Aqua-Gem Investments Ltd. v. Minister of National Revenue, [1986] 1 CTC 2528, 86 DTC 1392

‘Tremblay, T.CJ.:—This case was heard on May 31, 1985 in the City of Toronto, Ontario and was taken under advisement on August 28, 1985 on reception of the last written submission of the parties.

1. The Point at Issue

The point is whether the appellant company, incorporated in 1975, with wide ranging powers, is correct in the computation of its income for its 1979, 1980 and 1981 taxation years, to treat as active business income, within sections 125 and 129 of the Income Tax Act, S.C. 1970-71-72, c. 63 as amended, roughly $173,681 (1979), $299,290 (1980) and $346,840 (1981). These sums were declared as interest income, dividends and taxable capital gains.

The respondent considered those amounts as not being active business income on the basis that interest income, dividends and taxable capital gains are Canadian investment income as defined in subsections 129(4) and 129(4.1) of the Act. Moreover, the respondent contends that in 1980 and 1981 the appellant carried on a specified investment business within paragraph 125(6)(h) of the Act because it did not employ throughout those years moré than five full-time employees.

2. The Burden of Proof

2.01 The burden of proof is on the appellant to show that the respondent's assessment is incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195; 3 D.T.C. 1182.

2.02 In the same judgment, the Court decided that the assumed facts on which the respondent based his assessment or reassessment are also deemed to be correct. In the present case, the assumed facts are described in paragraph 2 of the amended reply to notice of appeal as follows:

2. In computing its income for the 1979, 1980 and 1981 taxation years, the Appellant sought to treat the following amounts as active business income:

	1979 1980 1980		1981
Interest Income	$173,681.00	$299,290.00	$346,840.00
Dividends	1,196.00	299.00	299.00
Taxable Capital Gains	171.00		37,867.00

At the beginning of the hearing, the appellant admitted or denied the following facts as stated in paragraph 4 of the amended reply to notice of appeal:

4. In assessing tax as aforesaid, the Respondent relied, inter alia, upon the following findings or assumptions of fact:

(a) the facts hereinbefore pleaded;

(b) the Appellant was incorporated in 1975; [Admitted]

(c) shortly after its incorporation, the Appellant purchased a marina business which in turn leased to an operating company; [Admitted]

(d) in 1979, the Appellant took over complete responsibility for the operation of the marina business and the operating company became inactive; [Admitted]

(e) that the marina business operated at a loss for each of 1979, 1980 and 1981 taxation years; [Denied]

(f) that on May 25, 1979, the company’s shareholders Eric and Verna Stovold, advanced $2,133,530.00 to the company; [Admitted]

(g) that the amount of $2,133,530.00 advanced by the shareholders was subsequently invested in term deposits with the Royal Bank; [Denied]

(h) that on February 11, 1980, the Appellant cashed $750,000.00 worth of the term deposits and paid its shareholder, Eric Stovold, the same amount : [Denied]

(i) that on November 15, 1980, the Appellant cashed $233,530.00 of its term

deposits and paid to its shareholder, Eric Stovold, the same amount; [Denied]

(j) that loans from the shareholders were unsecured, interest-free and payable on demand; [Admitted]

(k) income earned by the Appellant in the 1979, 1980 and 1981 taxation years

was Canadian investment income and not active business income; [Denied]

(l) the Appellant employed less than five full-time employees who were not specified shareholders. [Denied]

3. Partial Agreement at the Beginning of the Trial

At the beginning of the trial, the Court was informed by counsel for the respondent that the sole question that the Court had to determine was whether capital gains, dividends and interest constitute active business income or not. The fact that the employees were not specified shareholders as described in subparagraph 4(1) of the amended reply to notice of appeal quoted above is not at issue before the Court but the fact that the appellant employed less than five full-time employees is.

4. The Facts

4.01 As the parties, in their written submissions, well described the given evidence, the Court widely used their description after checking the transcript.

4.02 The only witness, Mr. Christopher Lee Stovold, in his examination testified that:

(a) During the years involved he was president, officer, general manager and employee of the appellant company (TS page 11, lines 7 to 10).

(b) The appellant was incorporated in 1975 with wide ranging powers from the outset (Exhibit A-1) (TS page 12, lines 16 and 17):

6. The Objects for Which the Corporation is Incorporated are:

Investments

(a) To purchase, receive, hold, own, sell, assign, transfer, mortgage, pledge and otherwise acquire or dispose of shares, bonds, mortgages, debentures, notes and other securities, obligations, contracts and evidences of indebtedness of any person, firm or corporation or association, or of any government, state, municipality or body politic; and to receive, collect and dispose of interest, dividends and income upon, of and from any of the shares, bonds, mortgages, debentures, notes, securities, obligations, contracts, evidences of indebtedness and other property held or owned by the Corporation; and to exercise in respect of all such shares, bonds, mortgages, debentures, notes, securities, obligations, contracts, evidences of indebtedness and other property any and all the rights, powers and privileges of individual ownership thereof, including the right to vote thereon;

(e) To carry on the general business of a boat marina and trailer camp operators.

(f) To build, manufacture, repair, equip, store, buy, sell, operate, charter, let for hire and deal in ships, yachts, sail boats, motor boats, row boats, canoes and vessels of all kinds, tents, Travel Trailers, motor homes, truck campers, mobile homes, office trailers and trailers of all kinds and all furniture, wharfing, mooring tent and trailer sites and all other equipment and services related thereto.

The fiscal year of the appellant was from December 1st to November 30th (Exhibit R-1).

(c) The shareholders of the Company were Eric Stovold (father), Verna Stovold (mother), and their children, Charlotte Stovold, Jean Stovold, Amy Stovold, Jeffery Stovold and the witness himself Christopher Lee Stovold, each one being a one-seventh shareholder (TS page 12, lines 21 to 29);

(d) Christopher Lee Stovold is the oldest child of the family. When the appellant acquired Kontiki Marine Ontario Limited (the marina) in 1979, the children had no prior business experience even if the father had been a successful businessman. He wanted to train his children in a “‘live it and do it, type philosophy” (TS page 14, lines 14 to 18). Eric Stovold, indeed, had for 17 years carried on a business called Conduits-Amherst, a business which he sold (Mr. C. Stovold, Cross-Examination, page 63, line 26 to page 64, line 11).

(e) From 1975-1979, the appellant owned a marina business which it leased to an operating company. In 1979, the appellant took over complete responsibility for the operation of the marina business and the operating company Kontiki Marine Ontario Limited became a dormant company (TS page 8, lines 5 to 8, page 20, line 16 to page 21, line 8).

At page 14, line 24 to page 15, line 2, Mr. Stovold stated:

In the early years the marina remained an operating company called Kontiki Marine Ontario Limited. It was done for the purpose of goodwill which had been accrued by the marina. Carrying on the name, it had been a name used for twenty-five years and it is still named Kontiki Marine. That, until ’79, was the way we operated.

(f) Between 1976 and 1979, expansion of the facilities moved the operation from a 50-boat slip to approximately a 200-boat slip marina (TS page 15, lines 18 to 20). From the outset, Aqua-Gem was required to take an active role in the management and development of the marina. “We just had to go in and clean house, get a feel for the business, understand what we were dealing with and as so could develop it” (TS page 15, lines 22 to 24).

(g) Originally Aqua-Gem paid about $500,000 for the marina (TS page 18, lines 21 and 22). In 1979, expansion and development of a sailboat basin required the further investment of some $225,000 including land and renovations (TS page 20, lines 4 to 6). Moreover, in examining of Exhibit R-1, the financial statement for 1979, “Statement of Changes in Financial Position” indicates that $148,796 of capital investment funds were actually expended in 1979, as well as the repayment of $225,000 in that same year on account of the outstanding mortgage.

4.03 Mr. Christopher Lee Stovold also testified:

(a) There was the long-term plan to restructure and redesign in order to make the best use of property and develop the marina (TS page 16, line 25 to page 17, line 3).

(b) In 1979, the Company pursued an opportunity to acquire another marina facility, located approximately three miles north of the Kontiki site (TS page 19, lines 3 to 5, lines 9 and 10).

By 1979, a good deal of the Kontiki site, after dredging, restructuring and expansion had been completed, was significantly devoted to sailboats, in which the company was a pioneer on Lake Simcoe in terms of developing a sailboat basin (TS page 21, lines 13 and 14; page 43, lines 8 to 14).

The acquisition of the other marina, mainly devoted to powerboats, would have enabled the company to “get really into the sailboat business and market on Lake Simcoe” (TS page 19, lines 17 and 18).

The marina facility in question was a “substantial size in relation to Kontiki” (TS page 23, lines 13 and 14).

This other marina “may be available again in a very short period of time” (TS page 23, lines 23 and 24).

Aqua-Gem “{has] approached the owners and we have had a meeting with the owners re: the sale of their marina” (TS page 24, lines 7 to 9). The company was outbid (TS page 51, line 18).

(c) In 1980 Aqua-Gem “started to develop franchises for sailboat sales” (TS page 21, lines 17 and 18) “[having] a sailboat basin now pretty much completed” (TS page 21, lines 13 and 14).

The Company also “made more inroads in the recreational marine trade” (TS page 21, lines 16 and 17).

There was an “opportunity ... to develop a business and become an established reputable dealer for certain sailboat manufacturers” (TS page 21, lines 21 to 23).

In this regard the company “did a number of shows in promoting our facility. It didn't happen overnight” (TS page 22, lines 3 to 5).

The company “entered into negotiations for franchises in carrying a line of boats and pursued it and were successful in handling the Adele Line and subsequently . . . we invested in sailboats and at the time the rule and the games for sailboats, you had to pay up front before you got your product” (TS page 42, lines 7 to 12).

The appellant “had at one point in time an inventory of $200,000” (TS page 42, lines 16 and 17).

(d) In 1983, the company purchased a property and building containing 5,000 square feet “for a substantial, a further sales/service exposure in the industry” (TS page 42, lines 23 and 24).

The company attempted to purchase the business involved in the manufacturing of the Adele Line in 1981 but was unsuccessful in its bid for the acquisition of the assets from the Receiver General (TS page 43, lines 3 to 6).

(e) The appellant pursued its objective of expanding the profit of its business in the fall of 1980 with the purchase of Wood Door Limited, a large company engaged in the manufacturing of sliding glass doors and windows in Newmarket, Ontario. The appellant owned 55 per cent of the business and operated the business as a partner with three shareholders of the previous company who held 45 per cent. The appellant took steps to ensure the business’ survival but sold out three months after acquisition due to the inability to continue with the other three shareholders of the business. The taxable capital gain of $37,867 reported in 1981 came from the sale of Wood Door Limited (TS page 12, lines 8 to 15; page 22, lines 8 to 27; page 24, line 13 to page 25, line 27; page 26, lines 12 and 13; page 68, lines 16 to 19; page 69, lines 2 to 27).

(f) In 1981, a few months after the sale of Wood Door Limited, the appellant also acquired an interest in John Breakey Inc., an ailing company located in Québec which consisted of a pulp and paper mill, a cedar shingle mill, a sawmill and a fishing lodge located on 5,000 acres of land in Québec. The appellant assumed the company’s indebtedness to the Bank of Montreal for $1.2 million and other mortgages, $1.9 in securities. The appellant shut down the pulp mill and the sawmill and operated the cedar shingle mill. The pulp mill, sawmill and cedar mill were subsequently sold by the appellant (TS page 26, lines 7 to 22; page 27, lines 17 to 23; page 29, lines 4 to 26; page 31, lines 12 to 16).

Mr. Stovold emphasized the importance of moving quickly in acquiring Breakey. The Bank of Montreal was ready to proceed with bankruptcy and liquidation. The appellant's decision to buy an interest in Breakey was made the same day the Bank of Montreal was prepared to foreclose. The appellant had, in 1981, money in cash in the form of deposits. This money went back to mid-1979. This money, in excess of $1.5 million was lent to John Breakey (TS page 30, line 22 to page 31, line 11; page 31, lines 5 to 8; page 32, line 26 to page 33, line 17).

(g) In March 1983, the appellant purchased Conduits-Amherst, a company then in receivership. Conduits-Amherst, was the company formerly owned by Eric Stovold. It operated from a head office in Mississauga but had a division in Québec and Nova Scotia and had a manufacturing facility in Ireland. It manufactured molded trim and wood trim, for residential and commercial projects (TS page 35, line 7 to page 36, line 4).

The appellant's investment in March 1983, in Conduits-Amherst was $1,300,000. The appellant converted Conduits-Amherst into a highly successful business with profits of $700,000 — $800,000 in 1983 and 1984 (TS page 36, lines 5 to 8; page 36, line 23 to page 37, line 5).

Mr. Stovold again emphasized the importance of acting quickly in this deal and noted that the appellant bought 88 per cent of Conduits-Amherst with a $1.3 million cheque from the appellant (TS page 38, lines 12 to 24).

(h) The appellant also purchased a restaurant in September 1984, which it currently owns and operates. In September 1984, the gross sale for that month was $10,000. In April 1985, it was $28,000 (TS page 39, lines 4 to 10).

4.04 In each of the above acquisitions, active management by Aqua-Gem subsequent to the takeover has resulted in either a later sale of the business for a profit or a significant turnaround in operating results (TS page 25, lines 10 to 12; page 29, lines 27 and 28; page 34, line 15; page 36, lines 26 to 28; page 37, line 5).

In each case, the acquisition was made at a point where the business in question was either in receivership and/or on the verge of bankruptcy, or was undergoing significant management problems (TS page 22, lines 13 and 14; page 27, lines 19 to 21; page 35, lines 7 and 8; page 39, lines 7 to 10).

4.05 On its 1979, 1980 and 1981 tax returns the appellant showed its business as "marina services” and in 1981 "marina services and various business activities” (Exhibit R-1).

The marina business operated at a loss for the 1979, 1980 and 1981 taxation years (TS page 62, lines 17 to 20), however, because of interest and dividend income, the appellant’s net income was as follows (Exhibit A-2):

4.06 On May 25, 1979, Eric and Verna Stovold advanced $2,133,530 to the appellant as shareholder’s loans (TS page 8, lines 20 to 23; page 64, lines 11 and 12).

The said amount was invested by the appellant with the Royal Bank in 30-day short-term deposits bearing interest but with availability on 24-hours notice (TS page 64, lines 16 to 19 and line 22 to page 25, line 8).

During the three years, the loan totalled nearly $7 million. In the years involved, interest earned by the appellant totalled $173,681 (1979), $299,290 (1980) and $346,840 (1981) (Exhibit A-2).

The moneys were held on short-term deposits to enable the appellant to purchase new capital assets in the form of businesses which the appellant intended to run. As stated in the appellant’s notice of objection for the 1980 taxation year, the "temporary investment of surplus funds on hand was managed throughout the year on a basis that provided for twenty-four hour [sic] cancellation notice in the event [that] a suitable . . . business opportunity was found.''

And as stated in the notice of appeal:

In [1979], substantial additional funds were made available to the Company and it immediately commenced the pursuit of other suitable active business [activities]. The available funds were held on short term [sic] deposit arrangements that provided for 24 hour [sic] recall in the event that an appropriate active business opportunity became available. [TS page 65, lines 15 to 18; page 72, lines 6 to 17 to page 73, line 6.]

Mr. Stovold testified that the different businesses were bought to be operated for profit, and not bought to be sold. This fact is confirmed by the financial statement for 1981 wherein profits from the sale of business assets was computed and reported as a capital gain and not income from business Or an adventure in the nature of trade (TS page 66, lines 9 to 17).

4.07 Mr. Christopher Lee Stovold continued this testimony saying that:

(a) The appellant’s purchases of new businesses were funded by the shareholder loans of Eric and Verna Stovold. The shareholder loans totalled $3,080,912, $2,018,152 and $1,831,652 as of November 30, 1979, 1980 and 1981 respectively. As Mr. Christopher Stovold said: “Why — it’s a gut feeling — pay somebody else when you can do it yourself?” (TS page 32, line 26 to page 33, line 2; page 44, lines 18 and 19; Financial Statements of the appellant for the 1979, 1980 and 1981 taxation years, Exhibit R-1).

(b) The appellant had the ability to manoeuvre, to make these kinds of acquisitions because of its decision to keep large sums available on short-term deposits (Mr. Christopher Stovold, Examination-in-Chief, page 53, lines 15 to 22).

(c) The appellant deliberately chose short-term deposits so as to keep its money available for future acquisitions (see TS page 54, lines 2 to 10; page 54, line 25 to page 55, line 20):

A. . . . Because of the nature and the type of things that we do in Amherst — sorry, Aqua-Gem, and in most cases our acquisitions have something in common in that they are right down to the wire, and being able to have the ability to react in the times that we have reacted, needed to have resource through our funds on hand and we were prepared, in advance, knowing that although the funds were available, whatever that short period of time before we took them, we were forgiving the interest.

Q. In 1981, Aqua-Gem acquired a fifty-five percent interest in Wood Door. In 1981, Aqua-Gem acquired a subsequent interest in the John Breakey company and I believe you indicated earlier that the amounts involved were in excess of $1 million. We have talked about up to $1.5 million or more. How were you in a position to do that, to spend that kind of money in your next business acquisitions?

A. Because the funds were available to us.

Q. They were available to you — sorry, Your Honour. How were they available to you?

A. The funds were available to us because we had, in our planning, organized on, again, a twenty-four basis, we had the shortest possible terms and the accessibility to our funds in order to do — really, that’s a tool that the business has used. Amherst Industries was written on a cheque for $1.3 million in an eight hour period.

Q. How were you able to do that?

A. Again, it’s part of, as a businessman, an entrepreneur, you know what you’re going to do and prepare yourself and have a plan. You win some, you ose some. We haven’t gotten everything that we ve actually wanted and chased, but putting in all the pictures of the puzzle, working hard at it and positioning. . . .

(d) “From a growth point of view, we have done nothing but continue to grow’, said Mr. Stovold. The appellant had grown to a net worth in excess of $4 million (TS page 59, lines 1 to 13).

4.08 In his testimony, Mr. Christopher Stovold stated that the money in the short-term deposits was also used as working capital for the marina business (see TS page 79, lines 7 to 21):

A. Going back to what I said before, I guess as a proud person, letting the company go down the tubes is not in my best interest or in my will or desire. Isolating that particular loan from those particular two, I guess it served a couple purposes as I stated before. One, it provided a working capital for the company to do and in order to do the things that they’ve done. It secured our position in the marketplace. I can only say in 1979, 1980 and 1981, it wasn’t the best time in this economy. The banks were scared, the whole marketplace was uncertain, and I sincerely mean that cash spoke in those times. That money was needed. It was very much needed, one, to support — without paying dearly on the other side of the equation — it was used to support the losses, the development, the ongoing situation and made this company profitable. Yes, it was needed very much in the operation of this company.

5. Law — Cases at Law — Analysis

5.01 Law

The Income Tax Act (the Act) was amended by S.C. 1980-81-82-83, c. 48, concerning the main provisions involved in this case applying after 1979 i.e., effective for taxation years commencing in 1980 and after. As the appellant’s fiscal years involved are 1979 (December 1, 1978 to November 30, 1979), 1980 (December 1, 1979 to November 30, 1980) and 1981 (December 1, 1980 to November 30, 1981), the provisions of the Act involved in this case for the different years are as follows:

Re: 1979 and 1980 taxation years:

(i) Definition of amounts qualifying for small business deduction:

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,

(ii) Definition of “active business":

Active business was not defined in 1979. Paragraph 125(6)(d) defining active business was added re taxation years commencing after 1979.

(iii) Definition of “Canadian investment income":

129. . . .

(4) In subsection (3)

(a) “Canadian investment income” of a corporation for a taxation year means the amount, if any, by which the aggregate of

(i) the amount, if any, by which the aggregate of such of the corporation’s taxable capital gains for the year from dispositions of property as may reasonably be considered to be income from sources in Canada exceeds the aggregate of such of the corporation’s allowable capital losses for the year from dispositons of property as may reasonably be considered to be losses from sources in Canada,

(ii) all amounts each of which is the corporation’s income for the year (other than exempt income or any dividend the amount of which was deductible under section 112 from its income for the year) from a source in Canada that is a property (other than a property used or held by the corporation in the year in the course of carrying on a business), determined, for greater certainty, after deducting all outlays and expenses deductible in computing the corporation’s income for the year to the extent that they may reasonably be regarded as having been made or incurred for the purpose of earning the income from that property,

(iii) all amounts each of which is the corporation’s income for the year (other than exempt income) from a source in Canada that is a business other than an active business, determined, for greater certainty, after deducting all outlays and expenses deductible in computing the corporation's income for the year to the extent that they may reasonably be regarded as having been made or incurred for the purpose of earning the income from that business,

exceeds the aggregate of amounts each of which is a loss of the corporation for the year from a source in Canada that is a property or business other than an active business. . . . [Emphasis is mine.]

Re: 1981 taxation year:

(i) Definition of amounts qualifying for the small business deduction:

While this section was amended, the changes arose with respect to partnerships and therefore the amendment is not relevant to the appeal.

(ii) Definitions of “active business”, “income of the corporation for the year from an active business” and “specified investment business” in paragraphs 125(6)(d), (e), (h) added by S.C. 1979, c. 5, s. 38(6) and amended by S.C. 1980-81-82-83, c. 48, s. 70(6) applicable to taxation years commencing after 1979 read as follows:

125. . . .

(6) In this section and section 129,

(d) "active business” carried on by a corporation in a taxation year means the business of manufacturing or processing property for sale or lease, mining, operating an oil or gas well, prospecting, exploring or drilling for natural resources, construction, logging, farming, fishing, selling property as a principal, transportation or any other business carried on by the corporation other than a specified investment business or a non-qualifying business;

(e) “income of the corporation for the year from an active business” means the income of the corporation from an active business carried on by it, including any income pertaining to or incident to that business and amounts deemed by subsection 129(6) to be income from an active business, but does not include income for the year from a source in Canada that is a property (within the meaning assigned by subsection 129(4.1));

(h) "specified investment business” carried on by a corporation in a taxation year means a business (other than a business carried on by a credit union or a business of leasing property other than real property) the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties), unless the corporation employs in the business throughout the year more than five full-time employees who are not specified shareholders of the corporation or persons related thereto;

(iii) Definition of “Canadian investment income”:

129. ..

(4) In subsection (3),

(a) "Canadian investment income” of a corporation for a taxation year means the amount, if any, by which the aggregate of

(i) the amount, if any, by which the aggregate of such of the corporation's taxable capital gains for the year from dispositions of property as may reasonably be considered to be income from sources in Canada exceeds the aggregate of such of the corporation’s allowable capital losses for the year from dispositions of property as may reasonably be considered to be losses from sources in Canada, and

(ii) all amounts each of which is the corporation’s income for the year from a source in Canada that is a property (other than exempt income, any dividend the amount of which was deductible in computing its taxable income for the year or income from real property of a corporation that is not a Canadian-controlled private corporation) determined after deducting all outlays and expenses deductible in computing the corporation’s income for the year to the extent that they may reasonably be regarded as having been made or incurred for the purpose of earning income from that property,

exceeds

(iii) the aggregate of amounts each of which is the corporation’s loss for

the year from a source in Canada that is a property; and

(4.1) For the purposes of paragraph (4)(a) and subsection (6), "income” or "loss” of a corporation for a year from a source in Canada that is a property includes the income or loss from a specified investment business carried on by it in Canada other than income or loss from a source outside Canada but does not include income or loss

(a) from any other business,

(b) from any property that is incident to or pertains to an active business or a non-qualifying business carried on by it, or

(c) from any property used or held principally for the purpose of gaining or producing income from an active business or a non-qualifying business carried on by it.

5.02 Cases at Law and Doctrine

Representatives for the parties referred the Court to the following cases at law and doctrines.

A. Cases at Law

1. Cosmopolitan Investments Co. Ltd. v. M.N.R., [1974] C.T.C. 2335; 74 D.T.C. 1252;

2. The Queen v. Rockmore Investments Ltd., [19761 2 F.C. 428; [1976] C.T.C. 291; 76 D.T.C. 6156;

3. E.S.C. Holdings Limited v. The Queen, [1976] C.T.C. 295; 76 D.T.C. 6158;

4. The Queen v. M.R.T. Investments Ltd., [1976] 1 F.C. 126; [1975] C.T.C. 354; 75 D.T.C. 5224; [1976] C.T.C. 294; 76 D.T.C. 6158;

5. Lois Hollinger v. M.N.R., [1972] C.T.C. 592; 73 D.T.C. 5003;

6. Joseph M. Weintraub v. M.N.R., [1975] C.T.C. 112; 75 D.T.C. 5050;

7. The Queen v. Marsh & McLennan, Limited, [1983] C.T.C. 231; 83 D. T.C. 5180;

8. The Queen v. Ensite Limited, [1983] C.T.C. 296; 83 D.T.C. 5315;

9. The Queen v. Brown Boveri Howden Inc., [1983] C.T.C. 301; 83 D.T.C. 5319;

10. Canadian Marconi Company v. The Queen, [1984] C.T.C. 319; 84 D.T.C. 6267;

11. King George Hotels Limited v. The Queen, [1981] C.T.C. 87; 81 D.T.C. 5082;

12. Eric Burri v. The Queen, [1985] 2 C.T.C. 42; 85 D.T.C. 5287;

13. The Queen v. Compagnie Immobilière B.C.N. Limitée, [1978] S.C.R. 865; [1979] C.T.C. 71; 79 D.T.C. 5068;

14. Riviera Hotel Company Ltd. v. M.N.R., [1982] C.T.C. 30; 82 D.T.C. 6045.

B. Doctrine

15. V. Krishna, “Characterization of ‘Income from Business’ and ‘Income from Property*/* Canadian Current Tax, (Butterworths) August 1984, Vol. 1, No. 8 at pages C37-C38.

16. Interpretation Bulletin IT-73R3 issued on April 15, 1980.

5.03 Analysis

5.03.4 Admission by the appellant

In his first written submission, the agent for the appellant admitted that dividends of $1,196 in 1979, $299 in 1980 and $299 in 1981, as well as taxable capital gain of $171 in 1979 were no longer at issue.

Following the written submission of the respondent concerning the taxable capital gain of $37,867 in 1981, the agent for the appellant, after re-examining section 129 as amended by the 1979 amendments, concluded that the respondent was correct in his argument and conceded that the 1981 taxable gain of $37,867 did not constitute an active business income.

The substance of the respondent's argument is that one cannot contend that an amount is a taxable capital gain and at the same time contend that it comes from an active business. The Court thinks it is useful to quote the well-founded argument of counsel for the respondent:

Herein, the parties are in agreement that the amount is a taxable capital gain.

What the Appellant now seeks to do is treat this taxable capital gain as active business income. This position is wholly untenable for two reasons:

1. Paragraph 129(4)(a) specifically provides that Canadian Investment income of a corporation for a taxation year means:

(i) the amount, if any, by which the aggregate of such of the corporation’s taxable capital gain for the year from dispositions of property as may reasonably be considered to be income from sources in Canada exceeds the aggregate of such of the corporation’s allowable capital losses for the year from dispositions of property as may reasonably be considered to be losses from sources in Canada, (emphasis added).

Definitions containing the word “means” have been referred to as “true definitions.” That is, words following it constitute a comprehensive listing of what is included in the defined term. (The Queen v. Compagnie Immobilière B.C.N. Ltee 1979 D.T.C. 5068 (SCC).)

A capital gain, specifically referred to, is thus by definition, Canadian Investment income.

2. What the Appellant is advocating is inconsistent with the basic tenets of the Act. The Canadian Income Tax Act classifies income and loss based on their source. Capital gains, by definition, cannot at the same time be income from business. If a disposition is on account of capital, one-half must be included in income forming part of a private corporation’s Canadian investment income. If the disposition has the characteristics of being an income transaction and if it qualifies as active business income, the entire profit is included as income from business and subject to the small business deduction if it so qualifies. The transaction has been characterized by the Appellant as a capital gain and accepted by the Appellant as a capital gain for the purposes of Part I of the Act. This characterization is consistent with the evidence at trial. The source of transaction cannot be characterized as being on capital account for the purpose of computing the amount of the gain in computing income under Part I of the Act and then reclassified as being from a different source for the purpose of determining a tax credit under the same Part.

5.03.2 The appeal now concerns only the treatment of interest income of $173,681 in 1979, $299,290 in 1980 and $346,840 in 1981.

The crux of the matter is whether the said interest income is an income from an active business or an income from property.

5.03.3 Taking into account the objects of the appellant and the evidence of its activities (par. 4.03), there is no doubt, and it is not really in dispute, that the appellant carried on an active business during the three said years, despite the fact that the marina business operated at a loss.

5.03.4 On one hand there is the nature of active business characterizing the general activity of a corporation during a period and on the other hand there is the nature of the source of interest income earned by the same corporation during the same period. Generally speaking, interest is considered as income* from property.

As a general consideration, it might be useful to quote an extract from the article of Vern Krishna referred to above in paragraph 5.02(15).

In many, and perhaps most, cases the distinction between business income and property income does not affect the end result. A taxpayer's income for a taxation year from a source that is business or property is his profit therefrom for the year. Income from both of these sources is generally calculated according to the same commercial and statutory rules. There are, however, a few circumstances in which the distinction between the two is critical. For example:

— the attribution rules, which require that income earned by one taxpayer be taxed to another person (usually the taxpayer’s spouse or parent), only apply to income from property and do not apply to business income;

— the first $200,000 of active business income earned by a Canadian-controlled private corporation is taxable at a combined federal-provincial rate of approximately 25 per cent; in contrast, income from property earned by a private corporation is usually taxed at an effective combined federal-provincial rate of approximately 33% per cent;

— active business income in excess of $200,000 per year is taxable at a combined federal-provincial rate of approximately 50 per cent; in contrast, as noted above, income from property may be taxable at an effective rate of 33% per cent.

In general terms, income from property can be described as the investment yield on an asset. Rent, dividends, interest, and royalties are typical examples. The yield is generally earned by a relatively passive process once the investment is made. Thus, a taxpayer who purchases land, stocks, bonds, or intangible property, and collects the investment income therefrom without doing much more than holding the property has income from property.

Business income is generally generated from the use of property as part of a process that combines labour and capital. To take a simple example: a taxpayer may invest in bonds to earn the interest income therefrom; alternatively he may trade in bonds to earn a profit from his trading activities. In the first case, his earnings are income from property; in the second case, his earnings are income from business.

Although the distinction between income from business and income from property is easy enough to state in general terms, the borderline between the two is often blurred. The distinction is always a question of fact, but determined according to principles of law.

5.03.5 It is a non-disputed fact that interest-income involved in the instant case, Originated from short-term investments. The invested amount of $2,133,530 had been advance by the two shareholders, Eric and Verna Sto- vold, in May 1979. They were 30-day short-term deposits with availability on a 24-hour notice (par. 4.06).

Vern Krishna referred to above, well summarized the characterization of that kind of income at page C39:

The characterization of income from short-term investments involves a two-step process. The first step is to determine whether the taxpayer’s investments are an integral part of his other business activities: if they are, then the income from the investments is business income; if they are not, the second step is to determine whether the taxpayer's investment activities constitute a separate business. If they do, the income from those activities is business income. If the investment activity does not constitute a separate business, the income from those activities is income from property.

In the instant case, the second step is not really at issue; investment activities do not constitute a separate business of the appellant. There is no evidence to this effect.

5.03.6 In 1983 and 1984, the Federal Court of Appeal rendered four decisions concerning the nature of interest from short-term investments.

Was it investment income or business income?

(a) The Queen v. Marsh & McLennan, Limited (par. 5.02(7)):

The taxpayer insurance broker received premiums from clients and was required to remit such premiums, less its commission, to the appropriate insurance companies. The vast majority of its income came from commissions. There was often a delay of approximately two months between the date on which the taxpayer received the premiums and the date on which it paid them to the insurance companies. During this period, the taxpayer would invest such “unremitted premiums” in short-term obligations. The taxpayer contended that the sum of $1,345,632 which it received as interest from Canadian sources was “Canadian investment income” and therefore eligible for the dividend refund. The Tax Review Board (79 D.T.C. 314) and the Federal Court — Trial Division (81 D.T.C. 5307) agreed with the taxpayer. The Crown appealed to the Federal Court of Appeal.

Held: The Crown’s appeal was allowed. The disputed income was income from a source in Canada that was a “property used or held by the corporation . . . in the course of carrying on a business” and therefore excluded from the statutory definition of “Canadian investment income.”

(b) The Queen v. Ensite Limited (par. 5.02(8)):

The taxpayer corporation decided to finance the establishment of a manufacturing plant in the Philippines. The taxpayer decided that it would commit up to five million dollars of its own money in direct, long-term investment while the rest of the capital requirements, up to forty million dollars, would be provided by loans. The loans were made available through “swap arrangements” between the Central Bank of the Philippines and the commercial banks which made the loans to the taxpayer’s Philippine branch. The commercial banks obtained Philippine pesos from the Central Bank upon depositing U.S. dollars with the Central Bank. The taxpayer made U.S. dollar deposits with the commercial banks, which then made the peso loans in an equivalent amount to the taxpayer’s Philippine branch. The U.S. dollar deposits were made by the taxpayer out of surplus cash retained from its operations. The taxpayer took the position that the’interest earned on the U.S. dollar deposits was foreign investment income. The Federal Court — Trial Division agreed with the taxpayer (81 D.T.C. 5326) and the Crown appealed to the Federal Court of Appeal.

Held: The Crown’s appeal was allowed. The fund represented by the U.S. dollar deposits was committed to the carrying on of the taxpayer’s business in the Philippines. It was employed and risked in the business because it was an integral part of the arrangements by which the business was being financed. The Court therefore concluded that the U.S. dollar deposits were property used or held by the taxpayer in the carrying on of its business and the interest earned on them was not foreign investment income. The Court allowed the Crown’s appeal accordingly.

(c) The Queen v. Brown Boveri Howden Inc. (par. 5.02(9)):

The taxpayer corporation was engaged in a manufacturing business. It was the normal practice of the taxpayer's business to require progress payments. The taxpayer placed the total amount by which such progress payments exceeded its current cash requirements in short-term notes. The taxpayer took the position that the interest earned on the notes was Canadian investment income and the Fedeal Court — Trial Division (unreported) agreed. The Crown appealed to the Federal Court of Appeal.

Held: The Crown's appeal was allowed. The common ground of the majority judgment in The Queen v. Marsh & McLennan, Limited (83 D.T.C. 5180) was that the interest earned by an insurance broker on the short term deposit of unremitted premiums was not Canadian investment income because it was from a source that was property used or held by the corporation in the carrying on of its business. The Court held that the same conclusion must be reached with respect to the interest earned on the short term notes in the present case. The interest was therefore not Canadian investment income and the Crown’s appeal was allowed accordingly.

(d) Canadian Marconi Company v. The Queen (par. 5.02(10)):

In the years 1973 to 1976, the appellant had substantial income (21.4 per cent to 52.7 per cent of total income) from the investment in short-term paper of funds of some $20 million realized from the sale of its broadcasting facilities It included this as active business income in calculating its credit related to manufacturing and processing income. In its assessment the Crown rejected this view and treated the income as being from property, not business. The trial judge found for the Crown, relying in part on judgments of the Trial Division in The Queen v. Marsh & McLennan Ltd, and The Queen v. Ensite Ltd, both of which were subsequently reversed on appeal. The trial judge appeared also to have based his decision on the position that the income itself had to be from manufacturing and processing profits, a position not taken by the Crown in this appeal and rejected by the Court, which held that the distinction was between income from property and income from a business, the Crown having admitted that the business was active. The appellant argued that the purpose of the investments was profit, citing the time taken to manage them, and that if considered separately, the investment activity constituted an active business.

Held: The Marsh & McLennan and Ensite cases were distinguished. In this case the investments did not form a unit with the other business of the taxpayer and were not employed or risked therein, except as they would be available to claims of unsatisfied creditors. That risk was too remote in this case. That an activity is engaged in for profit does not decide the question of whether the income from it is from a business or from property. Here it was from property.

Appeal dismissed with costs, but for reasons differing from those of the Court below.

It is important to underline that the taxation years involved in those cases are the 1974, 1975 and 1976 taxation years. Hence, they are under the same legislation as the one that applies io 1979 and 1980 taxation years in the instant case.

5.03.7 As it appears from those summaries, in two of the cases, the funds used in short-term investments were funds coming directly from the business: insurance premiums received (Marsh & McLennan case); progress payments (Brown Boveri Howden Inc. case). In the other two cases, the funds came from loans (Ensite Limited case) and from the sale of the facilities of a broadcasting division (Canadian Marconi Company case).

Moreover, in all cases, the funds were employed and risked in the taxpayer's business.

However, to be considered as an integral part of the business, the two taxpayers’ activities, business and investment, must be interdependent.

For a better understanding, it is useful to quote Lord Mersey in The Liverpool and London and Globe Insurance Co. v. Bennett (Surveyor of Taxes), [1913] A.C. 610 at 612; 6 T.C. 327 at 379-80:

It is said that the dividends in question are derived from investments made . . . and that such investments form no part of the “business” of the Company. In my opinion there is no foundation either in fact or in law for this contention. It is well known that in the course of carrying on an insurance business large sums of money derived from premiums collected and from other sources accumulate in the hands of the insurers, and that one of the most important parts of the profits of the business is derived from the temporary investment of these moneys. These temporary investments are also required for the formation of the reserve fund, a fund created to attract customers and to serve as a standby in the event of sudden claims being made upon the insurers in respect of losses. It is, according to my view, impossible to say that such investments do not form part of this Company’s insurance business, or that the returns flowing from them do not form part of its profits. In a commercial sense the directors of the Company owe a duty to their shareholders and to their customers to make such investments, and to receive and distribute in the ordinary course of business, whether in the form of dividends, or in payment of losses, or in the formation of reserves, the moneys collected from them.

5.03.8 In the instant case, funds were legally loaned by the appellant from its shareholders. They were used for working capital purposes:

(a) sufficient funds to cover the operating losses in 1979 ($75,000), in 1980 ($62,000) and in 1981 ($157,000);

(b) improvements to the marina property ($225,000);

(c) repayment of marina mortgage ($225,000) (pars. 4.02, 4.08).

Funds were also used for the acquisition of profitable businesses pursuant to the objects provided in the appellant's letters patent (par. 4.02).

All those acquisitions are described in paragraph 4.03 and the philosophy of the use in paragraph 4.07.

The appellant had grown to a net worth in excess of $4 million.

Even if the Court finds that funds were employed and risked in the business, can it be said however that there is an interdependence between short-term investment and the appellant’s business so that investment be an integral part of the business?

The investment simply comes from surplus of available money. Was such a surplus of available money required for the appellant’s business in 1979, 1980 and 1981?

I think first that interdependence is a concept that relates to the nature of the business. In this respect, I would be inclined to say there is no interdependence — investment and construction and/or management company. A construction company does not need “per se” a surplus of available money as in the case of the insurance company as explained by Lord Mersey quoted above (par. 5.03.7).

Is it possible that special circumstances have the effects that available surplus be required for the carrying on of a business which ordinarily would not be required? The appellant wanted to take advantage of the opportunities of the economic depression as it was from 1978 to 1983 to acquire businesses. It was a sine qua non requirement to have an available surplus to act quickly and then to take advantage of the opportunities. All the businesses the appellant acquired indeed in the years involved and after were “right down to the wire” (par. 4.04, par. 4.07(c)).

The Court then is inclined to admit, because of those special circumstances, that the interests from the short-term investments are an integral part of the business. Surplus was required to reach the goals of the appellant and then short-term investments became appropriate. It was contended by counsel for the respondent that there is no evidence that the total loan of nearly $7 million was required to reach the goals of the company. At first glance, it seems to be true. However, there is also evidence that the appellant had grown to a net worth in excess of $4 million. “It has done that because of its financial strength.” (TS page 59, lines 1 and 2).

The Court thinks that in the circumstances it is a reasonable conclusion to allow the appeal for the 1979 and 1980 taxation years.

5.03.9 1981 taxation year

With the legislation in force after 1979, the point at issue is whether the interest income from the short-term investment is an “income pertaining to or incident to” the appellant’s business. (Definition of “income of the corporation for the year from an active business” in paragraph 125(6)(e) quoted above.) The French version says “. . . [un] revenu qui se rapporte directement ou de manière accessoire à cette entreprise . . .”.

Because of the goals of the appellant during the economic depression, explained above for 1979 and 1980, the Court thinks it is also reasonable to conclude that the interest income for 1981 from short-term investments is income “incident to” the appellant’s business.

In the Interpretation Bulletin IT-73R3 issued by the respondent on April 15, 1980, hence after the 1979 amendments, one can read the following in paragraph 9 concerning interest income:

9, Dividend and interest income from property held for long-term investment is rarely categorized as income from an active business unless there is a clear relationship to a business carried on by the corporation e.g., investment of reserve funds in long-term bonds by a general insurer. On the other hand, shortterm investments are usually categorized as income from an active business, but exceptions to this rule include investment of the proceeds from the sale of a business formerly carried on by the corporation or investment of the portion of the corporation's capital that is clearly in excess of the amount required to carry on existing levels (or planned levels on a short-term basis) of business activity, having due regard for cyclical business fluctuations.

The appeal is also allowed for the 1981 taxation year.

6. Conclusion

For these reasons, the appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment.

Appeal allowed.