The COVID-19 pandemic has resulted in unprecedented economic strain and an increase in the market for distressed debt. Taxpayers who purchase distressed debt may be interested in the Tax Court’s decision in Leonard v The Queen, 2021 TCC 33, where it was held that a particular distressed-debt transaction was “an adventure in the nature of trade” and thus, resulted in a non-capital loss.
In Leonard, the taxpayer lent $1.5M to a real estate developer to purchase and develop land. Upon the developer’s default, the taxpayer purchased the land back from the developer and acquired the underlying debt, mortgage and promissory note from the bank for $1.3M (a 300K discount from the $1.6M in principal and interest owing). After failing to resell the lot at a profit, a deficiency judgment was filed in favour of the taxpayer, and the taxpayer deducted $1.5M in computing his income. The Minister reassessed the taxpayer and disallowed the deduction.
The taxpayer took the position that he was participating in an adventure in the nature of trade in relation to the mortgage, note and debt with the intention of making a profit, and the resulting loss was a non-capital loss. The Crown argued that the taxpayer’s objective was to hold the lot as a long-term investment and the loss was a capital loss.
THE TAX COURT’S ANALYSIS
In analyzing whether the loss was capital or non-capital, the Tax Court adopted the approach set out in the Supreme Court of Canada’s decision Friesen v the Queen , 3 SCR 103. In Friesen, the Supreme Court stated that a taxpayer must have “a legitimate intention of gaining a profit from the transaction” in order to be carrying on an adventure in the nature of trade. The Tax Court considered the factors set out in Friesen for determining whether a transaction involving real estate was an adventure in the nature of trade, namely:
- the taxpayer’s intention;
- the nature of the business;
- the nature and use of the property; and
- the extent to which borrowed money was used to finance the transaction and the length of time the property was owned.
The Tax Court also considered the factors in Happy Valley Farms Ltd. v MNR, 86 DTC 6521 (FCTD), in particular, the work expended on or in connection with the property realized, and the circumstances that were responsible for the sale of the property.
In Leonard, the Tax Court held that the taxpayer had a scheme for profit-making and concluded that the acquisition of the mortgage, note and debt, and his subsequent efforts to realize a profit, were part of an adventure in the nature of trade. The Tax Court based its conclusions on:
- the subjective and objective manifestations of the taxpayer’s intentions, specifically, the taxpayer’s testimony that based on previous sales in the community, he predicted the undeveloped lot would sell for significantly more than he paid for the distressed debt;
- the unlikelihood that the taxpayer would receive interest payments on the debt, meaning that the debt would be sold for profit rather than held as an investment; and
- the taxpayer’s use of borrowed funds in acquiring the mortgage, note and debt.
Further, the Tax Court considered the realization principle, which requires a disposition of property in order for a gain or loss to be recognized. The Tax Court held that the taxpayer disposed of the mortgage but not the note or the debt, since the taxpayer continued to hold the debt after the deficiency judgement. However, the Tax Court ultimately allocated almost all of the consideration to the mortgage and only nominal consideration (0.1%) to the note and debt, because they were essentially worthless.
In determining the amount of the loss, the Tax Court disagreed with the taxpayer’s claimed deduction of $1.5M. Instead, it held that the loss was approximately $830,000. This was calculated by subtracting the net proceeds from the judicial sale of the lot of $470,000 from the amount the taxpayer paid for the mortgage, note and debt of $1.3M.
Leonard demonstrates a specific set of circumstances in which a distressed-debt transaction can be considered an adventure in the nature of trade and give rise to a non-capital loss. The case highlights to taxpayers the extent to which their intentions and subsequent actions, when entering into a transaction, may affect the outcome of the court’s analysis.