Ben Barbary Co. Ltd. v. MNR, 89 DTC 242, [1989] 1 CTC 2364 (TCC)

Mogan, T.C.J.:—The issue in this case is whether certain interest derived from a mortgage and promissory note and paid to the appellant corporation during the 1984 and 1985 taxation years was income from an “active business" within the meaning of subsection 125(1) of the Income Tax Act or "Canadian investment income” within the meaning of subsection 129(4).

In 1962, Mr. Ben Barbary purchased eight acres of land on the south side of Highway 7 at Silver Lake, approximately 70 miles west of Ottawa. By 1972, he operated on that site a restaurant, a convenience store, a gas bar and a sporting goods business. In 1973, Mr. Barbary caused the appellant to be incorporated and transferred to the appellant the eight acres of land plus the businesses operated thereon. At all relevant times, Mr. Barbary was the sole shareholder of the appellant.

In 1982, the appellant sold to Rick Barbary (son of Mr. Ben Barbary) and Rick’s wife Sharlene the sporting goods business, the convenience store, the gas bar and the underlying land (approximately 1.5 acres) on which those three businesses were located. The appellant retained the restaurant and the remaining 6.5 acres of land. Rick and Sharlene Barbary operated their newly acquired businesses as a partnership under the name "Silver Lake Sports”.

The partnership was not able to pay cash for its new acquisitions and so the appellant took back a mortgage on the land in the amount of $51,600 and accepted a promissory note in the amount of $176,303 as the net amount owing for certain inventory and equipment less certain liabilities assumed by the partnership. Both the mortgage and the promissory note bore interest at the rate of nine per cent per annum.

The partnership acquired its three businesses on October 1, 1982 and, within one year, the promissory note was paid down to $119,115. No further payments of principal were made on the promissory note in the following two years but interest at the rate of nine per cent per annum was paid to the appellant monthly. Therefore, in each of the two taxation years under appeal ending September 30, 1984 and 1985, the appellant received interest of $15,364 being nine per cent of $170,715 ($51,600 plus $119,115). It is the characterization of this interest which is in dispute.

Counsel for the appellant put forward the following three arguments to support the proposition that the interest in question was income from an

active business: (1) the interest derived from the mortgage and promissory note fell with the objects set out in the appellant's charter; (2) the involvement of the appellant through its sole shareholder and principal officer in the businesses of Silver Lake Sports was sufficient to qualify the interest paid by Silver Lake Sports to the appellant as active business income of the appellant; and (3) under paragraph 129(4.1)(b), income of a corporation from property that is incident to or pertains to an active business carried on by the corporation is excluded from the corporation's “Canadian investment income”. I shall consider these three arguments in order.

The articles of incorporation of the appellant dated January 25, 1973 contain nine object clauses of which the following are relevant:

6.(a) To purchase, lease, take in exchange or otherwise acquire lands or interests therein, together with any buildings or structures that may be on the said lands or any of them, and to sell, lease, exchange, mortgage or otherwise dispose of the whole or any portion of the lands and all or any of the buildings or structures that are now or may hereafter be erected thereon, and to take such security there for as may be deemed necessary or desirable;

6.(c) To take or hold mortgages for any unpaid balance of the purchase money on any of the lands, buildings or structures so sold, and to sell, mortgage or otherwise dispose of the said mortgages;

The appellant relies on the decision of the Supreme Court of Canada in Canadian Marconi Company v. The Queen, [1986] 2 C.T.C. 465; 86 D.T.C. 6526 for the proposition that, in the case of a corporate taxpayer, there is a rebuttable presumption that income received from or generated by an activity done in pursuit of an object set out in the corporation's charter is income from a business. In her reasons for judgment in the Supreme Court of Canada, Wilson, J. reviewed the history of that proposition and then relied on the presumption and the "large-scale investment activity” of Marconi to hold that the income in question was from a business.

Any presumption arising from an object clause set out in a corporate charter is, of course, rebuttable. In Sutton Lumber and Trading Company Limited v. M.N.R., [1953] 2 S.C.R. 77; [1953] C.T.C. 237; 53 D.T.C. 1158, the Supreme Court of Canada held that the evidence contradicted the presumption and Locke, J. for the Court stated at page 244 (D.T.C. 1161):

The question to be decided is not as to what business or trade the company might have carried on under its memorandum, but rather what was in truth the business it did engage in.

In the subsequent appeal of Western Leaseholds Limited, v. M.N.R., [1959] C.T.C. 531; 59 D.T.C. 1316, the Supreme Court of Canada held that the evidence supported the presumption. Locke, J., again speaking for the Court, stated at page 544 (D.T.C. 1323):

. . . That the appellant, consistently with one of its declared objects, carried on the business of dealing with the rights it had acquired from Minerals with a view to profit appears to me to be demonstrated by the evidence.

Reference to an object clause set out in the corporate charter to assist in determining the character of corporate income was apparently first employed in Canada in Anderson Logging Company v. The King, [1925-27] C.T.C. 198; [1925] S.C.R. 45. At that time, almost all corporations were formed for the purpose of trading or commerce and the corporate objects were probably custom drafted in accordance with the instructions of the incorporators. In recent years, however, a significant number of companies are incorporated for purposes that have nothing to do with trade or commerce. For example, to avoid death taxes in connection with foreign real estate, it is common to form a private corporation in Canada for the sole purpose of holding all the issued shares of a foreign private corporation which, in turn, is formed for the sole purpose of holding a foreign vacation property. Similarly, in estate planning, private corporations are frequently used in conjunction with inter vivos trusts to hold family assets for the purpose of facilitating the distribution of both income and capital and the transfer of property from one generation to the next.

When there is now a widespread use of private corporations for purposes other than trading or commerce, it may not be desirable to scrutinize the objects of a private corporation in search of a presumption which may assist in attributing a “business” character to income from a particular source. In the Marconi case, Canadian Marconi Company was not a private corporation in the ordinary commercial sense although it may have been a “private corporation” under the technical definitions in the Income Tax Act.

In the Marconi case, Wilson, J. raises the question as to whether the "objects presumption" would apply to corporations formed under the Canada Business Corporations Act and similar legislation. Such corporations do not need to list their objects because the respective statutes provide that corporations have the capacity, rights, powers and privileges of a natural person. If the wording of an object clause in a corporate charter is to be a significant fact in determining the character of corporate income, one could visualize a careful lawyer drafting specific objects and tracking the language of section 125 or section 129 of the Income Tax Act depending upon the taxation goals which the incorporators wanted to achieve.

When the charter of a modern corporation requires or permits a statement of corporate objects, a variety of object clauses may be extracted from precedent books by the incorporating lawyer and grafted like boiler plate onto the corporate charter with relatively little input from the actual client/ incorporator. All nine object clauses in the appellant's articles of incorporation, when read in their entirety, represent a good example of the precedent-based "cover-the-waterfront" style of drafting a corporate charter prevalent since the 19505. In Regal Heights Ltd. v. M.N.R., [1960] C.T.C. 384; 60 D.T.C. 1270, when the appellant relied on one of its objects to support its argument that a gain realized on the sale of certain land was a capital gain, Judson, J. (for the majority in the Supreme Court of Canada) stated at page 390 (D.T.C. 1272):

Nothing turns upon such a statement in such a document. The question to be determined is not what business or trade the company might have carried on but rather what business, if any, it did in fact engage in.

In order to determine the character of income from a particular source within a private corporation, it should be possible to rely only on actual transactions and corporate conduct without reference to any objects whether declared in the charter or provided in the legislation.

Because the appellant herein places so much reliance on the Marconi case, it is necessary to review the appellant's transactions from the time of incorporation in 1973 to the taxation years under appeal to determine if there was any commercial activity consistent with clauses 6(a) and 6(c) of its corporate objects. Immediately after incorporation, Mr. Ben Barbary transferred to the appellant the eight acres of land near Silver Lake and the four businesses operated on that land (the restaurant, convenience store, gas bar and sporting goods store). From 1973 to 1982, the appellant operated those four businesses. There was evidence that the appellant attempted to operate one of its buildings as a trucker’s motel in the late 1970s and, after 1982, converted the building to office space and a rental apartment; but that activity is not material in view of the other ongoing businesses. As stated above, the appellant sold three of its business operations (the convenience store, gas bar and sporting goods store) and part of its land to Rick and Sharlene Barbary on October 1, 1982. After that date, the appellant operated only the restaurant; and its income was derived from the restaurant, the mortgage and the promissory note.

On October 13, 1982 immediately after the sale to Rick and Sharlene Barbary, the appellant was authorized by a director's resolution to execute a guarantee in favour of the Bank of Nova Scotia guaranteeing the indebtedness and liability of Rick and Sharlene Barbary and Silver Lake Sports to the Bank. The guarantee apparently was related to the funds which were used by Rick and Sharlene Barbary as a down payment for their three businesses and was also related to a line of credit which the Bank established in favour of the partnership, Silver Lake Sports.

During 1983, 1984 and 1985, one-half of Mr. Ben Barbary's working hours were devoted to the operation of Silver Lake Sports for which neither he nor the appellant received any compensation. Counsel for the appellant suggested that if the appellant had received a management fee for the services provided to Silver Lake Sports by Mr. Ben Barbary, the interest on the mortgage and promissory note would have been reduced. There was no objective evidence to support the suggestion, however, and I regard the amounts paid by Silver Lake Sports to the appellant with respect to the mortgage and promissory note as interest in both form and substance.

The only witnesses who testified were Mr. Ben Barbary, sole shareholder of the appellant, and Mr. Steven W. Cross, C.A., the public accountant who prepared and commented on the financial statements of the appellant. Mr. Cross stated that the annual interest rate of nine per cent on the mortgage and promissory note was about two per cent below the prevailing arm's length rates in 1982/83. He further stated that the rate was set lower because Mr. Ben Barbary wanted his son to succeed.

Although the appellant’s objects clause 6(a) refers to the disposition of realty and the taking of “such security therefor as may be deemed necessary", and clause 6(c) provides for taking or holding "mortgages for any unpaid balance of the purchase money" on the lands sold, the mortgage for $51,600 from Rick and Sharlene Barbary appears to be the only mortgage that was ever held by the appellant. Looking at the object clauses of the appellant as a whole, it is not clause 6 which is important but the first five clauses which may be paraphrased as follows:

1. To carry on the business of caterers and suppliers of food, refreshment and services to the public;

2. To buy, sell or deal in goods, wares and merchandise;

3. To carry on the business of hardware merchants and suppliers;

4. To carry on the business of a restaurant;

5. To let out on lease or otherwise, apartments, hotels, flats and housing accommodation of any nature.

The appellant's actual operations of a restaurant, gas bar, convenience store and sporting goods business from 1973 to 1982 and the appellant's attempted operation of a trucker's motel are more accurately described in its first five object clauses than in any of the words in clause 6. It was obvious from the testimony of Mr. Ben Barbary that the appellant was incorporated in 1973 to take over and operate those four existing businesses without any thought to holding mortgages or promissory notes.

In Canadian Marconi Company v. The Queen, supra, Wilson, J. could truly refer to the “large scale investment activity” of Marconi during the years in question because its fund of $18,000,000 was invested in short-term securities requiring a frequent turnover. In this appeal, the mortgage for $51,600 was a five-year mortgage not due until September 30, 1987; and the promissory note, although payable "on demand" according to its terms, was described in the notes to the appellant's 1984 financial statements as payable on demand after September 30, 1985. Therefore, the appellant could not demonstrate any investment activity on a large or small scale from its incorporation until the end of the years under appeal. I have no difficulty in concluding that any presumption created by the appellant’s object clause number six is not supported by any activity of the appellant from its incorporation until the end of its 1985 taxation year. In other words, the presumption is rebutted.

With reference to the decision of the Supreme Court of Canada in Ensite Limited v. The Queen, [1986] 2 C.T.C. 459; 86 D.T.C. 6521 (judgment delivered the same day as judgment in the Marconi case), the appellant's property (i.e. the mortgage and promissory note from Rick and Sharlene Barbary) was not employed or risked in the appellant's restaurant business at any time. In the Ensite case, Wilson, J. again delivered the judgment of the Court and stated at page 464 (D.T.C. 6525):

The rebuttable presumption that corporate income is income from a business (see: Canadian Marconi Co. v. The Queen, [1986] 2 C.T.C. 465, released concurrently herewith) is of no application here as it would tend to collapse the distinction between active business income and other sources of income which Parliament clearly intended to preserve in its amendment of subsection 129(4) of the Act.

It would appear from the above-quoted statement that any rebuttable presumption arising from an object clause set out in a corporate charter will not apply if the taxpayer is a private corporation and the issue is whether income from a particular source is "active business income” or "investment income". If my understanding of the Ensite case is correct, the object clauses in the appellant's corporate charter are irrelevant in deciding the appeal herein.

As a second argument, counsel for the appellant submitted that the nature and degree of involvement of the appellant, through its sole shareholder and principal officer, in the business of Silver Lake Sports was sufficient to qualify the interest received from Silver Lake Sports with respect to the mortgage and promissory note as active business income. There is no doubt from the evidence that Mr Ben Barbary was actively involved in operating the businesses of Silver Lake Sports through 1983, 1984 and 1985; he received no compensation from Silver Lake Sports for his services; and his personal income was derived only from the appellant. I concluded that Mr. Ben Barbary, when assisting in the management of Silver Lake Sports, was motivated in part by the natural love and affection of a father anxious to see his son and daughter-in-law succeed in their business partnership; and that he was also motivated in part by the commercial need to ensure that the principal and interest with respect to the appellant's mortgage and promissory note would be paid in a timely manner.

I see no need to compare these motives to determine which is stronger because, even if Mr. Ben Barbary was representing the appellant as a significant creditor of Silver Lakes Sports, his involvement in the business of Silver Lake Sports would not change the character of the interest received by the appellant from Silver Lake Sports with respect to the mortgage and promissory note from investment income to business income. When a receiver/ manager is appointed to operate the business of a debtor corporation, the business of the debtor corporation does not thereby become the business of the creditors; and the interest accruing to the creditors on their outstanding loans does not acquire the character of income from the debtor's business. In my view, the second argument does not assist the appellant.

The appellant’s third argument was concerned with the application of subsection 129(4.1) of the Income Tax Act. Under paragraph 129(4.1)(b), income of a corporation from property that is incident to or pertains to an active business carried on by it is excluded from the corporation's “Canadian investment income”. The appellant submits that the interest received from Silver Lake Sports with respect to the mortgage and promissory note was important to and used in the appellant’s restaurant (i.e. its active business); and the evidence indicates that this submission is true.

The truth of that statement does not assist the appellant, however, because the mortgage and promissory note, regarded as property, were not incident to and did not pertain to the appellant's restaurant business. The mortgage and promissory note were no more connected with the restaurant than any other income-producing investment which the appellant might have purchased with redundant capital if it thereafter used the income from such investment to support the operation of the restaurant.

The fact that a corporation, carrying on an active business and holding certain property (i.e. investments) unrelated to the business, uses the income from the property in connection with the operation of the active business does not mean that the property is “incident to or pertains to" the active business.

In my opinion, the interest which the appellant received from Silver Lake Sports with respect to the mortgage and promissory note was income from property within the meaning of subparagraph 129(4)(a)(ii) of the Act and it was not income from an active business. The appeal herein is dismissed

Appeal dismissed.