The Queen v. Malone, 82 DTC 6130, [1982] CTC 145 (FCTD)

Mahoney, J:—This is an appeal from a decision of the Tax Review Board ([1979] CTC 2619; 79 DTC 540) which allowed the deduction of a $139,500 business loss by the defendant in his 1971 taxation year. The defendant abondoned his counterclaim at trial.

The defendant was a licensed securities salesman and a shareholder, director and president of Malone Lynch Securities Limited, hereafter “Malone Lynch”, a licensed securities dealer with a seat on the Toronto Stock Exchange, hereafter “the TSE”. Malone Lynch had been formed by amalgamation in 1970. There is no material distinction to be made between it and the amalgamating entity of which the defendant had also been a shareholder, director and president except that, as president of the larger entity, the defendant was required to devote more time to administration and had less to devote to selling and, so, for the first time, was paid a salary.

The defendant’s income breakdown for the years 1964 to 1971 follows:

Malone Lynch was bankrupted in 1971. The defendant lost $139,500 he had loaned it. The loan had grown over the years as the TSE required the principals of Malone Lynch to improve its net free capital position, a prescribed level of working capital essential to the maintenance of its right to trade on the TSE. The prescribed level would ordinarily increase as the volume of business increased. That, as well as a reduction in the position due, for example, to a client’s default, led to routine and special demands for shareholders’ advances to increase or restore the position. As required by the TSE, it was a subordinated loan. It bore and paid interest at 7% per annum, about the prime rate of the day. Other shareholders had made like loans, proportionate to their shareholdings. All were active salesmen for Malone Lynch. It is said that the loans were intended to be short term although, in fact, no repayments were ever made and I do not see that they could have been repaid in the short term in view of Malone Lynch’s fiscal policy unless, of course, business volume fell.

Commissions on TSE transactions were earned by the securities dealer, ie, Malone Lynch, not the salesmen. A salesman was entitled to be paid a portion of the commissions in his transactions by Malone Lynch: one-half, if a shareholder, or one-third, if not. Malone Lynch regularly distributed enough of its earnings as bonuses to reduce its income for its fiscal year to a level that would attract corporation income tax at the low rate. The bonuses were distributed pro rata to the recipients’ equity positions. No dividends were paid. As I understand exhibits 3, 4 and 5, as at March 31, 1971, Malone Lynch’s net free capital stood at $447,227, $43,723 more than its prescribed minimum, whereof $363,500 was provided by subordinated loans from its shareholders. The defendant’s loan, at March 31, was $117,000. In addition to the loan, the defendant had invested approximately $60,000 in common shares and $80,000 in preferred shares of Malone Lynch.

I accept that the defendant was in the business of stockbroking for his own account. Malone Lynch was the vehicle by which he necessarily carried on that business. Without it, he would have required to be associated with another having a similar license and seat on the stock exchange and, to maximize his rate of commission, he would have had to be a shareholder.

Commissions, his income from his business, were a substantial element of his total income. The defendant was also an employee of Malone Lynch and, while the breakdown as between salary and bonus is not in evidence, I accept that salary ie, income from an employment or office, was not an important element of his total income in 1971, or at all prior to 1970. The defendant was also an investor in Malone Lynch. The nominal interest on the subordinated loan was not a significant element of his total income nor, in my view, a determining factor in the resolution of whether or not the loan was made by him on account of capital. Bonuses were clearly an important element of his total income; the more so, the less his salary.

It is significant that the bonuses were distributed to salesmen pro rata to their equity positions, rather than their sales or commissions. Implicit in that is the fact that the same sort of bonus, if any at all, was not paid to salesmen who were not also shareholders. The bonuses were not simply a flow- through to the salesmen of commissions they had earned, net of expenses incurred by the company; rather, the bonus system was the method chosen to distribute the company’s net earnings to the shareholders.

Disregarding the interest on the loan, the defendant’s position that Malone Lynch provided only a necessary vehicle for his personal business as a stockbroker is untenable; he, in fact, realized significant income qua investor as well as qua salesman. Malone Lynch’s shareholders chose to provide its necessary capitalization by way of loans. The defendant’s loan was capital in nature and its loss was a loss of capital, the deduction of which from income was prohibited by paragraph 12(1 ) (b) of the Act*as [1] it stood in 1971.

The appeal is allowed with costs. The Minister’s assessment will be restored.