William a Johnson, Bernard Kredentser v. Minister of National Revenue, [1980] CTC 2471, 80 DTC 1418

D E Taylor:—These are appeals heard on common evidence on March 21, 1980 at the City of Edmonton, Alberta, and are against tax assessments for the year 1974 in which the Minister of National Revenue allowed an amount of $37,216 to each of the appellants as a capital loss, but denied their claim that it be considered as a business loss. In so assessing, the respondent relied, inter alia, upon section 39 of the Income Tax Act, SC 1970-71-72, c 63, as amended.

Background

Bernard Kredentser is a medical doctor, and William A Johnson a lawyer, both in the practice of their respective professions in the City of Edmonton, Alberta. The appellants were at all material times the shareholders of a private company known as Golden Bear Cafeteria Ltd (Golden Bear) which carried on a restaurant business. On July 30, 1973, Golden Bear entered into an agreement with Bar Circle M Holdings Ltd (Bar Circle) pursuant to which Bar Circle purchased the assets of Golden Bear. In connection with the purchase, Bar Circle arranged for a loan from the Toronto-Dominion Bank in Edmonton (Bank) and the appellants personally guaranteed that loan. At that time the appellants received a promissory note for the amount guaranteed, signed jointly by Bar Circle and its major shareholder, William Mappin (Mappin) personally; and in addition a second promissory note in the amount of $10,000 at 10 /4% interest. The proceeds of the Bank loan to Bar Circle were used to pay Golden Bear for the assets purchased. Golden Bear used the monies to repay its earlier borrowing from the Bank. Bar Circle carried on the restaurant business for approximately one year before it failed. As a result of the failure of Bar Circle the appellants were each obligated to pay the sum of $37,216 to the Bank pursuant to their guarantee of the Bar Circle loan. The appellants both deducted the sum of $37,216 as a business loss in filing 1974 income tax returns.

Contentions

For the appellants:

—THe $37,216 loss for each appellant was a loss from business, as defined in section 248 of the Income Tax Act, which includes an adventure or concern in the nature of trade.

For the respondent:

—The appellants were not in any business within the meaning of the definition of that term in the Income Tax Act, with respect to the transactions at issue.

Evidence

The testimony of Mr William A Johnson generally substantiated the background information given above, and in addition provided the following factors of note:

— It was the appellants’ understanding that Mappin had tried but had been unsuccessful in obtaining the required funding from the Federal Industrial Development Bank.

—“. . . we were very anxious to be out of the business because we were, of course, bound by our professional obligations and the business at that time was breaking even, but it obviously would have gone slowly downhill possibly. . . . So we suggested that we would want two securities from Mr Mappin and his company, one was a note equal to the bank loan which was $65,000 payable by Mappin and Bar Circle jointly to us. That was $65,000 and we fixed the rate of interest on that at 10 /4%. I believe the rate at the bank at the time was about 10 /4 or 10 /2 in that area. We also asked for a bonus of $10,000 which Mr Mappin advised he didn’t have at that time, but he could pay within one year. So we agreed to take a $10,000 note additionally from both Mappin and Bar Circle for the $10,000 also at 10 /4% with interest to be paid monthly and the full amount to accrue in one year.

—. . . the proceeds of the winding-up . . . of Mappin’s business resulted in payment only to the landlord who was first, plus some taxes. So that the bank and ourselves were left with nothing, with the result that we honoured the guarantees, of course, and proceeded to (try to) collect from Mappin (without success). . . . Yes, the bank assigned us the debenture and offered us the opportunity to try and recover from Mappin.”

—“So just to sum up then, the price that you and Doctor Kredentser charged for signing a guarantee was those two notes—the $65,000 note _.. and the $10,000 bonus?”—“Yes.”

—After the sale to Mappin, the appellants had placed Golden Bear into voluntary liquidation and they had no connection with the restaurant business which continued under Mappin as the Bar Circle. The unsecured creditors of Golden Bear had received something less than full payment on their accounts.

—The relevant notes, entered as Exhibits A-1 and A-2 respectively, were provided and are reproduced hereunder. Neither note contains a date for payment, although it had been the recollection of Mr Johnson that at least the $10,000 note was for a period of one year only.

Exhibit A-1:

PROMISSORY NOTE

$10,000 August 27, 1973

FOR VALUE RECEIVED we jointly and severally promise to pay to the order of WILLIAM A JOHNSON and BERNARD KREDENTSER at 1107 Baker Centre, Edmonton, Alberta, the principal sum of $10,000 together with interest thereon or so much thereof as shall from time to time remain unpaid at the rate of 10 /4% per annum calculated yearly and not in advance and shall be payable on demand. The Promissors shall have the privilege of per-payment of the full balance or any part thereof at any time without notice or bonus.

The Promissors and any endorser or guarantor hereof severally waive demand and presentation of payment, notice and non-payment and notice of protest of this note.

BAR CIRCLE M HOLDINGS LTD

PER: (Sgd) W Authur Mappin

(Sgd) W Arthur Mappin

WILLIAM A MAPPIN

(personally)

Exhibit A-2:

PROMISSORY NOTE

$65,000 August 27, 1973

WHEREAS the parties signing this note jointly and severally have obtained an advance from the TORONTO-DOMINION BANK, Edmonton, Alberta in the sum of $65,000.

AND WHEREAS the Promissees named herein agreed to guarantee the said Bank loan in consideration of the within note being given to them as collateral security, (italics mine)

NOW THEREFORE for value received we jointly and severally promise to pay to the order of WILLIAM A JOHNSON and BERNARD KREDENTSER at 1107 Baker Centre, Edmonton, Alberta, the principal sum of $65,000 together with interest thereon or so much thereof as shall from time to time remain unpaid at the rate of 10 /4% per annum calculated yearly and not in advance shall be payable on demand, provided a default has occurred in the principal amount or the interest payable to the TORONTO-DOMINION BANK aforesaid under its loan made to the Promissors. The Promissors shall have the privilege of pre-payment of the full balance or any part thereof at any time without notice of bonus.

The Promissors and any endorser or guarantor hereof severally waive demand and presentation of payment, notice and non-payment and notice or protest of this note.

BAR CIRCLE M HOLDINGS LTD

PER: (Sgd) W Authur Mappin pres

(Sgd) W Arthur Mappin

WILLIAM A MAPPIN

(personally)

Argument

Counsel for the appellants summarized:

So, the facts in this case ... indicate that these appellants signed a document at a bank called a guarantee, and the price that they extracted for that was security by way of a note for $65,000 being roughly equivalent to the amount of the guarantee carrying interest, plus a $10,000 bonus which was to be payable regardless, that note also carrying interest at 103%4%. Both interest rates apparently being a half or three-quarters or so above the lending rate of the banks at that time. The guarantees had to be met and so really, at that time, both appellants paid the banks on the guarantee but simultaneously acquired at that time a debt from Bar Circle and from Mappin. But they really acquired a worthless debt, that’s why the bank called the guarantee ... So they lost, in other words, they took the risk of signing a guarantee for $65,000 in consideration for security plus a $10,000 bonus, plus interest, and the loss was $65,000 plus bank interest being about $74,000 which was satisfied equally, and that’s how we get to the roughly $37,000 figure mentioned in the pleadings.

It was submitted that the business there is the business of signing a guarantee for the purpose of making a profit from doing that, that is the $10,000, the note plus the interest that it carried. That’s an adventure or concern in the nature of trade. The $10,000, if that were paid, would have been income. We also submit that the converse of that, ie the loss of the $65,000 plus interest, ie the loss of $74,000 should be deductible.

When Mr Johnson and Dr Kredentser paid $65,000 to the bank, I don’t think that anybody could suggest that they were acquiring at that time an asset of a longterm or enduring nature, which is the usual test in determining whether or not payment is on account of capital. In fact, the opposite would seem to be the case, and that is that they paid $65,000 because they had to, and when they did that, they were really acquiring something of very little, if any, value, and in fact, turned out to be of no value.

So, I would say . . . that the $65,000 was not a payment on account of capital to acquire an asset of long-term or enduring advantage, it was a last debt ina speculative transaction involving a guarantee that I think must be considered to; be speculative, having consideration to the evidence, ie that the purchaser or the principal behind the purchaser company could not get further funds from his own bank, either may or may not have been able to get them, it would have taken some time to get funds from the Federal Business Industrial Bank. . . . They hoped to make $10,000 but they didn’t, they lost $74,000.

They were getting out of that (restaurant) business, and they were embarking on an adventure or a concern in the nature of trade, hoping to make a $10,000 bonus.

Case law referenced by counsel in support of the appeals was:

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

Her Majesty the Queen v F H Jones Tobacco Sales Co Ltd, [1973] CTC 784; 73 DTC 5577;

(and referred to in Jones (supra): MNR v Henry J Freud, [1968] CTC 438; 68 DTC 5279);

H Griffiths Company Limited v MNR, [1975] CTC 2120; 75 DTC 97; (Crown’s appeal allowed: [1976] CTC 454; 76 DTC 6261);

(and referred to in Griffiths (supra): MNR v George H Steer, [1966] CTC 731; 66 DTC 5481);

Margaret Ann Frappier v Her Majesty the Queen, [1976] CTC 85; 76 DTC 6067;

(and referred to in Frapper (supra): Canada Starch Company Limited v MNR, [1968] CTC 466; 68 DTC 5320).

Counsel for the respondent noted in response:

. . . the Minister’s position then rests on the provisions with respect to the acquisition and disposition of capital items, section 39 which has a further limitation in section 40(2)(g)(ii) which reads:

‘‘a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property . . . or aS consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length,”

In other words, (unless in that situation) the loss from the disposition of a debt would not be deductible unless the debt itself had been acquired for the purpose of gaining income, so that is a somewhat similar proposition to the 18(1)(a) (situation), only on the capital side, rather than on the ordinary expense side.

Now, the Mininster has allowed the deduction as a capital loss in acquiring the fact that the bonus arrangement, if paid, would have resulted in not just income, but taxable income. The Minister has accepted that the debt was acquired therefore for the purpose of gaining or producing income in form of the bonus but only on the capital side, not on the 18(1 )(a) side.

Now, the provision 40(g)(ii) proved a little harsh in a number of instances were taxpayers in a perfectly legal and natural commercial sense, had advanced monies to their own companies or partnerships without interest, and under this limitation of section 40(2)(g)(ii), these amounts would not have been deductible.

So the policy now has been relaxed, and it is not reflected in the Act, but it is a policy that is expressed in an Interpretation Bulletin (I think its 239R) that allows the deduction on the capital side as a capital loss, even in circumstances where no gain resulted, but where (certain) conditions have been fulfilled.

. . . in plain terms, as the Minister sees it, the sale of the restaurant itself was a bail-out... They found that they could get out only, they had only one opportunity to get out and that was by accepting Mr Mappin’s offer, no matter with what misgivings, but it was the only offer there.

It seems to me when you are forced into a situation, a bail-out of this kind, I don’t think you are really talking of an adventure any more.

.. . the Minister sees this as a transaction on account of capital, that if a loss has been suffered and it has been suffered, it should be a capital loss because the Minister is unable to see in it, the business undertaking of the kind to which, or which is usually and very often in the court, caught by the extended meaning of business, an adventure in the nature of trade in 248, but rather on the capital side in the meaning of the provisions of the Income Tax Act that apply to . . . section 40

Counsel made reference in his argument to Donald Preston McLaws v MNR, [1970] CTC 420; 70 DTC 6289; [1972] CTC 165; 72 DTC 6149 (taxpayer’s appeal dismissed (SCC)), in addition to noting the comparisons which should be made between this case and that of Steer (supra).

Findings

Reference was made by counsel for the respondent to a change in assessing policy of Revenue Canada, illustrated by Interpretation Bulletin IT-239 as it was under date of August 4, 1975, and as it became by designation of 239R under date of April 18, 1977. Counsel did not attempt to relate to policy under Bulletin 239R to the import of the relevant sections of the Act themselves, but did agree that the allowance of the loss as even a capital loss (as was done by the Minister in the relevant assessment dated December 28, 1977) would be very difficult to conceive under the original Bulletin #239.

The argument of counsel for the appellants is twofold:

(a) Since the outlay in question (the payment to the Bank of $65,000 plus interest totalling $74,432) did not bring into existence “an asset of a longterm (nature) or of enduring advantage”, barred by paragraph 18(1 )(b) as a deduction, then it must have been made for the purpose of producing income, which is allowable as a deduction under paragraph 18(1 )(a); and

(b) it can be shown that the guarantee provided was intended to produce a profit of the $10,000 bonus note, clearly fitting it in any event under paragraph 18(1)(a) of the Act.

As I follow counsel’s first argument therefore, it places into direct juxtaposition and makes mutually exclusive, paragraphs 18(1)(a) and 18(1 )(b) of the Act, requiring thereby that an outlay or expense fall into either one or the other category. Accordingly, a “current”, “income”, “revenue” (or whatever term is used), outlay or expense comes under, and is deductible under paragraph 18(1 )(a) by virtue of the fact that it was “made for the purpose of producing income”. Conversely, if I follow counsel correctly, it is disallowed as a deduction under paragraph 18(1)(a) only if it produces some enduring advantage, and then it is disallowed only because it was not made “for the purpose of producing income”.

Counsel might like to read certain portions of the cited judgments in support of such a proposition, but I do not share such a conviction, and I would particularly note from F H Jones (supra) at pp 790 and 5581 respectively:

Clearly, as I have already indicated, the payment made by the Jones company was one which fell within the exception provided in paragraph (a) of section 12(1). It was in fact made for the purpose of gaining or producing income from defendant’s business, and the evidence establishes that until the bankruptcy of La Société des Tabacs de Québec Inc it actually yielded considerable income by the sale of tobacco made by the company to the latter concern.

The only question the Court must now determine is whether the payment of this amount falls within paragraph (b) of section 12(1), as an outlay, a payment on account of capital, or a loss of capital. Plaintiff’s counsel argued that it does, and it is possible that in certain circumstances it might be so regarded.

and from Frappier (supra) at pp 93 and 6071 respectively:

I believe that the deduction made was therefore a proper one unless it is considered as a payment on account of capital within the meaning of Section 12(1)(b) of the Act, which is Defendant’s second ground of contestation.

The question of the relationship between paragraphs 18(1 )(a) and 18(1 )(b) has been considered by the Courts on many occasions, but I would make specific reference to the precedent-setting judgment in British Columbia Electric Railway Company Limited v MNR, [1958] CTC 21; 58 DTC 1022. In the above judgment, two separate versions of reasons for judgment were provided, and while both were in agreement on the result, each judgment took a different perspective and gives certain important points to be noted. At pp 25 and 1024 respectively, Justice Locke (Justice Cartwright concurring) remarked:

The appellant company contends that these payments were made for the purpose of gaining or producing income from its business, within the meaning of s 12(1)(a) of the Income Tax Act 1948, c 52, and that such payments were not outlays of capital or payments on account of capital, within the meaning of s-s 1(b) of that section.

It is not decisive of the question as to whether the payments were made for the purpose of gaining income, within the meaning of the subsection, that making them resulted in an increase of the income of the appellant. Since, however, that question does not arise if they fall within the prohibition of s 12(1 )(b), this question should be first considered.

And at pp 31 and 1027 respectively, Justice Abbott (The Chief Justice and Justice Fauteux concurring) commented:

Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made “for the purpose of gaining or producing income” comes within the term of s 12(1)(a) whether it be classified as an income expense or as a Capital outlay.

Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or a capital outlay. The principle underlying such a distinction is, of course, that since for tax purposes income is determined on an annual basis, an income expense is one incurred to earn the income of the particular year in which it is made and should be allowed as a deduction from gross income in that year.

As I read these two perspectives, Justice Locke says that since the outlays claimed in that appeal were clearly capital expenditures prohibited by (the then) paragraph 12(1 )(b) of the Act, there is no need to consider whether or not they would meet the test in (the then) paragraph 12(1)(a) of the Act, but is quite clear to me that in the event the test in paragraph 12(1 )(b) had been passed, the appellant would have been scrutinized then under paragraph 12(1)(a); whereas Justice Abbott puts forward that in view of the general limitation characteristic of (the then) paragraph 12(1 )(a) “for the purpose of gaining or producing income”, it may be applied to all deductible expenses before a determination of whether it is of an “income” or “capital” nature is required. I see no indication in either perspective that would provide comfort to a taxpayer attempting to counter-position paragraph 18(1)(b) against paragraph 18(1)(a), thereby escaping the unwanted provisions of one section simply by complying with the provisions of the other.

In the instant appeals, the burden on the appellants if necessary is (a) to demonstrate both that the payment in question was not a capital payment prohibited by paragraph 18(1)(b), and that it was made for the purpose of gaining or producing income permitted by paragraph 18(1)(a). Dealing first with the appellants’ proposition that the amount involved was not a capital outlay, I would refer first to the comments of Justice Abbott from BC Railway (supra) in which he found no difficulty at all in fitting that expenditure into the relatively narrow definition of capital because it was made “with a view of bringing into existence an advantage for the enduring benefit of the appellant’s business”. In this matter, by proposing that nothing of value, in fact something worthless (the purchaser’s uncollectible note for $65,000) was received by the appellants, counsel for the appellants is attempting a discreet segregation between the $65,000 bank loan for the purpose of buying the restaurant business, and the guarantee itself allegedly made for the purpose of earning a profit. In effect, counsel says that the matters related to the sale of the business can be viewed as separate and distinct from the agreement to guarantee the note. The evidence to support such a conclusion has not been demonstrated to me—indeed, there is no evidence that the business could have been sold without the required guarantees. The funds in question ($65,000) did not leave the control of the Bank, and there was no point in time as I understand the situation that the appellants were freed from their original personal obligations to the Bank—whether in their own right as borrowers, or as guarantors of the purchaser’s loan. In Frederick Tim Smye v MNR, [1980] CTC 2372; 80 DTC 1326, the Board examined the impediments which exist to prevent the claim of assignment (transfer) of a marketable security, as required under subsection 20(14) of the Act, and concluded as follows:

In my view, the Board cannot accept the “agency” assertion where there was any impediment whatsoever to the appellant himself accepting delivery (transfer) of the securities. The lack of payment in full to the “purchasing agent” (whether the same party or a different party than that proposed as the “holding trustee or agent”) would constitute such an impediment and leave the transaction outside the parameters of the term ‘‘assignment or other transfer”. I cannot feature that a taxpayer in the circumstances of these appeals can place a second or third party in a position more advantageous than that which he himself enjoys, simply by calling that other party “an agent”. In this connection, I would make general reference to Smith, Stone and Knight Ltd v Birmingham Corp, [1939] 4 All ER 116.

To some degree, an analogy (although in reverse) can be drawn here—the appellants are saying that they individually ceased to be debtors of the Bank because the purchaser took their place as the party responsible for funds owing to the Bank, and then, voluntarily and for a profit, they assumed a position as guarantors for the same funds owing. I would consider that proposition if it could be shown that at any point in time such a total disengagement from their own obligation to the Bank existed. In my view, the appellants’ basic obligation to the Bank did not change by virtue of the inclusion of the purchaser in the repayment program for the loan. The premise of the appellants which is fundamental to classifying the loss as “business” rather than “capital” fails because the obligation to the Bank for the capital funds borrowed remained constant and uninterrupted through the transaction, right up until the date it was eventually paid by them. A separation might be made between the sale and the guarantee on one hand, and the bonus note on the other, but I do not see how that would serve the cause of the appellants. The amount at issue was an outlay at its origin for the purpose of bringing into existence an enduring benefit—the assets and business of Golden Bear which were sold or perhaps, more appropriately termed lost, and as such it was capital within the definition of that term. Even if consideration should be given to the proposition of counsel for the appellants that no such “enduring advantage” would be perceived (presumably because of the intervening transaction and events), I doubt that this outlay could pass any test which took into account the comments of Justice Locke noted earlier from BC Railway (supra):

To say, however, that an expenditure made with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade is a capital expenditure is not to say that all other expenditures must, in order to be properly classified as outlays of a capital nature or on account of capital, be made in order to produce such a benefit.

It would appear from the above that any outlay for the purpose of preserving, salvaging or even preventing further deterioration in a taxpayer’s posi- tion in a business might well come within the parameters described by the learned Justice.

Since the Board in the instant appeals has associated granting the guarantee with the sale of the business, not with obtaining the bonus note, the necessary relationship between the alleged business (the guarantee) and the alleged profit (the bonus note) does not exist, and no final determination of the arguments proposed to fit the claim under paragraph 18(1)(a) is needed. I would note, however, that it might be contended with certain validity that the $10,000 note (if it had been paid) would exhibit characteristics similar to a delayed and contingent payment made on account of the sale of the business rather than as asserted by the appellants. Further, in view of the financial situation of both Golden Bear and Mappin at the date of the sale, it would be advisable for the appellants to demonstrate that there was a reasonable expectation that they would not be required to fulfill the obligation under the guarantee, and also that they would realize on the bonus note, both situations inherent in the proposition that there was a business venture.

Summary

Support for the proposition that the outlay was made “for the purpose of producing income” has not been demonstrated to the Board, and to that degree at least the appellants have failed to meet the mandatory stipulation in paragraph 18(1)(a) of the Act. Further, it is the determination of the Board that the evidence supports a conclusion that the outlay was of a capital nature for which no deduction by exception is provided in paragraph 18(1 )(b) of the Act.

Decision

The appeals are dismissed.

Appeals dismissed.