Queenswood Land Associates Ltd. v. R., 97 DTC 1048, [1997] 2 CTC 2688 (TCC), rev'd 2000 DTC 6065, Docket: A-182-97 (FCA)

Lamarre Proulx T.C J .:

These appeals concern the Appellant’s taxation years ending December 24, 1986, December 31, 1987 and December 31, 1988.

The questions in issue were presented to me by both parties as follows:

a) whether the forgiveness of a debt in the amount of over $8,303,261, incurred pursuant to a loan agreement having for purpose the acquisition of lands, was the forgiveness of a capital debt or a trade debt;

b) whether the amount of $1,229,990 paid by the Appellant in the process of acquisition of a real estate company having incurred huge losses, was in the nature of a fee or a reduction of the indebtedness.

I find, after a reading of the case law to which I was referred by both parties, that the first question at issue should rather be whether the forgiveness of a debt incurred in a borrower-lender relationship, should be reflected in the statement of profit and loss in accordance with paragraph 80(1)(f) and section 9 of the Income Tax Act (the “Act”). Respecting the content of the second question at issue, I find it to have been well stated.

By consent, Exhibits A-1, A-2, R-l and R-2 were filed. Exhibit A-1 is composed of seventy-six documents appearing at Tabs 1 to 76. Exhibit R-l is composed of thirty-three documents appearing at Tabs 1 to 33. Exhibit A- 2 is the Loan Agreement between R-104 Holdings Ltd., (which hereafter will be referred to as R-104), and First City Developments Ltd. It is from the application of this agreement that the debts, whose forgiveness is at issue, will be incurred. Exhibit R-2 is a summary completed by an agent of the Minister of National Revenue (the “Minister”), of the amounts borrowed by R-104 from First City Financial Corporation Ltd. [1] from April 1, 1979 to July 31, 1986 for a total amount of $11,185,095 inclusive of interest and a summary of the costs of the inventory for the same corresponding amount and for the same period of time.

Mr. Hyman Soloway, an officer and director of the appellant since its incorporation in the early 1960s, testified for the Appellant. Mr. Kenneth Staple, an auditor at Revenue Canada, who was the Minister’s officer in the Appellant’s assessment, testified for the Respondent.

There was not really any dispute as to the facts. Queenswood Land Associates Ltd., an Ontario corporation, acquired on December 2, 1986 the shares of R-104, a British Columbia corporation that had been continued under the laws of the Province of Ontario on July 31, 1986. On December 24, 1986, the two corporations were amalgamated. I shall refer to the Appellant before its merger with R-104, as Queenswood No. 1.

Queenswood No. 1 was in the real estate business having to do mostly with land development and resale in Ottawa. It was doing well financially in the years when the events of this case took place.

R-104 was in the real estate business and had suffered considerable economic losses due to the fall of its real estate value, located in the municipality of Delta, in the district of New Westminster, located at a distance of about 15 miles from Vancouver, British Columbia.

Queenswood No. 1 had been informed by its accountants of a corporation in Alberta which was carrying losses, but for some reason, Queenswood No. 1 was not interested. Then in the spring of 1986, its accountants, through their branch in Vancouver, were informed of a loss company that was looking for a buyer. Mr. Soloway said that he went to Vancouver to look at the real estate owned by R-104 and to have it appraised. It was evaluated at $2,155,000. Both Queenswood No. 1 and First City, the financing corporation, were satisfied that this was the correct value of the real estate owned by R-104.

First City had financed R-104 for the acquisition of lands. As previously mentioned, Exhibit A-2 is the contract of loan between these two corporations. The recital clauses read as follows:

WHEREAS:

A. First City has agreed to arrange a loan or lines of credit for R-104 for its corporate purposes, including financing the Project (as hereinafter defined) upon the terms hereinafter set forth;

B. R-104 has agreed that First City is to participate in the revenues generated by R-104 from the Project upon the terms hereinafter set forth;

C. First City has agreed to arrange a Loan (as hereinafter defined) for the purposes as aforesaid upon and subject to the terms and conditions hereinafter set forth;

Counsel for the Respondent asked the witness, Mr. Soloway (who is an experienced lawyer), whether a loan agreement, which included participation in profits, was a normal financing agreement. The witness answered that this was not at all unusual and that by the clause for participation in profits, the lender was only looking for a better return on its investment. Counsel for the Respondent informed the Court immediately that this was not his view and that he would argue the contrary. No evidence to the contrary was adduced and at the time of argument, no supporting jurisprudence was presented.

Counsel for the Respondent also referred the witness to the following clauses of the agreement:

2.1 Subject as hereinafter provided, First City will lend or arrange to lend to R- 104 amounts required from time to time to fund Project Costs.

2.2 R-104 will pay interest from the date of the advance on all amounts advanced in respect of the Loan and outstanding and on overdue interest thereon at the rate of 2% per annum over the Prime Rate Factor (“Prime Rate Factor” defined in the Debenture).

3.2 At each time Statements are to be delivered to First City pursuant to the provisions hereof, and after the repayment of the Loan, R-104 shall pay to First City on account of the Additional Payment, one-half (1/2) of the Net Cash Flow from the Units or the Lands or the Project, the sales proceeds of which are or are required to be reflected in the Statements then delivered or required to be delivered to First City.

and Counsel for the Respondent relied more particularly on sub-clause 7-1(4):

(4) expend all drawdowns under the Loan for no purpose other than in connection with the acquisition of the Lands and the construction and completion of the Project and in accordance with the plans and specifications and change orders of the Project approved by First City;

Again, the witness saw nothing unusual in these clauses and only the lender’s interest to protect its advances.

The agreement shows also that the shareholders had given their personal guarantee for the loans and that the loans were secured by a charge on the lands and a floating charge on the assets. Clauses 2.5 and 2.6 of the said agreement read as follows:

2.5 The Loan, and payment of the Additional Payment, will be unconditionally guaranteed by the shareholders of R-104.

2.6 The Loan will be secured under the debenture dated May 1, 1979 and created, issued and deposited by R-104 to First City Trust Company and creating a first fixed charge on the Lands and a first floating charge on the assets and undertaking of R-104.

Tab 21 of Exhibit R-l is the unsigned and undated Memorandum of Understanding by three parties: R-104, First City Development Corp. Ltd., on behalf of itself and First City Trust Company and First City Financial Corporation Ltd., and Queenswood No. 1. The witness said that the Memorandum would have reached the final form in which it appears at Tab. 21, on May 21, 1986, after discussion between accountants and lawyers.

It stated among other things:

10. R-104 will file all returns of income required by the Income Tax Act (Canada) in respect of its taxation years ending March 31, 1985 and 1986, and concurrently with filing those returns, R-104 will refile its returns of income for its prior taxation years. All such returns will be prepared on the basis that interest expense and property tax in respect of any such taxation year will be capitalized in order to form part of the cost to R-104 of its interest in the Land for income tax purposes and that such cost will aggregate not less than $10,000,000....

10A. The obligation of Queenswood to purchase the Shares will be subject to no law having been passed on or before the closing date which prohibits the capitalization (for purposes of the Income Tax Act of Canada) of interest and property taxes as contemplated in clause 10 and subject also to no public statement having been made by or on behalf of the federal government announcing a proposed prohibition which is to be effective in respect of the capitalization contemplated in clause 10.

10B. Queenswood shall receive such proof as it and its auditors shall consider satisfactory that the land held by R-104 constitutes inventory and not capital property for purposes of the Income Tax Act Canada.

11. R-104 will receive a notice of assessment or re-assessment, as the case may be, from Revenue Canada, Taxation accepting the returns of income referred to in clause 10 as filed or substantially as filed.

13. Prior to Queenswood acquiring the shares of R-104, First City will release and forgive all but $1,400,000 of the indebtedness now owing by R-104 to First City, whether pursuant to the Debenture or otherwise, (without impairing or affecting the liability of any other person in respect of such indebtedness) and will enter into an agreement with R-104 to the effect that the remaining indebtedness owing by R-104 to First City will not bear interest after the date of such release and forgiveness (again, without impairing of affecting the liability of any other person in respect of such indebtedness).

17. The purchase price payable by Queenswood to Dawson pursuant to the Share Purchase Agreement will be $10.00...

Fee to First City

19A. Concurrently with the execution of the Share Purchase Agreement, Queenswood will execute an agreement with First City (the “Fee Agreement”) pursuant to which Queenswood will agree to pay to First City a total of $1,229,990 either as a fee to consent to the transactions contemplated by this Memorandum or otherwise. Queenswood will pay that fee in cash or by certified cheque to First City as follows:

a. as to $750,000, to First City concurrently with the closing of the Share Purchase Agreement; and

b. as to $120,000, to Shrum, Liddle & Hebenton, Barristers and Solicitors, in trust, concurrently with the closing of the Share Purchase Agreement together with an irrevocable direction to Shrum, Liddle & Hebenton to pay that amount together with all interest accrued thereon, if any, to First City twelve months after the date of closing of the Share Purchase Agreement; and

C. as to the balance of that fee, $359,990, to First City twelve months after the date of closing of the Share Purchase Agreement.

The obligation of Queenswood to pay such amounts to First City will be subject to each of the Preliminary Matters having been completed.

On December 22, 1986, the deal was concluded. The lender released the borrower, R-104, from the responsibility of paying any amount in respect of debts in excess of $3,384,990. This amount is composed of the value of the lands at $2,155,000 and the amount of $1,229,990 that Queenswood No. 1 had agreed to pay to conclude the deal. As we have just seen, in the Memorandum of Understanding, this amount was described as a fee. In the documents executed on December 22, 1986, it was shown as a reduction of the debts owed by R-104. Queenswood No. 1 loaned the amount required to R- 104, which, in turn, undertook to pay it to First City: Funding Agreement between First City and Queenswood No. 1 and R-104 (Exhibit A-1, Tab. 58). Paragraph C of the recital clauses of this Agreement read as follows:

Queenswood has agreed to provide a total of $1,229,990 to R-104 in two installments to be used by R-104 for the purpose of satisfying part of its indebtedness to First City.

To the question why First City would proceed to such a forgiveness, the witness said that he could not answer for First City but that he believed that First City saw the deal as a way to reduce its loss.

The accounting treatment of the amount of the forgiveness of $8,303,261 was as follows: the amount was included twice in the financial statements attached to the Appellant’s 1986 tax return (Exhibit A-1, Tab 11). On the page entitled “R-104, Balance Sheet, December 24, 1986”, the amount of forgiveness was included under the heading “Liabilities” to reduce the amount of loan payable. On the page entitled “R-104, Statement of Loss and Deficit, December 24, 1986”, the amount of forgiveness of $8,303,261 was included as an “Extraordinary item - Gain on Forgiveness of Debt”. In the same statement, the cost of sales is shown in the amount of $8,150,696. In the “Reconciliation of Net Income per Financial Statements with Net Income for Federal Income Tax Purposes, December 24, 1986”, the amount of forgiveness is shown as an amount that need not be included in the Appellant’s income computed to comply with the Act [2] and therefore is not included.

Mr. Staple testified that he had assessed the Appellant on the basis that the debts under the loan agreement were trade debts, in that no borrowed moneys could be used otherwise than on the acquisition of lands as previously approved by the lender and, the loan agreement being of a participating nature, the lender was more in the situation of a vendor than in that of a lender. Therefore, he included in the Appellant’s income the amount of forgiveness. He also considered the amount of $1,229,990 paid by Queenswood No. 1 to be a fee and not an amount paid as a reduction of the debt owing. Therefore, he added it to the amount of forgiveness that he had included in the Appellant’s income.

I will deal with the second question at issue as it did not seem to be a contentious issue between the parties. That question was whether the amount of $1,229,990 was the payment of a fee, as contended by the Minister, or the reduction of the debt owing, as was the Appellant’s position. The issue was not really debated by Counsel for the Appellant. The documentary evidence showed that the common understanding of the parties to the agreement was that it was a reduction of R-104’s indebtedness. It is true that the expression “fee” was used in the Memorandum of Understanding but although the amount remained the same, it was not the legal means chosen by the parties to conclude the settlement agreement between themselves. Queenswood No. 1 agreed to pay R-104 the amount of $1,229,990, and this latter agreed to pay it to First City to reduce its debt owing. There is, in my view, no reason to see the matter otherwise than as a payment to reduce the debt owing. On this aspect, the appeal will succeed.

I will now deal with the main question at issue respecting the fiscal treatment of the forgiveness of the debt incurred under the loan agreement.

Counsel for the Appellant submitted that in a lender-borrower relationship the forgiveness of a debt incurred under such an agreement was the forgiveness of a capital debt, whereas in a relationship of a supplier-purchaser, such a forgiveness was the forgiveness of a trade debt. Counsel for the Appellant submitted that there was nothing in the Act that required the forgiveness of a capital debt to be included in income whereas the forgiveness of a trade debt should be included in the income under section 9 of the Act.

Counsel for the Respondent argued in a manner similar to what had been said by the Minister’s agent, the gist of whose testimony was related above. His argument was that the debt that had been forgiven was more in the nature of a trade debt than that of a capital debt because the funds borrowed were used in the acquisition of the lands that were the inventory of R-104 and that the loan agreement had provided for a participation of the profits in the real estate enterprise. They also argued that the commercial reality indicated that the person which had suffered the loss was the lender and not the Appellant.

Counsel for the Appellant referred first to the decision of the House of Lords in The British Mexican Petroleum Co. Ltd. V. Jackson H.M. (Inspector of Taxes), (1932), 16 T.C. 570 (U.K. H.L.). This case has been analyzed as to the facts and law by the Supreme Court of Canada in decisions that I will refer to later but I will say now that this was a case where a corporation found itself in a very difficult financial situation and its creditors, in order to allow it to survive, decided to forgive a substantial amount of their debts. Some of the amounts forgiven were added to the taxpayer’s income except for one. For this one, it was part of the agreement with the creditor, that the sum remitted should be applied by the debtor to reduce the amount. The debt forgiven was a trade debt and nonetheless the Courts found that the forgiveness of this trade debt should not be included in the taxpayer’s income because the purpose of the forgiveness was to restore the taxpayer’s capital. That decision was not therefore decided on whether the debt forgiven was of a capital or of a trade debt nature but rather whether in view of the purpose of the forgiveness, it should be reflected in the trading account as well as in the liabilities account. (There were also some comments by the House of Lords and the courts below as to the fiscal years where the amounts of forgiveness should be taken into consideration but it was not pertinent to the ratio decidendi of that decision. The point was not argued by counsel for either party and I will not comment on that aspect.)

Counsel for the Appellant referred thereafter to a decision of Cameron, J. in George T. Davie & Sons Ltd. v. Minister of National Revenue, (1954), 54 D.T.C. 1045 (Can. Ex. Ct.) where Cameron, J., after a review of the precedent concluded as follows at pages 1051 and 1052:

It will be noted that in the second paragraph of Lord Macmillan’s opinion, he was careful to reserve the question as to the effect of releasing a trade debt in the year in which it was incurred. In the instant case it is clear that much if not all of the indebtedness was incurred in the previous year, and that it has been argued by the Crown on the footing that the whole of the amount abated should be treated as income in the year 1949.

In my view, that case is authority for the proposition that the mere cancellation or abatement of an undisputed trade debt does not give rise to taxable income in the hands of a taxpayer whose trade debt has been cancelled or abated, subject perhaps to the question reserved by Lord Macmillan and which I have referred to above. That being so, it cannot be found that the abatement of a capital indebtedness — as in the instant case — can give rise to taxable income.

In my opinion, also, the benefit conferred on the appellant by the abatement of its capital liability was not something received in the course of its normal trading operations. It was outside those operations entirely. Moreover, to adopt the language of Lord Macmillan, it did not in 1949 receive payment of the sum of $450,000.00 or acquire any right to receive it. The liability was diminished purely as an act of grace, coupled possibly to some extent with matters of public policy and business motives. The benefit received by the appellant was not a profit from its business.

In that case, the forgiveness, of a debt incurred pursuant to a borrowerlender relationship, was considered to be on capital account because the forgiveness of the debt was not something to be included in the normal trading operation as it had been conferred as an act of grace. I repeat part of the above quotation of Cameron, J.: The liability was diminished purely as an act of grace, coupled possibly to some extent with matters of public policy and business motives. The benefit received by the appellant was not a profit from its business. In this decision, Cameron, J. followed the reasoning of the British Mexican case cited above, that is, if the forgiveness has for its purpose the reinforcement of the taxpayer’s capital, the forgiveness is on account of capital only.

There are two important decisions of the Supreme Court of Canada, which have examined in depth the effect of the British Mexican case above mentioned: Oxford Motors Ltd. v. Minister of National Revenue, (1959), 59 D.T.C. 1119 (S.C.C.) and Minister of National Revenue v. Tip Top Tailors Lid., (1957), 57 D.T.C. 1232 (S.C.C.). In the Oxford Motors, case it was found that rebates although taking the form of credits against the taxpayer’s liabilities were to be included in the calculation of income and in the Tip Top Tailors case, it was found that the increase in value, due to fluctuations in the exchange rate, of capital borrowed for the purpose of paying suppliers was to be included in the taxpayer’s income.

In my view, the Oxford Motors decision of the Supreme Court of Canada has authoritatively determined the ambit of the decision of the House of Lords in The British Mexican Petroleum Co. Ltd, (supra). It stated that in that decision of the House of Lords, the forgiveness amounted to restoring the capital of the corporation and therefore was not to be included in the calculation of income. The Supreme Court, however, added that that decision did not mean that the forgiveness of a debt should never be taken into account to ascertain the taxable profit in other circumstances. It seems evident to me from my reading of the Oxford Motors case that the British Mexican decision should be followed restrictively and within its scope.

The Supreme Court of Canada has determined in Oxford Motors that the rebates were related to the Appellant’s trading operation and although they were taking the form of credits against the taxpayer liabilities they had to be included in the taxpayer’s income. In deciding upon the meaning of income, the Courts are faced with practical considerations ... and whether a gain is to be classified as an income gain or a capital gain, the determination of that question must depend in large measure upon the particular facts of the particular case, (pages 1122 and 1123 of the Oxford Motors decision (supra) and I quote more extensively from the same pages):

These rebates were intimately related to the appellant’s trading operation, and in my opinion the profit realized from them was clearly a trading profit from the business.

In his able argument Mr. Hossie put his case squarely upon the basis that the benefit derived by appellant, was in law, a forgiveness of debt, and as such was to be treated as a capital accretion, and he relied upon the decision of the House of Lords in British Mexican Petroleum Limited v. Jackson, (1932) 16 T.C. 570, but in my view, that decision has no application in the circumstances of this case. In the British Mexican case the facts were as follows. The British Mexican company, in addition to certain other liabilities, actual and contingent, owed very large sums to two creditors who were also the principal shareholders in the company. This indebtedness represented oil purchased, and freight charges incurred, during a preceding accounting period. As the result of a sharp decline in prices, the value of the company’s assets had decreased, its working capital was seriously impaired and it was in fact insolvent. In these circumstances the two shareholder creditors and a third creditor, with whom the debtor company had entered into a contract for the construction of ten tank steamers on which there was a large sum owing, entered into a written agreement for the partial remission by the three creditors concerned, of their claims against the debtor Company. It was an express term of this agreement that the sum remitted should be applied by the debtor to reduce the amount shown in its books in respect of its assets “to a figure more nearly representing the present value thereof’. What really happened was that the three interested creditors assisted in restoring the capital position of the company by writing off claims which could no longer be paid out of the proceeds of available assets.

As Lord Hanworth M.R., delivering the judgment of the Court of Appeal, stated at p. 588, the release was given “not by way of return of something which had been taken out from the Company in a previous accounting period, but which was, by a new bargain made, to afford new capital and was under the terms of that bargain to be placed to the relief of the depreciation account and not otherwise. It cannot be brought into the profit and loss account of either 1921 or 1922”.

The British Mexican case did not decide, that under no circumstances can the forgiveness of a trade debt be taken into account, in determining the taxable profit arising from the carrying on of a business, and I have found no subsequent case in which it has been so held. No one has ever been able to define income in terms sufficiently concrete to be of value for taxation purposes. In deciding upon the meaning of income, the Courts are faced with practical considerations which do not concern the pure theorist seeking to arrive at some definition of that term, and where it has to be ascertained for taxation purposes, whether a gain is to be classified as an income gain or a capital gain, the determination of that question must depend in large measure upon the particular facts of the particular case.

(Emphasis added)

If in Oxford Motors the debts arose from a relationship between a supplier and a purchaser, this was not the case in Tip Top Tailors, where it was a matter of a relationship between a lender and a borrower and the results were nonetheless the same. The highest Court determined that the increase in the value of the borrowed capital was on income account in view of the use of the borrowed capital. In Tip Top Tailors, I quote at pages 1233, 1234 and 1235:

...What remained outstanding was the debt to the bank owing by the purchaser, and with this transaction the seller had nothing to do.

... The loan produced working capital used in the course of the company’s business; the loan was effected as each payment was made to a seller; but in substance the creation of debt in the bank was merely a substitution of creditor for the actual transactions: no advance was ever made or, so far as the case goes, was ever agreed to be made to the company itself.

...What was intended and done was the creation of indebtedness to the bank arising directly out of the business and we cannot distort that into a purchase from the bank and a payment, as a matter of choice, by the company to the supplier:

the accumulated debt was exclusively that of payments made in the course of the trade

Counsel for the Appellant argued that Oxford Motors and Tip Top Tailors were decisions on particular subjects, one being on rebates and the other on the fluctuation of moneys in international trade, and that they should be restricted to these areas. I cannot agree with this proposition. I find that the legal principles, expressed in these decisions which examined in depth the British Mexican decision that is the basis of the Appellant’s position, can and should apply to all cases of forgiveness of a debt or increase or reduction of capital. [3]

These legal principles are that the purpose of the forgiveness and the use of the borrowed moneys forgiven have to be examined to determine whether the debts that have been forgiven should be included in the calculation of the business income. Unless the purpose of the forgiveness is to restore the capital, the use of the borrowed moneys forgiven has to be examined to see how it related to the borrower’s business.

In this appeal, although there was no specific evidence on the purpose of the forgiveness, it is, however, clear from the circumstances of the deal entered into by the three parties, that the purpose of the forgiveness had nothing to do with the restoring of the taxpayer’s capital or the injection of new capital nor was it an act of grace. It is thus fundamentally distinct from the circumstances of the British Mexican decision and thus this decision does not apply to resolve the matter.

The loans were used to produce working capital in the course of the company’s business. The indebtedness created arose directly out of the business: the total amounts of the loans have been expended on the acquisition of the lands and the interest owed on the loans has been added to form cost of the lands. The suppliers (vendors) were paid through loans made to the purchaser by the lender and if it were not for the moneys borrowed, the amounts would still be owed to the vendors. The costs of acquisition were not owed to the vendors but were owed to the lender and ... in substance the creation of debt in the bank was merely a substitution of creditor for the actual transactions. (Tip Top Tailors (supra) p. 1234). On the lands a floating charge for the total amount of liability was registered as security.

When the debts (including the interest) were incurred for the acquisition of the lands, they were recorded in the liabilities account and at the same time they were recorded as a cost of the inventory of these lands. When the debts were forgiven, these amounts should therefore correspondingly be deducted from the costs of the inventory since these amounts that were owed to the substituted creditors (to the vendors) were no longer owed. It seems to me that it is a matter of ordinary commercial principles.

There was no expert evidence of the generally accepted accounting principles on the matter at issue and I shall then refer only to the ordinary commercial principles. [4] The previously described accounting treatment of the forgiveness of debt in this appeal, whereby the amount forgiven was deleted from liabilities and added as a receipt of income, although it was described as an extraordinary receipt, as well as the similar accounting treatment, also previously described, in Molstad Developments Co. Ltd. v. The Queen, confirm my belief that ordinary commercial principles require such treatment. In fact, I see no other way of showing the profit from the business pursuant to section 9 of the Act.

I understand that Rip, T.C.C.J. of this Court has rendered a decision on January 8, 1997, in Molstad Developments Co. Ltd. stating that the forgiveness of part of a loan was on account of capital and that there was nothing in the Act that required its inclusion in the calculation of income. However, in this decision, Rip, T.C.C.J. did not discuss the decision of the Supreme Court of Canada in Tip Top Tailors and on the particular facts before him in Molstad Developments, he drew conclusions that are different from mine.

On the basis of the principles developed by the Supreme Court of Canada in Oxford Motors and in Tip Top Tailors and considering the ordinary commercial principles, the appeals are allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that the amount of $1,229,990 was paid as a reduction of the debt owing and should then be deducted from the amount of forgiveness of the debt owing which was otherwise, in fact and in law, correctly included by the Minister in the calculation of the Appellant’s income.

The Respondent having substantially succeeded, costs will be awarded.

Appeals allowed in part.