Gordon v. The Queen, 96 DTC 1554, [1996] 3 CTC 2229 (TCC)

McArthur J.T.C.C.: — This is an appeal from a Notice of Reassessment wherein the Minister of National Revenue (the “Minister”) reassessed the Appellant’s tax payable for the 1990 taxation year. The Appellant had claimed an allowable business investment loss (ABIL) of $210,178. The Minister disallowed $151,872 and allowed $58,306.

The issue is whether Mr. Gordon, the Appellant, in 1990, is entitled to an ABIL in the amount of $210,178 pursuant to paragraph 39(1 )(c) of the Income Tax Act (the “Act”).

The following are relevant facts not in dispute:

- The Appellant is the sole shareholder and director of H. Gordon Engineering Ltd. (Engineering), a company incorporated under the laws of the province of British Columbia. Engineering is a small business corporation within the meaning of that term in subsection 248(1) of the Act. Engineering carried on a management consulting business.

- In 1985, Engineering acquired 50 per cent of the issued and outstanding shares of Wilhem Corporation (“Wilhem”), a company which carried on a wire products manufacturing business and was incorporated in California, U.S.A. The other 50 per cent was owned by Mr. and Mrs. Bill Dunlap who were the hands on operators of Wilhem.

- Grandview Holdings Co. Ltd. (“Grandview”) was a B.C. company that owned income producing real estate. The outstanding shares of Grandview were owned :

(a) 33 1/3 per cent by Hamor Investments Ltd., the Appellant’s family holding company;

(b) 33 1/3 per cent by Simgor Holdings Ltd., the family holding company of the Appellant’s brother, George Gordon; and

(c) 33 1/3 per cent by the Appellant’s nephew, Stephen Nemetz.

- The outstanding shares of Formete Structures Ltd. (“Formete”), a construction company were owned by the Appellant.

The Appellant and Engineering caused Grandview and Formete to advance funds to Wilhem on behalf of him and Engineering for use in Wilhem’s manufacturing business. Grandview advanced $231,186 and Formete advanced $123,031. The balances of these amounts owing as of December 4, 1990 were $121,736 and $133,080 respectively.

The evidence demonstrated that the Appellant and Engineering were obligated to repay Grandview and Formete the advances made by them to Wilhem. The Appellant gave his personal oral guarantee to the other shareholders owning 66.6 percent of Grandview.

Because it was convenient to do so, Grandview and Formete advanced funds directly to Wilhem without first directing the funds through Engineering. Wilhem was unable to repay Engineering the funds advanced by Formete and Grandview on behalf of Engineering. Harry Gordon was obligated to pay back Grandview and Formete.

In 1990 the Appellant paid $203,400 to Engineering which he stated was for Engineering to repay its debts to Grandview and Formete. The Appellant submits that the total debt owed to him by Engineering became uncollectible and therefore he wrote off the amount as a bad debt. The Appellant further submits that as a result of writing off the bad debt, he incurred an ABIL of $210,178.92 as provided for in paragraph 39(1)(c) and subsection 38(c) of the Act.

The broad issue is whether the Appellant incurred a capital loss in respect of a bad debt. Did Engineering owe a debt to the Appellant at December 31, 1990 which later became a bad debt? Was the debt acquired by the Appellant for the purpose of gaining or producing income from a business or property?

Legislation

Subsection 38(c), paragraph 39(1 )(c), subparagraph 40(2)(g)(ii) and subsection 50(1) read in part:

38(c)a taxpayer’s allowable business investment loss for a taxation year from the disposition of any property is 3/4 of his business investment loss for the year from the disposition of that property.

39(1 )(c) a taxpayer’s business investment loss for a taxation year from the disposition of any property is the amount, if any, by which his capital loss for the year from a disposition after 1977

(i) to which subsection 50(1) applies, or

(ii) to a person with whom he was dealing at arm’s length of any property

40(2)(g) a taxpayer’s loss ... is nil unless ...

(ii) ... unless the debt ..., was acquired by the taxpayer for the purpose of gaining or producing income from a business or property ....

50(1) For the purposes of this subdivision, where

(a) a debt owing to a taxpayer at the end of a taxation year ... is established by him to have become a bad debt in the year, or

the taxpayer shall be deemed to have disposed of the debt ... at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil.

Appellant's Position

The question before the Court is whether the Appellant incurred a capital loss in respect of a debt in the 1990 taxation year. The Appellant submits that he guaranteed the debts of Engineering, was liable to pay on that guarantee and when he did in fact pay, he became subrogated to the position of creditors Formete and Grandview and was entitled to be indemnified by the debtor Engineering. The Appellant referred the Court to the cases of National Developments Ltd. v. R. (sub nom. National Developments Ltd. v. Canada), [1993] 2 C.T.C. 3027, 94 D.T.C. 1061 (T.C.C.), Business Art Inc. v. Minister of National Revenue, [1987] 1 C.T.C. 2001, 86 D.T.C. 1842 (T.C.C.).

Counsel stated that subsection 50(1) of the Act deems that a debt has been disposed of if the debt owing to the taxpayer has become a bad debt. It must be established that the debt owed by Engineering to the Appellant was a bad debt. In the Appellant’s case the decision was made to wind up Engineering because it no longer had any source of income and did not have any major assets.

The Appellant states that the debt was acquired by him for the purpose of gaining or producing income from the Wilhem manufacturing business. The Appellant submits that the reason that he guaranteed the loans from Engineering to Grandview and Formete was because he expected to earn dividends on Engineering’s shares in Wilhem. The guarantees were therefore given for the purpose of earning income. The Appellant argues that following National Developments, supra, the time to examine if there was an income earning purpose was when the Appellant guaranteed the loans to Grandview and Formete, not when he was required to pay on his guarantee.

The Appellant states that the intent of subsection 39(12) is to assist the taxpayer. Where a taxpayer has to make a payment under a guarantee for a corporation’s liabilities, a debt does not arise between the corporation and the taxpayer until the payment is made. The 12-month period may not be sufficient time for the creditor to dispose of his debt or to establish that it has become bad so that it may be treated as having been disposed of for the purpose of subsection 50(1).

The Appellant submits that the reason that he paid Engineering was to settle his liabilities with Grandview and Formete. In the Appellant’s view, it does not matter which way the funds flowed in terms of deciding whether or not there was a payment pursuant to his personal obligation to Grandview and Formete.

In written submissions made subsequent to the trial, the Appellant presents that the facts of the recent unreported case Brown v. R., [1996] 1 C.T.C. 276, 96 D.T.C. 6091 (“Brown”) are similar to the present case. In Brown, the Federal Court-Trial Division (“Federal Court”) held that the money advanced by the taxpayer to the debtor to pay a creditor was for the purpose of earning income pursuant to subparagraph 40(2)(g)(ii) because as a shareholder of the debtor, the taxpayer was directly linked to its income earning potential. The Appellant added that the Court in Brown held that when a shareholder advances money directly to the principal debtor on account of his personal guarantee when the debtor has no remaining source of income, this constitutes a debt acquired as a result of the taxpayer’s personal guarantee incurred for the purpose of earning income. Therefore, such losses qualify for business investment loss purposes under paragraph 39(1 )(c).

Respondent's Position

The Respondent states that the legal status of the payment from the Appellant to Engineering is at issue. He submits that in the context of a guarantee the obligation of the guarantor is towards its creditors, and that when the Appellant advanced the money directly to Engineering it created a lender/borrower relationship, which obligations are distinguishable from a guarantor’s obligation to a lender. As Engineering reported the payment as a shareholder loan, the Respondent submits that an inference may be drawn that the payment was a loan.

The Supreme Court of Canada case Communities Economic Development Fund v. Canadian Pickles Corp., [1991] 3 S.C.R. 388, [1992] 1 W.W.R. 193, 85 D.L.R. (4th) 88, at page 106, is cited as authority for the proposition that in a contract of guarantee, the guarantor agrees to repay the lender if the debtor defaults. Therefore, it is submitted that since the Appellant did not pay the principal creditors, the Appellant must not have been a guarantor and the money advanced by the Appellant to Engineering was a loan and not repayment of a debt. It is submitted that a loan contract does not meet the criteria set under paragraph 40(2)(g) as it was not made for the purpose of earning income and therefore the Appellant may not claim an ABIL.

The argument is essentially that for the Appellant to have been paying his obligation as a guarantor, the Appellant should have advanced the money to the creditors, Grandview and Formete, and not to the principal debtor, Engineering.

The Respondent submits that when Engineering was paid on December 4, 1990, there was no expectation that Engineering would produce any income. It was virtually insolvent.

The Respondent states that for a taxpayer to be eligible for an ABIL, specific conditions in subsection 39(12) have to be met. The Respondent essentially repeats that the Appellant is not a guarantor. If he was a guarantor he would have paid the creditors, Granview and Formete, directly. The Appellant paid the debtor, Engineering.

The Respondent adds that Brown may be distinguished from the present case because the sole legal obligation at issue in Brown was the treatment of the loan that the taxpayer made to a debtor. It is alleged that the taxpayer in Brown was never called upon to pay as a guarantor, and that the Federal Court came to no conclusion on this point.

ANALYSIS:

In December of 1990 Engineering was unable to collect an amount in excess of $200,000.00 owing to it by Wilhem, Grandview and Formete were unable to collect the amounts totalling in excess of $200,000.00 owing to them by Engineering. The Appellant paid $203,400.00 to Engineering in December 1990 and Engineering then paid its indebtedness to Grandview and Formete. In this manner the Appellant satisfied his guarantee obligations.

I am satisfied from the evidence that the Appellant was legally liable to repay Grandview and Formete. A guarantor who has acquired a debt by virtue of the doctrine of subrogation, is able to support a claim for a capital loss. Judge Bowman, on this issue in a recent unreported decision of Cadillac Fairview Corp. v. R. (March 6, 1996), Doc. 92-2529 (IT)G (T.C.C.), (“Cadillac Fairview’’), stated at page 3:

Where a guarantee of a primary debtor’s obligation is given and the guarantor is required under the guarantee to pay and does pay to the creditor the primary debtor’s obligation, the guarantor is in the normal course subrogated to the position of the creditor ...

If, as is frequently the case, the principal debtor cannot pay, the debt may be regarded as having become bad. Section 50 of the Act deems the debt to have been disposed of by the guarantor at the end of the taxation year in which it became bad and to have been reacquired at a cost of nil immediately thereafter. Thus, through the combined operation of the law of subrogation and section 50 of the Act the disposition necessary to support the claim for a capital loss is achieved.

[Emphasis added. I

Applying this reasoning to the present instance, I find that Engineering owed a debt to the Appellant as is required under subsection 50(1) and paragraph 39(1 )(c) of the Act in order to claim a business investment loss.

A difficulty in the present case arises from the fact that the Appellant paid the debtor directly, instead of paying the creditor. The Respondent argues that the form in which payment was made to the creditors prevents the Appellant from claiming an AB II

A similar situation was indirectly addressed in Brown. The taxpayer in Brown was the shareholder of two related companies, Medway International Tractor Inc. (“Medway”), and 447579 Ontario Limited, (“447579”). The taxpayer’s bank lent money to 447579 and the taxpayer guaranteed this loan. Medway then went into receivership leaving 447579 with no source or expectation of income. The taxpayer lent money to 447579 to enable it to pay interest on the bank loan that the taxpayer had guaranteed, and when Medway went into receivership the taxpayer claimed an AB IL for the amount of the loan.

The Federal Court accepted that the taxpayer advanced money to the principal debtor in order for the debtor to make interest payments on a loan that the taxpayer had personally guaranteed to the bank, and that a debt existed between the taxpayer and 579. The only issue to be decided in the appeal was whether the debt, acquired by the taxpayer, was for the purpose of gaining or producing income from a business or property within the meaning of subparagraph 40(2)(g)(ii). The Federal Court did not address the distinction of the guarantor’s payment to the debtor as opposed to the creditor, the implication being that this was not relevant to the outcome of the case.

I do not feel it serves a useful purpose to review the jurisprudence on “substance over form”. It is sufficient to state that the common law doctrine applies to the present situation. Had Grandview and Formete advanced funds to Engineering instead of advancing the funds directly to Wilhem and had the Appellant advanced funds on its guarantee directly to the creditor, then the case would likely not be before this Court. The fact that the guarantor did not directly pay the creditors does not alter the end result that the creditors were paid by money provided by the guarantor, and that Engineering is now indebted to the guarantor. The commercial reality, substance over form, is that Harry Gordon had to pay back Grandview and Formete the money he had directed these companies to pay Wilhem on behalf of Engineering. Wilhem had failed and could not pay Engineering. Engineering was impecunious. The money owing to Formete and Grandview had to be repaid. The Appellant under his guarantee had to pay the loans. The payment he made to Engineering was to satisfy his legal obligation to the creditors. Whether he paid the debt directly or through Engineering does not alter the nature of the payment.

Common sense and commercial reality leads to the obvious conclusion that the appropriate time to consider whether the Appellant had an income earning purpose was at the time that the guarantee was given, and not at the time the guaranteed debt was in fact paid.

Judge Bowman in Cadillac Fairview is again of assistance in his statement at pages 3 and 4:

In many cases if a guarantor is obliged to make good under a guarantee it is because the principal debtor is unable to pay the obligation. From this, it follows that the guarantor’s right of subrogation against the principal debtor is, at the time of acquisition, likely to be, in many instances, worthless or virtually worthless. A narrow and mechanical reading of subparagraph 40(2)(g)(ii) would lead one to conclude that on the payment of the guaranteed amount the guarantor’s acquisition of the worthless subrogated debt could not possibly have as its purpose the gaining or producing of income from a business or

property. Such an interpretation in my view lacks commercial sense. A functional and more commercially realistic interpretation would subsume in the purpose of the acquisition of the subrogated debt the purpose for which the guarantee was originally given.

[Emphasis added.]

As a shareholder of Engineering, the Appellant was directly linked to Engineering’s future earnings. The purpose of the Appellant’s guarantee to Engineering was to earn dividend income from Engineering as a result of Engineering’s investment in Wilhem. An income earning purpose is possible when a shareholder makes a no- interest loan to a corporation in anticipation that the loan will assist the corporation to earn income and pay dividends to its shareholders. This conclusion was taken in Brown where the Court stated at page 277 (D.T.C. 7):

... [as] a shareholder of the real estate company [the debtor], the plaintiff was directly linked to its income producing potential. Under these circumstances, there exists a clear nexus between the taxpayer and the potential future income to be earned from the acquired debt, and accordingly paragraph 40(2)(g)(ii) does not apply.

Subsection 39(12) deems a taxpayer’s payment under an arm’s length guarantee as a debt owing by a small business corporation if the debtor was a small business corporation in the 12 months before an amount first became payable under the debt and when the debt was incurred. This subsection does not provide a blanket exclusion to preclude a guarantor from claiming an ABIL where an amount is paid to a person with whom the guarantor is not dealing at arm’s length. If a taxpayer and a debtor are not dealing with each other at arm’s length, and the taxpayer attempts to claim an ABIL on a debt that was disposed of when the debtor was no longer a small business corporation at any time in the 12 months preceding the disposition of the debt, then subsection 39(1) would not assist the taxpayer in claiming an ABIL because the debtor would no longer be a small business corporation as is required under paragraph 39(12)(c). I find nothing in subsection 39(12) that operates to preclude a taxpayer from claiming as a debt an amount paid to a related company where the related company was a small business corporation at the time when the debt was disposed of.

The appeal is allowed with costs.

Appeal was allowed.