Isaac Meisels Investments Ltd. v. The Queen, 85 DTC 5029, [1985] 1 CTC 9 (FCTD)

Rouleau, J:—This is an appeal by the plaintiff from a decision of the Tax Review Board dated April 21, 1983 whereby the sum of $101,000 was disallowed as a deduction in computing plaintiffs taxable income for 1977.

Prior to trial, counsel for the parties agreed upon the following reproduced statement of facts:

AGREED STATEMENT OF FACTS

1. The Plaintiff Isaac Meisels Investments Limited is a company incorporated under the laws of the Province of Ontario, having its head office at the Municipality of Metropolitan Toronto, in the Judicial District of York and carries on an active real estate business which at various times has included rentals, buying, selling, construction, developing (including re-zoning) and exploitation for maximum profits of real estate property of all kinds. Such business has been carried on by the Plaintiff for about 15 years.

2. The Plaintiffs real estate ventures are carried on by itself, or as a partner, or member of a joint venture. At times it is a direct participant and at other times it uses a limited company specifically incorporated for a particular venture. If a proposed project or investment appears to be speculative, the Plaintiff has used a separate, usually newly incorporated limited company for such project or investment so as to limit the exposure and liability of the Plaintiff to the amount invested by it in such project or venture so that the Plaintiff would not be responsible for any additional losses sustained in such project or venture.

3. Louis Weisfeld (Ontario) Ltd (“Weisfeld Ltd”) is a company duly incorporated under the laws of the province of Ontario, having its head office at the Municipality of Metropolitan Toronto, in the Judicial District of York. It was incorporated specifically by the Plaintiff together with others (being a family named Ferracutti) for the purpose of purchasing a parcel of real property for development, resale and/or construction with the sole purpose of Weisfeld Ltd financially exploiting that real property in the most advantageous way possible as a single venture only. Such parcel of real property was located in Guelph, Ontario.

4. In due course, a business decision was made by the Plaintiff together with its partner that the most advantageous way of exploiting the real property and maximizing any profits to be realized therefrom, was the construction and sale of some 36 condominium units and 64 townhouse units with the intent of building the units, selling the units, dividing the anticipated profits and the ultimate winding up of Weisfeld Ltd.

5. In order to fund the Weisfeld Ltd venture, the Plaintiff advanced to it the sum of $40,000 in or about August, 1973, the sum of $40,000 in or about September, 1973, the sum of $10,000 in or about July, 1974, and the further sum of $11,000 in or about August, 1974, totalling in the aggregate, $101,000. In addition, the Plaintiff as an equal participant in the venture, subscribed for 50 per cent of the issued shares of Weisfeld Ltd at a subscription price of $50. The Plaintiff was credited with a shareholder’s advance in the amount of $101,050 by Weisfeld Ltd prior to the Plaintiffs 1977 taxation year.

6. The corporate entity, Weisfeld Ltd, was utilized for the purpose of acting as a corporate vehicle for the transaction and to shield the Plaintiff and its partner from any further liability in connection with the venture and more particularly, from the substantial liability to the Manufacturers Life Insurance Company, the mortgagee providing the financing. The benefit of limited liability, in view of the substantial risk to the venture, was essential. In particular, a first mortgage in the amount of $1,000,000 was obtained by the said Weisfeld Ltd from the Manufacturers Life Insurance Company without the requirement of such mortgage being guaranteed by either the Plaintiff, Isaac Meisels Investments Limited or its partner, the Ferracutti family of by any of the principals of such partnership individually.

7. The speculative venture proved to be a financial disaster, substantial losses were incurred and on or about the 7th day of January, 1976, foreclosure proceedings were commenced by the Manufacturers Life Insurance Company against Weisfeld Ltd. In due course, a final order of foreclosure was obtained during the Plaintiffs 1977 taxation year (being its fiscal period ending the 31st day of May, 1977) thereby culminating in a loss to the Plaintiff. If the Plaintiff and its partner had not utilized the said Weisfeld Ltd for this transaction, the loss in question would have amounted to additional hundreds of thousands of dollars for which the Plaintiff would have been responsible jointly and severally.

8. In computing its income for its 1977 taxation year, the Plaintiff in its Corporation Income Tax Return dated November 28, 1977 listed the sum of $101,050 as a ‘‘bad debt”. In its Amended Corporate Income Tax Return dated January 11, 1979, the Plaintiff restated the $101,050 to be a non-capital loss and claimed as a deduction from income the sum of $101,050 as a non-capital loss realized in its 1977 taxation year.

9. In reassessing the Plaintiff for its 1977 taxation year the Minister of National Revenue has disallowed as a deduction from income the non-capital loss claimed by the Plaintiff in its 1977 taxation year in the amount of $101,050 as aforesaid.

Counsel for the plaintiff contended that the advances totalling $101,000 were a non-capital loss that should be deductible against any income source and should not be treated as a capital loss (ie fifty per cent of the amount can be applied to offset other capital gains). There is, as I understand it, a twofold thrust to counsel’s submission. The first, considering the very nature of the company’s activities it cannot realize a capital gain. The second, which overlaps somewhat with the first, is that the advances were made in the course of plaintiffs varied real estate business operations and, as such, are deductible against other income pursuant to paragraph 18( l)(a) of the Income Tax Act:

18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) An outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

Counsel for the plaintiff referred me to the case of MNR v Henry J Freud, [1963] CTC 438; 68 DTC 5279. Briefly, this matter concerns a Canadian taxpayer who along with a partner set up a corporation in Michigan to develop and sell to a major car manufacturer a prototype of a personal sports car. After some years of development, work and money spent without success, the Canadian taxpayer, in a last ditch effort to sell the concept, advanced the sum of $13,840 to the corporation. This also failed. The $13,840 expense was claimed as a deduction against other income by the taxpayer and it was allowed. From the headnote I quote:

. . . The $13,840 expended by the respondent was deductible from his other income for 1960. The amount had to be considered as an outlay for gaining income from an adventure in the nature of trade and not as an outlay or loss on account of capital. The venture, from its inception, was not for the purpose of deriving income from an investment but for the purpose of making a profit on selling the prototype — the venture was purely a speculation. If a profit had been obtained, it would have been taxable irrespective of the method adopted for realizing it. If the respondent and his friends had been successful in selling the prototype sports car, they might well have completed the transaction by selling their shares in the company instead of having the company sell the prototype and based on certain real estate cases, the sale of shares would have been held to be merely an alternative method of realizing a taxable profit from a trading venture.

Counsel then brought to my attention the case of Paco Corporation v The Queen, [1980] CTC 409; 80 DTC 6215, 6328. This decision concerns a Canadian corporation that had developed a machine and a process to manufacture a type of brick; they did not manufacture the bricks themselves. Machinery and plant equipment had been sold in North America. When attempting to venture into the European market, it was discovered that the Paco Corporation could not succeed in selling the concept without setting up a prototype in France. This was done in cooperation with others. By way of acquisition of shares, considerable sums were invested in the French plant. It was intended to show prospective European purchasers the equipment. Their primary purpose was not to manufacture the bricks or cement blocks, but to sell the equipment or concept. This venture was also unsuccessful and the loss claimed. Mr Justice Dubé wrote at 411 [6329]:

Through his counsel the Minister alleged that the PACO investment by the purchase of AFCOREX shares constituted a capital outlay: the property acquired whether shares or debts, was capital property within the meaning of the Act. In addition, even admitting the purpose of PACO’s actions, namely their intent to set up a demonstrator physically located in Europe, the monies allocated to the purpose were intended to secure a “permanent benefit of lasting value’’. Section 57(b)(ii) defines “capital property” as “any property . . . any gain or loss from the disposition of which would . . . be a capital gain or a capital loss, as the case may be, of the taxpayer”.

And at 411 [6330]:

It would appear at first glance that this is likely to be an investment of a lasting nature in view of the large sum involved, the fact that the transaction relates to the purchase of another company’s shares, and the initial tax return assigning these losses to capital outlays.

However, what is important is the substance of the transaction, the overriding intent of the taxpayer. In Algoma Central Railway v Minister of National Revenue 67 DTC 5091, 68 DTC 5096, [1968] SCR 447-450, a decision of the Exchequer Court, affirmed by the Supreme Court of Canada, it was held that outlays made by this railway company to obtain geological surveys for the purpose of increasing traffic on its line were income-related expenses. What the company had “in mind” was obtaining information to place at the disposal of potential customers. If these expenditures were incurred for the purpose of producing income, they were “current expenses”.

And finally at 413 [6331]:

Although this transaction was not merely a loan, but also involved the purchase of another company’s shares, and so was a transaction which prima facie would appear to be an expenditure on capital account, it is important not to be misled by appearances. The Court must look at the substance of the transaction, and this is characterized above all by the overriding intent of the taxpayer at the time the money was invested, namely the intent to establish a demonstration project in Europe.

Counsel argued that the main issue decided by Dubé, J was that the investment had to be a permanent benefit of lasting value. Even so, Mr Justice Dubé determined, as I interpret it, that the expenditure was made to build a plant for demonstration purposes; he treated it as loss of income because it was money expended to promote further business, sale of machinery. It was an income- related expense.

Crown counsel submitted that had Meisels acquired only shares for their advances and intended to realize a profit from the sale of these, there is no doubt it would have been income; but, under the existing plan of advances it is obvious that any profits accruing to the Weisfeld Corporation would have been retained by them and not taxed as income by the plaintiff corporation. The fact that a second corporation was necessary to protect them from liability should not necessarily change the nature of the advances. The question 1s: what was intended?

He then suggested that one has to doubt the plaintiffs intentions because it originally claimed the advances as a bad debt; then, fourteen months later, it amended its tax return to treat the moneys as a non-capital loss deductible against income for the 1977 taxation year.

Counsel proceeded to distinguish the Freud case, (supra). He argued that the first amount advanced by the taxpayer was not to set up a manufacturing plant but was used to sell a concept. The amount allowed was expended as a “last ditch effort”. Generally speaking, advances of this nature are held to be from the capital account; only in exceptional circumstances are they not treated as such.

As for the Paco case, (supra), counsel for the Crown submitted that the plant was set up for demonstration purposes. It was not intended to secure a permanent benefit of lasting value by selling bricks. It was intended for the sale of plant equipment and machinery while having ultimately benefited the Canadian company. It was in effect an income-related expense.

Counsel for the defendant referred to three cases for consideration. The Queen v H Griffiths Company Ltd, [1976] CTC 454; 76 DTC 6261, summarizing from the headnote:

The defendant taxpayer company, engaged in the highly competitive field of mechanical contracting, incorporated a subsidiary to provide it with an adequate supply of competitively priced sheet-metal products. Subsequently, the subsidiary, faced with fi fi- nancial problems, borrowed moneys from the bank, including a sum of $75,000 guaranteed by the [defendant] company. Eventually, the subsidiary went into bankruptcy and the [defendant] company repaid the loan of $75,000 and sought to deduct it computing his income.

Dubé, J held that:

the $75,000 repayment constituted an outlay on account of capital and is not deductible as an expense under subsection 12(1) [now 18(1)] of the Act.

In Charles Chaffey v MNR, [1978] CTC 253; 78 DTC 6176, again from the headnote:

The taxpayer [Chaffey], in partnership with T, held a number of shares in a company formed to operate a tourist attraction on land which was acquired by the two P ^ and their associates. To finance the project, the partnership and other shareholders made loans to the company. When the operation of . tourist centre proved to be financially unsuccessful, the partnership sold, early in 1968, half of their shares and half of the indebtedness owed to them by the company on the advances. The;P ^ ship incurred a loss on the sale, and each partner claimed his share of the loss in the 1968 taxation year. The Minister disallowed the deduction and the taxpayer appealed arguing that: (1) the losses were incurred in an adventure in the nature of trade and accordingly were deductible, or (2) that the loans were made in the ordinary course of the partnership’s business and the loss was deductible as a bad debt under the Pulsions of s 1 l(l)(0 [now 20(1)(p)] of the Act. The Federal Court, Trial Division, [74 DTC 7478] dismissed the appeal holding that the loans were capital outlays and that the taxpayers were not in the business of lending money. The taxpayer appealed further.

For the Court of Appeal, Le Dain, J in dismissing the appeal wrote at 257 [6179] that:

It may well be that one could reasonably come to a different conclusion on this

evidence from that which was reached by the learned . ^ ’X in my ha tïè opinion it cannot be said that he was clearly wrong in coming to the conclusion that did . . .

In agreeing with the conclusion of the trial Judge, he had this to say on the second issue, also at 257 [6179]:

It may well be that one could reasonably come to a different conclusion on this evidence from that which was reached by the learned trial Judge, but in he

opinion it cannot be said that he was clearly wrong in coming to the conclusion that he did . . . sic]

Stewart & Morrison Ltd v MNR, [1972] CTC 73; 72 DTC 6049 appears to be the most relevant case. In order to improve its US business, Stewart & Morrison Ltd incorporated a wholly-owned US subsidiary company to operate the New York office. The funding took the form of direct advances and a guaranteed bank loan. The New York operations were unprofitable and the office had to be closed. In computing its income for the 1966 taxation V ’Stewart & Morrison Ltd deducted as an expense the $72,345. It had written off as a bad debt the advances made to its subsidiary. The Minister disallowed the deduction. The Appeal Board allowed the company’s appeal, but the Exchequer Court reversed this decision. The taxpayer company brought the matter before the Supreme Court of Canada which held that the money provided by the parent company to the American subsidiary was an outlay of a capital nature and thus not deductible. Judson, J delivering the judgment for the Court at 74 [6050] wrote:

The learned trial judge has correctly characterized these dealings between the parent company and its American subsidiary. The parent company provided working capital to its subsidiary by way of loans. These loans were the only working capital the American subsidiary ever had with the exception of the sum of $1,000.00 invested by Stewart & Morrison Limited for the acquisition of all the issued share capital of its subsidiary. The money was lost and the losses were capital losses to Stewart & Morrison Limited. The deduction of these losses has been rightly found to be prohibited by s 12(l)(b) [now 18(l)(b)] of the Income Tax Act.

In reply, counsel for the plaintiff suggested that the Griffiths, Chaffey and Stewart cases should not be followed since they were dealing with long-term investments and that short-term advances should not be treated as capital.

I am not persuaded that “short-term consideration” is relevant. The appeal in the Paco case, (supra), as I appreciate the decision, was allowed because the arrangements entered into were for the purpose of promoting a Canadian business. It had nothing to do with term.

I now turn to plaintiffs first ground of appeal, that the plaintiff corporation cannot possibly realize a capital gain considering the very nature of its activities. I fail to see any basis for this submission.

In South Shore Estates (Saltfleet) Ltd v The Queen, [1981] CTC 252; 81 DTC 5181, Grant DJ said at 257 [5185]:

I have not overlooked the fact that the 4 shareholders of Pendevco were contractors who, prior thereto, were engaged in the business of buying land and constructing homes thereon for the purpose of resale and that by reason thereof a heavy onus lies on the plaintiff to establish its contention that the plaintiff's management and shareholders intended to retain the apartment building to be erected as a rent producing asset for themselves and that the question of resale by them at a profit, if the primary intention could not be accomplished, formed no part of their reason for purchasing. However, I am convinced that this was a distinct and different enterprise on their part which did not include at that time . . . any intention of resale of any part of such project . . .

I also concur with the words of W S Fisher, KC, a member of the Income Tax Appeal Board, who said in No 13 v MNR, 3 Tax ABC 397; 51 DTC 117 at 402 [120]:

. . . I am not prepared to find that a person who is in the building and contracting business is precluded from making an investment in a building and that, even if he does it in such a way as to indicate his obvious intention of holding it as an investment, nevertheless he will be subject to income tax upon any profit which he makes upon the realization of his investment. The facts in each case must be carefully scrutinized and if such a taxpayer is able to bring forward evidence to show that what ordinarily might be deemed to be a profit earned in the ordinary course of business was, nevertheless, a profit obtained upon the realization of what can be truly found to have been an investment, then I think he is not subject to income tax on what should be deemed to be an accretion of capital and not ordinary business income.

As to the second ground of the plaintiffs appeal, it must also be rejected. I am not convinced that the advances were made or incurred for the purpose of gaining or producing income as contemplated by paragraph 18(1)(a) of the Act.

It is obvious from the facts of this case that the second corporation, Weisfeld Ltd, was set up to deal with the property in Guelph; it was going to be developing the real estate acquired by building townhouses and condominiums. Any profits derived therefrom would have been treated as income by Weisfeld Ltd. The latter company would have been taxed on the income, not Meisels; any profits remaining may have been transferred by way of dividends to the plaintiff Meisels and could have remained in its coffers untaxed until such time as it disposed of it by way of dividends to shareholders. Had Weisfeld Ltd been successful, there is no evidence of any other intention but to repay Meisels for the loan.

Had the plaintiff corporation been a direct participant in the development, the resulting profits, in the event the venture proved successful, would have been income and therefore taxable at the corporate rate. Likewise any losses therefrom would have been deductible to offset other income. It would have been an income-related expense. Mr Justice Pigeon referred to this consideration in Freud, (supra), as “fairness to the taxpayers” at 441 [5281]:

Such being the principles to be applied in cases when a profit is obtained, the same rules must be followed when a loss is suffered. Fairness to the taxpayers requires us to be very careful to avoid allowing profits to be taxed as income but losses treated as on account of capital and therefore not deductible from income when the situation is essentially the same.

The principals behind the plaintiff corporation decided otherwise from the outset; it used a newly incorporated vehicle to shield it from further liability other than the amount subscribed for.

The Stewart & Morrison case, (supra), is on all fours with the case at bar. The Supreme Court stated that the appellant provided its subsidiary with working capital by way of loans. The money was lost, and the losses were on account of capital, and the deduction prohibited by paragraph 12(l)(b) of the Act. That, I believe, was the substance of the transaction.

I am in complete agreement with the conclusions of D E Taylor, member of the Tax Review Board, who wrote:

. . . The loan of $101,000.00 was provided as working capital — nothing more and nothing less — during the years 1973 and 1974, not during the year under appeal — 1977. The financial difficulties of Weisfeld did not engulf the company until some time not earlier than 1976. It cannot be said that the loan in question here was advanced in order to protect the income base inherent in the capital stock of Weisfeld held by Meisels. The loan was a separate and distinct transaction — it had all the characteristics of just that (a loan) — quite distinctly different than that portrayed in Freud, (supra), and it was an investment on capital account, not a trading operation on income account. It must be so dealt with for income tax purposes.

For the foregoing reasons, the appeal is dismissed with costs.