Vander Nurseries Inc. v. The Queen, 95 DTC 91, [1994] 2 CTC 2347 (TCC)

Sarchuk J.T.C.C.:— This is an appeal by Vander Nurseries Inc. from assessments of tax by virtue of which the Minister of National Revenue (the Minister) revised the taxable income of the appellant for its 1986,1987 and 1988 taxation years by disallowing interest expenses of $39,205.13, $222,419.28 and $79,760 respectively. As a consequence of the foregoing the Minister also revised the appellant’s taxable income for its 1985 taxation year by disallowing a non-capital loss of $93,536 carried back from 1987.

In assessing as he did the Minister proceeded on the basis that the amounts claimed as interest expenses were not amounts paid in the year or payable in respect of the year pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property pursuant to paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") as amended.

The appellant was incorporated on January 11, 1984 with a fiscal year end of January 2. William N. Vander Zalm (Vander Zalm) and his wife Lillian both owned shares and were the sole directors of the appellant during the years in issue. Fantasy Garden World Inc. (Fantasy) was a corporation related to the appellant, and had only one class of common shares which also were owned by Vander Zalm and Lillian.

On June 17, 1984 Fantasy sold land and buildings with a fair market value of $2,650,000 to the appellant (the property). The consideration for the sale was an interest bearing note in the amount of $282,860 and 100 Class C redeemable preference shares with a redemption value of $23,671 per share (the shares). After the purchase the appellant leased the property to a party at arm's length, Art Knapp Plantland Ltd. (Plantland). The lease gave Plantland an option to purchase the property for $2,650,000 by June 25, 1985 with a right to extend. It did not exercise its option on that date, rather it sought and obtained an extension until December 31, 1993.

Fantasy also owned land in Richmond known as Fantasy Gardens which was encumbered as a result of its acquisition cost and subsequent improvements. In 1985 Fantasy was in need of funds to expand and improve Fantasy Gardens and for that purpose attempted to negotiate a loan of $2,000,000 from the Canadian Imperial Bank of Commerce (CIBC). According to Vander Zalm the CIBC would not lend that amount to Fantasy directly, but was prepared to do so to the appellant. It agreed and a mortgage on the property was in due course registered in favour of the CIBC. [1] Advances were made by the CIBC directly to Fantasy be inning in September 1985; by December of 1985 $1,650,000 was advanced followed by an additional $350,000 the following year as monies were required for the continuing improvement of Fantasy Gardens. The loan was fully repaid to the CIBC by the appellant on or about June 27, 1987 with proceeds received when Plantland finally exercised its option. The foregoing transactions were reflected in the appellant's financial statements for 1986 and 1987 as a liability (bank loan secured by mortgage) to the CIBC and a receivable from Fantasy without interest or specific terms of repayment.

In filing its tax returns for the taxation years in issue the appellant deducted the interest payments on the CIBC loan from rental income it received from Plantland.

The foregoing facts are not in dispute. It is, however, the appellant's position that on June 5, 1985 it redeemed all of the shares held by Fantasy for their aggregate redemption value of $2,367,100. The amount used to repay a major portion of the redemption was the $2,000,000 borrowed by the appellant from the CIBC. The circumstances surrounding the alleged redemption were described by Vander Zalm and John H. Vegt (Vegt), a chartered accountant with Peat, Marwick, Thorne (Peat, Marwick) [2] and partner in charge of the files for both the appellant and Fantasy during the periods in issue.

According to Vander Zalm it was always intended that when the option was exercised by Plantland the proceeds would be paid to Fantasy in order to redeem the shares. These funds were essential to Fantasy to complete development of its display gardens. When Plantland advised the appellant it would not exercise its option it became necessary to obtain funding for Fantasy from another source and Vander Zalm approached the CIBC for that purpose. The discussions led to the proposal that the appellant borrow the funds instead. On June 5, 1985 Vander Zalm met with Vegt and his associate Otto Killy (Killy) to consider the appellant's position.

Prior to the meeting Vegt had discussed the various options available with Mr. John Kenyon (Kenyon), a tax specialist with Peat, Marwick. They considered such matters as the redemption of the shares; a possible merger of the appellant and Fantasy and the question whether the appellant would be in a position to deduct for tax purposes the interest payments if it borrowed the moneys from the CIBC. Vegt says that at the meeting with Vander Zalm these options were canvassed in some detail and the appellant agreed with their recommendation to proceed with the borrowing and redemption. Vander Zalm’s recollection is that:

I accepted their recommendation and suggested that they should prepare whatever necessary in order that we could proceed on that basis. And as I recall I also then said that I would check with my wife to make sure that she had no objection to us proceeding on that basis, and I called Mr. Vegt the very same day and told him to proceed.

Both Vegt and Vander Zalm conceded that there is no contemporaneous written record evidencing the redemption. The treatment of the transaction in the financial statements as a loan from the appellant to Fantasy was described by Vegt as occurring "through inadvertence of not advising lawyers to prepare the documents after June 5, 1985”.

During a field audit conducted in 1987 Revenue Canada asked Peat, Marwick to provide the basis for deducting interest expenses in Vander Nurseries on the CIBC loan. According to Vegt it was only when he endeavoured to respond that he realized that they had “failed to carry this (the redemption) out".

Vander Zalm was advised of the problem in 1988 and says he asked Vegt "to proceed to whatever was proper and necessary that hadn't been done previously as required”. In May 1988 Vegt instructed a solicitor at MacQuarrie, Hunter to take appropriate measures to reflect that the redemption took place on June 5,1985. The resulting documents were tendered as exhibits and included: the Register of Members (Vander Nurseries Inc.) showing the redemption of the shares from Fantasy (Exhibit A-2); the share certificate bearing the annotation "redeemed June/85” (Exhibit A-3); minutes of two directors meetings held on June 5, 1985, undated (Exhibits A-4 and A-5); the notice of redemption (Exhibit A-10); surrender of share certificate (Exhibit A-11). The latter two documents are both dated June 5, 1985 but were in fact signed on May 17, 1988 by Lillian Vander Zalm as secretary. It is not disputed that all were executed on or about May 17,1988. [3]

Appellant's position

The appellant sought advice from its accountants on the best means of financing the Fantasy Gardens project. It received a recommendation to redeem the shares, to borrow money from the CIBC to satisfy the debt thus created and to deduct the resulting interest payments in accordance with the Income Tax Act. The appellant’s directors accepted the recommendation and on June 5, 1985 passed a valid directors' resolution authorizing redemption. Pursuant to section 259 of the Company Act of British Columbia, 1960 R.S.B.C. c. 67. "A company may, by resolution of its directors, redeem shares on the terms and in the manner set out in the Articles of the company”. Counsel submitted that at common law a corporate resolution is validly passed at the time that those entitled to vote agree to take the actions set out in the resolution. Neither the Company Act nor the Articles of the appellant nor the common law require that the resolution be reduced to writing immediately and placed in the corporate records (Roman Hotels Ltd. v. Desrochers Hotels Ltd. (1976), 69 D.L.R. (3d) 126 (Sask. C.A.)). The appellant is in a better position than the plaintiff in Roman Hotels in that it has produced documents, albeit prepared subsequent to June 5, 1985, evidencing the resolution. The fact that the minutes were not signed and entered until sometime later is not in itself sufficient to rebut the presumption that a resolution to redeem the shares was passed. The minutes signed in 1988 are not back-dated documents, they merely reflect what occurred on June 5, 1985, the date on which the decision was made by the directors of the appellant to redeem the shares. Counsel argued that the existence of minutes, regardless of when they were prepared, provides prima facie evidence of the facts stated therein.

The fact that the share certificates were not cancelled by the appellant and the proper entries not made in the share register also does not derogate from the fact that the shares were redeemed. An individual may become or cease to be a shareholder even though a share certificate has not been issued or cancelled and the proper entries have not been made: Alberta Rolling Mills Co. v. Christie, [1919] 58 S.C.R. 208, 1 W.W.R. 572, 45 D.L.R. 545; Steen v. Canada, [1986] 2 C.T.C. 394, 86 D.T.C. 6498 (F.C.T.D.). These cases, counsel submitted, also establish that the date when shares are acquired is the date on which a binding agreement is reached to acquire them. In the present case the appellant entered into a binding and enforceable agreement with Fantasy on June 5, 1985 to redeem its shares.

The absence of any evidence of a redemption in the appellant's financial statements was irrelevant. The fact that advances to Fantasy were recorded as an inter-company loan and not a share redemption was not evidence that the redemption did not occur. An irregular entry made by the accountants did not have the effect of altering the fact and existence of the redemption: M.N.R. v. Société Coopérative Agricole de la Vallée d'Yamaska, [1957] C.T.C. 132, 57 D.T.C. 1078 at page 142 (D.T.C. 1084).

Respondent's position

The respondent contended there was no redemption of the shares at any time material to this appeal. It was only after an audit by the Minister that the appellant and Fantasy filed new income tax returns showing, retroactively, the shares as having been redeemed on June 5, 1985. The various corporate minutes, a copy of the register of members and cancelled share certificates purporting to evidence the redemption on June 5, 1985 were prepared in May 1988. The position of the respondent is that the funds borrowed by the appellant were not used to redeem the shares but were advanced without interest to Fantasy, thus the amounts claimed as interest expenses were not amounts paid in the year pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.

Counsel for the respondent argued that as contrasted to the facts in the cases cited on behalf of the appellant there is no extrinsic evidence which would demonstrate that there was a redemption of the shares in fact and in law on June 5, 1985. The meeting between Vander Zalm and the accountants may have produced a recommendation that redemption was the most appropriate method but as to the nature of the decision taken one must look at certain memoranda written contemporaneously by the accountants. These not only fail to mention that a decision had been taken but appear to establish the contrary. The same can be said for the financial statements in which the transaction is described as an intercompany loan with no indication that there had been a redemption of shares. As to the relevance of the appellant's intentions counsel for the respondent referred to The Queen v. Friedberg, [1992] 1 C.T.C. 1, 92 D.T.C. 6031 (F.C.A.) [aff'd [1993] 4 S.C.R. 285, 2 C.T.C. 306, 93 D.T.C. 5507], where Mr. Justice Linden speaking for the Court said at page 2-3 (D.T.C. 6032):

In tax law, form matters. A mere subjective intention, here as elsewhere in the tax field, is not by itself sufficient to alter the characterization of a transaction for tax purposes. If a taxpayer arranges his affairs in certain formal ways, enormous tax advantages can be obtained, even though the main reason for these arrangements may be to save tax (see Canada v. Irving Oil, [1991] 1 C.T.C. 350, 91 D.T.C. 5106 (F.C.A.), per Mahoney J.A.). If a taxpayer fails to take the correct formal steps, however, tax may have to be paid.

With respect to ex post facto documents and the weight to be given to them counsel for the respondent referred to the following comments of Mr. Justice Heald in R. v. Neudorf, [1975] C.T.C. 192, 75 D.T.C. 5213 at page 196 (D.T.C. 5215):

It is my further view that since one of the parties to the arrangement was a corporation, there is more formality required (such as corporate resolutions, for example) than in the case of individuals and particularly where the details of a relationship are important as against third parties such as the Revenue.

He submitted that where a taxpayer in a non-arm's length situation asserts that a transaction or a series of transactions occurred which transactions were designed to take advantage of provisions under the Income Tax Act, the form of the transaction must be operative and complete without defects in all relevant respects. That is not the case here thus it cannot be said that the Minister erred in assessing as he did.

Conclusion

To succeed the appellant must establish that on June 5, 1985 its directors passed a valid resolution authorizing the redemption of the shares. The issue comes down to the adequacy of the evidence adduced on behalf of the appellant. It is not as precise and unambiguous as contended nor does it unerringly point to the conclusion sought by the appellant. Counsel for the appellant urged the Court to find that “procedural or technical irregularities" and “irregular entries by accountants” did not derogate from the fact asserted that the redemption had been completed on June 5, 1985. True, the absence of a formal resolution or an irregular entry in the financial statements, standing in isolation, would not necessarily lead to a conclusion a resolution was not passed. But that is not the reality of the established facts in this case. The transaction which is the subject of this appeal was in fact recorded, incorrectly the appellant asserted, as an intercorporate loan in the financial statements of both the appellant and Fantasy. The validity of this assertion can only be determined by an assessment of the relative weight to be given to these entries, to the oral testimony, to other contemporaneous (and often contradictory) documents and to the absence of any documentary evidence regarding redemption. [4]

There are no specific rules to guide a trier of fact as to the comparative probative value of oral and documentary evidence. In such circumstances the Court must carefully scrutinize everything that an appellant says it has done to ensure that in fact it has been done. As a first step it is necessary to look at the assertions of Vegt and Vander Zalm. Neither is a disinterested witness. I accept that the appellant intended to redeem the shares at some point of time. It might have happened if the option had been exercised by Plantland in 1985 but that did not occur. Moneys were required for Fantasy Gardens, discussions took place between Vander Zalm and the CIBC and a loan arrangement involving the appellant was proposed. Vander Zalm and the appellant’s accountants discussed various treatments for the transaction. It is most evident that the primary objective of these discussions was to ensure the deductibility of interest paid on any funds which might be borrowed by the appellant or by Fantasy. [5] In these discussions the option of redeeming the shares was one of several choices considered.

With respect to his discussions with Vander Zalm on June 5, 1985 Vegt said: As far as I’m concerned to that time the redemption had occurred. I think what was left for us to do at that time was to review the interest deductibility issue further and look after the preparation of a documentation of the redemption.

Notwithstanding his assertion that the appellant's instructions were clear, nothing recorded in the files of Peat, Marwick on a contemporaneous basis confirms the existence of a director's “decision to redeem" on that day. Furthermore, almost everything Peat Marwick did thereafter conflicts with the oral testimony, both Vegt's and Vander Zalm's.

I turn first to Vegt's assertion that a decision to redeem had been taken on June 5. It is instructive to look at his June 6 memorandum to Bruce Flexman (Flexman), a tax partner in his firm. Vegt outlined the respective tax positions of Fantasy and the appellant and then posed the following question:

Assuming Vander Nurseries Inc. would replace its Class C preferred shares, which were the rollover shares, with this debt, would then Vander Nurseries Inc. have any problems in deducting the interest on the mortgage for tax purposes?

Vegt then proposed a second solution to the interest deductibility problem being a merger of the appellant and Fantasy. He says the reference to merger was not significant and was merely a matter of documenting that it had previously been discussed with Kenyon. All in all it seems odd, given Vegt's penchant for documenting discussions, that no reference is made in this, or any other memorandum, of the previous day's meeting with Vander Zalm or of the decision to redeem he says was made.

In this memorandum Vegt also expressed concern about:

The other major consideration in all this is to determine whether Fantasy Garden World Ltd. should trigger a capital gain on the Lougheed store [6] property by not filing a section 85 Election on the due date of June 30, 1985. I think we would need to discuss the risk factors in the qualification of the Bota Gardens [7] as replacement property for the sale of the Lougheed store as opposed to the payment of tax as soon as Art Knapp Plantland exercises its option to purchase the land and building.

I would expect that the risk with calling Bota Gardens replacement property is not as large as hoping that Rod Senft will not exercise the purchase of the Lougheed store until 1993. In other words it would seem prudent to report for tax purposes the sale of the Lougheed store and offset the capital gain with the replacement property of Bota

Gardens. Bill is very anxious to have some advice in this regard as he is presently discussing with the bank financing of Bota Gardens and would like a short letter to himself answering the above questions.

[Emphasis added.]

It is difficult to accept Vegt's assertion that his June 6 memorandum was of little import and that he was just “seeking comfort from tax people on the redemption of shares". Furthermore I am not convinced that the language used by Vegt in this memo supports his assertion that all options and relevant factors had been considered by the appellant and that a firm decision to redeem had been taken on June 5, 1985.

Kenyon replied to this memorandum (Exhibit A-14). He dealt with the question of interest deductibility and concluded that if the appellant were to borrow to redeem the shares in such case the interest on the borrowed funds would be deductible. In his discussion of the question he considered the alternative possibility that the appellant be wound up or amalgamated with Fantasy Gardens. He noted that in such case Fantasy could borrow to fund its capital expenditures and there would then be no question of interest deductibility. He also discussed at some length the section 85 election issue raised by Vegt and noted that:

Certainly any doubt as to the deductibility of interest on funds borrowed in excess of the redemption amount less preferred shares should be removed if the transfer of the land and buildings is elected to be at fair market value for income tax purposes as no deferred tax would then be applicable to be on the balance sheet.

On the face of the contemporaneous documents produced it appears that as late as June 14 all options were still under review.

Another document in which one might reasonably expect that redemption would be mentioned is a letter from Killy to Vander Zalm dated June 13, 1985. Killy (who was present at the June 5 meeting) recommended that Fantasy pay off its current loan and that the appellant obtain a mortgage of $2 million to $2.1 million (Exhibit A-13). He noted that such an arrangement would allow the appellant to deduct interest against its rental income and would result in a substantial tax saving and improved cash flow. There is no mention of redemption of the shares in this letter. It is also evident from Killy’s letter that funding for a “redemption” had not yet been secured since he advised Vander Zalm to obtain assurances from the CIBC with respect to a loan, adding "Should you not obtain a satisfactory response, you may wish to consider other sources of financing”. Vander Zalm's testimony confirms that the CIBC had not given a firm commitment and that the matter had not been “finalized on June 5, not even June 13, but shortly thereafter, I am sure".

I turn next to the appellant's financial statements. The transaction is recorded as a loan without interest to Fantasy. Entries on the balance sheet show receivables from Fantasy of $1,839,293 and $2,190,030 on January 2, 1986 and January 2, 1987 respectively. Vegt also prepared Fantasy’s financial statements. They were not produced but the evidence is that for the years ended December 31, 1985 and December 31, 1986 they continued to show an investment in the shares of the appellant in the amount of $2,367,140. Vegt and Vander Zalm testified that the financial statements of both companies were reviewed annually. According to Vander Zalm the entries in the appellant's financial statements went unnoticed because they did not receive as much scrutiny as those of Fantasy. He said emphasis was placed on Fantasy’s statements because the appellant "was basically a leasing company" while Fantasy "was an operating and very active and very involved company, so I suppose our attention was largely, perhaps, almost entirely at times focused on Fantasy. . . .” Vegt for his part provided no reasonable explanation why the "inadvertent error" had not been picked up other than saying that a reclassification on the balance sheet to indicate the conversion of equity to debt was not particularly significant since it merely affected reclassification between related parties and from that point of view “It was first not all that obvious, and on a consolidated basis insignificant." Assuming redemption had taken place, it is difficult to accept that the entries did not constitute a significant and obvious error on the financial statements.

As to the cases cited by counsel for the appellant, most are distinguishable on their facts. That does not preclude the application of any logical principles stated therein, however, the problem facing the appellant is that in stark contrast to the matter before me the assertions made in those cases were overwhelmingly supported by extrinsic evidence. Let me by way of example refer to Roman Hotels, supra, where the issue was whether failure to file a copy of a resolution respecting the sale of the company's whole undertaking could be construed to provide that such a resolution is an essential prerequisite to the validity of such a sale. The Court held that it did not on the basis that there was evidence that all directors participated in the decision to sell; there was documentary evidence including an offer to purchase, a signed acceptance by the three directors and notification to the purchasers that the offer had been accepted. There was also evidence that the purchasers had incorporated a company for the express purpose of acquiring and operating the business in question. There is no such supporting evidence before me.

Relying on Classic Hosiery Co, v. Fillis, [1920] 18 O.W.N. 17 (Ont. H.C.), and Hood v. Eden, [1905] 36 S.C.R. 476, counsel for the appellant argued that there was an agreement between the appellant and Fantasy in place on June 5, 1985 with respect to the redemption of the shares and that absent any evidence to the contrary that agreement must be held to be binding and enforceable. The issue in Classic Hosiery arose after the fact when previously acquiescing shareholders changed their minds and attempted to overturn the agreement on the basis that there was no record of the agreement in the corporate books. The Court had before it a written agreement ratified by all of the shareholders and no evidence that the meeting was held irregularly. That is a far cry from the evidence before me.

It is not disputed that rigid formalities are not required to create a contract. If there is a consensus ad idem the Court will give effect to it and in order to do so the whole transaction, both words and conduct of the parties will be looked at (per Bastin J., Grant v. The Queen). An examination of the transaction before me, both words and conduct does not lead to the conclusion sought by the appellant. Although Fantasy's records were not produced what is certain is that it borrowed money from the appellant. We also know that its financial statements for 1985 and 1986 show an investment in the shares of the appellant. There is no other substantive evidence regarding Fantasy's position. Did its directors meet, did they agree to waive the required notice under the Company Act? Were they prepared to accept less than full payment upon redemption? There is no real evidence of a consensus ad idem before me. The only possible basis for the proposition put forward is that Vander Zalm was involved as a director of both Fantasy and the appellant which per se ought to lead to the inference that such an agreement existed. On the evidence before me this is not an appropriate inference to draw.

Each case presents its own evidentiary convolutions. The appellant wishes to characterize the transaction in issue as a completed redemption of shares. Much of the evidence before me is either contradictory of that assertion or at best equivocal. I recognize that the absence of a formal resolution or of a written agreement or other documentation is not per se fatal to the appellant’s case. As Mr. Justice Urie said in Massey Ferguson Ltd. v. R., [1977] C.T.C. 6, 77 D.T.C. 5013 at page 13 (D.T.C. 5017):

The whole development of commercial law over the centuries is replete with examples of the Courts recognizing that business men do not always depend on expert documentation to prove the true characterization of their transactions. Rather, they tend to achieve their desired ends, particularly when the relationships between them are close, in informal and expeditious ways which perhaps are abhorrent to lawyers. In doing so they ran [run] the risks inherent in such a practice of determining their respective rights. Frequently no difficulties ensue, but if they do, in the absence of contracts or other documents, Courts must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind.

It is necessary in such circumstances to weigh the testimony very carefully, both oral and documentary, and to consider the probability of the facts sworn to. Entries reflecting an inter-company loan were made in both the appellant and Fantasy's financial statements in each of two fiscal periods. These statements were reviewed by the appellant's director and the responsible accountant. I am unable to conclude that the manner in which the transaction was recorded did not reflect the manner in which it took place. The making of these entries on separate occasions can only be conscious acts taken by the accountant and were not an inadvertent error. The tone and content of memoranda contemporaneously prepared by the accountants is inconsistent with the testimony of Vegt and Vander Zalm and with the conclusion that a redemption took place on June 5, 1988. The evidence before me raises substantial doubt as to what in fact took place and does not permit me to conclude on a balance of probabilities that the shares were redeemed as asserted.

The onus is on the appellant to demonstrate that the Minister's assumptions of fact and his consequent assessment are wrong. That has not been done. The appeal is dismissed with costs to the respondent.

Appeal dismissed.