Adrian L. Hamoen v. Her Majesty the Queen, [1994] 2 CTC 2278, 94 DTC 1915

Sarchuk J.T.C.C.:—This is the appeal of Adrian L. Hamoen from an assessment of tax for his 1986 taxation year. With respect to that year Hamoen filed an amended income tax return to reflect the disposition of farm property and sought to deduct as interest expense the sum of $250,733.59 which amount was disallowed by the Minister of National Revenue (the Minister).

The following statement of facts agreed to by both parties was filed with the Court at the commencement of the trial:

1. At all times material to this appeal, the appellant carried on business of farming near Vega, Alberta.

2. On or about January 1, 1986, the appellant was the beneficial owner of an estate in fee simple in respect of various pieces of farmland which had been acquired before 1986 having the following legal descriptions:

(i) NW 23-63-2-W5th ("Land No. 1 ")

(ii) SW 23-63-2-W5th (“Land No. 2”)

(iii) E 23-63-2-W5th (“Land No. 3”)

(iv) NE 1-63-4-W5th ("Land No. 4")

(v) NE 36-62-4-W5th ("Land No. 5")

(vi) SE 6-63-3-W5th (“Land No. 6")

In respect of his 1986 taxation year, the appellant had elected that his income from the farming business be computed in accordance with the cash method as defined in subsection 28(1) of the Income Tax Act, R.S.C. 1952, C. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

3. On or about January 7, 1976, the Farm Credit Corporation ("F.C.C.") loaned the sum of $75,600 ("F.C.C. Debt No. 1”) to the appellant for use in his farming business. The appellant granted to the F.C.C. as security for the F.C.C. Debt No. 1 mortgages registered against the following properties:

(i) Land No. 1

(ii) Land No. 2

(iii) Land No. 3

(iv) Land No. 4

4. On or about May 26, 1983, the F.C.C. loaned the sum of $100,000 ("F.C.C. Debt No. 2") to the appellant for use in his farming business. The appellant granted to the F.C.C. mortgages in respect of the aforesaid F.C.C. Debt No. 2 registered against the following properties:

(i) Land No. 2

(ii) SE Section 23-63-2-W5 (part of Land #3)

(iii) Land No. 6

5. On or about May 30, 1983, the F.C.C. loaned the sum of $310,000 ("F.C.C. Debt No. 3") to the appellant for use in his farming business. The appellant granted to the F.C.C. as security for the aforesaid F.C.C. Debt No. 3 mortgages registered against the following properties:

(i) Land No. 1

(ii) Land No. 2

(iii) Land No. 5

(iv) NE Section 23-63-2-W5 (part of Land #3)

6. On or about October 6, 1983, the Toronto Dominion Bank loaned the sum of $300,000 (the "T.D. Debt") to the appellant for use in his farming business. The appellant granted to the Toronto Dominion Bank (the “T.D. Bank") as security for the aforesaid T.D. debt mortgages registered against the title to the following properties:

(i) Land No. 1

(ii) Land No. 2

(iii) Land No. 3

(iv) Land No. 4

7. In his 1985 and 1986 taxation years and at all times material to this appeal, the appellant was in default in respect of each of the aforesaid T.D. Debt, F.C.C. Debt No. 1, F.C.C. Debt No. 2 and F.C.C. Debt No. 3.

8. On or about January 22, 1986, the appellant signed an interim agreement with Harry and Hermina Van Raalte to sell Land No. 5 to them for the sum of $180,000 and livestock thereon for the sum of $70,000. This was an arm's length transaction.

9. On or about January 27, 1986, the appellant and his spouse Elizabeth Katherine Hamoen executed an interim agreement to sell the Land No. 6 to Henry Veenstra for the sum of $100,000. This was an arm's length transaction.

10. The appellant being unable to satisfy the F.C.C. of his ability to fulfil his obligations under the mortgages securing the F.C.C. Debt. No. 1, F.C.C. Debt No. 2 and F.C.C. Debt No. 3 entered into a quit claim agreement with the F.C.C. dated March 21, 1986. The aforesaid quit claim agreement of March 21, 1986 dealt with the rights of the F.C.C. and the appellant and his wife in respect of:

(i) the mortgage for the sum of $75,600 (F.C.C. Debt No. 1) bearing registration number 762069061 and date of registration April 27, 1976;

(ii) the mortgage for the sum of $100,000 (F.C.C. Debt No. 2) bearing registration number 832127551 and date of registration June 1, 1983;

(iii) the mortgage for the sum of $310,000 (F.C.C. Debt No. 3) bearing registration number 832124886 and date of registration May 30, 1983.

11. On or about April 9, 1986, the appellant executed a quit claim agreement with the TD Bank pursuant to which he agreed to transfer ownership of the Land No. 4 to the T.D. Bank.

12. On or about May 16, 1986, the sale proceeds of the Land No. 5 to the aforementioned Van Raalte in the sum of $176,853.49 was paid by the lawyer of the appellant to the F.C.C. on account of the indebtedness of the appellant to it. On or about May 16, 1986, the proceeds of the sale of the hogs in the sum of $69,796.50 was paid by the lawyer of the appellant to the T.D. Bank. On or about April 8, 1986, [1] the sum of $99,590.65, being the net proceeds of the sale of Land #6 was paid to the F.C.C. on account of the indebtedness of the appellant.

13. On or about April 9, 1986, the appellant owed to the T.D. Bank the principal sum of $233,455.76 and accrued interest in the sum of $83,742.74 in respect of the T.D. Debt.

14. On or about March 01, 1986, there was due and owing by the appellant to the F.C.C. the principal sum of $479,981.17 and accrued interest in the sum of $166,990.85 in respect of the F.C.C. Debt No. 1, 2 and 3.

15. On or about May 16, 1986, a transfer of land signed by the appellant was registered pursuant to which he transferred ownership of Land #4 to the T.D. Bank. The affidavit of value on the transfer of land stated that Land #4 had a fair market value of $200,000.

16. On or about April 8, 1986, a transfer of land signed by the appellant was registered by which he transferred ownership of Land #1, #2 and #3 to the F.C.C.. The affidavit of value on the transfer of land stated that Land #1, #2 and #3 had an aggregate fair market value of $140,000.

17. In his 1986 taxation year, and in relation to this personal income tax returns, the appellant deducted as interest expenses the sum of $250,733.59 on the basis that the said sum had been paid by him to the T.D. Bank and the F.C.C. as interest payments in relation to the F.C.C. Debt #1, F.C.C. Debt #2, F.C.C. Debt #3 and the T.D. Debt. However, the Minister of National Revenue disallowed the deduction of the aforesaid sum of $250,733.59 on the basis that no part of same had been paid.

In addition the Court heard the testimony of the appellant, the salient portions of which follow. By 1985 he was in default on his indebtedness to both the F.C.C. and to the Toronto-Dominion Bank (the bank). It was the view of the F.C.C. that the appellant's indebtedness was insurmountable given the existing resources. In December 1985 a series of meetings took place between the appellant and representatives of the F.C.C. and the bank at which his financial affairs were discussed. The creditors insisted that the debts be repaid either by liquidation, by way of quit claim or by way of foreclosure, if that became necessary. The appellant understood that no other alternatives were available. At this meeting the possibility of a sale of certain lands by the appellant to third parties was also discussed and it was agreed, if that occurred, they would be sold by him for the benefit of the F.C.C. and the bank.

Subsequently the appellant approached Henry Veenstra, offered to sell land #6 for $100,000 and on January 27, 1986 entered into an agreement with him with respect to that land. On January 22, 1986 the appellant entered into an agreement with the Van Raaltes to sell land #5. The appellant asserts that he alone negotiated with the purchasers, set the price sought and concluded all arrangements for the sales. Both the F.C.C. and the bank were aware of these arrangements and, while there are no documents evidencing assignment the appellant does not dispute that prior to the sales he had agreed that the proceeds thereof would be assigned directly to the F.C.C.. It is common ground that upon completion of the transactions referred to in the Statement of Agreed Facts the appellant's debts to the F.C.C. and the bank were extinguished. [2]

Issue

The question to be determined is whether the Minister properly disallowed the deduction of the sum of $250,733.59 as interest paid by the appellant to the F.C.C. and to the bank in his 1986 taxation year.

Appellant’s position

The appellant relies principally on subsection 28(1), paragraph 20(1 )(c) and section 79 of the Income Tax Act. [3]

The appellant, being a farmer, accounts for income on the cash basis. The cash method of accounting is defined in section 28 of the Act. This section permits amounts to be deducted when paid. A payment need not be made in cash but also refers to payment of an amount that is determinable by reference to its cash value. The term “amount” appears in several places in section 28 and is defined by section 248 as "money, rights or things expressed in terms of the amount of money or the value in terms of money of the right or thing”. Thus the transfer of certain lands to the F.C.C. and to the bank constitutes a payment in kind equal to the fair market value of the lands transferred. [4] In accordance with the mortgage agreements and the common law regarding payments of interest and principal, all payments (including payments in kind) are to be applied firstly to outstanding interest and secondly to outstanding principal. Therefore the combination of the various cash payments so made to the F.C.C. and to the bank and the payments in kind by the transfer of other lands, constitutes a payment of interest of $250,733.59 by the appellant in 1986 which is properly deductible in accordance with subsection 28(1) and paragraph 20(1 )(c) of the Act.

The provisions of section 79 do not preclude the operation of section 28. Section 79 does not by its wording suggest that it applies for all purposes of the Act, it merely sets out a number of rules for determining the cost base and proceeds of disposition that flow from transfers of land between creditors and debtors. Counsel contended that section 79 is not an income computation section but merely a section that determines the amount of capital gain or loss on foreclosure. Thus where a transfer of property takes place within the meaning of section 79 all that section requires is that one take the principal amount of the loan less the cost base of the property to establish a capital gain or loss but it does not alter the fact that resources of a certain economic value were given up by the taxpayer which resources or amounts should first be applied to interest and second to principal.

Counsel further argued that failing to consider such a transfer of property to be a payment is inequitable in that pursuant to section 79 the appellant realized a capital gain but received no proceeds; his pool of capital losses and/or cost basis of property is eroded by virtue of the operation of section 80 but he receives no deduction for interest. On the other hand, accrual based taxpayers receive a deduction for interest expense even if it is unpaid, it merely need be payable. Counsel argues that Parliament could not have intended that sections 79 and 80 would exclude the operation of section 28 for to do so would be to ignore commercial reality.

In the alternative, even if the transfers of land are not to be considered a payment of interest, the common law rule that payments are appropriated first to interest applies nonetheless to those amounts remitted in cash to the creditors as a result of the sale of properties #5 and #6 together with the proceeds of the hog sale, which in aggregate, amounted to $350,000. In support of this alternative counsel submits that section 79 applies on a property by property basis but these three transactions fall outside of that section. Paragraph 79(d) of the Act provides that any payment made after the acquisition or reacquisition of property is a loss. The subsequent payment giving rise to a loss must bear some relationship to the property acquired or reacquired. Second, section 79 only applies when the creditor claims beneficial title to land. Counsel says the terms and conditions of the sale of lands #5 and #6 and the hog sale were in place in January 1986, prior to the transfer to the F.C.C. and the ban PY way of quit claim on March 21, 1986. Consequently section 79 cannot apply to these payments as they were made prior to the creditor gaining beneficial title or acquiring or reacquiring the property. Applying the common law rule these cash remittances were made first on account of interest and the appellant should be entitled to deduct them pursuant to paragraph 20(1 )(c) of the Act.

Respondent's position

Counsel for the respondent submitted that the purpose of sections 79 and 80 is not limited strictly to a determination of a capital gain or loss on foreclosure as urged on behalf of the appellant. The sections no doubt have relevance in the latter context but their legislative purpose is the computation of income. Such a conclusion is consistent with their inclusion by the legislators in Division B (Computation of Income), Subdivision F (rules relating to the computation of income) of the Act. Counsel contended that the operation of sections 79 and 80 of the Act disenable the application of the proceeds of disposition in respect of each of the transactions first to interest and then to principal, as otherwise section 80 would be rendered function less. Section 28 operates in its own sphere for the exclusive purpose of ensuring that no deduction of interest is permitted with regard to a cash basis person except where paid. Section 79 contains all of the relevant rules for dealing with transactions such as the one before the Court and does not operate subject to section 28.

In his 1986 taxation year the appellant was unable to satisfy the F.C.C. and the bank of his ability to make payments in respect of the mortgages and he was in default of his payment obligations in respect thereto in relation to each of the lands #1, #2, #3, #4, #5 and #6. By virtue of the terms and conditions of the mortgage agreements, and the two quit claim agreements dated March 21, 1986 and April 9, 1986, the F.C.C. and the bank had acquired rights of beneficial ownership in respect of the aforementioned lands. Furthermore, pursuant to the quit claim agreements the F.C.C. Debts #1, #2, #3 and the TD Debts had been extinguished along with the arrears of interest due thereon. Counsel argued that because the legal obligation of the appellant to pay the interest arrears was extinguished by the terms of the quit claim agreements there was no payment of interest by the appellant in respect of the principal sums due and owing, therefore he was precluded from deducting such amount against his farming income under the provisions of paragraph 20(1 )(c) of the Act.

Conclusion

The appellant's position is that the provisions of section 79 of the Act which deem certain income tax consequences to the appellant, to the bank and to the F.C.C. with respect to the quit claim agreements are only applicable to him with respect to the calculation of capital gain, recapture of capital cost allowance and terminal losses. This section, according to counsel for the appellant, does not supersede and is not inconsistent with subsection 28(1) of the Act which governs the determination of income for farmers electing to report their income on a cash basis.

This submission must fail. First, the premise that section 79 of the Act only governs how the appellant is required to record the disposition of his property but does not apply to him for the purposes of income computation is untenable. It is not possible to read the provisions of that section so as to apply it fully only to taxpayers other than farmers who have elected to report their income on a cash basis.

Second, section 79 cannot be read as though it stood alone. On a proper construction of sections 79 and 80 of the Act, section 79 applies to determine, as far as a taxpayer is concerned, the tax consequences regarding the extinguishment of the “principal amount" portion of any mortgage indebtedness. This is because the term “principal amount" which is used in paragraph 79(c) of the Act is defined in subsection 248(1) as an amount payable on an obligation otherwise than by way of or on account of interest. The tax consequences applicable to interest in such cases (and to the accrued but unpaid interest in the appellant's case) are dealt with by subsection 80(4) and paragraph 80(1 )(d) of the Act. The provisions of section 79 form a part of a scheme which includes the provisions of section 80 and by virtue of the applicability of section 80, the proceeds of disposition contemplated in section 79 excludes interest.

I am satisfied the provisions of sections 79 and 80 govern the appellant's situation and that the appropriation of the proceeds of disposition to interest as sought by the appellant is precluded by the operation of those sections. An obligation is settled or extinguished when all liability to pay it is legally terminated. The principal sums due and owing in respect of the F.C.C. Debts #1, #2 and #3 and the TD Debt were extinguished by the quit claim agreements. This constitutes the proceeds of disposition in respect of the lands #1, #2, #3, #4, #5 and #6 pursuant to the provisions of paragraph 79(c) of the Act. The Minister was correct in assessing on the basis that these proceeds of disposition constitute payment of the principal amount of the debts which had been extinguished as a result of these transactions, and not of the arrears of interest due thereon. The arrears of interest thus extinguished is dealt with in accordance with the provisions of section 80 of the Act. Whether the combined operation of sections 79 and 80 is unfair to a cash basis taxpayer such as the appellant is not a matter I need determine.

The alternative argument advanced on behalf of the appellant is that beneficial ownership was not acquired by the creditors until the quit claims were executed. Consequently any payments made from the proceeds of the two interim agreements must be applied first to interest. This position appears to be dependent on isolating each transaction and treating it as though it had no relationship to the others. I do not believe that would be in accord with the evidence. Neither the hog and cattle sales nor the sale of lands #5 and #6 and the consequent allocation of the proceeds of disposition took place in a vacuum. The same can be said for the transfer of land #4 to the bank.

The appellant was indebted to the F.C.C. by way of three separate debts totalling $485,600. These three debts were secured by mortgages covering lands #1 to #6. He was also indebted to the bank in the amount of $300,000 secured by mortgages on lands #1 to #4. The two-fold objective of the parties in December 1985 and thereafter was to maximize the recovery to the creditors and to extinguish the appellant's indebtedness. On the face of it the F.C.C. mortgage security took priority. Nonetheless the ultimate allocation and distribution of the proceeds leads to the irresistible inference that a much more comprehensive agreement existed between the parties than that described by the appellant. Evidence of such an agreement can be found in several places. First, the appellant’s testimony that the sale of any lands by him was to be for the benefit of the creditors. Second, that the proceeds of any such sale were assigned to the F.C.C. Third, the quit claim agreement between the appellant and the F.C.C. which was signed on March 21, 1986 specifically provides:

2. The parties of the first part agree to transfer all of their right, title and interest in the following lands together with all buildings situated thereon to the farm credit corporation:

NE 36-62-4-W 5th—(Land #5)

SW 23-63-2-W 5th—(Land #2)

SE 23-63-2-W 5th—(Land #3)

NE 23-63-2-W 5th—(Land #3)

NW 23-63-2-W 5th—(Land #1) [5]

3. The parties further acknowledge and agree that the parties of the first part are selling the SE 6-63-3-W 5th on behalf of the Farm Credit Corporation and shall forward to F.C.C. the net sale proceeds resulting from the sales transaction, and further in the event that the sale should not proceed for any reason, they shall immediately notify Farm Credit Corporation and, upon demand, transfer title to the SE 6-63-3-W 5th to F.C.C. (Land #6 sold to Veenstra.) [6]

Fourth, the F.C.C. for its part agreed to extinguish all of the appellant's indebtedness to it upon performance of the conditions contained in the quit claim. Fifth, the references by the appellant’s solicitors to trust conditions imposed by the F.C.C. with respect to the sales of lands #5 and #6 support an inference that the creditors were the beneficial owners of the lands. On these facts I can only conclude that on entering the interim agreements in January 1986 the appellant was acting on behalf and for the benefit of the F.C.C. and the bank. [7]

The evidence as a whole fails to support the appellant’s contention that section 79 cannot apply to the proceeds of the sales of lands #5 and #6 and of the cattle and hogs because they were made prior to the creditors gaining beneficial title or acquiring the property. This ground of appeal also fails.

Counsel for the respondent conceded that in the event the appellant’s arguments are rejected, certain adjustments would nonetheless be required. In particular the capital gain realized by the appellant in respect of the disposition of lands #5 and #6 as well as the capital gain deduction is to be adjusted to reflect the application of section 79 to each of these transactions.

The appeal is allowed to that extent. Costs are awarded to the respondent. In accordance with Rule 169 of the Tax Court of Canada Rules (General Procedure) the respondent's solicitor may prepare a draft of an appropriate judgment to implement the foregoing and if the appellant's solicitors accord their approval as to form, may submit it for signature.

Appeal dismissed for the most part.