Johnston v. R., [1996] 1 CTC 2001, 96 DTC 1888

Beaubier J.T.C.C.:-These matters were heard together on common evidence pursuant to the General Procedure of this Court at Victoria, British Columbia on September 19, 1995. At the opening of the hearing the appeal of Wescan Hotel Corporation Ltd. was withdrawn, without costs, by consent. The appellants testified and called Gordon Joyce, C.A., as a witness.

The appellants each claimed allowable business investment losses in 1989 and 1990 which were disallowed. Mr. Johnston also claimed carry backs and carry forwards for 1987, 1988 and 1991 and Mrs. Johnston also claimed carry backs to 1987 and 1988 resulting from their 1989 and 1990 losses. All of these were also disallowed. They appealed. In their appeals the appellants claimed that the losses for both 1989 and 1990 were either business losses or allowable business investment losses.

Mr. Johnston and Mrs. Johnston were born in Saskatchewan in the 1920’s. They resided there most of their lives and throughout the period in question. Mr. Johnston is a professional engineer. Mrs. Johnston described herself as a housewife. They have been married a long time. Mr. Johnston has been very active in business and engineering. Mrs. Johnston is an intelligent and astute lady who was involved in the transactions in question because, as she said, she was in business with her husband. In their views and in the Court’s view, their transactions and intentions were identical.

Exhibit A-1 is a chart showing the bare structure of what follows. It reads:

[Not reproduced. I

Deloyd Management Ltd. (“DML”) was formed by the appellants in 1978 to do investments in the United States of America because of U.S. tax laws. It immediately became a shareholder in Viking Lumber Ltd. (“Viking”) which operated a lumber business in Regina, Saskatchewan. In 1986 the Johnstons’ holdings were restructured and thereafter V.L. Properties Ltd. (“VLP”) only owned rental properties. At the year end of either 1987 or 1989 Viking’s lumber business was concluded.

In 1982 Deloyd Management U.S. Ltd. (DMUSL) was formed as a wholly owned subsidiary of DML. DMUSL owned four properties in the United States. By 1984 DMUSL had only one of these properties left. DMUSL was formed for the purpose of entering into the 44th Street Partnership (“44th”) in Phoenix, Arizona, U.S.A. 44th’s purpose was to acquire all of the lots in an area of 12 acres, tear down the buildings on them and to rezone the properties for mixed commercial and residential uses of various densities. It was stated that thereafter it was to sell the land to developers. Mr. Johnston testified that he saw this as a final transaction upon which he and Mrs. Johnston could retire.

By 1987 44th had purchased all except two of the properties in the 12 acres. Other partnerships were purchasing properties in another 13 acre development. The partnerships all agreed to amalgamate. In 1987 they formed Camelhead Equities Limited Partnership (“Camelhead”). All of the members of the various partnerships joined. DMUSL became a limited partner of Camelhead which then became DMUSL’s only investment. In order to finance the development of the property, which Mr. Joyce stated was then valued at $18,000,000 to $20,000,000 (U.S.), Camelhead borrowed $13,000,000 (U.S.) from Lincoln Savings and Loan Association (“Lincoln”). Mr. Joyce testified that when Camelhead was formed, the partners’ total equity was about $4,000,000 and the borrowed money in the property was $8,000,000 to $9,000,000. The rest of the $13,000,000 was spent on interest or development work. In his opinion the equity was 25 per cent at that time and the rest was borrowed.

Each of the limited partners was required by Lincoln to guarantee 20 per cent of the $13,000,000 (U.S.) loan plus, as it turned out in subsequent litigation, all of the additional interest and costs related to the loan. The Canadian limited partners in Camelhead were all corporations. However, Lincoln would not accept these corporations’ guarantees. The U.S. limited partners were all individuals. All of the guarantees had to be signed by individuals. Mr. Johnston testified that in 1987 he and Mrs. Johnston jointly signed these guarantees, an alleged draft form of which was filed in evidence as Exhibit A-9. All of the $13,000,000 was drawn down by Camelhead. In about February 1989, Resolution Trust Corporation (“Resolution”) was appointed as receiver of Lincoln. The $13,000,000 loan matured on May 1, 1989.

On October 27, 1989 the general partner of Camelhead wrote to “Mr. & Mrs. Lloyd Johnston Deloyd Management U.S. Ltd.” in Regina for an additional assessment of $135,869 as a share of $1,000,000 assessed, to be due December 1, 1989 (Exhibit R-5). This assessment was not paid. On March 21, 1990 the solicitors for Resolution demanded payment of the $13,000,000, interest and costs from Camelhead (Exhibit R-6). It was not paid.

Mr. Johnston testified that by this time any hope for a profit was gone. However, he stated, the rezoning applications continued in an effort to alleviate the losses on the guarantees which would arise when the property was to be sold by Resolution. He stated that for this purpose the Johnstons sent $50,000 to U.S. attorneys in trust on about May 4, 1990 (Exhibit A-7). This is the only money that they personally paid on account of these transactions.

Until December 1989, money was forwarded to the U.S.A. by the Royal Bank of Canada from DML’s U.S. borrowing account. The testimony is that these funds were forwarded without any separate written agreements in accordance with a practice that had been agreed upon for the U.S. investments over the years.

On September 16, 1990 the Johnstons sold all of their shares in DML to Pakit Holdings Ltd. (“Pakit”), a corporation wholly owned by their

daughters (Exhibit A-2). They transferred the following:

Mr. Joyce testified that the Johnstons felt at that time that a “freeze” was appropriate to protect their assets from Lincoln. In their view at the time DML’s only assets were its investments in Viking and VLP which were estimated to be worth a total of $200,000 net. He stated that they failed to consider that DML owed approximately $400,000 to the Royal Bank of Canada. He stated that when they realized this in June of 1992, they rescinded the September 16, 1990 agreement on the basis of mistake of fact. In this “rescission”, the shares were left transferred but the agreement to transfer the loan was “rescinded”. No documents respecting the alleged rescission were exhibited.

In October 1990 the Camelhead property was transferred to Resolution. Resolution put it up for sale and purchased it at the sale. The general partner of Camelhead went bankrupt.

On June 30, 1991 DMUSL executed Exhibit A-5 which reads:

PROMISSORY NOTE PREAMBLE

WHEREAS DELOYD MANAGEMENT US. LTD., is a wholly owned subsidiary of DELOYD MANAGEMENT LTD.,

AND WHEREAS DELOYD MANAGEMENT U.S. LTD., is engaged in certain speculative real estate investments in the United States.

AND WHEREAS DELOYD MANAGEMENT US. LTD., is funded by way of loans provided from time to time, as required, by DELOYD MANAGEMENT LTD.

WHEREAS the loans provided by DELOYD MANAGEMENT LTD., to DELOYD MANAGEMENT U.S. LTD., bear interest at the same rate that DELOYD MANAGEMENT LTD., is charged by the Royal Bank of Canada.

AND WHEREAS DELOYD MANAGEMENT LTD., is funded by loans from shareholders and/or by loans from affiliate Canadian Companies, and/or by loans from the Royal Bank of Canada. Then DELOYD MANAGEMENT LTD., hereby acknowledges and agrees, loans that are provided to DELOYD MANAGEMENT U.S. LTD., by any or all of the aforementioned lenders, shall be deemed to have been first loaned to DELOYD MANAGEMENT LTD., and subsequently loaned to DELOYD MANAGEMENT U.S. LTD.

THE ABOVE UNDERSTANDINGS and AGREEMENTS shall hold true and shall be applicable whether or not the funds loaned by the lenders to DELOYD MANAGEMENT U.S. LTD., flow through the bank accounts of DELOYD MANAGEMENT LTD., or are transferred directly to DELOYD MANAGEMENT U.S. LTD., or in fact directly to Limited Partnerships of which DELOYD MANAGEMENT U.S. LTD., is a Registered Limited Partner.

Dated at the City of Regina, in the Province of Saskatchewan this thirtieth day of June, A.D. 1991.

PROMISSORY NOTE NOTE

Now therefore, in honour of all funds loaned by DELOYD MANAGEMENT LTD., to DELOYD MANAGEMENT U.S. LTD.

For value received, DELOYD MANAGEMENT U.S. LTD., as maker, promises to pay DELOYD MANAGEMENT LTD., $399,172.00 Dollars principle and with $325,000.00 Dollars interest, all in U.S. funds, by payments of such amounts and at such times as is authorized by a Resolution of the Board of Directors of DELOYD MANAGEMENT LTD., duly confirmed by a Resolution of the shareholders of DELOYD MANAGEMENT LTD., and new promissory notes shall be executed annually to reflect any change in terms, conditions or amounts that have occurred during the fiscal year.

Dated at the City of Regina, in the Province of Saskatchewan, this thirtieth day of June, A.D. 1991.

DELOYD MANAGEMENT U.S. LTD.

The appellants claimed allowable business investment losses in 1989 and 1990 as follows:

Lloyd: $83,760.33 (1989); $182,241 (1990)

Delia: $24,890.49 (1989); $145,146 (1990)

The 1989 claims were disallowed on the basis that DML, DMUSL and Camelhead were active throughout the year and the debt was not wholly bad. The 1990 claims were disallowed on the basis that the appellants did not adjust the claims for the assignments to Pakit.

The appellants base the business losses claimed in the appeals on the premise that the two corporate bodies, DML and DMUSL can be looked through and that the Camelhead partnership was an adventure in the nature of trade. As a result, the business losses simply flow through to the appellants. The appellants’ counsel argued that Fraser v. Minister of National Revenue, [1964] S.C.R. 657, [1964] C.T.C. 372, 64 D.T.C. 5224, and the cases flowing from that indicate that the appellants are entitled to make that argument. In Fraser two promoters incorporated corporations which owned land. They then sold the corporate shares rather than the land. This was found to make no difference. It was merely a profit in the ordinary course of business. The respondent’s counsel pointed out that if Camelhead had been successful the Camelhead property could have been sold, or DMUSL could have been sold in its entirety along with all the other partnership interests, or DMUSL could have been sold by itself, or DMUSL could have been wound up, or it could have paid back loans, or salaries, or bonuses or dividends. Now that Camelhead has failed, the appellants want to act as if the elaborate legal structures did not exist.

The appellants owned DML. DML’s nominal interests in Viking and VLP were in the $500,000 range; these were acknowledged to have a. value of $200,000 at the time of the Pakit assignment. This is compared to an acknowledged nil value of DMUSL. DMUSL originally owned four properties. There is no evidence as to whether the value of the three properties disposed of was flowed through to the Johnstons or how they were dealt with. The Court was not told about what happened to the fourth property. Nor is there any evidence except Mr. Johnston’s testimony respecting the Camelhead limited partnership whether by way of the partnership agreement, other documents or another partner’s testimony.

DML was created for tax purposes. Both DML and DMUSL were used in various ways. Exhibit A-5, the Promissory Note, was executed by DMUSL after the event. The alleged rescission of the Pakit deal was not carried out entirely but only to the extent that was convenient for the appellants. All of these things are like the present allegations of a flow- through business loss. They are allegations made afterwards to serve the current purposes of the appellants.

There is no evidence that the appellants received any fee for making the guarantees. They were not lending money themselves or in the business of lending the money in question. There is no direct connection between their income and the loans. Nor did the appellants own the shares of any of the borrowers as an adventure in the nature of trade rather than a capital investment.

The appellants had elaborate purposes and elaborate legal mechanisms to realize their purposes. All of them were designed to keep the appellants out of business. None of them anticipated the losses which occurred. But if their purposes had proved out, the mechanisms would have offered a variety of opportunities for tax relief and tax planning. None of them permitted the appellants to be in business. There is no accepted evidence that the appellants were in business. The losses are not business losses of the appellants.

The respondent’s pleadings confine the denial of the 1989 claims for an allowable business investment loss to the question of whether the debts claimed were bad debts in 1989. In particular, Camelhead’s general partner issued an assessment for $1,000,000 (U.S.) on October 27, 1989 (Exhibit R-5) which, in the respondent’s view, indicated viability in October 1989. By way of contrast to this, Lincoln was in receivership in about February 1989 and the loan was due on May 1, 1989. The receivership occurred for the purpose of liquidating the assets and winding up Lincoln. Thus, in the Court’s view, once the receivership occurred there was no doubt that the loan would be called as soon as the receiver got around to it. Camelhead was behind its schedule in May of 1989. Because the loan was that of a lender in receivership, it appears to the Court that another lender was not going to step into Lincoln’s position on a project that was behind schedule. In addition Mr. Johnston testified that it was then obvious that the Phoenix market was flooded with similar projects and that Camelhead was at the back of the line in a bad market. In these circumstances, the general partner’s assessment of October 27, 1989 appears to the Court to be an effort to collect some income or fees for himself.

The appellants described part of the debts owed to them as bad debts in 1989. This partial write-off in 1989 is verified by the events described in the preceding paragraph. The partial write-off in 1989 also indicates that the appellants retained an expectation in 1989 that the remaining part might be recovered. The fact that they sent $50,000 to the United States on May 4, 1990 and that they did not complete the assignment to Pakit until September 16, 1990 confirms that they still entertained expectations in 1989 respecting some of the outstanding money. The appeal of Lloyd Johnston is allowed to permit him to deduct an allowable business investment loss in 1989 of the amount claimed, namely $83,760.33. The appeal of Delia Johnston is allowed to permit her to deduct an allowable business loss in 1989 of the amount claimed, namely $24,890.49. These are the only amounts established in the hearing of these matters set for that purpose. These matters are referred to the Minister of National Revenue for reconsideration and reassessment accordingly. The appellants’ appeals for the remaining years before the Court are also referred to the Minister of National Revenue for reconsideration and reassessment respecting any loss carry forwards or carry backs which may arise out of the appellants’ appeals which are allowed for 1989.

The 1990 disallowance was based on the failure by the appellant to adjust the amounts to allow for the assignment to Pakit. That assignment does not contain an indemnification respecting money owed by DML to the Royal Bank of Canada. Nor is there any evidence that DML agreed to pay a fee to the appellants respecting their guarantees to the Royal Bank of Canada. There is no acceptable evidence that the Royal Bank of Canada loans were first loaned to the appellants and then to DML. In particular, Exhibit A-5 is rejected as being self-serving, after the fact and, further, not reflective of the facts at the times the monies themselves were advanced. No rescission agreement respecting the Pakit assignment was filed in evidence and the appellants still own the preferred shares they received for the transfer of the loans described in the Pakit agreement. It is also noteworthy that the appellants personally signed the assignments and that DML and Pakit’s signatories were, in each case, the two appellants. Therefore, the Court finds that the Pakit assignment was not rescinded. In these circumstances, the basis of the Minister of National Revenue’s disallowance of the appellants’ claims to allowable business investment losses in 1990 was correct. The appeals respecting 1990 are dismissed. The appellant’s lost their claims for business losses. However, the success respecting their appeals of the reassessments themselves was evenly divided. In these circumstances there is no order respecting costs.

Appeals allowed in part.