Lawrence John Bailey v. Minister of National Revenue, [1976] CTC 2169, 76 DTC 1137

Delmer E Taylor:—This is an appeal from an income tax assessment for the year 1967. The matter at issue is the transaction used by the appellant to deal with an outstanding balance in his shareholder’s loan account in a company he controlled, Baileys Restaurants Ltd, which balance stood at $51,064.43 on December 31, 1967, and would have become taxable in his hands as income for the year 1967, unless repaid by December 31, 1968. This transaction relates to a bank loan taken out by the appellant on December 31, 1968 for the purpose of repaying the shareholder’s loan, and the events which flowed therefrom involving another company, Angelus Ventures Ltd, also controlled by the appellant. The appellant claims to have well and truly repaid the said “Shareholder’s loans from Baileys Restaurants Ltd”; or in the alternative to have repaid the said loans at least in the amount of debt owed to him by Angelus Ventures Ltd.

The respondent asserts:

(1) the transaction involving the Bank of Montreal pursuant to which the appellant purports to have repaid to Baileys Restaurants Ltd a sum of $55,000 on December 31, 1968 did not constitute the repayment to Baileys Restaurants Ltd of the shareholder’s loan;

(2) that in the alternative if the transaction did constitute the repayment by the appellant of the shareholder’s loan, the repayment was made as a part of a series of loans and repayments;

(3) that alternatively the deduction of the amount of the shareholder’s loan from the appellant’s income for his 1967 taxation year would, if allowed, under the circumstances surrounding the alleged payment, unduly or artificially reduce the appellant’s income for his 1967 taxation year.

The respondent relies, inter alia, upon subsections 8(2) and 137(1) of the Income Tax Act, RSC 1952, c 148.

With respect to the three arguments raised by the respondent, two of them may be dealt with rather quickly. The alleged payment cannot be regarded as having “unduly or artificially” reduced the appellant's income, since there were none of these characteristics in the transaction. There was nothing sinister about it. It was intended as a process designed to reduce the appellant's income to the lowest level ascertainable, in a clear and positive manner. This is supported by the wording on Exhibit R-1 submitted by the respondent, dated December 30, 1968, under the section headed “Manager’s Remarks”: “. . . for taxation purposes, our customers are required to repay share holders’ loans of $55,000 to Baileys Restaurants Ltd.” For later reference purposes, this document Exhibit R-1 is quoted in its entirety:

BANK OF MONTREAL

Application for Credit

Name L John Bailey and Mrs Laura Bailey	December 30th 1968
1-4 Vancouver, B.C. Branch
Enciosures:
Forms 516A, B, C and D,
Banker’s Report — Baileys Restaurants Ltd
Manager’s Remarks

Further to our letters of December 19th, for taxation purposes, our customers are required to repay shareholders’ loans of $55,000 to Baileys Restaurants Ltd, a company controlled by L John Bailey, by December 31st, 1968 and the following steps have been arranged:—

December 31st, 1968	(1) The Baileys pay
	Baileys Restaurants Ltd
	$55,000 to retire advances
	to shareholders.
January 2nd, 1969	(2) Baileys Restaurants Ltd pay
	Angelus Ventures Ltd $55,000.
January 2nd, 1969	(3) Angelus Ventures Ltd pays the
	Baileys $55,000 to repay Bank
	advances in their name.

In this instance, the account of Baileys Restaurants Ltd is at the Nova Scotia but we anticipate eventual transfer to this office: incidentally, this is the only portion of the Baileys’ business carried outside the Bank of Montreal. The entries relative to accounts at this branch have been made up, including Baileys Restaurants Ltd cheque drawn on the Nova Scotia who are aware of this transaction, and we can see no difficulty in the latter being completed as planned. The foregoing transaction will culminate In the Baileys owing $55,000 to Angelus Ventures Ltd instead of Baileys Restaurants. Ltd.

In view of our experience to date, we consider the proposed advance to e safe.

We recommend.

(Signed) W Forsyth

Manager

W Forsyth

The second point in the respondent’s arguments with which we can deal directly, is the charge that this is ‘“‘a part of a series of loans and repayments”. There was no evidence presented that this was indeed such a transaction within the same company. That two separate companies (Baileys Restaurants Ltd and Angelus Ventures Ltd) were involved is acknowledged, but I am not disposed to accept the proposition that such an involvement alone would invalidate the transaction.

Turning therefore to the third argument from the respondent (although it is actually the primary argument raised), it becomes a question of determining if the transaction established that “the loan was repaid within one year from the end of the taxation year”.

In examining the precise course of events one may refer again to Exhibit R-1, and it is very probable that due to the time factor, January 1, 1969 being a banking holiday, the Bank of Montreal in fact did not lose control of its funds at any time. In support of this, the following from Exhibit R-1 should be noted:

The entries relative to accounts at this branch have been made up, including Baileys Restaurants Ltd cheque drawn on the Nova Scotia who are aware of this transaction, and we can see no difficulty in the latter being completed as planned.

The “Baileys Restaurant Ltd cheque drawn on the Nova Scotia . . LE

would have been in the amount of $55,000, payable to Angelus Ventures Ltd, a customer of the Bank of Montreal, and it was obviously already prepared and ready on December 30, 1968—although it may have been dated January 2, 1969. Short of the Bank of Nova Scotia not honouring its agreed obligation to the Bank of Montreal, a situation which I would consider highly improbable, there was no possibility of risk for the Bank of Montreal and therefore the credit of the appellant, or the security available, was not necessarily a major factor, if a factor at all, in the bank agreeing to the personal loan. Although the respondent’s argument with the artificiality of the total transaction has not impressed me, this particular aspect of it—the retention of control of its funds by the lending institution—does impress me. There are two other technical points arising from a perusal of Exhibit R-1 which should be recognized. First, that the application for credit is made out in the name of both L John Bailey and Mrs Laura Bailey, and that the document refers to shareholders’ (plural) loans. It could well be suggested that the extension of this further specific loan of $55,000, even for a short period. and under such circumstances was based on the bank’s opinion of the personal credit not just of the appellant, but to whatever degree the bank considered it a factor, the credit of the appellant and his wife together. This view would be consistent with the evidence provided that one of the major sources of possible funds available to the appellant at this particular time, was the equity in the family farm.

The three parts of the total transaction as indicated on Exhibit R-1 would have been recorded in the books of the two companies approximately as follows, if a process of general journal accounting entries was used:

In the Books of Baileys Restaurants Ltd

Dr Bank of Montreal	$55,000
Cr Shareholders Loans
(L John Bailey)	$55,000

To record the deposit in the company bank account of the proceeds of a personal bank loan by L John Bailey on December 31, 1968, to retire outstanding loan balances.

Dr Loan Receivable from Angelus

Ventures Ltd	$55,000
Cr Bank of Montreal	$55,000

To record the loan of this amount without security on January 2, 1969, to a company controlled by L John Bailey.

In the Books of Angelus Ventures Ltd

Dr Bank of Nova Scotia	$55,000
Cr Loan Payable to Baileys
Restaurants Ltd	$55,000

To. record the borrowing of this amount without security on January 2, 1969, from a company controlled by L John Bailey.

Dr Shareholders Loans

(L John Bailey)	$55,000
Cr Bank of Nova Scotia	$55,000

To record the preparation of a cheque on December 30, 1968, but issued and reocrded on January 2, 1969, to repay a portion of the controlling Shareholders loans to the company, the cheque to be deposited with the Bank of Montreal for repayment of a personal loan by L John Bailey.

It is obvious that the “banking” transactions merely cancelled out one another in each case and that the entire matter could have been accomplished by the accounting entries in the records of both companies, substituting a loan payable to Baileys Restaurants Ltd from Angelus Ventures Ltd for a loan payable to Baileys Restaurants Ltd from L John Bailey. The involvement of the banks and the negotiation of the cheques involved was quite superfluous, in view of the control of both companies by the appellant. Since evidence was adduced that the advice for this series of transactions was provided to the appellant by his accountant, and indeed the accountant, due to inclement weather preventing the appellant attending at the banks personally at the appointed time, performed the necessary function himself on the instruction of the appellant. It can therefore be assumed that as a professional accountant he was aware that the entire transaction could have been conducted through the books of the company, without the complicated banking processes, and certainly in a very simple manner.

There was also an even more direct route to the resolution of the appellant’s dilemma—that was to simply write a cheque drawn on the Bank of Nova Scotia on December 31, 1968, from the Angelus Ventures Ltd bank account, in the amount of $55,000, and deposit it the same day in the Baileys Restaurants Ltd account at the Bank of Montreal. That neither the appellant nor his accountant, nor his bankers chose this direct route leads one to the conclusion that there were not available to the appellant at that time the funds in Angelus Ventures Ltd for such a transfer. There was considerable evidence advanced by the appellant with regard to his very substantial total credit position, and indeed it was substantial, including a hotel, a farm, a partially completed motel and interests in other businesses. There was also considerable evidence provided both in examination and cross-examination that the appellant’s credit position at that particular time (December 31, 1968) was not available to him, in any of his enterprises, in a liquid or immediate way, although during the course of the following twelve months much of this “over-invested” and “under-capitalized” situation was not only corrected but very properly put in balance. Nevertheless the fact remains that at December 31, 1968 probably the only asset immediately available to the appellant to satisfy his obligation to Baileys Resaurants Ltd was the ledger balance to his credit in the accounts of Angelus Ventures Ltd.

Although the transaction already begins to fall short of the requirements one might reasonably expect, even to meet the December 31, 1968 date, there remains a further point—was the value provided to Baileys Restaurants Ltd by the assignment of this loan receivable from Angelus Ventures Ltd in substitution for a loan receivable from the appellant, sufficient to meet the criteria necessary to say that the “loan was repaid”, at that particular date, December 31, 1968? There was no evidence presented that this loan receivable from Angelus Ventures Ltd was a marketable security in any accepted form. It was simply a book obligation from the controlling shareholder to the company, not negotiable in the ordinary manner, and for which there appeared to be no formal evidence of notes payable, co-signors, guarantors, collateral, or possibility of independent action for collection by Baileys Restaurants Ltd. Neither bank apparently considered it sufficient security by itself to advance further credit to the shareholder. It was not an account receivable in the accepted trading sense of the word wherein outside, independent obligations were due to the company, were assignable as business security, and barring unusual developments would be paid within reasonably determined periods of credit, and under certain terms and conditions. There were available no goods or produce represented by the receivable in the hands of a customer, which could be seized in the event of default on payment. It would not necessarily follow that merely the assignment of a normal! business account receivable in satisfaction of an outstanding shareholder’s obligation to a company would in all cases present sufficient evidence that “the loan was repaid”; but at the minimum there must be made the distinction between a normal trade account receivable. and a personal “account receivable” in such transactions involving two corporations, both of which are controlled by the same shareholder. That such a distinction should exist has been recognized in the Income Tax Act by virtue of the substantially different treatment accorded one and the other, in the potential for attracting income tax liability.

In providing the $55,000 bank loan at issue, even in the unusua! way described earlier, the Bank of Montreal position was based on an understanding of the personal credit of the appellant, even to the very minor extent to which the bank might have been exposed to any risk. Baileys Restaurants Ltd was already in the position of having such personal credit of the appellant, to the extent that the accounting records clearly showed his personal indebtedness to the company, in the form of this unsecured loan to the shareholder. If one therefore concludes that on the basis of the evidence, and on the written record. Angelus Ventures Ltd could not have paid to the appellant on December 31, 1968 the amount of $55,000 on account of his loan to that company, then one must reach the conclusion that Angelus Ventures Ltd could not have repaid the loan to Baileys Restaurants Ltd on December 31, 1968. Neither is there anything to indicate that Angelus Ventures Ltd would have been in any more favourable position two days later, on January 2, 1969, io repay the loan. The substitution of Angelus Ventures Ltd as the debtor of Baileys Restaurants Ltd for the loan of $55,000, rather than the appellant, cannot be regarded as having improved the relative position of Baileys Restaurants Ltd, let alone be regarded as payment of the loan. It could be argued that in fact the relative position of any of the creditors of Baileys Restaurants Ltd had been adversely affected, if a serious financial problem developed in Baileys Restaurants Ltd since they would be required in the first course of action for the collection of this debt to proceed against Angelus Ventures Ltd, a company experiencing a shortage of liquid assets, and as a corporation, limited in its liability to only its capital stock; whereas the earlier position would have allowed more direct action against the appellant and his personal assets, which even if not liquid, were substantial.

The appeal is dismissed.

Appeal dismissed.