Gilmour v. The Queen, 81 DTC 5322, [1981] CTC 401 (FCTD)

Collier, J:—This appeal arises under the “old” Income Tax Act, RSC 1952, c 1-48, as amended to and including 1971. The taxation year under consideration is 1971.

There are two issues:

(a) whether an advance, or payment, to a shareholder of a company, of certain funds should be deemed to be a dividend received within the meaning of section 81 of the Act;

(b) whether, in calculating undistributed income on hand of the paying company, a discount on debentures issued by it is deductible within the meaning of section 82 of the Act.

A good number of the allegations in the statement of claim were admitted. The parties filed a “partial agreement as to facts” (Ex 29). The husband of the plaintiff, a chartered accountant, gave factual and expert evidence.

The plaintiff was the sole shareholder of LVG Holdings Ltd. That company qualified as a personal corporation under section 68 of the Act. LVG, at the material times, owned 105 shares of Trident Investment Management Limited (Trident). This holding amounted to / of Trident’s issued common shares. Trident was in the oil business. It held controlling shares in three companies:

Western and Texas Oil Co. Ltd. (Westex)

Clover Petroleum Ltd. (a royalty company)

Wizard Petroleum Ltd.

In 1971 an offer was made by Western Decalta Petroleum Ltd to purchase from Trident all the shares of Westex which Trident held. The closing date was March 19, 1971. Certain warranties were given to Decalta. Their expiry date was six months from the date of closing, that is, September 19, 1971. A release by Decalta of those warranties was not formally given until April 1972.

Trident, following this transaction with Decalta, determined to wind up its affairs, distribute its assets and surrender its charter. On March 22, 1971, in anticipation of liquidation and winding up, it paid out to its shareholders, from its capital surplus cash on hand, $420,000. A further sum of $240,000, from capital surplus cash on hand, was, pursuant to a board of directors’ resolution dated August 3, 1971, paid.

The total amount so paid to shareholders was $660,000. LVG received $220,000.

The Minister of National Revenue took the view those monies were deemed dividends. He taxed the plaintiff on the full amount. Subsequently, the Minister reduced that amount to $61,536; that this represented LVG’s proportion of Trident’s undistributed income on hand in 1971. But the Minis- ter’s calculation did not make any deduction for discounts which Trident had given on certain bonds issued in earlier years, and later redeemed.

The first issue is as to whether the so-called advances in anticipation of liquidation are to be deemed dividends. Subsection 81 (1) of the statute is as follows:

Undistributed Income

81. (1) Where funds or property of a corporation have, at a time when the corporation had undistributed income on hand, been distributed or otherwise appropriated in any manner whatsoever to or for the benefit of one or more of its shareholders on the winding-up, discontinuance or reorganization of its business, a dividend shall be deemed to have been received at that time by each shareholder equal to the lesser of

(a) the amount or value of the funds or property so distributed or appropriated by him, or

(b) his portion of the undistributed income then on hand.

The plaintiff argued the amounts paid in anticipation of liquidation were not a distribution or appropriation. It was said the plaintiff and the other shareholders of Trident might, because of the six month warranty given by Trident to Western Decalta, have been required to repay the advances.

I see nothing in the agreement between Trident and Western Decalta imposing any legal responsibility on Trident shareholders to meet any legal liability of Trident under the so-called warranties. It was further submitted that while the warranties expired in September, 1971, the shareholders did not regard themselves as free to deal with the funds, as absolute owners of them, until the warranties had been released. The plaintiff invested the advances to her corporation in short term deposits, “in case the money had to be paid back”.

Again, I cannot see that the Trident warranties personally bound, in any way, the shareholders of the company, in the sense some restitution of funds might have to be made by shareholders.

The warranties, on the material before me, expired in September, 1971. There is once more, nothing in the agreement by which the warranties survived until a formal release by Western Decalta was given.

The funds, therefore, became the absolute property of the plaintiff’s personal corporation in 1971.

The evidence is clear the main asset in the business of Trident had been disposed of when its shares in Westex were sold. The whole plan was to wind up and discontinue Trident. For various reasons, including the coming into force of the new tax Act in 1972, the actual winding up or discontinuance of Trident’s business was postponed.

But as a practical matter there was “a winding up, discontinuance or reorganization” of its business in 1971. See Smythe et al v MNR, [1970] SCR 64 at 71-72; [1969] CTC 558; 69 DTC 5361.

The plaintiff therefore fails on the first issue.

I turn to the second issue.

On January 29, 1958 Trident issued 3 /2% income debentures of $112,500. They were sold to an underwriter at a discount of $37,440. On December 1, 1959, a new series of 3% income debentures of $283,695 were issued. They were sold to an underwriter at a discount of $104,895. Taking into account the discount, the effective rate of interest on the 3 /2% debentures was 5.02%. The effective interest rate on the 3% debentures was 4.76%. The Bank of Nova Scotia prime lending rate in January and February 1958 was 5.25%. In December 1959, it was between 5.25% and 5.50%.

The discounts were, in 1958 and 1959, written off against retained earnings of Trident.

The first set of debentures were, on April 24, 1958, repaid to the extent of $75,000. The balance of $37,500 was, on December 1, 1959, converted into the 3% income debentures.

The 3% income debentures were repaid over the years 1967 to 1971 inclusive.

No part of the total discount of $142,335 was claimed by Trident as a deduction from income for tax purposes in any year. Nor was it ever allowed as a deduction by the Minister of National Revenue.

The plaintiff now asserts the discount is, in calculating Trident’s undistributed income on hand as of 1979 and pursuant to subsection 82(1) of the Act, to be subtracted from its aggregate incomes*. [1] I set out the relevant provisions of the subsection:

82. (1) In this Act

(a) “undistributed income on hand” of a corporation at the end of, or at any time in, a specified taxation year means the aggregate of the incomes of the corporation for the taxation years beginning with the taxation year that ended in 1917 and ending with the specified taxation year minus the aggregate of the following amounts for each of those years:

(i) each loss sustained by the corporation for a taxation year,

(ii) each expense incurred or disbursement made by the corporation during one of those years that was not allowed as a deduction in computing income for one of those years under this part except

(A) an expense incurred or disbursement made in respect of the acquisition of property (including goodwill) or the repayment of loans or capital

(B) an outlay or expense the deduction of which was not allowed by reason of subsection (3) of Section 12, or

(C) unless the undistributed income on hand is being determined for the purpose of subsection (1) of section 81, any part of the payment referred to in section 76 that has not been allowed as a deduction in computing income for one of those years.

The plaintiff argued the discounts fell within subparagraph 82(1 )(a)(ii); they were an expense or disbursement made by Trident that had not been allowed as a deduction in computing income.

The Minister contended the discounts fell within the exception set out in clause 82(1 )(a)(ii)(A); they were an expense or disbursement made in re

The plaintiff’s husband is an experienced chartered accountant. He was, at all material times, a director and secretary treasurer of Trident. He oversaw the company’s books and records. He charged to income, in the years in which the two sets of debentures were issued, the discounts. They were recorded as deferred charges or expenses, as of those times. They were not recorded as an expenditure on the redemption of the debentures.

The accounting practice in 1958 and 1959 was not to amortize the discounts on some suitable basis, say, over the life of the bond. The more recent practice is to amortize.

Mr Gilmour drew a distinction between a bonus paid to a bondholder on the maturity of a bond, and a discount given at the time of issue:

A bonus is an amount paid to a bondholder at maturity over and above the face value of the bond, usually as an inducement to persuade the lender to subscribe to the bond.

On the other hand, a discount arises at the time the bond is issued where the interest demanded by the lender is greater than the interest rate paid on the bond.

He testified further:

(a) Discount on an obligation will rise where the amount received by the borrower is less than the face amount of the obligation issued, and reflects the fact that the effective rate of interest demanded by the lender is higher than the stated rate of interest payable on the obligation. This discount is normally considered to be prepaid interest at the time of issue.

(b) Where an obligation is issued at a discount, it is customary in Canada to record the obligation issued at its fact value, and to record the discount (prepaid interest) as a deferred charge that should be charged to income on some reasonable basis.

Mr Gilmour testified all of the above was in accordance with generally accepted Canadian accounting principles. His was the sole expert evidence. His opinions were, in cross-examination, not really challenged, tested or explored.

I accept his evidence on these points. Based on his evidence, I find the discounts were, from an acceptable accounting view and practice, and from an acceptable and realistic business viewpoint, a form of prepaid interest.

I see nothing in A/G Ontario v Barfried Enterprises Ltd, [1963] SCR 570 which indicates a discount, of the kind here, cannot be a form of interest. Indeed, Judson, J said, at 575:

. . . The foundation for the judgment under appeal is to be found in the adoption of a wide definition of the subject-matter of interest used in the Saskatchewan Farm Security Act reference. The judgment of this Court in that case was affirmed in the Privy Council. Interest was defined:

In general terms, the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to, another,

this is substantially the definition running through the three editions of Halsbury. However in the third edition (27 Hals., 3rd ed, p 7) the text continues:

Interest accrues de die in diem even if payable only at intervals, and is, therefore, apportionable in point of time between persons entitled in succession to the principal.

The day-to-day accrual of interest seems to me to be an essential characteristic. All the other items mentioned in The Unconscionable Transactions Relief Act ex- cept discount lack this characteristic. They are not interest. In most of these unconscionable schemes of lending the vice is in the bonus.

In the cases decided in this Court under s. 5 of the Interest Act, it is settled that a bonus is not interest for the purpose of determining whether there has been compliance with the Act.

(italics mine)

The plaintiff relied on paragraph 12(1 )(f) of the statute:

Deductions not allowed in Computing Income

12 (1) In computing income, no deduction shall be made in respect of

(f) an amount paid by a corporation other than a personal corporation as interest

or otherwise to holders of its income bonds or income debentures . ..

This prepaid interest, it is said, was an expense or disbursement . not allowed as a deduction in computing income” for 1958 and 1959 (see subparagraph 82(1 ) (a) (ii).

The defendant, as earlier stated, contended the discounts are caught by clause 82(1 )(a)(ii)(A): they are expenses incurred in respect of the repayment of loans or capital. It was said the issue of the debentures and their repayment were in the nature of capital transactions; the expenses, incurred by way of discounts, were in respect of capital.

It is not enough, in my view, that the expense or disbursement be in respect of a loan, or in respect of capital. There must be the element of repayment. The expense must be incurred in respect of repayment, and at that time. A bonus might well fall within the words relied on by the defendant. I do not have to decide that. But the discounts here, in my view, were prepaid interest. They do not come within the words relied on by the Minister.

The plaintiff succeeds on the second issue.

The assessments will be referred back to the Minister with the direction that in computing Trident’s undistributed income on hand for 1971, the discounts totalling $142,335 are to be deducted. The plaintiff’s share of Trident’s undistributed income will be reduced accordingly.

Success is divided. There will be no costs.