Jean Crevier v. Minister of National Revenue, [1976] CTC 2271, 76 DTC 1208

Guy Tremblay:—This case was heard in Montreal, Quebec on Aoril 8, 1976.

1. Summary

The issue is whether or not the capital loss of $25,000 incurred by Mr Jean Crevier following the purchase of preferred shares in Arrow Plastics Ltd is allowed as a deduction pursuant to paragraphs 3(e) and 40(2)(g) and subsection 50(1) of the Income Tax Act (SC (1970-71-72, c 63).

2. Burden of Proof

The appellant has the burden of proving that the respondent’s assessment is erroneous. This burden of proof is based not on any particular section of the Act but on the decision of the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. The Facts

3.1 In 1958 the appellant and two other persons, Messrs Foisy and Dextras, formed Arrow Plastics Ltd which was to manufacture shoe heels.

3.2 Between 1958 and 1961 the company borrowed the sum of $90,000 from the bank, and the shareholders, including the appellant, each personally endorsed the loan for $30,000.

3.3 Between 1958 and 1968 the company operated a flourishing business.

3.4 In 1965 Mr Foisy bought the shares of the other shareholders. The appellant sold his for $35,000. He had bought them for $20,000.

3.5 The guarantee the appellant gave the bank in the years between 1958 and 1961 remained in effect, even after the shares were sold, since the company had not paid off the loan.

3.6 At the end of 1970 the company still had not paid off the loan, despite repeated requests by the appellant to the president of the company. The appellant’s signature still served as a guarantee.

3.7 During this period at the end of 1970 and the beginning of 1971, since the company’s financial situation was precarious, the appellant, Mr Foisy and the estate of his former associate, Mr Dextras, decided to reinvest in the company by each purchasing $25,000 in preferred snares.

3.8 This purchase was not followed by an issue of shares. However, the financial statements of the company on December 31, 1971 showed the future existence of the said shares. In Note 4 of the financial statements the accountants, Gaudette and Gaudette, CA stated that “senior preferred shares worth $75,000 were subscribed and paid for pending receipt of supplementary letters patent”. In fact the evidence does not indicate that the company obtained supplementary letters patent authorizing it to issue the said preferred shares.

3.9 An American company, which was to play a major role in the affairs of the company, was also to invest $25,000. This company subsequently decided not to invest. However, the appellant, the Dextras estate and Mr Foisy had already deposited $25,000 each, believing that the American company would follow suit.

3.10 According to the appellant’s own statement, he reinvested first to protect his signature, which he had given to the bank as a a guarantee. He hoped that the business of the company would become flourishing again and that the loans would then be paid off. The issuance of dividends attached to the preferred shares was also a major incentive for him.

3.11 The existence of the Signature at the bank seems to have played a major role, however, since according to the appellant himself. he would perhaps not have bought the preferred shares if he had not been the guarantor of a sum of $30,000 owed by the company. The appellant said that if he had foreseen that the company would go bankrupt he would certainly not have invested.

3.12 The company’s financial situation did not improve despite the fresh infusion of $75,000 and Shortly after this investment, in 1971, the company made a proposal in accordance with the Bankruptcy Act.

3.13 During 1972 the company went bankrupt pursuant to the Bankruptcy Act. According to the statements of both parties the bankruptcy was ratified in November 1972 by the Superior Court of Quebec. According to the trustee Martin, in his letters of January 22 and 31, 1975, no dividends were paid out during this bankruptcy, except $150 ‘or rent.

3.14 The appellant derived nothing from the bankruptcy. In fact he ubsequently had to honour at the bank the guarantee he had given.

315 In filing his tax return for 1972, the appellant claimed when calculating his net income a capital loss of $1,000 resulting from the loss of his debt, pursuant to paragraphs 3(e) and 40(2)(g) and subsection 50(1) of the new Act.

3.16 In his assessment of July 19, 1974 the respondent refused to allow this loss.

3.17 The appellant having objected on August 13, 1974, the respondent replied on September 29, 1975, and this reply now constitutes the assessment.

3.18 On December 18, 1975 the appellant appealed to the Board.

4. The Problem

Do paragraph 40(2)(g) and subsection 50(1), and consequently paragraph 3(e), apply to the present case?

More specifically, could the appellant dispose of the shares at the time of bankruptcy when they had not been issued to him by the company?

Were the shares bought for the purpose of gaining income?

In view of the fact that the new Act came into force on January 1, 1972 and that the value of the shares on December 31, 1971 is very important in calculating the capital loss, what was the value of the shares on that date?

5. Comments

5 1 Is the Purchase of Shares Valid? Does Subsection 50(1) Apply?

The Board considers that since letters patent authorizing Arrow Plastics Ltd to issue so-called ‘‘senior” preferred shares had not been issued, there was no purchase of preferred shares even though that was the intention of the parties and even though the payment was made.

The Board considers, moreover, that since the company could not become $25,000 richer without cause, it had in any case a debt toward the appellant. This debt toward the appellant would result from a contract in the nature of a loan made to the company even if no rate of interest was set.

There exists, therefore, a debt owing to the appellant, a debt subject to subsection 50(1), on condition, however, that paragraph 40(2)(g) applies, as explained below. Subsection 50(1) reads as follows:

50. (1) For the purposes of this subdivision, where a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to him in respect of the disposition of a personal-use property) is established by him to have become a bad debt in the year, he shall be deemed to have disposed of it at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil.

Could one have come to the same conclusion, namely that subsection 50(1) applies, if the appellant had been the owner of preferred shares rather than a lender? The Board thinks not. Subsection 50(1) clearly speaks of a debt. Is a shareholder a creditor toward his company? The Board thinks not. He is the owner of shares. The fact that a shareholder makes a loan to the company constitutes another situation, which would obviously make him a creditor also. However, this would not have been the case if the company had been able to issue preferred shares legally.

Irrespective of this obiter dictum, however, the appellant in the present case can claim the presumption of subsection 50(1), namely the presumption that the debt has been disposed of when there is a bankruptcy, only on condition that the said debt is the consequence of an investment made for the purpose of gaining income pursuant to subparagraph 40(2)(g)(ii).

5.2 Was the Investment Made for the Purpose of Gaining Income?

Subparagraph 40(2)(g)(ii) reads as follows:

40. (2) Limitations.—Notwithstanding subsection (1),

(g) a taxpayer’s loss, if any, from the disposition of a property, to the extent that it is

(ii) 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 (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length, or

is nil.

After studying the various aspects of the evidence, the Board has come to the conclusion that although protection of the guarantee may have played a major role, hope of gaining income was even more important and was the ultimate reason for the investment. If the appellant had wanted only to protect his debt, he would have paid the bank directly and would not have reinvested another $25,000 with the risk of losing this latter amount, all the while remaining guarantor of the debt of $30,000. The appellant perhaps miscalculated; no doubt he also neglected to take all the necessary precautions concerning the American company which was to invest, but in his mind the hope of gaining income was the ultimate reason for his action. Moreover, and this is very important, the money invested was not used to pay off the bank debt. After the bankruptcy the appellant had to honour the guarantee he had given.

An interest-free loan is ordinarily conclusive of the fact that an investment is made without any hope of gaining income. In the present case this point is immaterial in determining the appellant’s intention. The circumstances explained above, which lead the Board to conclude there was a loan, speak for themselves. The appellant thought he was buying preferred shares, which normally carry fixed dividends, and not making an interest-free loan.

The intention on the part of the appellant to gain income, and consequently the application of subparagraph 40(2)(g)(ii) and subsection 50(1), having been decided, there remains the issue of whether there is really a capital loss admissible as a deduction under paragraph 3(e).

For this purpose it is necessary to find out the value of the debt on December 31, 1971. The new Act, which allows capital losses for the first time, came into effect on January 1, 1972. Since the appellant’s debt had a “nil” value at the time of the bankruptcy in 1972, its value on December 31, 1971 will determine the amount of loss.

5.3 What is the Value of the Debt on December 31, 1971?

Although Arrow Plastics Ltd’s financial statements on December 31, 1971 were filed as Exhibit A-1, the Board does not consider itself obliged to determine the value of the debt directly from the financial statements of this company, which was then proposing bankruptcy.

6. Conclusion

As the points of law have been decided and as only a question of assessment remains, and in view of the powers of the Board under section 171, the Board allows the appeal and refers the assessment to the Minister for reconsideration and agreement with the appellant on the value of the debt on December 31, 1971 and for reassessment, if necessary.

Appeal allowed.