James Douglas White v. Minister of National Revenue, [1972] CTC 2215, 72 DTC 1209

W O Davis:—This appeal was heard before me at Calgary, Alberta on November 8, 1971 at a sittings of the Tax Appeal Board as it was then constituted.

The appellant has appealed from a reassessment to’ income tax dated April 19, 1971 wherein tax was levied in respect of the taxation year 1969.

During the year 1966 the appellant exercised a stock option which he held, entitling him to purchase 20,000 shares of Prairie Oil Royalties Limited at a price of $2.81 per share. The stock option had been granted to the appellant by Prairie Oil Royalties Limited while he was an employee of that company.

In order to exercise the option, the appellant was obliged to borrow $56,200 from the Bank of Nova Scotia. Following such purchase, and pursuant to the provisions of section 85A of the Income Tax Act, the appellant declared, and paid income tax on, a benefit of $32,000 realized by him in exercising the said option.

As a result of a series of mergers and amalgamations, the appellant’s 20,000 shares of Prairie Oil Royalties Limited were converted into shares of Canadian Industrial Gas and, eventually, into 6,666 shares of Northern and Central Gas Company Limited. These shares were held by the appellant during the 1969 taxation year under appeal herein, and were pledged by him, to the Bank of. Nova Scotia as security for the outstanding balance of the loan he had obtained from that bank in order to exercise his option.

In filing his income tax return for 1969, the appellant claimed as a deduction from investment income. the interest paid by him during the year to the Bank of Nova Scotia, as well as further interest in the amount of $2,432.56 paid to Midland-Osler Securities Limited on a margin account covering further share purchases. The appellant did not, however, apply this interest expense against his dividend income for the year from Canadian companies for the purpose of calculating the dividend tax credit allowable under the provisions of subsection 38(1) of the Income Tax Act, RSC 1952, c 148 and amendments thereto, which reads:

38.(1) An individual who was resident in Canada at any time in a taxation year may deduct from the tax otherwise payable under this Part for a taxation year 20% of the amount by which

(a) the aggregate of all dividends received by him in the year from taxable corporations in respect of shares of the capital stock of the corporations from which they were received and of all dividends that he is, by subsection (3) of section 8 and section 81, deemed to have received from such corporation in the year, to the extent that the dividends so received or so deemed to have been received, as the case may be, were included in computing his income for the year,

exceeds the aggregate of

(b) the amount, if any, deductible from income in respect of those dividends by virtue of a regulation made under subsection (2) of section 11, and

(c) all outlays and expenses deductible in computing the taxpayer’s income for the year to the extent that they may reasonably be regarded as having been made or incurred for the purpose of earning the dividend income.

In the original Notice of Assessment sent to the taxpayer on August 19, 1970 in respect of his 1969 taxation year, the Minister of National Revenue disallowed the margin account interest of $2,432.56 as a deduction from investment income but, subsequently, in the reassessment issued on April 19, 1971, in answer to the appellant’s Notice of Objection, the appellant was allowed to deduct this expense from his gross income for the 1969 taxation year.

In the said reassessment, the Minister has proceeded on the basis that the shares of Northern and Central Gas Company Limited held by the appellant during his 1969 taxation year represented property exchanged for property originally purchased by the appellant with the proceeds of a loan from the Bank of Nova Scotia and, in any event, were property pledged by the appellant as collateral for the loan with the said bank.

Carrying this reasoning still further, the Minister concludes that the interest paid to the Bank of Nova Scotia by the appellant in 1969 was accordingly an amount which was applicable to the dividends received by the appellant from the shares of Northern and Central Gas Company Limited, as the said interest can reasonably be regarded as having been paid for the purpose of earning those dividends.

On this premise, the Minister of National Revenue reduced the aggregate of all the appellant’s dividends from Canadian taxable corporations by the amount of interest paid by the appellant to the Bank of Nova Scotia in 1969 in respect of the loan which he had taken out to exercise his option in 1966, as the amount of interest so paid ex- ceeded the dividends received from Northern and Central Gas Company Limited alone.

The appellant said that at the time of the hearing of this appeal (November 8, 1971) the original loan of $56,000 had been reduced to an outstanding balance of $14,000, which will continue to bear interest until paid off.

The evidence of the appellant was that his sole purpose in borrowing the $56,200 from the Bank of Nova Scotia in 1966 was to enable him to exercise the stock option which he held and thus obtain the benefit of acquiring the shares at far less than market price and also the benefit of the subsequent multiplication of shares as a result of the various mergers and amalgamations with other companies which ensued. The option agreement contained a provision whereby the appellant agreed to hold the Prairie Oil Royalties stock as an investment rather than dispose of it on the open market.

It is beyond question that the original loan was for the purpose of exercising the stock option and acquiring the Prairie Oil Royalties shares. By the same token, the loan was also, albeit somewhat indirectly, related to the shares of Northern and Central Gas by which the Original shares of Prairie Oil Royalties have been replaced. As a result of the various mergers and amalgamation negotiations (of which the appellant admittedly had foreknowledge), the 6,666 shares of Northern and Central Gas are the ultimate substitutes for the 20,000 shares of Prairie Oil Royalties Limited which he purchased under his option, and which, at the outset, were pledged to the Bank of Nova Scotia as collateral for the loan and have since been replaced as collateral: by the Northern and Central Gas shares.

This problem reduces itself to the question of whether the Minister acted on proper principles in reducing the aggregate of the appellant’s dividends from taxable Canadian corporations by the amount of interest paid to the Bank of Nova Scotia before attempting to compute the amount of the tax credit to which the appellant would be entitled for 1969.

This matter arose on an earlier occasion in the appeal of Bertram Loeb v MNR, 35 Tax ABC 53, where the appellant therein had received dividends from “taxable Canadian corporations” in the amount of $68,133, of which $24,215 was derived from stock which he had inherited. His carrying charges amounted to $55,054, so that his net dividend income was $13,079. The appellant Loeb sought to compute his dividend tax credit as 20% of $24,215 on the ground that none of the carrying charges related to the inherited stock. The Board held that the amount deductible as a tax credit was limited to 20% of $13,079, being the net aggregate income from taxable corporations.

It is not correct to say, as the appellant White has attempted to do, that he found himself an involuntary victim of the numerous mergers and amalgamations which followed his exercise of the stock option which he had been given. It was well known to all concerned that the stock option was in fact a means adopted by Prairie Oil Royalties Limited to protect the position of certain of its senior executives in the face of these very oncoming mergers and amalgamations. Mr White, in his evidence, acknowledged that there was ‘“‘a takeover proposition” looming and that such amalgamations and mergers as would certainly ensue were events beyond the future control of himself and those other executives who also held stock options. He had this to say on the subject:

We had knowledge that these were coming. Our problem was, of course, that we were not certain until very late in the game whether or not we might have been able to, for example, stop at Canadian Industrial stock, or whether we would be forced to go all the way through.

Paragraph 38(1 )(a) of the Income Tax Act refers to “the aggregate of all dividends” from taxable corporations. This can only mean the sum total of all dividends. Thus the tax credit is to be computed at 20% of the amount by which the sum total of all dividends exceeds the aggregate of all outlays and expenses deductible in computing the taxpayer’s income for the year “to the extent that they may reasonably be regarded as having been made or incurred for the purpose of earning the dividend income”.

Subsection 38(1) appears to be quite clear and unambiguous on this point: that from the total amount of dividends received from taxable corporations in the year, the taxpayer may deduct, for the purpose of computing his dividend tax credit, the total amount of interest which can reasonably be regarded as having been paid for the purpose of earning any of that dividend income. It will be seen that the issue now before the Board is not the question as to whether or not such interest is deductible from the appellant’s income. That is a completely separate issue and has been decided in favour of the taxpayer. The only issue now to be dealt with is the question of whether this interest should be applied against his aggregate dividend income in such a way as to impair the dividend tax credit to which he might otherwise be entitled.

Clearly, if there had been no exercise of the stock option, there would be no dividends. And without the bank loan, there could not have been an exercise of the stock option. It is therefore my conclusion that the bank interest may reasonably be regarded as having been incurred for the purpose of earning “the dividend income” in question.

I am unable to detect any error on the part of the Minister in applying the provisions of subsection 38(1) of the Act as he did, and the appeal is therefore dismissed.

Appeal dismissed.

LOUIS POLSKY, Appellant,

and MINISTER OF NATIONAL REVENUE, Respondent.

Tax Appeal Board (W O Davis, QC), December 7, 1971.

Income Tax Act, RSC 1952, c 148 — 8(1) — Appropriation of property to

There were two issues in this appeal.

(1) In 1956 the appellant became part-owner of 105 acres of raw land in return for making certain mortgage payments. The land produced no income and was not zoned for development. Financial problems increased over the years and the land was put up for sale in 1964, being finally sold in 1966. The profit was treated as income by the Minister.

(2) The appellant sold his business to a newly incorporated company of which he was the principal shareholder. The goodwill was valued ai $59,000 and this was reduced by the Minister to $17,000. The difference was treated as moneys appropriated to a shareholder and made taxable under subsection 8(1) of the Act.

HELD:

(1) The appellant was engaged in an adventure in the nature of trade with regard to raw land and the profit was income.

(2) The valuation of $59,000 was reasonable and acceptable on the basis of good accounting principles and there was no reason for altering it.

Appeal allowed in part.

R R Walker, QC for the Appellant.

D J A Rutherford for the Respondent.

W O Davis:—This matter came on before me for hearing at Windsor, Ontario on December 6 and 7, 1971 at a sittings of the Tax Appeal Board as it was then constituted. Two issues are involved. For his 1966, 1967 and 1968 taxation years the appellant appeals against the inclusion in his income for those years of his proportionate share of the net profits arising from the sale of certain real property for which a reserve was granted under section 85B of the Income Tax Act. The appellant alleges that any such profit was a capital gain not subject to tax whereas the Minister of National Revenue contends that it was profit from an adventure in the nature of trade and must be taxed accordingly.

The second issue, which concerns the appeals for the taxation years 1966 and 1967 only, involves an amount of $59,000 allocated in respect of goodwill in the purchase price when the appellant. transferred the assets of a drum and barrel business run by him as a sole proprietorship to a company which he had caused to be incorporated for the purpose of carrying on the operation of the said business. The appellant alleges that this was the true value of the asset of goodwill, whereas the Minister contends that it was a gross overvaluation and that any amount in excess of $17,000 represents money appropriated by the appellant from the newly incorporated company, and is thus properly assessable as taxable income pursuant to subsection 8(1) of the Income Tax Act.

By a written offer dated February 8, 1956 two real estate promoters, Abe Mono and Harry Zekelman, agreed to purchase from Eugene and Marie Laporte an area in excess of 105 acres of raw and undeveloped land in the Township of Sandwich East at a price of $1,000 per acre. Upon acceptance of the offer, an initial deposit of $2,500 was paid to the vendors and, upon closing the transaction, a further payment of $2,500 was made and a mortgage was given to the vendors for the unpaid balance of $107,000, bearing interest at 4% per annum. The mortgage agreement, dated April 17, 1956 (Exhibit A-2) called for a payment of $5,000 plus interest on May 15, 1956 and instalments of principal in the amount of $10,000 each, payable on October 1, 1956 and on the 1st days of April and October in each of the years 1957, 1958, 1959 and 1960, the balance (including interest) to be paid on April 1,1961.

By an agreement (Exhibit A-3) dated February 20, 1956, that is, less than two weeks after the signing of the said agreement to purchase, the appellant Louis Polsky and his brother Ralph entered into a contract or agreement with Mono and Zekelman whereby those two gentlemen agreed ‘‘to convey or hold in trust for” the Polskys a 40% interest in the Laporte property upon the condition that the Polskys would pay the initial deposit of $2,500 and pay a like amount due on the closing date of the contract to purchase, as well as undertake to make the two other payments due in 1956, namely, $5,000 of principal on May 15 and $10,000 principal plus interest on October 1. In other words, the Polskys were to provide all the cash payments required during the first year after the date of purchase. It was also agreed that 60% of the payments so made by the Polskys was to be reimbursed to them by Mono and Zekelman “in due course” .,

On January 4, 1966 Louis Polsky executed a document entitled “Indemnity Agreement” whereby he said that, notwithstanding that his brother Ralph Polsky had joined as a party to the agreement of February 20, 1956 with Mono and Zekelman whereby it was provided that the Polskys were to acquire a 40% interest in the Laporte property, he Louis Polsky had in fact advanced all the moneys required of the brothers under the agreement dated February 20, 1956, and that his brother Ralph Polsky had in fact advanced no moneys whatsoever and therefore had in fact no interest in the Laporte property.

It appeared from the evidence that both Mono and Zekelman were well-known and well-experienced land speculators who had in fact been entirely without funds at the time the original purchase from the Laportes had been arranged, and had entered into the secondary agreement with the Polskys for the sole purpose of gaining the Polskys’ financial backing in order that the initial payments due on the purchase of the Laporte property could be met. This became increasingly clear as and when payments accrued under the mortgage agreement of April 15, 1956, when Mono and Zekelman again looked to the appellant for the funds necessary to cover same.

The previous record of Mono and Zekelman in the field. of real estate promotion makes it clear that their numerous real. estate ventures in the area round and about that of the Laporte property had included the buying and selling of undeveloped land as well as the buying and developing of land for various purposes, after which they either leased or sold outright the completed projects. (See A & H Management Limited v MNR, 25 Tax ABC 378.)

Mr Zekelman, in his evidence, said the property had initially been acquired by himself, Mono and the Polskys with the thought in mind of building a shopping centre. Mr Zekelman referred to this as “taking a holding position”. There was no evidence of any serious feasibility study having been made or commissioned with regard to the suitability of the land for such an undertaking, nor of any plans having been prepared by an architect, nor of any statement of anticipated revenues having been compiled. Nor had any prospective tenants for such a development been approached to sign letters of intention, or, if they had, no such documentary evidence was disclosed in support of Mr Zekelman’s statement that the partners had considered erecting a shopping centre on the Laporte property. In short, none of the usual preliminary steps had been taken before — or even after — acquiring the said property.

As matters progressed, financial problems with regard to the property increased. Both Mr Mono and Mr Zekelman found it increasingly difficult to meet their share of the payments due under the mortgage, and the appellant resisted making any further payments or contributions himself until he had received reimbursement for the funds he had already advanced. On April 10, 1959 Messrs Mono and Zekelman succeeded in negotiating an agreement with the Laportes to reduce the half-yearly payments of principal from the $10,000 called for in the original mortgage to $5,000 each and, on November 1, 1960, a further modification in the terms of the said mortgage was agreed to: a payment of $7,000. was called for on November 1, 1960, together with a postdated cheque for $3,000, and the balance of $49,203 then remaining was payable in half-yearly instalments of $5,000 each until the said balance had been fully paid, the first of such semi-annual instalments to become due and payable on April 1, 1961. No interest was to accrue in respect of the said outstanding balance subsequent to November 1,1960.

By 1966 matters had reached a point where Mr Zekelman had become completely disenchanted with the entire venture and had made up his mind to sell in spite of the fact that Mr Polsky did not want to do so. Mr Zekelman expressed his feelings on the matter at that time as follows:

I insisted on selling; I didn’t want to have any more partnership, because I feel when partners expect that one partner should do all the work and not get paid and put out money out of their pocket it wasn’t right, and I wanted to dispose of that regardless what happened, and came along a buyer, I insisted, we sold.

Mr Mono agreed with Mr Zekelman’s sentiments in this respect.

Mr Zekelman testified that, as early as 1958 and 1959, he had endeavoured to find a purchaser for his and Mono’s interest in the project because he was financially hard-pressed. This fact had been mentioned to a real estate firm known as Joe Marks Real Estate Limited, a firm which, in conjunction with H Lome Abramson, the solicitor for the group, had been attempting for some time to get the land in question rezoned. In May of 1964, Messrs Zekelman and Mono and the appellant Louis Polsky signed an agreement of purchase and sale of the land in question, which agreement purported to be with Boatwright Investments Limited and had been drawn on a real estate form of J Marks Real Estate Limited. Mr Joseph Marks, the witness. to the three signatures, was said to have been the agent for the group. The selling price specified in this offer was $230,000. However, this document was never executed by the purported purchaser, Boatwright Investments Limited.

A second agreement of purchase and sale, drawn up by the same real estate company and in which Lee Plaza Hotel was the designated purchaser, seems to have been signed by Messrs Zekelman and Mono on April 13, 1965, although where that date appears elsewhere in the document it has been corrected in ink to read July 9, 1965. The purchase price named was $250,000. This offer was not signed by the prospective purchaser, Lee Plaza Hotel.

In so far as these two purported offers are concerned, Mr Zekelman, as already indicated, has acknowledged that as early as 1958 or 1959 he himself had instructed Mr Marks to find a purchaser for the property which was the subject of these offers.

Eventually, on February 15, 1966, a sale of the said property to Equitable Development Corporation for $275,000 was negotiated, of which the appellant’s 40% share was $110,000 and his share of the net profit on such sale was computed to be $51,808.37, which amount was added to the appellant’s taxable income for 1966 subject to a reserve of $40,504.72 under section 85B of the Income Tax Act in respect of mortgage instalments receivable in later taxation years. The parties are in agreement as to the amount of the net profit and the calculation of the reserve and the matter in dispute is limited to the question of whether this profit was a capital increment or whether it was a profit from an adventure or concern in the nature of trade which would be subject to tax in the appellant’s hands.

After a full consideration of the lengthy evidence introduced in respect of the real estate matter at issue in these appeals, I have reached the conclusion that the appellant was involved in an adventure or concern in the nature of trade in the purchase and subsequent sale of the raw, undeveloped land referred to herein as “the Laporte property”. To my mind, as l indicated at the hearing, there is ample evidence of an intention to turn the property in question to account for a profit as and when a suitable opportunity presented itself. It could hardly be regarded as a viable investment as, during the entire period it was held, it produced absolutely no revenue.

In his own evidence, Mr Polsky admitted that the property that had been purchased was raw farm land producing no income and not zoned for development. He was brought into association with the two other individuals involved allegedly for the purpose of developing a shopping centre, even though the rezoning of the area to permit such a development was still very much in doubt. The shopping centre development had been conceived on the basis of what Mr Zekelman referred to as his own feasibility study, a statement to which I do not attach too much importance. It is evident from the witnesses heard that both Mr Zekelman and his colleague Mr Mono were, and had been for some time, very actively interested in turning over real estate at. a profit, whether developed or undeveloped, whenever opportunity presented itself and, in the present instance, with little or no financial security of their own behind their enterprise.

If the appellant’s evidence is to be accepted, it was, to say the least, somewhat surprisingly naive of him to join and associate himself with two persons whom, on his own evidence, he did not know, and to involve himself in a venture of this nature and these proportions if he had no real wish to speculate on the outcome.

All in all, as I stated at the conclusion of the hearing, I am satisfied that the appellant was involved in an adventure or concern in the nature of trade with regard to his dealings with the Laporte property, and the appeals for 1966 and 1967 must be dismissed in so far as this issue is concerned while the appeal for 1968 is dismissed in its entirety.

Dealing next with the matter of the valuation of the goodwill of the business which Mr Polsky sold to the newly incorporated company Windsor Barrel & Drum Company Limited, the evidence was that the appellant, in 1937, established a business concerned with the recycling of metal drums and containers and known as Windsor Barrel and Drum Company, of which he was sole proprietor. In 1963 this business was sold to a company which the appellant had caused to be incorporated and of which he was and is the principal shareholder.

Following incorporation of this company, the appellant continued his association with Windsor Barrel & Drum Company Limited as its president. When this limited company purchased the appellant’s sole proprietorship, it purchased all the assets of the former business “as a going concern”. One of the assets purchased according to the agreement of purchase and sale, was the goodwill of Windsor Barrel and Drum Company, an asset for which the new company agreed to pay $59,000, which the appellant contends was the fair market value of the goodwill accruing to him at that time from such business, having regard to all the relevant circumstances.

In assessing the appellant after examining the documentation of the said sale, the Minister of National Revenue reduced the fair market value of the goodwill asset to $17,000 and added the difference of $42,000 to the appellant’s taxable income for the taxation years immediately following the sale in amounts proportionate to the instalments of the purchase price of the entire business which were due and payable each year. These additions to income were designated by the Minister as moneys appropriated by the appellant from the company in his capacity of shareholder, and were stated to fall to be taxed under the provisions of subsection 8(1) of the Act.

On the forms T7W-C attached to the assessments appealed against for 1966 and 1967, the amounts added to income in respect of these alleged “appropriations” are shown as $7,635.18 and $3,176.67 re- spectively, and the T7W-C for 1966 also mentions similar appropriations in the amount of $6,102.84 for 1965 although that year was not the subject of an appeal to the Tax Appeal Board at the time of the Windsor hearing.

The relevant portion of subsection 8(1) of the Income Tax Act reads as follows:

8.(1) Where, in a taxation year,

(a) a payment has been made by a corporation to a shareholder otherwise than pursuant to a bona fide business transaction,

(b) funds or property of a corporation have been appropriated in any manner whatsoever to, or for the benefit of, a shareholder, or

(c) a benefit or advantage has been conferred on a shareholder by a corporation,

the amount or value thereof shall be included in computing the income of the shareholder for the year.

In the. matter of the valuation of the goodwill of the business which Mr Polsky sold to the newly incorporated company, I must say that I was impressed by the evidence of two well-qualified accountants who testified as to the manner in which they had computed the value of the goodwill in question.

Sydney Morris, the first of the two accountants to testify before the Board, and who appeared to be a completely reliable witness with a thorough grasp of the problem before him, gave evidence in considerable detail in an effort to establish what he considered to have been the value of the goodwill in question, basing his conclusions on what he recognized as good and acceptable accounting practices and principles.

Having examined the financial statements of the appellant’s proprietorship for the years 1958 to 1963, plus those for the four-month period ending April 30, 1964 (the date of the sale of the business to the newly incorporated company), and having determined the true net profits for those periods as distinct from the actual taxable income of the business, Mr Morris, as a result of his examination and of his computations, arrived at a figure of $58,691.61 as the value of the goodwill of the proprietorship of the appellant at the time of the sale, a figure which he rounded off at $59,000.

Mr Joseph Tomsich, a chartered accountant of long standing and considerable experience in such matters, outlined with care, and also in considerable detail, the procedure by which he computed the value of the goodwill of the appellant’s former business on a “pure average” basis, which he calculated to be between a low of $49,637 and a high of $59,165, the difference depending on the manner in which the normal earnings of the business were treated.

It should be noted here that, some time prior to the end of the hearing, on a recalculation of value by the Minister of National Revenue, it was conceded by his counsel that the Minister was prepared to establish a valuation of $30,749 for the goodwill of the Windsor Barrel and Drum Company.

Mr Harry Montrose, an officer in the Windsor District Office of the Taxation Division of the Department of National Revenue, was heard on the matter of valuation of goodwill. However, he was unable to add anything of material value to the evidence already tendered in this regard.

After considering the evidence dealing with the value to be attached to the goodwill of the appellant’s proprietorship business, and having regard to the jurisprudence in this respect and, in particular, the comments of the Honourable Mr Justice Thorson, then President of the Exchequer Court of Canada, in Losey v MNR, [1957] CTC 146, I have reached the conclusion that the valuation of $59,000 attributed to goodwill by the appellant in the agreement of sale of his proprietorship business to Windsor Barrel & Drum Company Limited, an incorporated company of which he was principal shareholder, was a reasonable and acceptable valuation on the basis of good and sound accounting principles, and I can see no justifiable reason for altering it. I would therefore allow in full that part of the appellant’s appeals for 1966 and 1967 dealing with the matter of alleged appropriations of funds in respect of the valuation of the goodwill of the proprietorship.

As already indicated at the conclusion of the hearing, the appeal in respect of the appellant’s 1968 taxation year, dealing as it does solely with the matter of taxable profits on the sale of the Laporte property, Is dismissed and the assessment dated December 4, 1969 is confirmed.

The appeals in respect of the assessments for the appellant’s 1966 and 1967 taxation years are allowed in part, and the matter is referred back to the Minister for reassessment in order to eliminate from the appellant’s income for those years any amounts attributed to appropriations under subsection 8(1) as a result of alleged overvaluation of goodwill at the time of the sale of the appellant’s proprietorship business in 1964.

Appeal allowed in part.