Alfred M Kotelko v. Minister of National Revenue, [1977] CTC 2274, 77 DTC 205

The Assistant Chairman:—When Alfred M Kotelko (hereinafter referred to as the ‘‘appellant’’) filed his income tax return for the 1971 taxation year, he stated he was the president of Telco Realty Ltd. To arrive at his total income for the year he showed that, for a business income, he had a loss of $44,460. This loss, according to his Notice of Appeal, arose in the 1971 taxation year as a result of the bankruptcy of Triangle Paving Limited (hereinafter sometimes referred to as “Triangle”). He is alleged to have suffered that loss in 1971 as a result of advances made to Triangle in the year. The appellant alleged that the loss claimed was the total of expenses incurred by him in the year within the ambit of paragraph 12(1 )(a) of the Income Tax Act, RSC 1952, c 148, as amended.

The respondent admits that the appellant made the deduction as alleged, but does not admit he is entitled to such deduction. The respondent alleged that the appellant was not in the moneylending business and that the advances to Triangle were not business expenses of the appellant. The respondent’s contention was that the loss suffered by the appellant was a capital loss within the ambit of paragraph 12(1 )(b) of the Income Tax Act, and so its deduction was prohibited.

In 1962 the appellant, with others, caused an Ontario corporation, Triangle Paving Limited, to be formed. At that time the object of the company was to do “road work” and “paving”. There were four, and later three, individuals behind Triangle, including the appellant. The appellant was in reality a passive investor, having invested about $5,500 in Triangle. The manager of Triangle was Joe Gorowka, who was also a shareholder. Triangle, in the years 1962 to 1968, was moderately successful.

In the fall of 1969, the Canadian National Railway (hereinafter referred to as “CNR”) called for tenders to supply crushed stone for ballast in the area around Fort Frances, Ontario. The shareholders discussed the possibility of Triangle submitting a tender and it was decided to do so at a figure of $1,600,000. Gorowka and the appellant expected a profit of about $300,000 to $350,000 if Triangle were awarded the contract. The tender was submitted and the contract was awarded to Triangle. CNR, however, wanted more money in Triangle to show that it had the working capital to do the job. As his share to meet the requirement of CNR, the appellant, in December 1969, put $33,333 into Triangle as did the other two shareholders, and a floating charge was received from the same. CNR also required a tender deposit of $87,000 together with a performance bond, the premium on the latter being $6,000 a year. Triangle started to work on the contract early in 1970 and difficulties were experienced from the beginning. The rock was difficult to drill, blast and crush. It was harder than normal granite. As money was needed the appellant paid it to Triangle or on its behalf. Mr Gorowka, from Fort Frances, told the appellant that $10,000 had to be paid immediately to Industrial Acceptance Corporation or it would possess certain essential machinery and Triangle would default on the contract. In March 1970 the appellant paid the money. The appellant, in March 1971, put a further $5,000 into Triangle and again, in June 1971, a similar amount to placate creditors and keep Triangle alive. In April 1971 the appellant paid $8,777.22 as interest on a mortgage on his house. It was interest at the rate of 24%. The appellant put the mortgage on his house in December 1969 so that he could advance the $33,333 to Triangle. The floating charge carried interest at the rate of 24%, the same as the mortgage. Needless to say, he was not paid interest. Finally in June 1971, the appellant paid to Canadian Industries Limited $1,500 to purchase dynamite. This product was needed if there was any hope of carrying out the contract. Triangle tried to renegotiate the contract with CNR but it was not successful. In August 1971, Triangle had to pull out from the contract and finally, in February 1972, it made a proposal in bankruptcy. From that, Triangle never recovered. The appellant was a secured creditor for about $40,000, as were the two other shareholders. He was also an unsecured creditor for over $11,000.

The appellant over the years received nothing from Triangle—no wages and no dividends. It had a profit every year until 1967, at which time it had retained earnings of over $108,000. It had a small loss in 1968, and then a loss of over $334,000 in 1969, and $145,000 in 1970. The appellant has been a real estate salesman and broker for many years. Originally he was with the National Trust Company, and then in 1971 he formed his own company, Telko Realty Ltd. He had received bonuses from that company over the years. The appellant’s representative agreed that he had been allowed the sum of $8,777.22 as a deduction by the Minister so that, if he were completely successful, the loss would be reduced by that amount.

Triangle, at all times, had its own office, equipment, staff, corporate bank accounts, and firm of accountants. The advance of $100,000 secured by the floating charge was shown on the books of Triangle as loans from shareholders. With a profitable contract, the debenture would be paid off, interest paid and the shares would go up in value. No interest was charged by the appellant on the other advances he made to Triangle.

The manager of Triangle explained that he was a civil engineer and that he and a Mr Anderson had worked with several construction companies. They thought they should go into the road-building business and so got in touch with the appellant and Dr Kolyk, the result of which was that Triangle was formed. Triangle had had many contracts before 1969, the largest one being for about $300,000. Over the next few years Triangle diversified its operations from road building into the aggregates business and Gorowka felt it could handle the CNR contract even though it had had a loss in 1969 on a joint venture in connection with the sale of aggregates.

It is with this factual background that the appellant submits he is entitled to the deduction claimed (as amended). His representative contends that the loss was incurred in the course of an adventure in the nature of trade and so was a business loss and so deductible in determining his income for the 1971 taxation year. Reliance was placed on the following cases: MNR v Henry J Freud, [1969] SCR 75; [1968] CTC 438; 68 DTC 5279; George Edward Day Ross v MNR, [1970] Tax ABC 436; 70 DTC 1282; and Pigott Investments Limited v The Queen, [1973] CTC 693; 73 DTC 5507.

The respondent contends that the amounts laid out were not made or incurred for the purpose of gaining or producing income from a business or property, but rather, made on account of capital and so are not deductible. The respondent relied on many cases, especially the following: Donald Preston McLaws v MNR, [1972] CTC 165; 72 DTC 6149; and Stewart & Morrison Limited v MNR, [1974] SCR 477; [1972] CTC 73; 72 DTC 6049.

I may say that I have no difficulty in accepting that the appellant disbursed the money which he claims as a business expense. The appellant was a good witness and, to the best of his ability, gave his answers promptly and clearly. Of some facts he was not certain, but this could readily be appreciated as they were events which had occurred in the previous ten years.

I am of the opinion that the Freud case and the Pigott case do not apply to the facts in this case. Here Triangle had a contract with CNR which its shareholders and officers believed would produce, at the end of the contract, a substantial profit. Such was not the case. Rather. difficulties were encountered and to endeavour to still make a profit out of the contract which Triangle already had, the appellant and others put further money into Triangle. The respondent does not admit that what the appellant was doing was an adventure in the nature of trade.

In the Freud case at page 80 [441, 5281] Mr Justice Pigeon says:

In the present case, appellant [the Minister] does not deny that the venture in itself was an adventure in the nature of trade so that if respondent and his friends had embarked upon it in their own names, the loss would be deductible. It is in this light that the four contentions advanced on behalf of appellant must now be examined.

Mr Justice Pigeon at page 83 [444, 5283] also says:

In the present case as we have seen, the basic venture was not the development of a sports car with a view to the making of a profit by going into the business of selling cars but with a view to a profit on selling the prototype. Therefore, the venture, from its inception, was not for the purpose of deriving income from an investment but for the purpose of making a profit on the resale which is characteristic of a venture in the nature of trade. Nothing indicates that the character of the operation had changed when the outlays under consideration were made. On the contrary, the venture had become even more speculative, it was abundantly clear that respondent could have no hope of recovering anything unless a sale of the prototype could be accomplished. The outlays cannot be considered as a separate operation isolated from the initial venture, they have none of the characteristics of a regular loan.

In the Pigott case at page 698 [5511] Mr Justice Noël, the Associate Chief Justice, approached the matter as follows:

The situation, however, is not as simple as this in that the amounts expended by Pigott happen to have been spent over a period of four years in an endeavour, unsuccessful it is true, but one attempted to obtain a construction contract which is plaintiff’s business. The question must, therefore. also be whether these expenses can be regarded as a cost of carrying on Pigott’s construction business on the basis that the benefit that the payment was calculated to achieve was, from Pigott’s own point of view, a benefit of a revenue nature, the earning of profit from the construction of the complex.

At page 701 [5513] he stated as follows:

It appears to me that the amounts expended were not in so far as Pigott is concerned an investment any more than the amounts expended by Mr Freud in MNR v Freud (supra) were investments. The outlays made in the Freud case were so made in the hope of making a profit on the whole transaction of developing a prototype of a sports car. The outlays expended by Pigott were of a similar nature. The spending of the amounts by Pigott were merely, in my view, one facet of a commercial transaction, the ultimate object of which being to earn income therefrom. . . . I think it is even open to the Court to come to the conclusion that First Wentworth here was used by Pigott as a vehicle in a commercial operation or a method of obtaining a profitable construction job. If that is the situation, and I believe that the proper inferences to be drawn from the evidence so indicate, then First Wentworth must be considered to have been or to have become the mere agent of Pigott and it follows, of course, that the expenses of the agent are those of the principal.

While the appellant did not guarantee loans as happened in the McLaws case, he put money into the company as well as paying a creditor directly. Hall, J, speaking for the Supreme Court in the McLaws case, agrees with the conclusion of Kerr, J of the Exchequer Court when Kerr, J stated [at p 171 [6153]]:

“In my opinion the appellant’s outlays were on account of capital, within the meaning of Section 12(1 )(b) and the claimed deductions are prohibited. In my view of the situation, the guarantee was given to protect and preserve the source of income, a business which was in immediate danger of bankruptcy and whose existence was imperilled. The character of the ensuing outlays in honouring the guarantee is quite different from expenditures which fall naturally into the category of income disbursements and business losses. In my opinion, the outlays are of the character of payments on account of capital and are not of the kind of expenditures that the Statute contemplated to be allowed as deductions under the language ‘made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of a taxpayer’, in Section 12(1)(a), or under the language ‘business losses sustained . . . in the course of the carrying on of a business’, in Section 32(5)(d).”

Judson, J, speaking for the Supreme Court in the Stewart & Morrison case at page 478 [73, 6050], adopts the conclusion of the learned trial judge of the Exchequer Court as follows:

“The evidence adds up to this, as I appreciate it. The respondent decided that an American subsidiary, to be wholly owned by the respondent, would be incorporated and would carry on business in the United States and be a source of income and profit for the respondent. The subsidiary would carry on business as a separate American company in its own name and right, but it would, to use Stewart’s words, be ‘masterminded’ by its parent company and their affairs would be closely related and managed. The subsidiary needed capital, but had none. The respondent would supply, or arrange to supply, the needed capital. It arranged and guaranteed a bank loan direct to the subsidiary and also made direct advances of money to enable it to get started and continue to operate. The advances were treated by both companies and by their auditors, and in the respective books and accounts, as loans from the respondent. Book entries do not necessarily denote the true nature of transactions, but I think that the advances in question were correctly treated as loans. The fact that the money so provided was used by the subsidiary to pay its operating expenses, and was lost in a losing cause, does not determine or change its nature of money lent by the respondent to the subsidiary.

In my opinion, the advances were outlays by the respondent of a capital nature, so far as it is concerned, the deduction of which is prohibited by section 12(1)(b) of the Act and the appeal may be disposed of on that finding alone.’’

The learned trial judge has correctly characterized these dealings between the parent company and its American subsidiary. The parent company provided working capital to its subsidiary by way of loans. These loans were the only working capital the American subsidiary ever had with the exception of the sum of $1,000 invested by Stewart & Morrison Limited for the acquisition of all of the issued share capital of its subsidiary. The money was lost and the losses were capital losses to Stewart & Morrison Limited. The deduction of these losses has been rightly found to be prohibited by paragraph 12(1)(b) of the Income Tax Act.

The result is that I have concluded that the disbursements made by the appellant were not made in the course of an adventure in the nature of trade, but were a capital loss of the appellant, the deduction of which is prohibited by paragraph 12(1 )(b) of the Income Tax Act.

The result therefore is, the appeal is dismissed.

Appeal dismissed.