John Fabry, Sr v. Minister of National Revenue, [1981] CTC 2760

John B Goetz:—This is an appeal with respect to the appellant’s income tax assessments for the taxation years 1974, 1975 and 1976.

The appellant was the sole and beneficial shareholder of Direct Lumber Company Limited (hereinafter referred to as “Direct Lumber”) and in 1974 Direct Lumber, on behalf of the appellant, credited to his registered retirement savings plan the sum of $4,000 for which it did not issue a T4 slip as it did with employees of the Company. Counsel for the appellant, at the outset of the hearing, acknowledged that the $4,000 so advanced should be included in the income of the appellant for his 1974 taxation year, so this portion of the appeal is no longer in issue.

The only issue that remains is the determination of whether advances made to the appellant by Direct Lumber in the years 1975 and 1976 come within the provisions of subsection 15(2) of the Income Tax Act, SC 1970- 71-72, c 63, as amended.

In assessing the appellant, the respondent relied, inter alia, upon subsections 15(1) and (2) of the said Act. The relevant portion of subsection 15(2) reads as follows:

(2) Where a corporation has in a taxation year made a loan to a shareholder, the amount thereof shall be included in computing the income of the shareholder for the year unless

(a) the loan was made

(ii) to an officer or servant of the corporation to enable or assist him to purchase or erect a dwelling house for his own occupation

and bona fide arrangements were made at the time the loan was made for repayment thereof within a reasonable time. (Italics mine).

The appeal resolves itself to my determining whether or not bona fide arrangements were made at the time of these loans for repayment thereof within a reasonable time.

Facts

(1) On the 8th day of August 1975, John Fabry Sr, purchase from one Samuel Teitelbaum a partially constructed home and in the deed without dower, the affidavit sworn to in that document by the transferor, Samuel Teitelbaum stated: . . in that the land was acquired for $115,000 and the cost of construction to date exceeds $400,000.” (Italics mine). The purchase price was $510.000. This home, as stated by counsel for the appellant, was only partially built at the time of purchase.

(2) The appellant was president of Direct Lumber and sole shareholder since 1960. He had over 200 employees in his business of selling lumber to building companies. He also owned Fabry Lumber Company Limited which is involved in later documentation.

(3) On August 18, 1975, the appellant and his wife entered into a mortgage with Direct Lumber and Fabry Lumber Company Limited (hereinafter referred to as “Fabry Lumber”) with a face value of $375,000 bearing interest at the rate of 12 /2%, payable as follows:

The sum of $400 on account of principal shall become due and payable on the 20th day of each and every month in each and every year from and including the 20th day of September, 1975, to and including the 20th day of July 1980, and the balance of the said principal sum of $375,000 shall become due and payable on the 20th day of August, 1980 and interest monthly at the said rate as well after as before maturity and both before and after default on such portion of the principal as remains from time to time unpaid on the 20th days of each and every month in each year until the principal is fully paid.

This document was duly registered on the 20th day of August, 1975.

(4) At a meeting of the directors of Direct Lumber purportedly held on the 20th day of August, 1975, the company Direct Lumber, authorized a loan to the appellant for $375,000 against the security of a first mortgage on the property being acquired by him, hereinbefore referred to. In the same minutes, Direct Lumber together with Fabry Lumber has agreed with a Mr Harold Kay to borrow from him the sum of $375,000 against the security of a promissory note in substantially the same form and under the terms and conditions as more particularly contained in the mortgage dated August 18, 1975, which was produced as Exhibit A-2 and shall be referred to as such hereinafter. The appellant says that of the $510,000 purchase price, he paid the full amount in cash on advances from the company of $230,000 and “the rest came from my own pocket”. In the directors’ minutes, in paragraph “C” on page 2 thereof, it is stated:

(c) The Corporation be and the same is hereby authorized to advance to Fabry by way of loan the sum of $375,000 or any portion thereof, for the purposes of assisting the said Fabry in the purchase of the said lands, all in accordance with Section 17(2)(b) of The Business Corporations Act aforesaid, against the security of a first mortgage on the said lands under the terms and in substantially the same form as the said Schedule “A” hereto;

(5) On August 18, 1975, Direct Lumber and Fabry Lumber entered into an assignment of mortgage (A-2) to one Harold Kay who at that time advanced $375,000 to the said companies. The companies were therefore under an obligation to pay Kay according to the terms of Exhibit A-2.

(6) The appellant filed a ledger sheet entitled “Shareholders’ advances to purchase a dwelling” which shows the following entries:

(7) Exhibit A-7 is a new mortgage entered into on March 10, 1977, between the appellant and his wife as mortgagors and Direct Lumber and Fabry Lumber as mortgagees, said mortgage having a face value of $492,800. Simply put, the terms of repayment on this mortgage more or less are the same as those in Exhibit A-2, namely that the amount of principal of $492,800 was repayable at a rate of interest of 12 /2%, $400 monthly on account of principal and the full balance to be paid on August 28, 1980.

The appellant explains that the $492,800 mortgage was to cover the balance owing to the company and blanket his original mortgage of $375,000. There was a meeting of the directors (Exhibit A-8) purportedly held on March 11, 1977, authorizing a loan of $500,000 to the appellant and also authorizing Direct to borrow the sum of $500,000 from Deacon Investments Limited. The security for Deacon Investments Limited was that the company would repay Deacon Investments Limited on the same terms as the mortgage filed as Exhibit A-7 dated March 10, 1977, and further on the security of a promissory note. One of the conditions of borrowing from Deacon Investments Limited was the assignment of the mortgage (A-7) from Direct to Deacon Investments Limited. In actual fact John Fabry Sr, Katherine Fabry and Direct Lumber and Fabry Lumber were parties to a promissory note dated March 10, 1977, acknowledging receipt from Deacon Investments Limited of the sum of $125,000 with interest thereon at 12 /2% per annum, payable monthly, the whole of principal and interest to be paid by August 20, 1980. This promissory note, although signed by all the other parties, was not signed by the appellant.

(8) On February 7, 1978 John Fabry, being sole shareholder of Direct Lumber, held a meeting whereby he authorized the loan from Direct Lumber to be increased from $500,000 to $650,000 and the terms of the payments to vary so that the loan would be repayable at the rate of $20,000 per annum on account of principal only. On the same day, a meeting of directors signed by John Fabry and Harvey M. Kerbel, which meeting, of course, preceded that of the shareholders authorized the variation of the authorized loan from Direct Lumber to the appellant beyond $500,000.

(9) On September 10, 1980, John Fabry Sr and Katherine Fabry entered into an obviously arm’s length mortgage with Standard Trust Company for a loan of $450,000, bearing interest at the rate of 14 /4% per annum, calculated half yearly with monthly payments of $5,364 commencing on the 29th day of September 1980, and on the 29th day of August 1985, and the full amount of principal and interest became due and payable on the 29th day of each and every month thereafter including the 29th day of August 1985, and the full amount of principal and interest became due and payable on the 29th day of September 1985.

Findings

As can be seen, the loans by Direct Lumber and Fabry Lumber to the appellant were neatly and carefully documented with some arrangements made at the time the loans were made for repayment which were also carefully documented. I cannot find any jurisprudence directly on point; all of the cases seem to involve oral agreements or arrangements entered into after the fact. I must therefore very carefully appraise the whole of the dealings of Direct Lumber vis-à-vis the appellant and determine whether “bona fide arrangements were made at the time the loans were made for repayment thereof within a reasonable time”. (Italics mine).

In Amelia Rose v MNR, [1973] CTC 74; 73 DTC 5083, at 77 and 5085 respectively, it is stated:

It does not seem to be in doubt that the reason for the scheme under which the corporations in question would be constituted a partnership to undertake management services for Central Park Estates Limited was to achieve tax advantages for the individuals owning the shares of some or all of those corporations.* [1] While this does not affect the result actually achieved by what was done, it does, in my view, warrant a very careful appraisal of the evidence when considering whether what was projected with that end in view was actually carried out.

The appellant was obviously an astute and wealthy businessman, thoroughly acquainted with construction business, and the owner of two lumber and supply companies. I am sure that the appellant followed his accountant’s (Mr Goldfarb) advice throughout without questioning. The documentation was obviously put together by Mr Goldfarb and legal counsel. The cornerstone of the arrangement made by the appellant at the time of the loan and for repayment of the loan, is the mortgage (A-2) dated the 8th day of August 1975. This mortgage had been suggested to the appellant by Goldfarb as giving him a tax advantage and was approved by the appellant.

The appellant made no payments to Direct Lumber until 1978, when it was agreed that he could pay $20,000 a year which he did in 1978, 1979 and 1980. The appellant did not take possession of his new home until late 1977. He says that his reason for not making the payments on account of Exhibit A-2 or the blanketing mortgage of March 10, 1977, in the amount of $492,800, was that it would “mix things up”, and further, that the building costs accelerated so fast that there was no point in making monthly payments although he intended to do that.

Exhibit A-6, being the General Ledger of entries of shareholders’ advances to purchase a dwelling, indicates that as of August 1977, the company had advanced to the appellant the sum of $644,790.44. I find it difficult to accept the appellant’s reasons for not paying anything until 1978 on account of his indebtedness to the company. He obviously ended up with what could be termed a “mansion” and he would appear to be a man of substantial means. A home of such dimension with extra excavations (if necessary), and the refinishing and extensions, would mean changes to the existing plans (if any) and he would, on a construction of that scale, undoubtedly have the advice of an architect with plans and specifications and estimates of costs and I feel it is only reasonable that he had these in his possession on or about the time of purchase in August 1975. He indicates that immediately upon possession, he knew that it was going to cost him extra money beyond the original purchase price. In my view, he knew prior to purchase that his plans for alterations and extensions would require more money. Exhibit A-2 was entered into within days of the purchase of the house from Samuel Teitelbaum. Although the original mortgage called for monthly payment of interest of 12 /2%, no interest was entered into the shareholders’ advance purchase of dwelling ledger sheet, nor, of course, were any payments. Goldfarb, when being cross-examined with respect to the non-entry of interest in this ledger sheet, simply said: “I have no explanation”. Surely, Mr Goldfarb, who was the guiding hand in the arrangements made to repay the original loan, would have some idea of why no interest was paid. However, the payment or non-payment of interest is indeterminative but it certainly shows that the appellant did not comply with the payment of interest terms of his Original mortgage.

The appellant introduced as Exhibit Exhibit A-7 a mortgage dated March 10, 1977, with Direct Lumber and Fabry Lumber. The face value thereof was $492,800. At that time the actual advances from the companies to the appellant were $461,000.

Counsel for the appellant cited the case of Emile Morin v MN Fl, 26 Tax ABC 161; 61 DTC 161, on the question of non-foreseeability of the added cost to the purchase price. I feel that the Morin case (supra) is of no assistance to me whatsoever and, further, we are dealing here with an appellant fully conversant with the building business.

When Mr Goldfarb was asked why the appellant had not made any payment under Exhibit A-2 he said that they were keeping the matter in abeyance which obviously contemplated further advances from the companies to the appellant. I feel that, as Goldfarb admitted, he was the mastermind behind the whole process. Holding back payments under the original repayment arrangement mortgage on the instructions from Goldfarb, is certainly a marked departure from the obligations under that mortgage. The appellant was obviously a wealthy man and indicated in cross-examination that there was no lessening of his earnings during the relevant period. The original loan to Fabry for the year 1975 amounted to $230,000, although at the time of purchase he entered into a mortgage (A-2) permitting him to borrow $375,000, from the company.

The blanket mortgage (A-7) entered into on March 10, 1977, was discharged in September 1980 when it became due. This, of course, is subsequent to the appellant getting a standard house mortgage with the Standard Trust Company. The loans to Direct Lumber from Harold Kay and Deacon Investments Limited tie in closely and are intertwined with the advances made by Direct to the appellant. Kay, for instance, advanced $375,000 on the security of the appellant’s original loan arrangement made in insuring under Exhibit A-2. In that the original mortgage appeared complete, it was obviously usable as collateral for Mr Kay. Goldfarb admitted that initially they were deducting as a business expense, interest payments to Kay, until stopped by the Department of National Revenue. My findings in this appeal are not predicated on the Kay transactions.

All successive documentation in chronological order constitutes steps taken by the appellant through his companies, Direct Lumber and Fabry Lumber, to enable him to get a standard mortgage from a regular line mortgagee with a completed million dollar home as security and collateral. In other words, these documents performed or acted as a bridge to the appellant, carrying on for three years without paying interest or principal on the loans he received from the company in August 1975 and 1976. I agree with counsel for the appellant that Mr Kay, who advanced the $375,000 was acting on a completely arm’s length basis for the company in 1975, but this was wholly predicated on the appellant conforming to the terms of the original mortgage to Direct Lumber in 1975, which he did not do. He further argued that it is the vital time to consider “at the time the loan was made” whether or not there was a bona fide arrangement made and he indicates that the declared intention of the shareholder or namely the appellant, to repay is evidence of bona fide.

I think the appellant’s intention to pay was vague and nebulous and that his actions speak louder than words. I am not suggesting in any way that I am impugning his integrity. He was merely co-operating with Mr Goldfarb who in turn honestly felt that he had carefully prepared documentation which satisfied the requirements of subsection 15(2) for a tax advantage. Counsel for the appellant states that at the end of the original five years relating to the original mortgage dated August 1975, approximately 80% of the amount of advances for the taxation years 1975 and 1976 was paid.

In the intervening years, from August 1975 to September 1980, the appellant only paid $60,000 on account of his loan, the payment of interest having been thrown away by Direct Lumber, in other words by the appellant, which, of course, was his prerogative. This he could not do with the Standard Trust Company mortgage.

I must find against the appellant on the basis that the transaction referred to in the statement of facts constituted a sham, within the definition of that word in Snook v London & West Riding Investments, Ltd, (1967) 1 All ER 519, where Lord Diplock said at 528:

.. . if it has any meaning in law, it means acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.

I consider that the words “bona fide” and repayment thereof within a reasonable time” as contained in 15(2)(a)(ii) of the Act must be read conjunctively. No interest was paid on either of the mortgages entered into by the appellant with Direct Lumber; no one made a demand for payment, or sought to force the appellant to abide by the terms of his mortgages. Minimal payments, when made, were not according to the terms of his mortgages nor were they made within a reasonable time.

I feel that the departure by the appellant from the terms of his original mortgage and subsequent documentation indicate to me that the arrangements made at the time the loan was made were not bona fide and repayment was certainly not made within a reasonable time. The appellant, through advice received by him, was able to proceed to construct a large expensive home, using funds of the company which he wholly controlled, without payment until 1978, 1979 and 1980, in which years he repaid the sum of $60,000, providing him with a balloon on which he floated from the time of the initial purchase price to the obtaining of the standard mortgage from a mortgagee loaning money to him at arm’s length after he had completed his home as originally intended. The obligations of the appellant under his mortgages with Direct Lumber were embraced almost in toto within the Standard Trust Company mortgage. The appellant’s obligations for repayment of his loans from Direct were not made within a reasonable time.

In light of the admission made by counsel for the appellant, the $4,000 advance to the appellant should be added to his income for the 1974 taxation year. The loan relating to the $230,000 advance to the appellant should be added to his income for the 1975 taxation year, and the sum of $91,921.81 should be added to his 1976 taxation year.

Decision

For the above reasons, the appeal is dismissed.

Appeal dismissed.