Western Union Insurance Co. v. The Queen, 83 DTC 5388, [1983] CTC 363 (FCTD)

Dubé, J:—The central issue raised by this appeal is whether a bonus in the amount of $325,000 earned by the plaintiff company on a loan of $1,125,000 it made to WWW Developments Ltd (“WWW”) in 1974 was income of the plaintiff taxable in its 1976 taxation year, when the loan was paid in full, according to the reassessment of the Minister of National Revenue, or whether the bonus ought to be considered as a capital gain for that year, as characterized by the plaintiff in its income tax return, or alternatively whether it was taxable in the 1974 taxation year, the year the loan was advanced (and therefore statute-barred), as claimed by the plaintiff in its statement of claim, or whether it ought to be amortized over the duration of the loan, as characterized by the plaintiff in its own financial statements.

The plaintiff is an Alberta general insurance company with head office at Calgary. It is in the nature of its business to invest excess funds in a largely diversified portfolio of investments consisting primarily of bonds, debentures and dividend-yielding stocks. Only on one occasion had it made a previous loan, some 15 years before making the loan in question.

In 1974 the plaintiff was approached by WWW which was desirous of developing a 2,500 acre parcel of land near Calgary. Apparently, WWW could not obtain the loan from banks or other lending institutions. Both companies, whose chief excecutive officers are on friendly terms and control a holding company (“Wesco”) with 25% of the shares in WWW, came to an agreement spelled out in a letter, dated September 25, 1974 from the solicitors of the plaintiff to the solicitors of WWW.

The agreement provides that the plaintiff will lend the sum of $1,125,000 on the security of a first registered mortgage on the land in question, that WWW “will pay Western as a bonus for the making of the loan the sum of $325,000, payment to be made by deduction from the proceeds of the loan and/or at the time of advance thereof”. The loan will bear interest at 3% over the prime rate of interest charged by the Canadian Imperial Bank of Commerce, said interest payable on the entire balance of $1,125,000, both the loan and interest thereon to be paid in full by October 2, 1978. The sum of $800,000 (the amount actually received by the borrower) will be unconditionally guaranteed by Wesco for 25%, by Weber Bros Realty Ltd for 20%, and by several other reputable guarantors for the remaining 55%. WWW will be entitled to obtain partial discharges on parcels of the mortgaged land at a release price of $2,000 per acre.

In answer to the letter aforementioned of September 25, 1974, WWW replied that it accepted the terms and “has agreed to pay to you the sum of $325,000 as a bonus for the making of such loan. Payment is to be made by deduction of the sum of $325,000 from the proceeds of the loan at the time it is advanced”. In a separate letter, WWW directed the plaintiff and its solicitors to advance the bonus money and the balance of the loan to its own solicitors. On September 25, 1974 the plaintiff sent to its solicitors its cheque in the amount of $800,000 and on October 21, 1974 another cheque in the amount of $325,000, the latter amount being described as “balance of loan”. The $325,000 was not remitted to the borrowers, that amount was returned by the solicitors to the plaintiff.

On September 27, 1974 the plaintiff had received another offer of a loan from Heitman Financial Services (Quebec) Limited for an amount of $1,400,000, carrying a bonus (called “interest reserve”) of $300,000, a rate of interest of 4% over the prime commercial lending rate of the Bank of Montreal, to be repaid in full in 24 months. That offer was turned down by WWW, apparently because certain features of the loan were more stringent than the plaintiff’s conditions, namely the requirements for personal joint and several guarantees by all the guarantors, the shorter duration of the loan and the higher costs per acre ($12,000 and $18,000) for mortgage release.

On May 7, 1976 WWW exercised its right to prepay the principal amount and interest thereon and paid the plaintiff the sum of $1,396,748.06 representing its entire indebtedness to the plaintiff under the loan.

Although the plaintiff characterized the bonus as a capital gain in its 1976 income tax return, on its books it had amortized / of the amount for the year 1975, and /3 * 1976. In so doing it had followed the advice of its accountants: the loan was for four years, but the year 1974 was almost over when the loan was made and the loan was repaid two years earlier than anticipated. In other words, the plaintiff intended to amortize the bonus over the full duration of the loan, but the advanced repayment caused it to complete the amortization in the second year.

The bonus issue was first raised in June 1979 when officers of National Revenue met with the president of the plaintiff’s company in his office. He thereupon turned all the relevant documents over to them. On December 15, 1980 in his notice of reassessment the Minister reassessed the bonus as income earned in the plaintiff's 1976 taxation year. That year is the sole taxation year before me under the instant appeal.

Each party called on a chartered accountant for its expert evidence.

On behalf of the plaintiff, Mr R J Whitehead of Coopers & Lybrand advised that generally accepted accounting principles require that the bonus either be recorded as income in 1974, or amortized over the term of the loan. If the bonus can be regarded as having been paid to secure a favourable rate of interest, then the bonus essentially become prepaid interest and ought to be amortized over the term of the loan. However, if the bonus is considered to be in the nature of a commitment fee to guarantee the availability of funds, or in the nature of compensation to the lender for making the loan, then the bonus ought to be recognized as income upon receipt in 1974. The expert felt that the second option ought to prevail. He stated that either the high rate of interest or the extraordinary size of the bonus “should not necessarily lead to the conclusion that the loan in question involved a high degree of risk’. He was unsure as to why the chartered banks were unwilling to finance a transaction of this nature, but he presumed “that such reluctance probably stemmed from uncertainty as to whether the borrower would have sufficient cash flow to meet its required payments of principal and interest in a timely fashion”. He thought that because of the valuation of the property (over $1,000,000) “there was virtually no chance of Western Union failing to recover the full amount of principal and interest”. He concluded that the bonus ought to “be regarded as consideration for providing the loan and was therefore earned in 1974, the year during which the financing took place”.

The chartered accountant called on behalf of the Crown, W K Detlefsen of Thorne Riddell, suggested that there were three ways in which the bonus might have been recorded as income in the accounts of the plaintiff: (a) at the time of the loan in 1974, (b) amortized throughout the duration of the loan, (c) after full collection in 1976. In his view, the first alternative is con- trary to generally accepted accounting principles. In his opinion, “the substance of the flow of funds in 1974” was that the plaintiff advanced $800,000 to WWW. In effect, the $325,000 bonus never left the control of the plaintiff. He stated that “one of the objectives of accounting is to report the results of economic events”. He quoted Skinner on Accounting Principles: [1] “While legal rights and obligations are important, it is also important that they not be permitted to obscure the economic effect of transactions entered into”. The witness felt that one must look to the substance and not the form of the transaction. He offered several quotes and opinions from well known authorities in support of his view that the second alternative ought to be followed, namely that the bonus be recorded on a pro-rata basis during the duration of the loan. (Again, that was the procedure used by the plaintiff in its own financial statements, but not in its income tax returns.)

Another and more definite case of discount on mortgages arises where the mortgagor “pays” a bonus for the loan, a condition especially common in connection with junior mortgages. [2]

Where the investor pays a fee or commission in order to secure the mortgage, in addition to the face of the instrument, the mortgage is in effect being acquired at a premium. [3]

In our opinion, the difference between purchase cost and the ultimately realizable face value of the mortgage, ie, the discount, is earned neither at the time of purchase (it is a generally accepted accounting principle that one does not recognize a profit on a purchase) nor at the time of final payments. Such discount, which essentially is in the nature of interest additional to that specified in the mortgage instrument, is earned and should be recognized ratably over the life of the loan. [4]

Furthermore, if the association does not function in a particular case as a “money broker”, ie, bringing another willing lender and the borrower together, but on the contrary, directly commits or lends its own funds to the borrower, then any “loan commission” (not currently collected and not substantially equivalent to actual costs incurred in placing the loan on the books) charged to the borrower by advancing funds of a lesser amount than the face value of the note, may generally be deemed a euphemism for unearned interest or discount (or for additional unearned interest if the note explicitly provides for interest on the unpaid balance of funds actually advanced). As stated in Audits of Savings and Loan Associations (ACIPA, 1962) at pp 42-3: ...whenever the initial service charges materially exceed the cost of originating and placing new loans on the books, such excess should be deferred over the life of individual loans or deferred through use of a representative block method, related to the life of all loans. [5]

In our opinion, it is improper and contrary to generally accepted accounting principles for the bank to take the entire amount of discount into income upon purchase of the mortgages. As for the amortization period, we believe it is acceptable to amortize unearned discount over a period approximating the average life of mortgage loans or purchased mortgages on the books of the accounting entity. [6] Under par value accounting, securities are recorded at par at the time of purchase and the premium or discount is recorded in a separate deferral account and schedules for amortization to maturity of the security. [7]

Mortgage investments and guaranteed investment certificates (held in the longterm investment fund) should be considered to be fixed term securities and accounted for as such. If mortgages are bought at a premium or discount, they should be amortized toward face value at maturity. [8]

Premiums and discounts on the purchase of fixed term securities should be amortized over the term of the securities. [9]

Mortgages should be accounted for as fixed term securities. [10]

In my view, the plaintiff received no bonus in 1974. The substance of the transaction reveals that the amount that really passed between the plaintiff and WWW at the making of the loan was the sum of $800,000. The fact that the plaintiff placed its $325,000 cheque in the hands of its own solicitors, who returned an equal amount to their principal, does not constitute a bonus paid by WWW to the plaintiff. At the end of the loan period, had the borrower only repaid the $800,000 it received, then the plaintiff would have touched no bonus at all. It is only after the $800,000 actually advanced was repaid that the bonus came into the hands of the plaintiff along with the balance of the loan, and that was not in 1974.

The decision in Lee v Commissioners of inland Revenue, 25 TC 494, is authority for the proposition that no payment is actually made when amounts are merely exchanged between a convenantor and a covenantee.

In Unconscionable Transactions Relief Act, [1962] OR 1103 at 1118, it was held that a bonus is earned, not at the time of the loan, but through the passage of time. In Royal Trust Co et al v The Queen, [1980] CTC 2900; 81 DTC 5338, Addy, J of this Court said that one must look at the substance of the transaction, where a vendor uses his own money to assist the purchaser. The Supreme Court of Canada in Cox v MNR, [1971] CTC 227; 71 DTC 5151, looked at a simultaneous exchange of cheques and described it as a machinery used to effect a gift.

The third alternative, recording the bonus in 1976, was considered by the expert as acceptable and even preferable, if the loan was to be considered very risky, “of such severity as to question the recoverability of the loan”. He felt he did not have adequate information to formulate an opinion on that score.

It is to be recalled, however, that the plaintiff’s own expert suggested that the loan did not present a high degree of risk. In my estimation, the loan was not specially hazardous. After all, the $800,000 actually paid out by the plaintiff was fully secured by solvent guarantors. Moreover, the land in question mortgaged to the lender was considered to be worth at least $1,000,000 and probably much more. The President of the plaintiff testified that he had been provided with an evaluation dated July 16, 1974 placing a value of $9,900,000 on the land, based on the present worth of future developments.

I find therefore that the bonus ought to be amortized over the duration of the loan, as the plaintiff did in its own books showing two-thirds of the bonus as earned in the taxation year 1976.

I now come to the second prong of the issue, whether the bonus constituted capital gain or income. I do not find it either necessary or useful to review all the classic cases usually canvassed in trading matters. Suffice it to repeat that the mere fact that this is an isolated transaction of its kind, or almost, does not eliminate the possibility that it was an adventure in the nature of trade (see Lord Simonds in Edwards v Bairstow)." [11] Another criterion is that if the transaction is of the same kind and carried on in the same way as a transaction of an ordinary trader in the field, then it may fairly be called an adventure in the nature of trade (see MNR v James A Taylor, [1956] CTC 189; 56 DTC 1125). Any gainful use to which a taxpayer may put any of its assets prima facie amounts to the carrying on of a business (see American Leaf v Director-General of Inland Revenue, [1978] STC 561.

Closer to the mark, in an Exchequer Court of Canada decision [12] of 1964 Cattanach, J held that a bonus of $56,000 for a loan of $125,000 was income earned by the lender, a former distributor of truck parts who was gradually disposing of his assets. The learned judge said that, if the bonus was the sole consideration for the loan, there would appear to be a very strong probability that it was interest, but where there was interest plus a bonus, then the bonus was to be considered as an inducement to the lender to incur the risk and “the lump sum payment, not being payment merely for the use of the money, is, in the absence of very special circumstances, a profit from an adventure in the nature of trade”. He continued at 527:

There can be no doubt that a moneylender who advances money in the course of an established business on terms whereby he charges interest as such plus a fixed amount determined by reference to the special risk involved, would count as profits from his “trade” not only the interest collected as such, but the additional amounts charged by reason of special risks. If it be true that such an amount is a profit from a moneylender’s trade, it follows, in my view, that, when a person who is not a moneylender enters into such a contract and thus embarks on an adventure in the nature of the moneylender’s trade and earns a similar profit, he acquired a profit from an adventure in the nature of trade.

He concluded that “what the appellant did here is precisely what an ordinary moneylender would do”.

In that case, as well as in Stuyvesant-North Ltd v MNR, [1958] CTC 154; 58 DTC 1092, the Court distinguished the Lomax case [13] wherein certain premiums, obtained by an English company from its wholly owned Finnish subsidiary in refunding an indebtedness of the latter to the parent company over a long period, were held to be capital and not income. Thurlow, J, as he then was, held that the question which was being considered in Lomax by the Court of Appeal was not whether or not the premiums were profits of a trade, but whether or not they were income chargeable to tax under Case V of Schedule D of the English Statute. He found that the question in issue in Stuyvesant was whether or not the bonus is income. He held that “if it is a receipt from a transaction carried out in what is truly the carrying on or carrying out of the taxpayer’s business”.

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 own established business. It did precisely what an ordinary moneylender would do except, perhaps, that it charged more.

The plaintiff contends that even if the bonus were to be considered income, the year 1974 is still the only appropriate taxation year during which the bonus must be recognized for tax purposes under the provisions of subsection 76(1) of the Income Tax Act, which reads:

76. (1) Where a person has received a security or other right or a certificate of indebtedness or other evidence of indebtedness wholly or partially as, in lieu of payment of, or in satisfaction of, a debt that was then payable, the amount of which debt would be included in computing his income if it had been paid, the value of the security, right or indebtedness or the applicable portion thereof shall, notwithstanding the form or legal effect of the transaction, be included in computing his income for the taxation year in which it was received.

In my view the subsection does not apply to the bonus in question which cannot be considered to be “a debt that was then payable”. Again, the substance of the transaction indicates that the amount of $325,000 was not effectively payable by the borrower in the first year of the loan but in the course of its duration.

My conclusions are that the plaintiff earned $325,000 in income from its loan to WWW and that the amount ought to be amortized over the duration of the loan, as reflected in the plaintiff’s own bookkeeping. Therefore, /3 of the bonus ought to be included in the plaintiff’s income for the year 1976, the sole taxation year in issue in this appeal. Accordingly, the reassessment for the plaintiff's 1976 taxation year should be referred back to the Minister for further reassessment so as to reduce the reassessed income from $325,000 to $216,539.

Each party, being partly successful, will bear its own costs.