L.B. Blair Management Limited and Lyle B. Blair v. Minister of National Revenue, [1994] 1 CTC 2319, 94 DTC 1126

Mogan, J.T.C.C.:—The appeals of Lyle B. Blair v. M.N.R. (Court No. 90-2581) and L.B. Blair Management Ltd. v. M.N.R. (Court No. 90-2978) were heard together on common evidence. In these reasons for judgment, Lyle B. Blair will be referred to as "the appellant" and L.B. Blair Management Ltd. will be referred to as "the company". At all relevant times, the appellant was the sole shareholder of the company. Certain issues raised in the pleadings of these two appeals were settled by the parties prior to the commencement of the hearing. Two questions remain to be decided.

In the appellant’s case, the question is whether penalties assessed under subsection 163(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") for the 1984 and 1985 taxation years should be upheld or cancelled. The circumstances giving rise to the penalties are described below. In the company's case, the question is whether a certain debenture issued by Storwal International Inc. in 1976 and purchased by the company in 1982 was held by the company as capital property or as a trading asset acquired for quick redemption or resale. The taxation years under appeal by the company are 1982, 1983, 1984 and 1985.

The appellant is a successful Canadian businessman. In 1955, he graduated from the Business School at the University of Western Ontario and went to work for Proctor and Gamble. Ten years later, in 1965, Proctor and Gamble sent the appellant to the U.K. as general manager of their Scandinavian Division. He resided in the U.K. for six years. In 1971, he was recruited by the Pepsicola Company to become president of Pepsicola Canada responsible for all activities in Canada. In 1973, he was appointed senior vice-president of Pepsicola responsible for operations in the Western Hemisphere, and was required to move to the U.S.A. to hold this position. As senior vice-president, he was indirectly responsible for the Pepsicola operations in Canada. In 1975, he returned to Canada as president of Pepsicola Canada.

In 1970, Pepsicola Canada had made no profit but in 1975 it made a profit of $10,000,000. Although the appellant recognized this as an achievement under his management, he concluded that he could use his business talents to better advantage as an independent bottler for Pepsicola products. In 1976, he resigned from the Pepsicola Company to purchase and operate Thames Valley Bottling Ltd. ("TVB") a corporation carrying on business in Ontario with a franchise to bottle and sell Pepsicola products. The beverage business became the anchor of his enterprises and he operated TVB successfully from 1976 to 1988.

In 1976, the appellant incorporated the company as a vehicle through which he could operate a management consulting business. In 1976, the company acquired a contract with the Labatt Corporation to help its wine division. The contracts between the company and Labatt had the indirect result of making the appellant the de facto president of the Labatt wine division. In this capacity, ne negotiated with the Ontario Government in 1980 to permit the blending of foreign wines with Ontario wines up to the level of 30 per cent. The appellant's connection with the wine division of Labatt was an extension of his involvement in the beverage business. The above sum- mary of the appellant's business career from 1955 to 1980 is only background for tne transaction through which the company acquired a debenture. I will consider first the company's appeals for its taxation years 1982, 1983 and 1984.

In 1980, the appellant was approached by a non-resident corporation ("Messina") which controlled Storwal International Inc. ("Storwal") through holding a Storwal debenture and owning one-half of the issued Storwal shares. Storwall was a small Canadian corporation with a plant in Pembroke, Ontario where it manufactured high quality steel filing systems for commercial office use. For 1979, Storwal had sales of $14,000,000 but was losing money. Messina wanted the appellant to manage the Storwal business. The appellant examined the Storwal operation and concluded that the manufacturing assets were good; the product was good; but the business itself was badly managed.

The appellant agreed to take over the management of Storwal and, in July 1980, he purchased for a nominal amount one-half of the issued Storwal shares (the voting shares) previously owned by residents of Canada. At the same time, he acquired an option to purchase from Messina the other half of the issued Storwal shares (the non-voting shares). The appellant was confident that he could turn the Storwal business around and make it profitable. His confidence was justified because, from 1980 to 1985, U.S. sales grew from $2,000,000 to $34,000,000; Canadian sales decreased from $12,000,000 to $6,000,000; and total annual sales grew from $14,000,000 to $40,000,000. As the appellant observed the improvement in the Storwal business, he decided to exercise his option and acquire 100 per cent control of Storwal.

By agreement dated July 6, 1982 (Exhibit A-1), the company agreed to purchase from Messina (i) one-half of the issued Storwal shares (the nonvoting shares); (ii) a debenture dated December 1976 in the original principal amount of $4,875,000 on which was owing $4,525,000; and (iii) a promissory note dated July 1980 in the principal amount of $1,137,466 without interest on which the full amount was owing. The purchase price paid by the company to Messina was $4,400,000 allocated $4,399,999 to the debenture and promissory note and $1 to the non-voting shares. In order to pay and satisfy the purchase price, the company delivered to Messina two promissory notes requiring payment as follows:

$2,000,000 payable without interest in ten equal instalments of $200,000 on luly 30 in each year commencing on July 30, 1983; and

$2,400,000 payable with interest at the rate of 6'/2 per cent per annum in four equal instalments of $600,000 on May 25 in each year commencing May 25, 1983.

To secure the payment of the two promissory notes representing the purchase price, the company pledged to Messina the issued shares of Storwal and the 1976 Storwal debenture. Paragraph no. 16 (set out below) in Exhibit A-1 makes it clear that the company’s obligation to pay the two promissory notes delivered to Messina was conditional upon the good performance of the Storwal business:

16. The parties hereto acknowledge that it is the intention that the obligation of the purchaser to make the payments due and owing under the two promissory notes referred to in paragraph 4 hereof is subject to the purchaser receiving payments from the corporation (i.e., Storwal) either as payments under the purchased debenture or dividends on the purchased shares and the vendor agrees that the vendor has no claim for payment against the purchaser save to the extent that the purchaser has received such funds from the corporation provided that. . . .

For all practical purposes, the whole purchase price of $4,400,000 paid by the company was allocated to the 1976 debenture and the 1980 promissory note. At the time of purchase, the amounts owing on those two debts were $4,525,000 and $1,137,466 respectively, making an aggregate debt of $5,662,466. Effectively, the aggregate debt was purchased at a discount of 22.3 per cent. On that basis, the cost of the 1976 debenture to the company was $3,516,135 and the cost of the 1980 promissory note was $883,864. In its taxation years 1982, 1983 and 1984, the company received payments under the 1976 debenture in the following amounts:

The company argues that the acquisition of the 1976 debenture was an adventure in the nature of trade and the profit (if any) realized by the company on the debenture would be taxable as income and not as a capital gain. Accordingly, the company further argues that no profit or gain was or would be earned or realized until it begins to receive amounts in excess of its cost of the debenture.

The respondent argues that the 1976 debenture was acquired as an investment and was capital property in the company's hands. The respondent further argues that each principal payment received by the company with respect to the debenture was a redemption in part of the debenture resulting in the realization of a capital gain. When assessing the company for its taxation years 1982, 1983 and 1984, the Minister of National Revenue regarded the company as having realized capital gains computed as follows:

The basic issue in the company's case is the character of the 1976 debenture when acquired by the company in 1982: was it capital property or a trading asset? The company relies on the decision of the Supreme Court of Canada in M.N.R. v. Sissons, [1969] S.C.R. 507, 69 C.T.C. 184, 69 D.T.C. 5152. In Sissons, the individual taxpayer acquired in an arm's length transaction (i) all the issued shares of Semco; (ii) a Semco debenture of $102,000; (iii) 2,100 preference shares of Sonograph having a $100 par value; and (iv) a Sonograph debenture of $100,000. Mr. Sissons paid approximately $15,000 for the above pieces of paper in 1961.

At the time of the transaction, Semco and Sonograph were insolvent; they were related corporations with significant business losses and no prospect of financial recovery from the original businesses which produced the losses. Mr. Sissons caused his successful corporation to sell its stamp business to Sonograph. By operating the stamp business at a profit and using ast losses to avoid tax, Sonograph was able to pay its inter-corporate debt or $112,000 to Semco which, in turn, used the funds to redeem its debenture of $102,000. Semco paid $72,000 in 1962 and the remaining $30,000 in 1963. The Supreme Court of Canada held that the gain realized by Mr. Sissons on the redemption of the Semco debenture was income and not capital. In other words, the Semco debenture was a trading asset to Mr. Sissons.

The facts in Sissons are quite different from the company's purchase of the 1976 Storwal debenture. In 1961, neither Semco nor Sonograph had a business which could be revived. In 1980, the appellant examined Storwal and concluded that its existing business had good assets and a good product but was badly managed. He therefore acquired one-half of the issued Storwal shares and became manager of the existing Storwal business. He proceeded to increase the sales of Storwal from $14,000,000 in 1980 to $40,000,000 in 1985.

The really significant difference between Sissons and the company's appeal is the target or objective of the purchaser. Mr. Sissons was aiming at the Semco debenture of $102,000 which he purchased for $15,000. He had no interest in the underlying dormant businesses of Semco or Sonograph. He knew that, if he transferred his stamp business into Sonograph, it would earn profits (sheltered from tax by prior Sonograph losses) which could be used to pay the intercorporate debt to Semco and thereby permit the speedy redemption of the Semco debenture. It all happened within two years! By contrast, the appellant and the company were aiming at the underlying business of Storwal. The appellant was confident that he could use his business talents to change the Storwal business from losses to profits, and he wanted to own and enjoy the fruits of his management skills.

When the appellant was sworn in as a witness, he identified his occupation as "entrepreneur". That was an honest and accurate description. Over the years, he has used his considerable business talents to improve the profit performance of Pepsicola Canada from 1971 to 1976; to operate Thames Valley Beverages successfully from 1976 to 1988; to manage Storwal from 1980 to 1992; and to commence and operate a successful U.K. subsidiary of Storwal from 1986 to 1992. Unlike Mr. Sissons whose target was only a piece of paper (i.e., the Semco debenture), the appellant’s target and the target of the company was always the underlying business in Storwal.

It is interesting to note the allocation of the purchase price between shares and debt. A shareholder who is about to sell control of his corporation ordinarily will insist that the purchaser also acquire any debt like a promissory note or debenture representing funds which the vendor advanced to his corporation while in control. No vending shareholder wants to remain as the secured or unsecured creditor of a private corporation under the control of someone else. Alternatively, the purchaser may insist that any shareholder debt be forgiven or that the vendor make a contribution to surplus or acquire more shares in exchange for such debt. When any person attempts to purchase share control of a small closely held corporation engaged in business, the acquisition or elimination of the former shareholder's debt is ordinarily a necessary component of the share purchase, and it may not affect the amount which the purchaser will pay for the business as a going concern. This appears to have been the position of the company in 1982 when it decided to acquire 100 per cent of the issued Storwal shares. Messina and the company agreed that the 1976 debenture and the 1980 promissory note would be lumped in with the remaining half of the issued Storwal shares.

The allocation of the $4,400,000 price may not have been important to Messina because it appears that the price was less than the aggregate of Messina's adjusted cost base of the 1976 debenture, the 1980 promissory note and the remaining half of the shares. I assume that those three securities were capital properties of Messina and any allocation of the price among them would only distribute a net capital loss. The allocation of the purchase price was probably more important to the company because it would expect to hold the shares for a long time but would expect to replace the shareholder debt with bank financing or some other third party debt. In those circumstances, it was better for the company to allocate a higher cost to the debt and a lower cost to the shares because the debt would be disposed of first and a higher cost would mean a lower gain or profit on the repayment or redemption of the debt. Although the allocation of a lower cost to the shares would result in a higher gain upon disposition, that gain would be deferred because the shares would be held for a longer term. The allocation of the purchase price almost exclusively to debt indicates to me an absence of hard bargaining between Messina and the company with respect to allocation although there was no direct evidence on this question.

The company's argument that the acquisition of the debenture was an adventure in the nature of trade causes me to question the character of the 1980 promissory note and the Storwal shares as capital property or trading assets in the company's hands. If the company’s argument is well founded, were the promissory note and the shares also trading assets? If so, was there no "investment" by the company with respect to Storwal when the company intended to own and operate the Storwal business as a profitable enterprise? Does the company regard the Storwal shares as its investment (i.e., Capital property) while the debenture and promissory note were trading assets? If so, then the company invested only $1 but speculated with $4,399,999. That does not strike me as a reasonable result. Does the company regard the Storwal shares and the promissory note as its investment while only the debenture was a trading asset? If so, how does it distinguish between the promissory note and the debenture as debt instruments?

Having regard to the agreement of July 6, 1982 (Exhibit A-1), I find that the whole purchase price ($4,400,000) which the company agreed to pay for the Storwal business was an outlay on account of capital. Therefore, the three pieces of paper acquired by the company (the Storwal shares, the 1976 debenture and the 1980 promissory note) were all capital property to the company.

I am supported in this conclusion by the decision of the Federal Court of Appeal in The Queen v. Eidinger, [1987] 1 C.T.C. 36, 86 D.T.C. 6594. Mr. Eidinger sold the shares of his family business (FP Ltd.) to a third party who continued the business and loaned money to FP Ltd. When FP Ltd. suffered losses and was in trouble, Mr. Eidinger repurchased the shares and also acquired the third party's loan receivable from FP Ltd. Because of the financial instability of FP Ltd., Mr. Eidinger did not draw any salary but caused FP Ltd. to repay part of the loan which was owed to him as assignee of the third party. When the Minister of National Revenue included the loan repayments in Mr. Eidinger's income, he appealed. The Federal Court-Trial Division dismissed his appeal relying on the Supreme Court decision in Sissons. The Federal Court of Appeal allowed Mr. Eidinger's appeal distinguishing Sissons and holding that the loans acquired from the third party were capital property. MacGuigan,]. stated at pages 37-38 (D.T.C. 6594):

The fact that the assignment of the loans was "part and parcel” of the appellant’s reacquisition of a business which he himself founded years earlier and which he wished to rescue from its financially perilous position must lead to the same conclusion with respect to the loans as would be drawn for the business itself, viz., that, although in aspiration a profit-making venture, it was unquestionably a capital investment. For that reason we are all agreed that the partial repayments on the loans made by the business to the appellant in the 1971 and 1972 taxation years were not income arising from the appellant’s business in those years.

In the 1982 transaction with Messina, the purchase of the 1976 Storwal debenture and the 1980 Storwal promissory note was "part and parcel” of the company's purchase of the remaining issued Storwal shares. Although the purchase price was allocated disproportionately between shares and debt probably for income tax purposes (and I find no fault with that), the three pieces of paper (the shares, the debenture and the note) were inextricably bound together in the company's acquisition of 100 per cent control of Storwal. Again, to distinguish from Sissons, the company and the appellant genuinely wanted to own and operate the Storwal business. The Storwal securities (shares, debenture and note) represented the company’s investment in the Storwal business and they were not acquired for trading purposes.

Counsel for the company cited a number of other authorities in support of his basic argument but most of them are cases purporting to follow Sissons and can be distinguished in the same manner as I have distinguished Sissons above. In the company’s case, the question of whether the 1976 debenture was Capital property or a trading asset is decided in favour of the respondent. If that were the only issue, the company's appeals would be dismissed but there are other issues raised in the pleadings and settled before trial which will require the company's appeals to be allowed in part with respect to particular items. I will now consider the appellant’s appeals.

Commencing in 1983, the company purchased certain houses in Toronto, Ontario and London, England which the appellant occupied and used as his personal residences. The Minister of National Revenue concluded that the appellant had not paid adequate rent to the company for his personal use of the houses and, therefore, added to the appellant’s reported income for 1984 and 1985 the amounts of $131,244 and $213,401 respectively as shareholder benefits within the meaning of subsection 15(1) of the Income Tax Act. The address, acquisition date and purchase price of the respective houses are listed below:

According to the appellant's testimony, the acquisition of the houses in London was connected with his desire to extend the market for the Storwal products (steel filing systems for commercial office use). When the appellant took over the management of Storwal in 1980, he increased the U.S. sales from $2,000,000 to $34,000,000 over a five-year period. Many of the new U.S. sales were to the financial and banking communities in major cities like New York. Around 1985, there was a deregulation of the investment banking business in the U.K. and some of the leading U.S. investment bankers and brokers were planning to open offices in London. If some of the new U.S. customers of Storwal opened offices in London, the appellant concluded that there would be an instant market for Storwal products in the U.K.

The appellant decided that it would be better to manufacture the Storwal products in the U.K. than to import them from Canada. Therefore, he was looking at small manufacturing facilities in the U.K. which could be acquired. After some investigation, he caused Storwal to purchase Main Engineering Ltd., a U.K. corporation which Storwal then licensed to manufacture the Storwal products. The appellant felt comfortable operating a U.K. subsidiary of Storwal because he had lived in the U.K. from 1965 to 1971.

The company had acquired the Springfield Road house in December 1983. The appellant started to use that house in mid-1984 during his search for an appropriate U.K. manufacturing facility. He continued to use the Springfield Road house and, later, the Templewood Avenue house whenever he visited the U.K. in connection with his management of Main Engineering. During the last half of 1984 and throughout 1985, he spent about 10 days in the U.K. every second month. This would amount to about 60 days per year. The amounts added to the appellant's reported income with respect to the use of the company's houses were allocated between imputed benefits and operating expenses as follows:

The imputed benefits were determined by applying a percentage (like the prevailing first mortgage interest rate per annum) to the aggregate of (i) the cost of furniture and fixtures, plus (ii) the company's equity in each particular house. There were no details in the pleadings or in the evidence to indicate how the operating expenses were determined but I assume they include interest paid on any mortgage. Initially, the appellant pleaded that no house benefit was conferred on him by the company and that the above amounts should not have been included in his income for 1984 and 1985. When the hearing commenced, however, the appellant’s counsel stated that his client would consent to judgment dismissing his appeals with respect to the amounts ($131,224 and $213,401) added to his reported income as housing/ shareholder benefits. The only remaining issue in the appellant’s appeal is whether he should be penalized under subsection 163(2) of the Income Tax Act because he did not report any such housing benefit when filing his income tax returns for 1984 and 1985.

When issuing the assessments under appeal, the Minister of National Revenue used subsection 163(2) to assess penalties for 1984 and 1985 in the amounts of $11,870 and $19,751 respectively. The Act provides as follows:

163 (2) Every person who, knowingly, or under circumstances amounting to gross negligence in the carrying out of any duty or obligation imposed by or under this Act, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return, form, certificate, statement or answer (in this section referred to as a "return") filed or made in respect of a taxation year as required by or under this Act or a regulation, is liable to a penalty of. . . (a formula for determining the amount of the penalty follows). . . .

The appellant testified that the company purchased the houses in question because, at the time, the company had the funds and he did not. Since 1973, the appellant has received personal income tax advice in Canada from Mr. Robert J. Reid, a chartered accountant who is a partner in one of Canada’s national accounting firms. Mr. Reid knew of the risk of income tax on a shareholder benefit when the company purchased the first house at 46 Castlefrank Road in May 1983; and he advised the appellant to pay fair market value rent for his use of the house as a personal residence. According to the company’s books and records, the appellant paid rent with respect to 46 Castlefrank Road at the rate of $2,000 per month for only five months in 1984 and five months in 1985. This explains the two $10,000 items identified as "less rent paid" in the above computation by Revenue Canada Taxation of the amounts which the appellant now acknowledges were shareholder benefits. The appellant did not pay any rent in 1984 or 1985 with respect to the houses in the U.K. or the house on Chestnut Park Road in Toronto.

One of the appellant’s exhibits is a letter (Exhibit A-12) dated April 16, 1984 from Johnston & Daniel (a Toronto real estate company) to the appellant expressing the opinion that the current (1984) rental market value of 46 Castlefrank Road was $2,000 per month. This letter explains why the company's books and records show rent paid at the rate of $2,000 per month for five months in 1984 and for five months in 1985 but it does not explain why there was no rent paid at all for the other seven months in 1984 or 1985.

The circumstances for the Toronto houses are different from the circumstances for the U.K. houses because the appellant was a permanent resident of Toronto. The appellant needed a dwelling in Toronto day-by-day throughout the year. With respect to the Toronto houses, it is difficult to see how the appellant can escape the penalty under subsection 163(2). Although the burden of establishing the facts which justify the penalty is on the Minister of National Revenue under subsection 163(3), the facts which in my view justify a penalty with respect to the Toronto houses come from the appellant’s admissions, his exhibits and his testimony. First, the appellant consented to the dismissal of his appeal for the very large amounts which the Minister had added to his reported income as shareholder benefits. He thereby tacitly admitted that he had received significant income which he had not reported. Second, the Johnston & Daniel letter (Exhibit A-12) proves that, as early as April 1984, he had acted on Mr. Reid’s advice and obtained an opinion concerning the rental market value of 46 Castlefrank Road. In other words, the appellant knew in April 1984 of the possible income tax problem concerning his personal use of a house owned by his company. And third, the appellant could not explain in oral testimony why he had not acted on the Johnston & Daniel opinion sooner and followed through with rental payments for Chestnut Park in the latter months of 1985.

The appellant is an intelligent and sophisticated person. He has been a successful businessman since his return to Canada in 1971 as president of Pepsicola Canada Inc. He has had available high quality accounting and income tax advice. Specifically, he was advised to pay "fair market" rent to the company for his personal use of the house at 46 Castlefrank Road. Although he paid rent for five months in 1984 and five months in 1985, he paid no rent for the remaining 14 months in 1984 and 1985 and does not now contest the value of the benefit which has been assessed for tax. The appellant's statement of his income in his income tax returns for 1984 and 1985 was false to the extent that he omitted any amount of shareholder benefit with respect to the Toronto houses. I find that that false statement of income was made under circumstances amounting to gross negligence within the meaning of subsection 163(3) of the Act. The penalty with respect to the Toronto houses is sustained.

The houses in London were used in different circumstances because the appellant was not a permanent resident of the U.K. His trips to London were usually in connection with his ambition to extend the Storwal business and develop a Storwal subsidiary in the U.K. The appellant testified that he reported no income or shareholder benefit for his personal use of the London houses because, in his mind, they took the place of a hotel suite for him and an entertainment centre for new U.K. customers of the Storwal subsidiary. Also, the appellant was advised by Mr. Reid to pay some rent for the London houses only when they were used for non-business purposes. The appellant could not remember using the London houses for non-business purposes.

In Venne v. The Queen, [1984] C.T.C. 223, 84 D.T.C. 6247 (F.C.T.D.), Strayer, J. was required to consider the application of subsection 163(2) of the Income Tax Act and he stated at page 234 (D.T.C. 6256):

"Gross negligence" must be taken to involve greater neglect than simply a failure to use reasonable care. It must involve a high degree of negligence tantamount to intentional acting, an indifference as to whether the law is complied with or not.

And further at page 236 (D.T.C. 6258):

The subsection obviously does not seek to impose absolute liability but instead only authorizes penalties where there is a high degree of blame-worthiness involving knowing or reckless misconduct. The section has in the past been applied subjectively to taxpayers, taking into account their intelligence, education, experience, etc., and I believe this implies that an ignorance of the law which is not unreasonable for the particular taxpayer in question and the particular circumstances may be acceptable as a defence to the application of penalties.

Because the appellant used the London houses only or primarily in connection with his management of the Storwal subsidiary in the U.K., I think he was not grossly negligent when he regarded those houses as similar to accommodation on a business trip. Also, the advice he received from a qualified income tax accountant encouraged him to think that there was no need to pay rent for the London houses. This is in contrast with the advice he received from the same accountant to pay rent for his use of the Toronto houses. I have already found that the appellant was grossly negligent with respect to the Toronto houses when he did not follow the advice of Mr. Reid and pay a reasonable rent. I am not inclined to find that the appellant was grossly negligent with respect to the London houses when he followed the advice of Mr. Reid. Although the appellant is a very knowledgeable businessman and has now admitted that he received a shareholder benefit within the meaning of subsection 15(1) with respect to his use of the London houses, I have concluded that he was not grossly negligent when he failed to report the value of that benefit in his income tax returns for 1984 and 1985.

The appeal of Mr. Blair will be allowed in part only to reduce the penalty under subsection 1 63(2) to the extent that the penalty was based on his use of the London houses. I specifically uphold the penalty with respect to Mr. Blair’s use of the Toronto houses. The appeal of his company concerning the 1976 Storwal debenture is dismissed. The formal judgment will take into account the other issues which were settled prior to the hearing. There will be no costs awarded.

Appeal allowed in part.