McDonald v. R., [1996] 1 CTC 2585, 98 DTC 2223

P.R. Dussault J.T.C.C.: — This is an appeal of an assessment for the appellant’s 1989 taxation year whereby the Minister of National Revenue (the “Minister”) refused the deduction of an amount of $52,387 being the balance carried forward in that year of an allowable business investment loss which the appellant claimed in 1988. The Minister treated two-thirds of the loss of $226,000 as a net capital loss of the appellant for that year.

Counsel for the parties filed a Partial Agreed Statement of Facts which reads as follows:

1. In computing his income for the 1989 taxation year the Appellant sought to deduct a non-capital loss in the amount of $52,387.00.

2. At all material times Bernard Audia was the shareholder of two related corporations Parkplace Lodge Ltd. and Olde Elevator Steak House Ltd. (“the companies”) which were Canadian Controlled Private Corporations(“CCPC’s”).

3. Bernard Audia is the brother in law of the appellant and Marcelle Audia is the sister of the Appellant.

4. Bernard and Marcelle Audia provided personal guarantees and security to the Bank of Montreal in respect of the indebtedness of the two CCPC’s to that bank.

5. On or about August 1988 the CCPC [sic] were in default with respect to their indebtedness to the Bank of Montreal.

6. On or about August 22, 1988 the Appellant borrowed an aggregate amount of $225,000 from various sources.

7. On August 22, 1988 the Appellant, through the Audias’ lawyer, paid the $225,000 to the Bank of Montreal.

8. The amount of $225,000 was paid to the Bank of Montreal in complete satisfaction of all of the guarantees of Bernard and Marcelle Audia of the indebtedness of the companies and reduced the indebtedness of the CCPC [sic].

9. On October 14, 1988, the Supreme Court of British Columbia issued an order placing the companies in receivership.

10. On or about December 22, 1988, the Appellant received a promissory note from Bernard and Marcelle Audia for the principal amount of $226,000 and an interest rate of prime plus 1.5 per cent. [1]

11. The Appellant paid the Bank of Montreal the $225,000 with the view to discharging the obligations of Bernard and Marcelle Audia and with the view to facilitating the acquisition of the assets of Parkplace Lodge Ltd. and Olde Elevator Steak House Ltd.

12. In computing his income for the 1988 taxation year, the Appellant treated the $226,000 as a business investment loss with the result that he would be entitled to an allowable business investment loss of $150,667.

13. In computing his income for the 1988 taxation year, he sought to deduct a portion of an allowable business investment loss and in computing his income for the 1989 taxation year, he sought to deduct the remaining amount as a non-capital loss carried forward from 1988.

The appellant’s position is that the payment to the Bank of Montreal (the “bank”) in the amount of $226,000 on August 22, 1988, resulted in an indebtedness of the two companies to the appellant who had advanced the money, so that upon their subsequent insolvency the appellant sustained a business investment loss for that year as provided for in paragraph 39(1 )(c) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the “Act”).

The respondent’s position is that no such indebtedness resulted for the companies from the payment made to the bank. Rather, it is argued that the payment resulted in a personal debt for the appellant’s sister and brother- in-law, Marcelle and Bernard Audia, on whose behalf the payment was made and who were thus released from their personal guarantees for the two companies’ indebtedness to the bank. [2]

The appellant testified that in early 1988 he had been informed of the companies’ financial difficulties and had decided to get involved in helping his sister and brother-in-law, who were managing the companies’ businesses, to solve the problems associated with a very large debt of the two companies to the bank. The debt, in the order of $3,500,000, could not be serviced anymore due to insufficient cash flow and income.

The appellant testified that he had provided the funds for the $226,000 payment to the bank with a view to eventually being in a position to buy, along with his sister and brother-in-law, either the shares of the capital stock of the two companies held by third parties or the assets of said companies, following a restructuring of their indebtedness to the bank. However, the documents produced in evidence indicate that the payment was not made on behalf of the companies but rather on behalf of the appellant’s sister and brother-in-law who had personally guaranteed the companies’ indebtedness to the bank, and in order to settle the bank’s claim against them. Even if the appellant received two payments of interest, one in the amount of $2,550 in September 1988 and one of $1,000 in October 1988, by cheques drawn on the bank account of Parkplace Lodge Ltd. and The Olde Elevator Steak House Ltd. respectively, those cheques were prepared and signed by the companies’ bookkeeper on the sole instructions of Bernard Audia. As we shall see, there is simply no evidence that a loan was made by the appellant to the companies or that the companies became indebted to the appellant, by way of the transfer or assignment of their debt by the bank, in an amount equivalent to the payment made through the Audias’ lawyer.

It is obvious that by June 1988 the companies were in default on their payments to the bank and that demand letters requiring payment had been sent to the Audias pursuant to various guarantees. A lawyer named Daniel Fournier of the firm then known as Duncan Collins in Calgary had already been retained to negotiate a settlement with the bank. In turn, his firm contacted another law firm in Vancouver, Lawson, Lundel, Lawson & McIntosh (“Lawson & Ass.”) to handle the possible litigation between the Audias and the bank if need be. A letter sent by Mr. Michael

W. McCachen, student-at-law, from Mr. Fournier’s firm to Mr. Brad Armstrong of Lawson & Ass. in Vancouver, on June 30, 1988, copy of which was sent to the appellant, is most illustrative of what was really going on during the critical period preceding the payment of the $226,000 to the bank through the Audias’ lawyer . That letter, filed as exhibit A-l, reads as follows:

Further to your telephone conversation with Dan Fournier, the following is a summary of information relevant to the possible litigation between Mr. and Mrs. Audia and the Bank of Montreal. We act for Bernard and Marcelle Audia only, and not for either of the corporations involved (The Parkplace Lodge Ltd. and The Olde Elevator Steak House Ltd.), nor for any other of the involved parties. The bank has retained Sandy Shandro of Campney & Murphy.

If a decision is made to litigate the issues it will be framed as a defence to the bank’s claims under various guarantees. The guarantees involved are as follows:

1. Guarantee:

Dated June 29, 1981

Amount: $75,000

Guarantor: J. Audia & Son Ltd. (Bernard Audia)

2. Guarantee:

Dated July 3, 1981

Amount: $1,500,000

Guarantor: Bernard & Marcelle Audia

3. Guarantee:

Dated December 16, 1983

Amount: $200,000

Guarantor:Bernard Audia

4. Guarantee:

Dated June 29, 1981

Amount: $1,500,000

Guarantor:The Olde Elevator Steak House Ltd. (Bernard Audia)

5. Guarantee:

Dated February 23, 1984

Amount: $200,000

Guarantor: Bernard Audia

6. Guarantee: Dated July 3, 1981

Amount: $133,500

Guarantor:Allison Audia (Bernard’s mother)

The demand letters relating to the above guarantees all require payment “within thirty (30) days” from the date of those letters (June 9, 1988). Therefore, the time allotted expires, according to my calculation, on Saturday, July 9, 1988.

I enclose a copy of our response to the demand letters which questions the reasonableness of the notice period in keeping with the principles of Lister and Dunlop, and Mister Broadloom.

The following is a brief summary of the background to the Audia file. Bernard and Marcelle Audia manage both The Parkplace Lodge and The Olde Elevator Steak House, both located in Fernie, B.C.

The Audias, together with other shareholders friendly to the Audia’s position, control the two companies. The shareholdings of these two companies are identical and are as follows:

SHAREHOLDER/NUMBER OF SHARES

M & P Roofing Ltd.: 13

Boundary Electric: 42

G. Wolfe Enterprises: 6

Labey’s Mechanical Ltd.: 29

P & R Installations [sic] Ltd.: 10

Anthony S. Servello: 20

J.W. Fetzko: 5

John Valikoski: 5

J.S. Hampson: 20

J.B. Audia: 50

Because of less than optimal business conditions in Femie, the debt of Parkplace is not presently being serviced and the bank has, consequently, made demands on the listed guarantees. Concomitantly, negotiations are ongoing between the Audias and the bank with an eye to avoiding a receivership. The perception is that a receivership could well be detrimental to all parties because of the harm it might do to the businesses.

Broadly, what is contemplated by the negotiations with the bank is a purchase by a newly incorporated company (“Newco”) of the assets of Parkplace Lodge and Olde Elevator. The Audias and other guarantors would quitclaim property and cash to the bank to improve its position while “Newco” would provide security in the form of debentures, guarantees, assignment of book accounts, and mortgages. The overall effect would be to lighten the debt load on the business operations and simplify the corporate arrangement.

The situation is complicated somewhat by the existence of certain disaffected shareholders (Tony Servello and J. Valikoski). Mr. Servello is represented by Mr. Gord Leffler of Fernie and Mr. Valikoski is not, to our knowledge, represented by counsel.

I have enclosed the demand letters from the bank and copies of the accompanying guarantees as well as the various debenture instruments creating the indebtedness to the bank. Also enclosed is the Audias’ current offer of settlement with the bank which may prove informative.

Dan Fournier has discussed your possible involvement in this matter with Bernard Audia in the event the matter becomes litigious. Should it become necessary to retain you in this matter we will have Bernard Audia contact you directly so that necessary arrangements can be made for your fees. In the interim, please call if you require any further information or clarification on any point.

The documents referred to in this letter and more particularly “the Audias’ current offer of settlement with the bank” were not filed in evidence.

However, in a letter dated August 4, 1988, by Mr. Fournier, acting for the Audias, to Ms. Deborah D. Anderson of the Vancouver firm of Campney & Murphy, acting for the bank, the terms of the settlement reached some time earlier are described as follows:

We enclose the following:

(a) Releases of the Audias in favour of the Bank;

(b) Consents to Venue of Foreclosure Proceedings;

(c) Consents Order Nisi;

(d) Consents Order for Sale;

(e) Consents to Receivership by the Companies; and

(f) Releases of the Companies in favour of the Bank

(g) the appraisal is of Allison Audia’s residence; and

(h) Power of Attorney executed by Marcelle Audia (the “Documents”)

The Audias have agreed to pay to the Bank a total sum of $225,000 (the “Settlement Amount”) in complete satisfaction of all their guarantees of the indebtedness of the Companies to the Bank.

The Documents have been executed upon, and are delivered to you subject to the terms of settlement set out in your Mr. Shandro’s letter of July 27,

namely that:

(a) upon payment of the Settlement Amount by August 22, 1988, the Bank will discharge and return all guaranties and security given by the Audias in support of the indebtedness of the Companies to the Bank;

(b) upon payment of the Settlement Amount by August 22, 1988, the Bank will provide to the Audias a covenant not to sue in respect of any guarantee given by the Audias of the indebtedness of the Companies to the Bank;

(c) the Consents to Venue of Foreclosure Proceedings, the Consents Order Nisi, and the Consents Order for Sale executed by the Audias will not be used in any way whatsoever by the Bank unless the Settlement Amount is not paid in full by the Audias on or before August 22, 1988;

(d) the Bank agrees not to act on the Consents to Receivership executed by the Companies for a period of forty-five (45) days, commencing as of July 27, 1988, unless;

(i) the Audias cease to operate the businesses conducted by the Companies,

(ii) the Bank, in its sole discretion, perceives that its security is in a position of increased or increasing risk, or

(iii) any term of the settlement is breached;

We confirm that the Bank as of July 27 did not perceive that its security was in a position of increased or increasing risk;

(e) the Bank will not object to the Audias being employed by a receiver or receiver manager of the Companies should one be appointed, and if the Audias are so employed the Bank will not object to their being paid an aggregate sum of $5,000 per month as remuneration for their services; and

(f) the Bank has agreed not to sue the Audias for any deficiency which may arise in connection with foreclosure proceedings and documents referred to in paragraph (c) above.

We hope you will excuse the appearance of the documents executed by Allison Audia. Receipt of these documents was via unsupervised telecopier and they were, unfortunately, reproduced on the end of a paper roll resulting in the discoloration of those documents. We apologize for any inconvenience this may cause.

We trust the above and the enclosures are, in their substance, satisfactory. [3]

A subsequent memorandum, dated August 19, 1988, by Mr. Fournier to Mr. J. Rob Collins of his firm confirms the arrangements made with the bank. The pertinent parts read as follows:

I enclose a copy of my letter dated August 4, 1988 to Deborah Anderson of Campney & Murphy, solicitors for the Bank of Montreal. This letter confirms the arrangements made with the Bank at the time we delivered the various releases and consents as set forth in the opening paragraph of the letter.

If we are in the position to pay to the Bank the sum of $225,000 by Monday, August 22, two things are to happen: firstly, the Bank will discharge and return all guarantees and security given by the Audias (Bernard, Marcelle and Allison) in support of the indebtedness of Parkplace Lodge Ltd. and The Olde Elevator Steak House Ltd. and, secondly, the Bank will provide to the Audias a covenant not to sue in respect of any of the guarantees given by the Audias. The form of the covenant has already been agreed to. [4]

On August 22, 1988, in order to complete the transaction, Mr. Collins wrote to Mr. Martin Vandenham at the bank in the following terms:

Further to the telephone conversation between Ms. Anderson of Campney & Murphy and Dan Fournier of our office on August 19, 1988, I enclose our cheque in the sum of $225,000 in settlement of your claim against the Audia’s relating to the above corporation and the Olde Elevator Steak House Ltd.

By copy of this letter to Ms. Anderson, I am asking her to forward to me as quickly as possible the documents releasing the Audia’s from their obligations to the Bank in this matter.

Please acknowledge receipt of the above sum by signing and returning the extra copy of this letter enclosed for that purpose. [5]

Finally, in a letter dated August 29, 1988, Mr. Fournier confirms to the Audias, following their payment of $225,000, the undertaking by the bank not to take any action arising out of their guarantees, as follows:

I enclose the Covenant of the Bank of Montreal dated August 4, 1988. This Covenant arises out of your payment to the Bank of Montreal (the “Bank”) of $225,000 in return for which the Bank undertakes not to take any action against you arising out of your guarantees of the indebtedness of Parkplace Lodge Ltd. and The Olde Elevator Steak House Ltd. to the Bank.

You should keep this Covenant in a safe place for future reference. [6]

On September 5, 1988, the appellant wrote to his brother-in-law, Bernard Audia, giving details of what he referred to as “the recent loan” and as to how he expected to be reimbursed. From the arrangements described in the previous documents one can only conclude that the appellant advanced money to the Audias and not to the companies. It is clear that the purpose was to free them of their obligations under the various personal guarantees given to the bank for the companies’ indebtedness and to ensure that the bank would not take any further action against them. It is also clear that the companies were never parties to nor were they involved in any manner whatsoever in the arrangements between the appellant and the Audias and the settlement agreed upon between the Audias and the bank.

Following their settlement with the bank, the Audias kept running the businesses for a while. However, on October 14, 1988, a receiver-manager was appointed by the Supreme Court of British Columbia on application by the bank. Meanwhile, an offer by the Audias to purchase the shares of other shareholders did not materialize. A subsequent offer to buy the assets of the two companies while in receivership was also turned down by the receiver-manager who finally sold the assets to third parties in early 1989. The net proceeds were remitted to the sole secured creditor, the bank, and proved insufficient to cover all the companies’ debts. The two companies were dissolved in 1991 and 1992 respectively for failure to file pursuant to British Columbia corporate legislation.

The appellant, in his attempt to secure documentation in support of his claim of an allowable business investment loss for his 1988 taxation year was provided with the following promissory note from the Audias dated December 22, 1988:

FOR VALUABLE CONSIDERATION, Bernard and Marcelle Audia jointly and severally promise to pay, on demand, to or to the order of Cliff McDonald the sum of Two Hundred and Twenty Six Thousand Dollars ($226,000) (Canadian) with interest thereon at the Prime Rate plus One and One Half Percent (1«%).

Prime Rate means the prime lending rate of The Royal Bank of Canada announced from time to time as such to its Canadian borrowers of Canadian dollars.

Interest on this note will be calculated semi- annually and will accrue on the outstanding amount of principal outstanding from time to time beginning on the 22nd day of August, 1988 at the Prime Rate both before and after default and judgment.

Notwithstanding that demand under this note may be made at any time, the outstanding principal and accrued interest payable under this note will be due and payable on the second anniversary year from the date of this note.

Bernard and Marcelle Audia will have full prepayment privileges without notice or bonus.

At the request of Cliff McDonald, Bernard and Marcelle Audia will grant to Cliff McDonald such security interest over their assets, property and undertakings as may be requested to secure the amount of principal and interest outstanding under this note.

Bernard and Marcelle Audia waive presentment, notice of dishonour, protest and notice of protest of this note for themselves and all other parties from time to time liable hereon. [7]

Although the appellant stated that the note might have been executed later than December 22, 1988, a letter sent to him by the Audias on February 12th 1989 also refers to the “business loan” that he had provided in the following terms:

We were not successful in our attempt to reacquire the assets of Parkplace Lodge nor The Olde Elevator Steak House Ltd. The $226,000 cash you provided satisfied our bank position at the time (August 20, 1988) and allowed us to proceed with a business offering and avoid bankruptcy. The Bank of Montreal was the sole and entire recipient of these funds. In late October the operation was placed in receivership.

We have now been informed that our offer to the Receiver was not successful. As you know, the proposal to the Bank provided for repayment of the business loan you’ve provided over a 3 to 5 year period. We expected the operations to either generate the funds or would have looked to selling the business in this period. The fact that we are no longer owners of any part of this business mitigates repayment of your business loan in any fashion. This is extremely unfortunate and we regret any inconvenience this may cause you. [8]

Although that letter might not indicate as clearly as one would wish to whom the loan was provided, there is not a single document of any kind from the companies or the bank in support of the position that the loan was made to the companies or that their debt was transferred or assigned to the appellant. In fact, the promissory note merely confirms what is already apparent in the other documents referred to, namely that the payment to the bank was made by the Audias through their lawyer with funds borrowed from the appellant and that such payment was the condition for the settlement of the bank’s claim against them under the various guarantees given.

My analysis of the whole evidence and more particularly of the documents referred to leads me to the conclusion that the appellant has not established, on the balance of probabilities, that a debt was owing to him at the end of his 1988 taxation year by a small business corporation so as to satisfy the requirements of paragraph 39(1 )(c) of the Act.

It seems clear to me that the payment of the $226,000 represented a loan to the Audias personally and not to the companies and that it did not result in any indebtedness of the companies to the appellant.

Similarly, I do not think that the appellant can avail himself of the provisions of subsection 39(12) of the Act enacted in 1994 and made applicable to payments by a guarantor after 1985. My view is that it is the Audias, who made the payment with funds borrowed from the appellant or advanced by him, who should be considered guarantors for the purpose of that provision.

In view of the foregoing, the appeal is dismissed with costs to the respondent.

Appeal dismissed.