Kurt Pieckenhagen and Julita Pieckenhagen and Julita Investments Ltd. v. Minister of National Revenue, [1990] 1 CTC 2075, 89 DTC 725

Brule, T.C.J.:—There are three appellants before this Court. The first two are Mr. Kurt Pieckenhagen and his wife, Mrs. Julita Pieckenhagen. They are appealing reassessments for the 1977 taxation year. The third is Julita Investments Ltd. ("the Corporation") which is appealing reassessments for its 1977,1979 and 1982 taxation years. In that the essential facts are relevant to all the appeals counsel agreed that they should be heard together on common evidence.

Facts

At all material times, Mr. and Mrs. Pieckenhagen were shareholders of Casa Topaz Ltd., which in turn owned 997 of the issued 1000 common shares of the capital stock of the Corporation. The remaining three shares of the capital stock of the Corporation were owned equally by Mr. and Mrs. Pieckenhagen.

Prior to the years under appeal Mrs. Pieckenhagen's parents, Mr. and Mrs. Karl Frischke, who were residents of Germany, provided funds which were used by the Corporation to purchase apartment buildings. Over the years the total advance amounted to $301,581.38. Of this amount it was admitted that $281,581.38 came from Mr. Frischke and $20,000 from his wife. In 1974 Mr. Frischke issued a writ against the appellants and two other related companies. This action apparently arose as a result of some disagreement as to Mr. Frischke's interest and an accounting of the funds advanced. The action was settled by the parties in 1977 pursuant to which the Corporation paid an amount of $850,000 to Mr. Frischke. In addition to this the Corporation during 1977 sold four apartment buildings realizing a profit of $2,622,049.

As a result of these transactions the Minister reassessed each of the two personal appellants the amount of $279,209.31. This amount was arrived at as being one half of $548,418.62 being the difference between the $850,000 paid to Mr. Frischke and the amount of $301,581.38 recognized as having been advanced by him. The basis for the reassessments was that such amounts were considered to be benefits conferred on the appellants by the Corporation.

With respect to the Corporation the Minister reassessed for the 1977 year on the basis that the payment of $548,418.62 to Mr. Frischke was not an outlay or expenditure made or incurred for the purpose of gaining or producing income from its business. Also in the 1977 taxation year, the profits from the sale of the four apartment buildings were included in income while the Corporation had filed its return on the basis that such profits were on capital account.

Issues

There are three issues involved in these appeals:

(1) Was the Corporation entitled to deduct the $548,418.62 paid to Mr. Karl Frischke (a) in 1977 or (b) in years prior to 1977?

(2) Did the payment of the $548,418.62 to Mr. Karl Frischke represent a benefit conferred on Mr. and Mrs. Pieckenhagen in their capacity as shareholders?

(3) Whether the gain realized by the appellant in 1977 as a result of the sale of the buildings resulted in a capital gain or a gain on account of income.

There are no additional issues raised in the 1979 and 1982 taxation years of the Corporation. These years are under appeal as a result of the calculation of the non-capital loss carry-forward arising from the issues pertaining to the 1977 taxation year. The assessments for those years will be determined in accordance with the results of the appeal for the 1977 taxation year of the Corporation.

Appellant's Position

With respect to the first issue as to whether or not the Corporation was entitled to deduct the $548,418.62 paid to Mr. Frischke, counsel for the appellant stressed that the claim was primarily against Julita Investments as all funds went there. This, it was submitted, is reflected in the balance sheets given to the Court in evidence. The fact that interest was to be paid is found in the statement of defence and if the Minister acknowledges that the Corporation owes the principal to Mr. Frischke it also owes the interest to him. Hence the deduction was proper. It was alleged that in the said statement of defence an agreement was indicated to pay interest at 15 per cent per annum and such should be deductible under the provisions of paragraph 20(1)(c) of the Income Tax Act. As to the deductibility the Court was directed to the case of Immobiliare Canada Ltd. v. M.N.R., [1981] C.T.C. 2049; 81 D.T.C. 58 as being authority that if the interest could not be deducted in 1977 it could be in earlier years. A schedule was presented indicating what should be allowed in the years 1973 to 1976 inclusive as a deductible portion of the interest claimed.

While there was no written agreement as to the payment of interest the appellants relied upon the judgment in the case of Ka/mar Realty Limited v. M.N.R., [1968] Tax A.B.C. 127; 68 D.T.C. 178. Also the Court was told that reference could be made to the corporation's balance sheets as indicated in the case of La Société d'Assurance des Caisses Populaires v. M.N.R., [1967] Tax A.B.C. 632; 67 D.T.C. 455.

In brief, counsel said the position was quite clear as set out in the oral evidence presented, the balance sheets of the Corporation entered as exhibits and the statement of defence of the appellants.

The second issue for determination is whether or not the alleged interest payment by the Corporation conferred a benefit on Mr. and Mrs. Pieckenhagen in the capacity as shareholders of Julita Investments Ltd. Counsel said there was no benefit to the shareholders. A statement of claim can show anything but the facts and circumstances were clear in the case as to who owed the money. The personal appellants had no choice but to sign the final release and agreement.

A question of capital gain or income gain was involved in the third issue when the Corporation disposed of four properties in 1977. Counsel for the appellant Corporation said that the properties were purchased for investment. There was no evidence offered to the Court to indicate that these and other properties were purchased for resale nor was there any direct pleading or suggestion of a secondary intention.

During the period involved it was common practice for real estate agents to attempt to put together purchase and sales transactions, often without any solicitation by a vendor. All the offers presented to the Corporation, including the sale of four properties to one purchaser in 1977, came as a result of unsolicited offers. Reference was made to the case of California Copper Syndicate v. Harris (1904), 5 T.C. 159 in support of the Corporation's position and saying that the sales should be on capital account.

Minister's Position

As to the first issue it was pointed out that the moneys which eventually found their way into the Corporation were actually loans to the two personal appellants. Reference to this is found in their statement of defence in the lawsuit mentioned above. In paragraphs 3, 4 and 6 of that document there is ample indication that the loans from Mr. and Mrs. Frischke were to them personally. The Corporation's financial statements show that there were shareholders' loans of the moneys involved. This was subsequently changed but only after the Frischkes commenced their law suit, and such was a selfserving change.

The second issue questions whether or not a benefit was conferred on Mr. and Mrs. Pieckenhagen as shareholders of the Corporation. The settlement of the law suit made no mention of a breakdown of capital and interest and no evidence was given to show such and therefore the two cannot be distinguished. The Corporation's records do reflect that $301,581.38 was owing by way of loans. The difference between this amount and the $850,000 paid to Mr. Frischke was $548,418.62. To this was added legal fees of $10,000 with the result that $558,418.62 was considered as appropriated funds for the benefit of the two personal appellants under the provisions of subsection 15(1) of the Income Tax Act. Accordingly, $279,209.31 was properly reassessed to each of Kurt and Julita Pieckenhagen.

The third issue is whether the funds received were capital gains or income on the sale of the four apartments in 1977. Over the years the appellants had purchased fourteen buildings and sold eight. Counsel pointed out that Mr. Pieckenhagen in his evidence indicated that he put in as little equity as possible in his purchases, while Mrs. Pieckenhagen said she and her husband looked at possible appreciation at the time of purchase, both indicia of a trading practice. It was suggested that in making the purchases there was always the motivating factor of reselling at a profit and therefore the gains made in 1977 were properly reassessed to the Corporation as income.

Analysis

Dealing with the first issue, counsel for the appellants told the Court that one must look at the oral evidence, the balance sheets of the Corporation and the statement of defence. I have considered all of these and the case law presented to the Court.

There seems to be no doubt that the funds were, at least originally, loaned to the personal appellants. This was admitted by Mr. Pieckenhagen in his testimony. The financial statements present an interesting revelation. In the 1966 balance sheet of Julita Investments Ltd. there is an entry showing that the Corporation received "Advances from Shareholders" of some $129,000, the same amount that Mr. Pieckenhagen admitted receiving from his father-in-law, Mr. Frischke. The same entry is found in the 1976 statement. An entry for "Advances from Shareholders" appears in each of the 1968 and 1969 statements, while in 1970 and 1971 there is simply reflected "Loans Payable”. From 1972 on there is indication that amounts were owed to Mr. Frischke’s company in Europe by Julita Investments. The 1972 statements were amended in 1974 and the 1973 statements in 1975, both amendments occurring after the law suit was commenced. This is an indication that the amendments were made for self-serving purposes.

Reference was made to the statement of defence. In paragraphs 3, 4 and 6 it is patently clear that moneys were loaned to the personal appellants. Further it is mentioned that Mr. Frischke had an agreement regarding interest with Mr. and Mrs. Pieckenhagen. All of this indicates the loans were made to the personal appellants. If the moneys then went to the Corporation there is no evidence supporting this. No agreements, no corporate minutes, no evidence of any transfer was presented to the Court. The conclusion therefore is that the Pieckenhagens were the debtors and that the Corporation retired their debt with its funds.

As to the cases advanced for this issue which were: Immobiliare Canada Ltd. v. M.N.R., supra, Kalmar Realty Ltd. v. M.N.R., supra, and La Société d'Assurance des Caisses Populaires v. M.N.R., supra, I can find nothing that assists the appellants. The first case deals with non-capital losses and their application to certain years. The Kalmar case involved the matter of agency wherein Mr. Kalmar borrowed money on behalf of his company. Evidence was entered there of this relationship and also Mr. Kalmar received trust certificates from the company when he turned over funds. No such exchange took place in the present case. The third case involved the inspection of the company's balance sheets when no evidence could be shown in the company's records. While counsel for the appellant did this in the present case by presenting the Corporation's statements or set out above the material changes were carried out ex post facto.

A schedule was put forth to the Court illustrating how interest could be calculated in each material year but inasmuch as I cannot find the Corporation to have any right to deduct interest this schedule is not applicable.

The second issue involves the Pieckenhagens being reassessed on the basis that a benefit was conferred on them as shareholders when the Corporation paid $548,418.62 to Mr. Frischke to settle the lawsuit. Having determined that no proper transfer of funds borrowed from Mr. Frischke by the personal appellants was made to the Corporation it then follows that when funds were paid by the Corporation for the settlement a benefit was conferred on Mr. and Mrs. Pieckenhagen. This is therefore taxable to each under the provisions of section 15 of the Income Tax Act.

In the case of No. 523 v. M.N.R., 19 Tax A.B.C. 360; 58 D.T.C. 379 the Court held that where a corporation paid out funds in settlement of a judgment against the principal shareholder there was a benefit conferred on that shareholder. While in the present case there was no judgment there was a settlement. Having determined that the settlement involved the personal appellants and the final release and agreement discharged the Pieckenhagens one must conclude that there was a benefit conferred on them and accordingly this issue in the appeal fails.

The third issue is a trading one. It involves the sale of four buildings by the Corporation in 1977 and the resulting gain being taxed by the Minister as income. The appellant, Mr. Pieckenhagen, traced the acquisition and disposition of properties owned by the Corporation over the years. All were said to result because of unsolicited offers. This is plausible when one under- stands that real estate agents are always attempting to induce people to buy and owners to sell. Explanations were provided why over the years properties believed to be good investments turned out not to be such. An examination of the balance sheets reveals that in all years except 1969 the Corporation did not have any taxable income. This covered the period from 1966 to 1977 inclusive. In 1969 there was net income of $729.12 while holding property valued at $374,906.07. In 1977 there was a loss of $2,079,247 while owning property with a value of $19,772,501. In 1977 moneys were required to settle Mr. Frischke's lawsuit. All were sold to one purchaser.

In the Californian Copper case, supra, at page 165 the Court said:

It is quite a well settled principle in dealing with questions of assessments of Income Tax, that where the owner of an ordinary investment chooses to realize it, and obtain a greater price for it than he originally acquired it at, the enhanced price is not profit in the sense of . . . the Income Tax Act.

No evidence was provided to the Court suggesting any property was purchased for resale. In fact counsel for the Minister said there was no suggestion that a primary intention to acquire properties was for profit: but perhaps a motivating reason for purchases was the possibility of reselling at a profit.

Such a suggestion brings into focus whether or not there existed a consideration of resale for profit at the time of purchase. If so, then what is known as the “Doctrine of Secondary Intention” comes into play. There have been many cases wherein this secondary intention theory has been advanced to the Courts. To put this in its proper perspective reference may be made to the Exchequer Court decision in the case of Paul Racine, Amédée Demers and François Nolin v. M.N.R., [1965] 2 Ex. C.R. 338; [1965] C.T.C. 150; 65 D.T.C. 5098 wherein Noel, J. said at page 5103:

In examining this question whether the appellants had, at the time of the purchase, what has sometimes been called a "secondary intention” of reselling the commercial enterprise if circumstances made that desirable, it is important to consider what this idea involves. It is not, in fact, sufficient to find merely that if a purchaser had stopped to think at the moment of the purchase, he would be obliged to admit that if at the conclusion of the purchase an attractive offer were made to him he would resell it, for every person buying a house for his family, a painting for his house, machinery for his business or a building for his factory would be obliged to admit, if this person were honest and if the transaction were not based exclusively on a sentimental attachment, that if he were offered a sufficiently high price a moment after the purchase, he would resell. Thus, it appears that the fact alone that a person buying a property with the aim of using it as capital could be induced to resell it if a sufficiently high price were offered to him, is not sufficient to change an acquisition of capital into an adventure in the nature of trade. In fact, this is not what must be understood by a "secondary intention” if one wants to utilize this term.

To give to a transaction which involves the acquisition of capital the double character of also being at the same time an adventure in the nature of trade, the purchaser must have in his mind, at the moment of the purchase, the possibility of reselling as an operating motivation for the acquisition; that is to say that he must have had in mind that upon a certain type of circumstances arising he had hopes of being able to resell it at a profit instead of using the thing purchased for purposes of capital. Generally speaking, a decision that such a motivation exists will have to be based on inferences flowing from circumstances surrounding the transaction rather than on direct evidence of what the purchaser had in mind.

In a more recent decision the Federal Court of Appeal considered the question in Hiwako Investments Ltd. v. The Queen, [1978] C.T.C. 378; 78 D.T.C. 6281. In his judgment the Chief Justice said at pages 383-84 (D.T.C. 6285):

In my view, an intention at the time of acquisition of an investment to sell it in the event that it does not prove profitable does not make the subsequent sale of the investment the completion of an "adventure or concern in the nature of trade". Had the alleged assumption been that there was an expectation on the part of the purchaser, at the time of purchase, that, in the event that the investment did not prove to be profitable, it could be sold at a profit, and that such expectation was one of the factors that induced him to make the purchase, such assumption, if not disproved, might (I do not say that it would) support the assessments based on "trading" if not disproved.

On the next page we find the following:

I might also add a word with reference to “secondary intention”. In my view, this term does no more than refer to a practical approach for determining certain questions that arise in connection with "trading cases" but there is no principle of law that is represented by this tag. The three principal, if not the only, sources of income are businesses, property and offices or employments (section 3). Except in very exceptional cases, a gain on the purchase and re-sale of property must have as its source a "business" within the meaning of that term as extended by section 139. Where property is bought and re-sold at a profit or loss, the question whether the profit or loss must be taken into account for tax purposes depends, therefore, generally speaking, on whether

(a) it is a profit or loss from a “business” within the ordinary sense of that term, or

(b) it is a profit or loss from an undertaking or venture in the nature of trade.

To assist in determining whether purchases and resale of property should be on capital an income account, there are certain factors to be considered as set out in the various jurisprudence. An example of this is found in Happy Valley Farms Ltd. v. The Queen, [1986] 2 C.T.C. 259; 86 D.T.C. 6421 wherein Rouleau, J. spoke of several tests used by the Court in determining whether a gain is of an income or capital nature. In brief, there was mentioned, (1) the nature of the property, (2) the length of period of ownership, (3) the frequency or number of other similar transactions by the taxpayer, (4) work expended on or in connection with the property, (5) the circumstances that were responsible for the sale of the property, and (6) the motive of the taxpayer at the time of acquiring the property.

I have considered these tests as applying to this case and based on the evidence presented and the facts pleaded I conclude that the sales of property in 1977, while maybe not necessary, were of considerable assistance to the Corporation to provide needed funds.

Again referring to the Californian Copper case, supra, it is said at page 166:

What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being--Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?

In the present case the gain is an enhancement and this part of the appeal is therefore allowed.

These appeals will be referred back to the Minister for reconsideration and reassessment on the basis that the appeals of Mr. and Mrs. Pieckenhagen are dismissed and the appeal of Julita Investments Ltd. is allowed on the basis that the gain made on the sale of properties in 1977 is on capital account and in all other respects the appeal is dismissed. Costs are awarded with reference to the appeal of Julita Investments.

Appeal allowed for Julita Investments.

Other appeals dismissed.