Chisholm v. The Queen, 99 DTC 150, [1999] 1 CTC 2498 (TCC)

Mogan T.C.J.:

The appeals of Douglas Chisholm v. The Queen (Court file no. 96- 3332), Harvey Chisholm v. The Queen (Court file no. 96-3333) and Paul Chisholm v. The Queen (96-3334) were heard together on common evi- dence. The Appellants are cousins who own and operate a family business near Belleville, Ontario. For convenience, I shall refer to them individually as Douglas, Harvey and Paul because the word “Appellant” could apply to either one. The business now operated as “Chisholm Roslin Ltd.” was started in 1857 and the Appellants are the sixth generation to operate it within the family. The business consists primarily of selling forest products as builders’ supplies. The company either cuts or purchases logs; saws the logs into lumber; dries the lumber and then sells it. Each Appellant owns one-third of the equity in the business.

Each Appellant is married with children. At the end of 1987, the Appellants decided to act in accordance with certain advice they had received with respect to estate planning. The estate plans carried out by all three Appellants were identical in substance. If I describe the estate plan carried out by Douglas, it may be regarded as identical to the plans carried out by his cousins, Harvey and Paul. On December 30, 1987, by deed of gift Douglas gave 408 common shares in the capital stock of 548351 Ontario Inc. (herein referred to as “Co. 351”) to H. Van Winssen as trustee for James Douglas Chisholm (son of Douglas). The parties agree that the 408 shares of Co. 351 had a fair market value of $67,075. On February 1, 1988, Douglas purchased the 408 shares of Co. 351 for $67,075 from the trustee for James and, in lieu of cash, delivered his promissory note for $67,075 due 10 years later on January 30, 1998 and bearing annual interest at prime as charged from time to time by the Bank of Montreal.

On December 30, 1987, Douglas also gave 408 shares of Co. 351 to the same trustee for his daughter Sarah Louise Chisholm, and he gave a further 408 shares of Co. 351 to the same trustee for his son Peter Ron Chisholm. On February 1, 1988, Douglas purchased the 408 shares of Co. 351 for $67,075 from the trustee for Sarah; and he purchased the 408 shares of Co. 351 for $67,075 from the trustee for Peter. In lieu of paying cash, Douglas delivered to the trustee two promissory notes, each for $67,075 and having the same terms as the note given to the trustee for James. As at February 2, 1988, the trustee having entered into three separate trust agreements with Douglas, was holding three separate promissory notes from Douglas each in the amount of $67,075 and all three notes had identical terms.

In computing income for each of the years 1991, 1992 and 1993, Douglas deducted the aggregate amount of $20,122.56 as interest paid with respect to the three promissory notes delivered to the trustee upon the repurchase of the 1,224 (3 x 408) common shares of Co. 351. The Minister of National Revenue disallowed the deduction of such amount and Douglas has appealed to this Court. The other two cousins, Harvey and Paul, have also appealed because identical amounts of interest paid in identical circumstances were disallowed as deductions by the Minister of National Revenue. For Harvey, the years under appeal are 1991, 1992 and 1993. For Paul, the years under appeal are 1990, 1991 and 1992. The common issue in these three appeals is whether the aggregate amount of interest is deductible in computing income. The Appellants have elected the informal procedure.

The transactions are well documented. All of the appropriate documents appear to have been drafted and signed in a timely manner as circumstances required. In Exhibit A-l, tab 3 is the trust agreement dated December 30, 1987 between Douglas and Van Winssen with respect to Douglas’ son, James. Tab 4 is the deed of gift of 408 shares to the trustee for James. And tab 5 is the promissory note dated February 1, 1988 for $67,075 delivered to the trustee for James upon the repurchase of the 408 shares. Tabs 6, 7 and 8 are the corresponding documents for Douglas’ daughter Sarah. Tabs 9, 10 and 11 are the corresponding documents for Douglas’ son Peter. Tab 27 is the shareholder register for Co. 351 showing that the three Appellants each started with 7,502 common shares; that each transferred 1,224 shares on December 30, 1987 to a trustee for his respective children; and that each received a re-transfer of the 1,224 shares on February 1, 1988.

Tabs 28 to 44 are pages from the shareholders’ ledger. Tabs 45 to 61 are the various share certificates. Tabs 62 to 64, 66, 68 and 70 are executed transfers of the relevant shares. Tabs 65, 67, 69 and 71 are directors’ resolutions approving the relevant transfers. And lastly, Tabs 72 to 75 are minutes of directors’ meetings of Co. 351 held on four successive years showing that dividends were declared as follows:

There is no dispute between the parties concerning any of the documents. The Respondent acknowledges that each Appellant transferred as a gift 1,224 common shares of Co. 351 to his respective children on December 30, 1987; and that each Appellant repurchased the same 1,224 common shares at the fair market value of $201,225 (being $67,075 times three for the three children of Douglas) on February I, 1988. The only dispute is whether each Appellant may deduct in computing income the interest which he paid on the promissory notes which he delivered to the trustee for his children upon the repurchase of the shares.

All of the Appellants testified and their testimony was consistent on all relevant facts. I will therefore summarize only the evidence of Douglas. The three Appellants are the sixth generation within the Chisholm family to own and operate the business. They are hoping that the next generation will want continue the same family business. The primary object of the estate plan was to put funds in the hands of the children to purchase the business at some time in the future. This appears to have been accomplished because the trustee continues to hold the various promissory notes up to the time of hearing these appeals.

In a number of ways, the actual execution of the estate plan was different from the terms in certain documents. Each trust agreement (Exhibit A-l, tabs 3, 6 and 9) recited that the shares were to be held by the trustee “until the Beneficiary is eighteen years of age” but in fact the shares were repurchased in 32 days. Each deed of gift (Exhibit A-1, tabs 4, 7 and 10) stated that the grantor “wishes to gift the Shares” but they were qualified gifts because each deed (signed by both grantor and grantee) stated that the shares “shall not be transferred, assigned, encumbered, mortgaged or other- wise transferred or dealt with by the Grantee without the prior written consent of the Grantor”. Douglas said that when the estate plan was described to them by their professional advisors, it was always clear that the 1,224 shares gifted to his three children were going to come back to him. Each of the Appellants owned 7,502 common shares prior to December 30, 1987 and, in the estate plan, they were each gifting and repurchasing only 1,224 shares or about 16% of their one-third equity.

Each promissory note (Exhibit A-l, tabs 5, 8 and 11) stated that interest was “due and payable yearly” to or to the order of the trustee until a child became eighteen years of age. In fact, on March 15, 1988 (43 days after the promissory notes were delivered), the trustee executed a direction to Douglas in the following words:

To: Douglas Chisholm

Direction (L502/R4500/T2/BT2) test_marked_paragraph_end (1290) 0.839 0677_3697_3803

RE: Douglas Chisholm Promissory Notes each

Dated February 1, 1988 to:

Harold Van Winssen, Trustee for James Douglas Chisholm; Harold Van Winssen, Trustee for Sarah Louise Chisholm: Harold Van Winssen, Trustee for Peter Ron Chisholm

(the “Promissory Notes”)

You are hereby authorized and directed to reinvest the interest payments due to the undersigned with respect to the Promissory Notes as you shall deem fit in the names of each of the children, and this is your good, sufficient and irrevocable authority for so doing.

DATED this 15th day of March, 1988.

“Harold Van Winssen”

Trustee for James Douglas Chisholm,

Sarah Louise Chisholm and

Peter Ron Chisholm

Identical directions were executed by the trustee on the same date to Harvey and Paul. The three directions are tabs 9, 10 and 11 in Exhibit A-2. The directions of the trustee were followed in the sense that no interest was paid by Douglas or Harvey or Paul to the trustee. There is no evidence that the trustee required or even asked for an accounting from any of the Appellants to determine whether the annual interest amounts were reinvested “in the names of each of the children”.

In cross-examination, Douglas described how he paid the annual interest amounts. For 1991, he stated that he spent approximately $23,000 of the children’s “interest” money for the benefit of the children as follows:

James - age 20 in 199]

Douglas’ MasterCard	$2,994
Douglas’ wife’s MasterCard	904
	$3,898

[These amounts were for clothes, car repairs or car operating costs.]

In summary, Douglas stated that the annual interest amounts were generally spent on enriching experiences which he and his wife tried to provide for their children. For the three years under appeal, Douglas identified the following amounts expended for the benefit of his three children as amounts which he charged against the interest payable by him with respect to the three promissory notes (Exhibit A-l , tabs 5, 8 and 11).

Paragraph 20(1)(c) of the Income Tax Act is the provision which permits the deduction of interest. For these appeals, the relevant words are:

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s

income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i)

(11) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business...

(iii)

In simplistic terms, the position of the parties is as follows. The Appellants argue that the promissory notes represent amounts payable for property (1.e. those shares of Co. 351 which were repurchased on February 1, 1988) acquired for the purpose of gaining or producing income (i.e. dividends); and accordingly, any interest paid with respect to such promissory notes is deductible under subparagraph 20(1)(c)(ii). The Respondent argues that those shares of Co. 351 which were repurchased on February 1, 1988 were not acquired for the purpose of gaining or producing income within the meaning of subparagraph 20(1)(c)(ii) because they were acquired only for the purpose of completing the estate plan by placing capital amounts (i.e. the principal amounts of the various promissory notes) in the hands of the children.

The arguments of both parties require a more detailed examination of the estate plan and the share structure of Co. 351. As already stated, each Appellant held 7,502 common shares of Co. 351 in early December 1987. When Douglas gifted 1,224 shares to his three children, he disposed of 16.3% of his own shares but only 5.4% of all outstanding shares. In making the gift, Douglas used the rollover provision in subsection 73(5) of the Act as it applied in 1987 permitting a parent to transfer to a child a share of a small business corporation (like Co. 351) and defer any gain on such disposition by transferring to the child the parent’s adjusted cost base ("ACB"). Exhibit A-2, tabs 3, 4 and 5 are the Revenue Canada forms for the rollover gifts to James, Sarah and Peter showing that the fair market value of 408 shares was $67,075 and that the “deemed proceeds of disposition” was $408.

I infer from Exhibit A-2, tabs I to 8 inclusive that the ACB of each outstanding share to the three Appellants in early December 1987 was one dollar per share. The gifts were tax-free transfers through which the children of all three Appellants acquired not only the shares but also, under subsection 73(5) of the Act, their parents’ ACB. On February 1, 1988, the trustee for each child sold all of the gifted shares back to the donor parent at fair market value. Each sale created a significant capital gain because the fair market value was so much higher than the ACB. Each vendor child used the capital gains exemption in section 110.6 of the Act to shelter his or her gain from tax. The 1988 tax returns of the eight children in Exhibit A-3 show the reporting of the gains and the claiming of the exemption. By claiming the capital gains exemption, each child was able to make a tax-free sale and retain 100% of the proceeds of disposition. This was an important part of the estate plan because its principal purpose was to place the maxi- mum amount of capital funds in the hands of the next generation.

Apart from the “purpose” test in subparagraph 20(1)(c)(ii), the Appellants have a more basic problem in proving that they paid any interest in the years under appeal on the promissory notes which they delivered to the trustee on February 1, 1988. In a perfect world, Douglas would have paid the interest to the trustee on the anniversary date of each note (February 1, 1991, 1992 and 1993) in accordance with the terms of the note; and the trustee would have received such interest for the benefit of Douglas’ three children. The world, however, is not perfect. The Appellants are plagued by the three identical directions which were executed by the trustee on March 15, 1988 (Exhibit A-2, tabs 9, 10 and 11). These are important documents and, in paragraph 10 above, I set out in full the direction given by the trustee to Douglas with respect to his three children.

In effect, Douglas is directed not to pay the interest to the trustee with respect to any of the three notes but “to reinvest the interest payments ... as you shall deem fit in the names of each of the children”. I am puzzled by the word “reinvest”. It is not as if any interest payment had been already made and invested because the direction was executed on March 15, 1988 only 43 days after the delivery of the promissory notes. Why was Douglas not directed simply “to invest” the interest payments? Also, what did the trustee mean by the word “reinvest”? Was he using that word in a business sense like the purchase of a conventional security (a bond issued by a government, a GIC or the shares of a listed public company) or was he using it in a family sense like any payment which might advance the education, training or skill development of a child?

There is no doubt that Douglas took the word “reinvest” primarily in a family sense because the evidence was that the alleged interest amounts were paid for education, recreation, vacation, travel, clothing and the needs of James’ automobile. A residual amount was used to purchase GICs. These payments appear to have been made in the ordinary course of middle-class family living. Can they be regarded as a reinvestment of interest payments within the meaning of the trustee’s direction? Douglas obviously thought so because he designated a sufficient number of such payments to make an aggregate amount exceeding his annual interest obligation on the three promissory notes; he applied the designated payments against his annual interest obligation; and he concluded that he had paid his annual interest obligation by paying such designated amounts.

I should have thought that Mr. Van Winssen, as trustee, had an obligation to satisfy himself that the debtor (1.e. Douglas) made the interest payment on the due date in each year even if the trustee was content that such payment would then be invested by the debtor for the benefit of each child. A trustee has a fiduciary obligation to a beneficiary to make sure that a beneficiary receives what is his due. There is no evidence that the trustee attempted to discharge his fiduciary obligation with respect to the annual interest payments on the promissory notes. Indeed, I infer that Douglas as the debtor was left on his own to determine whether the annual interest payments would be made and, if so, how they would be “reinvested”, to use the word in the trustee’s direction.

In the absence of any evidence of accounting by Douglas to the trustee whereby the trustee could be satisfied that the annual interest payments had, in fact, been made and reinvested (whatever that word means) for the benefit of the children, I am not prepared to conclude that Douglas paid any interest on any of the promissory notes in the three years under appeal.

There was a separate trust for each of Douglas’ three children although the same individual (Harold Van Winssen) was the trustee of each trust. For example, as trustee for James, Mr. Van Winssen held a promissory note from Douglas in the amount of $67,075 bearing annual interest (due on February I in each year) at the prime rate as described from time to time by the Bank of Montreal. A promissory note is not a security like a mortgage but it is evidence of a debt.

According to the pleadings, Douglas claimed to have paid aggregate interest of $20,122.56 on the three promissory notes in each of the years 1991, 1992 and 1993. The three notes were all in the same principal amount of $67,075 (Exhibit A-1, tabs 5, 8 and 11). I therefore infer that the annual interest on each note was $6,707.52 being one-third of $20,122.56. In the table which appears at the end of paragraph 11 above, there is no reconcilia- tion between the amounts identified as having been expended each year for the benefit of each of Douglas’ three children and the amount of $6,707.52 which was the annual interest payable with respect to each note. This lack of reconciliation indicates that Douglas would not be able to satisfy the trustee that he (1.e. Douglas) had paid for the benefit of each child the amount of annual interest required by the terms of each note.

In each Notice of Appeal, the following fact is alleged:

12. The Appellant has, pursuant to the Direction executed by the Trustee, reinvested interest owed to each child for each year or alternatively has paid interest to each child in the form of goods and services of equivalent value to the interest owing on the Promissory Note.

In each Reply, the above allegation of fact is denied. Also, the Respondent alleged in its Reply to the Notice of Appeal that when the Minister of National Revenue assessed the Appellant, the Minister made certain assumptions of fact including:

4(n) the Appellant deducted an amount of $20,122.56 (the “Amount”) as interest

expenses for each of the 1991, 1992 and 1993 taxation years:

14(0) the Amount deducted by the Appellant referred to in subparagraph (n)

above was not interest payable for property acquired for the purpose of gaining or producing income from the property;

Each Appellant was put on notice from the pleadings that he was required to prove that he actually paid in each year the amount of interest required by the terms of the promissory notes. If such amount of interest was claimed to have been paid by providing goods and services having value equal to the interest, each Appellant was required to prove that such goods and services had such value, and were truly extraordinary and not simply part of the everyday lifestyle of a middle-class family. Not one of the Appellants met either standard of proof. I find as a fact that Douglas did not pay any interest on the promissory notes in the years under appeal. On the basis of the evidence heard from Harvey and Paul, I reach the same conclusion with respect to them.

Even if I were to conclude, without adequate evidence, that each Appellant had paid the claimed interest of $20,122.56 in each year under appeal, can the Appellants satisfy the “purpose” test in subparagraph 20( I )(c)(ii)? In paragraph 6 above, there is a table showing the aggregate dividends paid on the common shares in each year from 1988 to 1991. At all relevant times, there were 22,506 common shares issued and outstanding. Between December 30, 1987 and February 1, 1988, each Appellant gifted to his children and repurchased 1,224 common shares. The following table shows the portion of the aggregate dividend which was allocated to and paid on the 1,224 common shares which each Appellant gifted to and then repurchased from his respective children:

Each Appellant delivered promissory notes in the aggregate amount of $201,225 in order to repurchase the 1,224 common shares and, in the years under appeal, each Appellant claims to have paid total annual interest of $20,122.56 with respect to such notes. The high dividend paid in 1988 would have to be increased by a multiple of eight before it would equal (and exceed by $762) the annual interest of $20,122.56. The low dividend paid in 1990 and 1991 would have to be increased by a multiple of 31 before it would equal the annual interest. Would any reasonable person incur a debt of $201,225 and accept an annual interest obligation of $20,122.56 in order to earn dividends which, in the foreseeable future, would not exceed $2,610.55? I have great difficulty in concluding that the 1,224 common shares were repurchased (acquired) for the purpose of gaining or producing income.

According to the Appellants’ testimony, the principal purpose of the estate plan was to transfer significant capital amounts to the next generation in the hope that they would want to purchase and carry on this long-estab- lished family business. I believe that testimony. The estate plan was a success in the sense that the children of each Appellant acquired after-tax capital of $201,225. The repurchase of the shares on February 1, 1988 was a necessary step in the execution of the estate plan. The 1,224 shares repurchased by each Appellant were not acquired for the minuscule amount of dividends they might yield but they were acquired to complete the estate plan.

Counsel for the Appellants relied on the recent decision of the Supreme Court of Canada in Hickman Motors Ltd. v. R. (1997), 97 D.T.C. 5363 (S.C.C.). The Hickman case was concerned with the right to deduct capital cost allowance with respect to certain assets which were owned by the corporate taxpayer for a very short period of time. The Hickman case was not concerned with paragraph 20(1)(c). It was a four/three decision of the Supreme Court of Canada. I do not find any principle of law in Hickman which assists the Appellants in the interpretation of paragraph 20(1 )(c).

In Bronfman Trust v. R. (1987), 87 D.T.C. 5059 (S.C.C.), Dickson C.J.C. delivered the judgment for the Court and made the following statement with respect to the interpretation of paragraph 20(1)(c):

... In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve income-earning property but which are not directly “used for the purpose of earning income from ... property", (page 5067)

In 74712 Alberta Ltd. v. Minister of National Revenue (1997), 97 D.T.C. 5126 (Fed. C.A.), the Federal Court of Appeal emphasized the restrictive nature of paragraph 20(1 )(c). Linden J.A. stated at page 5129:

The interest payment deduction allowed by subparagraph 20( 1 )(c)(i) has been strictly applied by the Courts. This is so because these payments are usually made to increase the capital holdings of taxpayers. Without statutory authorization, therefore, no deduction at all would normally be permitted for these payments. However, because Canadian fiscal policy seeks to encourage the augmentation of income earning potential, certain deductions for interest are permitted in paragraph 20(1)(c).

Robertson J.A. made the following statement at page 5134.

The above extracts render it clear that the direct-use rule has two prongs. First, it is necessary to trace the borrowed funds to an eligible use, that is, to an incomeproducing source, whether it be from a business or property. Second, there must be a sufficiently direct connection between the use of the borrowed funds and the source of income. Thus, even in cases where the borrowed funds are used for a purpose which has the indirect effect of enhancing the taxpayer’s incomeearning capacity, the interest payments remain non-deductible. The incomeearning purpose is simply too remote.

In Mark Resources Inc. v. R. (1993), 93 D.T.C. 1004 (T.C.C.), the corporate taxpayer borrowed money to contribute to its foreign affiliate so that the foreign affiliate could earn investment income to absorb its accumulated U.S. losses for U.S. tax purposes. The corporate taxpayer attempted to deduct in computing income the interest on the borrowed money. In dismissing the appeal of the corporate taxpayer, Bowman J. stated at page 1012:

What, then, is the “direct” use to which the borrowed funds were put here? The direct and immediate use was the injection of capital into a subsidiary with the necessary and intended consequence that the subsidiary should earn interest income from term deposits from which it could pay dividends. The earning of dividend income cannot, however, in my opinion, be said to be the real purpose of the use of the borrowed funds. Theoretically one might, in a connected series of events leading to a predetermined conclusion, postulate as the purpose of each event in the sequence the achievement of the result that immediately follows but in determining the “purpose” of the use of borrowed funds within the meaning of paragraph 20(1)(c) the court is faced with practical considerations with which the pure theorist is not concerned. That purpose — and it is a practical and real one, and in no way remote, fanciful or indirect — is the importation of the losses from the U.S....

While there were no funds “borrowed” in these appeals, each Appellant incurred a significant debt ($201,225) upon the repurchase of the 1,224 shares. The practical consideration which I see in the delivery of the promissory notes was the completion of a well-conceived estate plan and not the earning of any income. In my opinion, the 1,224 common shares repurchased by each Appellant on February 1, 1988 were not acquired for the purpose of gaining or producing income within the meaning of subparagraph 20(l)(c)(ii). The appeals are dismissed.

The Respondent acknowledged that the trusts for the various children had in fact reported the interest income which the Appellants have attempted to deduct in the years under appeal. In these reasons for judgment, I have concluded that the interest was not paid by the Appellants and, alternatively, if it was paid, then it was not paid for the purpose of earning income within the meaning of paragraph 20(1)(c)

In argument, I asked counsel for the Respondent what the Minister of National Revenue would do with respect to the interest reported by the trusts and the children if I should conclude that the interest had not been paid or was not deductible. In response, counsel answered that Revenue Canada had already reassessed the children of Paul to delete any interest income they had reported in the relevant years. Counsel also stated that “under the fairness package” there was no reason why interest reported by the trusts and/or the children of Douglas and Harvey could not be reassessed in the same way so as to delete any interest income reported by such trusts and/or children. In dismissing these appeals for the reasons stated above, I assume that the Minister of National Revenue, as a matter of equity and under the so-called fairness package, will reassess either the trusts or the children of all three Appellants in order to delete from their income any interest which the Appellants have claimed to pay with respect to the promissory notes.

Appeal dismissed.