Barbican Properties Inc. v. The Queen, 97 DTC 122, [1996] 2 CTC 2615 (TCC), briefly aff'd 97 DTC 5008 (FCA)

Margeson J.T.C.C.: - This appeal is from Notices of Reassessment issued to the Appellant (and its predecessors) as follows:

There was an Agreed Statement of Facts filed as follows:

Agreed Statement of Facts

1. The Appellant is an amalgamated British Columbia corporation having its principal place of business at 650 West Georgia Street, Vancouver, British Columbia, V6B 4N7. Barbican’s predecessors include another corporation named Barbican Properties Inc. (“Old BPI”), three corporations named Barbican Developments Ltd. (“BDL-1”, “BDL-2” and “BDL-3”) and Village Gate Inns Ltd. (“Village Gate”).

2. This appeal relates to the following Notices of Reassessment issued to the Appellant and its predecessors:

Date	Notice Number	Taxpayer
			Taxation Year End
October 29, 1993	3838502	Appellant	December 31, 1991
October 29, 1993	3838486	Old BPI	December 31, 1990
October 29, 1993	3838499	BDL-3	December 31, 1990
October 29, 1993	3838487	Old BPI	December 31, 1989
December 16, 1994	3843393	BDL-3	December 31, 1989

3. The business of the Appellant and its predecessors is and was throughout the period relevant to this appeal the acquisition and use of real estate for the purpose of earning business income. The Appellant and its predecessors have always computed their income on the accrual basis for financial statement purposes and for income tax purposes.

4. In total, the Appellant and its predecessors examined between 150 and 200 properties of the Royal Bank and in the result acquired approximately 75 of those properties from the Royal Bank.

5. In 1985 and 1986, Old BPI and Village Gate borrowed money from The Royal Bank of Canada (the “Bank”) and used the borrowed money to buy real property from the Bank for the purpose of earning income. The dates and amounts of the loans, and the property acquired, are as follows:

		Amount Property Acquired
Date of Loan	Borrower
August 15, 1985	Old BPI	$ 3,150,000	Harvest Heights Apartments
			Estevan, Saskatchewan
August 31, 1985	Old BPI	$ 4,135,000	Commerce Building
			Regina, Saskatchewan
September 1, 1985	Village	$22,500,000	Terrace Inn Hotel
	Gate		Edmonton, Alberta
September 30, 1985	Old BPI	$ 1,550,000	Worldwide Energy Building
			Bonnyville, Alberta
January 31, 1986	Old BPI	$10,100,000	Maryland Office Park
			Calgary, Alberta
June 30, 1986	Old BPI	$11,500,000	Five Ten Fifth Office Building
			Calgary, Alberta

6. The terms of the loans relating to the accrual and payment of interest were similar and may be summarized as follows:

(a) The borrower was obliged to pay interest on the principal amount of the loan at a stipulated rate, accrued daily and payable monthly.

(b) If the operating revenue from the property net of operating costs in a calendar year was insufficient to cover the interest payable in that year, the borrower was entitled to defer payment of that interest for a limited period of time.

(c) The borrower was liable for any overdue interest until paid. Overdue interest bore interest at a rate equal to that charged on the principal amount of the loan. Any deferred interest and interest thereon was due and payable, at the latest, upon the maturity of the loan or upon the sale of the property, whichever occurred first.

7. The real estate acquired by Old BPI and Village Gate with the money borrowed from the Bank was property the Bank had obtained by foreclosure from defaulting borrowers.

8. Each of the loans was secured by a mortgage on the property concurrently acquired from the Bank, with the Bank’s recourse in the event of a default by the borrower being limited to the property.

9. The entire purchase price of each property was funded by the loan.

10. By a series of amalgamations between 1988 and 1990, the rights and obligations of Old BPI and Village Gate under the loans became the rights and obligations of the Appellant.

(a) On January 1, 1988, Village Gate and BDL-1 were amalgamated to form BDL-2, so that on that date the rights and obligations of Village Gate became those of BDL-2.

(b) On December 28, 1988, BDL-2 and Village Gate Developments Ltd. were amalgamated to form BDL-3, so that on that date, the rights and obligations of BDL-2 became those of BDL-3.

(c) On December 31, 1990, BDL-3 and Old BPI were amalgamated to form the Appellant, so that on the date the rights and obligations of BDL-3 and Old BPI became those of the Appellant.

11. The right to defer payment of interest on the loans was exercised by the borrowers and their various successors by amalgamation in each of their respective taxation years ending December 28, 1988, December 31, 1988, December 31, 1989, December 31, 1990 and December 31, 1991.

12. By Notices of Reassessment dated October 29, 1993, the Minister of National Revenue reassessed the Appellant to disallow the deduction of interest as follows:

		Taxation Year End Amount Disallowed
Notice Number Corporation		Taxation Year End
Notice Number	Corporation
		December 31, 1991	$2,101,203
(1) 3838502	Appellant	December 31,1991
(1)3838502	Appellant
(2) 3838486	Old BPI	December 31, 1990	2,160,689
	Old BPI
(2)3838486
	BDL-3	December 31, 1990	352,889
3838499		December 31,1990
(3)3838499	BDL-3
3838487	Old BPI	December 31, 1989	2,686,379
(4)	Old BPI	December 31,1989
(4)3838487
	BDL-3	December 31, 1989	663,819
(5) 3838500		December 31,1989
(5)3838500	BDL-3
	Old BPI		705,635
(6) 3838488		December 31, 1988
(6)3838488	Old BPI
		December 28, 1988	1,475.856
(7) 3838482	BDL-2	December 28,1988
(7)3838482	BDL-2
			$10,146,470

13. These reassessments resulted in increased tax payable for taxation years ending December 31, 1989, December 31,1990 and December 31, 1991.

14. There was no increase to tax payable for the years ending December 28, 1988 and December 31, 1988, but the disallowance of the interest deduction reduced the non-capital losses for those years and the resulting non-capital loss deductions for subsequent years, further increasing tax payable for those years.

15. By Notices of Objection filed on January 18, 1994, the Appellant objected to the reassessments (1) through (5).

16. A further notice of reassessment, number 3843393, having been issued in respect of BDL-3 on December 16, 1994 for the taxation year ending December 31, 1989, replacing reassessment (5) and allowing the objection only in part, the Appellant hereby appeals that reassessment to this Court pursuant to paragraph 169(l)(a)of the Act.

17. Ninety days having elapsed from the date of the filing of the notices of objection in respect of reassessments (1) through (4) without the Minister having notified the Appellant that he has vacated or confirmed those reassessments or reassessed, the Appellant hereby appeals the reassessments to this Court pursuant to paragraph 169( 1 )(b) of the Act.

Further evidence was given in Court. T.G. (Greg) Greenough testified that he was involved in the real estate business since 1959 as a developer of properties, mainly residential but including some commercial. His company was approached by The Royal Bank principally for its expertise. His company became a minor shareholder together with eight others as well as a pension fund in the creation of the Appellant company.

There were 1,000 common shares issued. Three hundred were class A shares with voting rights. The Royal Bank had 30, the pension fund at 30 and each of the 8 others had 30.

There were 700 class B shares - non-voting of which The Royal Bank had 660 and the employees had 40.

The equity was 3 million dollars. Each party with shares would name a director. Neither the bank nor the pension plan could vote on acquiring properties from The Royal Bank. The Royal Bank would propose properties to be purchased and the board would vote on their acquisition.

Each director had to attend every meeting without a substitute or else that entity had to sell its shares. The only exception was if a director was incapacitated from attendance.

The board formed a management team. The Royal Bank would present properties to the company which would come up with a fair market value for them. The Board decided whether to buy or reject the property based upon whether it reasonably believed the property would be able to earn income. In order to buy a Royal Bank property there had to be a quorum of five directors and four of these directors had to vote in favour of its purchase. This witness could not remember one such property being pur- chased where even one director voted against it. He said that the bank had no more coercive power than any other member. Seventy five properties were purchased out of 100-150 that were considered.

The properties were divided into two categories:

1) operating properties

2) development properties consisting of raw land or buildings with nonrevenue producing capabilities or short-term revenue producing properties where the value was in re-development for:

A) 1 to 3 years B) 3 to 5 years C) 6 to 7 years D) 8 to 10 years

The financing was by debenture with different terms for each class.

The company borrowed 100 per cent of the funds from The Royal Bank together with funds needed for renovation as they were done. The security consisted of the properties individually. There was no cross-collaterization.

The principal and interest had to be paid before any profit. The assumption was that there would be a profit. This did not always happen. It was believed that the company could improve management and turn previously unprofitable properties around even though there might be a periodic cash deficiency. There were times when there were periodic cash deficiencies but, subsequently, these deficiencies were made up and the properties continued to operate.

The six properties involved in this case were:

(1) Harvest Heights Apartments Estevan, Saskatchewan

(2) Commerce Building Regina, Saskatchewan

(3) Terrace Inn Hotel Edmonton, Alberta

(4) Worldwide Energy Building Bonny ville, Alberta

(5) Maryland Office Park Calgary, Alberta (Willowglen Business Park)

(6) Five Ten Fifth Office Building Calgary, Alberta

Exhibits A-2 and A-3 were the original debentures for the financing of Harvest Heights Apartments, Estevan, Saskatchewan and the Amended Agreement for the same property. The other five properties in question were covered by substantially similar agreements.

Both agreements included accrued interest clauses but the original document provided that when the accrued interest reached a certain amount it could trigger a default in the debenture. It was believed that this might happen so the amendment provided that the deficiency would be accrued and would become payable at the same time as the principal.

The witness believed that each of the six properties in issue were good investments and that when purchased it was believed that they would be profitable.

In 1989 the company had 165 million dollars in purchases and equity of 30 to 50 million dollars. The witness agreed that in the reassessments, Revenue Canada only disallowed the deduction for interest where it was deferred. The properties in question had no cross-collaterization so that in the event of a default in one property, the others were not affected even in the event of a deficiency in the failed property.

In cross-examination the witness agreed that the properties in question had all been “distressed” properties, so to speak. They had all been foreclosed on but the witness said that they did not believe any would fail.

By 1988 the company knew that these properties were not performing well. The witness reviewed Exhibit R-l, the Consolidated Operating Summary for 1988 showing three of the properties with a negative net operating cash flow and three with a 0 operating cash flow.

In 1989, Willowglen was negative, Five Ten Fifth was at 0, the CIBC Building was at $316 plus and World Wide Energy was at 0. In 1990, all were at 0 except the CIBC Building at $344 and in 1989 all six were at 0.

In spite of this performance, the witness believed that their decisions to purchase were fair and reasonable under the circumstances.

Counsel for the Appellant read in portion the discovery evidence of James Lawson including questions and answers 4 to 10, 50 to 52 and 63 to 65 with respect to the process of acquiring the properties, the basis for the reassessments and the nature of the security documents. Mr. Lawson had agreed in the examination tendered that this was not a tax avoidance issue.

The Respondent called Jim Lawson, a tax auditor for Revenue Canada who had audited the Appellant and recommended the disallowance of the interest deduction. He said that the Appellant was claiming a deferred interest deduction in the T2S1 but they were not claiming it in the company’s consolidated statement as an expense. “This stuck out” as far as this witness was concerned. He reviewed the Agreement, correspondence, talked to officials of the company, checked the file on each property, looked at the efforts to make the properties profitable, met with the controller of the company, the accountants and re-adjusted the return.

He reviewed correspondence from the Appellant and operating summaries which made him wonder if the interest was ever going to be paid. He did not believe that the cash flow was there. The properties were valued at nil for share value purposes. Harvest Heights was valued at 3 million dollars and had debts of 4 million dollars.

In cross-examination he agreed that there was a different set of considerations for deductibility under the Income Tax Act, (the Act) and the preparation of the consolidated statement but he concluded that it was a contingent liability and that it would not be paid even if there was a so-called “legal obligation” to pay the interest. He believed that some of the properties might be able to shed their non-profitable status.

In re-direct he said that he considered all the facts, the mortgage and the non-recourse aspects of the loan agreements in making his decision that the interest claims were contingent liabilities.

Mr. John Thomas Brown was the President of Barbican Properties Incorporated. He said that the company could have paid off the deferred interest between 1988 and 1991 but it did not because the properties were on a “stand alone basis”. They were treated in accordance with the loan agreements. Some of them had paid down the interest then the deferred interest built up again and in some cases the deferred interest was never paid down.

He agreed that the properties in question were “distressed” when bought and could not pay the deferred interest but he believed that with work done on them they would become “non-distressed” properties but did not know how long it would take. There was no net cash flow by 1988 on any of the properties. Deferred interest was accrued each year and increased to 1991. The plan was to pay deferred interest and current interest if possible.

He agreed that from January 1988, five of the properties were identified as problem properties. He confirmed earlier testimony with respect to the intentions of the amendment agreement. He was the author of Exhibit R-5. By 1990, they were trying to prevent a technical default but had not reached the stage where they believed that the deferred interest would only be paid in the event of a sale. He subsequently admitted that they had 1990 in mind as the year during which they would “give up on them” but would not agree that by February 1990, there was little chance of the deferred interest being paid. He indicated that perhaps today he would accept that date. For each of the six properties the share valuation was nil and the property valuations were less than the cash base.

He wrote the letter to the bank (Exhibit R-10) to advise them that they should take out a reserve for a loan loss in some properties.

He said that there was a point when Barbican changed its policy as to how it was to treat the deferred interest for tax purposes. Between 1985 and 1991, he could not say with certainty that the sales value of the properties or the operating income would be sufficient to pay off the indebtedness including deferred interest but they continued to try to do their best.

It was agreed that between 1988 and 1991, the company realized that there was a real risk that the deferred interest might not be paid out of operating income or from the sale of the properties.

His position was that at the time of acquiring the properties they reasonably believed that each individual property would be profitable but they might be wrong on one or more of them.

He recognized the Exhibits R-7, R-8 and R-9 as Real Estate Valuation Summaries prepared by Barbican on an annual basis.

In cross-examination he said that deferred interest was at first recorded as a footnote to show net value and not because it was regarded as a contingency. The statements’ primary purpose is to report fairly to the shareholders and in accordance with generally accepted accounting principals. The company did not believe it was a contingency.

He took the position that the company could not just walk away from the properties but had to “see them through to the end”. He said that Exhibit R-5 was not acted upon but was a negotiating letter.

This witness said that Exhibits R-7, R-8 and R-9 would vary monthly and had nothing to do with the company’s legal obligations.

He confirmed the purpose for the amendments. He said that there was no time between 1985 and 1991 that he knew that the deferred interest would not be paid.

Argument of the Appellant

In argument, counsel for the Appellant said that paragraph 20(1 )(c) of the Act is the relevant section to be considered in determining whether the deferred interest was deductible. You look to see what was payable in respect of the year pursuant to a legal obligation to pay. His position was that the section referred to a “legal obligation” and not a “factual obligation”. The obligation here was not contingent. The repayment clause made it clear that the legal obligation existed each month of each of the years in question. The question is, was it owing? He answered, yes. It was payable and therefore it was not contingent.

Counsel argued that an amount is “payable” if the taxpayer had a clearly legal, though not necessarily immediate, obligation to pay it. He cited Guay Ltée v. Minister of National Revenue (sub nom. Guay Ltd. v. Minister of National Revenue), [1971] C.T.C. 686, 71 D.T.C. 5423 (F.C.T.D.); affirmed [1973] C.T.C. 506, 73 D.T.C. 5373 (F.C.A.) affirmed [1975] C.T.C. 97, 75 D.T.C. 5094 (S.C.C.).

It was possible at each year end to calculate the amount of interest accrued to that point and the amount was certain. There was no unsatisfied future event or condition required to create the legal obligation or to determine the amount of that obligation.

It was the position of counsel that only the passage of time stood between the accrual of the interest and the date at which payment was due - August 15, 1995. It was not contingent. He cited Winter v. Inland Revenue Commissioners (sub nom. Sutherland (Deceased) v. Inland Revenue Commissioners), [1963] A.C. 235, [1961] 3 All E.R. 855 [House of Lords] and Lord Guest where he said at page 867:

Contingent liabilities must therefore be something different from future liabilities which are binding on the company, but are not payable until a future date. I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence on an event which may or may not happen.

Counsel distinguished Mandel v. R. (sub nom. Mandel v. The Queen), [1978] C.T.C. 780, 78 D.T.C. 6518 (F.C.A.) and Samuel F. Investments Ltd. v. Minister of National Revenue (sub nom. Samuel F. Investments v. Minister of National Revenue), [1988] 1 C.T.C. 2181, 88 D.T.C. 1106 (T.C.C.) and the case of J.L. Guay, supra.

The difference suggested was that in the case at bar, if at the end of each of the years, you asked the question, “what does the Appellant owe The Royal Bank?” the answer would be, “the principal amount and all interest accrued to that date that was not yet paid, including the deferred interest.”

Counsel cited Meteor Homes Ltd. v. Minister of National Revenue, [1960] C.T.C. 419, 61 D.T.C. 1001 (Exch.) with approval in support of his contention that “the possible occurrence of a condition subsequent to the creation of a liability is not grounds for postponing the accrual.”

He further argued that a limitation in the legal remedies of a creditor may preclude the recovery of the debt, but does not change the legal obligation to pay or cause the debt to become a contingent liability.

Counsel for the Appellant argued that his position was consistent with the scheme of the “Act”, sections 79 and 80. Those sections deal with the consequences of a default and foreclosure if the debt is not paid and section 80 applies in the event of a sale and deficiency.

Counsel contended that the position taken by the Respondent creates an unreasonable result. In the event that cash flow improves, if the property is sold in the future and some of the deferred interest is paid the Appellant could not claim it as a deduction since it is only deductible in the year it is payable and the Appellant could not force the Respondent to reassess the years 1988 to 1991.

Counsel submitted that the appeal should be allowed.

Argument of the Respondent

Counsel for the Respondent argued that there was no legal obligation by the Appellant to pay the deferred interest. The liability was contingent. If it was contingent it was not a legal obligation.

Counsel referred to Holotnak v. R. (sub nom. Holotnak v. The Queen), [1987] 2 C.T.C. 217, 87 D.T.C. 5443 (F.C.T.D.), in support of the contention that there was no legal obligation to pay or no enforceable covenant to pay under paragraph 20(1 )(c) of the Act. The bottom line was that the bank could not enforce payment.

In Samuel F. Investments Ltd. v. Minister of National Revenue (sub nom. Samuel F. Investments v. Minister of National Revenue), [1988] 1 C.T.C. 2181, 88 D.T.C. 1106 there was uncertainty as to the time of payment and as to whether or not it would ever be paid. It was contingent in that case as it is in the case at bar.

This was not a future obligation. If there were certainty, 1) that the payment would be made; 2) of the amount payable and, 3) the time by which the payment would be made but only the time of payment was deferred, it would still be a real and existing liability but in the nature of a future obligation. That is not what we have in the case at bar. See Winter v. Inland Revenue Commissioners (sub nom. Sutherland (Deceased) v. Inland Revenue Commissioners), [1963] A.C. 235, [1961] 3 All E.R. 855 (H.L.).

Counsel argued that just because you can calculate the amount owing at any time that does not make it a “legal obligation” if its payment can be precluded because of the provisions of the agreement. When you combine the effect of the clause in the agreement with the considerable evidence of the uncertainty that the properties would ever generate the necessary funds to enable the bank to require payment of the deferred interest, that clinches the matter. Mr. Brown may have had the best of intentions to operate at a profit but at any given time the company was not obligated to make payment of the deferred interest unless there were sufficient funds generated from operating income to pay it.

Counsel disagreed with the interpretation placed upon L.H. Mandel, supra, by counsel for the Appellant and said that that case was similar to the case at bar because it was not a liability to pay pending the happening of a certain event but was a liability to pay the balance if, but only if, the film was profitable, which was not that certain.

Counsel argued that the Court can look to surrounding circumstances and the normal practices of the Appellant to determine if the expense was definite. See Urichuk v. R. (sub nom. Urichuk v. Canada), [1993] 1 C.T.C. 226, 93 D.T.C. 5120 (F.C.A.); Isba Construction Inc. c. Ministre du Revenu national (sub nom. Isba Construction Inc. v. Minister of National Revenue), [1990] 2 C.T.C. 2491, 90 D.T.C. 1940 (T.C.C.); Moffat v. R. (sub nom. 398827 Ontario Ltd. v. Canada), [1994] 2 C.T.C. 2047, 94 D.T.C. 1534 and Minister of National Revenue v. Mid-West Abrasive Co. (sub nom. Mid-West Abrasive Co. of Canada Ltd. v. Minister of National Revenue), [1973] C.T.C. 548, 73 D.T.C. 5429 (F.C.T.D.).

Counsel argued that the Court should consider the true commercial and practical nature of the taxpayers transactions. See Bronfman Trust v. R. (sub nom. Bronfman Trust v. The Queen), [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059 (S.C.C.) and when it does it is clear that the taxpayer was only obligated to pay the deferred interest to the extent that the six properties generated a sufficient cash flow or to the extent that there was a sufficient capital appreciation of the properties at the time of sale. The happening of these events was uncertain and those facts did not occur in this case.

Counsel argued that the appeal should be dismissed.

Analysis and Decision

The Court is satisfied that the amounts sought to be deducted by the Appellant in the years in question were not “amounts paid in the year or payable in respect of the years” for which they were claimed to be deduct- ible, pursuant to a legal obligation to pay interest, in accordance with paragraph 20(1 )(c) of the Act.

Further, the Court finds that the amounts were contingent liabilities within the meaning of paragraph 18( 1 )(i) of the Act.

Counsel for the Appellants argued that there was a difference between a factual obligation (which he contended did not exist here) and a legal obligation (which he contended did exist here). Fundamental to him was the argument that the amount of interest which was payable was calculable at any point in time and therefore the amount outstanding created a legal obligation which was not contingent.

This would appear to disregard the essential term of the agreement which clearly provided that the deferred interest payments would only have to be made if the net cash flow exceeded the interest payable or if there was a sufficient capital appreciation of the properties at the time of sale and otherwise it could be deferred and was indeed deferred in each of the years in question.

The fact was that there was no legal obligation to pay unless and until one of the two above conditions was met. The legal obligation did not exist each month unless these conditions existed.

When the Court asks the question, was the amount owing, it must conclude that it was not owing unless one of the conditions was met. Surely, where one clause in the agreement specifies a repayment clause where interest is calculable with certainty but another clause specifies that no interest is payable under the earlier clause unless certain conditions are met, there is no legal obligation to pay the interest until the conditions are met and the liability to pay is “contingent”.

Simply put, as argued by counsel for the Respondent, the bottom line was that the bank could not enforce payment.

In this case, the Court finds that there was uncertainty as to whether the payment would ever be made because it would only be paid upon the satisfaction of one of the conditions. There was uncertainty as to the amount that would be paid because even though the repayment clause enabled the amount of interest that would normally be paid to be calculated, the only amount payable was to the extent of the net cash flow over the interest payable or the excess of the net sales value above the accrued amounts. There was uncertainty as to when the payment would be made because it would only be payable in any year when one of these conditions was met. That date was not certain at any time and indeed never arrived.

The conditions set out in Samuel F. Investments Ltd., supra, for disallowing the deduction on the basis of it being a contingent liability have been met.

The case at bar would appear to be very similar to the situation found in L.H. Mandel, supra and the Court finds here, as in that case, that what was involved “It was not, however, as to the balance, a liability to pay merely on the expiration of a period of time or on the happening of an event that was certain, or even likely, to occur. It was a liability — to become subject to an obligation to pay the balance if, (in this case the interest) but only if, an event occurred which was by no means certain to occur (in this case an excess of net cash flow over interest or excess of net sales value over the accrued amounts). The obligation was thus contingent on the happening of the uncertain event”. The Court in that case derived assistance from the speech of Lord Reid in Winter and Others, supra.

This Court is satisfied that what was involved here was not a future liability which was binding on the Appellant, but not payable until a future date. What was involved here was a “contingent liability”.

The Court finds no merit in the argument of counsel for the Appellant that such a finding reaches a result that is patently unreasonable or one that is not consonant with the Act.

The appeal is dismissed, with costs, and the Minister’s assessments are confirmed.

Appeal was dismissed.