R S Jackson Promotions Limited v. Minister of National Revenue, [1985] 1 CTC 2151, 85 DTC 145

Sarchuk, TCJ:—The appellant appeals from reassessments in respect of its 1978, 1979 and 1980 taxation years whereby the Minister adjusted the appellant’s active business income by disallowing bad debt expenses of $47,991 and $12,313 in 1979 and 1980 respectively. The reassessment issued in respect of the 1978 taxation year reflects a disallowance of the loss carry-back arising from the bad debt expense claimed in 1979.

The appellant is a corporation incorporated in 1971 under the laws of the province of Ontario and has its head office in the city of Toronto. It was incorporated by Russell Stanley Jackson (Jackson), a school teacher and a former professional athlete and coach. Upon retirement, Jackson, recognizing that the high profile he acquired during his playing days would soon dissipate, consulted advisors, including his solicitor and former teammate Gary Schreider (Schreider), and concluded that to take proper advantage of the situation, particularly the availability of promotional activities, it would be advisable to form a corporation. The objects of the appellant were formulated on the basis of the activities being carried on by Jackson in 1971 and on the desire to market Jackson personally for commercials, promotions and other media activities. These objects were expressed in the articles of incorporation as:

TO provide, engage and employ actors, variety performers, entertainers, athletes, theatrical and musical artists, announcers and any persons or services for radio, television and motion picture productions and commercials;

TO establish and carry on athletic schools and clinics;

TO carry on a general advertising and publicity business in all its branches (both as principal and agent) and to acquire and operate franchises or privileges for advertising purposes or for the buying or selling of advertising rights, franchises or privileges, and to deal in all other articles or things of a character connected therewith, and in general to undertake and transact all kinds of agency business which may be legally undertaken and transacted for or connected with any of the above objects and purposes; and

TO manufacture, construct, purchase or otherwise acquire, sell, hire, lease, use, distribute and otherwise deal in and with advertising devices and novelties of all kinds.

Mr Joseph Bones (Bones) is an experienced chartered accountant. He has been responsible for the appellant’s account for many years. His evidence was that the incorporation in 1971 created a logical vehicle for business opportunities whether these arose in the media field or in other commercial ventures which might result from Jackson’s status as a local football celebrity. He recalled that Jackson and the appellant were fiscally very conservative and were not inclined to borrow money to go into business or for investment purposes. The appellant was not interested in an active business such as a restaurant and in fact rejected opportunities to acquire an interest in such establishments.

In general the appellant’s promotion of the Jackson persona appeared to be successful. The football school on the other hand proved to be less so and it was decided not to continue with this activity. By 1972, the appellant had surplus earnings. Jackson, as president of the appellant, discussed the situation with the appellant’s advisors and a decision was taken that this surplus could be utilized for the purpose of investment in stocks and bonds and/or mortgages. Jackson stated that to enable the appellant to proceed in that direction a resolution, dated March 1, 1972, was passed (Exhibit A-2). In part it read:

. .. to accept and convey, assign, transfer or otherwise dispose of all or any shares, stocks, bonds, debentures, debenture stock and other securities of every description now or hereafter registered in the name of the Company or held or owned by the Company and to sign and execute on behalf of the Company all and any instruments of acceptance and transfer and other documents whenever necessary or proper to effectuate the same. . . .

No consideration appears to have been given at this time to amending the appellant’s Articles of Incorporation.

In 1974, during the course of further discussions of the appellant’s activities Schreider advised Jackson that he had a client who bought and sold properties, principally apartments, with the intention of renovating and renting them. To do so he needed financing and since the appellant was in funds an opportunity existed to earn premium interest rates. Schreider had personally looked at the property, considered the risk, the type of mortgage, the interest rate, the rentals available and recommended that the appellant should consider advancing funds to the client. The appellant agreed.

Schreider could not recall whether the corporation’s authority to invest in mortgages was raised at this time or not. He was aware that “‘there would have had to have been the right but because the appellant had ancillary powers an amendment to the articles was not necessary and did not warrant the expense”. It was his view that section 15(2)(b) of The Business Corporations Act, RSO 1970, c 54 was ‘‘the route to go”.

With respect to mortgage investments Bones recalled that the reason for the appellant’s involvement was that it had surplus funds. In 1974, mortgages were very attractive with losses being very rare and the potential returns very attractive. There was no other viable business which had attracted the appellant’s attention and in Bones’ view it was an excellent opportunity to realize a good return.

The initial investments were made in first mortgages. These produced positive results. Subsequently the appellant also invested in higher risk, higher interest rate, second mortgages. The borrower in all cases was the same person, a Mr Marshall. A substantial portion of the appellant’s assets were invested in this manner. In 1974 38 per cent of the retained earnings were invested, and at the peak of the relationship in 1978 approximately 98 per cent had been placed in “Marshall mortgages”. In total there were ten such mortgage transactions between 1974 and 1979 (Exhibit A-3), although three of them related to the same property and might more properly be categorized as one transaction.

In 1978, problems began to develop. Certain post-dated cheques the appellant had received were not being honoured. Marshall was in financial difficulty and his failure to meet the mortgage payments or to pay realty taxes and insurance created substantial difficulties for the appellant. Schreider, because of a developing conflict of interest brought in his associate George House (House) to act for the appellant. The deteriorating situation culminated in a meeting in November 1978, held at House’s office. To ensure that the appellant received sound advice the meeting was attended by a real estate appraiser, Mr Guenette and by Bones, House, Schreider and Jackson. It was apparent that a difficult decision had to be made. Property values had dropped, interest rates had gone up, tenants were defaulting in rental payments and there was a general depreciation of the appellant’s assets. Acting on the advice received steps were taken by the appellant to:

(a) foreclose on two mortgages;

(b) assume the first mortgage on another property to protect the appellant’s second mortgage (and to subsequently dispose of the property); and

(c) allow the first mortgagee to foreclose on the remaining properties, in effect disavowing or foregoing recovery on the appellant’s second mortgages on those properties.

According to Jackson these decisions were taken with the belief and understanding that any losses incurred would be treated as business losses.

The accounting treatment accorded to these mortgages during the relevant time was explained by Bones. When a new mortgage was placed Schreider would advise Bones and the mortgage would be recorded and carried on the appellant’s books at cost. In its tax returns the appellant, on the advice of Bones, reported all mortgage interest earned as investment income and not as active business income. The principal payments were recorded as reducing the balance owing under the mortgages. When difficulties arose the unpaid balances, to which were added legal and other costs were treated as a bad debt.

Bones testified that in his opinion Revenue Canada’s policy on interest and rental revenues was not consistent with generally accepted accounting principles. Since the appellant was a small company it was likely that Revenue Canada would not have treated the income it earned from these mortgages as active income. For this reason and because refundable tax dividends were available the appellant chose to treat and report earnings from this source as interest income rather than active business income. Bones added that although the appellant believed that the Minister’s policy was wrong it was not prepared to risk an appeal to prove its position.

The Appellant’s Position

Counsel for the appellant submitted that the corporation had two business activities, the first to exploit the promotional value of Jackson and the second to earn income on the assets of the company by carrying on the business of the lending of money. The losses incurred by R S Jackson Promotions Limited were therefore deductible pursuant to either paragraph 18(1)(a) or paragraph 20(1)(p) of the Income Tax Act.

At all times the appellant behaved with respect to the mortgage loans as a money-lender would. A full and thorough review was made by the appellant before advancing the mortgage funds. An appraisal, proper surveys, title searches and appropriate security were obtained. These are the normal precautions that a money-lender would take.

This was not an isolated transaction. The business involved a pattern of lending commencing in 1974 and continuing through to the middle of 1979. During this period of time the dedication of the retained earnings to the business of money-lending was significant and for the years in issue was in excess of 50 per cent on an average basis. In fact in 1978 the percentage dedicated to the money- lending business was 98 per cent. The return realized was not insignificant. In fact the interest rates varied from a low of 9.5 per cent to a maximum of 18 per cent which, if compared with the prime rates established by the Bank of Canada, demonstrated that a much higher rate of return was being realized on the loans.

It was submitted that the actions of the corporation after default by the borrower were indicative of the true character of the money-lending activities of the appellant. The decisions taken at that time displayed a business acumen more typical of the approach of a businessman than that of a simple investor. In the same context it was argued that it would be unusual for an individual investor in the normal course of his activities to buy out first mortgages in an effort to protect the position of his second mortgage. This was an action more often observed as being taken by a businessman experienced in the marketplace and having the ability to realize and protect his position than by an investor.

The Minister’s Position

To be successful in claiming the deduction whether pursuant to paragraph 18(l)(a) or 20(l)(p) the appellant must satisfy the Court that it was carrying on a money-lending business. The appellant maintained that it conducted two businesses, the first in relation to the promotion of Jackson and the second the purported money-lending business. It was clear that the mortgage loan activities had absolutely nothing to do with the former. Therefore, in the respondent’s view the appellant could not be successful under paragraph 18(l)(a) of the Act unless the Court were satisfied that a money-lending business did in fact exist.

The respondent contended that the appellant’s sole business activity was to provide the services of Jackson to the public and that the evidence adduced fell short of establishing that in the years in question it additionally carried on business as a money-lender. The nature of the investments, the level of activity, the absence of any of the usual “badges of trade” support the respondent’s conclusion. Neither the Certificate of Incorporation (Exhibit A-l) nor the Business Corporations Act (Exhibit A-8) support the appellant’s contention that it carried on a money-lending business. At best it could be argued that subsection 15(2)(b) of the Business Corporations Act permitted the appellant to invest and deal with the moneys of the corporation not immediately required for the business objects of the corporation.

The appellant failed to establish, on the balance of probabilities, that the Minister’s assumptions were wrong.

Reasons

The appellant submitted that it carried on as part of its ordinary business, the lending of money within the meaning of paragraph 20(l)(p) of the Act and that the losses arising on the loans are properly deductible thereunder. In this respect it was argued that the witnesses called by the appellant all gave uncontradicted evidence as to the purpose of the company and as to the manner in which its activities were understood and appreciated by its own directors, officers and advisors. It was stated that they operated firmly in the belief that the company was engaged in money-lending.

These statements are in my view retrospective and must be scrutinized with care. The situation is analogous to that arising in trading cases where it has often been said that the conduct of an appellant and the steps it took provide a much better indication of the nature of the activity than the evidence given by witnesses. To be successful it was necessary for the appellant to make a distinction between an activity which could be described as the act of carrying on the business of money-lending and an activity consisting of nothing more than the investment of surplus funds. Without reflecting on the credibility of the witnesses it is not surprising that they would insist that “they operated in the belief that the company was engaged in money-lending”.

I have concluded in the particular circumstances of this case that the appellant was not in the business of lending money but was investing its surplus assets. The appellant did not conduct this activity as a money-lender would. It never bought or sold mortgages at a discount and never borrowed money for the purpose of its alleged money-lending business but only invested its retained earnings. Money-lending was not one of the business objects of the corporation. It was not ready and willing to lend to all and sundry; there was no pattern of making funds available to potential borrowers nor was there a seeking out of borrowers; all mortgage loans were granted to the same individual and were made through one law firm. The appellant did not hold itself out as a moneylender either by advertising or word-of-mouth, was not licensed or listed as a money-lender and had no commercial organization. The number of loan transactions was extremely limited totalling ten in a period of six years. The principal officer in addition to his promotional and media activities was the principal of a high school in Ottawa from 1971 to 1974 and in 1975 and 1976 coached the Toronto football team and devoted little if any time to “managing” the business. There was no active business-like involvement by the appellant in the production of this income. In addition to the foregoing in its 1975, 1976, 1977, 1978 and 1980 taxation years the appellant did not take the interest earned into account in its active business income (for purposes of a small business deduction pursuant to section 125 of the Act) but rather treated such amounts as investment income.

Counsel submitted that the precautions which the appellant took before advancing mortgage funds and the manner in which the decisions to foreclose were made demonstrated a commercial acuity not normally associated with investors. I do not agree. The actions of the appellant are not at all inconsistent with the actions one would expect of a prudent investor in similar circumstances.

The appellant cited several cases to support its position that the extent or degree of the business activity was not by itself determinative of the issue. The case of MRT Investments Ltd et al v The Queen, [1975] CTC 354; 75 DTC 5224, was one of the cases so relied upon. It is distinguishable on its facts. MRT Investments Ltd was specifically empowered under its charter to carry on business as a financial agent and to make loans on the security of mortgages or otherwise. The Court found that the appellant in that case was always looking for new agents to enable it to increase its lending business. There were substantial negotiations with respect to the terms of the mortgages, the amount of the loans, the rates of interest, the duration of the loans and the terms of repayment. The taxpayer’s activities were so organized that it even had its own forms for loan applications. In light of such evidence it is not surprising that the Court held that the mere absence of employees or office space was not enough to establish that the appellant was not carrying on an active business. Similar facts do not exist in the case at bar.

The presence or absence of any single factor referred to does not by itself establish whether that the appellant was not carrying on the business of money- lending. It is the cumulative effect of this evidence that leads the Court to that conclusion in the case at bar.

The second issue raised by the appellant was that the ambit of paragraph 18( l)(a) was broad enough to permit the deduction of the losses in issue without requiring the Court to find that the appellant was in the business of the lending of money. This submission was based on the proposition that for the purposes of paragraph 18(l)(a) it was adequate if the corporation, in the course of its operations, carried on an activity which generated income. That result, according to the appellant, represents by its very nature a business or at the very least an adventure in the nature of trade involving the making of mortgage loans. The appellant cited MNR v Kelvingrove Investments Ltd, [1974] CTC 450; 74 DTC 6357 to support this proposition.

In my view there is a substantial distinction to be drawn between that decision and the case at bar. In Kelvingrove the transaction fell within the objects for which that company was incorporated ie to purchase or otherwise acquire and to hold for investment purposes real and personal property of every nature. In the words of the Court:

. . . these transactions are within the object for which the respondent incorporated and as such constitute the business in which the respondent was engaged.

Accordingly the Court found the profits arising from those transactions to be an integral part of Kelvingrove’s profit-making activities and conversely that any losses arising from those same profit-making activities were deductible under paragraph 2(l)(a) (now 18( l)(a) ) of the Act. The facts in the case at bar do not support the same conclusion.

In deciding this issue the Court considered other cases relied upon by the appellant, including The Queen v Ensite Limited, [1983] CTC 296; 83 DTC 5315; The Queen v Marsh & McLennan Limited, [1983] CTC 231; 83 DTC 5180, as well as the decision of the Federal Court of Appeal in Canadian Marconi Company v The Queen, [1984] CTC 319; 84 DTC 6267. As counsel stated these cases do not bear directly on the issue before this Court but are of some assistance. I found particularly useful the comments of Ryan, J in the Canadian Marconi decision. In that appeal the issue was whether interest earned on investments was income from property or income from business. The submissions made by the appellant therein are strikingly similar to the case at bar. I quote from Ryan, J at 328-30 [6274-76]:

The appellant’s major submission in this appeal was, however, that, apart altogether from carrying on its manufacturing business, it also engaged, during the taxation years in question, in an investment business; its dealings in short-term securities, it was said, constituted an active business carried on by it from which the interest income was earned.

It was contended that:

Its activities in buying the short-term securities and in their management constituted the carrying on of a separate business, an investment business or a lending business. The interest it received was not, as the Crown argued, income from “property”, but income from “business”. . . .

Counsel submitted that the purpose of all of these activities during the taxation years in question was to make a profit. The activities were thus a “business”, and the income earned business income.

After reviewing the circumstances of that case Ryan, J stated:

. . . I am of the view, however, that, for purposes of the Income Tax Act, the fact that an activity is engaged in for the purpose of making a profit cannot be decisive of the question whether income from it has its source in “business” on the one hand, or in “property” on the other.

and concluded at 331 [6276]:

I would characterize these activities as management of the Company’s investments rather than as the carrying on of an investment business. The better view is that the source of the interest in question was “property”, not “business”, and I would so hold.

It is a matter of judgment on the particular facts of each case as to whether the activity in issue is a business or not. I have concluded that the appellant, in advancing funds to Marshall, was not carrying on the business of the lending of money. I further find that its activity was nothing more than the investment and management of its surplus funds. The interest so earned was not derived from an activity which could be characterized as a business or an adventure in the nature of trade.

Accordingly I dismiss the appeals.

Appeals dismissed.