Owen D. Ellis v. Minister of National Revenue, [1988] 1 CTC 2081

Brulé, T.C.J.:— These appeals, heard in Vancouver, British Columbia, are against income tax reassessments for the years 1981, 1982 and 1984 in which the Minister of National Revenue disallowed claims of capital losses totalling $318,475.11.

Facts

In his reply to the notice of appeal, counsel for the respondent did not take issue with the following part of the appellant's statement of facts:

1. Owen D. Ellis (“Mr. Ellis"), age 62, has carried on business in the Comox Valley of British Columbia for more than thirty years.

2. Bay Stores Ltd. (“Bay Stores") is a company formed under the laws of British Columbia.

The shareholders at all relevant times have been:

Mr. Ellis	72 common shares
Doris Ellis	7
M.J. Watson	7
D.O. Ellis	7
B.A. Baillie	7
	100 common shares

Doris Ellis is the wife of Mr. Ellis. The other minority shareholders are a son and daughters of Mr. Ellis, all of whom are over 18 years of age.

Bay Stores owns commercial rental property and carries on a small retail business in Comox, B.C.

3. Aspro Enterprises Ltd. ("Aspro") is a company formed under the laws of British Columbia in 1979.

The authorized capital of this company is made up of Class A voting common shares and Class B non-voting common shares.

At all relevant times the registered shareholders of Aspro were as follows:

	Class A	Class B
Bay Stores	20	—
A.J. Thomsen	20	—
R.G. Jasper	20	—
Barry Howarth	20	20
S. Jensen	20	—
Doris Ellis	—	20
Gail Thomsen	—	20
Greta Jasper	—	20
Martha Jensen	—	20
	100 shares	100 shares

Mr. Ellis dealt at arm's length with all the shareholders of Aspro at all relevant times with the exception of Doris Ellis and Bay Stores.

4. Aspro was formed for the purpose of constructing and operating a hotel in Comox, B.C.

In 1980 this company began to assemble land for the proposed hotel. The company also incurred costs related to the design of the proposed hotel and other costs.

6. To finance the development of the hotel, Aspro incurred a debt in excess of $565,000 with the Canadian Imperial Bank of Commerce.

As Aspro had no significant unencumbered assets it was necessary for Messrs. Ellis, Thomsen, Jasper, Howarth and Jensen to guarantee the bank loans of Aspro. This guarantee was joint and several. Given this lack of unencumbered assets, no fee was charged to Aspro by these individuals for providing the guarantee.

8. The hotel project of Aspro failed. The reason for the failure was the inability of the company to raise the necessary financing to construct the building and other facilities required for the operation of a hotel. Subsequent to the incorporation of Aspro the economy of the Comox Valley became depressed and other hotels in the area went into receivership. The proposed hotel of Aspro ceased to be economically feasible.

9. Once the idea of constructing a hotel was abandoned the management of Aspro attempted to sell this property. However, the value of the land had fallen significantly by this time. Certain real property acquired by Aspro under agreements for sale was repossessed.

10. In 1984, the Canadian Imperial Bank of Commerce called upon Mr. Ellis and Mr. Jensen to honour the guarantee each had given in respect of the Aspro bank loans.

After considerable negotiation it was agreed that Mr. Ellis would pay to the bank $318,475.11 under the guarantee.

It is understood that Mr. Jensen agreed to pay a substantially lesser amount. The amount and terms, however, are not known.

The reason given for the decision of the bank to demand that Mr. Ellis bear substantially all the burden of honouring the guarantee was that other parties to the guarantee did not have the financial wherewithal to make good on their obligations.

Mr. Ellis has not taken action against the other parties to the guarantee because, in his view, it would not be worthwhile given the financial condition of these individuals.

11. In addition to the amount settled under the guarantee as owing by Mr. Ellis to the Canadian Imperial Bank of Commerce, it was agreed that Mr. Ellis would purchase from the bank certain real property which the bank had seized from Aspro. The purchase price was agreed to be $192,411.10.

12. The aggregate amount paid to the Canadian Imperial Bank of Commerce was:

Loan Guarantee	$318,475.11
Real Estate Purchase	192,411.10
	$510,886.21

This amount was paid by Mr. Ellis as follows:

March 20, 1984	$ 9,475.11
June 28, 1984	25,000.00
September 10, 1984	25,000.00
December 20, 1984	51,411.10
December 20, 1984	400,000.00
	$510,886.21

13. Aspro presently has no assets and is dormant. There are no plans to revive this company.

14. Mr. Ellis claimed a business investment loss in 1984 in respect of the $318,475.11 paid to the bank under the guarantee.

15. In 1987, Revenue Canada reassessed the 1984 return of Mr. Ellis to disallow the claim for the business investment loss.

In reassessing the appellant for the 1984 as well as for the 1981 and 1982 taxation years (that is the two years the appellant carried back his alleged capital losses), the respondent relied, inter alia, upon sections 18, 20, 40 and 50 of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended ("the Act").

Appellant's Position

Essentially, the appellant contended that when the Canadian Imperial Bank of Commerce ("the Bank") called upon him and Mr. Jensen for payment under the terms of the guarantee, a substantial share of the bank loan to Aspro became his bad debt. Further it is argued that the payments of the appellant's share amounting to $318,475.11 should be considered as capital losses and that subparagraph 40(2)(g)(ii) of the Act should not apply as to reduce the appellant's loss to nil.

In the appellant's view, subparagraph 40(2)(g)(ii) is not applicable to the circumstances in this case as the guarantee to the Bank was made for the purpose of gaining or producing income from a property in the sense that by guaranteeing Aspro's loan to the Bank, the appellant increased the possibility that profits from Aspro's operation would eventually trickle to him through Bay Stores. As explained in paragraphs 5 and 7 of the notice of appeal:

5. If Aspro had enjoyed the success that its shareholders had anticipated in 1980, Bay Stores, as one of the shareholders, would have profited and its ability to pay dividends to its shareholders would have been enhanced.

7. The ultimate and principal purpose of Mr. Ellis providing the guarantee of the debt of Aspro was to earn dividend income on his shares of Bay Stores. It should be noted that Mr. Ellis dealt at arm's length with Aspro at all material times.

Respondent's Position

For the respondent it was submitted that the expectation to earn dividend income from Bay Stores cannot be a sufficient consideration for the guarantee because the appellant's expectation of dividend in the present case is too remote. Accordingly, since the appellant’s loss was not incurred for proper consideration or for the purpose of gaining or producing income, subparagraph 40(2)(g)(ii) of the Act must apply with the result that the appellant's loss is deemed to be nil.

It was suggested by counsel for the respondent that the appellant's written submission has not shown the debt to be bad.

Analysis

At trial the question regarding whether the payment of $318,475.11 by the appellant in satisfaction of the Bank’s guarantee constituted a bad debt within the meaning of subsection 50(1) of the Act was considered from the outset. The appellant testified that when Aspro defaulted on its loan in 1984, he was the only guarantor in a position to substantially honour the guarantee. Property searches (such as the copies of land title searches of Mr. Howarth's properties filed as Exhibit A-2) confirmed that Messrs. Howarth, Thomsen and Jasper were insolvent. In the case of Mr. Jensen, it was suggested that although he might have made some payments to the Bank, the amount of $318,475.11 paid by the appellant was more than his share of the guarantee, and that since the payments of the debt in 1984, all attempts to be compensated by Aspro and his co-guarantors have been abandoned.

In response to this evidence counsel for the respondent noted that there was no evidence to contradict the assertion that a debt was assiged to the appellant in 1984, and that the same debt was bad. Concerning the evidence adduced on this point my finding at trial was thus to acknowledge that the debt acquired by the appellant was equal to the amount of his payments made under the guarantee and the debt in question was bad.

Having determined that there was a disposition of property, within the meaning of paragraph 39(1)(b) of the Act, and that the debt was bad, within the meaning of subsection 50(1) of the Act, the question remained as to whether or not subparagraph 40(2)(g)(ii) of the Act should apply to the present case. Clearly if subparagraph 40(2)(g)(ii) is to be avoided, the appellant must prove that the debt was acquired, or, in this case, that the guarantee was provided either for the purpose of gaining or producing income from a business, or for proper consideration. In 1984 this subparagraph of the Income Tax Act read as follows:

40. (2) Notwithstanding subsection (1),

(g) a taxpayer's loss, if any, from the disposition of a property, to the extent that it is

(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm's length,

is nil.

In support of the proposition that the appellant's guarantee was provided for the purpose of gaining or producing income, the appellant's agent relied on two recent decisions recognizing the prospect of dividend income as sufficient consideration for the granting of an interest-free loan by a shareholder to his company. In the case of The Queen v. Dr. Eugene Lalande et al., [1983] C.T.C. 311; 84 D.T.C. 6159, the Federal Court-Trial Division had to decide inter alia whether the fact that there was no interest charged for the loan of money by a partner to his partnership was a bar for considering that the debts at issue were acquired ”. . for the purpose of gaining or producing income from a business or property . . .”. At page 318 (D.T.C. 6164), Décary, J. succinctly answered:

This is essentially a question of weighing the facts of the case. 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.

In my view, the aim was to increase a professional practice and so increase income.

In the case of Business Art Inc. v. M.N.R., [1987] 1 C.T.C. 2001; 86 D.T.C. 1842 (T.C.C.), the taxpayer granted an interest-free loan to a company in which he held 48 per cent of the shares. After the company went into bankruptcy and failed to repay the loan, the taxpayer deducted his losses from his income. Subsequently, the Minister disallowed the claim of capital losses on the basis that an interest-free loan could not have been made for the purpose of earning income. In allowing the appeal, Rip, T.C.J. held at page 2008 (D.T.C. 1848) that:

However, even if no interest was chargeable I do not believe that would be fatal to the appellant's alternate submission. 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. See The Queen v. Lalande and Watelle, [1983] C.T.C. 311 at 318; 84 D.T.C. 6159 at 6164. It is not uncommon for a shareholder to lend money without interest and without security to the corporation since he anticipates that the loans will assist the corporation to earn income and to pay him income by way of dividends; the loan is made for the purpose of earning income from a property. Although the shareholder is a creditor of the corporation when he advances money to the corporation the shareholder does not see his advance of money to the corporation and his subscription for shares of the corporation as separate investments in two watertight compartments; rather he sees his money entering two compartments which open up into a single compartment for the use of the corporation. Purchasing shares and advancing money to a corporation are two ways of making an investment in the corporation. This is a sensible interpretation.

For the respondent it was argued that this excerpt is an obiter dictum and that it should be dismissed on the grounds that it cannot be reconciled with the established line of cases pertaining to the interpretation of the expression “for the purpose of gaining or producing income”. (Canada Safeway Limited v. M.N.R., [1957] C.T.C. 335; 57 D.T.C. 1239 (S.C.C.); D.W.S. Corpo- ration v. M.N.R., [1968] C.T.C. 65; 68 D.T.C. 5045 (Ex. Ct.); John A. Matheson v. The Queen, [1974] C.T.C. 186; 74 D.T.C. 6176 (F.C.T.D.)). These cases, it was contended, leave no doubt that interest paid by a shareholder on borrowed money that he decided to lend without interest or security to his company is too remote to be deductible as an expense incurred to earn income (i.e. dividends from his company). As Rand, J. puts it at page 343 (D.T.C. 1243) of Canada Safeway (supra) (a case where a company lent money to its subsidiary):

In the circumstances before us, the interposition of a new and distinct capacity as shareholder breaks the continuity of the company's act as being in its own business . . .

And further down at page 345 (D.T.C. 1244):

. . . the business of the subsidiary is not that of the company.

Applying to the present case the line of authorities which follows the logic expressed in the case of Canada Safeway (supra) counsel for the respondent urged this Court to consider the Lalande and the Business Art cases (supra) as decided on their own facts. In the present case, counsel submitted Aspro's business and the appellant's own interest as a gratuitous guarantor is just too remote to characterize the guarantee as used for the purpose of earning income.

I agree with this latter position. Clearly, the Lalande and the Business Art cases (supra) are distinguishable from this case in that here the appellant is one step removed from the scenario where the lender claiming relief is a shareholder of the company to whom he had lent money. In the present case, the appellant was not a shareholder of the company, Aspro, to which he provided a guarantee, and Aspro was in no way obligated to the appellant to see that if, indeed, the hotel project became profitable, some profits would flow from Aspro to Bay Stores, and that these profits would be redistributed in dividends from Bay Stores to its own shareholders including the appellant. In the Lalande and the Business Art cases (supra), even if no interest was charged by the lender to his company, it was established that true consideration to a shareholder can come in the form of future dividends or increased value of his stocks. Here, the fact that the appellant was not a shareholder of Aspro and that from his own admission he "dealt at arm's length with Aspro at all material times" makes it effectively impossible to argue that the Lalande and the Business Art decisions (supra) should apply to him.

Contrary to the appellant's submission I believe that it matters greatly that the appellant was not guaranteeing the loan of a company of which he was “a shareholder, or to its Canadian subsidiary" (See paragraph 6 of Interpretation Bulletin IT-239 R-2 entitled “Deductibility of Capital Losses from Guaranteeing Loans for Inadequate Consideration and From Loaning Funds at Less than a Reasonable Rate of Interest in Non-Arm's Length Circumstances").

Given the commonly accepted definition of the word “subsidiary”, which is held to be "a corporation the capital stock of which is owned or controlled by another company" (Wilson v. M.N.R., [1938-39] C.T.C. 161 at 170; 1 D.T.C. 478 at 482 (Ex. Ct.), it is possible that, if Aspro would have been a subsidiary of Bay Stores, the appellant could have argued that his 72 per cent ownership of Bay Stores allowed him to control the profits of its subsidiary, Aspro, making the prospect of dividends flowing from it through Bay Stores to the appellant a possibility, a different situation from the actual facts of this case.

In the present circumstances since the appellant neither owned shares nor a controlling interest in Aspro when he agreed to guarantee Aspro's loan without further consideration, I am of the opinion that the appellant's prospect of receiving dividends was only a possibility of benefit, which because of its remoteness was not undertaken for the purpose of gaining or producing income from a business or property. In view of this finding, I conclude that subparagraph 40(2)(g)(ii) of the Act should receive application in this instance and that the respondent's reassessments disallowing the appellant's claim for capital losses are confirmed.

The appeals are dismissed.

Appeals dismissed.