The Queen v. Loewen, 93 DTC 5109, [1993] 1 CTC 212 (FCTD)

Dubé, J.:— The issue to be resolved in this tax case is whether a $40,000 gain on redemption of a Scientific Research Tax Credit debenture ("SRTC") ought to be treated as income or capital gain. This is the first case involving the SRTC program, promoted by the federal government in the early 1980s, to reach the Federal Court.

1. The facts

In the instant appeal from the Tax Court of Canada, the facts are that on July 16, 1984, the taxpayer ("Loewen") purchased, for the sum of $200,000, a SRTC debenture from Dynaflex Industries ("Dynaflex") with a redemption price of $140,000 and a deemed cost of $100,000 under subsection 127.3(6) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). At Loewen's request, the debenture was redeemed on January 2, 1985. The Minister of National Revenue ("the Minister”) treated the resulting gain of $40,000 over the deemed cost of $100,000 as income from a business, in that it was profit realized from an adventure in the nature of trade.

Loewen's appeal was allowed by the Tax Court of Canada. That Court considered that the transaction in its entirety possessed none of the characteristics of an adventure in the nature of trade: the taxpayer had purchased the debenture for the purpose of obtaining a substantial $102,000 tax credit and had then redeemed it in due course. Thus, the $40,000 gain was capital in nature. The Minister appealed this decision.

Loewen is a Vancouver general accountant and not a specialist in taxation matters. He was seeking a tax shelter. His tax lawyer ("Baillie") suggested Dynaflex SRTC debentures. As it turned out Baillie was also Dynaflex's lawyer and he supervised the transaction in question, which was somewhat complex but entirely lawful and fully in accordance with the prescriptions of the Act then in effect.

Thus, on July 16, 1984, Loewen entered into an agreement with Dynaflex whereby he undertook to purchase a debenture “in the principal amount of $140,000 for the purchase and issue price of $200,000 and having a redemption price of $140,000”. At the closing, Loewen would pay with a $24,000 cheque and the balance of $176,000 by delivery of a promissory note. The promissory note was payable as follows: $24,000 on or before September 30, 1984 and $152,000 on or before December 31, 1984. On demand, Dynaflex would pay the $140,000 in full to Loewen. Pursuant to subsection 194(4) of the Act, Dynaflex would designate an amount in respect of the debenture equal to the full $200,000 and duly complete and file all the prescribed forms with Revenue Canada. The debenture was issued for the principal sum of $140,000 with interests at 24 per cent per annum. As security for the reimbursement of the principal amount, interests and moneys owing to Loewen, Dynaflex mortgaged all its properties by way of a floating charge to Loewen“ "and all other holders".

In August, 1984, Dynaflex made the designation in accordance with subsection 194(4) of the Act, thus allowing Loewen to use the tax credit of $102,000 for the 1984 taxation year. As agreed upon, Loewen made his two payments on the promissory note through Baillie, who retained in trust, in his firm's bank account, the sum of $140,000 from the last payment to Dynaflex as protection for Loewen's redemption money. On January 2, 1985, Loewen demanded redemption and the amount of $140,000 was paid to him from the lawyer's trust account.

On April 29, 1986, Loewen filed his income tax return for the 1985 taxation year and reported dispositions of capital property and unpaid tax due, but did not report or include in income any amount in respect of the SRTC transaction. Nor did he make any election under subsection 39(4) of the Act with respect to the disposition of the SRTC debenture. Subsequent to being contacted by National Revenue officers, on April 7, 1988, Loewen forwarded the prescribed election forms by virtue of which the disposition was deemed to be of a capital property. This late filing is a subsidiary issue which I will address later.

As it turned out, the actual out-of-pocket cost to Loewen for the Dynaflex debenture was only $60,000 for a tax credit of $102,000. Although the debenture provided interests at the rate of 24 per cent per annum and interests were also payable on the amounts owing under the promissory note made by Loewen to Dynaflex at the rate of 19.091 per cent per annum, no interests were paid or demanded by the parties. There was no written agreement to offset the interests and it would appear that the interests on both instruments were simply ignored.

2. The law

The relevant provisions of the Act are as follows:

127.3(2)(a) "scientific research tax credit" of a taxpayer for a taxation year means the aggregate of all amounts each of which is an amount equal to

(i) where the taxpayer is a corporation, 50 per cent, or

(ii) where the taxpayer is an individual other than a trust, 34 per cent

of an amount designated by a corporation under subsection 194(4) in respect of

(iii) a share acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to be a registered holder thereof,

(iv) a bond, debenture, bill, note, mortgage, hypothec or similar obligation (in this section and in Part VIII referred to as a“ debt obligation”) acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to be a registered holder thereof, or

(v) a right acquired by the taxpayer in the year where the taxpayer is the first person, other than a broker or dealer in securities, to have acquired that right,

less any amount required by subsection (5) to be deducted in computing the taxpayer's scientific research tax credit for the year; and

127.3(6) For the purposes of this Act, where at any time in a taxation year a taxpayer has acquired a share, debt obligation or right and is the first registered holder of the share or debt obligation or the first person to have acquired the right, as the case may be, other than a broker or dealer in securities, and an amount is, at any time, designated by a corporation under subsection 194(4), in respect of the share, debt obligation or right, the following rules apply:

(a) he shall be deemed to have acquired the share, debt obligation or right at a cost to him equal to the amount by which

(i) its cost to him as otherwise determined

exceeds

(ii) 50 per cent of the amount so designated in respect thereof; and

(b) where the amount determined under subparagraph (a)(ii) exceeds the amount determined under subparagraph (a)(i), the excess shall

(i) where the share, debt obligation or right, as the case may be, is a capital property to him, be deemed to be a capital gain of the taxpayer for the year from the disposition of that property; and

(ii) in any other case, be included in computing the income of the taxpayer for the year,

and the cost to him of the share, debt obligation or right, as the case may be, shall be deemed to be nil.

194(4) Every taxable Canadian corporation may, by filing a prescribed form with the Minister at any time on or before the last day of the month immediately following a month in which it issued a share or debt obligation or granted a right under a scientific research financing contract (other than a share or debt obligation issued or a right granted before October 1983, or a share in respect of which the corporation has, on or before that day, designated an amount under subsection 192(4) designate, for the purposes of this Part and Part I, an amount in respect of that share, debt obligation or right not exceeding the amount by which

(a) the amount of the consideration for which it was issued or granted, as the case may be,

exceeds

(b) in the case of a share, the amount cf any assistance (other than an amount included in computing the scientific research tax credit of a taxpayer in respect of that share) provided, or to be provided by a government, municipality or any other public authority in respect of, or for the acquisition of, that share.

248.(1) In this Act,

"business" includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), an adventure or concern in the nature of trade but does not include an office or employment.

3. The parties’ positions

As appears in the statement of claim, the Minister proceeded on the assumptions that Loewen purchased the debenture with a primary intention to earn a "quick flip” profit from the redemption of the said security, and that his motivation for the purchase of the debenture was to acquire the SRTC tax credit. According to the Minister, at no time did Loewen intend to retain the debenture as an investment. Rather, he was engaged in an adventure in the nature of trade with respect to the debenture. The $40,000 profit earned in 1985 therefore represented income from a business within the meaning of subsection 248(1).

In his defence Loewen denied the assumption of fact and claimed that the $40,000 gain realized on the redemption of the debenture did not result from an adventure in the nature of trade and was not income from a business of his: it must be considered a capital gain.

4. The jurisprudence

There are four Tax Court of Canada decisions involving the short-lived SRTC program, all released in 1989, and evenly divided as to the nature of the gain.

In Smith v. M.N.R., [1989] 2 C.T.C. 2069, 89 D.T.C. 331, the first case decided by the Tax Court of Canada, the taxpayer appeared on his own behalf. The judge relied on a 1969 decision of the Supreme Court of Canada, Sissons v. M.N.R., [1969] S.C.R. 507, [1969] C.T.C. 184, 69 D.T.C. 5152, in which it was held that a clear indication of" trade" was found in the fact that the acquisition of the securities in question was a part of a profit-making scheme: the purpose of the operation was not to earn income from the securities but to make a profit on prompt realization. It was essentially a speculation. The judge also applied the tests used by the Federal Court of Appeal, in First Investors Corp. v. The Queen, [1987] 1 C.T.C. 285, 87 D.T.C. 5176, for determining whether a gain is a capital gain or income.

He concluded that Smith had had a clear intention to “trade” and that his acquisition of the SRTC securities was part of a profit-making scheme. The transactions had none of the essential characteristics of an investment.

In Stanley Drug Products Ltd. v. M.N.R., [1990] 2 C.T.C. 2646, 90 D.T.C. 1664, the Tax Court of Canada allowed the taxpayer's appeal, finding that the transactions in question were not adventures in the nature of trade, but were wholly artificial devices remote from trade and intended to procure a tax advantage. The judge relied on two House of Lords’ decisions: Bishop v. Finsbury Securities Ltd., [1966] 3 All E.R. 105, 43 T.C. 591 and FA & AB Ltd. v. Lupton (Inspector of Taxes), [1972] A.C. 634, [1971] 3 All E.R. 948.

The third Tax Court of Canada decision is the one under appeal ([1990] 1 C.T.C. 2133, 90 D.T.C. 1009). The judge relied on the same two English cases to support his conclusion that Loewen had not embarked on an adventure or concern in the nature of trade. He noted that trading securities was not in the ordinary course of the taxpayer's business and that in fact Loewen had not traded in the subject debenture, but had merely purchased it for its inherent income tax attributes and had redeemed it from Dynaflex at virtually no risk to him.

The fourth decision released shortly after the Loewen decision is Financial Collection Agencies (Quebec) Ltd. v. M.N.R., [1990] 1 C.T.C. 2178, 90 D.T.C. 1040. In this case, the Tax Court judge dismissed the taxpayer's appeal on the grounds that the promissory note in question was not a Capital asset, it was non-interest bearing, and, after it became due, was redeemed within hours. The transaction was held to be an adventure in the nature of trade. He analyzed the situation as follows at page 2185 (D.T.C. 1046):

Quebec advanced RDF $200,000 for less than a day. In return RDF paid to the appellant $114,000 and permitted the appellant to use $100,000 of tax credits. RDF retained the $86,000 for its own purposes. As a result of the transaction the appellant gained an economic benefit of $14,000. There is, I wrote earlier, no actual acquisition of tax credits. Only the promissory note is subject to acquisition and disposition. Subsection 127.3(6) is a calculation for tax purposes of the economic gain to the “investor” on the complete transaction. It is a tantalizingly appealing argument that the promissory note be considered in isolation from the whole of the transaction; however, that is not the real story. What must be considered is the complete transaction and the reason the appellant undertook that transaction.

5. Analysis

The two English cases relied on in two of these Tax Court decisions involved forward stripping of dividends. The success of the transactions under consideration required that the purchasers of the securities in question, who were traders in shares and securities, be able to realize a business loss from trading the securities and a recovery of tax from Revenue. In both cases, the House of Lords found that the shares were not acquired as stocks in trade nor dealt with in the ordinary way a dealer in shares would handle his inventory. They had been acquired merely for the purpose of completing a transaction which had as its object securing a refund of tax. The House of Lords had to consider whether the acquisition of those shares had been done in the ordinary course of the taxpayers' business, as the tax refund was only available if this was the case. The House of Lords found that since the taxpayers had not acquired the shares to make a profit, except by means of their tax claims, the shares purchased were not part of their ordinary trade.

The relevance of these two cases was discussed by the judge in Financial Collection Agencies (Quebec) Ltd., at page 2187 (D.T.C. 1047). In his view the English decisions are not determinative, because the question they address is distinguishable from the question of how gains realized in cases such as the one at bar are to be characterized:

Firstly, the assessment under appeal was not issued on the basis that the acquisition and disposition of the promissory note was part of the appellant's trade. Indeed, the parties agree the transaction did not form part of the appellant's trade. Notwithstanding [that] the definition of “ business” in the Act includes an "adventure or concern in the nature of trade”, a person who participates in an adventure or concern in the nature of trade is not carrying on a business or more precisely, a trade. An adventure . . . is an isolated happening

I subscribe to this view, and also share the judge’s observation at page 2187 (D.T.C. 1047) that:

[T]he proposition of law laid down in Finsbury Securities Ltd. and FA & AB Ltd.. . . is not authority for the proposition that property acquired for tax avoidance purposes cannot be the subject of an adventure or concern in the nature of trade.

In M.N.R. v. Taylor, [1956-60] Ex. C.R. 3, [1956] C.T.C. 189, 56 D.T.C. 1125, President Thorson of the Exchequer Court thoroughly analyzed the leading British cases dealing with the meaning of the terms "adventure in the nature of trade" and expounded eight criteria which are conveniently abridged in the headnote of that case as follows at page 189-90 (D.T.C. 1126):

The terms “trade” and "adventure or concern in the nature of trade" are not synonymous expressions. A transaction which, by itself, does not constitute a trade may still be an adventure in the nature of trade. (2) The question whether a particular transaction is an adventure in the nature of trade depends on its character and surrounding circumstances and no single criterion can be formulated. (3) If a person deals with the property purchased in the same way that a regular trader in property of the same kind would ordinarily do, such a dealing may fairly be called an adventure in the nature of trade. (4) The nature and quantity of the subject matter of the transaction may be such as to exclude the possibility that its sale was the realization of an investment or that it could have been disposed of otherwise than as a trade transaction. (5) If the element of speculation is present, the sale of a property that is productive of income and might be regarded as an investment, can be a trade in the property rather than the realization of an investment. (6) The intention to resell at a profit may well be an important factor in determining that a transaction is an adventure in the nature of trade, but its presence is not an essential prerequisite to such a determination and its absence does not negative the idea of an adventure in the nature of trade. The considerations prompting the transaction may be of such a business nature as to invest it with the character of an adventure in the nature of trade even if there is no intention of making a profit on the sale of the purchased commodity. (7) The fact that the transaction is totally different in nature from any of the other activities of the taxpayer and that he has never entered upon a transaction of that kind before or since does not, of itself, take it out of the category of being an adventure in the nature of trade. (8) It is not essential to a transaction being an adventure in the nature of trade that an organization be set up to carry it into effect or that some operation be performed on the subject matter of the transaction to make it saleable.

In light of the foregoing it should be recalled that, although Loewen is not a broker and does not regularly deal in securities, this isolated transaction may nevertheless be an adventure in the nature of trade. He is an accountant by profession and has admitted having bought securities from time to time over the years. His 1985 income tax return shows ten different transactions in Canadian shares showing total proceeds of $40,460 and gains of $433.84. Loewen testified that the transaction under review was his first purchase of a SRTC debenture and I believe him, as he was a very credible witness.

However, he dealt with the SRTC debenture in the same way that a trader in property of the same kind would ordinarily, in the sense that he did not retain the debenture to earn interest income. In fact, as soon as the debenture was paid in full, he requested immediate redemption. A trader in such debentures would also quickly realize on them so as to free-up the funds invested.

The SRTC debenture in question was never designed to be held by the purchaser any longer than was required to enable him to obtain the tax credit. Immediate redemption was the incentive and long time investment was never contemplated. Moreover, only a small portion of the funds paid by Loewen remained with Dynaflex. The final $152,000 payment was held in trust by Loewen's solicitor to ensure that the funds would be available to him for the redemption. Thus, the final payment which represented the bulk of the purchase price was never in the hands of Dynaflex and could not have been invested in its operations.

Although the element of risk was minimal in the sense that the trust arrangement with the taxpayer's lawyer protected the redemption payment, yet if Dynaflex had failed to designate the full amount of the debenture under subsection 194(4) of the Act on time (that is by August, 1984), Loewen would have lost his $24,000 down payment and received no tax credit. The element of speculation is present in the sense that rather large sums of money flipped over a very short period.

The taxpayer himself admits that he was not interested in the business of Dynaflex, did not investigate either its operations or the real security provided by the floating charges on Dynaflex's assets. Loewen simply relied on his tax adviser, Baillie. Neither party was concerned with the interests payable on the promissory note of Loewen and under the redemption agreement with Dynaflex. Clearly, a gain was to obtain on the turnover of the debenture and not through the holding of it for any extended period of time.

Thus, while the attractive tax credit feature was a key factor in Loewen's decision to buy the debenture, he did purchase the debenture with a view to earn a profit. He did not merely want to obtain the tax credit. He wanted to redeem the debenture for $140,000, which gave him a $40,000 profit.

In my view, the classic decision of the Supreme Court of Canada in Irrigation Industries Ltd. v. M.N.R., [1962] S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131, in which an isolated transaction was found not to be an adventure in the nature of trade, can be distinguished from the case at bar on the basis of the nature of the subject-matter involved. In Irrigation Industries Ltd., supra, the shares purchased by the taxpayer were common shares of a mining company with no special attributes or characteristics similar to the tax credit features found in the SRTC Dynaflex debenture. These tax credits were provided by the Act for the purpose of encouraging scientific research and experimental development in Canada. Thus, the transactions involved with respect to such debentures are much different from those involving the purchase of common shares in a company. The shares in Irrigation Industries Ltd. were an investment in a corporation whereas the purchase of the debenture was a quick (and lawful) flip to benefit from the provisions of the Act.

In Sissons v. M.N.R., supra, the Supreme Court of Canada held that a taxpayer who had purchased debentures, not to earn income therefrom but to make a profit on prompt realization, had engaged in an adventure in the nature of trade. The Court referred to its earlier decision in Irrigation industries Ltd. and distinguished the two decisions at pages 187-88 (D.T.C. 5154):

For the respondent to escape taxation on his gain from the operation he has to show that it is to be characterized as an investment. Otherwise, the conclusion is inescapable that it is an adventure in the nature of trade. In support of the judgment in the Court below, counsel for the respondent relied essentially on the decision of this Court in Irrigation Industries Ltd. v. M.N.R. (1962), S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131.

Here the clear indication of "trade" is found in the fact that the acquisition of the securities was a part of a profit-making scheme. The purpose of the operation was not to earn income from the securities but to make a profit on prompt realization. The operation has therefore none of the essential characteristics of an investment, it is essentially a speculation.

In the case at bar, Loewen did not purchase the debenture to earn interest income, did not investigate the financial stability of Dynaflex, did not verify the existence of the assets charged by the debenture, did not intend to lose control of the major portion of the purchase price. His transaction cannot be characterized as an investment but was clearly a legitimate profit-making scheme.

Consequently, I find that the transaction in question was an adventure in the nature of trade and that the sum of $40,000 was taxable income in Loewen's 1985 taxation year.

6. Late filing of election under subsection 39(4)

I now turn to the second issue, whether or not Loewen is entitled to rely upon the provisions of subsection 39(4) of the Act to elect capital treatment for the amount in question. The subsection reads:

39.(4) Except as provided in subsection (5), where a Canadian security has been disposed of by a taxpayer in a taxation year and the taxpayer so elects in prescribed form in his return of income under this Part for that year,

(a) every Canadian security owned by him in that year or any subsequent taxation year shall be deemed to have been a capital property owned by him in those years; and

(b) every disposition by the taxpayer of any such Canadian security shall be deemed to be a disposition by him of a capital property.

As mentioned earlier, Loewen only made his election in 1988 after he had been advised by Revenue Canada that he had not reported his gain from the purchase and sale of the Dynaflex debenture in his return for the 1985 taxation year. However, the Tax Court judge did not have to deal with the question of late election in view of his conclusion that Loewen's gain was of a capital nature. On the other hand, in Financial Collection Agencies (Quebec) Ltd., supra, the judge held that the requirements in subsection 39(4) are mandatory and that the taxpayer's late election was not valid. He said as follows at page 2190 (D.T.C. 1049):

The appellant's submissions ignore what is stated in subsection 39(4). Subsection 39(4) is clear and unambiguous in both of our official languages: the election is to be made in prescribed form in the return of income. The provision is explicit and certain. While the manner of electing under subsection 26(7) of the Act and section 4700 of the Regulations to the Act may be directory rather than mandatory, the requirement in subsection 39(4) is mandatory. When Parliament writes a law, the law must have meaning. It is the function of a Canadian court to interpret the law and give the words to be interpreted in the law their normal, accepted, every day meaning. A Court should not look for ambiguity in a statute where none exists. Similarly, it is not the function of a court to add words to statutes nor is it its function to alter the intent of Parliament.

The Federal Court of Appeal had to deal with a forward average election under subsection 110.4(1) of the Act in Miller v. M.N.R. [1993] 1 C.T.C. 269. The Court analyzed the situation as follows at page 271:

As for the taxpayer having the right to amend an election after assessment or reassessment of his relevant tax return, it is not, in my opinion, a question of a limitation period. There were, in 1982, several provisions for late elections in the Act. No such provision was made for a forwarding averaging election; it had to be made not later than the date on which the relevant tax return was required to be filed and it had to be filed with the return. The intention of Parliament is, in my view, clear; the taxpayer was entitled to make the election on the basis of his circumstances as they existed, and as only he could know, at the time he filed his return. The Act did not contemplate the election being made on the basis of changed circumstances which might result from an assessment or reassessment of the return.

To allow amendment of the election, either by the Minister as part of the assessment process or the taxpayer after assessment, would, in my opinion, require an inadmissible reading into the Act of words that were not there. I would allow the appeal and restore the assessment.

Similarly, subsection 39(4) of the Act does not allow for late filing. It spells Out very clearly that the taxpayer must elect in his return of income for that year, which in the case of individuals must be filed on or before April 30 of the following year under paragraph 150(1)(d) of the Act. There are several provisions in the Act that specifically allow the taxpayer to file late (see subsections 83(3), 85(7), 93(5) and 96(5) for such examples). However, the Act contains no provision specifically allowing a taxpayer to file late under subsection 39(4). Consequently, the taxpayer's late election is not valid.

It follows therefore that the plaintiff's appeal is allowed on the basis that the defendant's gain from the disposition of the SRTC debenture gave rise to income from a business on the grounds that the transaction was an adventure in the nature of trade. Further, the defendant was not entitled to file a late subsection 39(4) election.

In my view, this is not an appropriate case for the awarding of solicitor to client costs, as requested by counsel for the taxpayer. (See National Capital Commission v. Mary Blanc, A-568-91, December 10, 1992 (unreported).) However, while the present appeal is not, strictly speaking, a test case, it clearly resembles a test case in the sense that this is the first appeal on SRTC tax credits to be brought to this Court. Under the circumstances, I think it only fair and equitable that each party bear its own party to party costs.

Appeal allowed.