Ernest Morgan Davis v. Her Majesty the Queen, [1995] 1 CTC 2256

Kempo J.T.C.C. (orally):—This general procedure appeal concerns the appellant’s 1989 taxation year. The appellant claims a deduction for a business investment loss arising out of $97,500 having been advanced to Malcan Packaging Machinery Ltd. (hereinafter called "Malcan Co.”) which became a bad debt during 1989. This deduction was disallowed by the Minister of National Revenue (the "Minister") on the premise that the appellant failed to establish the existence of loss which would qualify as a business investment loss, or at all.

The appellant claimed entitlement to this deduction under the provisions of paragraph 39(1 )(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). This was the only issue raised in this appeal.

The applicable parts of the relevant provisions of the Act follow.

A business investment loss is defined in paragraph 39(1 )(c) of the Act which reads:

39( 1 ) For the purpose of the 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

(ii) to a person with whom he was dealing at arm’s length of any property that is

(iv) a debt owing to the taxpayer by a small business corporation ...

exceeds the aggregate of....

A small business corporation is defined in subsection 248(1), the applicable parts being as follows:

"small business corporation" at any particular time means a particular corporation that is a Canadian-controlled private corporation all or substantially all of the fair market value of the assets of which at that time was attributable to assets that were

(a) used in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it.

and, for the purposes of paragraph 39(1 )(c), includes a corporation that was at any time in the 12 months preceding that time a small business corporation;

Subsection 39(12) was enacted by S.C. 1994 c. 7, Schedule II, subsec. 22(4), applicable to amounts paid after 1985, thusly:

39.(12) Guarantees .-For the purpose of paragraph (1)(c), where

(a) an amount was paid by a taxpayer in respect of a debt of a corporation

under an arrangement under which the taxpayer guaranteed the debt,

(b) the amount was paid to a person with whom the taxpayer was dealing at arm’s length, and

(c) the corporation was a small business corporation

that part of the amount that is owing to the taxpayer by the corporation shall be deemed to be a debt owing to the taxpayer by a small business corporation.

The appellant’s positions at trial were two-fold, the second as an alternative to the first. They were advanced at the hearing as presented by paragraphs 3 to 9 inclusive in his notice of appeal thusly:

3. From in or about October 1986 to and including 1987, the appellant loaned at arms length the amount of $97,500 to Malcan Packaging Machinery Ltd.

4. Such loans were made through the appellant’s agent, his personal corporation, Morgan Davis Printing Ltd., with funds advanced and/or guaranteed by the appellant.

5. Both Malcan Packaging Machinery Ltd. and Morgan Davis Printing Ltd. were Canadian-controlled private corporations, at all material times.

6. In 1989, the said loans were established to have become bad debts.

7. As a result, in 1989, the appellant suffered a capital loss of $97,500 and an allowable business investment loss of $65,000.

8. Alternatively, in 1989, the appellant suffered a capital loss of $97,500 and an allowable business investment loss of $65,000, because any loans from Morgan Davis Printing Ltd. to Malcan Packaging Machinery Ltd. were es- tablished to have become bad debts to Morgan Davis Printing Ltd. and any loans from the appellant to Morgan Davis Printing Ltd. were established to have become bad debts to the appellant.

9. The appellant claimed such allowable business investment loss in his 1989 TI return of income.

The appellant, Ernest Morgan Davis ("Mr. Davis") testified on his own behalf. He was the president of and owned all of the issued shares of Morgan Davis Printing Ltd. ("Printing Co.") which, he said, was engaged solely in the printing business and was not in investments nor in money- lending.

Mr. Davis said he was approached in 1986 by a friend who knew of a Mr. Cachia who was involved in the planning and building of a prototype machine for use in packaging yogurt. According to Mr. Davis, Mr. Cachia then owned all of the issued shares of Malcan Co., and in discussions with Mr. Davis told him he was looking for an investor with $125,000 to fund this idea in exchange for a 50 per cent ownership interest in Malcan Co.

Mr. Davis said that he got into this deal at the end of 1986. He produced copies of his personal cheques (Exhibit A-7) as evidence of having advanced his own personal funds to Printing Co. to assist them in their provision of the advances to be made by them to Malcan Co. Mr. Davis’ cheque dated January 16, 1987 was for $15,000 payable to the Bank of Nova Scotia (which was Printing Co.’s bank), a second was dated January 29, 1987 for $5,500 payable to Printing Co., the third was dated March 27, 1987 for $40,000 payable to the Bank of Nova Scotia and the last one was dated June 8, 1987 for $32,160, also payable to that bank. He said the bank was the payee on these cheques because Printing Co. had to draw down on its operating line of credit with them to make their advances to Malcan Co. He conceded these cheques totalled $92,660 and not the $97,500 as claimed, but that as far as he was concerned the higher amount was the correct amount.

It is appropriate to mention at this time Mr. Davis’ explanation for having produced only photocopies of the documents to be used as his evidence in his case. He said he photocopied and kept all of the pertinent original documents together which he then put away for safekeeping. Upon searching for the originals for use in this appeal he said they were all misplaced and could not be found. Accordingly, he was only able to produce his photocopies. I ruled that these documents were relevant and were admissible as photocopies for the reasons that Mr. Davis had either seen or was the author of these documents, that he was a credible witness, and that it was he who had made the photocopies.

Exhibit A-8 comprised of photocopies of Printing Co.’s current account banking statements with the Bank of Nova Scotia for the period December 31, 1986 to and including December 31, 1987 plus cheques (the backs of the cheques being omitted) ostensibly supporting Mr. Davis’ notations on the banking statements that they were the advances made to Malcan Co. Because the backs of these cheques were not reproduced, there was no independent documentary evidence regarding their actual negotiation. Mr. Davis said he had personally deposited all of these cheques into Malcan Co.’s bank account via a night depository service and therefore did not have any deposit receipts. These cheques totalled $83,000 and not $97,500 nor $92,660. No corporate or banking statements from Malcan Co. were tendered into evidence, and no explanation was advanced as to why Mr. Cachia was not called to testify as to any of the matters raised in this appeal.

Mr. Davis said that although he did not bring to court any of Malcan Co.’s corporate documents he believed he had received the promised 50 per cent of the shares of Malcan Co. in his own name sometime during 1987 and that they have not yet been disposed of by him. He confirmed he had not investigated Malcan Co.’s financial statements or business plans prior to entering into the arrangement but rather had focused on the idea of the proposed prototype and its potential. He also said he made no specific inquiries respecting ownership of the prototype, that is whether it belonged to Mr. Cachia or to Malcan Co., but apparently proceeded on the assumption it was corporate owned.

Mr. Davis produced no loan documents corroborating the amount and terms respecting the advances by himself to Printing Co. nor respecting the advances from Printing Co. to Malcan Co. His evidence was that all arrangements were made orally, the advances were to be interest-free, and that the agreement between himself and Mr. Cachia was that repayment would be made by Malcan Co. out of the first earnings derived from the prototype.

Exhibit A-9 is a photocopy of the purported guarantee given by Mr. Davis to Printing Co. It is dated October 8, 1986 and provides:

Re Malcan Packaging Machinery Ltd.

Advances of up to $125,000 is to be made by Morgan Davis Printing Ltd. to Malcan Packaging Machinery Ltd.

In consideration of Morgan Davis Printing Ltd. making such advances, I Morgan Davis personally guarantee repayment of these funds to Morgan Davis Printing Ltd.

Mr. Davis testified he believed Malcan Co. had occupied some premises, possibly under a lease, and that as far as he knew or could recall the advances had probably been used to pay rent, salaries and office supplies. This recall is difficult to reconcile with the fact that the subject advances were all made before the end of 1987 and yet the whole matter became defunct by July 1989 which is a year and one-half later. He obtained possession of the prototype in 1989 which he sought to have evaluated by competent engineers. No appraisers were called to testify, however acting on their opinions Mr. Davis said he left the prototype with them to pay for their consulting fees. The fees were said to be $200.

Exhibit A-10 is a photocopy of a July 3, 1989 written demand made by Printing Co. upon Malcan Co. to pay advances totalling $97,500 before August 3, 1989. Exhibit A-11 is a photocopy of a September 15, 1989 written demand made by Printing Co. upon Mr. Davis respecting moneys advanced by it to Malcan Co. totalling $97,500. Mr. Davis said the latter demand was prepared as a call upon him to pay under his guarantee and that these two documents were prepared in his accountant’s office and on their advice.

Printing Co.’s T-2 corporate returns of income for its taxation years ending December 31, 1988 and December 31, 1989 were marked as Exhibits A-5 and A-6 respectively. Attached thereto were financial statements for each year without any explanatory notes being appended. Mr. Davis pointed out that the 1988 statements included, under current assets, a note receivable — Malcan Packaging for $97,750 and under current liabilities the sum of $116,571.32 as advances from a director. For the 1989 year these two items were recorded at $nil and $36,511.05 respectively. The arithmetic difference from 1988 to 1989 respecting the director’s advances item is $80,060.27, not $97,750 as claimed, nor $92,660 as per his personal cheques nor $83,000 as per Printing Co.’s cheque advances.

Mr. Davis said his guarantee to Printing Co. was given for no consideration, that his payment to Printing Co. in 1989 was intended to be pursuant to and in accordance with his obligation to do so under that guarantee, ana that this payment was made via a reduction of their debt to him as confirmed in the 1989 financial statements. His accountant was not called to testify and no ledger accounts concerning his director’s loans were produced.

With respect to any consideration having been received for his guarantee, Mr. Davis opined it was derived in the form of a one- half ownership interest in Malcan Co., the debtor.

Mr. Parmar, an appeals officer with Revenue Canada, Taxation, testified for the respondent. The department had learned Malcan Co. was struck off the Ontario corporate rolls in October 1990. It had filed its T-2 corporate returns of income for only two fiscal periods January 11, 1985 to June 30, 1985 (incorporation was stated therein to be January 11, 1985) and July 1, 1985 to June 30, 1986. Both of these returns reported nil income, that its major business activity was inactive — no assets and that Mr. Cachia was the holder of all of the voting shares. No returns were recorded as being filed thereafter.

In my opinion the evidence as to how Malcan Co. spent the advances made to it by Printing Co. was unacceptably vague and fell far short of establishing whether it had been used for business purposes.

In argument appellant’s counsel first advanced the agency argument as alleged in paragraphs 3 to 7 of the notice of appeal as earlier reproduced and then, in reply to the respondent-counsel’s submissions, said perhaps agency was the wrong word and that Printing Co. was merely a conduit for Mr. Davis’ purposes. Obviously he was driven to retract the agency allegation as, analytically, the guarantee given by a principal (Mr. Davis) to his own agent (Printing Co.) would ultimately be nonsensical given that during 1987 Printing Co. had already been provided with funds by him to cover all of the advances made by them.

I do not accept Mr. Davis’ allegation that his claimed loss was sourced in his liability under the guarantee to Printing Co. Respondent’s counsel submitted that under common law a guarantee is an indemnity arising out of contract with valid consideration passing and cited Bank of Montreal v. Sperling Hotel Co. et al., [1973] 4 W.W.R. (Man. Q.B.) 417, 36 D.L.R.

(3d) 130. Printing Co. admittedly had nothing to gain to itself by advancing money to Malcan Co. and therefore had no consideration to offer Mr. Davis for his guarantee. Appellant’s counsel did not take issue with this submission. While I may have indicated that the proposition as advanced may well have been correct, I have now reconsidered this finding and make no ruling thereon as it is not necessary to do so in view of the facts and issues of this case.

In my opinion the appellant’s claim for a business investment loss founded upon the guarantee fails. It also fails on the ground of non- compliance with the provisions of subsection 39(12) of the Act which are applicable where the guarantor’s payment was made to an arm’s length recipient. Mr. Davis and Printing Co. were not at arm’s length at any time as he said he owned all of its issued shares.

It is also my opinion that Mr. Davis has not met his evidentiary onus of proof, on the balance of probabilities (I am paraphrasing paragraph 39(1 )(c) here) he had a business investment loss from the disposition of property arising out of an arm’s length dealing in respect of a debt owed to him by a debtor (1.e., Malcan Co.) which was small business corporation.

A small business corporation as defined in subsection 248(1), supra, is a corporation which used substantially all of its assets in the carrying on of an active business. The evidence here lacked acceptable proof of any sort of business activity; rather it was to the effect that Malcan Co. had no assets for use in the carrying on of a business and that it was and had remained in an inactive business state. Their corporate returns Exhibits R-l and R-2 so stated, and it was struck off the corporate rolls in 1990. Mr. Davis did not enlighten the court as to any business activity on Malcan’s part.

With respect to the appellant’s alternative grounds as expressed in paragraphs 8 and 9 of his notice of appeal, they are repeated for convenience.

8. Alternatively, in 1989, the appellant suffered a capital loss of $97,500 and an allowable business investment loss of $65,000, because any loans from Morgan Davis Printing Ltd. to Malcan Packaging Machinery Ltd. were established to have become bad debts to Morgan Davis Printing Ltd. and any loans from the appellant to Morgan Davis Printing Ltd. were established to have become bad debts to the appellant.

9. The appellant claimed such allowable business investment loss in his 1989 TI return of income.

In my opinion it does not follow that the debt thereby was a business investment loss that is deductible by Mr. Davis under the stated provisions of the Act. Any purported debt between him and Printing Co. was not a bad debt qua Printing Co. Any purported bad debt between him and Malcan Co. gua Malcan Co. is not deductible by him because, amongst other things, it has not been established that Malcan Co. was a small business corporation as defined. Further, and in any event, it appears that Mr. Davis had deliberately structured the whole matter in such a way that Malcan Co. was to be indebted to Printing Co. and not to himself. The reasons for this were not disclosed.

As appellant’s counsel so aptly put; Mr. Davis had advanced a lot of money and Malcan had not paid. This is very unfortunate indeed, however in fiscal cases the matter is to be decided on what the taxpayer actually did rather than what he could or should have done. The appellant appears to be advancing a substance over form approach which, in my view, would essentially involve the erasure of Printing Co. It was not suggested that Mr. Davis’ transactions with Printing Co. or their dealings with Malcan Co. were shams or legally ineffective. Indeed, all parties acted according to the plan as devised. In dealing with the nature of a transaction in light of the construction of documents and the testimony of the intent of the parties concerning it, Linden J.A. in Friedberg v. Canada, [1992] 1 C.T.C. 1, 92 D.T.C. 6031 (F.C.A.) at pages 2-3 (D.T.C. 6032) said in part:

In tax law, form matters. A mere subjective intention...is not by itself sufficient to alter the characterization of a transaction for tax purposes. If a taxpayer arranges his affairs in certain formal ways, enormous tax advantages can be obtained, even though the main reason for these arrangements may be to save tax....If a taxpayer fails to take the correct formal steps, however, tax may have to be paid. If this were not so, Revenue Canada and the courts would be engaged in endless exercises to determine the true intentions behind certain transactions. Taxpayers and the Crown would seek to restructure dealings after the fact so as to take advantage of the tax law or to make taxpayers pay tax that they might otherwise not have to pay. While evidence of intention may be used by the courts on occasion to clarify dealings, it is rarely determinative. In sum, evidence of subjective intention cannot be used to "correct" documents which clearly point in a particular direction.

Respondent’s counsel submitted that Mr. Davis would be in a fiscal non-arms’s relationship with Malcan Co. because he purportedly held a 50 per cent shareholder’s interest therein. No authorities nor legal submissions were advanced by either party on this aspect. Upon examination of paragraphs 251(l)(a) and 251(2)(b) of the Act this may not to be so. The nature and extent of Mr. Davis’ purported 50 per cent interest in Malcan Co. remained unknown and uncharacterizable and therefore could have purposefully denied him de jure control. Further, it was not shown that he was related to Mr. Cachia within the meaning of paragraph 251(2)(a) and there is no evidence concerning any possible de facto control having been exercised by him over Malcan Co.’s affairs either. Further, Printing Co. and Malcan Co. were not related, and because the same group of persons did not control both of those corporations the dealings, if any, between them would have been at arm’s length. However the only dealings between them were as described by Mr. Davis, and it is not Printing Co. that is claiming the loss deductions but Mr. Davis in his personal capacity.

Conclusion

In conclusion then, and for the reasons given, the appellant’s appeal respecting his claim for deduction of a business investment loss is dismissed with costs to the respondent on a party-to-party basis.

Appeal dismissed.