As is often the case, generous tax treatment attracts increased scrutiny from the Canada Revenue Agency (CRA), and often results in numerous court cases. In the MacCallum case, the taxpayer was successful in convincing the Tax Court of Canada (TCC) that a portion of the $162,852.27 amount paid by him to honour a guarantee of a debt owing by his son’s company qualified as an ABIL.
This case may be of assistance to other taxpayers in similar circumstances.
Mitchco Construction Inc. was a small-business corporation wholly owned by the taxpayer’s son. D&N Truck Lines Ltd. (D&N) was primarily a trucking company but also carried on a broker/shipper business for owners–operators of trucks. D&N was 100% owned by SeaReach Holdings Ltd., which in turn was owned by the taxpayer (51%) and his spouse (49%).
Beginning in February 1996 and continuing through June 1996, D&N provided equipment and materials to Mitchco in the amount of $394,805 to enable it to fulfil a large construction contract with the City of Miramichi. A contract dispute arose, putting Mitchco into financial difficulty.
On 29 July 1996, the taxpayer provided a guarantee on a line of credit for Mitchco in favour of the bank. Mitchco’s financial difficulties continued and it eventually went out of business. The taxpayer was required to honour his guarantee and paid the amount of $162,852.27 to the bank in June 2003.
The taxpayer and his son testified that there was a verbal agreement that the taxpayer was to be paid a fee for providing the guarantee, but gave conflicting evidence as to the terms of the agreement, and there was no evidence of a fee having been paid. The son paid the taxpayer $50,819.15, but the evidence suggested that this was not a guarantee fee, but rather was paid to reimburse the taxpayer, in part, for the cost to him of honouring the guarantee.
The taxpayer deducted the $50,819.15 reimbursement from the $162,852.27 he had to pay the bank under the guarantee. He then claimed the difference ($112,033.12) as a Business Investment Loss (BIL) and treated half that amount as an ABIL. The Minister reassessed to deny the ABIL deduction on the basis that the taxpayer incurred the debt to help his son in a business venture and there was no business purpose for the debt. The taxpayer appealed to the TCC.
The statutory scheme for ABILs is as follows. Section 3 of the Income Tax Act permits the deduction of an ABIL against income from any source. Section 38 defines an ABIL as one-half of a BIL. Generally, a BIL arises from the arm’s-length disposition (or deemed disposition) of shares of a small-business corporation or certain debts owed by a small-business corporation, as set out in paragraph 39(1)(c) of the Act. An ABIL cannot arise on non-arm’s-length intercorporate debt.
The Crown did not challenge the deduction on the basis that it failed to meet any of the above conditions required to meet the ABIL definition. Instead, it argued that the taxpayer did not incur the debt “for the purpose of gaining or producing income from a business or property,” as required by subparagraph 40(2)(g)(ii), such that the loss was not a capital loss, and therefore could not be an ABIL. In this case, no tax relief would be available to Mr. MacCallum for this loss.
Decision based on satisfying three tests
The TCC judge, Justice Valerie Miller, allowed the taxpayer’s appeal. In reaching her conclusion, she summarized the jurisprudence related to the application of paragraph 40(2)(g) as follows:
- Gaining or producing income need not be the exclusive or even the primary purpose of the loan, as long as it was one of its purposes (see Ludmer v the Queen,  2 S.C.R. 1082 (S.C.C.)).
- There does not have to be a direct link between the debt incurred by a taxpayer and the income he intends to earn (see the Queen v Byram,  2 C.T.C. 149 (FCA)).
- The anticipation of income cannot be too remote: “...[A] deduction cannot be so far removed from its corresponding income stream as to render its connection to the anticipated income tenuous at best. This does not preclude a deduction for a capital loss incurred by a taxpayer on an interest-free loan given to a related corporation where it had a legitimate expectation of receiving income through increased dividends resulting from the infusion of capital.” (Byram, paragraph 21)
The TCC was not satisfied on the evidence that the parties had agreed to the payment of a guarantee fee, so the taxpayer was unable to point to such a fee as his income-earning motive. However, the TCC was satisfied that the taxpayer had shown that one of his purposes for signing the guarantee in July 1996 was to support the continued existence of Mitchco, and thereby protect and collect a significant source of earnings for D&N and for himself, as reflected in the $394,805 debt Mitchco owed to D&N.
This purpose was not too remote to satisfy the requirements of subparagraph 40(2)(g)(ii) of the Income Tax Act. Therefore, the taxpayer was entitled to deduct the ABIL.
In the business world, guarantees of debt between related parties are fairly common. For example, corporations under common control often guarantee debts of other companies in the corporate group. Spouses often guarantee one another’s debts, and parents frequently guarantee debts of a child.
Ensuring an income-earning purpose exists, and is supported by appropriate documentation, is crucial to ensuring at least some tax relief is available to the guarantor in the event the guarantee is called. Payment of a guarantee fee should be considered in cases where a clear link between the loan guarantee and a source of income to the guarantor does not exist.
Even where a link can be supported, such as in the case discussed above, a guarantee fee would provide a clearer link, which could have saved Mr. MacCallum the costs incurred in supporting his claim before the Tax Court.