Judgments

Decision Information

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T-1406-74
The Queen (Plaintiff)
v.
Frank Leslie (Defendant)
Trial Division, Addy J.—Toronto, December 12, 1974; Ottawa, March 10, 1975.
Income Tax—Defendant selling business to company con trolled by him and taking promissory note as part payment— Repaying part of note 10 years later—Whether part of defend ant's 1969 income—Whether payment pursuant to bona fide business transaction and not an appropriation—Income Tax Act, R.S.C. 1952, c. 148 as am. ss. 8(1)(a), (b).
Defendant caused a company of which he was the controlling shareholder to be incorporated in order to acquire a business which he operated. Purchase price of $25,380 was paid by issuing 10,000 common shares to the vendor, and the balance was secured by a promissory note for $15,300. Net value of the business was $5077.85 and included in the balance was $20,222.15 allocated to goodwill. Ten years later $7,762.68 was paid in partial satisfaction of the note. Plaintiff claims that this amount should have been included in defendant's 1969 income under section 8(1)(a) or (b) of the Income Tax Act.
Held, setting aside the judgment of the Tax Review Board, and confirming the original assessment, this was not a bona fide business transaction; defendant was the controlling share holder, and assets worth $5,075.00 were transferred for $25,380. As to whether the note was unenforceable because of failure of consideration regarding the goodwill, the original agreement does not differentiate between goodwill and other assets. The note was given only for part of the balance of the price of all assets sold. Between parties who have entered into an otherwise enforceable contract, once the Court is satisfied that there is valuable consideration, it will not consider the sufficiency.
When an enforceable obligation has been entered into in one year and creates a taxable benefit to the obligee, and the obligation is paid in a subsequent year, it is when the benefit is created, not when the taxpayer actually receives payment, that the amount should be taken into account. The debt, however, must be well-secured. If there are not sufficient assets to create the expectation that the debt will be paid, the benefit is not conferred until assets are accumulated sufficient to create a real benefit. Here, no security existed for any amount in excess of the actual 1959 value of the assets. No benefit was then conferred in 1959.
Kennedy v. M.N.R. [1973] F.C. 839, followed. INCOME tax appeal.
COUNSEL:
G. W. Ainslie, Q.C., and C. H. Fryers for
plaintiff.
D. C. Nathanson for defendant.
SOLICITORS:
Attorney General of Canada for plaintiff. D. C. Nathanson, Toronto, for defendant.
The following are the reasons for judgment rendered in English by
ADDY J.: The defendant, who was at all ma terial times the owner of the majority of the voting shares of Headwater-Perth Cheese & Foods Lim ited (hereinafter referred to as "the Company"), had, pursuant to an agreement for sale, dated the 5th of March 1959, sold to the Company, as a going concern, a storage and food distribution business which the defendant had been carrying on for some time. The defendant had caused the Company to be incorporated as a private company under the laws of the Province of Ontario for the purpose of acquiring these assets. The letters patent incorporating the Company were dated the 4th of March 1959. The purchase price was paid by issuing 10,000 common shares to the vendor for a total expressed consideration of $10,000.00 and the balance was secured by a promissory note to the defendant vendor for $15,300.00. The promis sory note bore interest at 3% and contained privi leges and conditions extremely favourable to the purchaser Company.
The tangible assets, other than the goodwill, amounted to $11,851.41 and the current liabilities amounted to $6,773.46. The net value of the busi ness exclusive of goodwill was therefore $5,077.85. Included in the balance of the purchase price was an amount of $20,222.15 allocated to goodwill. It is uncontested and was freely admitted by the defendant at trial that, in fact, there was no value whatsoever to the goodwill.
Ten years after the sale, namely, in 1969, an amount of $7,762.68 was paid by the Company to the defendant in partial satisfaction of the promis sory note issued to him.
The plaintiff claims that the said amount of $7,762.68 should, by virtue of section 8(1)(a) or alternatively 8(1)(b) of the Income Tax Act', properly be included in computing the defendant's income for the 1969 taxation year. The defendant, on the other hand, claims that the said amount was a payment made pursuant to a bona fide business transaction within the meaning of section 8(1)(a) and did not constitute an appropriation under sec tion 8(1)(b) and, therefore, should not have been taken into account in computing the income in 1969, since whatever benefit the defendant did receive was in fact received in 1959, at the time of the closing of the sale, pursuant to the agreement for sale and the transferring of the assets. The relevant portions of section 8(1) of the Income Tax Act read as follows:
8. (1) Where, in a taxation year,
(a) payment has been made by a corporation to a sharehold er otherwise than pursuant to a bona fide business transaction,
(b) funds or property of a corporation have been appropriat ed in any manner whatsoever to, or for the benefit of, a shareholder, or
(e) a benefit or advantage has been conferred on a share holder by a corporation,
the amount or value thereof shall be included in computing the income of the shareholder for the year.
Having regard to the fact that the defendant vendor was the controlling shareholder of the com pany which was purchasing the assets from him, and having regard also to the fact that assets of the total net value of some $5,075.00 were trans ferred to the purchasing company for a total con sideration of $25,380.00, I find no difficulty what soever in concluding that the transaction cannot be termed a "bona fide business transaction" as con templated by section 8(1)(a) of the Act. Though, it might well be argued that, as the Company had no other assets in 1959 except those purchased from the defendant and that as a result the shares would not have had any value whatsoever, then, even when discounting the shares completely, the Company, at that time, had but a net worth business assets of $5,075.00 and a liability towards the vendor of $15,300.00, any such transaction could still not be characterized as a bona fide business transaction in view of the great and very
1 R.S.C. 1952, c. 148, as amended to 1969.
evident deficiency in the consideration passing from the vendor to the purchaser. It follows, there fore, that if "the payment was made" in 1969, then, pursuant to section 8(1)(a), the sum of $7,762.68 would be taxable in that year providing the other provisions of section 8(1) do not require the amount to be taken into account in 1959 rather than in 1969. Similarly, of course, if funds of the Company in that amount had to be considered as having been appropriated for the benefit of the defendant in 1959, then, also under section 8(1)(b), the amount would also be taxable in that year.
There can be no question of the defendant in this case being a holder in due course of the promissory note. The plaintiff, therefore, argues that, as there was a total failure of consideration in so far as goodwill is concerned, the promissory note of $15,300.00 was unenforceable as between the original parties to the note, namely the defend ant and the Company, and that the promise to pay by the Company in effect constituted a nullum pactum. As a consequence, no appropriation or payment took place in 1959 but that in 1969, when the amount of $7,762.65 was paid without any legal obligation on the Company to pay it, the payment or appropriation then took place.
In order to determine whether the promissory note constituted a nullum pactum, one must look at the original agreement for sale of which it constituted an integral part. There is no question of all of the formalities under The Corporations Act of Ontario not having been complied with or of the agreement not being valid on its face or properly executed. The issue was never raised by the plaintiff and the agreement, which appears to be regular on its face, is to be presumed to have been properly executed after the normal legal for malities had been complied with. The sole question is one of consideration: in the appendix to the agreement, the amount of goodwill is included with the other assets for total assets in the amount of $32,073.00 and the liabilities, as stated previ ously, amount to $6,773.00 for a total net value of $25,300.00 expressed in the agreement, which amount the Company was obliged to pay by the transfer of $10,000.00 worth of shares and the aforesaid note of $15,300.00. By the express terms of the agreement, there is therefore no distinction
made between the goodwill and the other assets in so far as payment for the transfer of same is concerned. The promissory note of $15,300.00 is not expressed in the agreement to be given for any part of the goodwill but merely for part of the balance of the purchase price of all of the assets sold. It is not a question, therefore, of there being no consideration for the note, which might very well have been the case if the note had been expressed in the agreement to be given in payment of the goodwill, in which case the promise to pay being a promise to pay something for nothing, would constitute a nullum pactum by reason of total failure of consideration.
On this issue, it is interesting to note that para graph 11 of the defendant's statement of defence reads as follows:
11. The amount assigned to goodwill by the Defendant and Headwater-Perth Cheese & Foods Limited was $20,222.15, which was paid for by Headwater-Perth Cheese & Foods Limited by the making of a promissory note in favour of the Defendant in the amount of $15,300 bearing interest at the rate of 3% per annum, the balance being covered by the issuance to the Defendant of fully paid common shares of Headwater- Perth Cheese & Foods Limited.
(This pleading is, of course, contrary to the express terms of the agreement as above mentioned.) Such an admission, as that contained in the above-quot ed paragraph, might well have been very damaging if not fatal to the defendant had the plaintiff chosen to admit the pleading as being factual, but the plaintiff in his reply pleaded as follows:
3. He admits that the amount assigned to goodwill by the Defendant and Headwater-Perth Cheese and Food Limited was $20,222.15, and otherwise joins issue with paragraph 11 of the Statement of Defence, and says that the parties to the agree ment of purchase and sale expressly agreed that the promissory note was merely to secure the unpaid purchase price payable under the agreement of sale.
The issue having been joined on that aspect of the case, the Court is then obliged to make a finding of fact on the matter and, as stated above, the evidence establishes that the facts coincide with the above-quoted pleading of the plaintiff.
There is a fundamental distinction to be drawn at law between a situation where there is total failure of consideration and one where the con sideration flowing from one party might not be commensurate with the value of the promise of or the value of what is given by the other party.
Between parties who have entered into a contract which is otherwise legal and enforceable, the Court, once it is satisfied that there exists in fact valuable consideration, will not concern itself with the sufficiency of same nor will it, on the grounds of insufficiency of consideration or inequality of undertaking, allow a party to a contract to avoid his obligations thereunder.
It seems to me clear, therefore, that the agree ment between the defendant and the Company did not constitute a nullum pactum nor did the pro missory note issued pursuant thereto. The note, which was given in 1959, was fully enforceable between the parties. The mere fact that an agree ment is not an arm's length transaction, or does not constitute a bona fide business transaction under the Income Tax Act, does not render that contract void or unenforceable between the parties. It might also be quite true that the agreement is the very type of agreement which, had there been creditors of the Company at the time it was made, might have been set aside at the suit of one of the creditors and declared void and unenforceable in so far as creditors are concerned. But, again, the fact that a contract might be voidable at the instance of creditors does not render it void, void- able or unenforceable as between the immediate parties thereto.
Since the defendant received in 1959 a valid negotiable instrument, which was enforceable against the maker, in the amount of $15,300.00 plus interest, and since the instrument could be validly negotiated at any time to a holder in due course, it might seem at first that, in accordance with the argument advanced by the defendant, pursuant to section 8(1)(b), funds in the amount of at least $15,300.00 2 were appropriated in 1959 to and for the benefit of the defendant or, alternative ly, under section 8(1)(c) a benefit in that amount was conferred on the defendant, and that, in both cases, the amount of the note (subject perhaps to some discount, having regard to the low rate of interest and the length of time before maturity) should, in accordance with the concluding words of section 8(1) have been included in computing the
2 (Shares in the nominal amount of $10,000.00 having also been received.)
income of the defendant for the year 1959 and would have nothing to do with the taxation year 1969.
Generally speaking, when a legally enforceable obligation to pay has been entered into, in one taxation year, and this obligation creates a taxable benefit in the hands of the obligee or of the payee and the legal obligation is met and paid in a subsequent taxation year, it is when the legally enforceable benefit is created and not when the taxpayer actually receives payment that the amount should be taken into account. This princi ple was approved by my brother Cattanach J. in Kennedy v. M.N.R. 3 and his decision was con firmed on this point by the Court of Appeal in Kennedy v. M.N.R. 4 .
In the above-mentioned case, Jackett C.J. also clearly re-states the distinction made in other cases between "income" and a "benefit" as contemplat ed in section 8(1) as follows (refer pages 842 and 843 of the above-mentioned report of the case before the Court of Appeal):
In the case of "income", it is assumed, in the absence of special provision, that Parliament intends the tax to attach when the amount is paid and not when the liability is created. (The courts naturally react against taxation before the income amount is in the taxpayer's possession.) Here, the question is when a "benefit" has been "conferred" within the meaning of those words in section 8(1). In my view, when a debt is created from a company to a shareholder for no consideration or inadequate consideration, a benefit is conferred. (The amount of the benefit may be a question for valuation depending on the nature of the company.)
Immediately following that, however, in the same paragraph he goes on to state:
On the other hand, when a debt is paid, assuming it was well secured, no benefit is conferred because the creditor has merely received that to which he is entitled. I am, therefore, of the opinion that the $53,000 promissory note must be taken into account for the purposes of section 8(1) in the year in which it created an indebtedness from the company to the appellant, namely, 1965. [The underlining is mine.]
He then goes on to state in the following paragraph:
The question of benefit or no benefit in the 1965 taxation year is, in my view, primarily a question of fact in connection
3 72 DTC 6357.
4 [1973] F.C. 839.
with which the onus of proof was on the appellant [taxpayer]. [The word in parenthesis is mine.]
The underlined words "assuming it (the debt) was well secured" obviously do not refer to the type of instrument under which the debt is secured, that is, whether it is secured by a simple promise, a promissory note, a charge or a mort gage, since in the Kennedy case (supra), the debt was only secured in that sense by a promissory note and it is evident that a promissory note of itself does not constitute security: the security, in so far as a promissory note is concerned, depends entirely on the maker's ability to pay. The type of security contemplated in the above-quoted passage must be taken to refer to the existence of sufficient assets to create a good or a sound expectation of the debt actually being paid. In such a case, a benefit is in fact being conferred at the time the legal debt is created. Conversely, if there are no assets, then, although a legal debt might be creat ed, there is no benefit conferred at the time, although a benefit might well accrue if and when assets are accumulated sufficiently to allow the obligation to mature into a real benefit.
In the case at bar, as stated previously, the net assets transferred to the Company amounted to $5,077.85 after deducting liabilities and these were the total assets of the Company. On the security of these assets, the Company gave the defendant vendor the promissory note for $15,300.00 and issued to him shares of the nominal value of $10,000.00. Whatever legal benefit was granted in fact to the defendant in 1959 necessarily must be something in excess of the actual value of the assets transferred to the Company by him, that is, an amount over and above the sum of $5,077.85. On the facts, it is clear that there existed no security whatsoever for any such amount in excess of $5,077.85 in 1959, since the Company had no other assets whatsoever with the result that no benefit was in fact conferred upon the defendant at that time. It is interesting to note that, at the time of the sale, the potential of the Company to generate revenue and to possibly accumulate assets in the future depended not on the Company itself but entirely upon the work, industry, ability, know- how and business connections of the defendant.
Had the Company possessed of itself any such potential, then, some value might possibly have been allocated to this asset as goodwill and the net assets of the Company would have been increased accordingly. Since, for the reasons above men tioned, no benefit was in fact conferred at the time of the sale in 1959, the Minister, in my view, was correct in assessing the taxpayer in 1969 under section 8(1)(a) for the amount which he actually received as it was a payment made by the Com pany to one of its shareholders otherwise than pursuant to a bona fide business transaction, and no taxable benefit to which this amount refers had been conferred on the taxpayer in 1959.
The assessment was actually made in the amount of $7,956.22. In the pleadings and at the opening of trial, counsel for the plaintiff agreed that there had been an error and that the assess ment should have been in the amount of $7,762.68, rather than $7,956.22, and agreed that, if he suc ceeded, the assessment should be confirmed in the lesser amount.
The judgment of the Tax Review Board will therefore be set aside and the original assessment confirmed in the amount of $7,762.68. The plain tiff will be entitled to costs.
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