National Developments Ltd. v. Her Majesty the Queen, [1993] 2 CTC 3027

Bell, T.C.CJ.:—The appellant is one of three Canadian corporations each of which sought to deduct a capital loss in its return of income for the 1985 taxation year on the basis that an amount owing to it by K-Tel International Inc. ("K-Tel") was a bad debt within the meaning of paragraph 50(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") at the end of that year.

The appeals of the appellant and of Tri-State Products Ltd. ("Tri- State"), both of whose taxation years ended on June 30, were heard on common evidence. The income tax affairs of the third corporation are of no concern to the court with respect to this appeal.

The appellant was controlled by Philip Kives whose evidence supplemented both an agreed statement of facts filed in respect of each of the appellant and Tri-State and facts admitted in the pleadings.

The appellant owned approximately 44.1 per cent of the issued and outstanding common shares of K-Tel, a Minnesota corporation, and Tri-State owned approximately 13.3 per cent of such shares, no preferred shares having been issued. K-Tel carried on the business of development and mass merchandising of consumer entertainment products. Philip Kives, his brother Ted Kives, who controlled Tri-State and their cousin, Raymond Kives who controlled the aforesaid third corporation (which owned approximately 10.9 per cent of the common shares of K-Tel) were directors and officers of K-Tel.

In September 1983, K-Tel was experiencing business difficulties and entered into a financing arrangement with a group of banks in the United States under which the banks undertook to provide K-Tel with loans up to $18,500,000 U.S. in loans. As a condition of providing financing to K-Tel, the banks required the K-Tel majority shareholders to guarantee a portion of K-Tel's loans by pledging certain cash collateral to the banks. The third corporation pledged the cash collateral required of it by the banks. Tri-State pledged the cash collateral required of it and of the appellant. At the same time the appellant entered into an agreement with Tri-State to indemnify it for the portion of the collateral pledged by Tri-State on behalf of the appellant, which indemnification was secured by assignment to Tri-State of a mortgage owned by the appellant.

K-Tel declared cash dividends from 1979 to 1984. The amount of dividends (Canadian dollars) received from K-Tel and reported for tax purposes by National and Tri-State were:

Although K-Tel declared dividends of the same amount in fiscal 1983 as in fiscal 1982, National, Tri-State and the third corporation voluntarily agreed to defer taking the 1983 dividends owed to them by K-Tel until after the end of the 1984 fiscal year of K-Tel. Due to the insolvency of K-Tel in October 1984 the payment of these dividends was not made by K-Tel at the end of 1984.

In September 1983, National, Tri-State and the third corporation gave certain guarantees of K-Tel's debt to the group of banks which were lending moneys to K-Tel.

Philip Kives testified that in 1983 the U.S. bankers of K-Tel were becoming nervous about K-Tel's financial position. He stated that although a line of credit of $18.5 million was negotiated for K-Tel, it was reduced to $16.4 million. Provision was made for the availability of this sum as a revolving credit commitment in a credit agreement dated as of September 19, 1983. An additional sum of $2 million was made available by the banks secured by a mortgage on real estate. The evidence indicated that the sum of $2.1 million was advanced pursuant to this arrangement. K-Tel agreed in such credit agreement that it would not pay or make any dividend or distribution on any shares of its capital stock. A pledge agreement was entered into whereby Tri-State on behalf of itself and of the appellant (as above described) and the third corporation pledged the aggregate sum of $1 million (U.S.) as a condition precedent to the making of advances by the bank to K-Tel pursuant to the credit agreement. Philip Kives gave evidence to the effect that the directors thought that the banks would not continue without this arrangement and that they thought they could turn the company's fortunes around, financial difficulties having arisen. Subsequently, the reasons for K-Tel's growing economic distress were that a subsidiary corporation, Candlelite Marketing Inc. was having great difficulty with respect to moneys owed to it in its business operations and the diminution in demand for and price of natural gas, the marketing of which was part of the oil and gas operations of K-Tel.

In September 1984, the banks demanded repayment from K-Tel of all the loans it had received under its financing arrangement. K-Tel was unable to satisfy its obligations to the banks and filed a voluntary petition under Chapter 11 of the Bankruptcy Code of the United States. The banks then seized the cash collateral pursuant to the guarantees given to them by the K-Tel majority shareholders.

These shareholders were subrogated to the position of the banks as creditors of K-Tel to the extent of the amounts of collateral seized by those banks. The amounts of debt so owed by K-Tel to them respectively were as follows (in Canadian dollars):

Within a year the Chapter 11 matter was resolved, K-Tel was reorganized and now continues to carry on business in a successful manner.

Appellant's counsel read into evidence a passage from the examination for discovery of Megan Elizabeth Smallman, a business tax auditor with the Department of National Revenue. She stated that it was an "administrative policy decision” of that Department that subparagraph 40(2)(g)(ii):

should be available solely to assist the financing of Canadian enterprises.

In filing its income tax returns for its 1985 taxation year, the appellant claimed a capital loss of $951,177 on the basis that the amount owing to it by K-Tel was a bad debt at the end of the year. The Minister of National Revenue reassessed the appellant on February 12, 1990 for its 1985 taxation year and reduced the capital loss of $951,177 to nil by applying subparagraph 40(2)(g)(ii) of the Income Tax Act on the assumption that the commitment entered into by the appellant with U.S. banks to enable K-Tel to obtain financing from them was not for the purpose of gaining or producing income from a business or property of the appellant. Since the reassessment of February 12,1990 was a nil reassessment which could not be appealed, the appellant requested the Minister of National Revenue to determine the amount of the appellant's loss for 1985. The Minister of National Revenue by notice of determination of loss dated May 30, 1990, determined that the net capital loss of the appellant for 1985 was $43,286.

The appellant filed a notice of objection to that determination of loss on the basis that its net capital loss for 1985 was $475,588 (i.e., one-half of $951,177). The Minister of National Revenue confirmed his determination of loss of May 30, 1990 by notice of confirmation dated April 30, 1991.

The appellant has appealed to this court regarding the determination of loss of May 30, 1990 for 1985 pursuant to subsection 152(1.2) and section 169 of the Act. The appellant's notice of appeal states two issues to be resolved, namely: Issues

1. Does subparagraph 40(2)(g)(ii) of the Income Tax Act apply to deem the appellant's capital loss of $951,177 in 1985 to be nil?

2. Does the Minister of National Revenue have the legal right to apply subparagraph 40(2)(g)(ii) of the Income Tax Act in an inconsistent manner among different taxpayers?

Appellant's arguments

Appellant's counsel referred to a number of cases supporting its position that the amount of $951,177 paid by the appellant pursuant to the aforesaid pledge and which it is agreed was a bad debt owing to it by K-Tel at the end of the 1985 taxation year, should be allowed as a capital loss and should not be deemed to be nil pursuant to subparagraph 40(2)(g)(ii) of the Act. I shall refer to this subparagraph as section 40.

The first such case is Business Art Inc. v. M.N.R., [1987] 1 C.T.C. 2001, 86 D.T.C. 1842 (T.C.C.). In this case, moneys were loaned by Business Art, a Canadian company, to a United Kingdom company of which each of the appellant and its general manager owned 48 per cent of the outstanding shares. It is not clear whether interest was payable on certain sums so advanced. In discussing the very issue arising here, Judge Rip of this Court said at pages 2008-9 (D.T.C. 1848) that the fact that there may have been no interest attached to the debts in question is not relevant in deciding whether they were acquired for the purpose of gaining or producing income. He made reference to The Queen v. Lalande, [1983] C.T.C. 311, 84 D.T.C. 6159 (F.C.T.D.); aff'd [1989] 2 C.T.C. 30, 89 D.T.C. 5286 (F.C.A.), a decision of the Federal Court-Trial Division at page 314 (D.T.C. 6164) where Mr. Justice Décary stated that:

The fact that there was no interest or costs attached to the debts in question is not relevant in deciding whether they were acquired for the purpose of gaining or producing income.

Counsel then referred to Auld v. M.N.R. (1962), 28 Tax A.B.C. 236, 62 D.T.C. 27 in which Mr. Auld borrowed from the bank and made advances to his wholly owned company. The question in issue was whether interest paid to the bank on such money was deductible. The Tax Appeal Board found that borrowed money was used for the purpose of earning income from property, namely the obtaining of dividend income, and allowed the deduction. In so doing it referred to Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717, [1957] C.T.C. 335, 57 D.T.C. 1239, in which deductibility of interest on borrowed money used to purchase shares of another corporation with which it had business dealings was not allowed on the ground that dividends it might receive would be exempt income. It is noted that the definition of exempt income for the taxation years in question in the case at bar would not produce that result.

Counsel then referred to Glass v. M.N.R., [1992] 2 C.T.C. 2133, 92 D.T.C. 1759 (T.C.C.) in which Judge Mogan found that the loss on a loan made, without interest, to a foreign corporation of which he was a 25 per cent shareholder was a capital loss when it was determined that it could not be repaid. He pointed out that a loan of this nature constituted a debt which may have been acquired by the shareholder for the purpose of gaining or producing income from business or property. He referred both to the Business Art case, supra, and the concession of the Minister of National Revenue in its Interpretation Bulletin IT-239R2 that the loss on a shareholder's loan "at less than a reasonable rate of interest" need not be nil under subparagraph 40(2)(g)(ii).

Appellant's counsel then referred to Fernandez v. M.N.R., [1991] 1 C.T.C. 2211, 91 D.T.C. 182 (T.C.C.) in which Fernandez and others had pledged prop erty to support third party loans to a certain company. When financial institutions forced the sale of the property Fernandez was able to determine the amount by which, by subrogation, he became an unsecured creditor of the company. Judge Mogan found that Fernandez thereby acquired a debt owing by the company, the amount of which was determined only after the sale of the property but that his investment in the debt related back to the time when the property was pledged. Applying subsection 50(1) of the Act Fernandez was deemed to have disposed of the debt and section 40 did not apply to deem his loss to be nil. Reference was made also to Steckel v. M.N.R., 92 D.T.C. 1904 (T.C.C.), in which Judge Mogan said that the facts that no interest was charged on advances made and no consideration was received for the guarantee given to the bank were not insurmountable impediments in claiming an allowable business investment loss which he then found to exist. In Laframboise v. M.N.R., [1992] 2 C.T.C. 2690, 92 D.T.C. 2299 (T.C.C.) the Minister of National Revenue did not apply section 40 in respect of the taxpayer's loss arising from honouring a guarantee. The same result pertained in K.]. Beamish Construction Co. v. M.N.R., [1990] 2 C.T.C. 2199, 90 D.T.C. 1584 (T.C.C.).

Counsel also referred to Ellis v. M.N.R., [1988] 1 C.T.C. 2081, 88 D.T.C. 1070 (T.C.C.) in which Judge Brulé of this Court found that Ellis gave his guarantee neither for the purpose of earning income nor for proper consideration. He argued that the decision, made without benefit of the above cited subsequent decision, was wrong. He then cited decisions in Panda Realty v. M.N.R., [1986] 1 C.T.C. 2417, 86 D.T.C. 1266 (T.C.C.) and Cantin v. M.N.R., [1981] C.T.C. 2918, 81 D.T.C. 311 (T.R.B.), in his favour, reasons for judgment in the latter case having provided, in part, that future dividends from certain shares were indeed sufficient financial incentive to justify a loan without interest.

With respect to a leading case on deductibility of interest, Canada Safeway, supra, appellant's counsel pointed out that dividend income at that time would have been exempt income and would accordingly, by statute, have been disqualified from deduction.

With respect to D.W.S. Corporation v. M.N.R., [1968] C.T.C. 65, 68 D.T.C. 5054 (Ex. Ct.); aff'd [1969] S.C.R. v (note), 69 D.T.C. 5203, in which the taxpayer's argument for deductibility of interest was not accepted by the Court, appellant's counsel submitted that Justice Thurlow had taken liberty with the Supreme Court of Canada decision in Canada Safeway by attempting to incorporate its reasoning as authority for the statement, at page 73 (D.T.C. 5050-51), that

. . .I think that the possibility of increased dividends by lending to World T. and I. Corporation must be taken to be too remote to characterize the lending of the borrowed money to it without interest as use for the purpose of earning income from the property represented by the loan.

In addition, counsel states that D.W.S. must be distinguished from this case because subsection 20(1)(c) of the Act includes a source concept, its opening words reading in part:

. . .there may be deducted such of the following amounts as are wholly applicable to that source . . . ."

whereas no such concept is found in the applicable portions of section 40 of the Act. He supports the proposition by submitting that section 40 is in the capital gains portions of the Act which is not part of the source concept. He also pointed out that the wording of subparagraph 40(2)(g)(ii) does not state specifically that there must be a purpose of gaining or producing income from the debt or other right to receive an amount which is disposed of but rather a purpose of gaining or producing income from business or property.

Further, he referred the Court to an article by Robert Reid, C.A., in the 1990 Canadian Tax Conference Report at page 20:17 in which the author states that a taxpayer must overcome the preamble in subsection 20(1) of the Act even though it uses words similar to those found in subparagraph 40(2)(g)(ii) where such preamble does not exist.

Appellant's counsel, in his second area of argument stated that the Minister of National Revenue must apply the laws on a consistent basis and in so doing made reference to Interpretation Bulletin IT-239R2. More will be said about this later.

He then referred to the matter of statutory interpretation, stating that the concept of strict interpretation, under which a taxpayer must clearly bring himself within a deduction section no longer pertains, that the concept of commercial reality has been recognized by the Courts and must be taken into account and that where a taxing statute is not explicit, reasonable uncertainty or factual ambiguity resulting from lack of explicitness in a statute should be resolved in favour of the taxpayer. He referred the Court to Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, [1985] 2 C.T.C. 111, 85 D.T.C. 5373 at page 72 (C.T.C. 126, D.T.C. 5384) and to Canterra Energy Ltd. v. The Queen, [1987] 1 C.T.C. 89, 87 D.T.C. 5019 (F.C.A.). In the latter case, Mr. Justice Urie of the Federal Court of Appeal, at page 93 (D.T.C. 5022), quoted E.A. Driedger in his text Construction of Statutes from page 87, namely:

Today there is only one principle or approach, namely, the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament.

this statement having been endorsed by Mr. Justice Estey in the Supreme Court of Canada decision in Stubart Industries Ltd. v. The Queen, [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305 at page 578 (C.T.C. 316, D.T.C. 6323). His submission respecting this matter included reference to the words of Mr. Justice Urie in Nowsco Well Service Ltd. v. Canada, [1990] 1 C.T.C. 416, 90 D.T.C. 6312 at page 424 (D.T.C. 6318), namely:

I am of the opinion that a common-sense, realistic and business-like appreciation of all of the foregoing indicates that

and to the judgment in McClurg v. M.N.R., [1990] 3 S.C.R. 1020, [1991] 1 C.T.C. 169, 91 D.T.C. 5001, where reference was made, in addition to the words of Chief Justice Dickson, therein to The Queen v. Golden, [1986] 1 S.C.R. 209, [1986] 1 C.T.C. 274, 86 D.T.C. 6138 and Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. Finally in this regard, reference was made to Macklin v. Canada, [1993] 1 C.T.C. 21, 92 D.T.C. 6595 (F.C.T.D.) at pages 26-27 (D.T.C. 6599) and pages 29-30 (D.T.C. 6601).

Respondent's argument

Counsel for the respondent stated that the loss under section 50 of the Act was not disputed. She stated also that the issue for determination was:

1. whether subparagraph 40(2)(g)(ii) applied in this case, and

2. what is the role of Interpretation Bulletin IT-239R2?

She submitted that the guarantee (pledge) was not given for the purpose of gaining or producing income but to preserve the value of the shareholder's capital asset. She stated that there was no consideration given for the guarantee and no provision for the payment of interest if the guarantee was honoured. She said that the guarantee was given at a time when the shareholders knew there would be no income from giving the guarantee. She referred to K-Tel's covenant not to pay dividends and submitted that there was no evidence as to commercial practice in that regard to which reference had been made by appellant's counsel. She submitted that the fact that K-Tel was under Chapter 11 for one year only was meaningless and that one must look to the time the guarantee was given, the purpose of same then being only to ensure a line of credit for K-Tel’s operations. She stated specifically that the loan proceeds were not to be used for the payment of dividends. She argued that Judge Rip did not have the benefit of the Bronfman Trust decision when he decided Business Art. She submitted that Business Art broadened and merged into a single transaction and that this was questionable in light of the Bronfman Trust decision. She referred to the words of Chief Justice Dickson in Bronfman Trust at pages 51-52 (C.T.C. 128, D.T.C. 5066), namely:

Although the Canada Safeway, supra, case did not relate specifically to an alleged indirect use of funds to preserve income-producing assets, the emphasis on directness of use of borrowed funds in the reasons of Justice Rand is antithetical to the submission of the taxpayer in the present appeal.

Respondent's counsel then suggested that Judge Rip was incorrect in his judgment in Business Art because he cited no authority for his conclusion and that his reliance upon Lalande, supra, was questionable because Mr. Justice Décary's basis for his statement quoted above was not clear. In response to a question from the Court she said that all cases following Business Art were wrongly decided.

She then submitted that prospective dividends did not meet the purpose test in Bronfman Trust.

Reply

In reply, appellant's counsel stated that Bronfman Trust did not deal with the purpose side of the statute but rather with the use side and he referred to page 50-51 (C.T.C. 127-28, D.T.C. 5066) of the judgment where reference was made to Canada Safeway, supra and the use of debenture moneys for the purchase of shares in another corporation and the specific statement that dividends from Canadian corporations were exempted from taxable income. He then submitted that Bronfman Trust, as he said, was "about tracing" the use of funds. He submitted that it is inappropriate to take the area of direct or indirect use and apply it to section 40 respecting direct or indirect purpose. He also stated that this provision does not talk about short- and long-term purpose and that there is no time test for the production of income from business or from property.

Conclusion

The facts were substantially agreed to and there was absolutely no evidence to contradict any testimony of Philip Kives. Based upon my interpretation of the facts and my comprehension of the authorities cited I am in accord with the submissions made by appellant's counsel. I therefore conclude that:

(a) the appellant voluntarily entered into the pledge arrangement with the banks and also into the security agreement because Philip Kives and the other directors believed in the potential of K-Tel to become successful again, the result of which success would be the reinstitution of the payment by K-Tel and a receipt by the appellant of dividends, a significant past record of which existed;

(b) the debt or right to receive the sum of $951,177 from K-Tel arising on the banks’ calling on the appellant's pledge related back to the time when the amount of that pledge was deposited in a collateral account as security for payment to the banks of K-Tel's obligations. Although it may be suggested that technically the reference to "debt or other right to receive an amount" being acquired must refer only to the date upon which the banks called K-Tel's loan and applied the moneys in the collateral accounts to K-Tel's obligation to the banks, such construction, in my opinion would be incon- sistent with the object and spirit of subparagraph 40(2)(g)(ii), would not be in harmony with the evident purpose of that provision, would lack common sense and would cast a blind eye to the commercial and economic realities of business transactions;

(c) the loss arising from the application of paragraph 50(1)(a) of the Act is a loss within the meaning of subparagraph 40(2)(g)(ii) of the Act from the disposition of a debt or other right to receive an amount acquired by the appellant for the purpose of gaining or producing income from property.

Respecting the above quoted sentence of Megan, Elizabeth Smallman in her examination for discovery, which being restated is that it was an "administrative policy decision” of that department that subparagraph 40(2)(g)(ii) “should be available solely to assist the financing of Canadian enterprises" there is no conceivable support for any interpretation of that paragraph to benefit Canadian corporations only.

Because of my conclusions, it is not necessary to deal with the argument by appellant's counsel respecting the application of the law by the Minister of National Revenue on a consistent basis. Accordingly the appellant's appeal is allowed on the basis that the appellant had a capital loss of $951,177 in its 1985 taxation year.

Appeal allowed.