Brown v. R., [1996] 1 CTC 276

Rouleau J.: — This is an appeal from the decision of the Tax Court of Canada dated June 18, 1991, wherein it was held that subparagraph 40(2)(g)(ii) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the “Act”), applied to the plaintiffs 1986 taxation year.

The parties rely on the following Agreed Statement of Facts:

1. The appellant was an officer and a one-third owner of the shares of both Medway International Tractor Inc. (Medway) and 447579 Ontario Limited (the real estate company). The shareholding was the same for both companies.

2. Medway was a farm equipment dealership and the real estate company was to hold land and build a building on the land for Medway. The building and land were to be leased to Medway.

3. The farm equipment dealership (Medway) was acquired in 1979. The International Harvester Co. who controlled the terms and conditions of the dealership as well as owning the land Medway operated on insisted that the dealership move to a location outside the City of London within one year. The move was required to make the dealership more accessible to the customers. The old site was within the City of London and not accessible to the farm clientele.

4. With the assistance of the International Harvester Co., land was located and an application for severance and rezoning was made on behalf of Medway. Medway acquired the land April 22, 1981.

5. The Bank of Montreal, as banker for Medway, did not wish to have anything to do with the farm dealership in relation to the land acquisition; as a result the real estate company was incorporated in 1980. The real estate company was to hold the land, build the building and lease both back to Medway. The Royal Bank, as banker for the real estate company, insisted that the Appellant and the other shareholders of the real estate company personally guarantee the monies borrowed ($50,000). The land was conveyed May 15, 1981 from Medway to the real estate company.

6. The two companies had an agreement (March 2, 1981) between them to the effect that Medway was to pay the down payment and pay all costs in acquiring, rezoning and holding the lands. The term of the agreement was five years. The intention was that the real estate company would make a profit through the advances made by Medway as well as the reduction of principal through the mortgage and the rents paid to the real estate company by Medway. Plans were made for the building but the economic conditions and the zoning delays did not allow the project to proceed.

7. As a result of high interest rates in 1980 and 1981 and a general business decline in the farm implement industry, in the fall of 1981 Medway went into receivership and the shareholders, including the appellant, enabled the real estate company to the pay the interest on the bank loan.

8. The shareholders loaned money without interest to the real estate company and the real estate company paid the interest payments on the debt to the bank from these monies.

9. No building took place on the property either before or after Medway was placed into receivership. Medway never occupied nor used the land.

10. The real estate company disposed of the lands in 1986. Thereafter, the company was without assets and the real estate company was sold. The taxpayer received $150 for his shareholdings. By way of shareholder loans to the real estate company, the appellant loaned the corporation $20,821 (the loans were without any interest rate).

11. The appellant, throughout his testimony before the Tax Court of Canada, emphasized that the intention from the beginning was to establish a viable commercial activity that would serve the interests of Medway.

In computing his income for the 1986 taxation year, the plaintiff sought to deduct the amount of $10,410.50 from his income as an allowable business investment loss. By Notice of Assessment dated August 26, 1987, the Minister of National Revenue disallowed the deduction on the grounds that the loss claimed by the plaintiff was not in respect of the disposition of a debt or other right to receive an amount that was acquired for the purpose of gaining or producing income from a business or property, within the meaning of subparagraph 40(2)(g)(ii) of the Income Tax Act.

The plaintiff appealed to the Tax Court of Canada which by decision dated June 18, 1991, dismissed the appeal for the following reasons:

After Medway was placed into receivership, the monies advanced to the real estate company were not advanced “to enable the corporation to operate as intended”. The loans were not advanced to earn income from property. The loans were made pursuant to the personal guarantees. The only activity of the real estate company was, after several years, to sell the static asset i.e. the land. The loans were not made “to earn income from property, that is, to place the corporation in a position where it will be successful and pay dividends”.

When Medway went into receivership, the real estate company lost its reason for being an active business. The real estate company at that point did not have a source of income and the assets of the real estate company were not used in an active business. There was no viable consideration for the acquisition of the debt as there was no expectation of gaining or producing income within the real estate company. The monies were advanced so that the personal guarantee of the Appellant would be met. As a result, the Appellant did not have a capital loss within the meaning of the Act and as a consequence did not have a business investment loss within the meaning of the Act.

The plaintiff now appeals from that decision on the grounds that the land was purchased and a building was to be constructed for the sole purpose and use by Medway, which would have paid sufficient rent to the real estate company, not only to cover all costs, but to earn a profit for the company as well. The plaintiff submits that the objective of both companies was the gaining of business income and accordingly, the sole purpose of the debt which he acquired as a result of his personal guarantee on the loans made to the real estate company, was to produce income from a business.

The defendant maintains that the business investment loss claimed by the plaintiff as a deduction was not in respect of the disposition of a debt that was acquired for the purpose of gaining or producing income from a business or property. It is submitted that none of the assets of the real estate company were ever used in a business activity and the company never had any source of income. Therefore, it is argued, subparagraph 40(2)(g)(ii) of the Income Tax Act applies so as to preclude a business investment loss as a deduction from income.

The relevant legislative provisions for the purpose of this appeal are sections 38, 39 and subparagraph 40(2)(g)(ii) of the Income Tax Act.

Section 38 of the Act provides rules for determining the portion of capital gains and losses which are included in computing a taxpayer’s income, while section 39 deals with a taxpayer’s business investment losses. A business investment loss is defined as a capital loss realized in certain circumstances on the shares or debt of a small business corporation. However, pursuant to subparagraph 40(2)(g)(ii), a taxpayer is not permitted to deduct a capital loss in respect of the disposition of a debt or other right to receive an amount, unless the debt was acquired for the purpose of gaining or producing income from a business or property or was acquired as consideration for the disposition of capital property in an arm’s length transaction. Any other loss arising from the disposition of a debt is considered to be nil. Subparagraph 40(2)(g)(ii) reads as follows:

40(2) Notwithstanding subsection (1)

(g) a taxpayer’s loss, if any, from the disposition of a property, to the extent that it is

(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length,

is nil.

The issue here quite simply is whether the debt acquired by the plaintiff for the loan made to the real estate company, was “for the purpose of gaining or producing income from a business or property”within the meaning of subparagraph 40(2)(g)(ii).

In Business Art Inc. v. Minister of National Revenue, [1987] 1 C.T.C. 2001, 86 D.T.C. 1842 (T.C.C.), the taxpayer corporation, originally in the business of franchising restaurants, commenced a business of franchising retail outlets to sell artwork. The source of supplies for these outlets was to be the United Kingdom and a new company was incorporated there for that purpose. The taxpayer, a shareholder of the British company, made loans to the company, which eventually went into bankruptcy and failed to repay the loans. Thereafter, the taxpayer deducted its losses from income but the Minister refused the deductions on the basis that the amounts were not expenses made or incurred for the purpose of gaining or producing income from the business of the taxpayer corporation.

The taxpayer appealed to the Tax Court of Canada which allowed the appeal in part, stating its reasons as follows at page 2009 (D.T.C. 1848):

It is not uncommon for a shareholder to lend money without interest and without security to the corporation since he anticipates that the loans will assist the corporation to earn income and to pay him income by way of dividends; the loan is made for the purpose of earning income from a property. Although the shareholder is a creditor of the corporation when he advances money to the corporation the shareholder does not see his advance of money to the corporation and his subscription for shares of the corporation as separate investments in two watertight compartments; rather he sees his money entering two compartments which open up into a single compartment for the use of the corporation. Purchasing shares and advancing money to a corporation are two ways of making an investment in the corporation. This is a sensible interpretation.

Similarly a shareholder of a corporation who may have incorporated a corporation for the purpose of acquiring product at a low cost and so reduce its Own costs may advance money without interest to the corporation to enable the corporation to operate as intended; in this example even if the shareholder is not making loans for the purpose of producing income from its business, by having reduced costs, the loan is being made to earn income from property, that is, to receive dividends on the shares it owns in the corporation. It is not unusual for a person to invest in a corporation by subscribing for share capital and lending money without interest; as far as he is concerned the shares and his loans constitute a single investment and if later on, he is called on to advance further funds without interest he is only increasing his investment. I cannot subscribe to the theory that in such an example the non-interest bearing loans were not incurred for the purpose of earning income from property; if the loans were not advanced the corporation may have become bankrupt and the shares may have become worthless. Clearly the loans were made to earn income from property, that is, to place the corporation in a position where it will be successful and pay dividends.

[Emphasis added.]

That reasoning has also been followed in National Developments Ltd. v. R. (sub nom. National Developments Ltd. v. Canada), 94 D.T.C. 1061 (T.C.C.) and Byram v. R. (sub nom. Byram v. Canada), [1995] 1 C.T.C. 66, (1994), 95 D.T.C. 5069 (F.C.T.D.) and in my view, it is entirely applicable to the case at bar.

Given the clear and indisputable facts here, the defendant’s position is not tenable. There is no question that the purpose of Medway and its associated real estate company was the gaining and producing of active business income. When the property on which the dealership was to be located had been found, Medway’s bank refused to get involved in further financing in relation to the acquisition of the land. It was for that reason that the real estate company was formed. As part of the terms of the agreement between Medway and the real estate company, Medway was to make all the payments on any mortgage placed on the property, including any new mortgage when building commenced. It was expected that the holding company would make a profit through the original advances made by Medway, as well as the reduction in the principal through the mortgage payments, until the principal had been fully paid off. Thereafter the company would make rental income.

There is no question therefore that the monies advanced by the plaintiff to 447579 Ontario Limited, in order to make interest payments on the loan from the bank, were for the purpose of producing income. As a shareholder of the real estate company, 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. The fact that the taxpayer’s objective were not met due to economic conditions does not in any way alter this conclusion.

The plaintiff’s appeal is therefore allowed. The Notice of Assessment dated August 26, 1987, is set aside and the matter is remitted back to the Minister of National Revenue for reassessment in accordance with these reasons. Costs to the plaintiff.

Appeal allowed.