Date: 19991001
Docket: 97-2817-IT-G
BETWEEN:
ANTHONY ORLANDO,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Lamarre Proulx, J.T.C.C.
[1] This is an appeal respecting the 1990 and 1993 taxation years.
[2] The issue is whether the Appellant is entitled in the year 1993 to a business investment loss regarding advances he had made to a corporation of which he was a shareholder. In the year 1993, the Appellant accepted to delete from the corporation's books the amount of loans and to accept, seemingly in compensation, shares of the corporation, nominally in the amount of the loans, although the fair market value of these shares was nil. In the same year, the Appellant sold these shares to his wife for an amount of $1.00. The year 1990 is under appeal as a consequence of the carrying back of the losses incurred in 1993 as a business investment loss.
[3] The facts upon which the Minister of National Revenue (the "Minister") relied in reassessing the Appellant are described at paragraph 14 of the Amended Reply to the Notice of Appeal (the "Reply") as follows:
a) At all material times, the Corporation carried on business in the construction field.
b) The Corporation's shareholders were Francesco Orlando, the Appellant and Vincent Solomita, each of whom owned one third of the shares.
c) Francesco Orlando and the Appellant are brothers.
d) At all material times, the Appellant, Francesco Orlando and the Corporation did not deal at arm's length.
e) The shareholders of the Corporation advanced certain amounts to the Corporation by making deposits into its bank account.
f) The advances made to the Corporation were non-interest bearing and were subject to no repayment conditions.
g) The advances to the Corporation were not made by the Appellant and Francesco Orlando for the purpose of gaining or producing income from a business or property.
h) On December 22nd, 1993, in consideration for the advances made to the Corporation, the Appellant and Francesco Orlando received Class B preferred shares issued by the Corporation.
i) The Class B preferred shares received by the Appellant were not retractable.
j) This transaction was reflected in the Shareholders' Advance Account which was reduced by an amount of $159,690; $79,844 with respect to the Appellant and $79,845 with respect to Francesco Orlando.
k) In addition, on that same date, the Class B preferred shares paid-up capital was increased by an amount of $159,690; that is $79,844, for the Appellant and $79,845 for Francesco Orlando.
l) A study conducted by Revenue Canada with a view to determining the fair market value of the Appellant's and Francesco Orlando's debt established that its fair market value was nil as of December 22nd, 1993.
m) The same study established that as of December 22nd, 1993, the fair market value of the Class B preferred shares of the Corporation was nil.
n) On December 28th, 1993, the Appellant and Francesco Orlando each sold their Class B preferred shares to their respective wives for the amount of $1.
o) With respect to that transaction, the adjusted cost base of the Class B preferred shares was $79,845.
p) At the end of his 1993 taxation year, the Appellant did not have a debt owing to him by the Corporation.
q) At the end of their 1993 taxation year neither the Appellant nor Francesco Orlando owned any Class B preferred shares issued by the Corporation.
r) At the end of 1993, the Corporation had not ceased permanently to carry on its business.
s) In this regard, at the end of 1993, the Corporation owned assets capable of producing income: five residences to be sold and one piece of vacant land. Efforts were still being made to sell the residences.
t) At the end of 1993, the Corporation had a valid construction licence.
u) In 1995, the Corporation was able to rent one of the residences.
Regarding the facts assumed by the Minister, paragraph o) of the original Reply read as follows:
o) With respect to that transaction, the adjusted cost base of the Class B preferred shares was nil.
[4] The Appellant and his brother, Mr. Francesco Orlando, testified in this matter.
[5] The Appellant admitted subparagraphs 14a) to 14f), 14h), 14j), 14n) to 14u) of the Reply. Mr. Francesco Orlando, who was the president of the corporation, admitted subparagraph 14i), 14l) and 14m) of the Reply.
[6] Respecting subparagraph 14g) of the Reply, the Appellant stated that money had been loaned to the corporation for the purposes of its business, so that it could pay dividends to him as a shareholder and enhance the value of its shares.
[7] Mr. Francesco Orlando explained that the advances had been transformed into shares because La Régie des bâtiments du Québec required, in order for the corporation to maintain its construction licence, that the ratio of capital over debts be increased. Therefore, the lenders accepted to show their debts as having been extinguished by the issuance of shares which increased the corporate capital. He explained that the shares were sold to their wives in that same year in order that they, as lenders, could take their real losses on the cancellation of the loan debts.
[8] In the first Reply, it was one of the Respondent's arguments that the Appellant's loss from the disposition of his debt was deemed to be nil according to subparagraph 40(2)(g)(ii) of the Income Tax Act (the "Act") because the debt had not been acquired for the purpose of gaining or producing income. Therefore, the Appellant had not incurred a capital loss. This position was not maintained at the time of the hearing, in view of the decision of the Federal Court of Appeal in Byram v the Queen, 99 DTC 5117. It was also one of the Respondent's original argument that the shares acquired as consideration for the cancellation of the advances had no value and therefore there was no capital loss when the Appellant sold them to his wife for $1.00. Counsel for the Respondent had sent to the Court before the hearing, a report of an expert witness to the effect that these shares were worth nothing. This report was not produced in view of the change of position taken by the Minister: the shares had an adjusted cost base in the amount of the forgiven loans. This position was expressed in the amended reply where the Respondent accepted that the Appellant had acquired the shares for the face amount of the forgiven loans and that there was a capital loss when the Appellant disposed of his shares for $1.00.
[9] However, the Minister found that the loss on the disposition of the shares did not meet the conditions of a business investment loss in the year of their disposition in 1993 by virtue of subparagraph 50(1)(b) of the Act. The shares must be owned at the end of the year and, more particularly, the corporation must be bankrupt or insolvent or not carrying on business at the end of the year. Counsel for the Respondent also submitted that the condition set out in subparagraphs 39(1)(c)(ii) and (iii) could not apply since the disposition was not made to a person with whom the Appellant was dealing at arm's length. The same reasoning applied to subparagraphs 39(1)(c)(ii) and (iv) of the Act regarding the debt owing to the Appellant.
[10] Respecting the loan debt, counsel for the Respondent submitted that the condition set out in subparagraph 39(1)(c)(i) of the Act which refers to paragraph 50(1)(a) of the Act was not met since no debt was due to the Appellant by the corporation at the end of the year 1993 as required by this subparagraph. She submitted that they had received payment of their debts by the issuance of shares.
[11] The Appellant and Mr. Francesco Orlando submitted simply that they really incurred the losses in 1993 when they accepted to eradicate their loans from the corporate books and accept in exchange shares that were worthless. They submitted that they acted in this fashion strictly for business purposes. It was in the same spirit that they had made the advances to the corporation.
Analysis and conclusion
[12] The relevant legislation reads as follows:
39(1) For the purposes of this Act,
...
(c) a taxpayer’s business investment loss for a taxation year from the disposition of any property is the amount, if any, by which the taxpayer’s capital loss for the year from a disposition after 1977
(i) to which subsection 50(1) applies, or
(ii) to a person with whom the taxpayer was dealing at arm’s length
of any property that is
(iii) a share of the capital stock of a small business corporation, or
(iv) a debt owing to the taxpayer by a Canadian-controlled private corporation (other than, where the taxpayer is a corporation, a debt owing to it by a corporation with which it does not deal at arm’s length) that is
(A) a small business corporation,
(B) a bankrupt (within the meaning assigned by subsection 128(3)) that was a small business corporation at the time it last became a bankrupt, or
(C) a corporation referred to in section 6 of the Winding-up Act that was insolvent (within the meaning of that Act) and was a small business corporation at the time a winding-up order under that Act was made in respect of the corporation,
...
40(2) Notwithstanding subsection (1),
...
(g) a taxpayer’s loss, if any, from the disposition of a property, to the extent that it is
(i) a superficial loss,
(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length.
...
is nil.
50(1) For the purposes of this subdivision, where
(a) a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to the taxpayer in respect of the disposition of personal-use property) is established by the taxpayer to have become a bad debt in the year, or
(b) a share (other than a share received by a taxpayer as consideration in respect of the disposition of personal-use property) of the capital stock of a corporation is owned by the taxpayer at the end of a taxation year and
(i) the corporation has during the year become a bankrupt (within the meaning of subsection 128(3)),
(ii) the corporation is a corporation referred to in section 6 of the Winding-up and Restructuring Act that is insolvent (whithin the meaning of that Act) and in respect of which a winding-up order under that Act has been made in the year, or
(iii) at the end of the year, the corporation is insolvent and neither the corporation nor a corporation controlled by it carries on business, and
(A) at the end of the year, the fair market value of the share is nil and it is reasonable to expect that the corporation will be dissolved or wound up and will not commence to carry on business, and
(B) in the taxpayer’s return of income under this Part for the year the taxpayer elects to have this subsection apply in respect of the share,
the taxpayer shall be deemed to have disposed of the debt or the share as the case may be, at the end of the year for proceeds equal to nil and to have reacquired it immediately thereafter at a cost equal to nil.
[13] I will first comment on subparagraph 40(2)(g)(ii) of the Act. That subparagraph provides a first restriction on the taxpayer’s ability to claim a business investment loss: the debt must have been acquired by the taxpayer for the purpose of gaining or producing income or the loss will be deemed to be nil. It appears now to be well established that a taxpayer that makes an interest-free loan to a corporation, of which the taxpayer is shareholder, may do so for the purpose of gaining or producing income from business or property. In Business Art Inc. v. M.N.R., [1987] 1 C.T.C. 2001, 86 DTC 1842, at page 1848, the following passage of Rip J.’s judgment has been often cited and reads as follows:
... It is not uncommon for a shareholder to lend money without interest and without security to the corporation since he anticipates that the loans will assist the corporation to earn income and to pay him income by way of dividends; the loan is made for purpose of earning income from a property. Although the shareholder is a creditor of the corporation when he advances money to the corporation the shareholder does not see his advance of money to the corporation and his subscription for shares of the corporation as separate investments in two watertight compartments; rather he sees his money entering two compartments which open up into a single compartment for the use of the corporation. Purchasing shares and advancing money to a corporation are two ways of making an investment in the corporation. ...
[14] In Byram (supra), the Federal Court of Appeal adopted the above reasoning. That Court determined affirmatively that a taxpayer could claim an allowable capital loss pursuant to subparagraph 40(2)(g)(ii) of the Act, for losses incurred on interest-free loans made to a corporation for the purpose of earning dividend income.
[15] It is my view that it stands out from the facts of this case that the only provisions that could be of application are subparagraph 39(1)(c)(i) and paragraph 50(1)(a). I refer to my description of the Minister's position regarding other provisions that may be pertinent at paragraph 9 of these Reasons. I agree with counsel for the Respondent that the facts of this case do not permit the application of these provisions.
[16] Paragraph 50(1)(a) of the Act provides that where a taxpayer is owed at the end of the year a debt that is established to be a bad debt, there is a deemed disposition of the debt. The taxpayer is deemed to have disposed of the debt at the end of the year for proceeds equal to nil and to have reacquired it immediately thereafter at a cost equal to nil. Because the Appellant has accepted to remove his debts from the corporate books for the issuance of share capital, counsel for the Respondent submits that there is no debt owing to the Appellant at the end of the year. There was no discussion as to whether the debt was correctly established to be a bad debt.
[17] On this last aspect, I will refer to one of my decisions in Granby Construction & Equipment Ltd v. M.N.R., 89 DTC 456, where I had made an analysis of the case law on how a debt is established to be a bad debt. The conclusion was that it takes a serious and thorough consideration of the financial position and capabilities of the business and that there is an honest and reasonable determination that a debt is not collectable at the end of the fiscal year, the whole made in a pragmatic businesslike manner. The evidence in this case shows nothing else.
[18] However, the point made by counsel for the Respondent was that there was no debt at all, bad or not, at the end of the fiscal year. It is an essential element and it must be there. In this respect, it is interesting to look more closely at the facts of the case in Byram (supra), more particularly to the one described at paragraph 7 of that decision. In that matter, the Appellant had made interest free loans to a corporation of which he was the majority shareholder. He had also made interest-free loans to a corporation that was a subsidiary of a corporation in which he was a shareholder. These loans were assigned on December 28, 1984 to an employee for $1.00, the year in which the business investment loss was claimed. There was no debate as to whether the transfer was made to a person with whom the creditor was dealing at arm's length, if it was an application of subparagraph 39(1)(c)(ii) and (iv), or whether the debt was still in existence, if it was an application of subparagraph 39(1)(c)(i) and paragraph 50(1)(a). The only issue before the Court was whether the interest-free loans were made for the purpose of gaining or producing income as articulated in subparagraph 40(2)(g)(ii).
[19] In this instance, in view of paragraph 50(1)(a) of the Act, the taxpayer must establish, in addition that it was a bad debt, that the debt was still outstanding at the end of the taxation year in question. In Beck v. M.N.R., [1992] 2 C.T.C. 2085, 92 DTC 1784, I found that a debt owed by a corporation to the taxpayer, a shareholder of the corporation, was extinguished as a result of an agreement, entered into in 1984, by which shares were issued to the taxpayer in satisfaction of the debt. In the year 1983, the taxpayer had deducted the debt as a bad debt. The Minister added it back to his income in 1984 which was disputed by the taxpayer. I rendered the decision on the basis that the shareholders had considered the issuance of shares as a payment, had acted pursuant to the agreement, had considered the shares to have the value of the forgiven loans and had claimed in 1989 a business investment loss on the disposition of the shares. I quote:
I cannot agree with the argument that the agreement of August 23, 1984 should be put aside as the fact is, that, it is an agreement that is a binding agreement between the parties. It has not been denounced or repudiated by the Appellant. On the contrary, in 1989, the Appellant acted pursuant to the agreement and accepted it when he claimed an allowable business investment loss with respect to the disposition of shares of the Corporation. ...
(Emphasis added).
[20] In the matter of Beck, I have found that the taxpayers had accepted that their loan debt had been paid by the issuance of the shares and had acted in that manner. In this instance, this is not the case. The shareholders never accepted the shares as payment of their loan debt. They knew that the shares were worthless: they immediately sold them to their wives for $1.00. If the shares were to increase in value, there would be a capital gain to the new shareholders. The only acceptation that the Appellant and his brother had made was to remove their loans from the books of the corporation and to consider them as non collectable in a pragmatic and businesslike manner.
[21] A debt remains outstanding even if, for business reasons, it has to be cancelled without receiving any payment. Not only did the Appellant and his brother consider these shares worthless, but it has to be remembered that it was a fact assumed by the Minister in subparagraph 14l) of the Reply, that the shares had no value at the date of their issuance. In the circumstances of this appeal, I find that the evidence has shown very clearly that the loan debt was not paid in the year 1993, could not have been collected and therefore, was still outstanding.
[22] In consequence, the appeal is allowed without costs.
Signed at Ottawa, Canada, this 1st day of October, 1999.
"Louise Lamarre Proulx"
J.T.C.C.