McHale v. MNR, 92 DTC 1781, [1992] 2 CTC 2105 (TCC)

Mogan, T.C.C.J.:—At all material times, the appellant was a substantial shareholder of Allcom Data Ltd. (referred to herein as "ADL") a Canadian- controlled private corporation as defined in the Income Tax Act, R.S.C. 1952,

c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). On April 22, 1981, the appellant delivered his personal guarantee to The Royal Bank of Canada with respect to a loan of $250,000 to ADL. Again on March 9, 1982, the appellant delivered another personal guarantee to The Royal Bank of Canada with respect to a loan of $380,000 to ADL. In the latter part of 1983, ADL became insolvent and by letter dated October 20, 1983, the Bank demanded payment of $581,004.29 from the appellant with respect to his two guarantees. The appellant did not pay any amount to the Bank in 1983 in connection with his guarantees but, when filing his 1983 income tax return, he claimed the amount of $290,502 (being one-half of $581,004) as an “allowable business investment loss” in accordance with paragraphs 38(c) and 39(1)(c) of the Act. The issue in this appeal is whether the appellant had sustained a "business investment loss" in 1983 within the meaning of paragraph 39(1)(c).

Prior to the insolvency, the appellant was a full-time employee of ADL; it was his everyday job. After issuing its letter of demand, the Bank did not press the appellant for immediate payment because there was one major asset in ADL which could be sold. That asset was sold in 1985 and the Bank received approximately $100,000 but, when the purchasers went bankrupt and defaulted on subsequent payments, the asset was repossessed by ADL. A subsequent sale of the same asset by ADL was for a royalty based on world sales but the Bank would not wait any longer for possible royalty payments and pressed the appellant for payment as guarantor.

In 1987, the appellant made a new agreement with the Bank under which (i) the appellant was to pay $15,000 to the Bank on or before September 30, 1987;

(ii) the appellant was to pay a further $25,000 to the Bank over five years as part of a fresh loan; and (iii) the Bank would release the appellant from any further liability on his guarantees if the $40,000 aggregate amount was paid within the specified time. Under this new agreement, the appellant paid $19,000 to the Bank in 1987.

By notice of reassessment dated June 29, 1989, the respondent disallowed the deduction of any "allowable business investment loss” for 1983 on the basis that no part of the $581,004.29 was paid to the Bank in 1983 by the appellant as guarantor of ADL's loans. Also, no amounts were paid to the Bank in 1984, 1985 or 1986 by the appellant as guarantor.

The only provision of the Income Tax Act which I have to construe is subparagraph 39(1)(c)(iv) which states (omitting words which are not relevant to this appeal):

39(1) For the purposes of this Act,

(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) . . . of any property that is

(iv) a debt owing to the taxpayer by a Canadian-controlled private corporation . . . exceeds the aggregate of

The appellant's argument may be summarized as follows. ADL was indebted to the appellant in 1983 for the amount he was required to pay to the Bank as guarantor. The debt owing to the appellant by ADL became a bad debt in 1983. The appellant is deemed to have disposed of the debt in 1983 pursuant to subsection 50(1) of the Act. The appellant is on the accrual basis of accounting and may therefore accrue in 1983 the full amount of his liability to the Bank under his two guarantees and the amount receivable from ADL. And finally, when the appellant is released by the Bank after paying the lesser amounts set out in the new agreement of 1987, he would be required to bring back into income any part of the aggregate amount ($581,004.29) which he did not in fact pay to the Bank. The respondent simply argues that there was no debt owing by ADL to the appellant in 1983 because the appellant as guarantor did not make any payment to the Bank in 1983; and if there was no debt owing by ADL to the appellant in 1983, there could be no disposition (deemed or otherwise) of a non-existing debt.

In my view, the issue in this appeal is decided on principles of commercial law which have been established independent of the Income Tax Act. I will consider a hypothetical situation in which a creditor (C) loans money to a principal debtor (D) on condition that a guarantor (G) delivers a guarantee to C with respect to C's loan to D. Assume that the guarantee is delivered; that the loan is made; that D becomes insolvent when there is a substantial amount owing on the loan; that C makes a demand on G to honour the guarantee and to pay the balance of the loan; and that one year after C's demand, G pays the balance owing on the loan. When, if ever, is there a debt owing by D to G? The answer to this question should determine when, if ever, there was a debt owing by ADL to the appellant within the meaning of subparagraph 39(1)(c)(iv) of the Income Tax Act.

The nature of a guarantor's right against the principal debtor is described in The Canadian Encyclopedic Digest (Ontario), (3rd ed.) at pages 69-154 and 69-155:

The basic right of the surety against the principal is a right to be indemnified in respect of the amounts that he has paid by reason of the guarantee of obligation. The liability of the principal to indemnity the surety is not restricted to the extent of the surety's ability to pay the guaranteed debt; it is the liability to which the surety is exposed that is relevant. The principal is under an obligation to save the surety harmless from any prejudice which arises from the non-performance of the guaranteed obligation.

A surety who makes a payment under a guarantee has a right of action against the principal debtor to recover the amount of that payment. This right is an independent right to the surety. It is not, strictly speaking, a right acquired by way of subrogation to the rights of the creditor. The primary distinction between subrogation and the rights of the surety is largely, although not wholly, procedural; the surety is entitled to sue the principal in his own name, whereas a person whose rights arise by subrogation may not; the surety has certain equitable rights prior to payment, whereas subrogation arises only upon payment.

Although the liability of the guarantor to the creditor arises at the time of the principal debtor's default in the performance of the guaranteed obligation, this is not the time at which a debt is created between the guarantor and the principal debtor. At common law, the guarantor's right to an indemnity from the principal debtor did not arise until the guarantor actually made a payment to the creditor. See In Re a Debtor, [1937] 1 Ch. 156 in which Slesser, L.J. made the following statements at page 160:

There is no doubt that a surety paying a debt is entitled to recover against the principal, as for money paid to his use: Morrice v. Redwyn ; Woffington v. Sparks; in the words of Cozens-Hardy, M.R., In Re Richardson, "It is settled at common law that, given a contract of indemnity, no action could be maintained until actual loss had been incurred. The common law view was first pay and then come to the Court under your agreement to indemnify”. This is the basis of an implied promise to pay.

Parker, J. in Re Mitchell speaks to the same effect when he says: "Until the surety is called upon to pay and does pay something under his guarantee, there is no debt or right at law at all; until then a surety's right is continued to a right to come into equity in order to get an indemnity against his liability to the creditor”. But though no question arises that there is no enforceable debt at law which can be enforced by the surety until the surety, being liable and obliged to pay, does pay the creditor (an event which here happened after the passing of the 1935 Act), it by no means follows that the obligation ofthe principal does not in appropriate circumstances arise by an implied agreement at the time of the giving of the guarantee that the principal, if and when the guarantor is called upon to pay, will indemnify the guarantor, though the event which gives rise to the enforceability of the promise falls later.

It was recognized in Jamieson v. Trustees of the Property of Hotel Renfew, [1941] 4 D.L.R. 470 that the amount which the guarantor may recover from the principal debtor is limited to the amount the guarantor actually paid to the creditor pursuant to the guarantee. Roach, J. stated at page 479:

The right of a surety against a principal is a right to indemnify only, and if he gets rid of the debt at less than its full amount he does not become a creditor of the debtor for more than he has actually paid.

If the amount which the guarantor may recover from the principal debtor is limited to the amount actually paid by the guarantor, it follows that the guarantor's rights against the principal debtor cannot be determined until after the guarantor has actually paid some amount to the creditor. In the hypothetical situation which I set out above, there would be no debt owing by D to G until after G had paid an amount to C in accordance with G's guarantee. By similar reasoning, there was no debt owing by ADL to the appellant in 1983 or, indeed until 1987 when the appellant made his first payment to The Royal Bank of Canada in accordance with the appellant's guarantees.

Having regard to the fact that the appellant was not in the business of lending money or guaranteeing loans, there was no business in which he could be regarded as having elected the accrual method of accounting. And even if he could have elected the accrual method, there was no debt owing to him by ADL in 1983 arising from his guarantees which could be accrued and then used to sustain a capital loss for the purposes of paragraph 39(1)(c). The loss which the appellant claimed in 1983 was carried back to 1982 and carried forward to 1984 and 1985; and all four years are under appeal. The appeals are dismissed.

Appeals dismissed.