Date: 19991217
Docket: A-182-97
CORAM: DÉCARY J.A.
LÉTOURNEAU J.A.
NOËL J.A.
BETWEEN:
QUEENSWOOD LAND ASSOCIATES LIMITED,
Appellant,
- and -
HER MAJESTY THE QUEEN,
Respondent.
Heard at Montreal, Quebec on Wednesday, November 24, 1999
Judgment delivered at Ottawa, Ontario on Friday, December 17, 1999
| REASONS FOR JUDGMENT BY: NOËL J.A. |
| CONCURRED IN BY: DÉCARY J.A. |
LÉTOURNEAU J.A.
Date: 19991217
Docket: A-182-97
CORAM: DÉCARY J.A.
LÉTOURNEAU J.A.
NOËL J.A.
BETWEEN:
QUEENSWOOD LAND ASSOCIATES LIMITED,
Appellant,
- and -
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
NOËL J.A.
[1] This is an appeal from a judgment of the Tax Court of Canada, dismissing in part the appellant"s appeal against reassessments with respect to its 1986, 1987 and 1988 taxation years.1
[2] By these reassessments, the Minister of National Revenue determined that the forgiveness of a debt owed by a company acquired by the appellant and then amalgamated with it gave rise to taxable income in the hands of the appellant to the extent of the amount forgiven. The outcome of this appeal turns on the characterization of this forgiveness of debt for income tax purposes.
Facts
[3] Queenswood Land Associates Ltd. ("the appellant"), an Ontario corporation, acquired on December 2, 1986 the shares of R-104 Holdings Ltd. ("R-104"), a British Columbia corporation incorporated in 1979 and continued under the laws of Ontario on July 31, 1986. On December 24, 1986, the two corporations were amalgamated.
[4] Prior to the amalgamation, the appellant operated a land development business in the Ottawa region. It was doing well financially and its management was looking for ways to decrease its income tax liability. It learned of the existence of R-104, which operated the same business in British Columbia and had suffered income losses due to the fall in value of its real estate assets.
[5] R-104 was heavily financed at the time. The outstanding loan between it and its lender, First City Financial Corporation ("First City"2) was a participating loan whereby the lender, in addition to interest payments at a rate of 2% over prime,3 was entitled to a share of the profits from the financed project.4 The agreement also provided that the use of the borrowed funds had to be approved by the lender.5 The loan was secured by a charge on the land and a floating charge on the assets as well as by the personal guarantee of R-104's shareholders.6
[6] At the time of its acquisition by the appellant, R-104's liability under the loan agreement stood at $11,185,095 including accrued interest in the approximate amount of $6,450,000.
[7] The transaction whereby the appellant acquired the outstanding shares of R-104 took place on December 22, 1986 together with two related transactions. On that day, First City agreed to release R-104 from the obligation to pay any amount of indebtedness in excess of $3,384,9907 and R-104 gave First City an option to acquire its land inventory for a price equal to its fair market value (i.e. $2,155,000) which option was exercised the same day.8
[8] As a result of the disposition of its land inventory, R-104 incurred a business loss in the amount of $9,442,196, that is the difference between the cost of the land sold ($10,950,696) and its portion of the proceeds from the sale ($1,508,500).9 The appellant acquired all the issued shares of R-104 for a price of $10.00 the same day10 and the two companies were amalgamated two days later. It is common ground that at December 22, 1986, R-104's interest in the land had a cost for income tax purposes of $10,950,696.11
[9] In filing its income tax return for its 1986 taxation year, the appellant took the position that it had incurred a loss of $9,942,196 from the sale of the land.12 The unused portion of these losses were carried forward and deducted against income earned for its 1987 and 1988 taxation years.
[10] The Minister issued a reassessment adding to the income of the appellant inter alia the debt forgiven in the amount of $8,303,261 for its 1986 taxation year.13 In issuing this reassessment, the Minister took the position that the nature of the debt forgiven was such as to give rise to income of a commensurate amount in the hands of the benefactor of the forgiveness. Alternatively, the forgiveness was said to reduce the cost of the land inventory in that year. Consequential reassessments were issued for the 1987 and 1988 taxation years.
[11] The appellant brought an appeal before the Tax Court of Canada. By judgment rendered on February 18, 1997, the appeal was denied in part.14 The appellant appeals from the decision of the Tax Court of Canada insofar as it denies it the benefit of the loss of $9,942,196 claimed to have been incurred during its 1986 taxation year.
Decision Appealed From
[12] The Tax Court Judge in her reasons quoted extensively from the decisions of the Supreme Court of Canada in Oxford Motors Co. Ltd. v. M.N.R.15 and Tip Top Tailors Limited v. M.N.R.16 She stated by reference to these two decisions:
| I find that the legal principles, expressed in these decisions which examined in depth the British Mexican decision that is the basis of the Appellant"s position, can and should apply to all cases of forgiveness of a debt or increase or reduction of capital.17 |
[13] The Tax Court Judge then outlined the test to be applied in deciding whether a forgiveness of debt gives rise to income or is to be treated on account of capital:
| These legal principles are that the purpose of the forgiveness and the use of the borrowed moneys forgiven have to be examined to determine whether the debts that have been forgiven should be included in the calculation of the business income. Unless the purpose of the forgiveness is to restore the capital, the use of the borrowed moneys forgiven has to be examined to see how it related to the borrower"s business. |
| In this appeal, although there was no specific evidence on the purpose of the forgiveness, it is, however, clear from the circumstances of the deal entered into by the three parties, that the purpose of the forgiveness had nothing to do with the restoring of the taxpayer"s capital or the injection of new capital nor was it an act of grace. It is thus fundamentally distinct from the circumstances of the British Mexican decision and thus this decision does not apply to resolve the matter.18 |
[14] She went on to hold as follows:
| The loans were used to produce working capital in the course of the company"s business. The indebtedness created arose directly out of the business: The total amounts of the loans have been expended on the acquisition of the lands and the interest owed on the loans has been added to form cost of the lands. The suppliers (vendors) were paid through loans made to the purchaser by the lender and if it were not for the moneys borrowed, the amounts would still be owed to the vendors. The costs of acquisition were not owed to the vendors but were owed to the lender and ... in substance the creation of debt in the bank was merely a substitution of creditor for the actual transactions. (Tip Top Tailors (supra) p. 1234).19 |
[15] Based on this reasoning, the Tax Court Judge concluded that the value of the forgiven debt should be deducted from the cost of the land inventory as the amounts due to the "substituted creditors were no longer owed".20
Analysis and Decision
[16] Section 80 of the Act deals with the tax treatment of a forgiveness of debt. This provision as it read during the 1986 taxation year provided that:
| 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 after 1971 without any payment by him or by the payment of an amount less than the principal amount of the debt or obligation, as the case may be, 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
|
80(1) Lorsque, à une date quelconque pendant une année d"imposition, une dette contractée par un contribuable, ou une autre obligation contractée par un contribuable de payer une somme, est réglée ou éteinte après 1971, sans que ce contribuable effectue de paiement, ou par le paiement d"une somme inférieure au principal de la dette ou de l"obligation, selon le cas, la fraction du moins élevé des montants suivants: ce principal ou le montant pour lequel l"obligation a été émise par le contribuable qui est en sus de la somme ainsi versée, le cas échéant, doit servir
|
unless ...
|
à moins que [...]
|
[17] As can be seen, paragraphs (a) and (b) of section 80 prescribe the manner in which a debt forgiveness is to be allocated for income tax purposes. They apply unless paragraph (f) is operative, that is unless the amount of the forgiveness is otherwise required to be included in income.
[18] In this instance the appellant, being of the view that the amount forgiven was not required to be included in income, applied paragraphs (a) and (b) of section 80 which left it with the quasi-totality of the forgiven debt available to be carried forward.21 The respondent on the other hand took the position that the application of section 80 was excluded as, in its view, the forgiven debt was "otherwise required to be included in computing [the appellant"s] income." Specifically, the respondent submits that the value of the debt forgiven is to be included in the appellant"s profit computation pursuant to subsection 9(1) of the Act.22 Alternatively, the respondent argues that the forgiveness operates to reduce the cost of the appellant"s land inventory pursuant to subsection 10(1).23
[19] The Act does specify the tax consequences arising from the forgiveness of a debt in specific instances, none of which arise here.24 Section 80 is the only provision which purports to deal with the forgiveness of a debt generally and, as can be seen from paragraph (f), it begs the question as to whether or not such an occurrence gives rise to income. In the absence of any statutory direction in this regard, reference must be made to the case law.
[20] Before considering the case law, it is important to note that no sham of any sort is alleged in this instance. The transaction giving rise to the business loss and the extent of that loss are not in issue nor is the transaction whereby R-104 and the appellant were merged into one. The only issue is whether the forgiveness of debt itself, agreed to have been in the amount of $8,303,261, should having regard to judicial precedents and well-accepted business principles,25 be included in the computation of the appellant"s profit. If not, the respondent concedes that the appeal ought to succeed.26
[21] The leading case on this subject, or at least the first ostensible authority in time, is the decision of the House of Lords in the British Mexican Petroleum Co., Ltd. v. Jackson.27 This case dealt with the forgiveness of a trade debt. British Mexican was in the business of purchasing and selling oil. Due to a substantial decrease in the price of oil, it found itself in a position where it was unable to pay its supplier for oil delivered. Rather than force British Mexican into bankruptcy, the supplier forgave a substantial portion of the debt.28
[22] The debt for the supply of oil had been incurred during British Mexican"s 1921 taxation year and the forgiveness had been granted during the subsequent taxation year. Both Lord Macmillan and Lord Thankerton with which the other Lords agreed held that the year in which the debt arose could not be reopened and that the forgiveness could not be said to be an act of trading in the year in which it was granted.29 Lord Macmillan in his reasons noted that the result may well have been different if the forgiveness had occurred during the year in which the subject debt had been incurred.30
[23] In Oxford Motors, an English supplier of cars gave its Canadian distributor a rebate of $250 for each car sold. The rebates took the form of credits against the appellant"s indebtedness for the cars delivered in the prior year. The appellant relied on the British Mexican decision to argue that the rebate was given in the year following that in which the debt was incurred and hence not taxable in that year.
[24] The majority of the Supreme Court Judges rejected this argument.31 The Court noted that the British Mexican case did not decide that the forgiveness of a trade debt can never be taken into account in computing the profit from a business. It disregarded the argument framed by reference to the proper taxation year and held that the rebates formed part of the trading profit of the appellant in the year in which they were granted:
| The result of the offer made by [the supplier] was that appellant"s inventory of cars, if sold in Canada, would yield to it an additional gross profit of $250 per car. Put alternatively, the cost of every car sold in Canada was reduced by $250. |
| ... |
| The rebates were intricately related to the appellant"s trading operations, and ... the profit realized from them was clearly a trading profit for the business.32 |
[25] In Tip Top Tailors,33 the ordinary practice of the appellant company was to pay for each lot of woolen cloth it bought in Great Britain by an individual purchase of sterling at the rate of exchange then prevailing. Toward the end of 1947, the appellant, believing that the pound would be devalued, arranged a line of credit which it used for some two years in making its purchases of wool. When the pound was devalued in 1949, the appellant settled its bank overdraft at the then prevailing rate realizing a gain of $170,000 which the Minister treated as income.
[26] The Supreme Court ruled that the Minister"s treatment of the gain was the correct one on two alternative views.34 Locke J.35 held that the appellant used the opportunity of purchasing wool in British pounds to reduce its cost because it anticipated the devaluation of the pound. He could see no difference between the short sale of sugar and the position of the appellant in regard to the profit made due to the fall in value of the pound. In his view, the appellant had simply embarked on a profit venture intended to reduce the cost of its wool supplies.36 Rand J. for his part,37 considered that the exchange gain was so intimately linked to the payments made by the appellant in the course of its trading operation as to form part of it.38
[27] I believe that it can be safely stated from these authorities that where the forgiveness of an amount owed by a business pertains to a "trade debt," or a debt that is so intimately connected with the trade of the business as not to be segragable from it, it will usually form part of the profit of the business.39 Where however the forgiveness pertains to a debt that is distinct and removed from the trading operations of a business, it will normally not impact on its profit for the year.
[28] Addressing this distinction between trading operations per se and activities that are ancillary to these operations, Rand J. stated in Tip Top Tailors:
| ... the capital machinery within and by means of which the business earning the income is carried on is distinct from that business itself; and the fluctuations in its value have no bearing on profits or losses from the business.40 |
He went on to explain the difference between the "capital machinery" of a business and its income earning operations by referring to the statement of Lord Macmillan in Montreal Coke and Manufacturing Company v. M.N.R.:
It is not the business of either of the appellants to engage in financial operations. The nature of their business is sufficiently indicated by their titles. It is to those businesses that they look for their earnings. Of course, like other business people, they must have capital to enable them to conduct their enterprises but their financial arrangements are quite distinct from the activities by which they earn their income.41
[29] Thus, it has been held that where a forgiveness occurs with respect to a debt incurred in a borrower-lender relationship entered into to finance the operations of the business, it will usually be treated as an abatement of a capital liability since the forgiveness falls outside the "normal trading operations of the business".42
[30] More recently, the Tax Court of Canada, in a case that appears to be on all fours with the present one had to rule on the character of the forgiveness of a debt owed pursuant to a loan advanced to finance the borrower"s land development business.43 Rip T.C.C.J. expressed the view that the question as to whether the forgiveness of a debt is on revenue or capital account depends on whether the debt itself is on revenue or capital account. He went on:
When a person subscribes for share capital in a corporation the transaction is a capital transaction regardless of the use the corporation applies the money. The corporation may use the funds to purchase a plant or use the funds to purchase its inventory; in both cases the money obtained from shareholders is capital. Similarly when a corporation borrows money from its banker to finance acquisition of assets, including inventory, for example, the transaction between the lender and borrower is a capital transaction. The debt is on capital account.44
Rip T.C.C.J. later concluded:
| The repayment of the loan by [the borrower] would not have affected its profit in the year of payment; neither should the forgiveness of part of the loan affect its profit. The partial forgiveness of the debt amounted to no more than a saving to [the borrower] and a saving of money is not to be included in a taxpayer's income.45 |
[31] The Tax Court Judge in this instance appeared to accept that the forgiveness arose in the course of a normal borrower-lender relationship. Counsel for the Minister had indicated during the trial that he intended to demonstrate that the participating loan was not a normal financing arrangement, but the Tax Court Judge notes in her reasons that "no evidence to [that effect] was adduced and at the time of the argument, no supporting jurisprudence was presented".46 As a result, the Tax Court Judge made no adverse finding with respect to the loan arrangement and there is no reason to believe that it departs from the type of loan which a lender and a land developer would enter into in the normal course of business.
[32] The Tax Court Judge in her reasons recognized that the income earning activities of the appellant consisted in the purchase, development and sale of land and that the loans were used to provide the appellant with working capital to be applied towards those ends. She acknowledged that the loans were in fact used to finance the acquisition of the land inventory and its development. Nevertheless, after noting that the loan arose "directly out of the business", she held, relying on Tip Top Tailors and Oxford Motors, that the loans and their forgiveness formed part of the trading operations of the appellant.
[33] In my respectful view, the Tax Court Judge in so doing misconstrued Tip Top Tailors and Oxford Motors. Tip Top Tailors is a decision which turns on its own facts. The loan arrangement in that case was put into place for the specific purpose of benefiting from an anticipated devaluation of the British pound. The appellant decided to deliberately pursue the policy of running a large overdraft in the pursuit of that goal. That is the context in which Locke J. held that:
| ... it was a scheme for profit-making in one necessary part of the appellant's trading operations, namely, the purchase of sterling funds and part of an integrated commercial operation being the purchase of the supplies and the payment for them in that currency.47 |
[34] In Oxford Motors, the Court was confronted with a rebate triggered by the sale of items of inventory which, not surprisingly, was found to be "intricately" linked to the appellant"s trading operations.
[35] Nothing of the sort took place here. The Tax Court Judge found as a fact that the loans were used to provide the appellant with the working capital necessary to conduct its land development operations. Nevertheless, she held that "the costs of acquisition were not owed to the vendors [of the land] but were owed to the lender".48 In her view, the lender upon advancing the borrowed funds merely substituted itself to the vendors of the land, and in effect became the creditor of the balance of sale.49
[36] In the absence of a sham, or some such finding, it was not open to the Tax Court Judge to recharactarize for tax purposes the appellant"s legal relationship with its lenders and its suppliers.50 Based on the evidence, the cost of acquisition of the appellant"s land inventory was owed and indeed paid to the vendors of the land in question and the lender merely advanced the funds necessary to finance these purchases. The Tax Court Judge fell into error when she effectively chose to recast the legal relationship between the parties based on her own perception of the matter. In the absence of a finding that the transactions in issue did not have the legal effect which the parties attached to them, it was not open to the Tax Court Judge to ignore their legal effect.
[37] During the hearing of the appeal, counsel for the Minister advanced an alternative ground in partial support of the decision under appeal. Accepting that the forgiveness did result in the abatement of a capital debt, he submitted that it should nevertheless be treated as income to the extent of that part of the forgiveness which relates to the accrued interests on the outstanding loans.
[38] His reasoning, as I understood it, was that the capital portion of the debt forgiven represents moneys which were actually disbursed towards the acquisition of the land inventory. As such it was appropriate to reflect this portion of the forgiveness in the cost of R-104's land inventory. The accrued interests, because R-104 opted to "capitalize" them, were also added to the cost of inventory. However, as a result of the forgiveness, they were never disbursed. Hence, counsel submitted that the portion of the forgiveness pertaining to the accrued interests should logically be added to the profit of the appellant as it represents a cost which was incurred but never paid.
[39] In advancing this argument, counsel confuses the cost of the appellant"s land inventory as it stood in 1986 with the subject matter of the forgiveness. The cost of R-104's land inventory for income tax purposes has not been challenged. It includes the cost of the land per se, the development cost, and the accrued interest which R-104 was entitled to add to the cost of the land pursuant to section 18(9) as it read in 1986. The respondent has conceded in this proceeding that on December 22, 1986, R-104's land inventory had a cost for tax purposes of $10,950,696.51
[40] The subject matter of the forgiveness on the other hand were amounts owed and unpaid under the loan agreement as at December 22, 1986. There is no question that these amounts were properly due and exigible at that time both as to their capital and interest component. That being so, the only question which must be answered for income tax purposes is whether the debt, at the time of the forgiveness, was on revenue or capital account. In this instance, it seems clear for the reasons that I have given that the debt was on capital account and it follows that its forgiveness has no impact on the appellant"s profit for the year.
[41] I would therefore allow the appeal with costs here and below, set aside the judgment of the Tax Court and refer the matter back to the Minister for reconsideration and reassessment on the basis that the forgiveness of debt in the amount of $8,303,261 is not required to be included in computing the appellant"s income for its 1986 taxation year.
"Marc Noël"
J.A.
"I agree.
Robert Décary J.A."
I agree.
Gilles Létourneau J.A."
__________________
1The decision is reported at 97 D.T.C. 1048.
2First City is the last of three interrelated companies which financed the operations of R-104 during its seven years of existence.
3Loan Agreement, para. 2.2, Appeal Book, vol. at 402.
4Ibid, clause B of preamble and para. 3.2 at 397 and 403.
6Ibid, paras. 2.5 and 2.6 at 402.
7Settlement Agreement, Appeal Book, vol. I at 94.
8Put/Call Agreement, Appeal Book, vol. I at 237.
9That is R-104's portion of the proceeds, i.e. 70% of $2,155,000. The remaining 30% was paid to R-104's three individual shareholders who each had acquired a 10% undivided interest in R-104's land inventory in the course of a prior refinancing. (see Settlement Agreement, supra note 6, para E at 95)
10Share purchase agreement, Appeal Book, vol. I at 130.
11Respondent"s Memorandum of Fact and Law, para. 11. The respondent takes issue with the impact of the forgiveness on this amount but the cost of the land is not otherwise contested.
12Income tax return, Appeal Book, vol. I at 72. The amount originally claimed was $9,443,657 but is now agreed to be $9,942,196.
13The amount of $8,446,605 is mentioned as the extent of the forgiveness at paragraph 16 of the Respondent"s Memorandum of Fact and Law, but the appellant states at paragraph 16 of its own Memorandum that $8,303,261 is the agreed amount.
14Also in issue before the Tax Court was the tax treatment of an amount of $1,229,990 paid by the appellant to First City through R-104 in the course of the transaction. In its judgment, the Tax Court agreed with the appellant"s submission that this payment operated to reduce R-104's indebtedness towards First City and hence did not form part of the debt which was forgiven. No cross appeal was taken from this decision.
1559 D.T.C. 1119, ("Oxford Motors").
1657 D.T.C. 1232, ("Tip Top Tailors").
17Supra note 1 at 1054, footnote omitted.
21An amount of $39,839 was applied on account of non-capital losses incurred in prior years pursuant to paragraph 80(1)(a). (See Schedule of Continuity of Losses Carried Forward, Appeal Book, vol. I at 75) Otherwise, the appellant had very little property of a depreciable nature, with the result that paragraph 80(1)(b) also had a limited application.
| 9(1) Subject to this Part, a taxpayer"s income for a taxation year from a business or property is his profit therefrom for the year. | 9(1) Sous réserve des dispositions de la présente Partie, le revenu tiré par un contribuable d"une entreprise ou d"un bien pour une année d"imposition est le bénéfice qu"il en tire pour cette année. |
| 10(1) For the purpose of computing income from a business, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation. | 10(1) Aux fins du calcul du revenu tiré d"une entreprise, les biens figurant dans un inventaire sont évalués au coût supporté par le contribuable ou à leur juste valeur marchande, le moins élevé de ces deux éléments étant à retenir, ou de toute autre façon permise par les règlements. |
24See for example paragraph 12(1)(x) and ss. 13(7.1).
25I use this expression in the sense attributed to it by the Supreme Court in Canderel Limited v. The Queen, 98 D.T.C. 6100 at 6107-08.
26Respondent"s Memorandum of Fact and Law, para. 17.
27(1932) 16 T.C. 570 ("British Mexican")
28Ibid, Reasons of the King"s Bench Division at 584-586.
29Ibid per Lord Tankerton at 592 and per Lord Macmillan at 593.
35With whom the Chief Justice concurred.
37With whom Fauteux J. agreed.
39The case of M.N.R. v. Enjay Chemical Co. Ltd., 71 D.T.C. 5293 (F.C.T.D.) illustrates the proper application of this principle.
41Montreal Coke and Manufacturing Company v. Minister of National Revenue, [1944] A.C. 126, [1944] 1 All E.R. 743, [1944] 3 D.L.R. 545 [2 D.T.C. 654].
42Geo. T. Davie and Sons Ltd. v. M.N.R., 8 D.T.C. 1045 at 1052 per Cameron J.
43Molstad Development Company Limited v. The Queen, 97 D.T.C. 913 (presently under appeal to this Court).
45Ibid at 921 (footnote omitted).
46Reasons for Judgment, supra note 1 at 1050.
49The relevant passage of her reason is quoted at paragraph 14 of these reasons.
50See the recent decision of the Supreme Court in Shell Canada Ltd. v. Canada, [1999] S.C.J. 30, and in particular para. 41 thereof.