debt for at least three years. The personnel of the partnership did not make any significant contribution to the supervision or management of the hotel after the partnership became legal owner in December 1984.

4. The amounts actually received by Texas and BV in 1985, 1986 and 1987 were not interest in the ordinary sense because they did not depend upon a fixed or floating percentage applied to a particular principal amount. They were only amounts in respect of interest. For 1986 and 1987, they were the minimum annual required payments as set out on page 2 of each note. And for 1985, they were the minimum annual required payments plus a small amount (approximately 0.5 per cent of the original principal amounts) made possible by the net cash flow from the hotel.

5. After the heavily leveraged purchase by the partnership, the hotel was so burdened with debt ($103,500,000) that it was operated primarily for the benefit of the secured creditor whose capital was most at risk (i.e., the second mortgagee). That second mortgagee was the vendors or their assignees as holders of the notes. After December 14, 1984, Texas and BV received all of the net cash flow from the operation of the hotel until June 30, 1988 when the partnership defaulted on the scheduled payments and the hotel became insolvent.

6. The appellant (through Texas, BV and PML) had amounts of capital invested in the hotel which were more than double the capital invested by the partnership. This was proven in 1990 when, upon the forfeiture of the hotel to Equitable Life as first mortgagee, Texas and BV lost the aggregate principal amounts of their notes ($33,500,000) plus accrued interest; and PML lost its third mortgage of $5,000,000 invested in renovations; but the partnership as legal owner lost its net invested capital of only $17,000,000.

Having regard to the above six examples of de facto ownership, there is no single example which, considered alone, would cause me to conclude that the amounts received and accrued by Texas and BV with respect to the notes were income from an active business. Considering all of the examples together, however, I cannot resist the conclusion that the appellant through its subsidiaries continued to operate the hotel after 1984 and that the amounts in issue were derived from the operation of an active business and not derived from the passive ownership of the notes. If the appellant’s subsidiaries had never operated the hotel as an active business, my conclusion probably would be different. In other words, if Arizona and Biltmore had been only a landlord, if the hotel had been leased out to a third party to operate (possibly using a company like Westin as manager), the income of Arizona and Biltmore as landlord would have been only income from property and the third party would have earned active business income from the operation of the hotel. But that did not occur. From 1977 through to 1984, the hotel was operated by Arizona and Biltmore successively as an active business. And from 1985 to 1988, the hotel was operated by PML for the financial advantage of Texas and BV which received all of the net cash flow. And hypothetically, if the hotel had survived to operate as a successful enterprise after 1989, Texas and BV would have participated in annual gross revenues exceeding $55,000,000 and in any value of the hotel exceeding $187,000,000. These participating elements are what I have referred to above as intrusive incidents of ownership.

In Canada, a family of corporations (parent and wholly-owned subsidiaries) is not permitted to file consolidated income tax returns. Each corporation must file its own return with corresponding financial statements. Within a family of corporations, however, there is a communal interest in the financial health of each company whether it be the parent or a subsidiary. In these appeals for the taxation years 1986 to 1989, there was an obvious concern on the part of the appellant as the parent corporation with respect to the ability of its foreign subsidiaries to recover their full proceeds from the sale of the hotel. That concern was reflected in (i) the extensive and participatory terms of the notes themselves; (ii) the supervisory management agreement (Exhibit A-3) authorizing PML to supervise the management by Westin; and (iii) the extent to which the appellant used the talents of its senior executives in Toronto to assist PML.

In argument, appellant’s counsel relied on the decision of the Supreme Court of Canada in Hollinger North Shore Exploration Co. v. M.N.R., [1963] S.C.R. 131, [1963] C.T.C. 51, 63 D.T.C. 1031, to support the proposition that income which would otherwise be income from property may be income from an active business if it is sourced in and dependent on the conduct of an active business by some third party. Respondent’s counsel distinguished the Hollinger case on the basis that it construed a particular phrase: "income derived from the operation of a mine"; and on the further basis that the Court found that the mine in question was operated by Hollinger and another company as a joint venture for their joint benefit. I favour the respondent’s distinction of the Hollinger case because the words to be construed are different and, having regard to the way these appeals were argued, I was not asked to find that Texas and BV (as holders of the notes) were in a joint venture with the partnership. Paragraph 5.10 of each note is against such a finding but it is not conclusive. Considering the rights which were imbedded in the notes to participate annually in the net cash flow and gross revenues of the hotel, and to participate in any increase in value of the hotel above a defined level, it could have been argued that Texas and BV were in some kind of joint venture with the partnership.

Subparagraph 95(l)(b)(i) uses the following words: "income for the year from property or businesses other than active businesses". These words may be contrasted with subparagraph 125(l)(a)(i) which states: "the income of the corporation for the year from an active business carried on in Canada". Any business must be carried on by one or more persons. On the facts of this case, there is no doubt that the hotel was owned by the partnership after December 14, 1984 but that ownership was qualified by the limited capital of the partnership and the significantly greater capital which the vendors invested in the hotel through their promissory notes. I find in the circumstances of the heavily leveraged purchase by the partnership, the passive character of the partnership, and the terms of the notes, that Texas and BV (as holders of the notes) were engaged in a kind of joint venture with the partnership concerning the operation of the hotel business. Texas and BV had the right to participate in net cash flow and gross revenues whereas the partnership participated only in profit which depended upon gross revenues. Any increase in value of the hotel from $120,500,000 (adjusted purchase price) up to $187,000,000 was to be for the benefit of the partnership alone but any increase in value above the level of $187,000,000 was to be shared between Texas and BV (as note holders) and the partnership. The hotel would increase in value only if it were operated profitably. Texas and BV (through their affiliation with PML and Arizona) could make a much more significant contribution to the profitability of the hotel than the partnership. In my opinion, the amounts received or accrued in respect of interest on the notes were income from an active business.

I will assume for the sake of comparison that Texas expended some of its surplus capital to purchase a bond paying annual interest and issued by the government of the U.S.A. There is no doubt that interest received from such a bond would be income from property and not income from an active business. If I were to conclude that any amount received or accrued by Texas in respect of interest on its promissory note was income from property, that amount would have the same character for the purpose of subparagraph 95(1 )(b)(i) as the annual interest which Texas would receive from such a bond. Considering the intrusive rights conferred on the holders of the promissory notes and the efforts expended by PML (as an affiliate of Texas and BV) to ensure that net cash flow would be sufficient to make the minimum required annual payments, I cannot persuade myself that the amounts received or accrued by Texas and BV in respect of interest on their notes has the same passive character (1.e., income from property) as the actual interest which Texas would receive from a government bond purchased with surplus capital.

The respondent relied on the decisions in R v. Marsh & McLennan Ltd., [1983] C.T.C. 231, 83 D.T.C. 5180, Ensite Ltd. v. The Queen, [1986] 2 S.C.R. 509, [1986] 2 C.T.C. 459, 86 D.T.C. 6521, and McCutcheon Farms Ltd. v. M.N.R., [1991] C.T.C. 50, 91 D.T.C. 5047. Those cases were concerned with the question of whether interest earned by a corporation from term deposits or from the deposit of U.S. dollars in a commercial bank was "investment income" within the meaning of section 129 of the Income Tax Act or income from an "active business" within the meaning of section 125. In each case, the corporation carried on an active business and the issue was whether the term deposits were collateral to the active business or whether the withdrawal of the term deposits would "have a decidedly destabilizing effect" on the active business. In my view, those cases do not apply to these appeals because neither Texas nor BV had a business to which the promissory notes could be collateral. Rather, the notes represented the appellant’s residual investment (through its subsidiaries) in the business of the hotel itself. It is the extraordinary provisions of the notes plus the supervision of Westin through PML which cause Texas and BV to be in a form of joint venture with the partnership.

Having decided the primary issue in favour of the appellant, it is not necessary for me to decide the three secondary issues set out above. The appeals for the taxation years 1986, 1987, 1988 and 1989 are allowed with costs.

Appeals allowed.