Harris Steel Group Inc. v. Her Majesty the Queen, [1994] 1 CTC 2410

Sobier, J.T.C.C. (orally):—The Court is now prepared to give reasons for judgment in the matter of Harris Steel Group Inc. v. The Queen, 91-1669G.

The appellant is a corporation continuing as a result of the amalgamation of G. & H. Steel Industries Ltd., ("G. & H.”), with Harris Steel Group Inc., ("Harris"). The appellant appeals from the reassessments by the Minister of National Revenue, (the "Minister"), for its 1982 and 1983 taxation years whereby the Minister disallowed the deduction, in 1982, of $250,000 in respect of advances made by

G. & H. to a joint venture known as Grizzly Rock Services joint venture number 96, (the "joint venture"), constituted between Grizzly Rock Services Ltd., ("Grizzly"), and Eberle Construction Ltd., ("Eberle").

In addition, the Minister reassessed the appellant for its 1983 taxation year on the basis that at the time of the disposition of its interest, advances, loans or investments in the joint venture, however it is characterized, (the “joint venture interest"), it did not deal at arm's length with the purchaser, Rebars Ltd., ("Rebars"), and therefore denied the loss on the disposition.

The issues therefore are: (1) whether the $250,000 of the advances made by G. & H. to the joint venture were properly deductible in 1982; (2) whether, in 1983, the year of the disposition of the joint venture interest, G. & H. did not deal at arm’s length with Rebars and therefore was not entitled to deduct any loss on the disposition of the joint venture interest and; (3) whether the loss, if any, on the disposition of the joint venture interest was on account of capital or income.

It will be noted that although, at the end of the day, all advances to the joint venture were repaid, they were repaid to the purchaser of the joint venture interest, Rebars, and not the appellant.

In 1981 the joint venture was established to obtain a construction contract, (the "contract"), to build a tunnel for the Greater Victoria Water Board, (the "project"), I will also refer to the Greater Victoria Water Board as (the "Board").

Since the joint venture and its principals were unable on their own to obtain a performance bond for the project, they arranged with G. & H. and its principal officers and shareholders, Mr. David Lyle Hadden, ("Hadden"), and Emil Weishaupt, ("Weishaupt"), to guarantee the bond in consideration of a fee being the greater of $150,000 or 15 per cent of the profit from the project. In addition, Messrs. Hadden and Weishaupt were to receive a total of $50,000 each.

An agreement dated August 18, 1981, (the "first agreement"), was entered into setting forth the rights and obligations of the parties and providing for the payment of the fees. At this point G. & H. had no significant interest in building the tunnel.

Because it was undercapitalized, the joint venture ran into cash flow problems and asked G. & H. to advance moneys to allow it to continue. G. & H. caused one of its directors, one Cole, to study the project. It was determined that the project was viable and if a boring machine was to be used to dig the tunnel, the project could be brought in under time and with significant profits.

G. & H. decided to advance up to $500,000 to the joint venture in return for 60 per cent of the profits from the project. To this end, the joint venture, G. & H., Hadden, and Emil Weishaupt Ltd., ("Weishaupt Ltd"), entered into an agreement made as of May 4, 1982, (the "second agreement").

The second agreement amended the first agreement and provided for more control by G. & H. over the administration of the joint venture. It also provided for maximum management fees to be paid to the principals of the joint venture as well as for fees to be paid to G. & H. for its services.

More significantly, the second agreement provided for G. & H. to receive 60 per cent of the profits from the project and the joint venture to receive 40 per cent of the profit. In the second agreement, profit did not include recoverables which were for the account of the joint venture.

The boring machine was brought on site and proved to be a complete failure to the extent that $93,000 of direct costs were lost, as well as one month’s work on the project. As a result of this, further funds were needed by the joint venture and negotiations were held between the joint venture and G. & H. which resulted in a third agreement made as of August 25, 1982, (the "third agreement"), which agreement was among the same parties as the first agreement.

The third agreement amended and expanded the second agreement and provided, among other things, that G. & H. may advance up to one million dollars to the joint venture. Also, the profits were to be divided 50 per cent to G. & H. and 50 per cent to the joint venture. G. & H.’s share of the profit was reduced to 50 per cent because the definition of project "profit" was now amended to include the recoverables.

It is significant to note that some of the parties to the third agreement which included the joint venture, its participants, and their principals were referred to as the "venturers", and G. & H., Hadden, Weishaupt were referred to as the "creditors". The third agreement also provided for security to be given by the joint venture by way of a debenture, an assignment of moneys due under the contract with the Board, an assignment by Grizzly of amounts owing to it by Commonwealth Construction, as well as mortgages on the homes of the principals of the joint venture, Messrs. Stuart and Murray.

Under the three agreements, $700,000 was advanced by G. & H. and, with accrued interest and other amounts, such as management fees, it eventually amounted to $726,000. Notwithstanding the new funds, the project continued to lag, and the losses on the project were anticipated.

Mr. Simon McLeod, controller of G. & H., gave evidence as to the operations, accounting, and administration of the joint venture as well as the controls insti- tuted as a result of the third agreement. He stated that as a result of his concerns over possible losses, he caused G. & H. to make a provision for uncollectible advances to the joint venture, that is, for the possible or anticipated loss through to the completion of the project.

Provision was originally made for $100,000 and later this was increased to $250,000. It was this amount which G. & H. deducted in calculating its income for the 1982 taxation year and which was disallowed by the Minister.

It was stated to be the policy of G. & H. to recognize a loss as soon as it was anticipated in order to show a true picture of G. & H.'s financial condition and so as not to be misleading.

Some time after the end of 1982, Harris, one of the amalgamating corporations, resulting in what eventually became the appellant, approached Hadden with a view to purchasing all of the shares of G. & H. Since Mr. Hadden, through Rebars, controlled G. & H. and Weishaupt also owned a significant number of G. & H. shares, a tender agreement dated February 24, 1983 was entered into to ensure that if an offer was made by Harris to the public shareholders to purchase their shares, Rebars and Weishaupt would tender their shares as well.

It was one of the conditions of the tender offer that G. & H. would execute an agreement, (the “sale agreement"), satisfactory to Harris whereby Rebars would purchase the joint venture interest at its net book value which, after the provision which had been taken, was $450,000. It was this price which, at the closing, Rebars paid to G. & H. for the joint venture interest.

The sale agreement provided that the purchase and sale of the joint venture interest was conditional on Harris purchasing all of the shares of G. & H. owned by Rebars pursuant to the tender agreement. These conditions are significant and will be revisited later in these reasons.

The shares of G. & H. were purchased by Harris and the joint venture interest was conveyed by G. & H. to Rebars for $450,000 at the closing on March 30, 1993. Rebars now owned the joint venture interest.

As it happened, and to be brief, the project was completed, and because the board purchased the recoverables in place, and with additional funds, there were sufficient funds available to pay Rebars the entire amount of the G. & H. advances together with interest. However, no amount was paid on account of profit since there was none.

The Minister contended that since Rebars and G. & H. were not acting at arm's length at the time of the sale of the joint venture interest, i.e., Rebars controlled G. & H., no loss could be claimed by G. & H. in respect of the disposition in 1983 because of the provisions of subparagraph 42(e)(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

Unless there is some provision in the Act permitting the deduction of the $250,000, it will not be allowed as a reserve because of the provisions of paragraph 18(1)(e) which prohibits the taking of reserves unless otherwise provided in the Act. The appellant claims that agreements two and three constituted

G. & H. a member of the joint venture or of a new joint venture to undertake the project and that therefore the moneys advanced were for its own business for work in process and that there was a shortfall. Let us examine the facts.

In neither the second or third agreement is there any reference to G. & H. being a member of any joint venture. Since there was to be a change in circumstances from the first agreement, i.e., from G. & H. obtaining a fee for providing a guarantee, to one whereby it advanced funds against the percentage of the profit, there was ample opportunity to constitute a new joint venture or to make it clear that G. & H. was a part of the old one; this was not done.

In fact, in the second and third agreements, the two sides are kept apart. They appear not to be co-joint venturers or partners. They refer to themselves as "venturers" on the one hand and the G. & H. group as "lenders" on the other. The agreements talk of G. & H. as being a "creditor".

The recitals to the third agreement read as follows:

"WHEREAS:

(A) Grizzly is the sponsor and manager of that certain joint venture between Grizzly and Eberle Construction, (the “joint venture”), formed for the excavation and construction of a 3.0 to 3.5 meter diameter by 3,490 meter long tunnel at Leech River, at or near Deception Creek, Sooke, B.C., under contract number 96 with the Greater Victoria Water District (the "contract").

(B) All of the parties hereto have entered into that certain agreement in writing dated as of August 18, 1981, a copy which is attached hereto as Schedule “A”, (the "first agreement"), pertaining to the involvement of the parties in certain matters relating to the joint venture and the contract.

(C) Certain of the parties hereto, to wit: Grizzly and Eberle Construction, as a joint venture, G. & H., Weishaupt by his holding corporation Emil Weishaupt Enterprises Ltd., and Hadden entered into that certain agreement in writing dated as of May 4, 1982, a copy of which is attached hereto as Schedule "B" (the "second agreement") regarding the operation of the joint venture in carrying on the contract and amending, by reference, certain of the provisions of the first agreement.

(D) All of the parties to the second agreement declare and confirm that the second agreement was entered into by those parties by reason of financial difficulties encountered by Grizzly and Eberle Construction, as a joint venture, in carrying out the contract.

(E) All of the parties hereto declare and confirm that Grizzly and Eberle Construction, as a joint venture, have encountered further substantial financial difficulties subsequent to the second agreement and that Grizzly and Eberle Construction have sought further financial assistance from G. & H. in order to allow them to carry on with the contract which assistance G. & H. is prepared to extend provided that, inter alia, this agreement be made among the parties hereto.

(F) The parties hereto wish to enter into this Agreement in order to set out in writing the further agreements made among them in connection with the management and operation of the joint venture, the remuneration payable to G. & H., Weishaupt, and Hadden, and the division of profits and assets of the joint venture on completion of the contract.

(G) Grizzly, Murray, Stuart, B & G, Eberle, and Eberle Construction are hereinafter together called the "venturers"; and G. & H., Weishaupt, and Hadden are hereinafter together called the "creditors". That is the end of the recitals.

Paragraph 1 of the third agreement reads as follows:

All the recitals numbered (A) to (G) of this agreement shall be included in this agreement as expressed and agreed upon representations of fact upon which the parties rely in entering into this agreement.

Paragraph (g) of the third agreement states:

Paragraph I [of agreement two], shall be deleted and the following substituted therefore: “At the completion of the contract, all recoverables as defined in paragraph (A) hereof, as amended, shall be and become the absolute property of G. & H. free and clear of any claims by the venturers thereto until such time as all of the indebtedness of the venturers to G. & H. has been fully repaid and satisfied.”

Paragraph 4 states:

Notwithstanding any other agreement made prior to the date hereof, all of the venturers do hereby covenant and agree with the creditors that any and all sums of money contributed by any of them to the joint venture, for any reason whatsoever, including initial capital contributions for startup costs, shall remain in the joint venture and shall not bear interest, and shall not be repaid by the joint venture in any way or amount unless and until any and all indebtedness of the venturers to the creditors has been repaid and fully satisfied.

It is clear from the recitals that the second agreement did not constitute a new joint venture since Grizzly and Eberle are referred to as constituting the joint venture. By no stretch of the imagination does the third agreement constitute a joint venture. There is a lender/borrower relationship. Counsel for the appellant states that there is no provision for repayment yet there are references to repayment in paragraphs 3(g) and 4. It is clear in the third agreement that the joint venture is still made up of Grizzly and Eberle, and that what is being sought and provided is financing by G. & H. to complete the project. In addition, an examination of the joint venture's financial statements for the period ending December 31, 1982 shows that the advances to the joint venture by G. & H. are liabilities of the joint venture to G. & H. The accounts of G. & H. also refer to advances as amounts receivable by G. & H. from the joint venture. These are carried as receivables and not as an investment as are shares in subsidiaries, etc.

I find that as a fact that G. & H. was not a member either of the original or any subsequent joint venture to carry out the project and, accordingly, not able to deduct any amounts of the advances as ordinary business expenses.

Next, turning to the question of dealing at arm's length, or whether at the time of the disposition of the joint venture interest, G. & H. was controlled by Rebars.

In setting out the facts earlier in these reasons, I pointed out the conditions in the tender agreement and the sale agreement. The condition in the tender agreement was not that the joint venture interest had to be sold before Harris was required to purchase the shares but rather that G. & H. enter into an agreement with Rebars for its purchase; whereas, in the sale agreement, the obligations of Rebars to purchase the joint venture interest was conditional upon Harris having purchased the shares. Timing is important. However, Hadden was clear that Rebars only paid for the joint venture interest after it received its money from the sale of the shares. Therefore, I find that at the time of the purchase and sale of the joint venture interest, Rebars did not control G. & H.

There was a shortfall from the amount advanced by G. & H. and the amount it received, i.e., $700,000 advanced and $450,000 received. The question becomes whether this is an income or capital loss.

I have established that G. & H. was not a member of a joint venture and therefore the advances were not in furtherance of the business of a joint venture of which it was a member. Therefore, is it an income item for some other reason?

The appellant's counsel urges the Court to find that what was sold was a number or bundle of rights and not just cash advances and the expenditure did not create an asset of an enduring nature and, therefore, was not a capital expenditure. He further argues that having left the pure fee income scenario of the first agreement, what we have then, if not a new joint venture under the second and third agreements, is an adventure in the nature of trade.

Counsel for the respondent, on the other hand, states that the advances were of a capital nature and that the loans were made for the purpose of earning income.

As to the argument that there was an adventure in the nature of trade, I think not.

In Cull v. The Queen, [1987] 2 C.T.C. 63, 87 D.T.C. 5322 (F.C.T.D.), the entire transaction including the acquisition of shares was for the purpose of making a profit from development of lands, and then either from the sale of the shares or of the sale of the company’s assets. In the case at bar, there was no such intention.

The advances were loans made for the purpose of earning income both by way of interest on the amounts advanced and by way of additional income which was geared to the profit of the joint venture. G. & H. entered into lending arrangements and, accordingly, the advances were of a capital nature. In addition, G. &

H. was not in the business of lending money and therefore the loans should be characterized as capital, see the M.N.R. v. Freud, [1969] S.C.R. 75, [1968] C.T.C. 438, 68 D.T.C. 5279, a decision of the Supreme Court of Canada where Mr. Justice Pigeon states at page 82 (C.T.C. 443, D.T.C. 5282):

It is, of course, obvious that a loan made by a person who is not in the business of lending money is ordinarily to be considered as an investment. It is only under quite exceptional or unusual circumstances that such an operation should be considered as a speculation.

Mr. Justice Pigeon then found that there were such unusual circumstances. However, I find no unusual circumstances here.

The moneys were lent to earn income based on joint venture's profit. G. & H. did not make an investment to earn profits. The word "profit" used in the various agreements is merely a method of determining the income to be received by G. &

H. for its advances and, therefore, the loss was on account of capital. However, harkening back to my finding that Rebars did not control G. & H. at the time of the disposition, the provisions of subsection 69(1) are not applicable.

For the above reasons, the appeal is allowed with costs, and the matter referred back to the Minister for reconsideration and reassessment on the basis that (1) the appellant had no interest in the joint venture in 1992; (2) that at the time of the disposition of the joint venture interest, G. & H. and Rebars were dealing at arm's length; and, (3) the loss on the disposition of the joint venture interest suffered by the appellant was on account of capital in the 1983 taxation year.

Appeal allowed.