Goulard v. MNR, 92 DTC 1244, [1992] 1 CTC 2396 (TCC)

Beaubier, T.C.C.J.:—This matter was heard in Saskatoon, Saskatchewan, on December 11, 1991.

Two witnesses testified for the appellant, Mr. Philip Muench, a retired manager of The Bank of Nova Scotia and Mr. Kerry Goulard, the appellant. The Minister did not call any witnesses.

The appellant is a chartered accountant. At all times material to this appeal he was:

(1) Vice-President, Finance, of Anaheim Management Ltd., (hereinafter called Anaheim).

(2) Sole shareholder, President, Secretary-Treasurer and Director of

a) 570020 Saskatchewan Ltd. (hereinafter called 570020), and

b) MNO Development Corporation (hereinafter called MNO), and

(3) A shareholder, the Secretary-Treasurer and a Director of 569354 Saskatchewan Ltd. (hereinafter called 569354).

By Loan Agreement dated 31 July, 1984 (Exhibit A-6), Mr. Goulard agreed with 569354:

(1) To subscribe for 98,341 Class "A" common shares of 569354, for a consideration of $98,341.

(2) To borrow from 569354 $98,341 to purchase the Class "A" common shares.

(3) To pay interest on the loan at 12 3/4 per cent per annum and as otherwise stated and repay the principal and interest on the loan at $1,066.70 per month and as otherwise stated.

569354's principal business was the development of real property for the purpose of earning leasing or rental income. In 1984, Mr. Goulard deducted $5,133 as interest paid on account of the loan from 569354 and the Minister of National Revenue denied the deduction. Assessments respecting the interest relating to this transaction were issued and appealed for 1984, 1985, 1986 and 1987.

The appellant entered into similar transactions with 570020 and MNO on January 15, 1985 and claimed similar interest deductions, and was assessed and appealed respecting his 1986 and 1987 taxation years. 570020 and MNO's principal businesses were also the development of real property for the purpose of earning income. All the appellant's share proceedings respecting these corporations were done on a timely basis. It should be noted that the appellant did not sign Exhibits A-4 and A-5, the 570020 and the MNO share purchase agreement in his individual right although he signed in other capacities. No explanation was offered respecting this omission. Nonetheless, the appellant and the other parties to the contract carried out the term of Exhibits A-4 and A-5 and the Court finds them to be valid contracts.

Each reassessment by the Minister of National Revenue was on the following grounds:

(1) The amount was not paid pursuant to a legal obligation to pay interest on borrowed money for the purpose of earning income from a business or property within the meaning of paragraph 18(1)(a) and subparagraph 20(1)(c)(ii) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

(2) The appellant did not receive any income producing property, thus the amount was not paid or payable as interest on an amount payable for property acquired for the purpose of gaining or producing income therefrom pursuant to paragraph 18(1)(a) and subparagraph 20(1)(c)(ii) of the Income Tax Act.

(3) In the alternative, the interest expenses would unduly or artificially reduce the appellant's income as contemplated by subsection 245(1) of the Income Tax Act.

Respecting these corporations, the following dates are important:

Each corporation borrowed money on a“ daylight loan” from the Bank of Nova Scotia and paid a cheque for the amount of the loan to the appellant who deposited the cheque in his account and wrote a cheque for an identical amount to the corporation which deposited the cheque in its account, all in one day. The Bank of Nova Scotia charged a fee of $100 for this service.

There was a series of these transactions with many people and the bank debited Anaheim's account for the $100 fees on March 18, 1985 (Exhibit A-8). Anaheim in turn charged the various corporations involved $100 each.

The Bank of Nova Scotia's records respecting the corporations’ transactions are stored or destroyed. The respondent filed as Exhibit R-1 a letter dated July 4, 1989 from the proper branch of the Bank of Nova Scotia stating there were no daylight overdraft arrangements by the Bank of Nova Scotia respecting 570020 or MNO. However, the then manager of the Bank of Nova Scotia, Mr. Muench, was Called by the appellant and particularly recalled the transaction respecting MNO being a one-day ("daylight") transaction and states he did the same thing respecting many other numbered corporations in respect to Anaheim's transactions and charged the fees to Anaheim; the Court believes him. The appellant states each transaction's cheques were cleared by an exchange of cheques in one banking day for each corporation and the Court believes that testimony as well. Exhibits filed respecting the bank transactions were copies of the appellant's personal cheques to each corporation (Exhibits A-1, A-2, A-3), and copies of The Bank of Nova Scotia statements respecting 570020 (Exhibit A-2), MNO (Exhibit A-1), and the appellant (Exhibit A-3) were also filed as Exhibits. The last was for the 569345 dates, since that corporation's bank statement could not be found.

A series of letters and work sheets being Exhibits R-3, R-6, R-7, R-8, R-9, and R-10 were filed by the respondent's counsel in cross-examination. These and the testimony of the appellant outlined the original plan developed by Anaheim and its accounting and legal advisors respecting these and similar transactions. The plan was, in essence:

1. A corporation is incorporated as a principal business corporation to develop and lease rental real estate.

2. Initial capital is nominal.

3. The corporation obtains 100 per cent interim financing to construct the project.

4. An individual investor borrows money from a bank to buy shares. This loan will be personal to the investor with collateral security provided by the principal business corporation by a mortgage on a housing unit.

5. When the shares are purchased that portion of that corporation's interim loan is paid off and the collateral mortgage is a first charge of collateral security for the bank. The amount of the purchase price of the shares, the amount of the loan, and the amount of the mortgage are identical.

6. Due to tax deductible soft cost deductions and capital cost allowance deductions, and to rising rents, the personal business corporation will accumulate a cash pool.

7. The cash pool accumulated by the company will be returned to the investors as a return of capital either on an annual or perhaps even on a monthly basis, and such funds will be used to pay the loan repayments on the loan arranged by the developer. The return of capital will not trigger an income tax liability.

The long-term financing should be held personally by the investors to allow them to write-off interest expense at their marginal tax rates and allow the corporation to utilize as soon as possible soft cost deductions and capital cost allowance deductions to reduce income in the corporation and flow those benefits out of the corporation to the investors as a return of capital.

8. Similarly, net income after taxes that is paid to the investors by way of dividends, will be used to pay the loan arranged by the developer to the extent necessary to meet the payments due on the loan.

(Exhibit R-10, page 2, paragraphs 7 and 8)

(See Exhibit R-10, letter from chartered accountant to Anaheim Management Ltd., dated January 17, 1984 as reviewed by Mr. Goulard in cross-examination)

The appellant approached The Toronto-Dominion Bank respecting this proposal. The bank did not want to make a personal loan on this basis with a mortgage from the corporation as a collateral security. This banking objection caused a delay in the transactions proceeding.

Eventually the Bank of Nova Scotia entered into a financing proposal that resulted in the transaction in question which, according to the appellant's testimony, proceeded as follows:

1. A corporation is incorporated as a principal business corporation to develop and lease rental real estate.

2. Initial capital is nominal.

3. The construction financing is long-term secured by a mortgage against each housing unit for 85 per cent of the price of each housing unit pursuant to CMHC Regulations.

4. The individual investor borrows money from the personal business corporation to buy shares in the personal business corporation and does so with those funds. For this purpose the personal business corporation does a daylight loan by writing a cheque on its bank account against an authorized overdraft.

5. When the shares are purchased the daylight loan is paid off on the same day by the personal business corporation depositing the investor's cheque in its bank accounts so as to pay the overdraft. This leaves the 85 per cent long-term first mortgage on the project in place, as it was originally. Mr. Goulard testified that the shares so purchased were issued to him.

6. (a) Rising rents are anticipated, so that after the first year a profit in the corporation was anticipated by Mr. Goulard according to his testimony.

(b) The soft cost and capital cost allowance deductions are to be deductible by the personal business corporation within the provisions of the Income Tax Act so as to create a cash pool.

In fact the soft Saskatchewan rental market prevented anticipated rent increases and so that there was no profit and no cash pool in any of the corporations.

7. The individual agreed to pay back to the personal business corporation the loan to purchase its shares at the same interest rate and on the same schedule of payments as the personal business corporation's first mortgage loan on the housing unit called for. The individual was to deduct that interest for income tax purposes. Each year the personal business corporation would pass a resolution reducing its stated capital by the same amount as was due from the individual and thus the payments would be achieved by a set-off. Mr. Goulard's testimony in cross-examination was that, in the first two years of 569354, the shareholder did not give a cheque to the personal business corporation to pay the shareholder's loan; it was satisfied by a journal entry. Thereafter the shareholder paid the mortgage payment which accrued each month. These were offset when the resolution to reduce the stated capital was passed by the personal business corporation. Thus the stated capital was reduced and the employee loan was paid off at the same time without immediate tax consequence. Exhibit A-7 consists of copies of Resolutions of the Meeting of Shareholders for each corporation for each year in question reducing the stated capital.

8. The individual deducted the interest on the loan to purchase the shares. The Minister of National Revenue assessed the individual and denied the deduction. The individual appealed.

Section 25 of the Saskatchewan Business Corporations Act, R.S.S. 1978, c. B-10, which was in effect at the time that Mr. Goulard purchased the Class "A" common shares from 569354 Saskatchewan, Ltd. reads as follows:

25 (1) Subject to the articles, the bylaws, any unanimous shareholder agreement and section 28, shares may be issued at such times and to such persons and for such consideration as the directors may determine.

(2) Shares issued by a corporation are non-assessable and the holders are not liable to the corporation or to its creditors in respect thereof.

(3) No share shall be issued until the consideration for the share is fully paid in money or in property or past service that is not less in value than the fair equivalent of the money that the corporation would have received if the share had been issued for money.

(4) In determining whether property or past services is the fair equivalent of a money consideration, the directors may take into account reasonable charges and expenses of organization and reorganization and payments for property and past services reasonably erected to benefit the corporation.

(5) For the purposes of this section, "property" does not include a promissory note or a promise to pay. 1976-77, c. 10, s. 25; 1979, c. 6, s. 9.

No articles or bylaws respecting the corporations in question were filed as exhibits. The only shareholders’ agreements filed were the purchase agreements between the shareholders and corporations,—Exhibits A-4, A-5 and A-6. These do not provide for any payment over time for the issuance of shares.

In respect to 569354 Saskatchewan Ltd., the agreement was dated July 31, 1984. However, the loan of money, its payment to 569354, and the actual purchase of shares did not occur until March 15, 1985. Thus, subsection 25(3) of the Saskatchewan Business Corporations Act R.S.S. 1978, c. B-10, was not complied with. For this reason, the Court finds that the appellant was not an owner of Class "A" common shares of 569354 in 1984 and the assessment of the appellant respecting the year 1984 is confirmed.

The following assumptions of the Minister of National Revenue, contained in section 5 of the reply, are particularly relevant to the determinations that must be made by the Court in this matter:

(1) in 1984, 1985, 1986 and 1987 the alleged interest expenses did not constitute interest on borrowed money used for the purposes of gaining or producing income from a business or property,

(m) full consideration, in money or property, was not provided for the shares, thus 569354, 570020 and MNO did not issue Class "A" shares to the appellant in his 1984 and 1985 taxation years, pursuant to and in accordance with subsection 25(3) of the Business Corporations Act of Saskatchewan;

(n) as a result of paragraph 5(m) supra, the appellant did not receive any income producing property in 1984, 1985, 1986 nor 1987, thus the alleged interest expenses were not paid or payable by him in those years pursuant to any legal obligations to pay interest on amounts payable for property acquired for the purpose of gaining or producing income therefrom;

(o) 569354, 570020 and MNO did not have sufficient funds nor were arrangements made for funds to be available to effect the purported loans referred to in paragraphs 5(e), 5(f) and 5(g) supra, thus, in substance, no loans were made;

(p) as a result, the appellant did not intend to create nor did he create any legal obligations to pay the alleged interest expenses in his 1984, 1985, 1986 and 1987 taxation years;

(q) the appellant's sole purpose in entering into the transactions as aforesaid was to unduly or artificially reduce his income in his 1984, 1985, 1986 and 1987 taxation years, by purportedly creating interest expenses as a company shareholder which otherwise would be non-deductible in his own hands.

Counsel for the Minister argued that each corporation had the housing unit or units in question before the sale of the Class "A" common shares to the appellant. Further, the respondent's position is that the appellant borrowed the share purchase price from the corporation and then paid it back to the corporation to purchase the Class "A" common shares, whereupon the corporation repaid its bank loan taken out for that purpose. Therefore, the Minister's position is that nothing was added as a consequence to these transactions.

This ignores a number of consequences of the transactions:

(1) The appellant acquired Class "A" common shares.

(2) Each corporation issued the paid up share capital which added substantially to its financial statement.

(3) The appellant owed a large debt to each corporation.

Each year thereafter the payments by the appellant and the reduction in stated capital by the corporation, while set forth in the original plan, may or may not have happened in each year. In fact, while they happened, due to difficult economic times the manner and method actually varied from what was planned.

These activities by the appellant and each corporation must be examined in the light of section 15 of the Income Tax Act which specifically describes a corporate loan to a shareholder to purchase its shares and offers the shareholder tax advantages which are not allowed to others. They must also be examined in the light of the"M.U.R.B." amendments, which left the soft costs deductions available to a principal business corporation but not to an individual; this meant that on a tax-paid basis, a principal business corporation would ultimately be better off financially than an individual as determined by policy choices of the Government of Canada. The appellant and the corporations reacted to these policy choices of the Minister of Finance of the Government of Canada and did so for their own profit. Now the Minister of National Revenue of the Government of Canada has assessed the appellant for doing so.

The appellant testified that the interest rates paid by the appellant on the money borrowed to purchase the shares was at market rate and that the rates were reasonable. There is no evidence to the contrary and this testimony is accepted. Mr. Goulard gave unrefuted testimony that, after the first year of operation he expected the rentals from each housing unit would increase and the corporations would be profitable. As a consequence and in due course, dividends would be paid on the Class "A" common shares as was planned originally. The Court finds that these expectations were reasonable, and further finds that it is reasonable in the course of business not to expect a profit in the first year of operation and that this does not affect the overall concept of expectation of profit in this case.

With respect to paragraphs (m), (n) and (o) of the assumptions, the appellant entered into and carried out legally binding agreements with each corporation to borrow money to purchase shares and to pay money back to each corporation. Full consideration was paid by means of the cheques from the appellant to each corporation for these shares in compliance with subsection 25(3) of the Business Corporations Act of Saskatchewan and within section 15 of the Income Tax Act. The Court accepts the appellants unrefuted testimony that the Class A common shares were legally issued to the appellant upon payment being received by each corporation.

These shares were purchased for the purpose of earning income by way of dividends from them. It was reasonable to expect that the shares would pay dividends. By these transactions, the parties intended to create and did create a legal obligation for the appellant to pay interest on borrowed money for the purpose of earning income from the shares within the meaning of paragraph 18(1)(a) and subparagraphs 20(1)(c)(i) and (ii) of the Income Tax Act.

The appellant received the Class "A" common shares from each corporation. While the corporate of resolutions reduced the stated capital of these shares (and thereby reduced the appellant's adjusted cost base in respect to them) the appellant nonetheless retained the shares himself and their entitlement to dividends. Moreover as the mortgage on each housing unit was paid down, the normal course of events would cause the equity of these shares to grow and the dividend producing capacity of the shares to improve. Part of the plan to allow these things to happen was that the corporation would be able to deduct the soft costs, thus improving the corporations’ overall cash flow position and the resultant ability to produce dividends.

So far as the rental market permitted, the corporations did perform these activities.

As a consequence, the Court finds that the amounts of interest sought to be deducted by the appellant for the interest expenses in 1985, 1986 and 1987 were deductible on account of interest paid for loans to purchase income producing property, pursuant to a legal obligation to pay that interest. The Court further finds that the property was received by the appellant.

The Minister of National Revenue's reply pleaded in the alternative that the interest expense deducted by the appellant would unduly or artificially reduce the appellant's income as contemplated by subsection 245(1) of the Income Tax Act. The Court has found that the interest in question was reasonable. It also found that the transactions between the corporation and the appellant were legally binding upon the parties and did result in mutual rights and duties being imposed between the parties to those contracts.

The Federal Court of Appeal has best described the results of these findings, as they apply to the appellant's case, in The Queen v. Irving Oil Ltd., [1991] 1 C.T.C. 350, 91 D.T.C. 5106 when it said, at page 360 (D.T.C. 5114):

In order to come within the terms of s. 245(1), a transaction or operation must have the effect of unduly or artificially reducing income; the artificiality of the transaction or operation itself does not determine the Issue. Heald, J.A., speaking for the Court in Spur Oil, at p. 124, said:

. . . the finding of artificiality in the transaction does not, per se, attract the prohibition set out in subsection [245(1)] of the Income Tax Act. To be caught by that subsection, the expense or disbursement being impeached must result in an artificial or undue reduction of income. Undue" when used in this context should be given its dictionary meaning of "excessive". In light of the Crown's concession that under the Tepwin contract the appellant would be paying slightly less than fair market value, it cannot be said that the Tepwin contract and the Tepwin charge result in an excessive reduction of income. Turning now to artificial, the dictionary meaning when used in this context is, in my view, “simulated” or "fictitious". On the facts in this case, the reduction in the income of the appellant can, in no way, be said to be fictitious or simulated.

It is likewise here. Since the respondent paid Irvcal fair market value, it cannot be said that payment resulted in an excessive reduction of income. There was nothing fictitious or simulated in the reduction of the respondent's income as a result of paying Irvcal 66 cents more per barrel of crude than the crude cost Irvcal. It was very real.

The ratio in Spur Oil was reached on the basis that the result of a non-arm's length transaction was the result that would have been reached at arm’s length. The appellant's submission that the fact, as found by the trial judge, that the respondent and Irvcal dealt at arm's length distinguishes this case from Spur Oil is therefore singularly unpersuasive.

Conclusion

The Supreme Court of Canada's decision in Stubart reaffirmed that it remains the law of Canada that Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.

On the facts as found herein, it is my opinion that the tax avoidance scheme contrived in the present case did not offend the Income Tax Act.

The appeal for the year 1984 is dismissed.

The appeals for the 1985, 1986 and 1987 taxation years are allowed and these matters are referred back to the Minister of National Revenue for reconsideration and reassessment on the foregoing basis.

The appellant is awarded party-and-party costs.

Appeals allowed in part.