Faucher v. The Queen, 94 DTC 1581, [1994] 2 CTC 2001 (TCC)

Lamarre Proulx, J.T.C.C.:— The appeals of Guy Faucher for the 1986, 1987 and 1988 taxation years were heard at the same time as that of Michel Daviault. The latter appealed in respect of the 1988 taxation year and the ground for his appeal was identical to one of the grounds of appeal of the appellant Guy Faucher for the 1988 taxation year.

The points at issue in the appeals of Guy Faucher were as follows:

(1) whether a loss of $96,000 incurred in 1986 following the disposition of shares of 118044 Canada Inc. ("118044") caused by the bankruptcy of this company was a business investment loss, half of which would be deductible in computing the appellant's income for the 1986 taxation year or a business loss;

(2) whether interest of $14,065 incurred for 1986, $10,018 for 1987 and $13,912 for 1988 was incurred in order to earn income within the meaning of paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act");

(3) whether the Court has the power to determine whether part of the income allocated to the appellants as partners was interest income or business income when the amount of tax assessed for the 1988 taxation year on such income was not disputed by the appellants.

The word “appellant” refers to the appellant Guy Faucher except as concerns the third point in dispute.

Counsel for the appellant told the Court at the start of the hearing that the appellant was withdrawing the ground of appeal pertaining to the union dues for the 1986, 1987 and 1988 taxation years and, for the 1986 and 1987 taxation years, was withdrawing the ground of appeal concerning the $12,500 loss in respect of the appellant’s bank endorsement for a professional partnership of which he was not a member. The appellant agreed on this point that the loss was a business investment loss.

The appellant is a chartered accountant. In 1982, he learned through his clients that a ceramic tile manufacturing plant had just declared bankruptcy and that it could be financially advantageous to purchase it and have it resume its production operations. The plant had purchased new equipment valued at $9,000,000 just before declaring bankruptcy. The appellant reviewed the plant's financial potential and he became convinced that this was an investment that would quickly increase in value.

He estimated that, including the building, “which was as big as a shopping centre” [translation], the plant had a replacement value of $20,000,000. It was put up for sale by the Federal Development Bank for $3,750,000. The bank agreed to lend $3,500,000, the amount that it had already invested in it. Thus, $250,000 remained to be injected into the corporation; as well, $1,200,000 in working capital had to be advanced.

The appellant succeeded in promoting the project through the use of four number corporations. The investors became shareholders of one of the four number corporations and each of these corporations purchased one-quarter of the shares of Les Tuiles Dynamark Inc. ("Dynamark").

The appellant and other investors purchased the shares of one of the number corporations, that is 118044. The appellant's portion of the shares of that corporation was 25 per cent. He invested $60,000 in 1982 and $36,000 during 1983 and 1984, so that by the end of 1985 the appellant held 85,197 common shares. The total purchase price was $96,000.

The acquisition cost is not in dispute. Paragraph (c) of the notice of appeal was admitted at paragraph 3 of the reply to the notice of appeal. Said paragraph (c) reads as follows:

(c) at the end of 1985, as a result of the stock transactions in the capital stock of 118044 Canada Inc. in which the appellant had an interest, the appellant held 85,197 common shares purchased for $96,000. .. .

. [Translation.]

As mentioned at paragraph (d) of the notice of appeal, also admitted, 118044 used these sums of money to subscribe and purchase shares in Dynamark's capital stock.

In April 1983, Dynamark purchased from the Federal Development Bank the ceramic tile manufacturing plant in Bécancour, consisting of the building and land, for the price of $3,750,000, $3,500,000 of which was financed by a loan from the Federal Development Bank. These facts were also admitted by the respondent.

The investors had no knowledge of ceramic tile production. They were allegedly advised by two officers of the Centre de recherche industrielle du Québec (“CRIQ”) who took part in the initial study and were in favour of the proposal. Dynamark's former owner was also very much in favour of the project.

Once the business was purchased, the investors recruited an Italian manager, but unfortunately he died suddenly soon after he was hired. Despite the efforts of the appellant, who at one time was even a part-time manager of the business, the plant never achieved commercial production levels. On September 10, 1985, a receiving order was issued in respect of Dynamark. That receiving order was initially appealed from, but such appeal was withdrawn on December 18, 1985 and the business was put into bankruptcy in 1986. 118044 also assigned its assets on September 23, 1986.

The appellant indicated that his intention had not been to become a tile manufacturer, but rather to resume the production operations of the plant and to resell his shares once their value had escalated. According to the appellant, the shares of 118044 were not purchased as a long-term investment, but rather for very short-term investment purposes, as tile manufacturing did not interest him in any way. He was only interested in a fast money play. The shares had been purchased in order to resell them as soon as the plant be in full operation. The appellant said that all funds used to purchase his share of the stock in 118044 were borrowed.

This testimony was confirmed by that of Mr. Richard L. Gervais, a businessman. He had known the appellant for 15 years. The appellant had acted as a consultant and accountant for him. The witness had also purchased shares at the time of this plant reactivation project. He purchased $100,000 of shares in another number company, namely 118042 Canada Inc.

He also said that the people who were involved in this investment had never operated a ceramic tile plant. The goal was to make money quickly. What was involved was the purchase, at a low price, of a plant with a replacement value of $20,000,000, and which it was said could only increase in value. He said that this was an investment known [in English] as a “fast move".

Mr. Gervais was introduced as a witness who had no interest in the outcome of this appeal, since he had declared his loss as a business loss and had been assessed on that basis by the Minister of National Revenue (the "Minister").

No document contemporaneous with the investment was adduced in evidence. Mr. Gervais remembered a document that had been given to him to encourage him to invest, but he did not have that document with him. Neither that document nor the shareholders’ agreements were filed at the hearing. According to the appellant, those documents were among those seized by the receiver at the time of the bankruptcy. The appellant filed a letter from the trustees regarding the Dynamark bankruptcy; such letter confirmed the destruction of the debtor's documents. No similar document was filed in respect of the bankruptcy of 118044.

Second point at issue

Regarding the deductibility of the interest paid for 1986, 1987 and 1988, the appellant filed a letter from an accounts manager of the National Bank of Canada, Business Services, South Shore, dated August 25, 1993 (Exhibit A-4), which reads in part as follows:

We hereby wish to confirm the amounts stated below which were paid during the year in respect of loans granted to your institution for investment.

1986:	$14,065.25
1987:	$10,018.32
1988:	$13,912.72
	[Translation.]

Although this letter was very recent, (it was dated August 25, 1993), the signatory failed to bring with him any document pertaining to these “loans for investment" [translation] granted by his institution or to describe the nature of those investments or to explain his allegation that these funds had been borrowed for investment purposes.

On the very morning of the trial, the appellant filed documents not previously disclosed to the opposing party, but of which the filing was nevertheless consented to before the hearing started.

These documents were, either draft or final versions, statements of the appellant's assets and liabilities. The purpose of their filing was to show a list of investments under the heading “investments” [translation], and to suggest that the interest had been paid for the purposes of one or other of those investments. Under the heading "investments" [translation] were the following entries: Faucher Daviault Capital Group, retirement savings, life insurance (estimated cash surrender value), capital stock of Débéritho Inc. (estimated market value). There was no explanation of the nature of these purported investments, or of the income allegedly earned so. Nor was there any evidence that the money used to purchase these investments was borrowed money.

Third point at issue

The appellant was a partner in the firm of Faucher Daviault & Associés, Chartered Accountants. Chapter Il of the partnership agreement (Exhibit A-5) entitled "Capital of the Firm" [translation], contains the following provision:

The capital of the firm will be determined by the partners every year and investments will be proportionate to the interest share of each of the partners. The basic capital will bear no interest. All surplus to basic capital will bear interest at the average prime rate of the firm's bank.

[Translation.]

The calculation of interest was described on a separate sheet filed as Exhibit A-6. It should be noted that this calculation was not part of the business’s financial statements. In the case of Mr. Faucher, Exhibit A-6 shows, for 1988: opening capital of $153,976, closing capital of $196,780, average capital of $175,378, allocated interest of $20,000, and an interest rate of 0.114 per cent. The appellant Faucher had therefore wished to report his income as follows: professional income of $33,727, and income from interest on capital of $20,000, for a total of $53,727.

The appellant Michel Daviault wished to report his professional income in the same manner by characterizing $20,000 as income from interest on capital in the amount of $20,000.

It was admitted by the parties that this sum of $20,000, whether characterized as interest or professional income, had no effect on the amount of tax to be paid in respect of that income for 1988. According to counsel for the appellants, this characterization might have an effect in later taxation years on the calculation of the cumulative net investment loss within the meaning of section 110.6 of the Act.

This mutual admission that the point in issue had no effect on the amount of tax payable for the year in question was not mentioned in either of the notice of appeal or in the reply to the notice of appeal. It would have been preferable for it to have been mentioned at that time. Counsel for the respondent informed the Court that he had informed counsel for the appellant of this admission, as well as of the tax principle that there is no right of appeal except from the amount of the assessment for the purpose of having it reduced.

Analysis

I shall first dispose of the third and last matter in dispute. With respect to the characterization of the income as interest paid to a partner, counsel for the respondent referred to the CCH Canadian Ltd. publication entitled Understanding the Taxation of Partnerships (2nd edition, 1987), page 29, at paragraph 230:

Interest paid to a partner by the partnership.

Interest paid to a partner by the partnership is ordinarily considered to be only a distribution of partnership income and not a deduction in reckoning "income" at the partnership level. This is especially true when interest is paid on the capital account of the partners; such a distribution is not interest, but allocated business income. A partnership is not precluded from entering into a true lender-borrower relationship with a partner under which "interest paid” would be property income and not a distribution of business income. Such property income would be recognized by a partner on a calendar year basis, not on the basis of the partnership's fiscal period. . . .

He also referred to Income Taxation in Canada, Prentice Hall, [Paragraph] 55,875.

Salaries and interest paid to partners.

Salaries and interest paid to partners are enerally not deductible in computing the income of a partnership since they are considered to be merely a method of distributing partnership income among partners and therefore do not constitute a business expense. In many cases what is called interest is essentially a distribution of profits and is not an expense incurred to earn income by the partnership. The so-called interest is computed by reference to the partner's capital account and not in respect of a debt of the partnership to the partner. Interest paid to partners may be deductible if the conditions aid out in paragraph 20(1 )(c) are met. For example, if, pursuant to a legal obligation, a partnership pal interest to one of its partners in respect of a bona fide loan from the partner, such interest would be deductible. However, if the interest is paid on the balance of the capital accounts of the partners, it would clearly not be deductible unless under the relevant statutes it could be held that the interest was an expense of the partnership laid out to earn income.

If interest is paid to a partner that is true interest, the partner must include it in his income as it is received (or becomes receivable) rather than as part of the partnership profits on a fiscal-period basis.

I have reproduced the citation for information purposes only, as it has long since been established that in tax law there is no right of appeal from an assessment unless a reduction in the amount of the assessment is in dispute.

There is no right of appeal from presumed or alleged errors on the part of the Minister in computing income tax due unless the result of that computation is in question. The right of appeal exists in respect of the result of the calculation of income tax due, not of the manner in which the calculation is made.

Counsel for the respondent referred in particular to The Queen v. Bowater Mersey Paper Co., [1987] 2 C.T.C. 159, 87 D.T.C. 5382 (F.C. A.), and to the remarks of Judge Rip in Soudures Chagnon Ltée v. M.N.R., [1990] 1 C.T.C. 2365, 90 D.T.C. 1197 (T.C.C.), at page 2368 (D.T.C. 1200):

The Court can only consider an appeal brought from a tax assessment if the taxpayer is asking for a reduction for the year at issue. . . .

In conclusion, there is no right of appeal from an assessment of a nil amount, or from an assessment of which a reduction is not requested and for which only the reasons that led the Minister to assess in a certain manner are disputed. I therefore do not have to determine whether part of the partners’ income could be characterized as investment income.

I now turn to the subject of the deduction of the interest which is the second point of contention. In order to be able to deduct interest, it must be proved not only that money was borrowed, but also that the money was borrowed for, and is still being used for, investments made for the purpose of earning income. Many people borrow money without doing so for the purpose of earning income, for example, to purchase a private property or a secondary residence, and for many other personal purposes. It would be unfair to other taxpayers to permit the deduction of the interest amounts in the present appeal without being certain that that interest arose from loans made in order to earn income.

On this subject, one need only refer to the judgment of the Supreme Court of Canada in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. The relation between borrowed money and its use in order to earn income from a business or property must be shown. The taxpayer in the resent case furnished the total amount of interest paid as interest and, as well, a list of alleged investments. The documents filed by the appellant at the trial proved nothing. The mere fact that an amount is recorded in relation to an item entered under the heading “investments” does not necessarily lead to the conclusion that such amount was borrowed. There was no evidence to show whether those investments were purchased in order to earn income, or whether they were purchased in whole or in part with borrowed money, nor to show the breakdown of interest in respect of the alleged investments. These deductions cannot be allowed in these circumstances.

It should be noted furthermore that sections 78 ff. of the Tax Court of Canada Rules (General Procedure) (the "Rules") request that the documents which the parties wish to file as evidence be disclosed to the other party within 30 days of the close of pleadings. This would have enabled the respondent to conduct a valid analysis of the documents and to establish her position before the Court. Section 89 of the Rules does, however, provide that the other party may consent to the use in evidence of documents not disclosed in advance, as was done in the instant case, but this is not an effective manner of proceeding.

Regarding the question whether the loss incurred at the time of the bankruptcy of 118044 was a business loss or a capital loss, counsel for the appellant referred in particular to the Federal Court of Appeal judgment in Becker v. The Queen, [1983] C.T.C. 11, 83 D.T.C. 5032, and particularly to the following passage at page 14 (D.T.C. 5034):

An important difference between Irrigation Industries v. M.N.R., [1962] S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131 and the present case is that the BCP venture did not simply involve a purchase of shares with an intention to resell them for a profit, but the purchase of a business with the intention of transforming it in order to turn it into a profitable enterprise.

Counsel for the respondent argued that this could not be a business loss as the tile manufacturing business was not operated by that corporation, but rather by Dynamark. To support the argument that this could not be a concern in the nature of trade since the business was operated by Dynamark and not by 118044, counsel for the respondent referred to K.J. Beamish Construction Co. v. M.N.R., [1990] 2 C.T.C. 2199, 90 D.T.C. 1584 (T.C.C.). I do not believe that such a conclusion follows from this judgment. In that case, Associate-Chief Judge Christie was of the view that the shares had been purchased as capital, and not for the purpose of resale, because of the specific circumstances of their acquisition. This finding was not based on the reason suggested by counsel for the respondent. I quote Judge Christie at page 2207 (D.T.C. 1590):

I find the shares in Garrison were an investment. They were acquired by the appellant with the intention of deriving income from them by way of dividends out of the profits expected to be realized by Garrison.

The point for determination, in the case at bar, is whether the shares of 118044 were purchased for the purpose of speculation or for long-term investment.

Counsel for the respondent also relied on Lachapelle v. M.N.R., [1990] 2 C.T.C. 2396, 90 D.T.C. 1876, per Judge Brulé. It was decided in that case that the corporation in which the taxpayer held shares was an entity separate from the taxpayer and that even if the activities of that corporation had been of a speculative nature, that did not have the effect of characterizing the holding of shares in that corporation as also being speculative in nature. In that case, however, the shares had been held for ten years before they were disposed of. Furthermore, at page 2401 (D.T.C. 1879) of that judgment, it is stated that the appellant had not alleged that he had purchased the snares in order to resell them at a profit, but rather wanted the Court to raise the corporate veil, which the Court rightly refused to do.

There is no doubt that 118044 and Dynamark were entities separate from each other and also from the appellant. What counsel for the appellant argued was that the shares of 118044 were purchased for speculative purposes, that is, that they were purchased in order to be resold as soon as Dynamark's operation had become profitable and the value of the shares had increased.

In Becker, supra, cited by counsel for the appellant, the appellant had purchased the majority of the shares in a lumber company in financial difficulty in order to review its operations. On the other hand, it should be noted, that an important element in Irrigation Industries, supra, was that the amount of shares purchased in the mining company was a small proportion of the total number of shares. In this regard, I quote Judge Martland at page 353 (C.T.C. 222, D.T.C. 1134):

Furthermore, the quantity of shares purchased by the appellant in the present case would not, in my opinion, be indicative of an adventure in the nature of trade, as it constituted only 4,000 out of a total issue of 500,000 shares.

The decision in Becker was that the share purchase was speculative in nature, whereas in Irrigation Industries it was a capital purchase. It therefore appears that in circumstances in which some administrative control may be exercised by the share purchaser, the courts may consider the purchase of shares as an adventure in the nature of trade.

Relying on the evidence presented, I am of the view that the appellant succeeded in proving that he purchased the shares for a speculative purpose. He had no experience in tile manufacturing and was not particularly attracted in an way to that field of activity, indeed, his intention was not to remain in that field. His intention, as corroborated by another "investor", was to make a quick profit by purchasing at low price shares which in his view could only increase rapidly in value.

It was the appellant who initiated the project and who designed the corporate structure. He also took part in the administration of the business in order to get it back on track and take off as he had imagined when he had originally conceived the acquisition plan. I believe that the purchase of the shares in these circumstances was more in the nature of a commercial business than that of a long-term investment.

The appeal of Michel Daviault is dismissed without costs.

The appeal of Guy Faucher for the 1986 taxation year is allowed in respect of the matter concerning the disposition of the shares. The appeals for the 1987 and 1988 taxation years are dismissed.

The appellant Guy Faucher is entitled to party-and-party costs.

Appeal allowed in part.