Colonial Realty Service Ltd. v. Minister of National Revenue, [1987] 1 CTC 2343, 87 DTC 259

Brulé, T.C.J.:—These appeals, heard in Toronto, Ontario, on January 28, 1987, are against income tax assessments for the taxation years 1978, 1979, and 1980. By his 1978 and 1979 assessments the Minister of National Revenue reclassified as “Canadian investment income" interest received on Guaranteed Investment Certificates which had been reported by the appellant as income from “active business”, thereby disallowing the appellant's claim for the small business deduction with respect to these amounts.

By his 1979 and 1980 assessments the Minister added to the appellant’s income interest deemed received per subsection 17(1) of the Income Tax Act on interest-free loans made to two non-resident corporations, which had been outstanding for more than one year.

Two Issues

The present appeals raise two distinct issues: One, pertaining to the 1978 and 1979 taxation years, relates to the concept of income from an active business, the other, pertaining to the 1979 and 1980 taxation years relates to the concept of deemed interest on intercorporate loans. I shall deal with each issue separately, beginning with the question of income from active business.

“Income From Active Business”

Facts

The appellant is a Canadian-controlled private corporation, the nature of its business for the 1978 and 1979 taxation years being described as rental and management of real estate. In the early 1970s the appellant received funds from the sale of real estate and invested these in Guaranteed Investment Certificates. The certificates were generally for a fixed five-year term. In filing its 1978 and 1979 income tax returns the appellant included the interest received on its investment certificates in its income from an active business and claimed a small business deduction with respect to these amounts. The Minister reclassified the interest received as “Canadian investment income" therefore disallowing the small business deduction. The interest received represented approximately 75 per cent of the appellant’s taxable income in 1978 and 90 per cent in 1979. The appellant had no employees but paid management fees of $5,000. In 1979 the investment certificates were used as security for obtaining a loan which was re-loaned interest-free to two non-resident corporations.

Issue

The first question at issue in the present appeals is whether the interest received by the appellant on Guaranteed Investment Certificates for the 1978 and 1979 taxation years constituted income from an active business in respect of which a small business deduction could be claimed.

Appellant's Position

The appellant’s counsel submitted that the funds received from the sale of real estate were placed in Guaranteed Investment Certificates temporarily because the company was not able to find suitable alternative properties to purchase at that time. Counsel submitted that the funds were placed in certificates with a fixed five-year term in order to obtain the best rate of return. This, to the appellant did not constitute a restriction on the availability of the funds since the certificates could be used as security for bank loans which could be repaid when the securities matured. It was pointed out that the certificates were in fact used as security for obtaining a loan in 1979. On behalf of the appellant it was submitted that the placing of surplus funds in Guaranteed Investment Certificates constituted part of its normal real estate business. For the appellant, the interest earned on the certificates therefore constituted income from an active business giving rise to the small business deduction.

Respondent's Position

Counsel for the respondent said the small business deduction could not be claimed with respect to the interest received as these sums were not income from an active business. He submitted the funds invested were never again used in the appellant’s business. The result was that the interest received was Canadian investment income.

Analysis

Section 125 of the Income Tax Act provides that a Canadian-controlled private corporation may qualify for a deduction from the tax it would otherwise be liable to pay. This is known as a small business deduction, and may be claimed only on the corporation's “active business” income. The Income Tax Act as it applies to the taxation years in question does not provide a definition of “active business”. The pertinent part of section 125 of the Act reads as follows:

125 (1) There may be deducted from the tax otherwise payable under this Part for a taxation year by a corporation that was, throughout the year, a Canadian- controlled private corporation, an amount equal to 25% of the least of

(a) the amount, if any, by which

(i) the aggregate of all amounts each of which is the income of the corporation

for the year from an active business carried on in Canada,

exceeds

(ii) the aggregate of all amounts each of which is a loss of the corporation

for the year from an active business carried on in Canada, . . .

Active business income cannot be defined without reference to the general statutory framework of the Act. The effect of section 125 of the Act is to tax the active business income of a small business at a lower rate than the normal corporate rate. Section 129 of the Act, on the other hand, allows a corporation to receive a refund of tax paid on its "investment income". The "investment income” on which the tax refund will be calculated includes income from property and income from a business other than an active business.

This view was expressed by St-Onge, T.C.J. (in his capacity as a member of the T.R.B.) in Marlee Investments Ltd. v. M.N.R., [1975] C.T.C. 2189 at 2191; 75 D.T.C. 153 at 154:

I agree with counsel for the respondent that section 125 of the new Act cannot be read alone and section 129 and 95 show that there are three types of income under the new Act. Also subsection 248(1) stipulates that property includes money.

Having made these distinctions, I have to consider whether the income in question was income from property, income from business, or income from an active business.

Not all income from property falls within the definition of "investment income’ giving rise to the tax refund. Section 129 of the Act specifically excludes from the definition of "investment income” income from property "used or held by the corporation in the course of carrying on a business".

The definition of “investment income” must therefore be kept in mind when deciding whether income is from an “active business”. Income from a business other than an active business and income from property other than property used or held in the course of carrying on a business will fall within the category of “investment income” giving rise to a tax refund. Income not falling within the definition of "investment income”, such as income from property used or held in the course of carrying on a business, may be considered income from an "active business” and therefore taxed at a reduced corporate rate.

A recent example of income from "property used or held in the course of carrying on a business” constituting income from an "active business” may be found in Ensite Limited v. The Queen, [1986] 2 C.T.C. 459; 86 D.T.C. 6521. The Supreme Court had the following comments on the proper test to apply in order to determine if income from property constitutes income from an "active business”.

In the Ensite case (supra), the Court referred at page 463 (D.T.C. 6524) to The Queen v. Marsh & McLennan, Ltd., [1983] C.T.C. 231; 83 D.T.C. 5180, saying:

The issue was whether the money invested was "property used or held in the course of carrying on a business” within the meaning of the exclusion in subparagraph 129(4)(a)(ii) of the Income Tax Act. A majority of the Court held that the exclusion did apply.

I n the course of his reasons for judgment Clement, J. stated at 242 (D.T.C. 5189):

"To use the words employed by Rowlatt, J. in Scales (H.M. Inspector of Taxes) v. Thompson & Company, Limited (1927), 13 T.C. 83, on the facts of this case there was between the broker’s business and the investment an interconnection, an interlacing, an interdependence, a unity embracing the investments and the business.”

Le Dain, J. concurred in the result but proposed at 243 (D.T.C. 5190) a differently worded test:

“Was the fund employed and risked in the business? In my opinion it was, because an amount equivalent to this notional fund was committed to the carrying on of the business in order to meet the company's obligations to the insurers.”

The Supreme Court by Wilson, J. continued later at 463 (D.T.C. 6524):

The precise difference in substance between the test employed by Le Dain, J. and that of Clement, D.J. is not easy to discern. In many instances property which is "employed or risked” in the business will be "interconnected, interlaced and interdependent” with the business. However, the wording of the test employed by Le Dain, J. seems more specific and therefore preferable because it emphasizes that the holding or using of the property must be linked to some definite obligation or liability of the business.

Such a test when applied to the present case inevitably leads to the conclusion that the holding or using of the Guaranteed Investment Certificates by the appellant was not linked to some "definite obligation or liability of the business”. The Ensite case (supra) can therefore not be used to exclude the interest received on the Guaranteed Investment Certificates from the category of “investment income” and to place it within the definition of "income from an active business”.

Chief Justice Jackett of the Federal Court had the following comment on the determination of the type of income in The Queen v. Rockmore Investments Ltd., [1976] C.T.C. 291 at 293, 76 D.T.C. 6156 at 6157:

In considering whether there is an “active business” for the purposes of Part I, the first step is to decide whether there is a “business” within the meaning of that word. Section 248 provides that that word, when used in the Income Tax Act, includes “a profession, calling, trade, manufacture or undertaking of any kind whatever” and includes “an adventure or concern in the nature of trade” but does not include “an office or employment”. Furthermore, the contrast in section 3(a) of the Act between “business” and “property” as sources of income makes it clear, I think, that a line must be drawn, for the purposes of the Act, between mere investment in property (including mortgages) for the acquisition of income from that property and an activity or activities that constitute “an adventure or concern in the nature of trade” or a “trade” in the sense of those expressions in section 248 (supra.)

In the case of a corporate taxpayer there exists: “a rebuttable presumption that income received from or generated by an activity done in pursuit of an object set out in the corporation's constating documents is income from a business” (Canadian Marconi Company v. The Queen, [1986] 2 C.T.C. 465; 86 D.T.C. 6526). The Supreme Court gives a detailed history of the presumption and Wilson, J. stated at 469 (D.T.C. 6528):

. . . Most recently, in England, the presumption appears to have been extended to corporations with a profit-making purpose and not just corporations whose precise objects are set out in their constating documents. In American Leaf Blending Co. v. Director-General of Inland Revenue, [1979] A.C. 676; [1978] 3 All E.R. 1185 (P.C.), Lord Diplock stated that “in the case of a company incorporated for the purpose of making profits for its shareholders any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business” (p. 684:1189).

and at 469-70 (D.T.C. 6529) sets out:

The traditional expression of the presumption restricts its application to corporations whose corporate objects are expressly set out in their constating documents. Corporations formed under the Canada Business Corporations Act, S.C. 1974-75-76, c. 33, the Ontario Business Corporations Act, 1982, S.O. 1982, c. 4, and similar legislation do not need to list their corporate objects. These statutes have simply provided that corporations have the capacity and the rights, powers and privileges of a natural person (Canadian Act, s. 15; Ontario Act, s. 15). Accordingly, an issue may be raised some day as to whether the presumption applies to such corporations (or, more particularly, whether the scope of the presumption should be extended as Lord Diplock has done in the American Leaf Blending Co. case, supra) but this issue does not arise for consideration in this appeal since C.M.C., being incorporated in 1902 under the Ontario Companies Act, R.S.O. 1987, c. 191, and continued in 1903 under a special federal statute (An Act to incorporate the Marconi Wireless Telegraph Company of Canada, Limited, S.C. 1903, c. 149 was required to state its objects.

The Court goes on to say at the same page:

Thus, C.M.C. had a specific “investment business” object and the traditional rebuttable presumption, in my view, applies in favour of its investment income being characterized as income from a business. Indeed, even if CMC’s investment objects were not expressed, I believe that a broader form of the presumption should apply. In a general sense C.M.C. was incorporated to earn income by doing business. There is no reason why any income earned by it should not be considered as prima facie income from a business so long as it is recognized that the presumption is a rebuttable one. This approach has commended itself to courts even where no express object was contained in constating documents: see, for example, Supreme Theatres Ltd. v. The Queen, [1981] C.T.C. 190; 81 D.T.C. 5136 (F.C.T.D.) and Fontaine Watch Co. v. M.N.R., supra.

Wilson, J. again stresses at 470 (D.T.C. 6529):

As I have indicated the presumption that income earned by a corporate taxpayer in the exercise of its duly authorized objects is income from a business is rebuttable.

and further states that:

The question whether particular income is income from business or property remains a question of fact in every case.

and suggests the following guidelines for making the determination:

It is trite law that the characterization of income as income from a business or income from property must be made from an examination of the taxpayer's whole course of conduct viewed in the light of surrounding circumstances: see Cragg v. M.N.R., [1952] Ex. C.R. 40; [1951] C.T.C. 322, per Thorson, P. at 46 (C.T.C. 327). In following this method courts have examined the number of transactions, their volume, their frequency, the turnover of the investments and the nature of the investments themselves.

In the case at bar the funds were not guaranteed in short-term securities but in fixed five-year Guaranteed investment Certificates. The corporation had no employees and there was no evidence of day-to-day intervention of the corporation's directors in the appellant’s business. The appellant did not advertise for clients and there was no evidence that it was actively seeking or reviewing other investment opportunities. A single loan was obtained in 1979 using the certificates as security and the funds were reloaned interest-free to two non-resident corporations.

These facts lead us to the conclusion that the presumption referred to in Canadian Marconi (supra) insomuch as it applies to the present case, has been rebutted. These same facts distinguish the case at bar from the Canadian Marconi case where the Court noted, among other factors: , .. the extensive activities of CMC's employees in purchasing short-term investments and the large number and high value of those transactions, .. .”

The present case must also be distinguished from The Queen v. Rock- more Investments Limited (supra), where the taxpayer was engaged in a money-lending business. The evidence adduced in the present case cannot bear the conclusion, reached in Rockmore (supra), that the appellant was engaged in “an activity or activities that constituted an adventure or concern in the nature of trade” as found in the definition of business in section 248 of the Act.

The facts in this case bear a certain resemblance to those of Charwood Investments Limited v. M.N.R., [1978] C.T.C. 2545; 78 D.T.C. 1411. In deciding that issue Judge Taylor stated at 2549 (D.T.C. 1413):

I am satisfied that at least some of the functions carried on by or on behalf of the appellant company demonstrate a measure of activity greater than that normally required of or intended by an investor (particularly one dealing in longterm securities) whose only involvement after acquisition of the properties would be to clip interest coupons, receive dividends or interest payments, and collect rentals. The Company engaged in reviewing alternate uses for its funds — loans, real estate, mortgages or company shares; reviewing applications for funds and inspecting properties involved where either mortgages or percentage purchases of rental commercial real estate was involved; liquidating certain types of investments from time to time and reinvesting in other forms of security; dealing with, consulting and being consulted by brokers seeking to find investment capital; and held a seat with other percentage investors on a “management committee" which, however distant from the day-to-day operations of the rental properties, nevertheless took a continuing interest in the security and good administration of the total investment.

The Court cannot find any significant "measure of activity greater than that normally required or intended by an investor (particularly one dealing in long-term securities)" in the case before it. The evidence did not establish the reviewing of alternate use of funds described in the Charwood case (supra).

For these reasons, the Court finds that the income received by the appellant from Guaranteed Investment Certificates in 1978 and 1979 taxation years did not constitute income from an active business.

The appeals must fail on this point.

I shall now examine the second issue raised in the present appeals.

Interest Deemed Received

Facts

The appellant has made interest-free loans to two non-resident corporations. In 1979 and 1980 these loans had been outstanding for more than one year and the Minister added to the appellant’s income for those taxation years, interest deemed received on the loans in accordance with the provisions of subsection 17(1) of the Income Tax Act.

The appellant’s shares are held in equal proportions, 50 per cent by Union Investment Corporation (“Union") and 50 per cent by Capital Investment Corporation (“Capital”), both Canadian corporations.

One of the non-resident corporations who benefited from the interest- free loans, Oakland Investment Inc. (“Oakland"), was a wholly-owned subsidiary corporation of Union.

The other non-resident corporation who benefited from the loans, Chieftain Investments Inc. (“Chieftain”), was Capital’s related corporation, both Capital and Chieftain being controlled by the same trust, the Paton Family Trust (“Paton Trust”). Capital's shares were entirely owned by the Paton Trust who also controlled Grandale Investments Ltd. (“Grandale"), 100 per cent shareholder of Chieftain.

The following diagram illustrates the corporate structure of the principals involved in the present appeals:

Issue

The second issue in the present appeals is whether interest may be deemed to have been received by the appellant, in the 1979 and 1980 taxation years, pursuant to subsection 17(1) of the Act, on interest-free loans made to two non-resident corporations, which had been outstanding for more than one year.

Appellant’s Position

Appellant’s counsel, presented two separate arguments. The first submits that the loans were made to corporations that came substantially within the definition of “subsidiary controlled corporation” and that subsection 17(3) of the Act, which states that deemed interest is not to be calculated when the loan was made to a subsidiary controlled corporation, should be applied to the case at bar.

It was also submitted that both non-resident corporations to whom the loans were made were related to the appellant. The non-resident corporations and the appellant would therefore all be members of a related group.

Having stated these submissions, appellant’s counsel argued that the principles governing the exception of subsection 15(2.1) of the Act, relating to loans made to foreign affiliates that are not dealing at arm’s length, should be applied by analogy to interest deemed received pursuant to section 17 of the Act.

In appeal 84-620 (IT) the notice of appeal summarized Colonial’s position as follows:

The Appellant submits that under Section 15(2.1) of the Income Tax Act, the provisions dealing with loans to shareholders and corporations which are connected to shareholders does not apply in the case of a foreign affiliate of a person resident in Canada with which the particular corporation does not deal at arm's length.

The Appellant submits that applying the same principles to Section 17(1), a deemed dividend should not be calculated where the loan has been made to a non-resident corporation, where the corporations are all members of a related group, and the non-resident corporations therefore fall substantially within the definition of “subsidiary controlled corporation" in which cases deemed interest is not to be calculated.

Analysis

Subsection 17(1) of the Income Tax Act deems interest to have been received on loans to non-resident persons that have been outstanding for more than one year. The subsection reads as follows:

17.(1) Where a corporation resident in Canada has loaned money to a nonresident person and the loan has remained outstanding for one year or longer without interest at a reasonable rate having been included in computing the lender's income, interest thereon, computed at a prescribed rate per annum for the taxation year or part of the year during which the loan was outstanding, shall, for the purpose of computing the lender's income, be deemed to have been received by the lender on the last day of each taxation year during all or part of which the loan has been outstanding.

Subsection 17(3) of the Act however provides the following exception:

17. (3) Subsection (1) does not apply if the loan was made to a subsidiary controlled corporation and it is established that the money that was loaned was used in the subsidiary corporation’s business for the purpose of gaining or producing income.

Section 248 of the Act defines “subsidiary controlled corporation" as follows:

“Subsidiary controlled corporation" means a corporation more than 50% of the issued share capital of which (having full voting rights under all circumstances) belongs to the corporation to which it is subsidiary.

It is the appellant’s contention that the loans in question fall under the exception found in subsection 17(3) of the Act, both non-resident corpora tions “coming substantially within the definition of subsidiary controlled corporation”. Subsection 17(3) of the Act is clearly an exempting provision. I would refer to the comments of the Supreme Court in Wylie v. City of Montréal (1885), 12 S.C.R. 384 at 386:

I am quite willing to admit that the intention to exempt must be expressed in clear unambiguous language: that taxation is the rule and exemption the exception, and therefore, to be strictly construed.

Thorson, J. in W.A. Sheaffer Pen Company of Canada Ltd. v. M.N.R., [1953] C.T.C. 345 at 349; 53 D.T.C. 1223 at 1225, after quoting the above passage added:

Then I put the rule of construction of an exempting provision of the Income War Tax Act as follows:

Just as receipts of money in the hands of a taxpayer are not taxable income unless the Income War Tax Act has clearly made them such, so also, in respect of what would otherwise be taxable income in his hands a taxpayer cannot succeed in claiming an exemption from income tax unless his claim comes clearly within the provisions of some exempting section of the Income War Tax Act: he must show that every constituent element necessary to the exemption is present in his case and that every condition required by the exempting section has been complied with.

More recently in the case of The Assessment Commission of the Village of Stouffville v. Mennonite Home Association of York County, [1973] S.C.R. 189, Spence, J. had the following comment at 194:

It is of course, clearly established that although the words of the statute must plainly assess the tax in order to bring the subject within the levy, the subject must, in turn, clearly establish that his case falls within the exemption in order to claim his benefits.

A strict interpretation of the expression “subsidiary controlled corporation” was adopted by the Tax Review Board in Distillers Corporation- Seagrams Limited v. M.N.R., [1980] C.T.C. 2737; 80 D.T.C. 1649. In that case the Board stated at 2749 (D.T.C. 1659):

After studying the meaning of “belong” in the dictionaries, and the meaning given by the courts, the Board concludes that the ordinary meaning of the word “belong” in the definition of “subsidiary controlled corporation” in paragraph 139(1)(aq) connotes “property”. Hence, the control of the subsidiary must be direct.

The facts indicate that the non-resident corporations’ shares were not the property of the appellant. The Court must adopt a strict construction of the definition of “subsidiary controlled corporation”, one that excludes both non-resident corporations in the present case.

In arriving at this conclusion the Court has considered the decision rendered in The Queen v. Bronfman Trust, [1987] 1 C.T.C. 117; 87 D.T.C. 5059 where Chief Justice Dickson stated at 128 (D.T.C. 5066):

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes (see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536 at 573-79; [1984] C.T.C. 294 at 313-16 and The Queen v. Golden, [1986] 1 S.C.R. 209 at 214-15; [1986] 1 C.T.C. 274 at 277), so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on what Lord Pearce has referred to as a “common sense appreciation of all the guiding features” of the events in question: B.P. Australia Ltd. v. Commissioner of Taxation of Australia, [1966] A.C. 224 (P.C.) at 264; [1965] 3 All E.R. 209 at 218. See also F.H. Jones Tobacco Sales Company Ltd., [1973] F.C. 825 at 834; [1973] C.T.C. 784 at 790 (T.D.), per Noël, A.C.J.; Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946), 8 A.T.D. 190 (High Ct.) at 196 per Dixon J.; and Cochrane Estate v. M.N.R. [1976] C.T.C. 2215; 76 D.T.C. 1154 (T.R.B.), per Mr. A.W. Prociuk, Q.C.

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

This does not mean, however, that a deduction such as the interest deduction in subparagraph 20(1)(c)(i), which by its very text is made available to the taxpayer in limited circumstances, is suddently to lose all its strictures.

The exemption provided by subsection 17(3) of the Act is clearly one which by its very text is available to the taxpayer only in the very limited circumstances described in the Act. To extend the definition of “subsidiary controlled corporation" in the manner suggested by the appellant would be inconsistent with the provision's text and purpose.

The Court has also considered the decision rendered in Massey-Ferguson Ltd. v. The Queen, [1977] C.T.C. 6; 77 D.T.C. 5013. In that case the Federal Court of Appeal was called upon to determine whether a loan was in fact made to a “subsidiary wholly-owned corporation" in order to determine if interest was deemed to have been received by the lender pursuant to subsection 17(1) of the Act. Because no sham transaction was involved, the Court refused to look beyond the debtor-creditor relationship the parties had intended and had in fact created. Applying that principle to this case, the Court must consider the debtor-creditor relationship existing between the corporations as it was intended and legally created by the parties to the transactions.

Counsel for the appellant also argued that the Court should, by analogy, apply the exception found in subsection 15(2.1) of the Act to the cases of deemed interest received pursuant to subsection 17(1) of the Act, in cases where corporations are all members of a related group. The pertinent parts of section 15 of the Act read as follows:

15. (2) Where a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) is a shareholder of a particular corporation is connected with a shareholder of a particular corporation or is a member of a partnership, or a beneficiary of a trust, that is a shareholder of a particular corporation and the person or partnership has in a taxation year received a loan from or has become indebted to the particular corporation, to any other corporation related thereto or to a partnership of which the particular corporation or a corporation related thereto is a member, the amount of the loan or indebtedness shall be included in computing the income for the year of the person or partnership, unless

Sec. 15(2.1)

For the purposes of subsection (2), a person is connected with a shareholder of a particular corporation if that person does not deal at arm's length with the shareholder and if that person is a person other than

(a) a foreign affiliate of the particular corporation; or

(b) a foreign affiliate of a person resident in Canada with which the particular corporation does not deal at arm's length.

The argument on behalf of the appellant has no substance. It has not been established that the corporations were all members of a related group or that the non-resident corporation fell within the exemptions of subsec- tion 15(2.1) of the Act. In any case the strict construction that exempting provisions must be given does not allow the Court to adopt the reasoning advanced for the appellant. For these reasons the appeals must fail.

The appeals are dismissed.

Appeals dismissed.