Brian Morris, Saul Morris and Anita Morris v. Her Majesty the Queen, [1993] 2 CTC 2924

Mogan, T.C.C.J.:— The appeals of Brian Morris, Saul Morris and Anita Morris were heard together on common evidence. Brian Morris is a lawyer practising in the City of Toronto. Saul Morris resides in Montreal and is a brother of Brian. Anita Morris is the wife of Saul. During 1988, the three appellants participated in a transaction through which they obtained options to purchase certain condominium apartments in a proposed building. In November 1988, they sold their options. The issue in this appeal is whether the gain realized upon the sale of the options is a capital gain or income from a business venture. Brian Morris was the only appellant to testify at the hearing and, for convenience, I shall sometimes refer to him as“ Brian”.

In 1988, Brookmount International Inc. (“Brookmount”) was trying to develop some property on the north side of Kingston Road in the City of Scarborough at the east end of Metropolitan Toronto. The property was three adjoining parcels of land located at 4200, 4206 and 4208 Kingston Road. The principal site was 4200 Kingston Road registered in the name of Brookmount on which a 48-unit condominium apartment building was to be constructed. The two adjourning sites at 4206 and 4208 were owned by 440136 Ontario Ltd. ("No.136") a corporation controlled by the same two individuals (Messrs. Fitzsimons and Prior) who controlled Brookmount.

On May 13, 988, Brookmount had granted to Marfran Holdings Ltd. f'Mar- fran") a first mortgage on the land at 4200 Kingston Road. A copy of the mortgage was entered as Exhibit A-1. The principal amount of the Marfran Mortgage was $600,000 bearing interest at 24 per cent per annum for a term of six months expiring on November 13, 1988. During its term, only interest was payable at the rate of $12,000 per month on the 13th day of each month; and the principal amount was due on November 13, 1988. By August 1988, the Marfran mortgage was in default; the documents indicate that no interest had been paid by Brookmount since May 13; Marfran had issued a notice of sale under mortgage which would mature on September 10; and Brookmount needed immediate financing to avoid a sale under mortgage.

Brookmount could not obtain financing from a bank because it had no cash flow; there was no immediate prospect for commencement of construction; and there were no presales of any condominium units. On the other hand, there was a valuation of the land at 4206-4208 Kingston Road in the amount of $1,100,000 as at August 31, 1987 and real estate values in Metropolitan Toronto had been rising in the intervening year. Also, there was a valuation of the proposed 48-unit apartment building at 4200 Kingston Road "as if constructed" as at May 19, 1988 and that valuation was $9,450,000.

Brookmount was a client of David Goodman, a Toronto lawyer who was also a friend of Brian Morris. Mr. Goodman phoned Brian in August 1988 to ask if he had any sources from which Brookmount might obtain financing on short notice (by September 10) for a short term (until November 13). Mr. Goodman testified at the hearing and stated that he had no hesitation in calling his friend because he thought the risk was so low and the security so good. What Brookmount needed was someone who would purchase the Marfran Mortgage and then give Brookmount some breathing time to put permanent financing in place. The interest rate was 24 per cent. The Marfran Mortgage would mature on November 13. A power of sale under mortgage would mature on September 10. And Brookmount was offering an option on six condominium units at the lesser of construction costs or $125 per square foot.

Mr. Goodman stated that the financing proposition was so attractive that he would have taken it himself if he had had the available funds. In any event, Brian Morris put together a group of persons associated with him by family or in his law firm who provided the necessary financing as follows:

In order to complete the transaction, there was a four-party agreement (Exhibit A-6) signed and dated September 8, 1988 among (i) Brookmount, (ii) No. 136, (iii) 794367 Ontario Ltd. and (iv) 794368 Ontario Ltd. Brian explained in evidence that his law firm had incorporated 794367 Ontario Ltd. (No. 367) to hold the participating interests of himself and his family associates, and had incorporated 794368 Ontario Ltd. (No. 368) to hold the equal participating interests of the Klein and Koplowitz groups. It is clear from the four-party agreement that No. 367 purchased by way of assignment the Marfran Mortgage on 4200 Kingston Road. Brookmount delivered to No. 368 a third mortgage on 4200 Kingston Road in the principal amount of $70,000 bearing interest at 15 per cent per annum until maturity on November 13, 1988 and thereafter bearing interest at 25 per cent per annum. No. 136 delivered to No. 368 an identical $70,000 collateral mortgage on the properties at 4206 and 4208 Kingston Road. Exhibit A-6 originally contained in paragraph 5 an option to purchase six condominium units but this paragraph was crossed out in the final agreement as signed. In a separate two-page agreement among Brookmount, No. 367 and No. 368 entitled “Option to Purchase” (Exhibit A-9), Brookmount granted to No. 367 an option to purchase five condominium units and Brookmount granted to No. 368 an option to purchase one condominium unit. The option price was the lesser of $125 per square foot or the actual construction costs of the condominium units.

On September 14, 1988, Mr. Goodman sent two letters to No. 367 and No. 368 reporting respectively the purchase of the Marfran Mortgage and the advance of a $70,000 mortgage. In his letter to No. 367, he stated that the "Option to Purchase” agreement would be registered on title but he encountered some difficulty because the Land Registrar insisted that it be registered as an agreement of purchase and sale requiring a Land Transfer Tax Affidavit and the payment of land transfer tax. The agreement was registered only after Mr. Goodman swore an affidavit that the options had a value of $30,000. This amount was based on $5,000 per unit for the six units being the deposit required under the Option Agreement when the project was registered under HUDAC, if the options were to be exercised. Mr. Goodman stated, and I believe him, that the $5,000 deposit per unit was simply a rationale to establish value for the purpose of paying the land transfer tax when there was no obvious means of determining a value for the options.

By two letters dated September 16, 1988, Brian reported to his brother Saul and to his law associates (Messrs. Klein and Koplowitz) respectively that the financing transaction had closed. These letters will be referred to in more detail later in these reasons. By a letter dated October 19, 1988, Mr. Goodman informed Brian that Brookmount had received an offer to purchase the property. The letter is important and its entire content is set out below:

As I indicated to you by telephone, my client has ust received an offer to purchase the property from an unrelated third party for $1,600,000.

The offer will be cash on closing, to close November 30, 1988.

The purchase will require that all encumbrances be removed, including the option agreement.

You and your investors know my client's financial position. There is enough money in this purchase to allow my client to pay for the levies and working drawings, all of which my client is required to pay for under the terms of this agreement. There is also enough money to discharge all the existing mortgages, including the $70,000 mortgage.

My client has requested that I propose the sum of $60,000 as an additional bonus on discharge of the mortgage to secure a release from the option agreement. I frankly think that the offer is low, and that the sum of $90,000 ($15,000 per unit) is much more appropriate.

Please advise as soon as possible whether the $90,000 figure is acceptable, and as well of course an extension to November 30, 1988 at the same rate under the mortgage (the $70,000 mortgage starts earning interest on November 13 as well).

May I hear from you as soon as possible as time is of the essence.

On October 24, 1988 Mr. Goodman wrote a further letter to Brian which stated in part:

This will confirm our telephone conversations herein, primarily between yourself and my secretary, wherein we agreed on behalf of our respective clients that the date for repayment under the mortgages noted below is extended to November 30, 1988 and that the option to purchase the six units will be discharged and the extension granted upon repayment on that date of the sum of $150,000.

By letter dated October 25, 1988, Brian instructed Mr. Goodman concerning the distribution of all funds due to be received on November 30 with respect to the Marfran mortgage and the $70,000 mortgage and, in particular, he instructed that the amount of $150,000 for the options be distributed as follows:

OPTIONS

The appellants claim a capital gain with respect to the options because, according to the evidence of Brian Morris, the options played no role in his thinking. The options were always offered by Brookmount from day one and were never requested by Brian Morris or his financing associates. The security for the Marfran Mortgage ($650,000 including accrued interest to September 9) was regarded as good because of the earlier arm's length appraisals when land values were rising. Also, the power of sale would mature on September 10 and would be preserved as an immediate remedy if there were a further default by Brookmount. And finally, after the Marfran Mortgage was granted by Brookmount in May 1988,the land had been rezoned to permit construction of the condominium apartment building and a building permit had been issued. Therefore, the underlying land had greater value in August 1988 because it then had the potential for immediate development depending only on financing and market conditions. Although the actual sale in November was not even on the horizon when the appellants agreed to purchase the Marfran Mortgage, that sale of 4200 Kingston Road for $1,600,000 confirmed the opinion of the appellants that their financing was secure based on land values alone.

The evidence established to my satisfaction that Brian Morris was not engaged in the business of lending money. He stated that he had not participated in this kind of financing transaction more than three times in the last ten years and I believe him. The properties which he and his brothers own in Parlmerston and Hawksbury, Ontario are held as investments for their rental income. There was no evidence that Brian Morris was engaged in the business of trading or developing real estate.

Although the appellants were not engaged in the business of lending money or trading in real estate, the respondent argues that the financing transaction in this case was, in itself, an adventure in the nature of trade; and that any profit or gain resulting therefrom would be on income account and not capital. I am inclined to accept that argument. To me, there was a commercial animus which permeated this entire transaction. It was not a long-term investment. The appellants purchased the Marfran Mortgage on September 9, 1988 in the expectation that they would be paid out by November 13, when the mortgage was due. If Brookmount defaulted, they had an immediate remedy in the power of sale under mortgage which was preserved. Alternatively, they could foreclose if they wanted to obtain the property for their own purposes.

This was not an acquisition of property which could appreciate in value and, over a long term, result in a capital gain. There was no accretion to the capital which was laid out on September 9 to purchase the Marfran mortgage and to pay the commitment fee. The appellants recovered all of that capital when the property was sold on November 30, 1988. On that date, they also received the other consideration which was part of the transaction they entered into on September 9. They received the accrued interest on the Marfran Mortgage at 24 per cent from September 9 to November 30. They received the accrued interest on the $70,000 mortgage at 15 per cent from September 9 to November 13 and at 25 per cent from November 14 to November 30. And they received $150,000 for their options.

I believe both Mr. Goodman and Brian Morris when they stated in evidence that the options on the six condominium apartments were offered by Brookmount and were not solicited or requested by the appellants. Having accepted that testimony, I do not accept the statement that the options played no role in the thinking of the appellants for the following reasons. (1) The options were an integral part of the transaction. (2) The options were part of the inducement for the appellants to purchase the Marfran Mortgage just like the value of the underlying land, the 24 per cent interest rate, the mature power of sale, and the quick turnaround within 60 days. These inducements were probably not of equal weight but they were inducements for the appellants to proceed with the financing. (3) The appellants, through Mr. Goodman, overcame the difficulties in registering the options on title to secure their position. (4) There was an apparent built-in profit in each option because the cost could not exceed $125 per square foot and Exhibit A-2 indicated that the project was expected to sell at $175 per square foot. No unit had less than $1,000 square feet. Therefore, each unit which was purchased under an option at $125 per square foot and resold at $175 per square foot would yield a profit of not less than $50,000 applying the $50 spread to at least 1,000 square feet. (5) There was no evidence that the appellants had any intention of retaining one or more of the six condominium units for rental income. Some condominium apartment buildings do not permit leasing. There was no evidence that any one of the appellants would reside at 4200 Kingston Road. Therefore, what could the appellants do with the six options or the six apartments but acquire them for resale? (6) When Brian Morris reported the transaction on September 16 to Messrs. Klein and Koplowitz (Exhibit A-14) and to his brother Saul (Exhibit A-15), the description of the options played an important part in the reporting letter. Each letter (Exhibits A-14 and A-15) contained the following paragraph:

In consideration of your participation in the above first mortgage, 794367

Although I am satisfied that the options did play a role in persuading the appellants to provide the financing to Brookmount, I would go one step farther. Even if the financing was secure on the value of the underlying land and the appellants were not motivated by the options, I would hold that the gain on the disposition of the options was income and not capital because the options were an integral part of the consideration for the financing, just as much as the interest on the Marfran mortgage and on the $70,000 mortgage. The options may not have had much value on September 9 when the financing closed but they were still part of the consideration; and they were sold within the same short term when the financing was to be repaid. The appellants did not retain the options; exercise them; and then hold the resulting apartment units for personal use or rental income. The options, however little their value on September 9, never matured into capital property in the hands of the appellants.

The argument was made that the options had no value because, on foreclosure, they would merge. A merging of interests may be the legal consequence of foreclosure but foreclosure was not inevitable. The appellants had preserved the power of sale. Those were possible remedies if the Marfran mortgage went into default. It appears, however, that the appellants entered into this transaction on the assumption that the Marfran mortgage would not be in default. They were confident in the security and value of the underlying land. As stated above, the options were just a further inducement or consideration for entering into the transaction; and their relatively little value on September 9, 1988 is irrelevant in determining whether the $150,000 consideration for the surrender of the options was income or capital.

Counsel for the appellants placed some reliance on the decision of the Federal Court-Trial Division, in Lunham & Moore Ltd. v. The Queen, [1975] C.T.C. 183, 75 D.T.C. 5131 (F.C.T.D.). 1 have reviewed that decision and, in my opinion, it is easily distinguished from the present case. In Lunham & Moore, the taxpayer corporation had operated a fleet of ships and decided to sell its ships and to operate with chartered vessels. Considering the possibility that it may later want to operate with its own ships again, the corporation used the proceeds from the sale of its ships as a pool of capital to invest.

Lunham & Moore purchased a debenture of a public company and also received a block of shares as an inducement to purchase the debenture. The debenture was only one investment acquired out of the pool of capital, and it was intended to be held for a long term. When the shares of the company issuing the debenture were sold, Lunham & Moore realized a gain which was claimed as a capital gain. The corporation was successful in the Federal Court, Trial Division in maintaining that the gain on the sale of the shares was capital.

In Lunham & Moore, supra, there was a pool of capital to be invested and no part of the investment of that pool could be regarded as an adventure in the nature of trade. In this appeal, the options were offered as an inducement to enter into a transaction which was itself an adventure in the nature of trade. There was no evidence in this case that the appellants were in this transaction for the long term. Indeed, it was structured to be a short-term transaction, having the appellants get in on September 9 and be out by November 13.

In these circumstances, I think that Lunham & Moore does not apply. Cases like this are determined mainly on their facts. On the facts in this particular group of appeals, I have concluded that the options were part of the consideration for the financing resulting in an income gain on their disposition. For these reasons the appeals are dismissed with costs.

Appeals dismissed.