Tor-Guelph Holdings Limited v. Minister of National Revenue and 309901 Ontario Limited v. Minister of National Revenue, 91 DTC 355, [1991] 1 CTC 2252 (TCC)

Brulé, T.C.J.:—Two issues are involved in this appeal by the appellants respecting their 1982 taxation years. The first is whether losses realized by the appellants are business losses or allowable business investment losses. The second is whether interest expenses incurred by the appellants on money borrowed to repay guarantees are fully deductible in computing their income. The appeal of both appellants was heard on common evidence.

Facts

The appellants, Tor-Guelph Holdings Ltd. "Tor-Guelph") and 309901 Ontario Ltd. (309901") are holding companies, incorporated under the laws of Ontario. At the material time each held a partnership interest in Bathurst Sales (Bathurst"). The appellants are neither moneylenders nor dealers in securities. Bathurst carries on business as a distributor of cosmetics.

In 1980, the appellants along with the partners of Bathurst acquired a partnership interest in G & G Packaging, a packager of manufactured cosmetics. In 1981, the partners transferred the business to G 8: G Packaging Ltd. (G & G") in exchange for shares. In October 1981, Bathurst acquired the outstanding shares of Eletex Distributors Ltd. CEletex") together with some outside investors. Eletex distributed a line of cosmetics different from Bathurst. Both Eletex and G & G were operated under the direction of Bathurst. The shareholders provided working capital to G & G and Eletex by means of interest-free advances. In addition, the partners of Bathurst guaranteed the indebtedness of Eletex to the Canada Imperial Bank of Commerce CCIBC").

Due partly to the economic downturn of the early 1980s, both G 8: G and Eletex became insolvent in 1982. Eletex made an assignment in bankuptcy on March 4, 1982 and G & G went into receivership sometime in May 1982. In April 1982, Bathurst borrowed $1,200,000 and advanced it to Eletex to enable Eletex to satisfy its indebtedness to the CIBC, not satisfied out of the assets of the estate in bankruptcy. The interest expense incurred by Bathurst on the loan totalled $111,024.19 or which Tor-Guelph's share was $16,654, and 309901's share was $9,378.

In 1982, the appellants claimed allowable business investment losses of $185,629 (Tor-Guelph) and $184,728 (309901), being 50 per cent of the losses incurred by the appellants on the disposition of their shares in Eletex and their portions of advances made to Eletex including the $1,200,000 advance. As well, the appellants deducted their share of the interest expenses incurred on the money borrowed to make the advance. The appellants also deducted $35,309 (Tor-Guelph) and $45,308 (309901) as allowable business investment losses, being 50 per cent of the losses incurred by the appellants on the disposition of debts owing to them by G & G.

By reassessments dated November 27, 1986, the Minister disallowed the deductions of interest claimed. In response, the appellants requested a loss determination under subsection 152(1.1). The appellants objected to the loss determination on the basis that the losses previously claimed as allowable business investment losses were business losses. The Minister confirmed the assessments and the appellants appealed to this Court.

Appellants’ Position

The appellants contend that losses realized by them during the 1982 taxation year on the disposition of their shares in Eletex and G & G are fully deductible business losses on the ground that they acquired the shares for the purpose of increasing their income from Bathurst Sales. The appellants also contend that any losses incurred on the disposition of debt in these two corporations are fully deductible business losses.

Further, the appellants contend that interest expenses incurred by them during the 1982 taxation year relating to advances to Eletex to permit Eletex to discharge its obligation to the CIBC are deductible from their income from Bathurst notwithstanding Eletex’s bankruptcy because Eletex was simply an offshoot of Bathurst and income and losses realized in connection with it formed part of the same source of income.

Minister's Position

The Minister contends that the shares held by the appellants in G & G and Eletex were acquired as a capital investment and that any loss is only deductible as an allowable business investment loss. Similarly, the Minister contends that the loss on the disposition of the debts owing by G & G and Eletex to the appellants is also a business investment loss within the meaning of paragraph 39(1)(c).

The Minister further contends that the interest expense was not deductible as it was a capital outlay within the meaning of paragraph 18(1)(b), and the borrowed money was not used for the purpose of earning income from a business or property within the meaning of paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

Analysis

The two issues referred to at the outset of this judgment involve four separate amounts over which the issue of deductibility is disputed. They are as follows:

(1) the appellants’ loss on the disposition of their shares in G & G and Eletex;

(2) the appellants' loss on their shares of the interest-free advances given to Eletex and G & G which were not repaid;

(3) the appellants' share of the loss on the $1,200,000 advance given by Bathurst to Eletex to enable Eletex to satisfy its indebtedness to the Canadian Imperial Bank of Commerce; and

(4) the appellants’ share of the interest costs relating to the $1,200,000 borrowed by Bathurst and advanced to Eletex to satisfy the unpaid liabilities referred to in (3) above.

1. Shares

The partners in Bathurst Sales, including the appellants acquired shares in both G & G and Eletex. These acquisitions diversified the appellants' holdings in the cosmetics business and, as a by-product, they hoped to enhance Bathurst's profitability. At the time of the acquisition the appellants did not intend to dispose of the shares at a profit, rather they intended to hold them for potential long-term benefits. As a result of this intention, the nature of the property involved, and the circumstances of the purchases (neither appellant being a dealer in securities) the Court has no difficulty in determining that the shares of G & G and Eletex were capital assets in the hands of the appellants and any losses associated with these shares are capital in nature.

2. Interest-Free Advances

As far back as 1908 in the case of English Crown Spelter Co. v. Baker, 5 T.C. 327 the Court held that "the income taxpayer had no right to deduct from the balance of profits or gain anything in the nature of capital expenditures"—per Bray, J. at page 333 of the report. The learned judge stated further at page 334:

The question, or one of the questions at all events therefore to be determined is . . . is this, properly speaking, capital expenditure? If capital expenditure, you have not to go and see where the money was before it was expended. It does not matter whether it is lying at the bankers of where it is. What you have to see is whether, in common parlance, it is capital expenditure, that is to say, an expenditure on account of capital—an expenditure which, on the ordinary profit and loss account, would not appear as a debit at all, but would appear as a debit when you are dealing with assets.

Generally speaking a loan made to a subsidiary company for the purpose of providing that company with working capital is a capital outlay, and any resulting loss is on capital account. This was the exact determination made by the Supreme Court of Canada in Stewart & Morrison Ltd. v M.N.R., [1972] C.T.C. 73; 72 D.T.C. 6049. This case was cited with approval by the Federal Court-Trial Division in The Queen v. H. Griffiths Co., [1976] C.T.C. 454; 76 D.T.C. 6261. In this latter case the taxpayer guaranteed a loan to a subsidiary incorporated to supply the taxpayer with product. Eventually the subsidiary went into bankruptcy and the taxpayer repaid the loan. The Court held that the taxpayer had incurred an expense to bring into existence an advantage of enduring benefit and the loss was therefore capital in nature and not deductible.

There are two limited exceptions to the general rule that a loan constitutes a capital outlay. The first exception arises when the taxpayer/shareholder is engaged in an adventure in the nature of trade and the loan is incidental to the venture, any gain or loss will be either a business profit or loss [See M.N.R. v. Freud, [1968] C.T.C. 438; 68 D.T.C. 5279 (S.C.C.) and Sydney John Becker v. The Queen, [1983] C.T.C. 11; 83 D.T.C. 5032 (F.C.A.).] For example, where a taxpayer holds shares in a corporation as a trading asset and the taxpayer lends money to the corporation, which is incidental to the venture, any loss suffered will be a fully deductible business loss. In the case at bar the appellants’ shares are capital assets and hence they cannot rely on this exception.

Second, a a loan, like a guarantee can escape classification as a capital outlay if the expenditure was incurred as an ordinary outlay in the taxpayer's profitmaking activities and it was not made to bring into existence a benefit or advantage of an enduring nature. [See The Queen v. FH. Jones Tobacco Sales Co., [1973] C.T.C. 784; 73 D.T.C. 5577 (F.C.T.D.), The Queen v. Romeo Lavigueur, [1973] C.T.C. 773; 73 D.T.C. 5538 (F.C.T.D.), and Panda Realty Ltd. v. M.N.R., [1986] 1 C.T.C. 2417; 86 D.T.C. 1266 (T.C.C.).] All these cases were cited by the appellants' counsel.

The following extract from Hannan and Farnsworth, Principles of Income Taxation (1952) at 442-43 sheds some additional light on the scope of this exception:

A brewery company lent money to its customers on the security of their public houses, each customer being under an obligation to purchase his supplies of beer from the company. The company also accepted moneys on deposit from its customers, and provided them with certain banking facilities. Losses incurred in respect of various advances were claimed as a deduction in the computation of its profits. Held that the claim should be allowed: Reid's Brewery Co. Ltd. v. Male (1893) 3 Tax Cas 279. Having referred to the practice of breweries to advance moneys to customers for the purpose of increasing the profits of their trade, the court considered that the appellant company was carrying on not two businesses, brewing and banking, but one business, to which the advancing of money and the provision of banking facilities were a valuable adjunct; that the advances were not permanent investments of capital; and that the losses thereby incurred were losses of money laid out wholly and exclusively for the purposes of the trade.

The difference between the case at bar and the F.H. Jones, Lavigueur and Panda Realty cases, supra, is that in these cases there is a direct correlation between the guarantees or loans and the earning of business income. In F.H. Jones, the taxpayer gave the guarantee to prevent the loss of an important customer. In Lavigueur, the taxpayer lent money to lessees on a regular basis in order to retain them as tenants. In Panda Realty the taxpayer guaranteed a loan of his tenant who carried on a manufacturing business. This guarantee was given to preserve an ongoing source of rental income and the Court found that the resulting loss was on account of income and that the rental income stream was not capital perse nor was it capital in nature. Therefore, the loans/ guarantees were an integral part of the taxpayer's profit-making activities. In the case at bar, it is difficult to conclude that the advances were part of the appellants' normal profit-making activities. Further, the advances were made for the purpose of securing a benefit of an enduring nature by enhancing the value of its shareholding.

The appellants did not loan money to G & G and Eletex to earn business income in the sense contemplated by the cases cited above. The appellants' purpose was to provide these corporations with funds to carry on their busi- ness. In the process they expected to enhance the size and profitability of their investment in the cosmetics industry. However, the advancing of money was not a valuable adjunct to the nature of Bathurst’s business, nor was it an ordinary outlay in the course of Bathurst's activities. The business income which resulted from the employment of the funds in G & G and Eletex, if successful, would belong to these corporations individually.

Nor can much weight be accorded to the appellants’ claim that Bathurst, G & G and Eletex should be treated as a single entity. First, the Court has no authority to ignore the separate existence of a corporation except where the company was a mere agent or puppet of its controlling shareholder and it would be flagrantly unjust not to do so. See the case of Kosmopoulos v. Constitution Insurance Company of Canada, [1987] 1 S.C.R. 2; 74 N.R. 360 wherein Wilson, J. said at page 10:

As a general rule a corporation is a legal entity distinct from its shareholders: Salomon v. Salomon & Co., [1897] A.C. 22 (H.L.) The law on when a court may disregard this principle by "lifting the corporate veil” and regarding the company as a mere "agent" or” puppet" of its controlling shareholder or parent corporation follows no consistent principle. The best that can be said is that the "separate entities” principle is not enforced when it would yield a result "too flagrantly opposed to justice, convenience or the interests of the Revenue”: L.C.B. Gower, Modern Company Law (4th ed. 1970), at p. 112.

at page 11 Wilson, J. went on to say:

There is a persuasive argument that “those who have chosen the benefits of incorporation must bear the corresponding burdens, so that if the veil is to be lifted at all that should only be done in the interests of third parties who would otherwise suffer as a result of that choice: Gower, supra, at p. 138.

Second, business and corporate structures are often designed to provide for a number of advantages. Each structure has its own legal characteristics which cannot be ignored. Can it be that a corporation should be treated as a separate entity for these reasons and not for tax purposes? Would this not, in effect, permit a consolidation of profits and losses within a corporate group which is not permitted under the Income Tax Act?

Third, if one were to treat Bathurst, G & G and Eletex as a single entity, where would the line be drawn? All losses on loans, guarantees and advances made within a corporate group would become fully deductible. If one follows the appellants’ reasoning in this matter, it would not be possible for a parent corporation, firm or business to hold shares in a corporation as a capital investment, if that corporation enhances or complements the business of the shareholder. Surely this is not conducive to the logical development of the case law.

Lastly, there is a marked difference between expending money within a business and lending money to a subsidiary or separate taxpayer. In Canada v. MerBan Capital Corp., [1989] 2 C.T.C. 246; 89 D.T.C. 5404 the Federal Court of Appeal was asked by the respondent to ignore the separate existence of a corporate entity for tax purposes. lacobucci, C.J. dealt with this argument as follows at page 254 (D.T.C. 5410):

I do not agree that the separate existence of the parent and subsidiary corporations involved in this matter should be disregarded. In my view, each of the corporations: MerBan, MKH, Holdings played specific roles and for income tax purposes were not "clones" or "artificialities" as described by the trial judge.

In short, there is no justification for ignoring the separate legal identity of both G & G and Eletex. To quote Mr. Justice Pigeon in Jack Appleby v. M.N.R., [1975] 2 S.C.R. 805; [1974] C.T.C. 693; 74 D.T.C. 6514 at page 698 (D.T.C. 6517; S.C.R. 813):

Ever since Salomon v. Salomon & Co., [1897] A.C. 22, it has been accepted that although the shares of a limited company may be beneficially owned by the same person who also manages it, its business is nevertheless in law that of a distinct entity, a legal person having its own rights and obligations. The Income Tax Act unmistakably implies that this rule holds good for tax purposes.

3. Advance to Eletex

Simply put, Bathurst's partners guaranteed the indebtedness of Eletex to the Canadian Imperial Bank of Commerce. Eletex became insolvent and Bathurst rather than satisfying the guarantee by paying the bank, advanced the money ($1,200,000) to the receiver of Eletex who paid the bank. This guarantee was given by the appellants and their partners to preserve and enhance their shareholdings. Whether the advance is viewed as a loan or a satisfaction of a guarantee, it is an outlay on account of capital and the loss, therefore, is a capital loss. For authority see M.N.R. v. George H. Steer, [1966] C.T.C. 731; 66 D.T.C. 5481 (S.C.C.) where an amount paid to discharge a guarantee was held to be a loss of capital and consequently a deduction was prohibited by paragraph 12(1)(b) of the Income Tax Act, now 18(1)(b).

Further, in the present case, even if the advance is viewed in isolation from the guarantee, it would not be deductible under paragraph I8(l)(a) of the Act because the appellants are satisfying a liability of a separate taxpayer This opinion was given by the Court in the case of No. 595 v. M.N.R. (1959), 21 Tax A.B.C. 225; 59 D.T.C. 76.

The Court has also dealt with the deductibility of loans and guarantees in some detail in the recent case of Roger Lachapelle v. M.N.R., [1990] 2 C.T.C. 2396; 90 D.T.C. 1876.

4. Interest Expense

The interest expense incurred by Bathurst relates to the loan of $1,200,000, supra, taken by the partners of Bathurst and advanced to Eletex. Eletex used the funds to satisfy its indebtedness to the Canadian Imperial Bank of Commerce. As explained above, this indebtedness was guaranteed jointly and severally by the partners of Bathurst, including the appellants. The loan was taken out in April 1982 approximately one month after Eletex was assigned into bankruptcy.

On this point the appellants’ counsel maintained that interest was deductible without recourse to paragraph 20(1)(c) of the Act on the ground that it was not capital indebtedness. In the alternative, he argued that the amounts in question were deductible pursuant to paragraph 20(1)(c) and that the source of income they are deductible from is that of Bathurst.

To make a determination of interest payments it is necessary to characterize the payments as on account of capital or income, and also to examine the right to deductibility.

(a) Characterization of the Payments

In the absence of any judicial authority interest expense must be considered a payment on account of capital although it has been argued that such payments may be incurred in the ordinary course of business. In Bowater Canadian Ltd. v. The Queen, [1987] 2 C.T.C. 47; 87 D.T.C. 5287 (F.C.A.) the appellant argued that interest incurred by it was an ordinary cost of doing business when required to pay interest on a loan guarantee. The Court, without rejecting the argument, found that the interest payments in question were on account of capital. Since a refinancing did not change the taxpayer's status as a guarantor; the interest costs remained capital outlays.

As the appellants are not in the business of borrowing and lending money any interest paid on the loss in question is undoubtedly a capital outlay.

(b) Deductibility

Interest payable on capital indebtedness is not deductible as an income expense in the absence of an express statutory allowance. Cartwright, J. agreeing with the majority decision in the case of Canada Safeway Ltd. v. M.N.R., [1957] C.T.C. 335; 57 D.T.C. 1239 (S.C.C.) said at page 354 (D.T.C. 1249):

For the reasons given by the Chief Justice and by my, brother Rand I agree with their conclusion that the borrowed capital, the interest on which was claimed as a deduction, was neither "used in the business to earn the income" nor "used for the purpose of earning income from a business or property (other than property the income from which would be exempt)" within the meaning of these expressions as used in the applicable statutes.

The allowance for reasonable interest expenses is found in paragraph 20(1)(c) of the Income Tax Act. The relevant portions of paragraph 20(1)(c) read as follows:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

or a reasonable amount in respect thereof, whichever is the lesser;

To be deductible under paragraph 20(1)(c), the borrowed money must be used for the purpose of earning income from a business or property. The purpose of paragraph 20(1)(c) is to provide a deduction to encourage the accumulation of capital which produces taxable income. [Per Dickson, C.J. in The Queen v. Phyllis Barbara Bronfman Trust, [1987] 1 C.T.C. 117; 87 D.T.C. 5059 (S.C.C.) at 124 (D.T.C. 5064).]

It is clear from the facts of this case that the income-earning capacity of the appellants was not augmented in any way by the loan taken to satisfy the The reason for this is not difficult to understand. The borrowed unds were no longer in the hands of the appellants, nor were they expended to acquire income-producing property. The money was expended to satisfy a guarantee. In short, this is an ineligible use of funds.

Even if it were possible to characterize Eletex as the source of income, the company had become insolvent prior to the loan being secured by Bathurst and therefore there was no reasonable expectation of earning income from the loan. In other words, interest paid on a loan which is re-lent to a bankrupt corporation is also an ineligible use of funds and no deduction follows under paragraph 20(1)(c).

The Court is also unable to accept the appellants' contention that Bathurst is an eligible source against which to deduct the interest expenses.

Interest expenses on indebtedness used to produce income from business must be employed in that business. Authority for this statement is found in the Safeway case, supra, wherein Rand, J. referring to paragraph 11(1)(c) of the Income Tax Act (now 20(1)(c)) said at page 345 (D.T.C. 1244) : ’ What is aimed at by the section is an employment of the borrowed funds immediately within the company's business.” Earlier, at page 343 (D.T.C. 1243), his Lordship in denying a deduction for interest on money lent by the appellant corporation to its subsidiary had this to say:

No doubt there is in fact a casual connection between the purchase of the stock and the benefits ultimately received; but the statutory language cannot be extended to such a remote consequence; it could be carried to any length in a chain of subsidiaries; and to say that such a thing was envisioned by the ordinary expression used in the statute is to speculate and not interpret.

The borrowed money was not used for the purpose of earning income from the appellants' businesses within the meaning of the Income Tax Act. In fact, the capital of which the interest relates was never employed in any business.

In cases involving the deductibility of interest Dickson, C.J. said at page 117 (D.T.C. 5064) of the Bronfman case, supra: . . . the onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction

In this case the appellants have failed to discharge the onus.

Conclusion

The appellants were correct when they originally claimed the losses on the disposition of shares and debt as allowable business investment losses. The interest expense claimed by the appellants is not deductible either as current expense or under paragraph 20(1)(c) of the Income Tax Act.

The result is that the appeals are dismissed.

Appeals dismissed.