Hugh Lowery v. Minister of National Revenue, [1986] 2 CTC 2171, 86 DTC 1649

Sarchuk, T.C.J.:— The appellant Hugh Lowery (Lowery) appeals with respect to a redetermination by the respondent of his net capital loss in the 1980 taxation year and with respect to a reassessment of his income tax for the 1982 taxation year.

The circumstances giving rise to the reassessments are not complex. The appellant, a businessman, is the vice-president and part owner of Standard Knitting Ltd., a sweater manufacturing concern located in the City of Winnipeg. In 1977 his son Glenn gave up his employment and evinced some interest in acquiring a business of his own. The appellant offered his assistance and a number of proposals were considered. Ultimately an existing retail outlet located in Beauséjour, Manitoba was purchased. On September 6, 1978, Glenn and his wife Joanne filed the requisite registration under the Business Names Registration Act (Manitoba) declaring, inter alia, that they intended to carry on business under the firm name of Lowery's Treads & Threads (Threads) and that no other person or corporation was associated with them in this business.

On September 18,1978 Threads established an operating line of credit of $5,000 and obtained a $40,000 non-revolving advance from the Bank of Montreal to cover start-up costs, fixed assets and leasehold improvements. On March 30, 1979 and June 11, 1980 the Bank granted additional nonrevolving loans of $5,000 and $15,000 for inventory and working capital for the business. In addition on July 23, 1979 the Bank granted the business a loan of $8,400 to assist in the purchase of a motor vehicle. It is not disputed that these loans and advances were granted to Glenn and Joanne Lowery for the account of their business solely on the strength of the appellant's personal guarantee.

In 1980 the business failed and the appellant was called upon by the Bank to pay the sum of $57,329.07 which amount was paid in part on October 1, 1980 and the balance on November 14,1980.

In his 1980 income tax return dated April 30,1981, the appellant claimed a loss of $40,000 in respect of this transaction. The appellant's accountant, Frederick W. Betton (Betton) testified this amount was an estimate, alleging that the actual loss was not known with any degree of certainty at that time. At some subsequent point of time the loss claimed was increased to $57,329.07.

In determining the net capital loss of the appellant for his 1980 taxation year the respondent did not allow the appellant's claim for a capital loss in the amount of $57,329.07 and in reassessing income tax for the appellant's 1982 taxation year the respondent disallowed the amount of $2,000 in respect of the net capital loss carried forward which the appellant claims was available to him. In so doing the respondent assumed inter alia that:

(a) the Appellant provided for no consideration his personal guarantee for the credit line provided by the Bank to LT&T;

(b) the guarantee was not provided by the Appellant for the purpose of producing income from a business or property;

(c) the Appellant acquired no interest or right in the profits of LT&T and never participated in any of the profits of LT&T;

(d) the Appellant was not a partner in LT&T;

Counsel for the appellant contended that Mr. Lowery gave the guarantee in part to enable his son to acquire a business and in part with the intention of gaining income from that business at some future point in time. He submitted that an informal understanding existed between the appellant and Glenn and Joanne Lowery with respect to the sharing of income from Threads and that the purpose of guaranteeing the liabilities of Threads to the Bank was to obtain this right or opportunity to earn income.

A summary of some of the evidence relied upon by the appellant is in order. It is a fact that Glenn Lowery had no capital resources to speak of and from the outset it was understood that Mr. Lowery would provide all of the required financing. In the initial stages of their search several fairly substantial businesses were considered. One, Empire Water Works of Canada Limited (Empire) was brought to their attention by Betton and a serious, although unsuccessful effort was made to acquire it. As time went on the ventures being considered became substantially more modest and the involvement of consultants such as Betton was reduced. By the time Threads was acquired Glenn had a "good grasp of the situation" and consequently there was little need for any in-depth financial analysis. Betton described Threads as a modest operation, the financing of which "could not cause too much financial hurt" to the appellant.

Betton was aware that the appellant would be required to provide the bulk of any capital required. He stated that Glenn would manage whatever business was eventually acquired while the appellant would remain in the background, involving himself only in major decisions. With respect to participation in profits Betton said that it was the appellant’s position that some sort of division of profits would occur if the business were to succeed. With respect to Threads he believed an informal understanding still existed and that Glenn and Joanne would “take modest drawings until the business produced a level of cash flow sufficient to enable it to commence repaying the indebtedness to the bank” at which time the appellant would share in the profits.

Counsel submitted that evidence of such an arrangement existed and could be found in certain draft agreements and memoranda prepared in January 1978 (Ex. A-1) relating to the attempted acquisition of Empire. It is a fact that the proposed purchase of Empire at a cost of some $350,000 was predicated upon a substantial financial involvement by the appellant. The documents filed show the appellant as purchaser, and other evidence disclosed that the appellant intended to own a very large portion of the issued shares while Glenn was to be the manager and a minority shareholder. The Empire arangements included the sale of a small minority interest to a third party with payment by the purchaser to be secured by a promissory note to the appellant.

It is evident that the appellant’s involvement and participation in this purchase was carefully considered and properly documented.

Glenn Lowery testified that after the Empire purchase fell through other businesses were considered and were rejected. In due course Threads attracted his attention. He described the acquisition of Threads as a situation where “Dad was helping me out” but which also "was to be strictly a business proposition”. Glenn conceded that the issue of sharing profits had never been discussed with the appellant. When urged by counsel to explain the arrangements between them Glenn stated that when a profit was made at that point of time it would be discussed and he and his wife "would sit down with my father and more than likely split that profit". Glenn discounted the declarations he and his wife made in the Business Name Registration stating: "This is wrong, it is more like a one-third split in business”.

The appellant testified that this was a family matter. The family operated on trust and no agreements were needed. He said that it was understood that when the business was profitable he would be entitled to a share of the profits. This right to share would occur “after fairly large drawings for them” and "when the business was less than 100 per cent financed". No evidence was given as to when this understanding between the parties was reached.

Joanne Lowery also testified with respect to the appellant’s participation in Threads. She said ‘‘we were to draw salary; after that Glenn and I shared two-thirds of the profits and Mr. Lowery one-third". In contrast to the other witnesses she maintained that the profit sharing issue had been discussed and was resolved at the time Threads was acquired.

Counsel contended that the evidence elicited from the appellant, from Betton, and from Glenn and Joanne confirmed the existence of an agreement. He described it as an informal but nonetheless definite understanding that Lowery would share in Threads' profits after reasonable salaries or draws were taken by the partners Glenn and Joanne. This understanding effectively provided consideration in the sense of qualifying the transaction within the meaning of subsection 40(2) in that the purpose entering into the guarantee included the right or opportunity to earn income from a business or property. Counsel submitted that entitlement to future profits was sufficient to give a business purpose to the transaction. He cited Robert G. Cantin v. M.N.R., [1981] C.T.C. 2918; 81 D.T.C. 811, in support of this proposition.

Counsel also argued that in addition to an intention to earn income by sharing in Threads' profits there was an added incentive in that the guarantee was being provided to a business which purchased its stock-in-trade from the appellant’s company Standard Knitting Ltd. The giving of a guarantee in such circumstances was both practical and necessary in a commercial sense. In this context counsel relied on, inter alia the decision in The Queen v. F.H. Jones Tobacco Sales Co. Ltd., [1973] C.T.C. 784; 73 D.T.C. 5577.

This alternative submission is not tenable. There was no evidence that sales by Standard Knitting Ltd. to Threads formed any part of the rationale for Mr. Lowery's guarantee of Threads' loans. Counsel urged the Court to draw an inference that such a motive existed. On the evidence before me that is not possible.

In this appeal it is not disputed that if there is to be an allowable capital loss under paragraph 38(b) of the Act there must have been a disposition of property within the meaning of paragraph 39(1)(b). That means that if the appellant is to succeed he must establish that there was a debt owing to him in existence at the end of the taxation year in the sum of $57,329.07. Then, to satisfy the provisions of paragraph 50(1)(a) of the Act, the appellant must prove that the debt owing to him at the end of the taxtion year has been established by him to have become a bad debt in that year. Once these two prerequisites are met, the appellant must, in order to prevent the application of subparagraph 40(2)(g)(ii), establish that the debt was acquired for the purpose of gaining or producing income from a business or property. This subparagraph provides:

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;

Since most of the testimony was elicited to establish compliance with this subparagraph I propose to consider, in the first instance, whether the guarantee was incurred by Lowery for the purpose of gaining income from a business or property.

On the evidence adduced I am not satisfied that there was any business purpose in the granting of the guarantee. Respondent's counsel submitted, and I agree, that it is not sufficient to make a general allegation that the appellant anticipated some participation in the profits of Threads at some unstated time in the future and on that basis to argue that some considéra- tion for the guarantee existed. There was no arrangement as to interest. There was no arrangement relative to repayment in the event of default by Threads. There was no agreement, oral or written, setting out the terms and conditions of the appellant’s participation. No mechanism existed enabling the appellant to control the level of earnings to be reached by Threads before his alleged right to participate in the profits could be invoked. The appellant stated that family matters did not require written agreements. This statement however is in some measure inconsistent with the manner in which his proposed investment in Empire was secured and documented. In my view the appellant’s involvement bears none of the hallmarks of a commercial or business transaction.

Furthermore, there are inconsistencies in the evidence of the witnesses on the matter of sharing profits. Glenn stated that no discussions had taken place while Joanne maintained that an agreement had been reached. Joanne stated that she and Glenn were to share their interest equally. However, Exhibit A-3, Threads’ financial statement as at July 31, 1979, disclosed that the net income of Threads had been distributed 70 per cent to Glenn and 30 per cent to Joanne. In so far as Betton's evidence is concerned it is a fact that with respect to Threads his involvement was minimal. I am constrained to say that his evidence as to the appellant’s right to share in Threads' profits appeared to be based on hearsay.

Although the relevant time with respect to the "purpose of earning income test" is the time at which the guarantee was given, it is proper in this case to consider as well the appellant’s conduct after he was called upon to pay the debt by the bank. None of the normal commercial considerations were given to collecting the debt from the partners. Not only does this call into question the basis upon which the appellant established the debt to be a bad debt in that year but it also suggests that the risk in guaranteeing the debt had its justification only in the fact of the father/son relationship and was not made for any business or commercial reasons.

The Court notes that similar facts were considered by the Tax Court of Canada, in Ena M. Casselman v. M.N.R., [1983] C.T.C. 2584; 83 D.T.C. 522. In that case Casselman guaranteed debts owed by her son's corporation to a bank. As contrasted to the present appeal Casselman had taken a number of steps allegedly for the purpose of protecting her interest such as entering into an agreement with her son’s company providing, inter alia, that the guarantees were given for consideration and that interest would be payable at the rate of one per cent per month. The Court found that there was no business purpose for the guarantee of the debt and dismissed Casselman's appeal. I see nothing to distinguish Casselman from the case at bar.

I have concluded that the guarantee was not incurred for the purpose of gaining or producing income from business or property and that the provisions of subparagraph 40(2)(g)(ii) apply to this transaction. In view of this conclusion it becomes unnecessary to consider whether there was a debt owing to the appellant in existence at the end of the 1980 taxation year and whether such debt had been established by him to have become a bad debt in that year.

The appeals are dismissed.

Appeals dismissed.