N M Tilley Realty LTD v. Minister of National Revenue, [1984] CTC 2386, 84 DTC 1343

Sarchuk, TCJ:—This is the appeal of N M Tilley Realty Ltd from income tax assessments in respect of its 1978 and 1979 taxation years. The appellant owned 33% per cent of the issued shares of Paramount Manufactured Homes Ltd (Paramount) and Crestview Properties Ltd (Crestview). Over a period of time it advanced a total of $31,087.01 to Paramount which was written-off in 1978 as a bad debt. In that same year the appellant paid $50,000 to the Royal Bank of Canada (Royal Bank) pursuant to its guarantee of certain loans made by the bank to Paramount in respect of which Paramount had defaulted. In 1979, the Royal Bank, pursuant to the aforesaid guarantee and a similar guarantee given by the appellant on behalf of Crestview, demanded the sum of $140,000 from the appellant in repayment of funds Paramount and Crestview had borrowed from the bank. Claiming that its ordinary business included lending money and guaranteeing loans the appellant, in computing its income for its 1978 and 1979 years deducted the sums of $81,087.01 and $140,000 respectively. The Minister of National Revenue disallowed the deductions claimed in each of the taxation years.

At the outset of the appeal counsel advised the Court that an agreement had been reached with respect to the appellant’s 1979 taxation year and that quantum was no longer in dispute. The respondent conceded that in 1979 the sum of $16,155.46 had in fact been paid by the appellant to the Royal Bank on behalf of Crestview, pursuant to a guarantee. As well, counsel for the respondent took no issue with the appellant’s position that the amounts paid by it in both 1978 and 1979 were, at the relevant times, uncollectable debts.

The Evidence

Mr Norman Tilley is the president and majority shareholder of the appellant, and personally has been in the real estate business since 1951. The appellant, incorporated in July 1962, carried on business in Portage La Prairie, Manitoba, selling real estate on commission, buying and selling properties for its own account and carrying on an extensive appraisal business. From 1974 to 1979 sales commissions ranged from $60,000 to $90,000 per year and amounted to approximately fifty percent of the appellant’s total revenue. As part of its real estate business the appellant would, from time to time, lend money to assist a client to complete a purchase, at times taking back a second mortgage or, when small amounts were involved, a promissory note. Occasionally when a lending institution declined a loan to a prospective purchaser the appellant would take a first mortgage position.

The population of Portage La Prairie is small and it was generally known that such financing could be obtained, not just from the appellant, but from all local real estate brokers. Failure to offer this service would have adversely affected the appellant’s business. From 1974 to 1979 the appellant had, on average, thirty-six or thirty-seven mortgages and/or promissory notes outstanding. While interest income varied from year to year, in 1974 approximately $13,000 was earned by the appellant, being eight per cent of its total revenue. In 1975 and 1976 interest income was approximately $21,000 and $37,000 or ten and fifteen per cent of total revenues respectively.

For a number of years the appellant had done business with Tan Oak Construction (Tan Oak), a building company owned by a Mr Shultz. Tan Oak built residential homes on a speculative basis in Portage La Prairie. The appellant sold these homes and although there was no written contract it had exclusive sales rights to Tan Oak’s inventory amounting to twelve or thirteen homes annually. In addition the arrangement provided the appellant with a commission of five per cent, as contrasted to the usual three per cent paid by other local builders. It was the appellant’s position that the right to sell a dozen homes per year made Tan Oak, in the context of the Portage La Prairie market, a good and valued client.

In 1974, Mr Shultz approached the appellant with a new building concept. Tan Oak had been able to lease premises which were suitable for the construction of homes “indoors”. Construction could go on throughout the winter and the homes would be ready for spring sale and delivery to building sites. Two corporations would be formed, Paramount to manufacture the custom move- away homes and Crestview to bank land, to purchase surplus homes from Paramount and to deliver them to building sites where it would complete the on-site work and sell the homes. It was intended that the for the most part these homes would be located on lots to be acquired and owned by Crestview. Tan Oak was in a position to invest $50,000 but this was not adequate to convince the bank to provide the financing required. Tan Oak’s solicitor, Mr Greenberg, and the appellant agreed to invest $50,000 each in the project. It was understood that in return the appellant would obtain the exclusive right to sell all homes produced.

The appellant became a 33'/, per cent shareholder in Paramount and Crestview and in fact Mr Tilley was, during the relevant time, the president and a director of both. The shares themselves were acquired by the appellant for a nominal amount. The capitalization of the two companies was effected by way of the advances of $50,000 made by each of the shareholders in return for which debentures were issued by Paramount and Crestview. The terms as to repayment of the aforesaid loans were not disclosed to the Court, however, it was common ground that the advances were non-interest bearing.

In addition, it was agreed that the Royal Bank would make an additional $300,000 available to Paramount and Crestview provided that the appellant, Mr Greenberg and Tan Oak would guarantee that indebtedness. No fee was charged by the appellant for the guarantee it gave.

According to Mr Tilley, the appellant’s sole purpose for advancing the money was to have a supply of homes for sale at all times. He said that certain national real estate companies such as Block, Century 21 and A E LePage were entering into arrangements with local brokers resulting in an increased level of competition. The appellant did not want to tie itself up with a “national” but, to meet the stiffer competition, believed that a working arrangement with a builder would be invaluable. Such an arrangement would provide assurance of ongoing business to supplement its ordinary business from other sources.

It was implied by Mr Shultz that if the appellant did not participate he would look for an alternative source of funding which was understood by Mr Tilley to mean that the appellant would lose its exclusivity for all Tan Oak, Paramount and Crestview sales. The fact that no written exclusive listing contract was entered into with Paramount and Crestview was explained as being a logical extension of the existing good relationship. Mr Shultz’s demonstrated loyalty coupled with verbal assurance that the appellant would retain the right to sell all of the homes was, in the appellant’s view, adequate.

At the time of incorporation of Paramount and Crestview the appellant was aware that approximately one hundred homes per year had been built in the Portage La Prairie area in 1973 and 1974. It was believed that this volume would continue and that with quality construction they would be able to secure approximately 50 per cent of the market. The plant had a production capacity of ten homes per month which would enable them to meet the anticipated demand.

In 1975 thirty homes were built by Paramount. Crestview took delivery of most of them and put them on building sites. However, in general terms the operation of Paramount and Crestview in 1975 and 1976 produced disappointing results. Only sixteen of the homes were sold during those two years. In Mr Tilley’s words, “there was disappointment in so far as my investment was concerned”. He stated that the timing of the commencement of operations was unfortunate. Interest rates began rising and concurrently demand for new homes decreased. Paramount’s homes were not selling. Mr Tilley suggested that prebuilt “move-aways” were, in a sense faddish and rural living had become less popular with increased transportation costs. In any event the market dropped, sales declined and financing became a substantial problem. The Royal Bank became testy and the appellant and Mr Shultz were advised that additional capital was required or the loans of Paramount and Crestview would be called.

Both companies continued to show substantial financial weakness in 1976 and 1977 as a result of which in the latter part of 1977 the appellant asked the Royal Bank to stop all further advances. This was done and the Paramount plant was shut down on April 1, 1978, there being no prospect of recovery or future profits.

As a result of the failure of Paramount the appellant, in its 1978 taxation year, was unable to recover the advances made to Paramount and was, in addition, required to pay certain amounts pursuant to the guarantees given by it to the Royal Bank in the aggregate amount of approximately $81,087.01. Demands on Paramount were unproductive. In computing its income for its 1978 taxation year the appellant deducted the said sum of $81,087.01 as a bad debt.

In 1979 the Royal Bank demanded that the appellant, pursuant to its guarantee, pay a further $140,000 on account of advances made by the bank to Paramount and Crestview and which it was unable to collect from them. The sum of $16,155.46, representing the accrued interest to that point of time, was paid by the appellant.

The respondent cross-examined Mr Tilley on the nature of the appellant’s business and suggested that the appellant was not truly a money lender nor was it in the business of giving guarantees. Mr Tilley had stated that prior to 1970, when banks were not allowed to take a mortgage, the appellant guaranteed its clients’ loans and charged a fee for that service. He conceded that often a guarantee was given without fee for the purpose of concluding the sale of the house. However, in the years after 1970 the appellant could recall but one instance where it had guaranteed a loan and that was clearly done as a personal favour to the individual and no fee was charged nor expected. At all times both prior to and after 1970 loans were never made, nor were mortgages taken and/or guarantees given other than to facilitate a sale on which the appellant would earn a commission.

The appellant admitted that it hoped that Paramount and Crestview would be profitable but insisted that it did not count on receiving dividends. It is fair comment that Mr Tilley was less than responsive to questions relating to the appellant’s expectation of future return on its $50,000 investment. He was prepared to concede that the appellant intended Paramount and Crestview to carry on into the foreseeable future as long as business was good.

Although the appellant claimed it became involved principally to secure and maintain exclusive rights to all sales, on the evidence before me it is clear that no such arrangement existed. On many occasions sales were made by other brokers in which case the appellant would not receive any commission at all. Between July 1975 and the closing of operations in 1978 approximately one hundred and fifty homes were produced and sold. Of these, 50 per cent were disposed of by Crestview in areas outside of Portage La Prairie. These sales were not made by the appellant, but were made for the most part by a Winnipeg broker and the appellant received no part of the commissions earned. A major portion of the remaining seventy-five homes were bought directly from Paramount by purchasers who owned their own building sites. In several other instances competing agents brought purchasers to Paramount. The appellant derived no commissions from these sales. the evidence elicited from Mr Tilley eventually established that during the relevant period the appellant sold only in the Portage La Prairie area and that its sales throughout the whole period approximated fifteen to twenty homes or 10 to 14 per cent of the total production of Paramount.

No further evidence was adduced by the appellant.

Appellant's Contentions

The appellant submitted that the amounts paid by it in 1978 and 1979 were fully deductible pursuant to the provisions of paragraphs 18(l)(a) and 20(1)(p) of the Income Tax Act.

It was argued that the amounts paid could be deducted pursuant to paragraph 20(1 )(p) of the Act since a part of the appellant’s business was the lending of money by way of mortgages and promissory notes and the guaranteeing of loans. Counsel emphasized the frequency of such transactions and the fact that at least 10 per cent of the appellant’s income was derived from those sources. On that basis the appellant states it was in the business of lending money, and that both the advances and the guarantees were made in the course of such business. It was contented that the payment on the guarantee was a loan as contemplated by this section and in this regard counsel cited as authority No 686 v MNR, 23 Tax ABC 376; 60 DTC 123.

The appellant further argued that when Mr Shultz approached it with his proposal the prospect of increased real estate sales and fees was self-evident as a result of which the appellant advance^ the necessary funds to and guaranteed the loans of Crestview and Paramount. Its primary purpose was to ensure commission income. The appellant urged the Court to look at its decision to become involved in the context of the local real estate market in 1975 when more than one hundred homes per year were being constructed and there was no reason to anticipate any change in the foreseeable future. The prospect of these future sales and income therefrom was stated to be the predominant motivating factor and not any investment potential. Accordingly, the expenditures of the appellant by way of advances and guarantees were made for the purpose of gaining or producing income from the appellant’s business within paragraph 18(1)(a). Counsel cited as authority the cases of The Queen v F H Jones Tobacco Sales Co Ltd, [1972] CTC 2433; 72 DTC 1355; [1973] CTC 784; 73 DTC 5577, and D J MacDonald Sales Limited v MNR, 16 Tax ABC 49; 56 DTC 481.

Respondent"s Submissions

Counsel for the respondent stated that the appellant is only entitled to claim a current deduction if it complies with both paragraphs 18(l)(a) and 18(l)(b) of the Act. That is, no deduction can be made except to the extent that it is incurred for the purpose of gaining or producing income from the business or property and then only if it is not an outlay in relation to capital. Certain facts precluded the appellant from falling within the purview of the exemption in paragraph 18(l)(a). These facts are:

(a) the advances and the guarantee were not made by the appellant to earn interest or a fee and were not in a direct sense made to earn income;

(b) the loans in issue were not at all like other loans made by the appellant which might be described as “‘real estate completion” loans; they had nothing to do with a specific sale of real estate;

(c) the appellant did not carry on a guarantee business; although during the 1960s it may have guaranteed some clients loans, it could not be said that such was the case during the relevant taxation years;

(d) there were three investors, including the appellant involved in Paramount and Crestview; all three investors took the same shareholdings and made the same advances to Paramount and Crestview; this was done as part of the start-up of the two companies and the $50,000 advanced by each of the shareholders was the capital by which Crestview and Paramount would operate; these moneys were the underlying initial financing; the loans and guarantees did not come about to assist an ongoing business; and

(e) Paramount and Crestview were separate corporate entities each designed with the intention of creating and developing a permanent ongoing business; this was not in any sense of the phrase a time-limited project.

Counsel for the respondent submitted that neither the advances nor guarantees were loans made in the ordinary course of the appellant’s business, were not debts arising from loans made in the ordinary course of business and accordingly paragraph 20(1)(p) would have no application. Furthermore, Paramount and Crestview were established with a view of gaining a permanent advantage in what was becoming a competitive situation and as such the outlay was capital in nature and not deductible. Counsel distinguished the cases cited by the appellant and submitted that The Queen v H Griffiths Co Ltd, [1976] CTC 454; 76 DTC 6261, was authority for its position.

Reasons

The evidence adds up to this as I appreciate it. The appellant decided to invest, along with two partners, in two companies to be incorporated to carry on business in Portage La Prairie and be a source of income and profit for the appellant. These companies needed capital and it was part of the arrangement that the appellant would supply, along with its partners, the needed capital. Accordingly, it made direct advances of money and guaranteed the necessary bank loans to enable Paramount and Crestview to get started and to continue to operate. No interest or fee was sought or paid. As far as I can ascertain the advances were treated by the appellant, as recently as in its financial statement for year ending July 31, 1978 as an investment.

The appellant claimed that the amounts were fully deductible under paragraph 18(l)(a) of the Income Tax Act, being expenses incurred by it for the purpose of gaining or producing income from its business and were not an outlay or payment on account of capital and thereby prohibited by paragraph 18(1)(b).

According to the appellant, investment was not a motivating factor and its purpose in advancing funds and guaranteeing bank loans for Paramount and Crestview was to obtain the immediate advantage of commission fees. To do so it was necessary to assure itself of an inventory. Counsel for the appellant suggested that the facts herein were on all fours with those in The Queen v F H Jones Tobacco Sales Co Ltd, (supra). I do not agree. I cannot accept the appellant’s contention that its motivation was primarily to obtain an immediate short term advantage. The encroachment by large national real estate brokers into the Portage La Prairie market would have had a harmful effect on the appellant’s business. It was necessary for the appellant to consider its future. It chose not to align itself with a “national” and it sought to protect itself against these very strong competitors. In these circumstances the only logical inference which can be drawn from its investment in Paramount and Crestview is that the appellant was seeking to establish for itself a permanent and enduring benefit. By becoming a shareholder the appellant protected its position in the real estate market in the short term, and, more importantly placed itself in an advantageous position for the foreseeable future because of its control of a steady supply of homes for sale. As well the appellant cannot have ignored the potential of Crestview and Paramount to pay dividends had the concept been successful. It must be remembered that not only was it intended to manufacture the homes but it was intended to acquire and bank land upon which these homes would be placed for subsequent sale. Again, it is logical to infer that the appellant contemplated the possibility of profit not just from the manufacture and sale of the homes but from the resale of the land which it proposed to acquire and bank.

The advances made and guarantees given were intended to provide both Crestview and Paramount with sufficient operating capital and as such were in my opinion an outlay on account of capital.

In The Queen v H Griffiths Co Ltd, (supra), Dubé, J reviewed a number of leading cases including the cases cited by the appellant. Dubé, J stated at 459 [6264]:

In my view, the outlay, or payment of the guaranteed loan, or deferred loan, was made with ‘‘a view of bringing into existence an advantage for the enduring benefit” of Griffiths’ business (See Algoma Central Railway (supra)). When Griffiths established the subsidiary it was ‘‘in view” of securing a source certain and permanent of sheet metal, admittedly a distinct advantage in a very competitive field. As it turned out, the advantage did not in fact endure, but it is quite clear that the establishment of the metal producing subsidiary was not meant to be a mere passing fancy.

These comments are equally applicable to the present case.

It follows that the advances to Crestview and Paramount do not fall within the ambit of paragraph 20(l)(p) of the Income Tax Act. While a small part of the appellant’s business may have been the lending of money these particular transactions were not made in the ordinary course of that business.

Applying the test enunciated by Jackett, P in Algoma Central Railway v MNR, [1967] CTC 130; 67 DTC 5091 at 134 [5093], I find that the payments made by the appellant were made on account of capital since they were made with a view of bringing into existence an advantage for the enduring benefit of the appellant.

The appeals are accordingly dismissed.

Appeals dismissed.