Leonard – Tax Court finds that distressed-debt transaction was an adventure or concern in the nature of trade

The Tax Court’s decision in Leonard v. The Queen, 2021 TCC 33, analyzed the oft-discussed legal concept of “an adventure or concern in the nature of trade”, which the courts use to distinguish between transactions of a business nature from those of a capital nature, in the context of a distressed-debt transaction. The decision also involved considering the realization principle and the disposition of a debt by way of a fundamental change in its terms.

Facts

Mr. Leonard had an acquaintance, Mr. Anderson, to whom he occasionally made loans. Prior to 2009, Mr. Anderson had acquired two lots in Hawaii, Lot B-2 and Lot B-3. Both lots were subject to mortgages, with the mortgage on Lot B-2 (the “Mortgage”) and the debt it secured (the “Debt”) being at issue in the case.

The 2008 recession had a significant impact on Mr. Anderson, and he became unable to repay his debts. As a result, the bank commenced foreclosure proceedings with respect to the Mortgage. Mr. Anderson was also unable to repay certain debts to Mr. Leonard, so the two men negotiated Mr. Leonard’s acquisition of the two lots at a discount to make amends for Mr. Anderson’s failure to repay. In 2009, Mr. Leonard acquired Lot B-3 and the Mortgage and Debt with respect to Lot B-2 from the bank for a total price of $5,700,000, with $1,300,000 allocated by the bank to the Mortgage and the Debt. At that time, the total principal and interest owing in respect of the Debt was found to be $1,606,528.65, meaning Mr. Leonard acquired the Debt at a discount of over $300,000.

Due to the foreclosure proceedings, Mr. Leonard could not deal with Lot B-2 until the judicial sale was completed. That did not occur until 2011, at which time Mr. Leonard was surprised to find that he was the only bidder for Lot B-2. He acquired the property for a bid of $500,000. As part of the foreclosure proceedings, a deficiency judgment in the amount of $1,472,006.44 was filed in favour of Mr. Leonard against Mr. Anderson with respect to the Mortgage and the Debt. Mr. Leonard testified that he had not forgiven the Debt but did not expect to be able to collect anything on it from Mr. Anderson.

In filing his 2011 income tax return, Mr. Leonard claimed a non-capital loss of $1,472,006 (the “Loss”). The CRA reassessed Mr. Leonard to disallow the Loss . Mr. Leonard appealed to the Tax Court.

Issues

The Court described the issues as follows:

• If there was a loss, was it a capital loss or a loss incurred in respect of an adventure in the nature of trade (i.e., a non-capital loss)?
• Was there a loss, and, if so, did Mr. Leonard realize the Loss in 2011, and what was the amount of the Loss?

Court’s Analysis

Adventure or Concern in the Nature of Trade

The first issue was whether Mr. Leonard acquired the Mortgage and the Debt as an investment or as an adventure or concern in the nature of trade. The Court adopted the approach set out by the Supreme Court of Canada in Friesen, [1995] 3 SCR 103, which held that one of the requirements for an adventure in the nature of trade is that it involve a “scheme for profit-making”: “The taxpayer must have a legitimate intention of gaining a profit from the transaction” (Friesen, at para. 16).

The Court agreed that Mr. Leonard’s stated intention was to make a profit but noted that it was required to review not only the taxpayer’s stated intention, but also the subjective and objective manifestations of that intention. Moreover, it was important for the Court to discern whether Mr. Leonard’s profit-making motive attached to Lot B-2 or to the Mortgage and the Debt. The Court found several objective manifestations of Mr. Leonard’s intention, including: the bank’s determination that the Debt was uncollectible; Mr. Leonard’s acquisition of the Mortgage and the Debt at a time when the Debt was in default; and the discount Mr. Leonard received on the Mortgage and the Debt.

The Court found that Mr. Leonard had two possible motivations for engaging in the transactions at issue: (1) hoping that someone would bid at the judicial sale and pay a price for Lot B-2 greater than the amount that he had paid to acquire the Mortgage and the Debt; and (2) bidding on and acquiring Lot B-2 himself and later selling the property at a profit. Under either alternative, Mr. Leonard was participating in a profit-making endeavour. Accordingly, the Court found that Mr. Leonard acquired the Mortgage and the Debt as part of an adventure or concern in the nature of trade.

Realization of the Loss

The second issue was whether Mr. Leonard had realized the Loss in 2011. Important to this discussion was the “realization principle”, described by the Supreme Court of Canada in Friesen as “the general principle that neither profits nor losses are recognized until realized” (para. 45).

In dealing with this issue, the Court analyzed the Mortgage and the Debt separately. The Crown acknowledged that the Mortgage had been discharged in 2011, and thus Mr. Leonard was deemed to have disposed of the Mortgage pursuant to subparagraph (b)(i) of the definition of “disposition” in subsection 248(1) of the Income Tax Act (Canada) (the “ITA”). The Crown’s position with respect to the Debt, however, was that it continued to exist in the form of the deficiency judgment, so it had not been disposed of. This caused the Court to analyze whether that change in form amounted to a disposition of the Debt itself.

In General Electric Capital, 2001 FCA 392, the Federal Court of Appeal confirmed that “where there are substantial changes to the fundamental terms of a debt obligation, the result may be the creation of a new obligation.” The Court reviewed the four factors set out in General Electric Capital, being (1) the identity of the debtor; (2) the principal amount; (3) the interest terms; and (4) the maturity date, and determined that the terms of the Debt under the deficiency judgment had not been so significantly changed that it constituted a disposition of the Debt and the acquisition of a new property. Accordingly, the Court found that Mr. Leonard only disposed of the Mortgage in 2011—not the Debt.

Amount of the Loss

The final issue was the amount of the Loss. Although the Crown admitted that the amount of the Loss was $1,472,006, the Court found that the evidence did not support that amount. Thus, the Court endeavored to recalculate the amount, citing its mandate to confirm or vary the reassessments based on the facts.

Since the Court found that Mr. Leonard had only disposed of the Mortgage, and not the Debt, it was necessary to determine the amount, if any, of the Loss which arose from the disposition of the Mortgage. In that regard, the Court found that the Debt was essentially valueless when Mr. Leonard entered into the relevant transactions (given Mr. Anderson’s numerous other debts and judgments). Guided by section 68 of the ITA (which deals with the reasonable allocation of a single amount among various properties), the Court allocated 99.9% of Mr. Leonard’s cost in the various assets acquired from the bank to the Mortgage. Accounting for Mr. Leonard’s proceeds from the judicial sale and the amount he paid to acquire the Mortgage and the Debt, the Court reduced the amount of the Loss to $826,426.

Takeaway

The Court concluded that the Loss arose from an adventure or concern in the nature of trade, and was thus a non-capital loss. However, the Court determined that the amount of the Loss was lower than the amount claimed by Mr. Leonard.

The case provides a useful review of the factors relevant to determining whether property is acquired as part of an adventure or concern in the nature of trade, particularly in the context of a distressed debt. The case also emphasizes the test for determining whether a debt has been disposed of as a result of a change in its terms, and highlights the distinction between a debt and any mortgage interest securing it. Finally, this case provides a useful reminder that the Tax Court’s mandate is to render a decision based on the facts, and that an admission by one party on a particular fact is not necessarily binding on the Court.