West Hill Redevelopment Company Limited v. Minister of National Revenue, [1986] 2 CTC 2235, 86 DTC 1685

Bonner, T.C.J.:—The appellant appeals from assessments of income tax for the 1976 to 1979 taxation years. Although many issues were raised by the pleadings all but two were settled by consent to judgment.

The first of the remaining issues is whether the appellant is entitled in computing its income for the 1977, 1978 and 1979 taxation years from the business of erecting and selling condominium apartment units to “discount" low interest rate mortgages which it took back from purchasers on the sale of the units.

The second of the remaining issues is whether the appellant is entitled to deduct losses sustained in the 1976 to 1978 taxation years from the operation of the yacht “Helua". Essentially this depends on whether the appellant carried on a business of providing the yacht for hire or reward within the meaning of paragraph 18(1 )(l) of the Income Tax Act. On this issue the respondent relied on paragraph 18(1)(a) of the Act as an alternative basis of support for his assessing action.

The appellant was incorporated in 1955 under the laws of Ontario. At all relevant times its shares were owned by Joseph and Wolf Lebovic. Joseph Lebovic is president of the appellant. Wolf Lebovic is secretary-treasurer.

The appellant has engaged in many different business ventures. One of the appellant’s main businesses has been the construction and sale of condominium apartment units. In order to promote sales by making the units affordable it is customary in that business to offer purchasers mortgage financing at the low rates of interest. With this objective in view some builders make payments to the financial institution which will hold the mortgages of units in the project in question. In consideration the financial institution lowers the interest charged on such mortgages by an agreed amount for an agreed period. However, mortgagees are apprehensive of the danger of defaults when loans made initially at low rates mature and must be renewed at unsubsidized rates which could be very much higher. They therefore impose limits on the extent to which they will decrease interest rates below prevailing market levels.

In order to secure a competitive advantage the appellant sought to avoid such limits. Commencing in 1977 with the sale of its Woodlands condominium project it adopted the practice of taking back and holding purchase money mortgages. Thus, as will be seen from Exhibit A-24 the number of mortgages held by the appellant and the principal amounts owing thereon increased suddenly in 1977.

The rates of interest charged by the appellant were as low as or lower than the lowest rate which the bank as mortgagee would have permitted had the appellant as vendor adopted the common practice of paying down the rate. Obviously such mortgages were worth less than they would have been had prevailing rates of interest been charged.

The appellant’s position is that in computing profit for purposes of section 9 of the Income Tax Act,

. .. mortgages must be brought into income at their value in the year of sale of the property to which they relate. In addition, as mortgages are originally brought into the accounts at a discount, they are to be valued at the end of each year at market value for the purposes of determining income pursuant to subsection 10(1) of the Act and Part XVIII of the Regulations since that accords with generally accepted accounting principles and also because, as discount mortgages, they are "inventory” as defined in subsection 248(1) of the Act.

Donald F. MacLean, F.C.A. gave evidence as an expert on accounting practices with respect to his view as to the appropriate accounting treatment when a company receives mortgages on the sale of property with an interest rate lower than the prevailing rate. Mr. MacLean said:

. . . The substance of the transaction is that the mortgages should (be) recorded at a discount rate, the discount obviously relating to the interest rates in effect at the time the mortgage was taken. That particular accounting policy, while not set out in the CICA Handbook, which is the prime authority for accounting standards in Canada, it is addressed in two other authoritative sources, and I have attached references there . . . (Exhibit A25). One is the CIPREC Guidelines. CIPREC being the Canadian Institute of Public Real Estate Companies. Those Guidelines were first published in 1970, is my recollection, and, in there, they clearly recommend to their members that, in mortgages that are taken back at less than the prevailing rate, they should be discounted and accounted for accordingly over the term of the mortgage.

. . . Furthermore, in 1971, the Canadian Institute of Chartered Accountants published a research study and it is on accounting for real estate development companies. Again, in that particular publication, the same guidelines were put forth, such as referred to from CIPREC. In other words, the proper accounting treatment of mortgages taken at a lower than prevailing rate should clearly be discounted for accounting purposes and that the discount would then be taken in on an appropriate basis over its term.

Mr. MacLean described the relevant accounting entries with respect to a sale of this type. His comments were related to a sale of an apartment unit at a price of $45,000 with a cash down payment of $10,000 and a mortgage back to the vendor of $35,000 on terms which, if the mortgage had been put up for sale in the mortgage market, would have necessitated a discount on sale of $3,000.

. . . The sale would be credited with the $45,000 in that transaction. There would be $5,000 [sic, presumably $10,000] that would be deposited as cash, debited to cash, and the balance would become a mortgage receivable of $35,000. At this point, one would have to calculate the discount and you would reduce the mortgage receivable by $3,000, which we had said was a hypothetical discount, by crediting the mortgage for the $3,000, and the balance then would be used to reduce the sale price.

He described the procedure to be followed at the vendor's year end as follows:

. . . Again, in my opinion, I believe that one still has to look at the going interest rates at the end of any accounting period and, if those rates have again changed from the rates we had originally set out on the mortgages, then we would either further adjust those by either writing them down or writing them up, as the case may be, depending on what the market has done. In other words, I believe that that particular portfolio of mortgages should be carried at its market value.

Mr. MacLean was of the opinion that such accounting treatment

. .. recognizes the economic realities of the transaction. One has, obviously in this case, sold a property at a price which in effect takes into consideration the discount allowed in the mortgage and if one was not to discount the mortgage for accounting purposes, you would end up with inflated income, because that income has not been realized in that period.

I do not share that view. The sale price of the unit is the price to which the parties have agreed. Although the price might well have been different had other terms of the agreement also been different the determination of income must rest on what happened and not on what might have happened. The discount of which Mr. MacLean speaks is one which quite likely would have been made had the appellant sold the mortgages. However, it did not choose to sell them. It held them until maturity at which time the mortgage debt was paid or the principal remaining was refinanced at prevailing rates. What is at issue is the determination of income from a business involving the erection and sale of condominium units and not the erection and sale of such units followed by a further sale of the attendant mortgage receivable.

Counsel for the appellant argued that the Court should take a “realistic approach” to the determination of the "true profit” of the appellant and consider the real substance of the transactions entered into. This, he submitted,

. . . requires a recognition that the low-interest mortgages taken back were clearly not worth their face amount, and only the value of such mortgages should be included in income.

In support of his position he relied on a number of authorities including John Cronk and Sons, Limited v. Harrison, 20 T.C. 612; [1936] 3 All E.R. 747 and Absalom v. Talbot, 26 T.C. 166; [1944] 1 All E.R. 642.

In my view the central fact in this case is that the mortgages taken back on sale and held by the appellant were held as security for the promise of the purchaser of each unit to pay the deferred balance of the purchase price. Paragraph 12(1 )(b) of the Act provides:

12(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(b) any amount receivable by the taxpayer in respect of property sold . . . in the course of a business in the year, notwithstanding that the amount or any part thereof is not due until a subsequent year, . . .

The promise to pay which is secured by a mortgage given back to the appellant as vendor is without question an amount receivable by the appellant in respect of property sold in the course of its business. The statutory language of paragraph 12(1 )(b) is plain and unambiguous. It requires the inclusion of the full amount of the receivable. It matters not that such inclusion may be contrary to accounting principles which would otherwise govern the computation of profit for purposes of section 9 of the Act. The position is laid down by the Supreme Court of Canada in Dominion Taxicab Association v. M.N.R., [1954] C.T.C. 34 at 37; 54 D.T.C. 1020 at 1021, per Cartwright, J.:

. .. The expression “profit” is not defined in the Act. It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.” [Emphasis added]

Cases decided under a statute which does not contain an overriding direction equivalent to paragraph 12(1 )(b) are of little assistance here.

Counsel for the Respondent relied on the decision of the Exchequer Court of Canada in M.N.R. v. John Thomas Burns, [1958] C.T.C. 51; 58 D.T.C. 1028 (appeal to S.C.C. dismissed at 59 D.T.C. 1328). That case involved a builder who constructed and sold houses under agreements providing for the delivery to him of second mortgages to secure a portion of the purchase price. He sought a deduction of an amount equal to the difference between the face value and the market value of the mortgages. Cameron, J. referred to the provisions of paragraph 85B(1)(b) of the former Income Tax Act, the predecessor of the present paragraph 12(1)(b). It required the inclusion in the computation of income of “. . . every amount receivable in respect of property sold . . . in the course of the business in the year . . . notwithstanding that the amount is not receivable until a subsequent year. . . ." In his reasons for judgment Cameron, J. stated at 58 (D.T.C. 1032):

Paragraph (b) of subsection (1) makes specific provisions for including in the computation of income every amount receivable in respect of properties sold in the course of the business in the year, notwithstanding that the amount is not receivable until a subsequent year .. .

. . . The respondent therefore is within the requirements of the first part of the paragraph. . . .

. . . It follows, therefore, that in computing his income he is required to include the amounts receivable from the second mortgages. As these amounts are expressed in terms of money, it is the amount of such monies that is to be included and not the value in terms of money of the right or thing. (See subsection 139(1)(a), which defines “amount".)

The relevant words of paragraphs 12(1 )(b) and 85B(1)(b) are almost identical. Nothing in the statutory context suggests that the words should be given different meanings. The substitution in paragraph 12(1)(b) of the word “due" for the paragraph 85B(1)(b) word “receivable” in the notwithstanding clause does not signify any change in legislative intent. It serves only to clarify a legislative intention to bring within the inclusion in income directed by paragraph 12(1)(b) amounts which the debtor is not required to pay to the taxpayer until sometime after the time of creation of the debt.

Counsel for the appellant advanced further argument based on subsection 76(1) of the Income Tax Act which reads as follows:

76(1) Where a person has received a security or other right or a certificate of indebtedness or other evidence of indebtedness wholly or partially as, in lieu of payment of, or in satisfaction of, a debt that was then payable, the amount of which debt would be included in computing his income if it had been paid, the value of the security, right or indebtedness or the applicable portion thereof shall, notwithstanding the form or legal effect of the transaction, be included in computing his income for the taxation year in which it was received.

The argument was that throughout the Income Tax Act the draftsman has, in recent years, substituted the word “due" or the phrase “due and unpaid" for the rather more ambiguous words “receivable” and “payable" where it was intended that the latter terms refer only to amounts due. Thus he argued that having regard to the careful use of language which has developed subsequent to the Burns decision,

. . . the word “payable" in subsection 76(1) now means and is intended to mean “payable in the future" or “payable immediately or in the future" but cannot mean “due and unpaid" as those words are used where that meaning is intended.

I do not agree. If the suggested equivalents for the statutory word “payable” are substituted for that word in subsection 76(1) it will be seen that the word “then” which precedes “payable” is rendered redundant. Similarly in the French version of the Act the word “alors” would also be redundant.* [1] Furthermore, the interpretation for which counsel contends would lead to a Capricious result, namely, that secured receivables would be brought into income at their value whereas unsecured receivables would, by virtue of paragraph 12(1)(b), be brought into income at their face amount. Accordingly, I am of the view that subsection 76(1) applies as did its predecessor, subsection 24(1) of the former Act,

. .. only to cases in which the taxpayer who received the security or other right, or a certificate or other evidence of indebtedness, was, by reason of some preexisting transaction, entitled to receive . . . [a] debt that was then payable and the amount of which would have been included in computing his income if it had been paid. The section envisages a situation in which the . . . debt then payable is not in fact paid, but, in lieu thereof, the one entitled receives a security or other right, . . . [per Cameron, J. in M.N.R. v. Burns (supra) at 56 (D.T.C. 1031)]

Although there was no evidence as to the content of a typical agreement of purchase and sale it is apparent from the fact that the appellant offered the low interest rate mortgages as a sale inducement that from the very outset the agreements of purchase and sale provided for deferred payment of the purchase price. Accordingly, the debts secured by the mortgages can never have been “payable” within the meaning of subsection 76(1) except at the times required by the mortgages. This branch of the appeals therefore fails.

In 1976, the appellant purchased the yacht Helua. It did so after a yearlong search for a boat suitable for use in the charter business. It hired two persons on a full-time basis as crew members. It placed the boat in the hands of a brokerage firm in order to promote and manage the charter operation. Projections made by an expert in the field who advised the appellant at the time of the purchase indicated that a profit might be expected in about three years after the combination of boat and crew had an opportunity to develop a following, that is to say, a group of persons loyal to both boat and crew who afforded repeat business. Unforeseen developments resulted in a failure to develop a following, in greater maintenance and repair costs than anticipated and in a decline in the general chartering business.

As a result the venture was unprofitable and the yacht was sold. In assessing tax for the 1976, 1977 and 1978 taxation years the respondent disallowed the deduction of the operating losses including capital cost allowance.

In argument counsel for the respondent did not make any submissions based on paragraph 18(1)(a) of the Act, although reference to that provision had been made in the amended reply to the amended notice of appeal. It will therefore be necessary only to note that in light of the evidence adduced at the hearing there can be no doubt that the appellant met the test laid down by paragraph 18(1)(a).

Paragraph 18(1 )(l) of the Income Tax Act upon which the respondent did rely provides as follows:

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(I) an outlay or expense made or incurred by the taxpayer after 1971

(i) for the use or maintenance of property that is a yacht, a camp, a lodge or a golf course or facility, unless the taxpayer made or incurred the outlay or expense in the ordinary course of his business of providing the property for hire or reward, or . ..

It was the respondent's position that this provision permits only deductions by a taxpayer whose ordinary business is that of providing the property, in this case the yacht, for hire or reward. He relied on the decision of the Tax Review Board in Andco Anderson Limited v. M.N.R., [1978] C.T.C. 2244; 78 D.T.C. 1197, reversed by the Federal Court — Trial Division sub nom. Jad- dco Anderson Limited v. The Queen, [1981] C.T.C. 11; 81 D.T.C. 5002, then further reversed by the Federal Court of Appeal, [1984] C.T.C. 137; 84 D.T.C. 6135. Nothing in the decisions of the Tax Review Board and the Federal Court of Appeal is authority for the proposition that the provision must be read as if the words of exception read . . unless the taxpayer made or incurred the outlay or expense in the course of his ordinary business of providing the property for hire or reward. . . .” I can conceive of no reason and, save for the decisions mentioned the respondent suggested none, for extending the paragraph 18(1 )(l) prohibition to ordinary expenditures made by a person whose business it is to provide property of the sort contemplated by the provision simply because the business of providing such property is not the taxpayer's ordinary or primary business.

Accordingly the appeals will be allowed and, in addition to the relief to which the parties have consented, the appeals from the 1976, 1977 and 1978 taxation years will be allowed and the assessments for those years referred back to the respondent for reconsideration and reassessment on the basis that the appellant is entitled to deduct its losses from the business of chartering the yacht Helua. The appellant will have its costs, save for those related to the mortgage issue.

Appeals allowed in part.