Helmut Mueller v. Minister of National Revenue, [1982] CTC 2182, 82 DTC 1174

D E Taylor:—These appeals were heard in London, Ontario, on January 18, 1982, and are against income tax assessments for the years 1977, 1978 and 1979 in which the Minister of National Revenue disallowed certain amounts of capital losses claimed by the appellant. The appellant is and was during the relevant taxation year a toolmaker residing in the City of Windsor, in the County of Essex, at 1465 Laurier Drive, Windsor. This residence was owned by the appellant and his wife Vera Mueller and was subject to a first mortgage in favour of the Bank of Montreal in the amount of approximately $30,000 and to a second mortgage in favour of the Bank of Montreal in the amount of approximately $19,638.

In February 1976, the appellant and his wife arranged to borrow a further $15,874.52 from the Bank of Montreal by way of a third mortgage on their said property and received the funds on or about March 1, 1976. The said mortgage carried interest at 14% per annum and was due and payable on July 17, 1976. The appellant and his wife borrowed the said sum of $15,874.52 for the sole purpose of re-lending the same to their son Norbert John Mueller in order to finance his purchase of a business in Leamington. A promissory note date February 17, 1976, given by the said Norbert John Mueller to the appellant and his wife carried interest at 14% per annum and was payable on demand. The sum of $950 was paid on account of principal in 1977. Shortly after the said payment, the son’s business failed.

In assessing the appellant, the respondent relied, inter alia, upon section 3, subparagraph 40(2)(g)(ii), paragraphs 50(1)(a), 111 (1)(b) and section 251 of the Income Tax Act, SC 1970-71-72, c 63, as amended.

Contentions

For the appellant:

— The promissory note represented a debt which was acquired by the appellant for the purpose of gaining or producing income from a property.

— The promissory note had become a bad debt in 1977.

— The promissory note held by the appellant was enforceable but worthless and remains so on this date.

For the respondent:

— No loss was incurred by the appellant in the 1977, 1978 and 1979 taxation years as the promissory note from Norbert Mueller to the appellant and his spouse did not become a bad debt at any time in those years.

— The appellant did not acquire the debt from Norbert Mueller for the purpose of gaining or producing income from a business or property.

— If a capital loss was incurred by the appellant, that said loss was one- half of the sum of the promissory note, as any loss would have been incurred by the appellant and his spouse equally.

Evidence

Both the appellant and his son testified regarding the events described above. The third mortgage for the amount of $15,874.52 was filed as Exhibit A-4 and also a copy of the promissory note in the same amount was filed as Exhibit A-5. It was the testimony of the appellant that the reason for the short period for Exhibit A-4 (5 months from February 17, 1976 to July 17, 1976) was that he was in the process of selling his house on Laurier Drive and expected to retire the mortgage during that time. There was no requirement for a bonus for early payment in the mortgage. The house did not sell, he was required to renegotiate the mortgage in July 1976, and finally renegotiated and consolidated all their mortgages in January 1977 into one first mortgage with a lower and more acceptable interest rate of 10%%. While the promissory note from his son did not call for specific payments, it was agreed between them that payments would be made as funds from the earnings of the business became available to the son.

At the date of commencement of his business (about April 5, 1976), Norbert Mueller had some $7,000 in cash which he put into the business as working capital. The amount at issue in the appeals (some $15,000) went to M Loeb Ltd for the franchise for the store. M Loeb Ltd also took back a chattel mortgage for some $50,000 on inventory and equipment. Norbert Mueller purchased a new cash register worth about $10,000 on a time payment plan with Niagara Realty Ltd, payments for which were extended over a four-year period. His wife became a co-signer on that obligation (related to the cash register), but was not involved in the other obligations to M Loeb Ltd. In August 1976, he transferred to his wife his interest in a house they owned jointly, in which the total equity at that time was about $10,000. After the failure of Norbert’s business, Niagara Realty Ltd realized on its debt by recovering payment from his wife out of the proceeds of the sale of the house in 1979, owned still by Norbert’s wife. As Norbert understood it, M Loeb Ltd lost money on the entire transaction but he did not satisfy that company’s deficit, nor was he forced to declare personal bankruptcy. There were no assets available to him at the date of losing his business in the spring of 1977 from which he could have paid his father. The debt is still outstanding to his father, he would like to pay it off but to date he has been unable to do so. He described his current financial situation in 1982 as at least as bad or worse than in 1977.

Argument

The basic position of counsel for the appellant was that the only reason for which the appellant borrowed the money by way of a third mortgage on his house was to lend the money to his son. He was to recover his interest costs by the income from his investment — albeit both of them at the same rate. When he did not sell his home (from which proceeds he would have retired the third mortgage and left himself with a straight income-earning investment in the promissory note from his son), he renegotiated his residence mortgage and effectively reduced his interest obligation to 103/40/0. As to the “bad debt” situation, there is simply nothing available to his son — he had no assets or equity, he was deeply in debt, and so he remains. The investment was lost in 1977 as far as enforceability is concerned. It should not be for the Minister to withhold the deduction available to the appellant under the Act, based on an assumptin that, at some time in the future, the son could repay the obligation. Counsel referred the Board to a recent decision — Robert G Cantin v MNR, [1981] CTC 2918; 81 DTC 811.

Counsel for the respondent noted that the promissory note should not be considered an investment — it bore the same interest rate as the relevant mortgage, no profit could be earned, and therefore it could not be said that it was to gain or produce income. On the “bad debt” issue, counsel noted the lack of any effort by the appellant to reinforce his claim against his son, place a lien or encumbrance on any assets available, or start legal action for collection or at least a judgment. Stress was finally placed by counsel on the clear evidence that the promissory note (Exhibit A-5) was to both the appellant and his wife and that, at best, the loss should be split equally, not allowed all to the appellant.

Findings

The Board notes for the record that there were certain circumstances and gray areas in the testimony and evidence, particularly with reference to times and dates. In addition, the end result that whatever equity Norbert Mueller had in his own home in August 1976 formed at least part of the satisfaction for the debt of Niagara Realty Ltd rather than the appellant’s, does not indicate primary concern on his part for the obligation in question in the appeals. In addition, no documentary evidence was presented to support the testimony of the appellant that he was attempting to sell his house in early 1976, nor was any serious explanation provided to account for the fact that he did not proceed to do so, and lives there to this day. Nevertheless, it is a fact that the promissory note in question contains the usual elements required for an investment. It is an acceptable negotiable instrument as security, it contains a current and reasonable interest rate, and it is signed properly by the appellant’s son. The evidence shows a clear line of passage for the funds in question from the bank to the son, by way of the appellant’s third mortgage on his home.

Presumably, the Minister proposes as one argument that since the appellant did no increase the rate of interest to his son over that he was obliged to pay the bank in the process, the transaction is invalidated as an investment. I accept that if only the note and the third mortgage are taken into account, there was no “reasonable expectation of profit” — there would be simply no expectation of profit at all. (See Donald A Porter v MNR, [1981] CTC 2445; 81 DTC 385. Whether that alone would invalidate the “investment” characteristics of the transaction, the Board is not required to determine the question since the appellant also contends that he intended to earn a profit by selling his house and paying off the third mortgage. Even though that prospect did not come to fruition, I am prepared to accept, on the basis of the fact that the total of the mortgages were renegotiated in 1977, that he had equity in the house and this was a viable option. It did not turn out to be a practical one, however, due to the depressed housing market, according to the testimony of the appellant. Doing so (realizing his equity in the house and discharging the third mortgage) would have left the promissory note with the essential characteristics of an investment, at least from a prima facia viewpoint — it now could produce a profit for the taxpayer.

A further point should be made that it is not the purpose for which the funds were borrowed (by the appellant from the bank) which is the factor upon which a determination of the end result of these appeals is to be made. It is the use to which tho'se funds were put which is critical to that determination. Bidhu B P Sinha v MNR, [1981] CTC 2599; 81 DTC 465.

In the instant case the appellant placed himself in funds by virtue of the third mortgage on his house and used those funds to acquire a property from which he stood to receive interest income at the rate of 14% per year and, as noted earlier, he stood to make a profit thereon due to his renegotiation intention. As I see it, the Minister’s only valid interest in the third mortgage situation would be if and when the appellant attempted to deduct the interest cost thereon from other income, including the interest income from his son. In the circumstances of these appeals, there is no reason to deny the appellant the classification of the promissory note as an investment, and qualified for the loss consideration available under subsection 40(2), at least to the degree that such identification so qualifies it. There remains the question of whether there has been a disposition of the debt (subsection 40(2)) and this falls under subsection 50(1) of the Act in the event that, if it is established that the promissory note became a bad debt in the year, the taxpayer shall be deemed to have disposed of it.

The promissory note is payable “on demand”. Counsel for the Minister emphasized quite properly that there was no evidence of formal effort to collect on the note by the appellant. There is his testimony, however, that he requested to know from his son how and when it would be paid, with the response being that the son would do so when and if he could, but at a later date. There were simply no assets or avenues for collection available to the appellant in 1977 after the failure of the business, according to the testimony. I have earlier commented on the “equity” in the son’s house. As I see it, a “formal” demand for payment would not have resulted in payment, it would only have resulted in a bankruptcy being declared by Norbert Mueller. That bankruptcy would not have produced payment either. Short of such a formal “demand” for payment, perhaps a reasonable test might be to examine whether the promissory note remained a negotiable instrument (a bill of exchange, a chose in action or whatever appropriate term might be applied to it), acceptable in the market place as a basis of commercial transfer. I cannot see that anyone would have paid anything for the note after April 1977, given the circumstances of Norbert Mueller described to the Board. Perhaps no one, other than the appellant, would have entered into the transaction in the first place, but that is not relevant to the point at issue here. In my appreciation of the facts, the debt from Norbert Mueller to the appellant was not collectable in 1977. There is no evidence that it has any value or provided any benefit to the appellant, which distinguishes it from the obligations in Frank Cusack v MNR, [1981] CTC 2912; 81 DTC 862.

We now turn to the final argument from the respondent — that the investment which became “uncollectable” (as has already been decided) was one in which the appellant had only a 50 per cent interest. The argument from counsel in support of that proposition rests on two points: first, that the source of the funds loaned was the equity in the family home shared equally by the appellant and his wife, and second, that the promissory note was made out to both of them: “ . . . I promise to pay to Helmut Mueller and Vera Mueller . .

As indicated earlier, I fail to see how, at this juncture, the source of the funds (a mortgage or equity in a home) has an impact on the issue before the Board and, accordingly, the only obstacle to be overcome is the two- party reference in the promissory note itself. The response of counsel for the appellant to this point was that all the business dealings involving the appellant’s son were conducted by the appellant, that the agreement to loan him the funds was made by the appellant, that the appellant was the only wage earner, and had always been the only wage earner in the family. Counsel also noted that at this point in the dispute between the parties, it was an “unworthy” argument from the Minister. While counsel did not elaborate on the nature of that unworthiness, it is one with which I agree. The assessment in question was not made against the appellant based upon only a 50% proprietorship in the promissory note, and there is no reference to such a situation in the explanations provided in the assessment. To raise the issue at all implies that the Minister alleges some form of “partnership” or business agreement between the appellant and his wife, to result in splitting of income which could have arisen from the promissory note. That is a proposition which the Minister has strongly and usually successfully resisted when raised by an appellant under not too dissimilar circumstances, eg when real property is held jointly in the names of a taxpayer and his wife. I am not persuaded that the only explanation, or even the rational one, which can be accorded the terminology used on the promissory note is that it represents a business arrangement entered into as a partnership between Vera Mueller and Norbert Mueller. Such an interpretation should not be attributed to it under these circumstances.

In summary, the promissory note entered as Exhibit A5 is a debt acquired by the appellant for the purpose of gaining or producing income on an investment — it became ‘‘uncollectable” in the year 1977 and the resultant loss is on capital for his account, for purposes of the provisions of the Income Tax Act.

Decision

The appeals are allowed and the matter referred back to the respondent for reconsideration and reassessment accordingly.

Appeals allowed.