Scott v. MNR, 89 DTC 218, [1989] 1 CTC 2305 (TCC)

Taylor, T.C.J.:—These are appeals heard in Toronto on February 9, 1989 against income tax assessments for the years 1984 and 1985 in which the Minister of National Revenue had disallowed amounts of interest expenses claimed. An agreed statement of facts was filed:

Agreed Statement of Facts

1. In the fall of 1983 the appellant, David Scott, along with two other investors incorporated 558872 Ontario Limited for the purpose of acquiring and operating an O'Tooles Roadhouse franchise in Brampton, Ontario. Mr. Scott subscribed for and obtained 1/3 of the issued common shares upon incorporation. Any dividend payments were to be paid on the common shares.

2. An O'Tooles franchise is a turn-key operation, meaning that the franchisor sets up the entire business in return for a set cost.

3. Because this was a start-up venture, compounded by the fact that it was a restaurant business, 558872 Ontario Limited was unable to obtain 100% bank financing to cover this cost. The banks were unwilling to loan the money to the numbered company even with the guarantees of the shareholders and required that the shareholders put their own equity into the company. The banks required a minimum of $90,000.00 so that each shareholder was required to place $30,000.00 into the company to obtain bank financing.

4. Mr. Scott used $5,000.00 in savings and borrowed $25,000.00 from the Peel Regional and Municipal Employees Credit Union Limited, which subsequently changed its name to Pace Savings & Credit Union Limited to come up with his $30,000.00.

5. The $30,000.00 was put into 558872 Ontario Limited as a non-interest bearing shareholder's loan.

6. Mr. Scott paid interest on this loan of $4,173.24 in 1984 and $2,970.52 in 1985 and in 1986 retired this loan with the Credit Union.

7. In the fall of 1984, Mr. Scott, along with the same two investors incorporated 596914 Ontario Limited for the purpose of acquiring and operating an O'Tooles Roadhouse franchise in Bramalea, Ontario. Again, Mr. Scott subscribed for and obtained 1/3 of the issued common shares on incorporation. Again, any dividend payments were to be paid on the common shares.

8. The banks once again would not provide 100% financing for the cost for the same reasons as set out in Paragraph 3. By this time though the costs of the franchise had increased to that the banks required a minimum of $120,000.00 to be placed in this numbered company so that each shareholder was required to place $40,000.00 into the company to obtain bank financing.

9. Mr. Scott used $14,000.00 of his own funds and borrowed $26,000.00 from the Royal Bank.

10. The $40,000.00 was put into 596914 Ontario Limited as a non-interest bearing shareholder's loan.

11. Mr. Scott paid interest on this loan of $954.00 in 1984 and $3,937.00 in 1985 and in 1986 retired this loan with the Royal Bank.

12. Total interest payments for 1984 were $5,127.24 and for 1985 were $6,907.52.

13. Both businesses, after initial start-up losses, earned income in their first full year of operation. The income generated was used by the companies to retire debts or was retained by the companies as retained earnings.

In the reply to the notice of appeal, the Minister stated:

8. The Respondent respectfully submits that unless the Appellant can bring himself within the provisions of paragraph 20(1)(c) of the Act, the interest payments allegedly made are not deductible by him. Since any interest payments made by the Appellant were not paid in respect to borrowed money used by the Appellant for the purpose of gaining or producing income from a business or property.

Mr. Brian McNally, chartered accountant, gave evidence and explanation regarding the transactions at issue.

Counsel for the appellant put forward two arguments in support of his client’s position. First, a general one, that a "purpose of earning income from a business or property" (paragraph 20(1)(c) of the Act) could be seen in the transaction, by virtue of the fact that the funds loaned to the company permitted the company to acquire the franchises, thereby providing a basis, which counsel regarded as the source of income, from which the appellant as a shareholder could expect to earn dividends. In my view that rationale does not hold up. It was not made clear to the Court that Mr. Scott had used the funds to establish a business —that is an operation in his own name, and under his direction as a taxpayer. The corporation to which the funds were loaned is a separate legal entity, certainly from an income tax viewpoint. Mr. Scott, with the borrowed and then loaned funds, acquired a property—the non-interest bearing note from the corporation. I do not believe that can be regarded as a source of income from which the interest paid which is at issue can be deducted, —and any dividends which might arise would come from completely separate property shares in the company. The crossing- over of these two properties, and the theoretical intermingling of real or potential earnings from them simply does not serve to support the case of the appellant. The second thrust from counsel for the appellant related to the words of Interpretation Bulletin No. IT-445, dealing with precisely this point, and I would particularly refer to paragraphs 3, 6 and 7 thereof. Dealing with the exceptions provided under paragraph 7, I am satisfied from the hearing on this matter, that conditions (a) and (b) thereof were adequately fulfilled. The condition to be considered is (c):

(c) the loan from the shareholder to the corporation at less than a reasonable rate of interest (or at no interest) does not result in any undue tax advantage being conferred on either the shareholder or the corporation.

In the instant case, the deduction of the interest charges at issue, by the appellant, provided a distinct tax advantage in the sense that the regular income tax liability which would have been imposed on the other reported income of Mr. Scott, was materially reduced. While it is just as clear that a tax disadvantage might have accrued to the corporation, by virtue of the lack of the interest expense as a deduction, the bulletin does not appear to make allowance for any such set-off. In my view the appellant cannot fit himself into the confines of the provisions of Interpretation Bulletin No. IT-445.

Counsel for the Minister did not vigorously attack the general principles espoused in IT-445, supra, merely noting that the circumstances of this case did not allow the deduction sought according to the terms of paragraph 20(1)(c) of the Act, as he understood it. I believe that is all that need be said about IT-445. The precise words of paragraph 7 are:

7. Notwithstanding the comments in 3, 5 and 6 above the Department will generally permit a deduction for the full interest expense incurred when a taxpayer borrows money at interest to be loaned to a Canadian corporation of which he is a shareholder. . .

Whether that is an appropriate application of the provision of paragraph 20(1)(c) of the Act becomes irrelevant in this matter, since the Department did not "permit" the deduction claimed or we would have no appeal. It is not for this Court to enlarge on the operative words of the Act in paragraph 20(1)(c), when their meaning as fundamental legislation is quite clear. The deductions sought in this matter do not qualify as interest expense to Mr. Scott. The appeals are dismissed.

Appeals dismissed.