Santel Investments Limited v. Minister of National Revenue, [1980] CTC 2352, 80 DTC 1305

Guy Tremblay:—This case was heard at Toronto, Ontario, on June 28, 1979.

1. Point at Issue

The problem is whether the appellant, a licensed broker-dealer in securities, is correct in claiming deductions of $17,100 [sic] for the 1972 taxation year, and $11,000 for the 1973 taxation year, on the basis that these amounts were outlays to enhance the potential value of North Shore Copper Limited and indirectly of Cannon Mines Limited. On the other hand, the respondent contends that the said amounts were monies lent by the appellant, whose ordinary business did not include the lending of money. The appellant also claimed $3,000 as cost of stock and $99.78 as inventory write-down.

2. Burden of Proof

The burden is on the appellant to show that the respondent’s assessments are incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. The Facts

3.01 The appellant is a licensed broker-dealer in securities. The company was formed by Messrs Edward B Ashton and G Clinton Snell for the purpose of underwriting speculative mining stocks. They were the main witnesses in the present case.

3.02 In 1969, 1970 and 1971, the appellant’s main activity centered around the promotion and development of Cannon Mines Limited, a public company. The appellant owned some shares of Cannon Mines Limited. There are about 400 individuals who are shareholders. The appellant was still active in Cannon Mines Limited in 1979.

(A) Facts concerning “bad debt”: $25,000

3.03 In the notice of appeal, the appellant states that in 1970, the following note appeared on the Cannon Mines Limited’s financial report:

The Company and Ashton and Ashton Limited (the underwriters) have in addition agreed, that should further funds be required by Cannon Mines Limited, that they would advance a further $175,000 by way of a secured loan. This loan is to have a convertible option whereby the underwriters may within twelve months of the advance of said funds exchange the loan for shares of Cannon Mines Limited .. .

3.04 The appellant advanced $65,000 to Cannon Mines Limited, taking as collateral a mortgage on a mill owned by Cannon Mines Limited.

3.05 The appellant and Mr G H Babcock, a mine engineer, through a new corporation, North Shore Copper Limited, planned to improve the Cannon Mines Limited operations.

3.06 The appellant and George Babcock, (Babcock) pursuant to an agreement dated June 20, 1972 loaned money to North Shore Copper Limited (North Shore): Babcock as representative of New Calumet Mines Limited: $57,000; Babcock personally: $25,000; the appellant: $25,000. The parts of the agreement are Babcock the appellant, North Shore and Cannon Mines Limited (Cannon Mines). The money was loaned to be used: “‘to repair the road, rehabilitate the mill, pay the cost of all labour, additional equipment, material, permits, government approvals (Ontario Water Resources for a tailing dump, etc) test the mill and prepare scales for processing and storing custom ore . . This loan agreement refers to a lease agreement. In fact North Shore leased from Cannon Mines the milling plant to operate it. Both leases were introduced as exhibit A-1. In cross-examination (SN p 27), Mr Snell testified the following:

A. Well, I think we had that agreement with North Shore and with Babcock to lend a total of $25,000. In good faith he was putting up $25,000 and in good faith we must put up $25,000 because this was the agreement with Babcock. This was also the protection we felt we were responsible for as far as shareholders were concerned.

Q. It was the corporation of the Cannon interests?

A. The protection of the Cannon interest. If we didn’t do it we thought perhaps there was no hope.

3.07 The appellant, with respect to its loan to North Shore in the amount of $25,000, made advances on September 30, 1972 and November 30, 1973 of $14,000 and $11,000. As they were not reimbursed, they were claimed as bad debts by the appellant. In his testimony Mr Hershoran, CA, accountant of the appellant, states:

One clarification and this does not bear directly, probably the term, bad debt that was used on the statement was a misnomer and this may answer an earlier question that was asked by the lawyers, questioning why we wrote off the 14,000 one year and then advanced 11,000 the next year, as well and that is because really we considered it more as an expense outlay to finance perhaps operating Cannon Mines. The result of getting Cannon Mines operating again would enable Santel Investments who are the underwriters for Cannon Mines to put through another underwriting, which I believe at the time was in the process. The actual history part I cannot tell you, but there was an underwriting process and the idea was to get the mine operational so they could support this underwriting and I also understand that once they committed these funds, even though and again maybe this is something maybe Mr Ashton and Mr Snell would be more knowledgeable, they had done drillings on the property and found out that even after they had done drillings on the property, they had to expend these funds in the nature of still putting the mine back into an operation, so the result would be that Santel would directly earn income as a result of the underwriting which was the nature of their business and as always has been, as promoters for Cannon Mines and there are probably a few other mines involved. (SN p 46 and 47)

3.08 North Shore was incorporated pursuant to the terms of the above- mentioned agreement and 50% of the shares of North Shore were bene- ficially owned by the appellant with the remaining 50% beneficially owned by Babcock; control of North Shore was as well equally divided (SN p 18).

3.09 North Shore was a company engaged in the milling of copper ore (SN p 18).

3.10 The year end of the appellant, at all material times, is October 31.

3.11 The appellant, at all material times, had a mortgage on milling plant and equipment owned by Cannon Mines; said mortgage was on June 20, 1972, in arrears.

3.12 Of the rent payable to Cannon Mines relating to the lease arrangement (Exhibit A-1), 90% was to be paid by North Shore directly to the appellant who was to pay the mortgage of about $50,000 that the appellant still had on the milling plant (Exhibit A-1, lease agreement, paragraph 4).

3.13 It is admitted by the appellant’s witnesses that at no time was part of all of the appellant’s ordinary business the lending of money.

3.14 It is the respondent’s contention that the said amount of $25,000 loaned by the appellant to North Shore was made to preserve the value of the existing mortgage held by the appellant on the milling plant and equipment of Cannon Mines. Mr Snell concerning that point said: “that’s correct”, and he elaborated:

I say it is correct to this point, that we, Santel had a mortgage on the mill. We were protecting that, but also we were protecting the shareholders of Cannon to this extent or perhaps to a greater extent because these things were in, certainly in our minds, going back to our form of philosophy. (SN p 20)

In cross-examination, on the same point:

Q. It was the protection of the Cannon interests?

A. The protection of the Cannon interest. If we didn’t do it we thought perhaps there was no hope (SN p 27, lines 24 and 28)

On the same point, Mr Ashton testified:

A. There was an engineer by the name of George Babcock, and he was doing some milling for—I forget the name of the operation, and he wanted to try and develop Cannon Mines. He had limited capital and he asked if we would put some up on behalf of Cannon. We negotiated a deal for the ore at so much a ton to go through that mill and the funds would then be generated to pay off the loan that was there and Mr Babcock advanced proportionately as he needed it and therefore it was spread over a period of time. I think that would account for the separate loans over the two years.

Q. The point I am trying to get at is in point K. (of paragraph 3 of the Reply to Notice of Appeal) The Minister is saying the $25,000 was loaned by Santel to North on account of capital to preserve the value of the existing mortgage. Now, basically was this money loaned to North Shore to preserve the existing mortgage on the mill equipment?

A. At that time, the negotiations went on with Comico and they are the largest in Canada and Mr Snell and I spent many hours negotiating a good deal to drill for uranium. We felt at that time if we got the copper going, we could get some money to further Cannon’s efforts. Unfortunately, we got uranium, but not in the quantity required. There was an agreement, if you look on the documents that we spent some $400,000 and we put hours in and never got a dime. It is the word capital, it is the wrong word. I did not put it in there, but we put the effort in. Mr Babcock put the money up and we put the money up to go along with it.

In Cross-examination, Mr Ashton said about Cominco:

It is a big company. It is owned by CPR. They were drilling. If they had a hit in uranium, now you can see the documents up there in my office. That stock would have gone like that. Do you think Mr Goodfellow would sell him out at 34¢? Santel Investments did the junior financing of Imperial Mines. It is in production today. But you don’t pick winners every day.

(B) Facts concerning $3,099.78 claimed as deduction

3.15 In the spring of 1968, according to the testimony of Mr Ashton, the appellant needed shares of a public company to cover a financially short position on the market. On May 2, 1968, the appellant borrowed from a Mr K Goodfellow, a friend of Mr Ashton, “15,000 shares of Cannon Mines Limited stock to trade at their discretion’’ as written in the agreement (part of Exhibit A-2) dated May 2, 1968. It continues “The stock to be returned in certificate form within 30 days or replaced by cheque at the market price of 34¢ per share.” The list of certificate numbers is given in the same document.

3.16 A few days later, May 7, 1968, Mr Goodfellow needed money. The appellant lent him $3,000, as it appears as part of Exhibit A-2 which reads as follows:

I, Mr K Goodfellow, have received $3,000 loan from Santel Investments Limited to be repaid upon return of Cannon Mines Limited stock which Santel has borrowed.

(Signed Ken Goodfellow)

Mr Ashton said in his testimony (SN pp 32 and 33):

THE WITNESS: There is one thing on technicalities, we depend on little words that get confusing to me because I depend on a professional to give me advice. We are in the loan business. Do you think we would loan money with no interest?

THE CHAIRMAN: Pardon?

THE WITNESS: Yes, if we are in the loan business, would we loan money without interest? There is a special arrangement there.

THE CHAIRMAN: How many loans did you make?

THE WITNESS: They said we made a loan. We made an arrangement with stock and we were going to sell the stock to him, but they said it was a loan and you are trying to say we are in the loan busines, but we are not charging interest. Quite often you borrow stock when you are doing some work to trade against the market. We have done it with other people. All brokers do it.

At p 39, Mr Ashton states again:

Mr Goodfellow loaned the stock that he purchased previously on the market along with other good people just to support the market so that we could control the market to try and raise funds and that is the way it is done, and if you hit, you then take down the money and you convert it into stocks. For instance, if this here Canadian Reserve Gas goes ahead and they are very fortunate, they have millions of dollars. They are going to try in another area for uranium. If they hit, Cannon will do an underwriting and that is where Santel will come back in. That is where we will make the dollars. In the meantime, we have been ladling it out.

3.17 The Cannon Mines stock has never been returned to Mr Goodfellow. According to the accountant, Mr Hershoran, CA, the shares were considered as part of the appellant’s inventory. The appellant has never paid Mr Goodfellow the difference of $2,100 (between the fair market value of the stock on May 2, 1968 of 34¢ per share ((15,000 x 34$) $5,100 and the loan which was $3,000). They never reimbursed the $2,100 because Mr Goodfellow never asked for it. (SN p 50 lines 15 and 17).

3.18 Mr Goodfellow never reimbursed the $3,000 to the appellant. However, he is still voting on the shares. Mr Ashton, in his testimony, on one hand States:

We mailed out a notice to the shareholders and we sent a notice to Ken Goodfellow that he is voting on 15,000 shares. And there is an affidavit up in our office signed by the President. (SN p 43)

On the other hand, in a letter dated June 22, 1977, which is part of the notice of appeal, he claimed the $3,000 as deduction because the amount relates “to payment for stock which was used to convert a short position”. A preliminary comment is that it is illegal for Mr Goodfellow to vote on shares which were sold to the appellant and consequently were part of its inventory.

3.19 The appellant, in its 1972 taxation year, wrote down 9,978 shares of Cannon Mines from 6¢ per share to 5¢ per share for a total amount of $99.78. According to subsection 10(1) of the law, the appellant also claimed a deduction of $3,000 as cost of the 15,000 shares of Cannon Mines.

3.20 According to the respondent, the said write-down of $99.78 is not justified as no trading in the shares of Cannon Mines has been reported since the 1970 taxation year and the said shares were not, at all material times, inventory of the appellant.

4. Law—Precedent Cases—Comments

4.1 Law

The main sections of the new Income Tax Act involved in the present case are subsection 10(1), paragraphs 18(1)(a), 18(1)(b) and 20(1)(p) which read as follows:

10(1) For the purpose of computing income from a business, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.

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

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part.

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(p) the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year, and

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) have included in computing his income for the year or a previous year.

4.2 Precedent Cases

The precedent judgments cited by the representatives of the party are:

1. Charter Industries Limited v MNR, [1975] CTC 2349; 75 DTC 270;

2. Freud, H HJ v MNR, [1968] CTC 438; 68 DTC 5279;

3. Malcolm C Kronby v MNR, 76 DTC 1226;

4. Dobieco Ltd v MNR, [1965] CTC 507; 65 DTC 5300;

The Board also referred to the case of:

5. Associated Investors of Canada Ltd v MNR, [1967] CTC 138; 67 DTC 5096.

4.3 Comments

4.3.1 Concerning the 15,000 shares of Cannon Mines borrowed from Mr Goodfellow and the $3,000 lent to Mr Goodfellow, the evidence is clear on many points and contradictory on others.

It is clear that:

(a) the stock was borrowed from Mr Goodfellow by the appellant to support the market (par 3.17);

(b) this was done on May 2, 1968, a date therefore before the loan of $3,000 to Mr Goodfellow. This loan took place on May 7, 1968 (par 3.17);

(c) the $3,000 was not reimbursed by Mr Goodfellow (par 3.16);

(d) the difference of $2,100 (between the fair market value of $5,100 and the loan of $3,000) was not reimbursed by the appellant to Mr Goodfellow (par 3.17).

The evidence is contradictory on the following point: Who is still the owner of the 15,000 shares? “The appellant” says the representative of the appellant (par 3.17). “Mr Goodfellow” says the respondent and Mr Ashton. Mr Goodfellow indeed is still voting on the shares (par 3.18).

However, the Board, considering the condition stipulated in exhibit A-2 that “The stock to be returned in certificate form within 30 days or replaced by cheque at the market price of 34¢ per share,” concludes that the appellant, by not returning the stock within the 30 days after May 2, 1968, bought the shares at 34¢ per share, even if he did not pay the difference of $2,100. Mr Goodfellow never asked for it (par 3.17). It is the legal point of view, despite the testimony of Mr Ashton concerning the fact, that Mr Goodfellow continued to vote which is contradictory to what he wrote on June 22, 1977 (par 3.18). There is nothing in the evidence that the appellant has sold the 15,000 shares, and hence they are supposed to be in the inventory of the appellant. However, in the financial statements of the appellant for 1972 there are only 9,978 shares of Cannon Mines. However, it claimed $3,000 as cost of the shares and $99.78 as inventory write down in 1972. How can the amount of $3,000 be claimed as a deduction in 1972? As explained before, the appellant legally bought the shares in 1968, and the loan of $3,000 was applied as an account. It is the Board’s opinion that the $3,000 had to be deducted in 1968, but not in 1972. Moreover, the total amount of $5,100 (15,000 x 34¢) had to be deducted in 1968, even if the balance of $2,100 was not paid. The appellant’s accounting system indeed is not a cash basis system, but an accrual basis system. It is clear to the Board that in a trade of the nature of the appellant (which is to buy and sell stock), the cost of the stock may be deducted and the sale price must be added in the computation of the income. Concerning the $99.78 deducted in 1972, because the shares of Cannon Mines fell from 06¢ to 05¢ (par 3.19) on the market, the Board, at first glance, would have been inclined to allow that expense. The respondent, however, disallowed it. No admission by the respondent and no evidence by the appellant were given that the market fell during the year 1972. During the argument of the appellant about that point, it was said that Cannon Mines: “It is a public company. The Chairman could find out that in- formation”, (SN p 57, lines 13 & 14). The Chairman does not give evidence. He only hears the evidence and makes a decision according to it.

According to the evidence neither the cost of the stock, $3,000, nor the inventory write down of $99.78 can be deducted in 1972.

The appeal is dismissed on those points.

4.3.2 “Bad debts" or expense: $25,000

The contention of the appellant is that the $25,000 put into Cannon Mines by the intermediary of North Shore is not an investment but “they hoped to make money from the underwriting” (SN p 59). Mr Lewis in his argument said: “If they could get the mine into production, Cannon Mines was a public company and therefore they would be handling the underwriting and they would derive their income from handling the underwriting of the stock.”

It is useful to quote again the testimony of Mr Hershoran:

The result of getting Cannon Mines operating again would enable Santel Investments who are the underwriters for Cannon Mines to put through another underwriting, which I believe at the time was in the process. (par 3.07)

Counsel for the appellant quoted the Supreme Court of Canada in the H J Freud case:

It is clear that monies were not invested to derive an income therefrom, but in the hope of making a profit on the whole transaction.

4.3.3 The contention of the respondent is that the nature of the arrangement between the appellant and North Shore was “to protect their capital investment that was already in existence and in that sense it was a capital investment and not a bad debt or a bad loan rather” (SN p 63).

4.3.4 First, it is clear and moreover admitted by the appellant’s witnesses that the appellant was not in the field of lending money, (par 3.13). Hence, the $25,000 could not be claimed as a “bad debt”. The term “bad debt” used in the financial statements according to Mr Hershoran, CA, “was a misnomer”, (par 3.07).

An account receivable indeed becomes a “bad debt” when the debtor is unable to pay and ordinarily, in the case of this nature it happened at least, one or two years after the loan, but not in the year of the loan. It would be difficult indeed to admit that the amount of $14,000 became a bad debt in 1972 and that the appellant made the loan of $11,000 in 1973.

4.3.5 If we refer to the testimony of Mr Snell and Mr Ashton (par 3.14), they clearly admitted that the amount of $25,000 lent to North Shore was mainly to preserve the value of the existing mortgage.

4.3.6 Moreover, in the Agreement A-1, paragraph 1, it is clearly said that “Santel and Babcock will participate equally in North Shore and will loan North Shore $25,000 each”. These loans bear interest. The last subparagraph of paragraph 2 of A-1 reads as follows:

Babcock and Santel covenant and agree to cause North Shore to repay all moneys advanced by Babcock and Santel at the earliest possible date and such loans shall bear interest at such rate as is agreed upon in writing by Santel and Babcock; Santel and Babcock will be entitled to receive from North Shore such security as they demand from time to time.

It is clearly an account receivable bearing interest.

It is possible that the same amount be considered, at the same time as an expense deductible in the year, and as an account receivable which can be received later with interest.

The Board does not know an accounting principle on which such a method is based. Basic accounting principles are used to construe the Income Tax Act (Royal Trust Co v MNR, [1957] CTC 32; 57 DTC 1055) unless the contrary is specified in a section of the Act. The Board does not know a section of the law which considers the same amount as an expense and as an account receivable. The latter can become a bad debt. To become a bad debt and be deductible, an account receivable resulting from a loan, must be downed by a person who is in the field of lending money (Charter Industries Limited v MNR, [1975] CTC 2349; 75 DTC 270). It is not the case of the appellant.

The principles involved in the case of Freud to which the appellant referred cannot be applied in the present case. The expenses, to manufacture a prototype of car in the referred case, were not for the purpose of deriving income from an investment, but for the purpose of making a profit on selling the prototype.

In the present case, the loans were first made to protect an investment of $50,000, and secondly to protect the shareholders of Cannon Mines. One important element is omitted from the evidence to let the Board consider this argument and especially the interest of the appellant for the sake of the other shareholders’ protection. There were 400 shareholders in Cannon Mines in 1972. The appellant’s company owned 9,978 shares (or 24,978 shares, the evidence is not clear). The evidence did not give the number of shares issued by Cannon Mines.

The Board also studied the case of Associated Investors of Canada Ltd v MNR, [1967] CTC 138; 67 DTC 5096, and could not find that the principles involved can be applied in the present case to allow the appeal. Hence, the appeal must be also dismissed on that point. The $25,000 cannot be deducted in 1972 ($14,000) and 1973 ($11,000).

5. Conclusion

The appeals are dismissed in accordance with the above reasons for judgment.

Appeal dismissed.