David M Dunlap v. Minister of National Revenue, [1985] 1 CTC 2438

Goetz, TCJ [ORALLY]:—This is an appeal of David M Dunlap whereby he has claimed as a deduction a business loss in his 1976, 1977, 1978, 1979, 1980 and 1981 taxation years. The appellant is a manufacturer in the successful operation of two plants: one manufacturing plumbing products; the other, auto parts. The appellant was a stockbroker from 1963 to 1973 in Toronto. He obtained his Bachelor of Engineering from the University of Toronto. In the process of being a stockbroker he acquired a wide range of knowledge, I would presume, of the business world. By virtue of an inheritance he had funds which he could use for investment purposes and he became a director of Venturetek International Limited (“Venturetek”) in 1972 which was an investment company.

Pop Shoppes International Inc (“Pop Shoppes”) was one of the investments of Venturetek. The appellant became quite conversant with the rapid growth of the Pop Shoppes enterprises across Canada and into the United States. He filed a number of brochures showing the potential of the Pop Shoppes type of business. He had other stock holdings, to which I will refer as “blue ribbon stock’’, and he indicated that he wanted to get into business for himself. As a result of his familiarity with the literature by way of brochures, etc which he obtained from Venturetek, the appellant decided that he would get into the Pop Shoppes organization. He incorporated a company in Virginia and had two friends who would operate the business at Richmond, Virginia, and obtained a franchise from Pop Shoppes International Inc. Before so doing he checked out the Pop Shoppes operations in Edmonton, Calgary, London and Toronto, all of which showed an operating profit which gave him confidence that proper management in Richmond through his two friends — he supplying the capital to establish the business — and he hoped he would be able to derive income through the profits of a successful operation there.

He was guided to Virginia by specific literature as being very possibly a lucrative market for this type of operation. His longtime friends undertook to physically operate the business at Richmond and they each subscribed for 3,300 preferred shares with a par value of $10 each, and 34 common shares with a par value of $10 each, so, his total subscription was $33,340 in US funds. The original company name was DMW Associates Inc and was changed to Soda Pop Systems Inc (“SPS”) in 1976. The financing was the sole responsibility of the appellant and between 1973 and 1976, he invested into this operation, secured by way of promissory notes from the company, the amount of $465,417.47 in US funds. He undertook to provide working capital up to $500,000. He had ample funds to do this.

Being, obviously, a cautious and astute person, the appellant knew that he had to analyze the operation quite carefully and he prepared, I believe, at least two cash flow projection sheets. As of December 31, 1974, the profit and loss statement showed a loss of $154,000 which he described as actually being a cash loss of about $100,000, because the balance represented indebtedness to him. I might add that the balance of the two-thirds shares of DMW Associates Inc were purchased by his two friends. He provided the loans to these gentlemen who still owe something on these personal loans, but that is not significant to the issue at hand. But, it does indicate his security as a financially independent person.

Through a series of events which I can sum up simply, the business did sour. His two friends wanted to withdraw from the operation in January of 1975 and the appellant ended up with 50 per cent of the stock and the balance of 50 per cent went to Pop Shoppes of America in return for which he received, of course, a promissory note, interest paid up until June of 1974 and, then, because of the unfortunate situation there, he gave up or forgave arrears of interest and concluded the payment of interest for a period of two years forward to January 1, 1977. His loans carried up to that time and carried the usual interest provisions of Royal Bank prime rate plus two per cent.

In early 1976 the appellant had two friends from New York, one of whom had a very good position with a bank, who nevertheless went to Richmond. At that point in time (January 1977) he surrendered his original note and common and preferred shares to the company. The note was signed by SPS, by a Mr Herbert, for $498,750.80 which included his original equity. He states he did this because he wanted to secure his note, and as a result, he got a second deed of trust on SPS’s land and buildings and also one on the fixtures and equipment. On December 29, to be exact, the appellant surrendered his notes for cancellation in return for which he received title to the land and buildings and he assumed the mortgage on the property.

He spoke in glowing terms about the parent Pop Shoppes company repurchasing or buying up franchises from a number of operators and it is at this point that both sides, the Crown and the appellant, went on divergent paths as to his purpose in making these loans to the Virginia company. He misinterpreted the market and felt that their site location was not the best.

The appellant was carefully cross-examined by Mr Malette and in spite of expert cross-examination the appellant stood up very well. I was quite impressed with him as a credible witness who was forthright in his evidence and I accept his assessment that the franchise in Virginia would be a success. On or about the time of setting up the Virginia franchise, the appellant obtained one in the Simcoe area near the City of Toronto, Ontario, Canada. He stated that he expected these operations to be successful. He has since sold the Simcoe operation. The selling price constituted $175,000 for goodwill and $230,000 for consulting fees which would be paid over a period of years.

The appellant knew that the Pop Shoppes operation had its risks and therefore he did a lot of preliminary study of the situation. As a result of that, even though he lived a great distance away, he thought there was a great growth potential whereby he would derive income. I did not take or get the feeling that he acquired the franchise for the purpose of building it up and then disposing of it by sale either to a private individual or to the parent company. That seems to be the key to the situation. The Crown placed great emphasis on the fact of his activities in seeking to secure himself against the loss of moneys advanced to the company for the purpose of acquiring all of the equipment, supplies, building, etc.

The Crown’s position was that this conduct on the appellant’s part changed the nature of the advances totally (the figure that I mentioned earlier) but I cannot agree with that position. Now, I realize that there are tests to determine whether a loss is a trading loss or a capital loss and there is no really rigid test or tests to guide me especially in the case such as the one before me where the facts are quite different than the usual trading or capital case. All that I can rely on is what I would refer to as the common sense approach to the basis of the appellant making these advances and taking the evidence as a whole.

Having regard to the cases cited to me by counsel and the sections of the Income Tax Act that were cited to me by counsel, namely subparagraph 40(2)(g)(ii) and paragraph 20(l)(p), and the whole of the evidence, without going into all the details, I have come to the conclusion that the advances made by the appellant were outlays on account of working capital for a business enterprise with a view to obtaining profit and income therefrom. That does not, of course, preclude the possibility of, at some time, disposing of the franchise at a profit, but that was not the motive, in my view, of his making these advances during the years in which he did. The attempt to secure himself against what he saw as a business failure and loss of the moneys advanced by him in the hope that he would establish a business from which he would derive profit and not necessarily have to be physically involved in the business, because he had two good friends operating it for him, that is of course vital to the decision. The Crown’s position is that they relied specifically on Exhibit A-24. That, to me, does not change the colour, the purpose, or intention of the making of advances for each year: 1973, 1974, 1975 and 1976. I have come to the conclusion that the appellant, though he attempted to protect himself by careful study, examination of the markets, cash projection flow sheets, etc, did in fact suffer capital loss and I allow his appeal accordingly.

Appeal allowed.