5 June 1992 Internal T.I. 9129917 F - Banks' Securities Transactions - Income or Capital

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

 

June 5, 1992

AUDIT DIRECTORATE	RULINGS DIRECTORATE
E.H. Gauthier	B.G. Dodd
Acting Director General	957-3495

Att: Blair Chisholm

Banking, Insurance and Financial Products

912991

24(1)

This is in reply to your T2003 dated October 28, 1991 requesting our comments on the October 11, 1991 submission by         24(1) on behalf of the Bank          24(1)          in connection with certain of their securities transactions. These transactions are being reviewed in the course of an audit by             24(1)     We apologize for the delay but in view of the significance of the issue, we concluded that an in-depth review was warranted.

We note initially that with respect to      24(1)         and the issue of securities transactions of venture capital corporations, we have already provided our views to the North York D.O. by memorandum dated October 24, 1991.

Because of its length and for ease of reference, we have broken down our reply into the following components:

PART I   - INITIAL COMMENTS

PART II  - ANALYSIS OF JURISPRUDENCE

PART III - JURISPRUDENCE ESTABLISHES INCOME TREATMENT AS THE RULE

PART IV  - CAPITAL TREATMENT BY EXCEPTION: DISCUSSION

PART V   - APPLICATION TO THE SPECIFIC TRANSACTIONS OF THE BANK

PART VI  - CONCLUSION

PART I - INITIAL COMMENTS

The October 11 submission indicates that the      24(1)        is proposing to reassess the Bank and           24(1)             to re-characterize certain securities transactions in for the 1985 and 1986 taxation years as being on income account. The first 17 pages of the submission, as well as Schedule "A" thereto, purport to set out the facts as they relate to the transactions, with pages 18 to 28 being a discussion of "the law".

At page 18, the submission states the following.

24(1)

In response to this insofar as this Directorate is concerned, it is and has been our opinion that it is possible for a bank to hold investments which are, on the facts, on capital account, but that the usual result will be income treatment, on the basis that transactions in securities form part of the ordinary course of a bank's business. In our view, this position is well founded in case law.

In PARTS II, III and IV below, we set out and discuss what we believe to be the significant jurisprudence relating to financial institutions in general and banks in particular. Very little of this was included in        24(1)        analysis of the law, an analysis which we find generally to be something less than bank- specific.

We note the submission discusses at some length the recent case of Waylee Investment Ltd. v. Commissioners of Inland Revenue, (1990) S.T.C. 780, a decision of the Privy Council. The significance attached to this decision by                24(1)  is twofold:

1.     the case confirmed that it is possible for a bank to hold investments which are on capital account; and

2.     the fact that a bank acquires shares in a customer because of the importance of that customer does not necessarily mean the shares are held by the bank on income account.

As noted above, it has never been our position that it is not possible for a bank to transact on capital account and so to that extent, Waylee Investment does not break any new ground. With respect to the second item, it seems to us that all the Privy Council is saying here is that a customer's importance may or may not be a relevant factor in determining the income vs. capital question. (We believe, however, that Waylee Investment stands for more than these two propositions, as discussed below.) 

PART II - ANALYSIS OF JURISPRUDENCE

The cases set out the principles to be applied in making the factual determination of whether the profits from the disposition of an investment are on income or capital account. The focus of this analysis of jurisprudence is, to the extent possible, from the perspective of financial institutions in general and banks in particular.

1.     In Scottish Union and National Insurance Co. v. Smiles; Northern Assurance Co. v. Russell (1889), 26 S.L.R. 330, 2 Tax Cas. 551 (scot. Ex. Ct.), the court held that the gain made by an insurance company realising an investment at a higher price than was paid for it is to be reckoned among the profits and gains of the company and is therefore assessable as income.

2.     In Scottish Investment Trust Company v. Forbes (Surveyor of Taxes (1893), 31 S.L.R. 663; 3 Tax Cas. 231 (Scot. Ex. Ct.), the issue was whether increases on realisation of stocks held by an insurance company are capital sums and therefore not liable to assessment for income tax. The court, following Scottish Union (above), held that such increases are liable to assessment for income tax because the "speculations" in stocks are "essential features of the business" and "among the appointed means of this Company's gains".

This case was followed by the Exchequer Court in Gairdner Securities (discussed below) in their decision which was upheld by the Supreme Court of Canada. It was also followed by the Exchequer Court in Associated Investors of Canada Ltd. v. M.N.R., 62 DTC 1315 and in First Torland Investments Ltd. v. M.N.R., 69 DTC 5109.

3.     The leading case on the issue of whether profit arising from the disposition of an investment is on income or capital account is California Copper Syndicate Ltd. v. Harris (1904), 5 T.C. 159.

Here the court considered the issue of whether gains realized by a business corporation as a result of buying and selling securities are on capital account. The court considered two extremes: the case of the owner of an ordinary investment who chooses to realise it and obtains a greater price for it than he originally acquired it at, and the person or company who buys and sells lands or securities speculatively, in order to make gain, dealing in such investments as a business, and thereby seeking to make profits. The court stated that each case must be considered according to its facts, and that the question to be asked in deciding whether the gains are on capital or income account  is as follows (at p. 166):

     "Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit- making?"

The court held, following Scottish Investment, that where the turning of investment to account was not merely incidental but rather an essential feature of the business, the gain was on income account.

California Copper Syndicate has been followed in numerous English and Canadian cases, including Anderson Logging Company v. The King, 52 DTC 1209 (S.C.C.) and Independence Founders (discussed below).

4.     In Liverpool & London & Globe Insurance Company v. Bennett, (1913) A.C. 610; 6 Tax Cas. 327 (H.L.), a company carried on a fire insurance business and a life insurance business. It invested its monies "not immediately required" abroad. The issue was whether the interest, which was remitted to the U.K., was part of the company's profits or gains and thus assessable for income tax purposes. The taxpayer argued that the investments were set and kept apart from the insurance business and neither invested nor used in the business. The House of Lords held that the investments were part of the insurance business of the company and the interest and dividends on the investments were part of the profits of the company, assessable as income.

Lord Shaw looked at general accounting principles, Scottish Union, and the fact that some of the investments were required as a condition of the company carrying on the insurance business.

Earl Loreburn held that the interest and dividends were profits regardless of the source from which the investment monies were derived and whether the investments were compulsory or not.

Lord Parker was of the view that the investments were reserves which were made for the purpose of, and were at risk in, the company's insurance business; they were made in order to have a fund easily realisable, if required, for the purposes of the insurance business, and thus were assets employed in the business.

Liverpool & London & and Globe has been followed by the Supreme Court of Canada in Anderson Logging and the Federal Court of Appeal in The Queen v. Marsh & McLennan Ltd., 83 DTC 5180.

5.     In Brown v. National Provident Institution; Ogston v. Provident Mutual Life Association, (1921) 2 A.C. 223 (H.L.), the issue was whether the difference between the amount paid for treasury bills held by insurance companies and the amount received on sale or maturity was a profit, assessable as income, or a capital accretion. The House of Lords held that it was assessable as income. Lord Sumner's view of the insurance company's investment in treasury bill is as follows (at p. 256):

     "It is to be remembered that this is a case of a company, which carries on a business and employs its funds for and in that business. The stated case finds no fact to distinguish these transactions from any other business use of money. It is not the case... of a private person, who, not in the course of any business at all, realizes an investment and comes well out of it."

6.     In C.I.R. v. The Scottish Automobile and General Insurance Company, Limited 1932 S.C. 87; 16 Tax Cas. 381 (Scot. Ct. of Session), the Commissioners of Inland Revenue assessed an insurance company for income tax on realisations of investments held as the company's reserve fund. According to its memorandum and articles of association, the insurance company had the power to invest and manage surplus funds. The profit from the sale of the investments was shown in the books of the company as being on revenue account. The investments were in British government securities. The profits from the sales of the investments were very small in relation to the amounts transferred from the revenue account to the reserve account. The taxpayer appealed to the General Commissioners, who held that the profit in question was not a trading profit. The Commissioners of Inland Revenue appealed to the court.

The court stated that the issue was a question of fact, of whether the company, in the particular transaction in question, traded as an investment company. In Lord Morison's view, the transactions had no relation to the taxpayer's insurance business. The court held that the General Commissioners had sufficient evidence on which to base their decision that the profits were not trading profits and not assessable for income tax.

This case has little, if any, relevance in view of the Privy Council's comments in the Punjab Cooperative Bank case (discussed below) that the dicta in Scottish Automobile "cannot now be relied on". (The case is regarded as an anomaly by Hannan & Farnsworth in The Principles of Income Taxation at page 192.)

7.     In Westminster Bank, Limited v. Osler (Inspector of Taxes (1938) A.C. 139 (H.L.), the taxpayer was a bank which had money invested in war bonds, which it exchanged for new stocks of greater value. The bank admitted that any profit  made by them on the realization of an investment was part of the profits of their trade for the purposes income tax. The issue was whether there had been a realization of            investments, since the transaction was an exchange rather    than a sale. Lord Buckmaster, citing California Copper with approval, held that the transaction was assessable for       income tax purposes.

8.     In Punjab Co-operative Bank Limited, Amritsar v. Commissioner of Income Tax, Lahore, (1940), A.C. 1055 (P.C.), the issue was whether the profits which arose from the realization of securities held by a bank as a reserve were taxable as part of the profits of the business of the bank. There was a dispute as to whether the realization was necessary in order to meet depositors' demands for withdrawals.

The Privy Council applied the principle in California Copper in holding that the profits were taxable. Viscount Maugham, who gave the decision for the Privy Council, stated as follows (at p. 1072):

     "... their Lordships do not wish to give any support to the contention that, in order to render taxable profits realized on sales of investments in such a case as that before them, it is necessary to establish that the taxpayer has been carrying on what may be called a separate business either of buying or selling investments or of merely realizing them.

The principle to be applied in such a case is now well settled. It was admirably stated in California Copper Syndicate, Ltd. v. Harris (Surveyor of Taxes), and the statement has been more than once approved both in the House of Lords and in the Judicial Committee; see, for example, Taxes Comr. v. Melbourne Trusts, Ltd. at p. 1010. Some dicta which appear to support the view that it is necessary to prove that the taxpayer has carried on a separate or severable business of buying and selling investments with a view to profit in order to establish that profits made on the sale of investments are taxable - for example, the dicta in Inland Revenue Comrs. v. Scottish Automobile & General Insurance Co. at pp. 388, 389, cannot now be relied on. It is well established that, to cite the exact words used in the California Copper case at p. 166:

     "... enhanced values obtained from realization or conversion of securities may be so assessable, where what is done is not merely a realization or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business."

In their Lordships' view, it was irrelevant that the realization may have occurred in order to meet withdrawals by depositors; the act was an act done in "what is truly the carrying on" of the banking business; the purchase and sale  of securities was as much a part of the bank's business as   receiving deposits; and therefore the profits were as much   business profits as the profits arising from receiving and   paying off deposits are (at p. 1073).

Punjab Cooperative Bank was cited with approval by the Supreme Court of Canada in Independence Founders Limited (discussed below).

9.     In Colonial Mutual Life Assurance Society Ltd. v. Federal Commissioner of Taxation (1946-47) 73 CLR 604, the taxpayer was a mutual life-assurance company, the general policy of which, with respect to its securities, was to hold its securities as investments, not to traffic in or make a profit from realizing them.

Per the Australian High Court at p. 608:

     "... and the real thing that has to be decided is what were the acts that were done in connection with the business and whether they amount to a trading which would cause the profits that accrued to be profits arising from a trade or business...

     ... Some of its investments were varied or switched from time to time in order to increase the effective interest yield to the Society. It was a normal operation or step in the carrying on of its business. It is true that these operations were small in comparison with the aggregate value of the securities which the society held as investments but that does make its acts in varying or switching its investments in order to increase its interest yield any the less an operation of business or establish the variation or switching as a mere realization or change of investment (Punjab Co-operative Bank Ltd., Amritsar v. Commissioner of Income-Tax, Lahore (5); Westminster Bank Ltd. v. Osler (6); Inland Revenue Commissioners v. Westleigh Estates Co. Ltd. (7)).";

and at pages 619 and 620:

     "... an insurance company, whether a mutual company or not, is undoubtedly carrying on an insurance business and the investment of its funds is as much a part of that business as the collection of the premiums... In Konstam, Law of Income Tax, 8th Edn.,p. 126, it is stated that the buying and selling of investments is a necessity of insurance business; and where an insurance company in the course of its trade realized an investment at a larger price than was paid for it, the difference is to be reckoned among its profits; conversely any loss is to be deducted."  This view is in line with that of the Privy Council in the case of a bank in Punjab Co-operative Bank Ltd., Amritsar v. Commissioner of Income Tax, Lahore (1). In our opinion there is no substantial difference between the business of an insurance company and that of a bank in this respect (emphasis added). The acquisition of an investment with a view to producing the most effective  interest yield is an acquisition with a view to producing a yield of composite character, the effective yield comprising the actual interest less any diminution or plus any increase in the capital value of the securities. Such an acquisition and subsequent realization is a normal step in carrying on the insurance business, or in other words an act done in    what is truly the carrying on of the business of the society.

The society employs an expert staff whose business it is continuously to supervise and plan the investment and, if necessary, the realization and re-investment of its funds as they exist and are augmented from time to time by fresh premiums with a view to obtaining the most effective yield. The accretion in capital value is used for the purpose of increasing the effective interest yield from the investment and therefore for an income purpose: Cunard's Trustees v. Inland Revenue Commissioners (2). It is as much a source of income as the interest payable on the investment: Inland Revenue Commissioners v. Desoutter Bros. Ltd. (3)."

10.     In M.N.R. v. Independence Founders Limited, 53 DTC 1177 (S.C.C.), the taxpayer was an investment company which purchased shares, deposited them with a trust company in return for trust shares and then sold the shares through a second trust company by means of investment certificates. The taxpayer was required to have sufficient trust shares in order to meet the outstanding investment certificates. The issue was whether profits realized from the purchase and sale of certain trust shares were taxable.

The Supreme Court of Canada held that it was taxable, on the basis that the taxpayer was bound to hold trust shares sufficient to meet its outstanding investment share certificates; therefore the dealings in trust shares were an essential part of its business; therefore the profits were assessable because what was done was "an act done in what is truly the carrying on or carrying out, of a business", as quoted from California Copper Syndicate.

11.     In Gairdner Securities Limited v. M.N.R., 52 DTC 1171 (Ex. Ct.); 54 DTC 1015 (S.C.C.), the taxpayer was a corporation which from 1930 to 1938 carried on business as a dealer in securities. In 1944, the taxpayer purchased a company, purportedly to provide management experience for the taxpayer's principal shareholder's sons, which it resold in 1946 at a profit. The issue was whether the profit realized from the purchase and sale of the company was a    capital gain or taxable income.

The Exchequer Court cited the Scottish Investment case in holding that the profit was taxable income. The decision was upheld by the Supreme Court of Canada.

12.     In Australasian Catholic Assurance Co. Limited v. F.C. of T. (1959) 100 C.L.R. 502, as set out in Commercial and General Acceptance Limited v. Federal Commissioner of Taxation 75 ATC 4201, at p. 4206:

     "In that case an assurance company whose principal business was life insurance sold fourteen blocks of flats realising a profit on the price for which they were purchased at various times during the years 1934 to 1941. The flats were acquired not for the purpose of profit-making by sale, but in pursuance of a policy to buy new or recently erected blocks of flats as a long term investment at a price which would give an estimated nett (sic) yield of 10 per cent on the amount outlaid. At the time of the purchase it was hoped that they would be held for about thirty years and then sold for approximately the price paid for them. Economic considerations dictated the sale in 1951. His Honour held that the profit on sale was made in the carrying on of the company's business and was assessable as a profit according to the ordinary usages and concepts of mankind."

13.     In Frasers (Glasgow) Bank Limited v. Commissioners of Inland Revenue, (1963) T.R. 17 (H.L.), the taxpayer was a small banking company and part of a corporate group, most of its customers being other companies in the group and their employees. The stock exchange price of the stock of one of the customer companies in the group began to fall in 1947, and the controlling shareholder of the taxpayer caused the taxpayer to acquire a block of stock in an effort to support the market. The taxpayer financed the purchase by overdraft on its trading account with the National Bank of Scotland. A further block was purchased in 1952 and similarly financed. The taxpayer held no other stocks or shares at the time. The taxpayer's controlling shareholder then purchased two large blocks of shares which were registered in the name of the taxpayer and paid for by advances to the taxpayer by the bank.

By 1958, the taxpayer's bank requested that the taxpayer reduce its overdraft. The taxpayer sold some of the stock of the customer company which had appreciated significantly in value, using the proceeds to reduce the overdraft. The issue was whether the profit on the sale of the stock was a trading profit and thus assessable for income tax.

Referring favourably to a lower court citation of the California copper Syndicate and Punjab Co-operative Bank    cases, the House of Lords rejected the taxpayer's arguments  that the transactions were not at all connected with the     banking business and were wholly divorced from its normal    activities, and confirmed that the profit was a trading profit.

14.     In Canada Permanent Mortgage Corporation v. M.N.R., [1971] CTC 694 (F.C.- T.D.), the taxpayer was a mortgage company whose business it was to lend money on first mortgage security, accept deposits from the public and issue debentures. The taxpayer held a portfolio of blue chip stocks. The issue was whether the profits from the sale of the stocks was income or a capital gain.

The taxpayer did not trade frequently in stocks. The stocks were sold to finance a program of expansion and because of rising interest rates. Many of the shares had been acquired by the taxpayer over the years through the acquisition by it of several other smaller companies in businesses similar to that of the taxpayer. The shares had been held for from 10 to 33 years. The taxpayer took no outside market advice. All of the shares paid dividends regularly. None of the shares were ever sold to meet the claims of depositors or debenture holders, or sold as security for company borrowings. Money deposited by the public was never used to purchase the shares; shareholders' funds were used. The portfolio was a "static" rather than a "trading" portfolio.

The court looked at the taxpayer's whole course of conduct and concluded that the shares were acquired by the taxpayer as investments and held as a source of income; therefore the profits on their disposition were capital gains.

It is noteworthy that Heald, J., in finding for capital treatment, distinguished the taxpayer's situation from that of banks in general at p. 5420, and in particular, from that of the banks in the cases of Punjab Cooperative Bank and Case No. P 52 (1963-64), 14 T.B.R.D. (Australia 236) at p. 5420-5421.

15.     In The Queen v. Roynat Ltd., 81 DTC 5072 (F.C.- T.D.), the taxpayer was in the money-lending business. As additional security in its lending operations, it sometimes obtained shares or share options from the debtors. The issue was whether the profit from the disposition of the shares was income or capital in nature. The court held that the profits were income because they (at p. 5082):

     "arose from operations or dealings which constituted an integral part of the profit-making activities of the defendant. The bonus shares or options were, in the course of the operation of its business of lending money, required by the defendant as extra compensation for the additional risks involved in these cases; it intended to make a profit from the eventual disposition of the shares and did not expect dividends nor did it   indeed receive any..."

16.     In Western Union Insurance Company v. Her Majesty The Queen, 83 DTC 5388 (F.C.- T. D.), the taxpayer was a general insurance company with a large diversified investment portfolio. The principal issue was whether a bonus earned by the taxpayer on a rare loan (the previous loan had been made fifteen years earlier) was a capital gain or income.

The court found that the loan transaction was carried out in the course of its business and was therefore income. At p. 5392, Dube, J. stated

     "In my view, the plaintiff in the instant appeal carried out the functions of conventional lending institutions and did so much in the same fashion as moneylenders do. The fact that this was only its second loan is not the determinant factor. It made a gainful use of its monetary assets, thus raising a presumption that it was carrying on a business. It earned a bonus because it agreed to advance money to the borrower and it did so in the course of its established business (emphasis added). It did precisely what an ordinary moneylender would do except, perhaps, that it charged more."

17.     In Waylee Investment Ltd. v. Commissioner of Inland Revenue (1990) STC 780, the taxpayer was a wholly-owned subsidiary of a Hong Kong bank (it was accepted that the purpose of the taxpayer and the bank were indistinguishable) which, in 1975, acquired 150 million new HK$1 ordinary shares of a very large Hong Kong trading company which was heavily indebted to the bank and which was in danger of imminent collapse. In purchasing the shares, the bank's concerns were the protection of its position as a creditor and the detrimental effect a collapse would have on public confidence in the general Hong Kong economy.

The acquisition by the taxpayer represented 30% of the issued share capital of the trading company and was on terms such that the bank would have effective control of the company so long as the bank held not less than 20% of the issued capital.

By 1977, the trading company recovered to the point where it was able to pay dividends. It then merged with another, whereupon the taxpayer received 90 million ordinary and 90 million preference shares of the merged company in exchange for the 150 million ordinary shares. The 90 million ordinary shares were sold in 1979 pursuant to an unsolicited offer. The issue was whether the resulting profit arose from the sale of a capital asset or the acquisition and sale of the shares amounted to an adventure or concern in the nature of trade. (The preference shares were held until 1983.)

In finding that the transaction was on capital account, the Privy Council concerned itself primarily with three factors, being:

(a)      the importance of the rescue operation to the bank's business generally;

(b)      the suggestion that the shares were intended to be sold at a profit as soon as possible; and

(c)      the argument that the if the shares had been held by the bank directly, they would have represented trading stock available to meet the demands of depositors.

With respect to (a) above, the Privy Council considered it to be a neutral factor in this case, noting that it is possible for a bank to acquire shares in a customer either as trading stock or as a capital asset, and that the customer's importance to the bank does not necessarily denote trading stock.

With respect to (b) above, the Privy Council referred to the admitted intention of the bank at the outset to effect a substantial reduction in its shareholdings of the trading company, but considered that the commissioner and a lower court had attached too much significance to this evidence. (The Privy Council noted that this intention related to the bank's desire to assure shareholders and the public at large that it was not involving itself on a long-term basis in the management of a general trading company. There was also a concern by the bank that any such reduction in the shareholdings should not disturb or distort the market.)

Rather, the Privy Council concluded that a lower court had been correct in inferring the bank's purpose from the whole of the evidence, including the fact that the shares were actually retained for over four years, they continued to be held long after the trading company achieved profitability and began paying dividends, and they were sold pursuant to an unsolicited offer rather than through the market.

With respect to (c) above, The Privy Council observed that the "clearest indication that an investment was acquired as a capital asset would be an indication that the bank intended to hold the investment as such for an indefinite period. The clearest indication that an investment was acquired as trading stock would be an indication that it was held by the bank as available to meet the demands of depositors whenever necessary. But the indications to show which category a particular investment belongs may be uncertain, inconclusive or even conflicting".

The Privy Council determined that the bank had never intended that the shares would be held as part of its circulating assets available to meet depositors' demands. This was based in part on their view that to do so would   have been quite inconsistent with or contrary to the notion  that the bank should be seen as having confidence in the     trading company. The Privy Council also was persuaded by the fact that the shares were held by the taxpayer, which was in accordance with the bank's uncontested policy that its long-term investments be held through subsidiaries.

The following citations, numbered 18 to 23 inclusive, are Australian cases. The descriptions are extracts from the Australian Income Tax Guide  (1991 CCH Australia Limited), pages 733, 734 and 737.

18.     In Ipec Insurance Ltd. v. F.C. of T., 75 ATC 4137, "The taxpayer, incorporated as a private company, was a member of a group of companies operating freight services. It was formed for the purpose of gathering up the insurance business that attached to the conduct of a freight business. After its conversion to a public company it involved itself in a wide range of activities including the buying and selling of a large number of shares. The Commissioner taxed the company on the profits from these sales. It was held by the Supreme Court of South Australia that the company used its shares in its early years to enhance the profits of the company; it was not merely the case of an owner of an ordinary investment choosing to realise it and obtaining a greater price for it than he originally acquired it at. It was a case of shares being used in the general business of the insurance company, and the profit on the sale of those shares was assessable."

19.     In London Australia Investment Co. Ltd. v. F.C. of T., 77 ATC 4398, "the taxpayer's main object was to invest in securities for the purpose of producing dividend income which it could distribute to its shareholders. Each month, the directors of the company met to decide whether shares should be bought or sold. One important consideration in buying shares was that they should immediately - or within a reasonable period - produce a dividend yield of 4% or better. Decisions to buy or sell were made with the object of ensuring the best dividend returns. The evidence was that the company did not purchase or otherwise acquire shares for the purpose of selling them at a profit. During the relevant years the company's purchases and sales were on a continuous large scale.

The High Court, by a 2/1 majority, held that the surpluses were income. Gibbs, J. came to this conclusion on the basis that the taxpayer was in the same position as a bank or insurance company (emphasis added). Jacobs, J. came to the same conclusion, but on a different basis... Jacobs, J. nevertheless considered that the taxpayer's acquisitions and disposals constituted part of its business. Relevant factors here were the large scale of the operations, and the taxpayer's investment policy, under which it anticipated rises in dividends by realization of the shares at an enhanced price."

20.     In Chamber of Manufacturers Insurance Ltd. v. F.C. of T., 84 ATC 4315, "Profits made on the sale of investments were, in principle, assessable to an insurance company whose business mainly comprised workers compensation, where the investments were intended as a reserve to meet the company's claims or expenses."

     It is noted from the Chamber case that, by way of exception, the profit from the sale of an insurer's head office will not generally be on income account.

21.     In Case W6, 89 ATC 147, a "Mortgage Insurance company which also engaged in considerable share investments was held to be assessable on profits made from the sale of the shares. Even though profit-making was not the dominant purpose in acquiring the shares, it was one of the aims. Many of the sales had been made within a short period after acquisition and few shares were held for a long period. Many of the shares had been acquired in the expectation that takeover offers would be forthcoming. Overall, even considering the share activities separately from the insurance business, they were similar to the realisation of investments in the London Australia case. The same applied to profits made by a subsidiary investment company set up by the taxpayer."

22.     In Unitraders Investments Pty Ltd. v. FC of T., 91 ATC 4454, a "General insurance company argued that it was not assessable on the profit made from selling its equity portfolio to a subsidiary in 1982 because the sale was part of a structural reorganisation and therefore the profits were capital profits. Held: investment formed part of the company's business and the sale of its equity portfolio formed part of that business regardless of the purchaser's identity.

     The subsidiary argued that it was not assessable on the sale of some of the equities acquired from its parent. Held: the sales were sufficiently frequent and routine to be classed as part of the subsidiary's business and the profits were therefore assessable."

23.     In AGC (Investments) Ltd. v. FC of T, 91 ATC 4180, "The taxpayer was a vehicle for the investment of funds provided to it by its parent which was a general insurance company. For many years its sales of listed shares was only a small percentage of the total value of its portfolio. However, in 1987 the taxpayer commenced selling its shares and moving its funds into fixed securities. For the 1987 year, the taxpayer sold 50% of its share portfolio realising $80m. Held: although not in the business of trading in shares, the taxpayer was carrying on a business that was integral to the insurance business of its parent. The shares were sold to preserve the gain which had accrued and the resulting profits were income assessable according to ordinary concepts."

PART III - JURISPRUDENCE ESTABLISHES INCOME TREATMENT AS THE RULE

Clearly the preponderance of jurisprudence in this area stands for the proposition that securities transactions by banks are a normal part of their ordinary business operations and that the usual result will be that gains and losses arising from such transactions will be on income account.

There are of course cases where particular transactions were found to be on capital account but these are demonstrably the exception rather than the rule. This is discussed more fully in PART IV below.

Accordingly, it is the Department's opinion that the jurisprudence has established a general premise that the securities transactions of banks are on income account. As such, it is our view that it is incumbent on a bank to demonstrate that any particular securities transaction is, on its facts, of such exceptional nature as to be on capital account.

PART IV - CAPITAL TREATMENT BY EXCEPTION: DISCUSSION

As indicated by the above analysis, the cases where securities transactions by a financial institution were found to be on capital account are few. The most significant of these are Canada Permanent and Waylee Investment and therefore bear closer inspection to see what it was that caused the courts to reach such a conclusion.

Canada Permanent - Significant Features

-     the taxpayer's share transactions were infrequent;

-     many of the shares had been acquired over a period of years by the taxpayer as part of the assets of smaller businesses which it purchased;

-     the shares were held for long periods of time, i.e. between 10 and 33 years;

-     all the shares earned dividends;

-     it was a blue chip stock portfolio;

-     the taxpayer took no outside market advice;

-     none of the shares were sold to meet depositors' claims;

-     shareholders' funds rather than borrowings were used to purchase the share portfolio;

-     the shares were sold to finance a program of expansion and because the taxpayer was caught in an interest rate squeeze.

The court thus considered that the taxpayer's whole course of conduct indicated the shares were acquired as investments and that the gains from their disposition were capital in nature. In so doing, the court specifically distinguished the taxpayer from banks. The court also distinguished the taxpayer's situation from that of an insurance company. Heald, J. cited the Colonial Mutual Life case but went on to say, at p. 5421:

     "It is interesting to note, however, at pages 617-18 of that judgement, that the High Court of Australia agrees that under certain circumstances, even Insurance Companies may be able to treat realization on change of investments as capital gains: (whereupon he quoted from Colonial Mutual Life in support of that proposition)".

However, while the passage selected by Justice Heald from Colonial Mutual Life does indeed contain a discussion of arguments supporting capital treatment in certain circumstances for insurers, the sentence immediately following the selected passage dispenses with those arguments and makes it clear that the High Court of Australia in fact is of the view that "the sounder view" is that income treatment will usually prevail:

     "But the insistence by Lord Shaw upon the correctness of the whole of the series of propositions enunciated in Northern Assurance Company v. Russell (4) after he had presumably read the remarks of Hamilton, J., in the court below, and the criticism by the Privy Council of some dicta in Commissioners of Inland Revenue v. Scottish Automobile & General Insurance Co. Ltd. (5) in Punjab Co-operative Bank Ltd., Amritsar v. Commissioner of Income-Tax, Lahore (6), coupled with the willingness of the Inspector of Taxes in Royal Insurance Co. Ltd. v. Stephen (7) to allow a loss on realization amounting to L754,000 as a deduction in computing it profits assessable under Case 1, tends to show that the sounder view is that profits and losses on the realization of investments of the funds of an insurance company should usually be taken into account in the determination of the profits and gains of the business (emphasis added)."

It bears repeating here that the Australian High Court saw no distinction between an insurance company and a bank in this area.

In view of this (as well as the favourable citation at pages 707- 708 of the discredited Scottish Automobile case) and the unusual facts of the case, it is our opinion that Canada Permanent has little application with respect to the securities transactions of banks.

Waylee Investment - Significant Features

-     a particular customer of a bank was a very large trading company in Hong Kong and was heavily indebted to the bank;

-     the customer was in imminent danger of collapse;

-     the bank was concerned that if there was a collapse, it would suffer both as an inadequately secured creditor and by the threat that such a collapse would undermine public confidence in the economy of Hong Kong generally;

-     to prevent the collapse, the bank caused its subsidiary (the taxpayer) to acquire 30% of the issued share capital of the customer;

-     the arrangements were such that the bank had effective control of the customer so long as the bank's shareholdings were at least 20%.

-     in an effort to signal that it was not involving itself on a long-term basis in the management of a general trading company, the bank indicated around the time of the acquisition that it intended to substantially reduce its shareholdings as soon as conditions permitted (without distorting or disturbing the market);

-     in two years the customer recovered such that it paid dividends; (meanwhile the customer amalgamated with another and the shares held by the taxpayer were exchanged for an equal number of ordinary and preference shares);

-     after four years, the taxpayer sold the block of ordinary shares pursuant to an unsolicited offer (the preference shares were retained for a further four years).

The Privy Council's perspective of this case is reflected by Lord Bridge's statement at p. 784:

     "Was it open to the Board of Review to find that the HIL shares were acquired by the bank as a long-term investment and that the profit now sought to be taxed arose from the sale of a capital asset which, even if held directly by the bank, would not have been part of the bank's trading stock? If it was, the Court of Appeal were not entitled to reverse that finding."

The Privy Council, at p. 783, cited from the Board of Review:

     "... We accept the evidence of (the bank's chairman) which was to the effect that this was not a normal banking transaction or a normal transaction falling within the business of the Bank. It was a most unusual and exceptional case."

In considering the bank's purpose, the Privy Council found that it would have been contrary to the bank's intentions in the rescue operation to have held the shares as part of its circulating assets available to meet depositors' claims. In confirming that Board of Review's decision was not erroneous in law, the Privy Council stated that the bank's purpose should be considered based on the whole of the evidence, and agreed that the Board of Review was entitled to take into account the fact that the shares were held for over four years, continuing long after the customer began paying dividends, and that the eventual sale was not the result of trading in the market but from the acceptance of an unsolicited offer.

It is our opinion that, while Waylee Investment is important in the sense that it is one of the few banking cases, it is nevertheless quite restricted in its application. In this respect, it was judicially recognized on its facts that it "was a most unusual and exceptional case" and did not involve "a normal banking transaction".

Factors Suggesting Capital Treatment

A.     The Canada Permanent and Waylee Investment CasesThese are the leading cases where securities transactions were held to be on capital account. The first was distinguished from banks and the second was recognized as not being a normal transaction falling within the business of the bank.

     Significance:  These cases are clearly exceptional in nature and their usefulness in dealing with securities transactions by banks is therefore limited to similar facts patterns. Waylee Investment does, for example, lend some support for the view expressed by Rulings for capital treatment on a previous D.O. referral involving the acquisition of shares to assist in thwarting a hostile takeover bid in an effort to preserve and maintain a valued business relationship.

B.     Securities Held for a Long Time.This was a factor in Canada Permanent (#14), where it meant 10-33 years, and in Waylee Investment (#17), where the shares were held for 4 years. However, in both cases it was only one of a number of factors leading to capital treatment.

     This was not determinative in Australasian Catholic Assurance (#12), where the gain on flats held for 10-17 years was on income account.

     Significance: The fact that securities are held by a bank for a long time is not in itself determinative of capital treatment. The whole course of conduct would have to suggest the particular transaction was not a normal part of the ordinary operations of the bank.

C.     Securities Not Required to Meet Demands of Depositors.This was a factor in Canada Permanent (#14) and Waylee Investment (#17). However, in both cases it was only one of a number of factors suggesting capital treatment.

     However, this was essentially irrelevant in Punjab Cooperative Bank (#8) where the gain was on income account.

     It was an effectively neutral factor in London & Liverpool (#4) where the gain was on income account.

     Significance: Because of the differing levels of importance attached to whether the shares are required to meet demands of depositors, its significance is unclear and at best, is the same as in B above.

D.     Fixed (vs Circulating) CapitalThis was a factor in Canada Permanent (#14) and in Waylee Investment (#17). However, in both cases it was only one of a number of factors leading to capital treatment.

     Otherwise, this does not seem to be widely cited as a factor in the cases dealing with financial institutions.

     It would seem that one of the difficulties here lies in determining whether particular securities are held by a bank as part of its fixed capital or its circulating capital. While the court in Canada Permanent used an arithmetic approach rather than a tracing approach (i.e. was the value of shareholders' equity sufficient to suggest it could have funded the particular shares, fixed assets and other capital investments), in Waylee Investment the approach was one of intention (i.e. whether the shares were held with an intention that they be part of the bank's circulating assets).

     Referring to Ammonia Soda Company, Limited v. Chamberlain, (1918) 1 Ch. 266, as providing a comprehensive description of fixed and circulating capital, Canada Permanent includes a partial quotation from that description. We note, however, that Ammonia Soda went on to say:

     "It must not, however, be assumed that the division into which capital thus falls is permanent. The language (i.e. fixed and circulating capital) is merely used to describe the purpose of which it is for the time being appropriated. This purpose may be changed as often as considered desirable, and as the constitution of the bank may allow. Thus bank premises (i.e. fixed capital) may be sold, and conversely the money used in circulating capital may be expended in acquiring bank premises. The term "fixed" and "circulating" are merely terms convenient for describing the purpose to which the capital is for the time being devoted when considering its position in     respect to (arriving at the amount of) the profits      available for dividend."

     Clearly, this is not a static concept and while its application seems less than clear (see Canada Permanent and Waylee Investment), it contemplates a factual determination.

     Significance: The fact that a particular security transaction involves fixed capital appears to be highly suggestive of a transaction on capital account. However, the cases indicate that other factors, and particularly the taxpayer's whole course of conduct, must also point to a capital transaction. In our view, the cases would not support the proposition that capital treatment would prevail where the particular securities were part of fixed capital but their disposition was a normal part of its ordinary business.

     The determination that a transaction involves fixed capital appears to be problematic particularly in the case of banks because of the fungibility of money, and the difficulty in tracing specific sources and applications of funds.

E.     Infrequent TransactionsThis was a factor in Canada Permanent (#14) but only one of many, leading to capital treatment.

     It was not relevant in Waylee Investment (#17).

     Income treatment resulted where there were few transactions in Frasers Bank (#13) and Western Union (#16).

     Significance: The fact that the securities transactions of a bank are infrequent is not in itself determinative of capital treatment. The whole course of conduct would have to suggest the particular transaction was not a normal part of the ordinary operations of the bank.

F.     Securities Held in "Investment Account" or SubsidiaryThe established practice of using subsidiaries to hold a bank's so-called "long-term investments" was a contributing factor in Waylee Investment (#17). (However, it was observed that the bona fides of this practice was never challenged nor had there been any suggestion that the subsidiary was a device aimed at avoiding tax.)

     IT-479R, in paragraph 14, suggests that the type of corporate account in which a security is held (eg. investment account, trading account), as well as the particular facts, will determine whether income or capital treatment is applicable.

     Significance:  Little, if any, significance should be attached to these factors. Given that it was accepted that the subsidiary's purpose and the bank's purpose were one and the same in Waylee Investment, it should be possible to argue that the use of a subsidiary is essentially a neutral factor. (If not, the effectiveness of such a practice should not remain unchallenged as it was in that case). With respect to the IT, it is being amended to indicate that securities transactions of financial institutions are generally on income account, subject to the facts of a particular case.

PART V - APPLICATION TO THE SPECIFIC TRANSACTIONS OF THE BANK

The Bank has been investing in Canadian and American securities for at least 25 years.

We understand the transactions in question pertain to dispositions in both the 1985 and 1986 taxation years.

          24(1)

The bank's submission contains a certain amount of detail on these transactions, including the name of the security, length of time held and the amount of the gain or loss.

          24(1)

In examining the transactions as described in the APPENDIX and applying to them the "income vs. capital" principles set out earlier in this memorandum, it is clear that the Bank routinely and on an on-going basis engages in securities transactions and, with the possible exceptions discussed in NOTES 1 & 2 below, it is abundantly clear that none of these transactions, whether by analogy or otherwise, is of an exceptional or extraordinary nature as recognized by any of the jurisprudence which favours capital treatment. Rather, the routine nature of the transactions is evident from the comments for each individual transaction and when taken together as a whole. The comments at page 8 of the APPENDIX on the          24(1)          concerning the rate of return policies and expectations of the Bank are also revealing: this is remarkably suggestive of Colonial Mutual (#9).

NOTE 1. The comments at page 9 of the APPENDIX regarding the Bank's acquisition of       24(1)        in 1971 suggest there may have been some unusual circumstances involved, possibly with some similarities to Waylee Investment.  If further analysis confirms this to be analogous to Waylee Investment, noting also the length of time the shares were held and that it was a fairly substantial investment of 10%, the disposition of these shares would, in our view, warrant capital treatment.

NOTE 2. As described at page 10 and 13 of the APPENDIX, the shares of           24(1)          were acquired in 1974 and 1955 respectively. It is unclear from the comments whether there were any unusual circumstances involved in either of these acquisitions. While we have no basis to conclude these were anything other than normal transactions of the Bank, they may warrant closer examination.

PART VI - CONCLUSION

Based on the foregoing, with the possible exceptions described in NOTE 1 & 2 above, it is our opinion that the Bank's securities transactions in question are on income account.

for DirectorFinancial Industries DivisionRulings DirectorateAttachment