Henry R. Loewen v. Minister of National Revenue, [1990] 1 CTC 2133, 90 DTC 1009

Garon, T.CJ.:—This is an appeal from a reassessment dated August 10, 1988 for the 1985 taxation year. The income tax treatment of the gain made by the appellant on the redemption of a scientific research tax credit debenture is the principal issue in this appeal.

The appellant has been a chartered accountant for 25 years. At the material times, he was practising his profession on a full-time basis and was a partner in an accountancy firm. He described his practice as being "business consulting and general accounting”. His professional expertise did not include the income tax area.

It is common ground that the appellant was not a broker or dealer in securities prior to the subject transaction. The appellant stated that in respect of the disposition of securities that he held he had never claimed trading losses but rather treated them as capital losses.

On July 16, 1984, the appellant entered into an agreement with Dynaflex Industries, ("Dynaflex"), a British Columbia company having its head office in Vancouver, whereby he undertook to purchase a scientific research tax credit debenture in the principal amount of $140,000 for $200,000 with a redemption price of $140,000. The debenture was redeemable on demand at the option of the appellant. The debenture was to be issued by Dynaflex.

For the purposes of this appeal, the most important clauses of this agreement where Dynaflex is designated as the “Issuer” and the appellant as the "Purchaser" read as follows:

1. The Issuer will issue and the Purchaser will purchase from the Issuer at the Closing one of the Issuer's 1984 Scientific Research Tax Credit debentures (herein called the "Debenture") in the principal amount of $140,000 for the purchase and issue price of $200,000 and having a redemption price of $140,000, the Debenture being substantially in the form attached hereto as Schedule A.

3. At the Closing, the Issuer will execute and deliver to the Purchaser the Debenture, and the Purchaser will pay the purchase price to the Issuer as follows:

(a) as to $24,000, by delivery of a cheque for $24,000 drawn on the trust account of Anderson, Baillie & Company, and

(b) as to the balance, by delivery of a promissory note in the amount of

$176,000 and substantially in the form attached hereto as Schedule B.

4. The Issuer will, on demand, pay the $140,000 principal amount of the Debenture in full to the Purchaser, on demand, in accordance with the terms and provisions of the Debenture against the surrender of the Debenture to the Issuer for cancellation.

5. The Issuer will pursuant to subsection 194(4) of the Income Tax Act (Canada), (the "Act") designate an amount in respect of the Debenture equal to the full $200,000 amount of the purchase price of the Debenture and for the purposes of such designation, the Issuer will duly complete and file the prescribed form (T2113) and prescribed information return (12114) with Revenue Canada, Taxation on or before the last day for filing as provided for in the Act and shall deliver copies of those documents together with evidence of their filing to the Purchaser on or before February 28, 1985.

6. The Issuer represents and warrants that:

(e) Subsection 194(4) of the Act permits the Issuer to designate the full purchase price of $200,000 paid for the Debenture for the purposes of Part I and Part VIII of the Act; and

(f) the Issuer is actively carrying on scientific research and development in Canada and has incurred and will incur expenses with respect thereto which qualify as expenditures incurred on scientific research for purposes of clause 194(2)(a)(ii)(A) of the Act and that within the period commencing March 31, 1984 and ending June 30, 1985, the Issuer will have incurred such expenses in an amount at least equal to $800,000;

(g) that if the Issuer should not, on or before June 30, 1985, incur sufficient expenditures on scientific research, that will completely offset the Part VIII tax liability under the Act that it incurred as a result of making the designation referred to under paragraph 5, the Issuer will pay Revenue Canada, Taxation the outstanding balance of such Part VIII tax liability on or before August 31, 1985;

and

(h) the Issuer will not wilfully, in any manner whatever, evade or attempt to evade payment of the Part VIII tax liability under the Act that it incurs as a result of making the designation under paragraph 5.

9(1) The Issuer hereby indemnifies and holds harmless the Purchaser from and against any Canadian federal and provincial income taxes and interest thereon which the Purchaser is required to pay solely as a result and direct consequence of the failure of the Issuer to comply with its obligations to duly complete and file the prescribed form and information return with Revenue Canada, Taxation within the time period provided for in the Act; provided that the Issuer's obligation with respect to interest shall not include interest which accrues following notification to the Purchaser by Revenue Canada, Taxation by notice of assessment or reassessment or other notice in writing from the Minister of National Revenue (the "Minister") as a result of which the scientific research tax credit (as defined by paragraph 127.3(2)(a) of the Act) of the Purchaser in respect of the Debenture is not equal to 34 percent, of the purchase price of the Debenture.

Pursuant to the agreement of July 16, 1984, the debenture was issued for the principal sum of $140,000 with interest at 24 per cent per annum and was delivered on the same day to the appellant. As security for the reimbursement of the principal amount, interest and other moneys owing to the appellant, who is also described as the ''Holder" in the debenture, Dynaflex mortgaged and charged “as and by way of a floating charge to the holder and all other holders of Series A Debentures, all its properties, assets and undertakings, for the time being, both present and future, and of whatsoever nature and kind and wheresoever situated, . . .”.

Clause 4 of the debenture provides for the non-negotiability of the debenture in the following terms:

4. Non-Negotiability

This Debenture is not a negotiable instrument but may be assigned by the Holder or any intermediate holder thereof.

Clause 5 is also of some interest:

5. Redemption

This Debenture may be deposited to secure advances from time to time on a current or running account, and shall not be deemed to have been redeemed by payment of advances or by such current or running account ceasing to be in debit. The Company may at any time repay the total or any part of the Principal Sum upon payment of accrued interest to the date of such repayment. If this Debenture is actually redeemed by the Company it shall be cancelled and shall not be re-issued and the aggregate principal amount of Series A Debentures shall be reduced accordingly.

It was disclosed that prior to the agreement of July 16, 1984, the appellant had no business relationship with Dynaflex. The appellant did not know that company but was informed at the time that the company’s business "fell into the realm of scientific development". However, he was not aware of the kind of scientific research and development Dynaflex was to undertake with the funds received on the issue of Series A Debentures, which issue included the subject debenture, nor did he have any idea of the kind of assets the floating charge related to. He completely relied on his tax consultant in carrying out this transaction with Dynaflex and beforehand he made no investigation into the solvency of that company.

It is admitted that in accordance with subsection 194(4) of the Income Tax Act, Dynaflex designated the full price of the debenture to the appellant as $200,000. Accordingly, the cost of the debenture to the appellant by reason of the provisions of subsection 127.3(6) was reduced by 50 per cent of the amount designated in respect of the debenture. The cost to the appellant of the debenture was therefore deemed to be $100,000.

The evidence is absolutely clear that the sole reason behind the appellant's decision to enter into this agreement relative to the purchase of this S.R.T.C. debenture was the gaining of the tax credit. The entire transaction was motivated by the value of the tax credit. The following extracts from the transcript of the evidence reproducing the questions put by the appellant's counsel, Mr. Baillie, and the appellant’s answers leave no doubt as to this:

MR. BAILLIE: Q. Now, Mr. Loewen, why did you enter into that agreement, into the first agreement, which is Exhibit A-1; what was the purpose of buying the debenture?

A. Well, the purpose of buying the debenture was to earn the benefits under the scientific research credit only.

Q. And what is that? What is a tax credit? Scientific research tax credit?

A. A scientific research tax credit was created by the government under the Income Tax Act, I believe in 1983, to provide an incentive for companies in scientific research and development of investors to invest in these companies, and in turn they would obtain a tax credit which would be beneficial to them.

Q. And the tax credit was—how much was the tax credit?

A. The tax credit was 34 per cent of the designated amount of the security.

Q. So, in your case if the amount designated was $200,000.00, then the tax credit would be 34 per cent of that?

A. Yes.

Q. And was that, that 34 per cent of that, a federal portion of credit, or is that the full credit?

A. That 34 per cent is only the federal portion of the credit. In addition, there would be a provincial tax credit that would be computed as a percentage of the federal tax credit which, in that year, amounted to approximately another 50 per cent of the federal tax credit.

Q. So, the total, then, the full total credit, you take 1.5 per cent—1.5 times the 34 per cent, is that correct?

A. Yes, that’s correct.

Q. So, given the circumstances, the amount designated, so what was the value of that tax credit to you?

A. The value of the tax credit was $102,000.

Q. And you paid $200,000 for it?

A. Yes, I did.

Later on in his testimony, the appellant added that in determining the ultimate return in respect of the transaction account must be taken of the fact that he had the right to redeem the debenture for $140,000. He then stated that his "out-of-pocket cost was $60,000 for a tax credit of $102,000.” Incidentally, it is worth noting that the appellant never considered selling the debenture.

Furthermore, the evidence establishes that to ensure that the principal amount of the debenture would be paid to the appellant upon his call for the redemption of the debenture, the outstanding portion of the purchase price of the debenture in the amount of $152,000 owing by the appellant on December 31, 1984 was paid in trust to the appellant’s solicitors on or about the same time that the appellant called for the redemption of the debenture. In this connection, the following passages in the transcript of the evidence are significant:

Q. So, how were you assured that you would get your, the principal amount back when you called for redemption?

A. Well, I was assured of that, and I was, I was concerned of that in the beginning. But I was dealing with a tax adviser, namely, yourself, Mr. Baillie. And the terms of the payment were such that the, and the conditions were such that the last payment was held in trust for—and then the redemption would be made out of that. And that was my understanding, and that is what happened.

Q. Now, was there a particular reason why you made demand immediately upon Dynaflex to redeem the debenture as soon as you had paid the money?

A. Well, I certainly relied on the security of the money that I paid going in, being kept in trust so it could be paid out. So, it couldn't—you know, that’s the only logic I can think of. It was paid in, held in trust, and then paid right out again, almost simultaneously. A few days.

As a matter of fact, the appellant called for the redemption of the debenture on December 23, 1984, the appellant's cheque in the amount of $152,000 in full payment of the balance of the purchase price of the Debenture was dated December 31, 1984, the debenture was redeemed on January 2, 1985 and the trust cheque of the appellant's solicitors in the amount of $140,000 was forwarded to the appellant by his solicitors on January 2, 1985 as well. This is evidenced by the appellant's letter of December 26, 1984 and by Mr. William J. Baillie of January 2, 1985, filed as exhibits. As a further protection for the appellant the debenture, as indicated earlier, charged by way of a floating charge all of the assets of Dynaflex.

There was no restriction on when the appellant was entitled to call for the redemption of the debenture apart from the appellant's obligation to pay off the balance of the purchase price of the debenture. On January 2, 1985, approximately six months after its purchase, the appellant, pursuant to the terms of the debenture, called for its redemption and was paid $140,000 by Dynaflex. In receiving that payment of $140,000 in respect of the debenture, the appellant made a gain of $40,000 since the cost of the debenture to the appellant was, as explained earlier, $100,000.

The appellant was not concerned about the payment of interest by the issuer of the debenture, Dynaflex. He did not demand it and received no interest. He was categorical that the debenture had no value apart from the tax credit. As for the appellant himself, he had to pay interest in respect of a few days in relation to the borrowing of the sum of $152,000 that the appellant made to effect the last payment on the purchase price of the debenture.

The appellant treated the gain of $40,000 as a capital gain and the respondent in reassessing the appellant considered that that gain from the redemption of the debenture was profit from an adventure in the nature of trade and therefore income from a business.

A second issue arises on account of the fact that the appellant did not include in his original income tax return the amount of $20,000, that is, one half of what he considered to be his capital gain. He reported this gain after being informed of it by the respondent, in his amended tax return for 1985 which was filed with the respondent in April 1988. With that return, he included his election under subsection 39(4) of the Act that every Canadian security owned by him in that every subsequent taxation year is a capital property. On that second issue, the respondent takes the position that the so-called election under subsection 39(4) is void because it was not made in the manner required by subsection 39(4) of the Income Tax Act.

I shall now advert to the first issue whether or not the purchase and the redemption of the debenture by the appellant can be considered to be an adventure in the nature of trade.

In light of all the circumstances of this case, I am of the view that this transaction does not possess the characteristics of a trading operation. In my opinion, the evidence is clear that trading in securities was not in the ordinary course of the appellant's business. Moreover, the appellant did not trade in the subject debenture. He merely purchased it from its issuer for its inherent income tax attributes and redeemed it from its issuer at virtually no risk to him. He did not deal with the debenture in the same manner as a person whose ordinary business is the buying and selling of debentures and other securities. The acquisition of the debenture was not for the purpose of earning income therefrom as it would normally be understood by persons engaged in buying and selling debentures because the manner in which the present transaction was structured made this impossible right from the start. Indeed, the only way that the holder of the debenture could recover some of the original purchase price of the debenture was to call for its redemption for an amount less than the original purchase price. I agree with counsel for the appellant that no profit in a trading sense arose from the acquisition and disposition of the debenture. Indeed, if the benefits of the tax credit are disregarded, a loss according to ordinary commercial principles arose upon the redemption of the debenture because the acquisition cost to the appellant of the debenture ($200,000) exceeded the proceeds of its disposition ($140,000) on redemption by $60,000.

I am also satisfied on the totality of the evidence that the risk of economic loss to the appellant in entering into this transaction was virtually nonexistent. Amongst other considerations, it will be recalled that the agreement of July 16, 1984 obligated Dynaflex to designate the full amount of the purchase price of debenture of $200,000 for the purposes of subsection 194(4) of the Act and to file a prescribed form and a prescribed return in order to enable the appellant to be entitled to the scientific research and experimental development tax credit. There was also a covenant requiring Dynaflex to incur expenditures in respect of scientific research and experimental development in an amount at least equal to the amount designated under subsection 194(4) of the Act.

In brief general terms, the appellant did not deal with the property as an ordinary trader in property of that nature in order to realize a profit from its sale.

If my analysis of the evidence is right, it follows in my view, that the purchase and redemption of the debenture in the circumstances disclosed by the evidence does not make this transaction “an adventure or concern in the nature of trade." This conclusion is supported by two decisions of the House of Lords: Bishop v. Finsbury Securities Ltd., [1966] 3 All E.R. 105; FA & AB Ltd v. Lupton, [1971] 3 All E.R. 948.

In the Finsbury Securities Ltd. case, the taxpayer was incorporated to carry on the trade of dealing in shares and securities and did carry on that trade after its incorporation. A few years later, the taxpayer company entered into some 15 sets of transactions with other companies, described as "forward stripping” operations. The company claimed that it had sustained a loss in the course of the trade of dealing in shares. The following comments in the speech of Lord Morris of Borth-y-Gest, speaking for all members of the Court, at pages 109 and 112 are particularly illuminating:

My lords, the various arrangements are not to be regarded as sham transactions. They were as real as they were elaborate; but I cannot think that there is room for doubt that they were no more than devices which were planned and contrived to effect the avowed purpose of tax avoidance. The company used their organisation and their resources so that shareholders in Warshaw and in other companies involved should not wholly be deprived of money that had to be paid in tax. The scheme was one whereby the Revenue would be denied certain sums of money. Such sums could be made to find their way to the pockets of the shareholders in the various companies less such proportion as was the payment for the skilful services rendered. That was the reality of the matter.

A consideration of the transactions now under review leads me to the opinion that they were in no way characteristic of, nor did they possess, the ordinary features of the trade of share dealing. The various shares which were acquired ought not to be regarded as having become part of the stock-in-trade of the company. They were not acquired for the purpose of dealing with them. In no ordinary sense were they current assets. For the purposes of carrying out the scheme which was devised the shares were to be and had to be retained. The arguments before your lordships depended mainly on the submission by the Crown that the shares were acquired for a period of five years as part of the capital structure of the company from which an income would be earned and, on the other hand, on the submission of the company that they were acquired as part of their stock-in-trade.

The same approach was adopted by the House of Lords in the Lupton case, the second case mentioned above. That reasoning is well expressed in this portion of the head-note that reads:

. . . it was an essential feature of the sale agreement that it should be followed by dividend-stripping and a claim against the Revenue; since the manifest object of the taxpayer company in entering into the transaction was to secure a tax advantage, the transaction did not constitute dealing in stocks and shares and did not therefore form part of the trading activities of a dealer in stocks and shares.

The factual context in these two cases decided by the House of Lords is no doubt different but I am of the opinion that the approach and reasoning are applicable to the present case.

I also find some support in the decision of Mr. Justice Mahoney of the Federal Court-Trial Division, as he then was, in the case of David S. Colville- Reeves v. The Queen, [1981] C.T.C. 512; 82 D.T.C. 6005. In that case, the issue was whether a profit realized by the taxpayer in 1971 on the disposition of an interest in an apartment complex bought in 1970 was a capital gain or income. At page 516 (D.T.C. 6008-009) Mr. Justice Mahoney commented as follows:

The availability of a tax shelter is undoubtedly a plus factor from the point of view of any taxpayer proposing to engage in any transaction; however. I fail to see that it can have any bearing whatever on the determination of whether he entered into the transaction in the course of his business or, if not, as an adventure in the nature of trade.

The question remains whether his acquisition of the interest in the Sandhurst was an adventure in the nature of trade. If his acquisition did not amount to that, then nothing in the circumstances of his ownership or disposition changed its character.

I therefore come to the conclusion that the appellant in the present case in entering into the transaction of July 16,1984 and in redeeming the subject debenture did not embark upon an adventure or concern in the nature of trade. If the notional gain made by the appellant is not a profit from a business within the extended meaning of this term under the Income Tax Act it follows, in view of the state of pleadings, that it must be considered to be a capital gain; it was not seriously argued that this gain could be something else.

I am fortified in this conclusion by the recent unreported judgment of Deputy Judge D.W. Rowe of this Court in the case Stanley Drug Products Ltd. v. M.N.R. In that case, the learned judge decided that the taxpayer in engaging in an S.R.T.C. transaction cannot be considered to have undertaken an adventure in the nature of trade.

I should also add that there is a recently reported decision of this Court in the case of Smith v. M.N.R., [1989] 2 C.T.C. 2069; 89 D.T.C. 331 where the learned judge came to a different conclusion on the tax treatment of certain gains made in connection with the purchase of a scientific research tax credit debenture. In that case, however, the taxpayer was not represented and the Court was not referred to the two decisions of the House of Lords mentioned earlier.

In view of the conclusion arrived at on the first question in the case at bar, it is not necessary for me to deal with the second issue respecting the validity of the election which purports to be made under subsection 39(4) of the Income Tax Act.

For these reasons the appeal is allowed with costs and the assessment is referred back to the respondent for reconsideration and reassessment on the basis that the gain of $40,000 made by the appellant on the redemption of the debenture was a capital gain.

Appeal allowed.