Baynham v. R., [1998] 1 CTC 2579, 98 DTC 1169

Margeson T.C.J.:

Both Appellants appealed to this Court from an assessment made by the Minister of National Revenue, (the Minister), notices of which were dated July 7, 1995, for the 1992 taxation year.

In those assessments the Minister included in their income, bonus and income interest, which was earned by the Appellants in the course of lending money.

In addition, the Minister assessed the Appellants a penalty under the provisions of subsection 163(2) of the Income Tax Act (the Act) together with arrears of interest for the year in question.

It was agreed at the outset that evidence given in one matter would apply equally to the other, where applicable.

Facts

Mr. Leslie Allen Bjola was the chief executive officer of 3840 Holdings Ltd., (the borrower), a development company. He met the Appellants in 1987, subsequently constructed a home for them and they became very good friends.

In 1992, the borrower was interested in a town house project in Sooke, British Columbia and it needed money. Mr. Bjola approached the Appellants with respect to a cash infusion. Ultimately, the funds were advanced to the borrower which in turn granted a second mortgage back to the Appellants on certain of its properties and signed a promissory note in their favour for $12,500 due on October 5, 1992.

The loan amount of $50,000 was obtained by the Appellants from The Royal Bank of Canada on their line of credit. They in turn gave a mortgage back to The Royal Bank of Canada as further security for the loan.

This witness advised the Appellants that there was no risk that they might lose their principal because he guaranteed it. Further, the arrangements included the payment of a bonus and interest to the Appellants. The interest was to be paid monthly and the bonus was to be paid irregardless of whether the mortgage went to maturity.

In essence the Appellants would receive interest monthly, $25,000 when the loan was repaid and the return of their principal.

This witness said that he was familiar with the various requirements of commercial lenders, such as, appraisals, business plans, lease commitments, zoning information, searches of title and interest reserves. The Appellants, (the lenders) did not require any of these documents before granting the loan to the borrower.

Further, they were required to obtain independent legal advice.

It was the position of this witness that the lenders did not treat the arrangement in the same way as would a regular lender.

The witness obviously believed that there was sufficient equity in the properties of the borrowers to protect the interests of the lenders.

The borrower was audited by Revenue Canada and subsequently sent a letter dated 95-05-08 to the Minister. This letter advised the Minister as to the terms of the loan from the Appellants, the interest and bonus payments made and the dates of the payment.

The borrower treated the $25,000 as interest expense for purposes of its accounting and reporting.

The witness said that the Appellants were paying a rate of interest of 9.25% on their line of credit. He believed that this was the same rate as they were to receive on the mortgage from the borrower. He confirmed that the interest payments were made each month and that the Appellants received all interest, bonus and principal as a result of the loan.

The Appellant, Charles Baynham was the manager of a construction products facility in Nanaimo, British Columbia. He possessed a general arts degree but said that he had no experience in “mortgage lending”.

He confirmed that the source of the funds and the security taken for the loan were as Mr. Bjola had indicated in his testimony.

This Appellant believed that he would be at risk in this venture only in the event of a catastrophe.

He confirmed that neither he nor his wife took any of the precautions that he believed a common lender would take, as outlined by Mr. Bjola in his evidence. Further, he did not pledge the note or mortgage, discount them or use them as security. He devoted no time to the management of this loan and held it to maturity. He did not create any legal entity to hold the security.

He filed an income tax return in 1992 but did not report the interest or bonus in this return. He said, “I believed that it was a moot point. I felt that I had a $100,000 capital gain exemption for that year. I made no claim for the interest paid by me on the borrowed money.”

After he was contacted by Revenue Canada his wife sent in documentation referable to this transaction. He told his accountant that he had not reported the amounts because he believed that they were a capital gain. After speaking to Revenue Canada, he told his accountant to file a “report” with his 1993 or 1994 return, within three years of the event. He believed that this would suffice. He believed that it was taken care of after his wife delivered a packet of documents to his accountant. However, on May 10, 1995, he received a letter from Revenue Canada demanding payment. His accountant had not filed anything further with Revenue Canada.

At the time of his first contact with Revenue Canada, no mention was made of a penalty.

In 1995 his accountant left his business, he was unable to work and was in a state of depression.

In cross-examination he agreed that his company was a large one and had been in the business in the area since 1990.

He agreed that he and his wife were to receive a $12,500 bonus on the mortgage whether it was paid back early or not. They would also receive a bonus of $12,500 on the note.

He admitted to having received interest at the same rate as they were paying on the line of credit. The inducement to loan the $50,000 was the $25,000 additional payment that they would receive.

He admitted that they received $2,804.08 interest from the borrower and paid $3,090.41 for interest on the line of credit.

He confirmed that he and his wife made a return of $25,000 in about two months or about an 85% rate of return over the year. This, he admitted, was significant.

This Appellant identified his 1992 income tax return which was admitted as Exhibit R-3. In it he disclosed an income of $66,000 but he did not include any income from this loan, either by way of bonus or interest, nor did he disclose any facts about this transaction.

He admitted at this time that he had claimed a capital gain deduction in 1989 as a result of the sale of some shares. He said that he had forgotten about it. Further, he had claimed interest in each of the years 1989, 1990 and 1991, but not in 1992.

The Appellant Linda Baynham also testified that she did not act as a commercial lender at the time of this transaction. This was the first time that she had been involved in a lending and mortgage transaction such as took place here.

She said that they accessed their equity in their home. They did not consider it to be a speculative venture. They trusted Mr. Bjola.

She admitted that she disclosed no information about this transaction in her 1992 income tax return. She believed it to be a capital gain.

She did not know that they had claimed a capital gain earlier. She did not believe that in failing to report this transaction in her 1992 return of income that they were evading tax and did not believe that they were saving tax by not including it.

She said that she was spending a lot of time in McDonald house that year as a result of her child’s illness.

After Revenue Canada contacted her she sent documents to them although she did not know why they were asking for them. She also sent the mortgage documents to her accountant.

She knew that three years would be up and that this income would have to be reported but her accountant did not file the necessary form.

In cross-examination she identified her T-l return for 1992 which disclosed income from employment of $7,775.00 and $7,739.01. She did not report any interest income in that year. She said that they had not received a “slip” from Mr. Bjola for the interest.

She did not discuss the matter with her accountant in 1992 when her return was filed or with Revenue Canada after being contacted by them in 1995. No T-l amended return was filed.

She said that she did not give any instruction to her accountant to file an amended return and left that up to her husband.

She admitted that in the income tax return for 1989, 1990 and 1991 years she had claimed interest income.

She was shown the promissory note, Tab-2 of Exhibit A-l which bore her initials. She said that they had obtained independent legal advice and believed that they had taken a second mortgage back from the borrower as a result of looking at the documents in Court. At first she left the impression that she may not have understood that when the documents were signed but after she was shown them she said, “I guess so”.

Argument of the Appellant

Counsel argued that what was involved here was truly a capital gain. It was not an adventure in the nature of trade and the amount involved was not income.

With respect to the matter of the imposition of the penalty under subsection 163(2) of the Act, the Respondent has not met the burden of establishing the requisite elements under this section because as soon as the Appellants found out about the necessity of reporting the gain, they did something about it. They were not under audit at that time.

In his written submission, counsel referred to No. 632 v. Minister of National Revenue, (1959), 59 D.T.C. 289 (Can. Tax App. Bd.) and Wood v. Minister of National Revenue, (1969), 69 D.T.C. 5073 (S.C.C.) in support of his position that a bonus or discount received on a mortgage investment is an accretion to capital and not income.

The taxpayer was not in the business of discounting or bonusing mortgages and therefore the gain should not be taxed as income. See Racine v. Minister of National Revenue, (1965), 65 D.T.C. 5098 (Can. Ex. Ct.).

Counsel continued that there was no adventure in the nature of trade as can be seen by examining all the circumstances surrounding the investment. He referred to Interpretation Bulletin IT-114 which discussed the various criteria that the Courts have considered in concluding whether or not a particular transaction is an adventure or concern in the nature of trade.

It was counsel’s position that when one examines all the facts and the circumstances as disclosed by the evidence given in Court, the conclusion should be that this transaction was clearly not an adventure or concern in the nature of trade, that the taxpayers here merely realized an accretion of capital from an investment.

With respect to the question of the penalty the Minister must establish more than a mere failure to use reasonable care. He must establish a high degree of negligence tantamount to intention or at least indifference as to whether the Act was complied with. He relied upon the case of McHugh v. R., (1994), 95 D.T.C. 778 (T.C.C.).

He took the position that since this was a penal provision, the Minister must establish mens rea on behalf of the taxpayers.

He referred to Boileau v. Minister of National Revenue, (1989), 89 D.T.C. 247 (T.C.C.) in support that proposition. In conclusion he argued that in the case at bar the taxpayers failed to include the mortgage bonus in their return based upon an honest belief that the bonus was a capital gain and that they were entitled to a capital gains deduction without filing.

He asked that the appeals be allowed with costs.

Argument of the Respondent

Counsel for the Respondent argued that Income Tax Bulletin 114 is not relevant to the present cases since the law has changed since it was prepared. Similarly, the cases referred to by counsel for the Appellant were not relevant for the same reason.

It was the position of counsel for the Respondent that this whole transaction was on account of profit and its purpose was to earn income. It was an adventure in the nature of trade. The purpose was to make a quick loan for a particular purpose. This was a very lucrative proposition to turn a profit of approximately 85% in approximately seven months.

There were many indicia that the taxpayers acted as a normal lender or broker would have acted. They borrowed the money that they were using from a bank, this was secured by a mortgage on their house. They paid more interest on their loan than they received from Mr. Bjola in interest in order to obtain a bonus of $25,000. This was the only reason they entered the transaction. Otherwise, they would have lost money.

There was no intention to leave the loan in place for a long time and thereby gain interest on it. This was a “in and out deal”.

The manner in which the Appellants conducted this transaction was consistent with an adventure in the nature of trade in accordance with the definition of “business” in subsection 248(1) of the Act.

Counsel relied upon the case of Western Union Insurance Co. v. /?.,(! 983), 83 D.T.C. 5388 (Fed. T.D.) at page 5392 indicating that there need only be one transaction so long as the transaction is of the same kind and is carried out in the same way as that of an ordinary trader. In such a case the transaction may be labelled as an adventure in the nature of trade.

In the case at bar the Appellants had very strong security for their loan. They were more than secured on the mortgage and also held a promissory note from the borrower. There was interest plus a bonus earned by the Appellants here as in Western Union, supra, and the lump sum payment was not merely payment for the use of the money.

Counsel also relied upon Kagna v. Minister of National Revenue, (1963), 64 D.T.C. 20 (Can. Tax App. Bd.), at page 23 in support of his position that this was not merely an accretion of capital. That case referred to the definition of “accretion” and there as here, the taxpayers were not being reimbursed for the risk that they were taking. What the Appellants received here were not additions to the original fund or property but were profits. They were making a loan to receive a profit. It was income.

In the case at bar as in Bird v. Minister of National Revenue, (1964), 64 D.T.C. 777 (Can. Tax App. Bd.) even though the Appellants may not have been in the business of lending money, they used the same methods as highly speculative money lenders (although in the case at bar the risk was almost non-existent). They did not intend to leave their money invested but wanted a quick return on a short term basis. It was a scheme for quick profit-making.

On the matter of the penalty, counsel argued that under subsection 163(2) of the Act an omission can be the subject matter of “gross negligence”.

In the returns of the Appellants there was no indication of the transaction whatsoever. These actions were not reasonable. Even if it were a capital gain, Revenue Canada had no way of judging it to be such since no information was given to them. It would not be reasonable to think that you need not include the information in the return.

The Appellants had reported capital gains before. The gain was very substantial in relation to other income. It was not something that one might just forget about.

The Appellants cannot blame their accountant because they did not tell him about it until after they were contacted by Revenue Canada.

Counsel argued that the case at bar is similar to that of Holley v. Minister of National Revenue, (1989), 89 D.T.C. 366 (T.C.C.) where the taxpayer only started to act responsibly after being contacted by Revenue Canada. “Wilful blindness by someone capable of acting in a responsible manner is not a matter of ‘ignorance of the law’ in its jurisprudential sense — it can amount to gross negligence in appropriate circumstances.”

In the case at bar the Appellants acted with such want of care that it amounted to no care at all and that is sufficient to amount to “gross negligence” and does so here.

Counsel relied upon the case of Sigouin c. Ministre du Revenu national, (1992), 93 D.T.C. 210 (Eng.) (T.C.C.) in support of his position that the case at bar is demanding of the imposition of penalties. The circumstances there were quite similar to those in the case at bar.

The appeals should be dismissed.

If the appeals are allowed, there should be no costs as the actions of the Minister were reasonable under the circumstances.

Rebuttal

In rebuttal counsel for the Appellants said that even if the amount earned was a profit, that is not conclusive that it was income.

The cases referred to by the Respondent involve large businesses and businessmen, but in the case at bar the taxpayers were a nurse and a salesman.

Further, the taxpayers received no information slip from the borrower about the interest paid and no deduction was taken by them for interest paid on the funds which they borrowed.

Analysis and Decision

There are two separate and distinct issues to be decided in this case. These issues have been identified by both counsel. The facts are not in dispute in any real sense nor are they complicated. However, the application of the facts to the issues leads to two different conclusions according to counsel.

The first issue is the proper characterization of the amounts received by the Appellants as a result of their loaning of money to the “borrower”. Neither the amounts that they received nor the manner of their receipt is in issue nor is the fact that neither the interest payment received nor the bonus amounts received were included in the income tax returns of the Appellants for the relevant years.

Further, there is no doubt that the failure to report these amounts was not due in any way to the acts of the taxpayers’ accountant or any other person and the responsibility there rests entirely upon the Appellants.

There is some issue about whether the Appellants took any action or any reasonable action once they were made aware of the omission. Counsel for the Appellants contended that the taxpayers did and counsel for the Respondent contended that they did not. In any event they only acted after being advised by Revenue Canada of the omission and that was already too late.

On that issue the Court is in agreement with counsel for the Respondent and the Court is satisfied that the reasonableness of the actions of the Appellants must be considered at the time that they filed their returns or at least at any time up to the time Revenue Canada made it clear to them that their returns were being reconsidered.

The Court disagrees with counsel for the Appellants that the state of the law is such that every time a bonus or discount is received on a mortgage that the amount is an accretion to capital and not income.

The case of Wood, supra, does not stand for that proposition. The Court takes that case as having decided that in that particular case, in light of the pattern displayed by the activities of the taxpayer, the Supreme Court of Canada was satisfied that the Appellant was not carrying on a business but making a personal investment. The facts were not the same as in the case at bar including the fact that the Appellant in that case was making a personal investment out of his own savings. The Court found that the amount received was an accretion to capital.

Further, the Court is not satisfied that No. 632 v. Minister of National Revenue, supra,stands for the proposition that a bonus or discount received on a mortgage investment is always an accretion to capital and not income, but if it does, this finding is inconsistent with this Court’s interpretation of Wood, supra, as early discussed.

Counsel for the Appellant cited Interpretation Bulletins IT-459 and IT- 114 as revealing some of the factors that the Minister considers in determining whether a transaction is an adventure in the nature of trade, but this list is not exclusive nor are such considerations binding on this Court. However, in the case at bar there are factors present which suggest an adventure in the nature of trade and there are factors present which suggest an investment.

It is only by examining all of the factors in light of the evidence and the credibility attached to the evidence that a final determination can be made.

In this case it is true that the Appellants were not in the business of “discounting or bonusing mortgages”, in the sense that they had done it before, but one transaction alone may be enough if they acted as an ordinary trader would have acted.

Here, the Appellants portrayed many of the attributes of a normal trader. They borrowed the money, they did not use their own, even though they used the equity in their house as security for the money they borrowed.

It is not insignificant that they paid more interest on the money that they borrowed than that which they received back, indicating that the bonus was the real reason that they loaned the money.

Further, the bonus was to be earned over a very short period of time, at a very high rate of interest, rather than having their investment grow over a longer period of time.

Again, the Appellants took back very substantial security, thereby reducing their risk to a negligible amount. They earned both a bonus and interest. The amount received was not just payment for the use of their money, as counsel for the Respondent pointed out when he was referring to the Western Union case, supra.

This Court is satisfied that the Appellants conducted this transaction in a manner consistent with an adventure in the nature of trade and that the amount that they received was not merely an “accretion to capital” as that term was discussed in Kagna, supra.

On the first issue this Court finds that the amount received by the Appellants was on account of “income” and was not “a capital gain” as proposed by the Appellants.

The second issue that arises is in relation to the application of subsection 163(2) of the Act. The duty in regards to the penalty imposed here is upon the Respondent. It must show that the Appellants conduct amounted to “gross negligence”. This gross negligence in this case must be found in the “omission” of the Appellants to include in their income the interest and bonus payments that they received in the year in issue.

The Court finds that the Appellants made no indication in their return that they had received any such amounts. Indeed they took no steps whatsoever, at any time, to file an amended return or to indicate in any way to the Minister that they had received any unreported amounts until after the Minister’s agents had contacted them. Indeed, even then the steps that they took were insignificant and they did nothing more than possibly instruct their accountant to file an amended return, without verifying that this was done and possibly forwarded some documentation to the Minister and their accountant. That was too little, too late, even if it were possible for them to have taken some action at that time to explain their “omission”.

It is significant that the Appellants had reported capital gains before, had reported interest income before and therefore should reasonably have been aware as to the requirement to report them even if they had an honest and reasonable belief that the larger amounts were a “capital gain” rather than “income”.

It is not a satisfactory answer to say that they had not received a statement of interest income from the borrower or that they had not claimed an “interest expense” on the money that they had borrowed on their line of credit.

As argued by counsel for the Respondent, the amount received was very substantial in relation to their other income and it should have been realized by any reasonable taxpayer that such amounts would at least have to have been reported.

The Court is satisfied here that the Appellants acted with such want of care, that it amounted to no care at all and that amounted to “gross negligence” on the facts of this case.

The case of Holley, supra, is helpful in this regard.

The facts in the case at bar are not unlike the facts referred to in Sigouin, supra, where, Dussault, T.C.J. said:

In fact, the appellant simply claimed that he was unaware of the obligation to declare a capital gain since, he said, he was entitled to a deduction of at least $50,000. This explanation is unconvincing because one need only reflect a moment in order to realize that the competent authorities must be able to verify the entitlement to a cumulative deduction limited in dollar terms. Furthermore, the fact that the appellant had realized a capital gain the previous year, that he had declared it and that he had claimed the capital gains deduction strengthens my conviction that I cannot allow this explanation.

The Court points out that before finalizing these Reasons for Judgment it took into account the case of Maltais v. R., (1991), 91 D.T.C. 1385 (T.C.C.) which apparently was also forwarded to counsel for the Respondent.

The appeals are dismissed and the Minister’s assessments are confirmed.

Appeal dismissed.