Leighton Enterprises Limited v. Her Majesty the Queen, [1994] 1 CTC 2859, 94 DTC 1554

O’Connor, J.T.C.C.:—These appeals were heard in Vancouver, British Columbia on January 10 and 11, 1994 pursuant to the General Procedure of this Court.

Issue

The years under appeal are 1986 and 1987 and the principal issue is whether certain expenditures made by the appellant qualify as expenses incurred to earn income, as maintained by the appellant, or are on account of capital, as maintained by the respondent, acting through the Minister of National Revenue ("Minister"). A subsidiary issue is one of timing; that is can the Court look at the 1988 year (which is not under appeal) to determine that amounts owing to the appellant ecame a bad debt in that year thus permitting the appellant to carry portions of any resultant non-capital loss in 1988 back to 1986 and/or 1987.

Facts

The facts are complex. In the years in question Harbour Air Ltd. ("Harbour Air"), a Canadian company, was engaged principally in flying operations. Its three equal shareholders were:

1. Cliff Oakley ("Oakley")

2. James M. MacDougall ("MacDougall") and

3. Key Lyn Holdings Ltd. ("Key Lyn”), a holding company of a Keith N. Fraser ("Fraser").

The principal contributions of these people to the business were as follows: Oakley was involved almost exclusively with being a pilot and maintaining aircraft, Key Lyn, through Fraser provided the administrative direction and MacDougall looked after scheduling of the aircraft and the pilots.

A shareholders’ agreement between these three contained a “shotgun clause”, which in effect meant that if one of the shareholders offered his shares to the others and they accepted the offer then in normal circumstances a sale would follow at the price fixed in the offer; but if the other shareholders rejected the offer within a specified period of time, then the shareholder who had made the offer to sell had the right to buy, again within a certain period of time, the shares of the others, at the same price as he had offered to sell his shares.

In 1985 each of MacDougall and Key Lyn, by separate offers, offered to sell to Oakley their total of A of the shares of Harbour Air for $100,000, that is to say $50,000 for each of the two offering shareholders. This offer contained a condition, however, that if the sales were to proceed the offering shareholders must be released of their guarantees of a $700,000 indebtedness of Harbour Air to certain creditors.

Oakley, after taking the advice of the appellant discussed later, accepted the offers but upon doing so the offering shareholders rejected his acceptance and said that they were withdrawing the offers. Oakley felt that in all of the circumstances, the offering shareholders were not entitled to reject his acceptance and he continued with attempting to raise the $100,000 required to purchase the shares. Further, after being unable to get releases of the personal guarantees of the two offering shareholders from the creditors, Oakley, again with the assistance of the appellant as hereinafter described, set about to obtain replacement financing for an amount sufficient to pay off those creditors.

Notwithstanding the earlier rejections of the offers Oakley and the appellant set up a proposed closing/tendering meeting on August 20, 1985 at Harper, Gray, Easton, the lawyers Oakley and the appellant had retained for the transaction. These lawyers had advised that the rejections of Oakley’s acceptance were invalid and that a tendering procedure was in order. At the meeting the two shareholders persisted in their rejections. Moreover at or prior to the meeting they produced a letter wherein Harbour Air fired Oakley as president and general manager. Since these two shareholders were the signing officers on cheques for the company and although the firing may not have been legal, it was nevertheless effectual as no more payment cheques could be expected by Oakley. The lawyers mentioned above advised Oakley that the actions of the other two shareholders were preposterous and they recommended that Oakley proceed to a summary hearing pursuant to Rule 18(a) of the Rules of the Supreme Court of British Columbia. This Rule provides for a very quick hearing based essentially on affidavit evidence and the said lawyers advised that Oakley would be successful and the dispute would end quickly.

The summary hearing was held in October 1985 before Justice Paris. He found, contrary to the expected outcome, that there might be a triable issue. Consequently the case went to trial before the Supreme Court of British Columbia in the spring of 1986 and by judgment rendered later, Justice Bouck decided that the original offers to sell were invalid, principally because they contained the condition relative to releasing the two offering shareholders of their personal guarantees. Again, on legal advice, Oakley decided to appeal to the Appeal Court. The appeal was heard on May 6, 1987 and by judgment rendered June 5, 1987 the Appeal Court held, for reasons not explained, that the other two shareholders had the right to purchase Oakley's shares at a price to be determined in accordance with directions to be obtained from the B.C. Supreme Court and if they did not do so, Oakley had the right to purchase their shares at the same price. This necessitated a further application to the B.C. Supreme Court as to the process of establishing the value of the shares and by order dated February 3, 1988 the B.C. Supreme Court appointed M.M. McFarlane, Q.C. as arbitrator to determine the values. After hearing evidence of experts the arbitrator ruled on April 7, 1988 that the value of all of tne shares of Harbour Air was $480,000. Eventually the two offering shareholders purchased Oakley’s shares and paid him $160,000 (i.e., /3 of $480,000).

It is necessary to explain the structure of the appellant's operations, appellant's involvement in all of the foregoing as well as to analyze the expenses the appellant incurred in relation to the court cases.

As to structure, Bob Leighton and Associates ("Associates") is an umbrella company involved in consultation on a broad range of business activities includ- ing valuations of assets or shares, marketing strategies, systems set up and organization and essentially any aspect of concern to any business. Associates had at the relevant times approximately 40 employees. It carried on its activities through the personal holding companies of several consultants including the appellant. Associates would provide backup services to the consultants such as office space, secretarial staff, courier, communications and the like. This gave the actual consultants freedom to be in the field attempting to get clients, visiting them, examining their operations, books, structures, systems, etc.

The appellant owns 100 per cent of the common shares of Associates and, as mentioned, the appellant is owned 100 per cent by Bob Leighton. This illustrates the importance to Bob Leighton of the operations of the umbrella company (Associates) and of his own consulting company, the appellant. The billing procedures are best illustrated by the testimony of Mr. Mueller, the accountant at Associates:

Q. What was the relationship between all of the associates and. . .Associates in terms of how the funding was done for disbursements between them?

A. Each associate, through his own incorporated company, would invoice. . .Associates for the time spent by that associate on his various consulting assignments plus any related disbursements that he had made to. . .Associates on a monthly basis.

Q. And then what would. . .Associates do with respect to the client?

A. . . .Associates would then take that invoice from the associate, add any office time, telephone calls, photocopying, typing services that had been provided for each client, allocate the billings, and then submit the billings to the individual clients.

Q. What would happen if the client didn't pay. . .Associates?

A. The rule at. . .Associates is that the associate and his incorporated company would only be paid if the client paid. . .Associates. If the account went bad the associate’s company would be responsible for any of those disbursements that had been made on that specific consulting assignment.

and later

Q. If the disbursements became uncollectible, Leighton Enterprises was responsible for those disbursements?

A. Yes, because. . .Associates would not reimburse them, the uncollected disbursements.

As to the appellant's involvement with Oakley, when Oakley received the original offers he asked the appellant in April of 1985 to look at Harbour Air and advise whether Oakley should accept the offers and buy the shares being offered or alternatively sell his own shares for $50,000. The appellant's initial advice was

(a) secure a lawyer to check the validity of the offers;

(b) have Harbour Air's assets appraised; and

(c) have Harbour Air's books audited.

A lawyer was retained (Terry O'Brien of Harper, Gray, Easton) who advised that the offers were indeed valid. An appraisal was done and arrangements were made with Pannell, Kerr and Forster to conduct an audit.

After preliminary findings with respect to the value of the assets and preliminary results of the audit were available, Bob Leighton advised Oakley to accept the offers and buy the shares. At this stage however, because of Oakley’s inexperience in matters other than flying and maintaining aircraft and limited by his grade 8 education, he requested the appellant to assist in obtaining the required financing and concluding the deal. At this stage the appellant’s mandate obviously had expanded from one of simply advising Oakley that it was a good deal to buy the shares, to now assisting him in implementing the entire transaction.

Several financial institutions were approached and after considerable effort, principally by the appellant, a loan commitment was secured from Vancouver City Financial ("VanCity") for $750,000, $700,000 of which was to pay off the existing creditors with $59,000 being destined as an addition to the working capital of Harbour Air. Also a loan commitment for $100,000 to pay for the shares was obtained from Western Pacific Bank.

VanCity wanted appraisals of assets, an audit and a business plan and these were supplied.

It was a serious concern of VanCity that after Oakley acquired all of the shares the contributions to the business previously provided by the other two shareholders would cease and Oakley would not be able to run the company alone.

It is useful to quote from the transcript of Bob Leighton's evidence as to how he intended to resolve this concern of VanCity:

Q. And what did they suggest or did anyone suggest anything?

A. Well, I suggested to Cliff, and he agreed, that I could provide the executive management for the company, that Jenny Clark and Beverly Browning in my office could provide the administration supporting requirements, and that he could take on the role of the operations manager, and one of his key people that he got on quite well with, Hammerton, could take on the maintenance function, and in doing that we would meet the requirements for VanCity in terms of an ongoing organizational structure.

Q. And to provide these management services, who were you intending to provide those? Were you intending to provide those personally or were they corporately being provided? How were they being provided?

A. As it outlines in the plan, if you go to the attachments of the plan, in fact there is an income and expense forecast titled "Assumptions", and these were the assumptions upon which we based the information we were providing to VanCity. You'll notice under the management salaries that I had agreed that I would provide two days per month at my per diem rate, which I would have billed through Leighton Enterprises. . . .

I also agreed that I would replace the two staff under admin salaries, replace the two administration staff they had with Jenny Clark and Beverly Browning. Now, that had a substantial advantage to our company because, in effect, they could have done the administrative work for both companies without — I was already paying their salaries in. . Associates, in any event, so — and Cliff was agreeable to that. He said he would go, and of course VanCity thought that was fine as well.

Q. So who would have billed Harbour Air to provide those management and maintenance salaries?

A. . . .Associates. In addition, the marketing salary and the marketing Commission were also to be provided by our company.

Q. So that would have been a benefit to the companies. . .Associates and —

A. That’s right. What I would have done, and what I planned to do, was to bill myself through Leighton Enterprises for my management activity. I would have billed on those billings Jenny Clark and Beverly Browning for their administrative activities, and I would have ultimately billed another associate who was going to take on the marketing responsibilities. I would have billed his time through as well.

We had also discussed, Clifford and I, that the company required better systems. It required, in effect, a better accounting system because the accounting system was a mess that they had. We were going to put in a computerized general ledger for them. We were going to put in computerized maintenance systems, and we were going to put in flight scheduling and operational systems for him as well, but that was going to be developed at a later date, as this relationship unfolded.

The testimony also revealed that VanCity wanted Bob Leighton to be president of and have a controlling interest in Harbour Air and further insisted on his personal guarantee of the $750,000 loan.

The plan referred to in Bob Leighton's testimony is a business plan which forms part of Tab 30 of Exhibit A-2. It was proposed as part of a submission to VanCity dated August 13, 1985. For the year September 1985 to August 1986 it projects total estimated revenues in Harbour Air of $2,079,231, total expenses of $1,822,639 and profit of $256,592. Under the heading "Expenses" are included $41,004 for “Admin. Salaries”, $11,000 for “Marketing Salary”, $26,499 for “Marketing Comm" and $50,040 for “Management Salaries”.

Mr. Leighton analyzed these figures as follows:

Looking at the expense side, the $41,000 was what would have been paid on a continuing basis to. . .Associates for the services of Jenny Clark and Beverly Browning.

If you look at the second item, admin salaries, that is the total amount of money that would have been paid to . . . Associates, and to our extent it was very valuable because we were already paying their salaries, so that would have been right to our bottom line, if you want, because we were already paying administration salaries at . . . Associates. We were simply going to be using that resource in this manner and being able to bill for it.

The management salary total, on that same schedule. Of that amount, the two days’ billing per month that I would have personally put in would have amounted to about $16,000. The rest would have been salaries paid to Cliff Oakley for his role as the operations manager.

In addition to that, under the marketing salary of $11,000 and under the marketing commission, all of that amount would have been paid to . . . Associates, totals a continuing payment from this company to our company of about $95,000 a year, and we also have the prospect of other assignments in the computerization.

Tab 30 also contains a chart showing the proposed employees or administrators of Harbour Air. It shows Bob Leighton as "President and C.E.O.”, J. Clark as "Administration Manager” and B. Browning as "Payroll".

There were considerable costs incurred in connection with the complex litigation described above, principally legal and audit fees. Oakley had no money and the appellant paid the bills on Oakley's behalf. After some adjustments and discussion counsel for the appellant and the Minister agreed that the expenses incurred were $78,185.27 in 1986, $13,812 in 1987 and $22,274.83 in 1988.

Issues in detail

It is the appellant’s position that the amounts spent by the appellant in payment of the above expenses constituted expenditures laid out for the purpose of earning income in the consulting business, that the claim to recover them from Oakley became a bad debt in 1988 causing a non-capital loss in 1988 and that the appellant is entitled to carry said loss back to 1986 and/or 1987 pursuant to paragraphs 111(1)(a) and (b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) ("the Act"). The Minister's position is that the amounts are to be considered as a loan to Oakley, that when the account went bad the appellant incurred a capital loss in 1988 and that there can be no carry back of that loss against income in 1986 and/or 1987. The Minister also argues that for the application of paragraph 20(1 )(p) there must be an offsetting item of income in the returns for 1986 and 1987 corresponding to the amount of tne expenses ultimately written off. On this last point the appellant responds that it refiled its 1986 and 1987 returns including the amounts in question in income, i.e., amounts expended in the consulting operations claimable from Oakley. There was a fair amount of confusion in this respect. It appears that the original returns filed treated the amounts in question as income (i.e., as an amount due from Oakley) and, since that income had not been received, the amount thereof was included on the balance sheet as an account receivable. Then it appears that an accountant, unauthorized by the appellant, "reversed" those entries by some means (but not by filing a return) and their inclusion as income was deleted. The appellant has contended however that the refiled returns for those years include the amounts in question as income. The Minister has also submitted that the amount of the expenses was unreasonable.

The principal provisions of the Income Tax Act are as follows:

9(2) Subject to section 31, a taxpayer's loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis.

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(p) the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year, and

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year;

67 In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

111(1) For the purpose of computing the taxable income of a taxpayer for a taxation year, there may be deducted such portion as he may claim of

(a) his non-capital losses for the seven taxation years immediately preceding and the three taxation years immediately following the year. . . .

Paragraph 111 (8)(b) contains a complex definition of what constitutes a "noncapital loss” but suffice it to say, for purposes of this case, that it means an income- related loss as opposed to a capital loss.

Analysis

The Minister’s principal position is that the outlays in question were made because the appellant’s intention in making them was to acquire shares in Harbour Air. Therefore they are capital in nature and give rise to a capital loss. The evidence with respect to this position of the Minister is as follows:

(a) the letter of Associates to VanCity of August 15, 1985 at Tab 30, Exhibit A-2 with an annexed "Description of the Company" containing the following statement:

The refinancing is being guaranteed by Leighton Enterprises Ltd. and Mr. Robert D. Leighton who will subsequently retain controlling interest in Harbour Air Ltd. and Harbour Air Holdings Ltd. The financing is being provided by Vancouver City Savings Credit Union.

(b) An affidavit of Oakley which was annexed to the original notice of objection which contained statements alluding to the possibility that Mr. Leighton might become a shareholder in Harbour Air.

(c) There is also the testimony of the auditor for the Minister, Mr. R.D. Murray, that Bob Leighton told him at a meeting on June 6, 1989 that he intended to acquire the shares but that at a further meeting on June 9, 1989 Bob Leighton told him that that was not his intention.

(d) Counsel for the Minister further pointed out that the guarantees of the VanCity loan of $750,000 by the appellant and Bob Leighton, plus his involvement in obtaining for Oakley the $100,000 loan from Western Pacific Bank somehow leads to the conclusion that the appellant was so tied into the deal to acquire the shares it must mean the appellant wanted the shares for itself. Counsel demonstrated on cross-examination of Bob Leighton that on discovery he stated he was involved in the $100,000 loan, whereas at trial he denied this. In other words he changed his story and perhaps his credibility is questionable.

Counsel also demonstrated that the business plan presented to VanCity and filed as an exhibit differed in some respects from a plan shown at time of audit to the Minister, the implication being that there might be some contrivance and once again the question of credibility arises.

Bob Leighton stated that his evidence on discovery was wrong and that the differences in the plans arose from the fact he had the basic plan on a computer and altered it from time to time depending upon the institution or person to whom the plan was being presented.

With respect to the foregoing:

(a) As to the letter of August 13, 1985 to VanCity the appellant through Bob Leighton stated that:

(i) the terms of the letter had been dictated by VanCity;

(ii) he never intended to acquire shares; and

(iii) he could exercise effective de facto control of Harbour Air by

— being President thereof with signing authority;

— having his own employees administer the company to a large degree;

and

— the fact that if he left Harbour Air during the ten-year period of his guarantee VanCity would call the loan and effectively put Harbour Air out of business.

(b) Oakley died in 1992 and it is impossible to obtain clarification of his affidavit. It is to be noted that the affidavit also confirms the consulting arrangement business between Oakley and the appellant and states that had Oakley been able to acquire the shares of Harbour Air, the appellant would have been reimbursed for the expenses incurred and the consulting fees of associates would have been paid.

(c) What Mr. Murray remembers is probably true but his evidence must be weighed against the sworn contradictory testimony given at trial by Bob Leighton and Mr. Mueller.

(d) Even if Bob Leighton and the appellant were guarantors and even if he was instrumental in getting the $100,000 loan for Oakley this does not lead to the conclusion that ne intended to acquire shares.

The evidence in support of the treatment of these expenses as expenses incurred to produce income was:

(a) the forthright testimony of Bob Leighton that the appellant had no intention to acquire any shares even though Oakley had suggested it from time to time;

(b) the supporting testimony in respect to (a) of the accountant for Associates, Mr. Mueller; and

(c) the business plan which shows that the appellant’s interest in Harbour Air related directly to the amount of income it expected to receive from Harbour Air commending as early as October 1985, if the summary hearing had produced a favourable result.

The Court accepts the testimony of Bob Leighton, supported by the business pian (Tab 30, Exhibit A-2) and concludes that the expenditures related to appellant's expectations of an income flow from Harbour Air for its consulting business commencing as early as October 1985. Moreover the Court considering the large amount of income the appellant expected to generate, had the court cases produced the desired result, does not find the amount of the expenses unreasonable. In coming to the conclusion that the expenditures are on income account, the Court took into consideration the principles developed in the case law discussed below.

The case law confirms that no single test or legal principle is useful in and of itself in the determination of the characterization of an expenditure as either being on capital or income account. In R. Bruce Graham Ltd. v. M.N.R., [1986] 1 C.T.C. 2326, 86 D.T.C. 1256 (T.C.C.), the Tax Court of Canada cited several authorities on the issue. At page 2337 (D.T.C. 1264) it was pointed out:

In B.P Australia Ltd., v. Commissioner of Taxation, [1966] A.C. 224, [1965] 3 All E.R. 209, Lord Pearce stated, at page 264 (All E.R. 218):

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree.

Very recently Mr. Justice Estey, in the reasons for judgment of the Supreme Court of Canada in Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, [1985] 2 C.T.C. 111, 85 D.T.C. 5373, extensively reviewed the jurisprudence and appropriate principles of law to be considered and applied to the determination of the classification of an expenditure as being either expense or capital. On pages 56-57 (C.T.C. 117-18, D.T.C.5377) he noted the pronouncement of Lord Pearce in B.P Australia Ltd., supra, and cited Dixon, J. in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946), 72 C.L.R. 634, 8 A.T.D. 190 (H.C.) at page 648 (A.T.D. 196) wherein it was stated:

[The] answer depends on what the expenditure is calculated to effect from a ractical and business point of view, rather than upon the juristic classification of the egal rights, if any, secured, employed or exhausted in the process.

At pages 2337-38 (D.T.C. 1265) the Court added:

Returning to the decision of Mr. Justice Estey in Johns-Manville, supra, at pages 70-71 (C.T.C. 125, D.T.C. 5358) he noted the observations made by Lord Wilberforce in Tucker v. Granada Motorway Services, [1979] 2 All E.R. 801, [1979] 1 W.L.R. 683 (H.L.) at page 804 (W.L.R. 686):

It is common in cases which raise the question whether a payment is to be treated as a revenue or as a Capital payment for indicia to point different ways. In the end the courts can do little better than form an opinion which way the balance lies. There are a number of tests which have been stated in reported cases which it is useful to apply, but we have been warned more than once not to seek automatically to apply to one case words or formulae which have been found useful in another. . . . Nevertheless reported cases are the best tools that we have, even if they may sometimes be blunt instruments.

Similarly, Lord Reid in Regent Oil Co. v. Inland Revenue Commissioners, [1966] A.C. 295, [1965] 3 W.L.R. 636 (H.L.) stated, at page 313 (W.L.R. 645-46):

So it is not surprising that no one test or principle or rule of thumb is paramount. The question is ultimately a question of law for the court, but it is a question which must be answered in light of all the circumstances which it is reasonable to take into account, and the weight which must be given to a particular circumstance in a particular case must depend rather on common sense than on strict application of any single legal principle.

The Minister also argues that the Court, since the 1988 taxation year is not before it, cannot rule on whether claims which have become a bad debt in 1988 and produced a non-capital loss in 1988 can be carried back to 1986 and/or 1987. On this last issue it must be remembered that the fact that the claim became a bad debt in 1988 has been admitted by the Minister. Also the 1988 tax return is in the record as an exhibit. I do not believe that the Court, having found that the related expenses were on income account and were reasonable, in deciding on the 1986 and/or 1987 years, which can be affected by events of 1988, is precluded from looking at 1988. The Court is not ''reopening" the 1988 year but is merely considering the impact of events occurring in 1988 on the 1986 and/or 1987 years.

It is clear that the Court does not have before it the 1988 taxation year. Counsel for the Minister explains this was the result of a foul-up in the Minister's department in that 1988 was not reassessed as was 1986 and 1987. Consequently the 1988 return was accepted as filed, apparently giving the appellant the treatment it desired for the expenses incurred in the 1988 year. The Court believes these difficulties should be resolved by the reassessment to issue pursuant to this judgment. In other words if in fact the appellant was, considering its overall income and expense situation in 1988, not obligated to take into account in 1988, the appellant is entitled to carry it back to the 1986 and/or 1987 years.

For all of the above reasons the appeals for the 1986 and 1987 taxation years are allowed with costs and the matter is referred back to the Minister for reconsideration and reassessment in accordance with these reasons for judgment.

Appeal allowed.