Swystun Mangement LTD v. Minister of National Revenue, [1979] CTC 2476, 79 DTC 417

M J Bonner:—The appellant appeals from an assessment of income tax for its 1975 taxation year. The appellant, in its return of income for the year, sought to deduct $123,330 with respect to doubtful debts. On assessing, the respondent disallowed the deduction to the extent of $110,067.62 on the basis that the amount in question owing to the appellant by The Port-May Hotel Ltd (hereinafter called “Port-May”) was not a debt arising from a loan made in the ordinary course of business within the meaning of paragraph 20(1 )(l) of the Income Tax Act.

The respondent pleaded that he assumed on assessing:

(a) that no part of the ordinary business of the appellant was the lending of money,

(b) that debts of $27,194.63 and $82,872.99 did not arise in the ordinary course of business of the appellant, and

(c) that the debts of $27,194.63 and $82,872.99 were not acquired by the appellant for the purpose of gaining or producing income from a business or property.

The respondent further argued that the $82,872.99 debt did not arise from a loan made by the appellant.

The $110,067.62 is composed of two parts named in the assumptions referred to above. It was common ground that the sums in respect of which the claim for $27,194.63 was made were advanced to Port-May directly by the appellant during a period commencing July 14, 1974. They are hereinafter called “the late 1974 advances”. The evidence established that during a period commencing April 15, 1974, and ending July 8, 1974, sums totalling $84,000 (hereinafter called “the early 1974 advances”) in respect of which the appellant’s claim was $82,872.99 were initially advanced to Port- May by Nestor Swystun, a shareholder of the appellant, in circumstances which will be detailed later. The appellant argued that those circumstances were such that the advances should be regarded as advances made by Mr Swystun as agent of the appellant.

The appellant was incorporated on February 28, 1974. Its objects were:

(a) To carry on the business of an investment and holding company, and in connection therewith to acquire, purchase, employ, hold, sell, assign, transfer, mortgage, lease, exchange, dispose of, improve and deal in property real and personal, of every kind and description including land and any interest therein and stocks, shares, bonds, chattel mortgages, debentures and securities and evidences of indebtedness and to enjoy and exercise all the rights and privileges of such ownership, including the right to build upon, work, operate, develop, improve or in any way utilize any such real or personal property.

(b) To engage in the formation, supervision, management or control of any business or corporation and for such purposes to appoint and pay managers, accountants, experts and agents to manage property, operate franchises and carry on undertakings of any such business or corporation.

(c) To carry on business as a collection agency.

(d) To carry on generally the business of real estate and mortgage brokers.

Half of the issued shares of the appellant were owned by Nestor W Swystun, a Winnipeg lawyer, and the other half by his wife, Maureen Swystun. It was incorporated with a view to managing Mr Swystun’s law practice and to facilitate the handling of money lodged by Mr Swystun’s clients with him for investment in mortgages.

Mr Swystun’s law practice had, over the years, become specialized largely in the hotel field. He became expert in assisting purchasers in obtaining necessary licenses and financing. Legal fees, placement fees and collection fees arising from hotel work formed more than eighty percent of Mr Swystun’s fee income. He held shares in and managed a number of corporations which engaged in the business of mortgage lending. The other shareholders of those corporations were groups of persons brought together through Mr Swystun’s law practice. In addition, Mr Swystun became involved personally in the money lending business.

The doubtful debts of immediate concern in the litigation were debts of Port-May, a company which owned and operated the Portage-Mayfair Hotel. Mr Swystun had acted for two individuals who purchased the hotel. After the purchase Mr Swystun arranged that two loans be made by other clients to Port-May, each such loan secured by mortgage on the hotel property. Differences between the owners than arose and a court-appointed receiver proceeded to sell the hotel. Mr Swystun saw an opportunity to buy for $623,000 a hotel which had cost its fromer owners $755,000 and an opportunity to make it viable and then sell it. In this way Mr Swystun expected that he could ensure full recovery on the mortgage loans arranged by him for his clients. Port-May was then incorporated. It purchased the Portage Mayfair Hotel from the receiver for $1 plus the assumption of existing indebtedness, including the two mortgage loans mentioned above.

The shareholders of Port-May were, initially:

The shareholders of Port-May all advanced money to the company by way of shareholders’ loans, although it does appear that a $45,000 advance made on November 30, 1972, may have been made by Mrs Swystun on behalf of her husband.

Mr Swystun testified that Mr James subsequently decided that he “wanted out” of Port-May. In October of 1973 Mr James assigned and transferred to Mr Swystun his Port-May promissory notes and shares. Also, in order to enable Port-May to keep current in its mortgage payments, Mr Swystun personally advanced to the company the following sums on the dates indicated:

On July 4, 1974, the appellant bought the Port-May shares and receivable previously held by Mr Prychitko. Deductions in respect of losses suffered on debts owing by Port-May to Mr Swystun arising from the 1973 advances are not, of course, in issue here.

In October of 1974 it first became apparent to Mr Swystun, as a result of information obtained from his auditors, that Port-May could not be operated successfully. Thereafter he refused to allow the appellant to make further advances to Port-May. Many of the advances which had been made by Port-May were made to enable it to pay its debts, including debts secured by mortgage. The company was then unable to meet its secured Obligations. It lost the hotel as a result of foreclosure and ceased to do business.

Evidence was given by Alan Burdette, Mr Swystun’s accountant. He testified that the incorporation of the appellant flowed from discussions between himself and Mr Swystun. It was planned that the appellant would engage in two lines of business:

(a) to manage and operate Mr Swystun’s law office, and

(b) to engage in secondary mortgage financing.

In the preliminary discussions Mr Burdette suggested, and Mr Swystun agreed, that after the appellant was incorporated all further loans to Port- May would be made by the appellant.

Between the 8th and 14th of July, 1974, Mr Burdette discovered that the promissory notes given by Port-May for the early 1974 advances were drawn in favour of Mr Swystun. Mr Burdette stated that, as a result, the promissory notes were ‘’changed” to reflect the situation “as it should have been”. The notes originally issued by Port-May for those advances were destroyed and the new notes were issued in favour of the appellant. No further steps were taken in July of 1974.

Mr Swystun had obtained the funds for the early 1974 advances to Port- May from bank loans made to him. The advances were made by cheque drawn on the Swystun & Company (law firm) trust account. In March of 1975 Mr Burdette noted the situation as revealed by the banking records of Mr Swystun and of the appellant. He suggested further corrective measures. Mr Swystun caused the appellant to borrow the amount in question, $84,000 from the bank and to pay it to him. He used the funds to retire his personal liability to the bank.

Mr Burdette testified that he thought that the bank had made an error in recording the advances in question as advances to Mr Swystun and not to the appellant. I do not believe that Mr Burdette’s analysis is correct. The funds were originally obtained from the bank as a result of a loan recorded as having been made to Mr Swystun. The advances to Port-May were made by cheque drawn on the Swystun & Company trust account. The promissory notes evidencing the Port-May indebtedness were originally issued to Mr Swystun. The “error” as I see it arose from a failure by the appellant to enter into several loan transactions of the type originally planned for it. The corrective measure subsequently taken cannot be regarded as having eradicated the transactions which did in fact take place. Those transactions were loans made by Mr Swystun to Port-May.

The facts do not bear out the appellant’s contention that Mr Swystun borrowed the $84,000 as the appellant’s agent and that the appellant subsequently ratified and adopted actions taken by Mr Swystun as its agent. It was not established that Mr Swystun either purported to or intended to make the advances as agent of the appellant. It appears to me that at the time the advances were made Mr Swystun simply did not direct his mind to any question whether he was advancing money qua agent. Consequently I cannot find that the $84,000 debt of Port-May arose as a result of a loan made by the appellant. Paragraph 20(1 )(l) of the Act cannot assist in respect to the $84,000 indebtedness. That provision permits a deduction only by the taxpayer who made the loan in question. Authority for that proposition may be found in the decision of the Federal Court of Appeal in Her Majesty the Queen v Pollock Sokoloff Holdings Corp, [1976] CTC 349; 76 DTC 6181. In that case Jackett, CJ, stated at p 351 [6182]:

In my view, section 11(1)(e) does not authorize the respondent to make a deduction of a reserve in respect of such debts because they did not arise from ‘loans made’ by the respondent. The submission of counsel for the respondent that, in the context of section 11(1)(e), the words ‘made by a taxpayer’ include loans made by a third party and subsequently transferred to a taxpayer does not require, in my view, any answer except that the word ‘made’ used in relation to the word ‘loans’ does not have any such sense. This is even clearer, in my view, when the French version of the provision is read with the English version. The submission of counsel that the use in section 11(1)(e)(ii) of the expression ‘a taxpayer’ instead of ‘the taxpayer’ extends the operation of the provision to permit the deduction of a ‘reserve’ for ‘doubtful debts’ arising from loans made by ‘a taxpayer’ other than the taxpayer whose income is being computed is, superficially, more persuasive. However, while section 11 (1 )(e)(ii) is not worded as explicitly as it might have been, I have concluded that it extends only to granting a ‘reserve’ in respect of debts arising from loans made by the taxpayer whose income is being computed. In other words they must have been made by the taxpayer part of whose ordinary business must have been the lending of money. In my (sic) event, even if the words were open to the other interpretation, the respondent cannot succeed in this submission unless the ordinary business of the lender was ‘the lending of money’ and, in my view, in this case, the evidence would not support such a finding of fact.

No similar problem under paragraph 20(1 )(l) stands in the way of the appellant’s claim in respect of the late 1974 advances.

However, the respondent raised two further arguments with respect to the applicability of that provision to the late 1974 advances. It was submitted that they were not made by a taxpayer, part of whose ordinary business was the lending of money. The evidence established that the appellant was, from August 22, 1975, onward, registered as a mortgage broker under The Mortgage Brokers and Mortgage Dealers Act of the Province of Manitoba. In subsequent years it advertised under the classification “Mortgages” in the yellow pages of the Winnipeg telephone directory and thereby held itself out as a mortgage lender. By the end of its 1975 taxation year the appellant had advanced money on the security of mortgages to five persons. In later years it made further mortgage loans. Having regard to such facts, to the course of business planned for the appellant and to the appellant’s objects, I have no difficulty in concluding that part of the ordinary business of the appellant was the lending of money. Although the late 1974 advances were apparently the first loans made by the appellant, subsequent events establish that the ordinary business of the appellant included the lending of money.

The respondent argued too that the late 1974 advances were not made “in the ordinary course of business”. It seems clear on the evidence that Mr Swystun was the directing mind and will of the appellant. He appears to be a shrewd businessman with particular expertise in matters related to the operation, management and financing of hotel businesses. Mr Swystun plainly believed when the advances were made that, in time, Port-May would be able to repay the appellant. As Mr Swystun put it, “I thought at October 1, 1974, the company (Port-May) and I would be a winner”. It is clear that as soon as it became apparent to Mr Swystun in October of 1974 that the Port-May operation was not and could not be made viable he decided, without hesitation, to cut off further advances. I cannot conclude that the advances which were made to Port-May would not have been made in the absence of the connection between Mr Swystun and that company. The failure to obtain security does not, in this case, make the loans so uncharacteristic that it cannot be said that they were made in the ordinary course. In short, the appellant was lending money on what Mr Swystun perceived to be the strength of the Port-May covenant as opposed to reliance on security. I have therefore concluded that the appellant is entitled to succeed under paragraph 20(1)(l) of the Act on that branch of its claim arising out of the late 1974 advances.

Although the appellant failed to establish a claim for relief under paragraph 20(1)(l) of the Act in respect of the early 1974 advances it is, I believe, entitled to a deduction in respect of them on the basis of an alternative ground advanced by its counsel. He submitted that the losses arose from transactions which were an integral part of the appellant’s profitmaking activities. Although the early 1974 advances to Port-May were made by Mr Swystun as a result of his failure to direct his mind to the decision which he had earlier made in consultation with his accountant that such advances should be made by the appellant, corrective steps commenced in July with the substitution of the promissory notes. The substitution took place prior to the time when it was determined that the Port-May business could not be made viable. As a result of the substitution of those notes it could hardly later have been argued that the appellant, although it technically speaking did not lend money to Port-May, had not secured an interest-bearing indebtedness. In doing so, the appellant, despite the sloppiness in failing to straighten up the situation at the bank, entered into a transaction which cannot, in my opinion, be regarded as anything other than a part of its ordinary profit-making activities. The situation in this case is not essentially different from that in MNR v Kelvingrove Investments Ltd, [1974] CTC 450; 74 DTC 6357.

The appeal is therefore allowed and the assessment in issue is referred back to the respondent for reconsideration and reassessment on the basis that the appellant is entitled to deduct the sum of $110,067.62, previously disallowed.

Appeal allowed.