Federal Court of Appeal Decisions

     A-309-94

CORAM:      HUGESSEN J.A.

     STRAYER J.A.

     DESJARDINS J.A.

B E T W E E N:

     HER MAJESTY THE QUEEN

     Appellant

     " and "

     DIVERSIFIED HOLDINGS LTD.

     Respondent

HEARD at Vancouver, British Columbia, on Thursday, February 27, 1997

JUDGMENT delivered at Ottawa, Ontario, on Tuesday, March 18, 1997

REASONS FOR JUDGMENT BY:      STRAYER J.A.

CONCURRED IN BY:      HUGESSEN J.A.

     DESJARDINS J.A.

     A-309-94

CORAM:      HUGESSEN J.A.

     STRAYER J.A.

     DESJARDINS J.A.

B E T W E E N:

     HER MAJESTY THE QUEEN

     Appellant

     " and "

     DIVERSIFIED HOLDINGS LTD.

     Respondent

     REASONS FOR JUDGMENT

STRAYER J.A.

Facts

     This is an appeal from a decision of the Tax Court of May 27, 1994, which involved various matters concerning related companies and their owners. The present appeal is limited to the Tax Court decision to set aside the Minister's disallowance of a $239,328 loss carry-forward in respect of the respondent's 1986 taxation year. The respondent also cross-appeals to set aside the Minister's determination that a percentage of operating costs of the respondent's K-2 Ranch were not deductible as they represented living expenses of the company's owner, Hans Hartwig. This case was heard together with the appeal in Hans Hartwig v. H.M. the Queen (A-313-94) in which the same expenses were in issue as a possible shareholder's benefit.

     The taxpayer, Diversified Holdings Ltd. (hereafter "D.H.") is a British Columbia corporation wholly owned by Hans Hartwig and his family and at the time in question operated a ranch and was a real estate developer. Fearing that it would have large taxable profits in 1984 and subsequent years it set out to buy some tax losses. It advertised in June, 1984 in newspapers to find a real estate company or construction company with losses in excess of $1,500,000. An appropriate company was identified, 860 Holdings, Limited (hereafter "860"),, another British Columbia company. As of October 31, 1984 860's assets consisted of $99 in accounts receivable, and land worth $731,000 operated as a parking lot on which there was a mortgage held by Central Trust Company on which, by September 30, 1985 there was owing $1,281,100. 860 is said to have had actual and "pregnant" losses of approximately $1,150,000 at this time. Through a series of transactions the following steps were carried out effective October 25, 1985.

(i)      D.H. purchased all of the shares of 860.

(ii)      Central Trust Company purchased the mortgaged land for $400,000, which sum it "paid" to 860.

(iii)      Title to the land was transferred by 860 to Central Trust Company which in return, inter alia, for the "payment" of the $400,000 passed by 860 to 173235 B.C. Ltd. (hereafter "173235") (another company wholly owned by Hans Hartwig) plus a real payment provided by D.H. of $50,000, transferred the mortgage to 173235.

(iv)      173235 discharged the mortgage, thus giving Central Trust Canada clear title to the land but retaining for itself a debt said to be of $1,281,110 previously owing to Central Trust Company and now to it, although no longer secured by the mortgage.

(v)      173235 retained the unsecured debt (variously described as $1,281,110 or $1,150,000 " the precise amount is not material) previously owed by 860 to Central Trust Company. No terms of payment or interest were prescribed in respect of this debt, and at time of trial nothing had been paid.

(vi)      Subsequently on December 30, 1985, 860 was amalgamated with D.H. which continued to carry on its business in 1986 as Diversified Holdings Ltd., and the amalgamated company was thus the successor debtor of 860's debt to 173235.

     D.H.'s total costs of acquiring 800's losses was $152,400 including the cost of 860's shares and the $50,000 paid to Central Trust Company for its transfer of the debt to 173235.

     860 in its tax returns had asserted, inter alia, a 1982 non-capital loss of $239,328. D.H. claimed this non-capital loss in calculating its taxable income for 1986, after 860 had been amalgamated with D.H. The Minister of National Revenue disallowed the 1982 non-capital loss carried forward of $239,328 on the basis that when the mortgage, previously held by Central Trust Company and then transferred to 173235 B.C. Ltd., was discharged by the latter effective October 25, 1985, the debt of 860 had been settled or extinguished within the meaning of subsection 80(1) of the Income Tax Act so as to eliminate any non-capital losses based on such a debt.

     D.H. appealed that reassessment and the Tax Court of Canada in a judgment of May 27, 1994 allowed the appeal. In response to arguments raised on behalf of the Minister at that time, the Tax Court judge found that: the debt continued despite the discharge of the mortgage because the mortgage represented only security, and thus there was a debt owing in 1986 by the amalgamated D.H. to 173235, the assignee of the debt; 173235 did not act as agent for D.H. in becoming the creditor of 860 and its successor-debtor, the amalgamated D.H.; and that 860's business had not come to an end prior to 1986 so as to prevent the amalgamated D.H. from continuing that business in 1986.

     The Crown raises the same issues on this appeal.

     With respect to the cross-appeal as to the nature of the expenses incurred by D.H. for the operation of the ranch house, the facts are dealt with briefly in the reasons in A-313-94.

Issues

     The issues for determination are therefore:

(1)      Was the debt settled or extinguished so as to prevent it from being available to establish a non-capital loss?

(2)      Did 173235 act as agent for D.H. in taking over the debt from Central Trust Company and in holding it as creditor of 860 or D.H. after October 25, 1985?

(3)      For the purpose of utilizing, in 1986, 860's non-capital loss, was the amalgamated D.H. carrying on the business in which these losses were incurred?

(4)      With respect to the cross-appeal, were any part of K-2 Ranch expenses in 1984, 1985 or 1986 taxation years personal or living expenses of Hans Hartwig and thus not incurred by D.H. for the purpose of earning income?

Analysis

     Was 860 Holdings Limited's debt "settled or extinguished"?

     Although the appellant questioned, in passing, the existence of an assignment of 860's debt to 173235, the Trial Judge obviously found there to be one and there is no clear basis for ignoring that finding. The question then is, by its mere passage to 173235 was the debt settled or extinguished?

     The relevant test here is provided by subsection 80(1) of the Income Tax Act which provides as follows:

80.(1) Where at any time in a taxation year a debt or other obligation of a taxpayer to pay an amount is settled or extinguished . . . without any payment by him or by the payment of an amount less than the principal amount of the debt or obligation . . . the amount by which the lesser of the principal amount thereof and the amount for which the obligation was issued by the taxpayer exceeds the amount so paid, if any, shall be applied

(a) to reduce, in the following order, the taxpayer's

(i) non-capital losses . . . .

for preceding taxation years . . . .

The appellant contends that, as is patently the case, these transactions had no business purpose but only the purpose of reducing the respondent's tax liability. Further, in terms of economic reality the debt obligations of 860 subsequently taken over by D.H. upon amalgamation have in any practical sense been terminated: the same man, Hans Hartwig, controls both the "creditor" (173235) and the "debtor" (D.H.), and there would be no reason for him to cause his debtor company to pay his creditor company. No terms of repayment or interest were ever specified and the "debt" remains unpaid.

     While I completely agree that for all practical purposes the debt no longer exists, it has not disappeared legally. Legally it would be open to 173235 to enforce this debt against D.H. Although as matters stood at the time of trial this would be a step wholly within the control of Mr. Hartwig, in theory it would be possible for someone else to acquire control of 173235 and exercise that company's rights to collect the debt, or judgment might be entered against 173235 in some action and this debt could be garnisheed to pay the judgment. The meaning of "settled or extinguished" in subsection 80(1) was considered recently by the Tax Court of Canada in Carma Developers Ltd. v. H.M. and the decision was confirmed by this Court in reasons from the Bench.¹ In that case creditors had assigned to a parent company debts owing to them by the subsidiary company, in return for the creditors getting shares in the parent company. The question arose as to whether the subsidiary's debts had thereby been settled or extinguished for purposes of subsection 80(1). Bowman T.C.C.J. in considering the meaning of subsection 80(1) stated as follows:

The term "settle" has a variety of meanings, some of which are colloquial, in the sense that a problem is resolved one way or another. The terms "settle" or "compromise" are used in some of the documents. In the context of section 80, however, "settle" connotes a final and legal resolution of a taxpayer's obligation whereby that obligation is reduced or brought to an end. It must be considered from the point of view of the taxpayer who would be affected by section 80, not the creditor. Moreover, it must be a final and legally binding termination or reduction of the debtor's obligations. That did not, as a matter of law, occur here. It is understandable that both the creditors and the CL group would view the implementation of the plan as a resolution of the immediate debt and cash flow problem confronting CDL, and in that sense the term "settlement" might loosely and colloquially be used. Its use by business persons does not imply that as a matter of law the debts have been settled. The effect of section 80 is to ascribe certain specific tax consequences to a formal and binding forgiveness or reduction of debt. . . .

It is true that in that case the creditors were at arm's length from the companies initially and that there was evidence of a clear intent that these debts should ultimately be paid. Nevertheless I respectfully agree with Bowman T.C.C.J. that for a debt to be settled or extinguished within the meaning of subsection 80(1) there must be a legally binding termination in form and that does not exist in the present case.

     The appellant referred us to various Supreme Court decisions discussing the proper approach to interpretation of the Income Tax Act² where it is alleged that the economic or business reality of a transaction does not fall within the apparent intended beneficial reach of the statute. I am unable to find in these references any sure guidance to cause me to give the words "settled or extinguished" an application other than their normal legal meaning would permit. I am not persuaded that the object and spirit of section 80(1) must be taken to include de facto settlement of debts. Further, the Minister has not alleged either a sham or an artificial reduction of income within section 245 of the Act, allegations which might, as the Supreme Court has indicated, lead to excluding the transaction from the protection of the plain legal meaning of a provision such as subsection 80(1).

     It is certainly easy to imagine abuses of subsection 80(1) through non-arm's length transactions but that is a matter for Parliament to address.

     Was 173235 an agent in acquiring or holding the debt

     owed by 860 and D.H.?

     In somewhat elliptical reasons the Tax Court judge found that 173235 was not acting as an agent or a nominee for D.H. in taking the assignment of 860's debt so as to make D.H. both the debtor and the creditor. While the Tax Court judge did not elaborate on his reasons for this conclusion, the appellant in argument was not able to demonstrate to us any substantial evidence of intent that there should be an agency relationship, nor any principle of law from which we should imply such a relationship. We therefore saw no reversible error committed by the learned Tax Court judge and we found it unnecessary to hear from the respondent on this point.

     Was D.H. carrying on in 1986 the business in which

     860 Holdings Ltd. incurred the original loss?

     The relevant dispositions of the Income Tax Act are as follows in relation to this issue.

     Subsection 87(2.1) provides in part as follows:

(2.1) Where there has been an amalgamation of two or more corporations, for the purposes only of

(a) determining the new corporation's non-capital loss . . . for any taxation year, and

(b) determining the extent to which subsections 111(3) to (5.4) apply to restrict the deductibility by the new corporation of any non-capital loss . . .

the new corporation shall be deemed to be the same corporation as, and a continuation of, each predecessor corporation . . . .

For present purposes that means that after amalgamation on December 30, 1985 the amalgamated company, D.H., would be deemed to be the same corporation as 860 for purposes of determining non-capital losses. In other words, everything else being equal, 860's non-capital losses incurred before amalgamation would be deemed to be the non-capital losses of D.H. after amalgamation.

     However one must then go to subsection 111(5) which provides in part as follows:

(5) Where, at any time, control of a corporation has been acquired by a person . . .

(a) such portion of the corporation's non-capital loss . . . for a taxation year ending before that time as may reasonably be regarded as its loss from carrying on a business is deductible by the corporation for a particular taxation year ending after that time

(i) only if that business was carried on by the corporation for profit or a reasonable expectation of profit

(A) throughout the part of the particular year that is after that time, where control of the corporation was acquired in the particular year, and

(B) throughout the particular year, in any other case . . . .

(Emphasis added).

I understand this to mean, in relation to the present case, that where as here control of the corporation was acquired in October, 1985, for a non-capital loss to be deductible as claimed in a "particular year" (in this case 1986, the taxation year in question) then the corporation taken over (860 as amalgamated with D.H.) must be carrying on in 1986 the same business that it carried on in the taxation year preceding the takeover in which the losses were incurred. In other words the expression "that business" in subparagraph (i) refers to the "business" mentioned in the opening words of paragraph 80(a) which means the business of the pre-takeover corporation at the time the losses were incurred.

     The appellant here contends that the pre-takeover business of 860 in which these losses were incurred in 1982 ceased to exist as of October 25, 1985 even though the shell of the corporation was preserved. It is argued that because, as of October 25th, 860 had disposed of its only asset capable of earning any revenue, i.e. the land which had been used as a revenue producing parking lot, and as it had nothing but debts and no prospect of any business activity, its business had therefore ceased well before the "particular year" in question here, namely 1986. Thus although by virtue of subsection 87(2.1) D.H. would be deemed to be the successor of 860 in 1986, and although D.H. was engaged in a kind of business similar to that in which 860 had once been engaged, there was a gap between the dissolution of 860's business in October, 1985, and the activities of the amalgamated D.H. in 1986.

     The trial judge apparently concluded that notwithstanding its loss of any revenue producing property as of October 25, 1985 and of any realistic prospects for carrying on business in the remainder of that year, 860 continued in its pre-existing business. As it became part of D.H., an ongoing development business, as of December 30, 1988, the interval of just over two months was seen by him simply as a "hiatus . . . not a long period of time for matters to be in some abeyance" in the development business.

     Counsel for the appellant has cited to us three decisions from lower tribunals in support of his general proposition that if as a practical matter a business has no prospect of carrying on, or is not carried on, in its previous form then subsection 111(5) cannot be invoked by its successor to deduct losses of the previous business. It must first be observed that these decisions, and many others dealing with this and related issues as to the termination of a business, depend very much on their particular facts. In Garden Investments Ltd. v. M.N.R.,³ a decision of the Tax Review Board, the losses which were claimed had been incurred in a year in which the evidence clearly showed that the company had done no business and, according to the evidence of a principal, had no intention of doing business. Thus the company was not allowed to deduct those losses in a later year when it resumed business. In North Pacific Towing and Salvage Limited v. M.N.R.⁴ another Tax Review Board decision, there was no evidence that the company had in fact resumed any business in later years. It will be noted that in neither of these cases was subsection 111(5) directly involved. It was however involved in Garage Montplaisir Limitée v. M.N.R.,⁵ a decision of the Tax Court of Canada. In that case the taxpayer company, engaged in a car dealership, bought out a competitor company also formerly engaged in a car dealership which had given up its franchise. The principal of the latter company went to work for the new, amalgamated company which invoked subsection 111(5) in order to deduct losses previously incurred by the company which had surrendered its dealership and had been amalgamated with the taxpayer company. The learned Tax Court judge took the view that the "business" for the purposes of subsection 111(5) was the particular enterprise of the company which had surrendered its franchise. She was unable to find that any of that enterprise had survived the amalgamation. Indeed the purpose of the amalgamation was to eliminate a competitor, not to continue it. This was certainly a conclusion open to the learned judge on the facts of that case, having particular regard to the special characteristics of an automobile dealership where the identity of the product and of the franchisee, and the latter's sales and service system, all went to define the "business". In the present case the learned trial judge was faced with a generic type of business, namely real estate development, and it was open to him to conclude that such business had not disappeared. It was also open to him to conclude that a period of inactivity of two months was not enough to demonstrate the end of such a business nor to establish that the business could not be carried on with a "reasonable expectation of profit" (the requirement for the application of subparagraph 111(5)(a)(i)). These were essentially findings of fact which there is no sufficient basis to disturb.

     The appellant also argued that subparagraph (111(5)(a)(i) by its very terms requires that the business had to have been carried on during the remainder of 1985 as well as throughout the taxation year in which the non- capital losses were claimed, that is 1986. It will be recalled that subparagraph 111(5)(a)(i) provides that where the control of a corporation has been acquired its business loss incurred before the change of control is deductible thereafter in a "particular taxation year" ending after the change of control only if the same business is carried on

(A) throughout the part of the particular year that is after that time, where control of the corporation was acquired in the particular year, and

(B) throughout the particular year, in any other case . . . .

As I understand the argument of counsel for the appellant, it is that sub-subparagraphs (A) and (B) are cumulative. Further he says that sub-subparagraph (A) applies here to the period from October 25, 1985 (when D.H. acquired control of 860) to December 30, 1985, when 860 was amalgamated with D.H. and that no business was carried on in that period even if it was carried on by the successor company in 1986. Firstly, it appears to me that the strict language of sub-subparagraph (A) applies only to the period of October 25, 1985 to October 31, 1985 which was the end of 860's 1985 taxation year. Control of 860 was acquired during that taxation year which is the "particular year" referred to in the sub-subparagraph. Secondly, and more importantly, in this context I am satisfied that the "and" at the end of sub-subparagraph (A) must be read disjunctively. What paragraph 111(5)(a) is directed to is the deductibility of an earlier loss in a "particular taxation year". Sub-subparagraphs (A) and (B) refer to two possible situations: (A) refers to the deductibility of such a loss in the same taxation year in which control was acquired; and (B) refers to deductibility of a loss in any other ensuing taxation year. Thus all we need to be concerned about is the application of (B), that is as to the business carried on in 1986. It is not suggested that the amalgamated D.H. was not carrying on real estate development business in 1986.

     Again it must be underlined that no allegation was made by the appellant of sham or of an artificial reduction of income within the meaning of section 245 and the learned Tax Court judge has applied the plain meaning of these provisions to the facts he was entitled to find.

     The Cross-Appeal

     For the reasons which we found in Hans Hartwig v. Her Majesty the Queen (A-313-94) that the learned Tax Court judge was correct in holding that a portion of the expenditure of D.H. in respect of the K-2 Ranch conferred a taxable shareholder's benefit on Mr. Hartwig, I would also confirm his finding that such expenses were not deductible from the income of D.H. because they were not incurred to earn income.

Conclusion

     The appeal and cross-appeal should therefore be dismissed with costs.

    

                                 J.A.

I agree

James K. Hugessen J.A.

I agree

Alice Desjardins J.A.

__________________

1      (1996) 96 D.T.C. 1798 (T.C.C.); aff'd October 15, 1996, unreported, A-449-96 (F.C.A.).

2      E.G. Stubart Investments Limited v. the Queen (1984) 84 D.T.C. 6305; Atosko v. the Queen (1994) 94 D.T.C. 6314.

3      (1974) 74 D.T.C. 1014 (T.R.B.).

4      (1975) 76 D.T.C. 1054 (T.R.B.).

5      (1992) 92 D.T.C. 2317 (T.C.C.).