Donald Preston McLaws v. Minister of National Revenue, [1970] CTC 420, 70 DTC 6289

KERR, J.:—This is an appeal with respect to income tax assessments under the Income Tax Act for the appellant’s 1963, 1964 and 1965 taxation years. It relates to amounts of $18,750 paid by the appellant in each of those years to the Royal Bank of Canada to make good a guarantee given by him to the bank by which he personally guaranteed the credit of Calgary Iron and Engineering Limited. The appellant deducted the payments in his income tax returns. The Minister disallowed the deductions. The appeal is against such disallowance.

The appellant’s Notice of Appeal states, inter aha:

It is submitted, however, that the facts of this case bring the loss. within the deductions allowed under Section 32(5) (d) of the Income Tax Act .... * [1]

The taxpayer entered into the guarantee with the company’s bankers for a consideration which itself would have been classified as income in the hands of the taxpayer under the provisions of the Income Tax Act. It is submitted that in entering into such an Agreement the taxpayer was carrying on a business, i.e., entering into an Agreement with the intention of earning income . . . .

The entering into of a guarantee for a consideration is an “adventure in the nature of trade”.

. . the taxpayer in. this case entered into the guarantee for the purpose. of earning income and in so doing was entering into an “adventure in the nature of trade”.

In the alternative, as the taxpayer was the owner of one hundred (100%) percent of the shares of Calgary Iron and Engineering Limited, the guarantee was entered into by the taxpayer in the hope that the said Company would make a profit and generate income, which would accrue to the taxpayer. The transaction was therefore an income transaction being in the nature of trade. The taxpayer relies upon the decision in Freud v. M.N.R., [1968] C.T.C. 438.

The interest portion of the payments made by the taxpayer to the Bank are in any event deductible as being interest paid for the purpose of earning income.

The main issue is whether, as contended by the appellant, the payments were business losses sustained by him in the course of the carrying on of a business and an adventure in the nature of trade, within Sections 32(5) (d) and 139(1)(e) of the Act, on the one hand, or, as contended by the Minister, the payments were capital outlays for losses within Section 12(1) (b) and were not payments made or incurred by the appellant for the purpose of gaining or procuring income from property or a business of the appellant, within the meaning of Section 12(1) (a).t [2]

The appellant is a barrister and solicitor who has practised law in Calgary continuously since 1940. That is his principal occupation but he has also had other fairly extensive business activities. At relevant times he was an officer and beneficial owner of all the shares of the aforesaid Calgary Iron and Engineering Limited, a company that he caused to be incorporated in 1953, which I shall refer to as ‘the new company’’.

There was an old predecessor company, Calgary Iron Works Limited. The life of this company went back to before 1900 and continued until 1953. The appellant’s father had control of it and owned 90% of its shares. The father died in 1950, at which time the company was a going concern. By his will he gave a fixed income to his widow and left her a life estate with the residue going to the appellant and the appellant’s younger brother, who was practising law with him.

The appellant explained why he caused the new company to be incorporated. He said that his brother had taken no interest in the old company, but he himself had taken an interest in it even while his father was alive and he wanted to keep its business going after his father’s death because he thought it would be a good source of income for himself. The old company was the major asset of his father’s estate. The other assets were not nearly suffiicient to keep his widow in the way she was accustomed to live, and after the father’s death efforts were made to sell the old company for a price sufficient to meet the widow’s needs. But no purchaser was found. The appellant then took steps to serve the dual purpose of providing his father’s estate with capital to meet the widow’s needs and of retaining the old company business for his own benefit. This involved a purchase

minus

(d) business losses sustained in the taxation year in the course of the carrying on of a business either alone or as a partner actively engaged in the business,

139. (1) In this Act,

(e) “business” includes a profession, calling, trade, manufacture or undertaking of any kind whatsoever and includes an adventure or concern in the nature of trade but does not include an office or employment;

12. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part,

by him of the assets of the old company from his father’s estate, incorporation of the new company, and a sale by him of the said assets to the new company that he owned and controlled. By an agreement dated January 2, 1952 he purchased the assets of the old company for a consideration which included payment of $225,000 and assumption of debts. In turn, by an agreement dated February 19, 1953, he sold the assets to the new company for a consideration which included a cash payment of $225,000 and issue of shares of the company.

He arranged the financing of the transactions though a bank loan of $150,000 and a second mortgage for $80,000, both of which were repaid by the company by 1958, in part by sale of its real property. After its incorporation the appellant also personally lent $25,000 to the company and it too was subsequently repaid.

The business of the old company was carried on until the incorporation of the new company much as it had been carried on before the father’s death, but when the new company was incorporated the appellant endeavoured to expand its facilities and improve its business. Until 1958 it made modest profits. It paid no dividends but the appellant took sums from it as salary or bonus.

Prior to 1960 the company had a limited line of credit with the bank, for operational purposes, in addition to its loan for purchase of the assets of the old company. The indebtedness varied from time to time. The appellant originally gave his personal guarantee to the bank with respect to the bank loans. However, it was not on that guarantee, but on an extension of it, that he was called upon to pay.

In the period 1958-60 the company was in financial difficulties and was operating at a loss, which the appellant attributed to an over-ambitious expansion program and ineffective management. Its indebtedness to the bank had increased, it had sold its real property and applied the proceeds towards the bank loan, it had taken a lease-back of the real estate and in that connection gave a chattel mortgage on the company’s equipment to the landlord. In 1960 affairs reached a crisis. Its liabilities exceeded its assets. It was facing bankruptcy. The bank proposed to call its loans, but offered to extend additional credit to keep the company going, provided that the appellant would give a formal personal guarantee and deposit security. He agreed and gave the guarantee, the one which he was later called upon to honour. He also deposited securities worth $70,000, of which $50,000 belonged to his wife. As additional security the company gave an assignment of book debts and accounts receivable to the bank. Thus the company was then able to continue in business and did so for about a year, but in 1961 the bank called its loans and realized on the company’s receivables. and inventory and on the securities deposited by the appellant. The landlord who held the chattel mortgage seized the company’s equipment. And the company went out of business. Then the bank required the appellant to honour his guarantee.

As already indicated the company had a line of credit with the bank in the years prior to 1960 in respect of which. the appellant had given a limited personal guarantee, but by the time of the 1960 crisis the limit of credit had been reached and additional bank financing was needed. The appellant said that he decided to try to keep the company going rather than have it eo into bankruptcy and that he gave the guarantee so that it could continue in business and be, as it formerly had been, a source of income for him. But he was concerned about the additional guarantee and the possibility that he might have to honour it. He consulted income tax experts on the implications, income tax-wise, of being called upon to make payments on the guarantee and the advice he received was that where a guarantee is given for consideration a payment under the guarantee would be deductible from income as a business loss. The result was that the agreement which he entered into with the company provided that in consideration of his guaranteeing its account with the bank it would pay him an annual fee. The terms of the agreement are set forth in a letter (Exhibit A-2), dated March 16, 1960, from the appellant to the company, as follows:

March 16, 1960. Calgary Iron and Engineering

Limited,

CALGARY, Alta.

Dear Sirs,

You have represented to me that you have been borrowing money from the Main Branch of the Royal Bank of Canada, Calgary, and I have heretofore guaranteed that account within certain limits.

You are now at the extent of your limits and require additional bank financing, which the bank is not prepared to give to you unless I extend my guarantee of your account and in addition pledge to the bank certain securities as security for my guarantee.

It is hereby agreed between us that if I- guarantee your account to the Royal Bank in an amount of $300,000.00 or in excess thereof you will pay me an annual fee of $3,000.00 as consideration therefor, such amounts to be paid to me on the annual dates of this letter agreement.

It is further agreed that if the amount of your indebtedness to the bank and to which my guarantee applies is reduced to $200,000.00, the aforesaid fee will be reduced to $2,000.00 and if the guarantee is reduced to $100,000.00, the fee will be reduced to $1,000.00.

Should your indebtedness be reduced or repaid at any time during the year and the guarantee be reduced or released you will then only be responsible for a pro rata amount of the fee applicable thereto.

Yours truly,

(Sgd.) Donald McLaws.

The foregoing is hereby agreed to.

CALGARY IRON AND ENGINEERING LIMITED

er: (Sgd.) W. Dixon.

At the trial the applant said that when he extended the guarantee he expected that the company would get on its feet and make profits and pay the fee. The following questions and answers from his Examination for Discovery were put in evidence on this aspect of the case:

Q. And these fees if they had been paid but none were paid, I take it? A. That is correct.

Q. These fees if they had been paid would have been income?

A. Oh, yes.

Q. Now, tell me, was the provision for these fees an afterthought, so to speak, and was your primary and basic intent in making the guarantee to save the company? A. Well, certainly, the only reason for giving the guarantee was so that the company could continue in business. I don’t think the intent was to save the company in the technical—I mean in the words that you used them. The intent was to save a source of income which I enjoyed for the past number of years. And the saving of the company was, of course, the mechanics by which that was done.

Q. In other words, your primary intent in making the guarantee was to protect your source of income? A. That is correct.

Q. Which the company was?	A. That is correct.
Q. Or had been, more correctly?	A. That is correct.

Q. And the payment of fees to you in connection with the guarantee was incidental and secondary thereto to that primary purpose?

A. At that time I began to realize that there was a possibility that the guarantees, I might be called on, if the company survived and I had considered what my position was going to be and I had taken advice of some tax people and the result I got was that a guarantee given for consideration, if you had to make a payment under a guarantee given for consideration that the loss would be deduction from income. It would be a business loss and, therefore, that was put in there.

The appellant’s previous guarantee for a more limited amount had no fee provision. The only loans or credit that he had otherwise guaranteed were a few for friends or companies with which he was associated, and none of them had a fee provision or was for valuable consideration.

The determination of the appeal depends upon a proper appreciation of the true nature of the transaction and payments on the guarantee. In my opinion the guarantee and the appellant’s outlays in honouring it and his agreement with the new company should not be considered in isolation, but in association with his basic venture to acquire the assets and business of the old company and continue to carry on the business through the new company for revenue earning purposes with the profits to flow through to himself personally as owner of all the shares of the new company. The acquisition of the plant and assets of the old company was of a capital nature, and the appellant gave a guarantee to the bank in that respect, which may properly be regarded as on account of capital, but the issue in this appeal is not on that guarantee but on the guarantee that he gave in 1960.

I accept the appellant’s testimony that he expected that the company would get on its feet and be a source of income for him, as it had been in some prior years. If he had not thought so, it is unlikely that he would have thrown good money after bad, so to speak, and committed himself to the new guarantee for a larger amount, and deposited $70,000 worth of his own and his wife’s securities as collateral. However, I attach little significance to the provision that the company would pay him an annual fee in consideration of his agreement to guarantee its credit. That was not really why he gave the guarantee. The fee provision was incidental and was resorted to in the belief that it would give the transaction the character of a business venture in the nature of trade and that a payment under it could qualify as a business loss that could be deducted from his income for income tax purposes. In my opinion, the reason why he gave the guarantee was to keep the company in business and prevent it from going into bankruptcy.

The Supreme Court of Canada said in Farmers Mutual Petroleums Lid. v. M.N.R., [1967] C.T.C. 396 at 400, that to be deductible for income tax purposes an outlay must satisfy at least two basic tests:

(1) It must be made for the purpose of gaining or producing income (Section 12(1) (a)).

(2) It must not be a payment on account of ‘capital (Section 12(1) (b)).

Both of these tests must be satisfied concurrently to justify deductibility. In British Columbia Electric Railway Company v. M.N.R., [1958] S.C.R. 133; [1958] C.T.C. 21, Abbott, J. said, at pp. 137, 31:

“Since the main purpose of every business undertaking is presumably to make a profit, any expenditure ‘made ‘for the purpose of gaining or producing income’ comes within the terms of Section 12(1) (a) whether it be classified as an income expense or a capital outlay.

Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be determined whether such disbursement is an income expense or a caiptal outlay.”

In the British Columbia Electric Railway Company case ([1958] C.T.C. 21) there referred to Abbott, J. also said, at p. 32:

The general principles to be applied to determine whether an expenditure which would be allowable under Section 12(1) (a) is of a capital nature, are now fairly well established. As Kerwin, J., as he then was, pointed out in Montreal Light, Heat ‘& Power Consolidated v. M.N.R., [1942] S.C.R. 89 at 105; [1942] C.T.C. 1 at 10, applying the principle enunciated by Viscount Cave in British Insulated and Helsby Cables Limited v. Atherton, [1926] A.C. 205 at 214, the usual test of whether an expenditure is one made on account of capital is, was it made “with a view of bringing into existence an advantage for the enduring benefit of the appellant’s business”.

In that case, also, Locke, J. said that neither the Canadian nor the Imperial Act attempts to define the term “capital” nor, in the case of our Act, what is meant by a payment on account of capital (p. 26). He also quoted from leading cases on the subject and referred to the principle enunciated by Viscount Cave (supra), and in that respect said, at p. 29:

To say, however, that an expenditure made with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade is a capital expenditure is not to say that all other expenditures must, in order to be properly classified as outlays of a capital nature or on account of capital, be made in order to produce such a benefit.

In seeking to distinguish capital from income it is not unusual for parties to argue from analogy, as they did here, the appellant relying largely on M.N.R. v. Freud, [1969] 1 S.C.R. 75; [1968] C.T.C. 488, while the respondent relied largely on M.N.R. v. Steer, [1967] S.C.R. 34; [1966] C.T.C. 731. In neither of those cases are the facts on all fours with the facts in the present case, but, in my opinion, this case resembles the Steer case more than the Freud case. The Steer case was in respect of a deduction claimed for a sum paid by the taxpayer to a bank under a guarantee of the indebtedness of a company ‘which needed money for the drilling of oil wells. In delivering the judgment of the court, Judson; J. said, at p. 871 [732] :

I have no difficulty in defining the character of this transaction. The company needed money for the drilling of three wells. The convenient way of supplying this money was by a bank loan with the respondent’s guarantee to the extent of $62,500. The guarantee meant that at some time the respondent might have to step into the bank’s shoes to this extent. This happened in 1957. He was then subrogated to the bank’s position. He subsequently proved as a creditor in the company’s bankruptcy and received two dividends

—one in 1959 for $6,119 and the other in 1961 for $3,200. The transaction was a deferred loan to the company, part of which was recovered in the bankruptcy.

In the Freud case (supra) the outlay of money was to develop a, prototype sports car and sell it. The venture from its inception was not for the purpose of deriving income from an investment but for the purpose of making a profit on the resale of the prototype, which was held to be characteristic of a venture in the nature of trade.

It is not disputed that the loans by the bank to the company, which were called by the bank, were for operating purposes of that company. But the business carried on by the company cannot be treated as being carried on by the appellant, even although he owned all the shares and was an officer of the company. The company had a separate corporate strueture and existence, it was not a sham, it was not his agent or a trustee for him. He had a control over it and its affairs by virtue of his ownership of the shares and in his capacity as shareholder and officer, and no doubt there existed a relationship between him and the company and there was a causal connection between the formation of the company and any benefits that he received from its operations, but it cannot be held that he personally was carrying on the business the company was engaged in.

The ultimate question we must decide is whether the outlays by the appellant on his guarantee were outlays, losses or payments on account of capital, within the meaning of Section 12(1)(b). If the answer is in the affirmative, their deduction is prohibited, even if the appellant’s entire venture was for the purpose of providing him with income and even if the money borrowed by the company from the bank was used in the process of performing its income-earning operations.

In M.N.R. v. Algoma Central Railway, [1968] C.T.C. 161, Fauteux, J., as he then was, said, at p. 162 :

Parliament did not define the expressions “outlay . . . of capital” or “payment on account of capital”. There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia,

[1966] A.C. 224, by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said, at p. 264 :

“The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.”

In my opinion the appellant’s outlays were on account of capital, within the meaning of Section 12(1)(b) and the claimed deductions are prohibited. In my view of the situation, the guarantee was given to protect and preserve the source of income, a business which was in immediate danger of bankruptcy and whose existence was imperilled. The character of the ensuing outlays in honouring the guarantee is quite different from expenditures which fall naturally into the category of income disbursements and business losses. In my opinion, the outlays are of the character of payments on account of capital and are not of the kind of expenditures that the statute contemplated to be allowed as deductions under the language ‘ ‘ made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer’’, in Section 12(1) (a), or under the language ‘‘business losses sustained . . . in the course of the carrying on of a business’’, in Section 32(5)(d).

There remains the contention of the appellant that, in any event, a portion of the payments in question were interest payments deductible under Section 11(1) (c) of the Act.

The nature of payments to a bank under a guarantee was considered in Commissioners of Inland Revenue v. Sir H. C. Holder et al., 16 T.C. 540. Lord Thankerton said, at p. 567 :

. . . Interest is the return given for the use of the advances and is due by the person who obtains the advances; the liability of the guarantor is direct to the creditor and is an undertaking to indemnify him against loss. The creditor computes his loss by the amount of the failure of the principal debtor to pay him principal and interest. In paying the amount of the indemnity, whether limited or otherwise, I am of opinion that the guarantor cannot be said to be paying interest to the creditor, though he is makinggood the loss of interest.

and Lord Macmillan, in referring to the guarantor’s relationship to the bank, said, at p. 569:

. . . The. short answer, in my opinion, is that the Appellants received no advance from: the bank and owed no interest to the bank,

Their relationship to the bank was not that of borrower and lender, and their liability to the bank was solely that of guarantors of a third party’s indebtedness to the bank. When they paid the sum of £64,482 163. 8d. to the bank, they did so in discharge of their liability to pay whatever sum, whether of principal or interest, Blumfield, Limited, owed to the bank.

and in the same respect. Viscount Dunedin said, at p. 564:

. . . The guarantor does not pay on an advance made to him, but pays under his guarantee. It is true that he pays a sum which pays all interest due by the person to whom the advance is made, but his debt is his debt under the guarantee, not a debt in respect of the advance made to him. That disposes of the whole case.

I think that the same reasoning may be applied to the payments made by the appellant to the bank in this case. He made them pursuant to his guarantee, which included interest due to the bank by the company to which it had advanced the amounts of the loans, but what the appellant paid the bank was his debt under the guarantee, not a debt in respect of money borrowed by him. Consequently, the appellant is not entitled to deduct any part of the payments as ‘‘interest’’ pursuant to Section 11(1) (c), whatever right, if any, to deduction he may have under other sections.

The appeal will be dismissed with costs.

MINISTER OF NATIONAL REVENUE, Appellant,

STEWART & MORRISON LIMITED, Respondent.

Exchequer Court of Canada (Kerr, J.), August 14, 1970, on appeal from a decision of the Tax Appeal Board, reported [1969] Tax A.B.C. 65.

Income tax—Federal—Income Tax Act, R.S.C. 1952, c. 148—Section 12(1) (a), (b)—Uncollectable advances to subsidiary corporation for operational expenses—Whether loss deductible by parent corporation

—Whether subsidiary operating independently or as branch of parent corporation.

In 1963 the taxpayer corporation, a firm of industrial designers, formed a U.S. subsidiary to carry on a similar business in New York. The New York office had its own staff, letterhead, invoices, etc. but was master-minded by the taxpayer, which supplied or guaranteed the funds required by the subsidiary for rent, salaries, travelling expenses and other operating expenses. Funds so advanced by the taxpayer were shown on the books as loans. The New York office failed to prosper and was closed in 1966, leaving the taxpayer with an irrecoverable outlay of $72,343 which it sought to deduct in that year on the ground that the New York office, though set up as a separate legal entity, was in fact operated as a branch of the Canadian company. That view was accepted by the Tax Appeal Board, from whose decision the Minister now appealed on the grounds that the outlay was not an expense incurred in 1966 nor was it incurred to earn income from the taxpayer’s business but was a payment on account of capital within Section 12(1)(b).

HELD:

The advances were correctly treated as loans and were outlays of a capital nature the deduction of which was prohibited by Section 12(1) (b). The Minister’s appeal was allowed.

D. G. H. Bowman and J. R. Power for the Appellant.

J. G. Edison, Q.C. and R. Dalgarno for the Respondent.

KERR, J.:—This is an appeal by the Minister of National Revenue from a decision of the Tax Appeal Board with respect to the Minister’s assessment of the respondent for income tax for its 1966 taxation year.

In determining its taxable income for that year the respondent deducted $72,348.14 as ‘ advances to New York office written off’’. The so-called New York office was Stewart & Morrison Inc. a wholly owned subsidiary of the respondent. The Minister disallowed the deduction. The respondent appealed to the Tax Appeal Board against the disallowance of the deduction and the Board allowed the appeal and referred the matter back to the Minister for re-assessment accordingly.

The respondent is a company incorporated under ‘the laws of the Province of Ontario. It is a firm of industrial designers. At all relevant times it was the beneficial owner of all the issued shares of its subsidiary, Stewart & Morrison Inc. This subsidiary was incorporated in December 1963 under the laws of the State of New York under the name Stewart Morrison Roberts Inc., subsequently changed to Stewart & Morrison Inc.

The respondent claims that its New York subsidiary was incorporated to serve as a branch office of the respondent and that the office in New York was a branch office of the respondent. In its Reply to Notice of Appeal it states, inter aha:

4. (c) Stewart & Morrison Inc. was incorporated as a branch of

the Respondent in order to emphasize to potential U.S. clients that the Respondent was in business in the U.S.A, and because the Respondent was aware of a reluctance of U.S. clients to deal with a “limited” company incorporated in a foreign jurisdiction;

(d) only a nominal amount of capital in the New York office was subscribed for by the Appellant as most of the financing of the New York office was to be provided by direct advances from the Respondent and bank loans guaranteed by the Respondent and one of its officers;

(e) the New York office did not prosper and eventually ceased operations in March of 1966. On June 30th, 1966, the New York office owed the Respondent $72,343.14 which debt was made up of funds which had been expended for operating expenses such as rent, salaries, travel expenses, etc. None of this amount was expended by the New York office on capital investment. Since it was obvious that no part of this amount could be recovered the whole amount of $72,343.14 was written off the books of the Respondent on the 30th day of June, 1966.

6. (a) the said amount of $72,343.14 represented expenses or disbursements

incurred or laid out by the Respondent for the purpose of gaining or producing income from property or a business of the Respondent;

(b) the funds advanced to the New York office were expenditures reasonably made by the Respondent as a business person for operating expenses of the New York office and for the purposes of gaining or producing income from a branch of its business operations;

(d) the New York office was incorporated for the purpose of attracting clients in the U.S.A. and for convenience of operation of the Respondent’s business and in fact the affairs of the New York office were fully integrated with the business operations of the Respondent;

(e) the business operations of the Respondent would have been seriously damaged if the Respondent had not assumed responsibility for and paid the expenses of the New York office.

As I understand the Reasons for Judgment of the Tax Appeal Board, the Board found that the situation was as so claimed by the respondent. The Board said, inter alia, that the New York office ‘‘was no more than a branch office of the appellant, despite its corporate name ’ ’ and that ‘ in financing it, the appellant was really striving to promote what was actually a part of its business’’, and “while the appellant had set up its New York office within a corporate structure, the resulting corporation was never more than such in name only’’.

The appellant disputes the respondent’s claim and says, inter alia, in the Notice of Appeal:

(a) the said amount of $72,343.14 was not an expense or disbursement incurred or laid out by the Respondent in the 1966 taxation year;

(b) it was not an outlay or expense made or incurred for the purpose of gaining or producing income from property or a business of the Appellant in the 1966 taxation year;

(c) it was a payment on account of capital

and that accordingly the deduction of this amount was prohibited by Sections 12(1) (a) and 12(1) (b) of the Income Tax Act.

In the alternative, the appellant submits that if the amount was incurred or laid out by the respondent for the purpose of gaining or producing income from property or a business of the respondent, it is income that is exempt in the hands of the respondent under Section 28 of the Act and accordingly the deduction of the amount is prohibited by Section 12(1)(e) of the Act in determining the taxable income of the respondent (para. 10 of Notice of Appeal). Also that if any of the payments are deductible, they are deductible only in the year in which they were made.

The subsidiary never prospered and it ceased operations in the spring of 1966, owing the respondent the amount in issue, $72,343.14, which was written off the respondent’s books in June 1966 as a non-recoverable debt. Additional amounts paid by the respondent on a guarantee that it gave to the bank in respect of a bank loan to the subsidiary were written off by the respondent in subsequent years, but they are not in issue for determination in this appeal.

Evidence was given by Clair Stewart, who is the respondent’s president and principal shareholder, and by its Chief Financial Officer, Harry Pope. The company started its business in 1960, operating from Toronto. It extended its business to other parts of Canada and into the United States. It had clients from that country, including General Foods, Eastman Kodak and Nestles, some of whom suggested that the company could get more business in the United States if it would open an office in New York. But it was thought that a purely Canadian incorporation with ‘‘Limited’’, rather than “Inc.”, as part of the company’s name, would be a disadvantage in doing business there, so it was decided to incorporate the subsidiary in New York to deal with clients and potential clients in the United States. It was also thought that an office in New York and an American name, in addition to being necessary or at least better for business dealings in the United States, would also assist the respondent’s operations in Canada, for its principal competition came from the United States, and Canadians appeared to have some preference for designs originating in the United States. Accordingly, the subsidiary was incorporated and commenced its operations from an office in New York. In the evidence and in these Reasons “the New York office’’ is distinguishable from the respondent’s Toronto office and sometimes the words are used synonymously with Stewart & Morrison Inc.

At the organization meeting of the subsidiary, held in New York in December 1963, 1,000 common shares were allotted to the respondent at an aggregate price of $1,000, and the following officers were elected :

Name Office

Stewart, Roberts and Morrison were elected directors. They were also directors of the respondent.

Roberts was entrusted with the organization, development and operation of the New York office. He spent about four days per week there, the remainder with the respondent in Toronto, and carried on in that way until April 1964. He was succeeded by Ziegler, who also went from the Toronto office to New York about four days per week until the fall of that year when another manager, Robert Fraser, took over.

A Procedure Plan for the New York office (Exhibit 5) was prepared in December 1963 by Roberts and approved by Stewart. It called, inter alia, for the Toronto and New York offices to interchange, weekly, a record of projects; setting up of a system of bookkeeping for New York dovetailed with Toronto; publicity in the United States; budget forecasts; payment by the New York office of Roberts’ living expenses in New York and payment by the respondent of his salary until July 1964, and also of expenses of the respondent’s directors on all their visits to the New York office from Toronto.

The New York office had a total staff of 4 persons, as compared with 40 to 50 in the respondent’s Toronto office. Officers and staff went from Toronto to the New York office from time to time, with their travelling expenses charged directly to Toronto. Stewart said that the New York office was masterminded from Toronto, with day-to-day details carried on in New York. He also said that the New York operation was entered upon with enthusiasm and in a hurry, he expected that it would make profits but the concern was to get it started and provide necessary money for it to do business; and not much thought was given to the mechanics or manner by which profits would flow back to the respondent by dividends or otherwise. Nor was any consideration given to charging interest to the subsidiary on advances made by the respondent.

The New York office was required to furnish weekly to the Toronto office a statement of business, expenses, bank account, clients and firms being solicited for business, and short, medium and long range business prospects.

The subsidary had its own corporate organization, letterhead and office. It solicited clients in its own name and billed them accordingly. It had accounts and bookkeeping separate from its. parent. It had employees of its own. When it did work for the Toronto office, it billed the respondent for it. The reverse was also the case. All of the subsidiary’s revenues came from its clients, except charges for work done for its parent company.

Loans from the Bank of Nova Scotia, Toronto, aggregating $40,000, were arranged for the New York office by the respondent. Payment of the funds was made to the New York office directly by Bankers Trust Company, New York, under arrangements with the Bank of Nova Scotia. They were guaranteed by the respondent and by its president in his personal capacity. Apart from the money so obtained, the respondent made advances of money from time to time to the New York office, sometimes using Bankers Trust Company as an intermediary between the respondent, the Bank of Nova Scotia and the New York office.

A summary, in round figures, of such advances and other payments by the respondent that make up the $72,343.14 written off by the respondent and claimed as a deduction, is set forth in Exhibit 14 as follows :

(Canadian Funds) $72,345

Those advances and payments, together with amounts aggregating $40,000 obtained through the bank loans, are also included in a letter, Exhibit 13, from Stanley Katz & Company, of New York, the accountants of Stewart & Morrison 1110., to Mr. Pope. The letter states:

In response to your request we are pleased to submit below a record of amounts received by Stewart & Morrison, Inc. from Stewart & Morrison Limited as capital contributions and loans payable. Please note that for December 1964 and December 1965, we indicate the month only since the corporate records do not show the day of receipt.

Jan. 17, 1964			$15,000.00
Mar.	5, 1964 _. ...		10,000.00
July 29, 1964			15,000.00
Dec.	1964:		10,000.00
Feb. 24, 1965			5,000.00
Mar. 25, 1965			5,000.00
May 17, 1965		_2._	5,000.00
July	7, 1965		5,000.00
Aug. 2, 1965			1,500.00
Sept. 13, 1965			5,000.00
Oct. 25, 1965			5,000.00
Dec.	1965		5,000.00
Dec.	1965		4,000.00
Jan. 24, 1966		....	1,650.00	(Total check is for
				$1,900 of which $250
				was allocated to
				A/C’s receivable.)

Jan. 27, 1966		...	152.00
Feb.	4, 1966		1,000.00
Feb. 14, 1966			1,400.00
Feb. 28, 1966			962.00
Mar. 21, 1966			1,474.52
April 25, 1966			1,520.51
TOTAL			$98,659.03

and after listing the advances adds the following :

Of the total amount $1,000.00 was allocated to Capital Stock and $97,659.03 was carried on the books of Stewart & Morrison, Inc. as Loans Payable—Stewart & Morrison, Limited.

The balance sheet of Stewart & Morrison Inc. for 1965, Exhibit 7, shows “Stockholders Equity” as follows:

Represented By:
Loans and/or Capital			$65,000.00
Less:	Net Loss for
	period ended
	June 30,	1965	54,528.23*
			$10,471.77

An accompanying covering letter from Katz & Company states that the total capital and loans are to be considered as $1,000 capital stock and $64,000 corporate loans.

A different method was used in its balance sheet for 1966, Exhibit 8, and Exhibit A to the respondent’s 1966 tax return, in which $97,105.85 was shown as ‘‘Due to Stewart & Morrison, Ltd.” and the Stockholders Equity was shown as follows:

Katz & Company explained the change in the following terms :

We have reviewed the reports for this corporation prepared by us for the fiscal years ended June 30, 1964, 1965 and 1966. In the first two years of this period, we presented the investment in Capital Stock and the loans advanced by Stewart & Morrison Limited as

“The balance sheet for 1964 (Exhibit 6) shows a similar method.

a combined figure in arriving at the total stockholder’s equity. In the year 1966, we showed as “Other Liabilities” the amount due to Stewart & Morrison Limited. We felt that this presented a clearer report since it did not require the reader to refer to the letter of transmittal to see the breakdown between Capital Stock of $1,000.00 and the loan balance for the remainder.

The respondent’s balance sheet, as at June 30, 1966, in its income tax return for that year, shows as an asset, investment in other companies, Stewart & Morrison Inc., a sum of $29,463.78 in 1965 and a corresponding item of $1 in 1966, with a note to the effect that the subsidiary has ceased business, its accounts have not been consolidated and no audited figures were available at that time, also that there is a contingent liability in respect of a $40,000 bank loan to the subsidiary.

Up to June 30, 1966 the subsidiary had gross profits of $22,589.34, expenses of $119,773.73 for rent, salaries and other operational expenses, and a loss for that period of $97,184.39, all as shown in detail in Exhibit 10. The advances from the respondent were used by the New York office in the operation of its business and were applied, along with revenues from its clients and loans from the bank, to pay the expenses of doing business. They were treated in the respondent’s books as loans to the New York office and were carried forward until written off in June 1966.

In a letter to Stewart & Morrison Inc., dated November 7, 1966, with which the company’s financial statements for its 1966 taxation year were enclosed, Katz & Company said that the company had available for carry-forward tax offsets of $97,000.

The question for determination is what was the true nature of the advances that made up the amount claimed as a deduction by the respondent.

The evidence adds up to this, as I appreciate it. The respondent decided that an American subsidiary, to be wholly owned by the respondent, would be incorporated and would carry on business in the United States and be a source of income and profit for the respondent. The subsidiary would carry on business as a separate American company in its own name and right, but it would, to use Stewart’s words, be master-minded” by its parent company and their affairs would be closely related and managed. The subsidiary needed capital, but had none. The respondent would supply, or arrange to supply, the needed capital. It arranged and guaranteed a bank loan direct to the subsidiary and also made direct advances of money to enable it. to get started and continue to operate. The advances were treated by both companies and by. their auditors, and in the respective books and accounts, as. loans from the respondent. Book entries do not necessarily denote the true nature of transactions, but I. think that the advances in question were correctly treated as loans: The fact that the money so provided was used by the subsidiary to pay its operating expenses, and was lost in a losing cause, does not determine or change its nature of money lent by the respondent to the subsidiary.

In my opinion, the advances were outlays by the respondent of a capital nature, so far as it is concerned, the deduction of which is prohibited by Section 12(1)(b). of the Act and the appeal may be disposed of on that finding alone.

Accordingly, the appeal will be allowed, the decision of the Tax Appeal Board set aside, and the re-assessment made upon the respondent by the Minister will be restored. The appellant is also entitled to his costs of the appeal, to be taxed.