Attis v. MNR, 92 DTC 1128, [1992] 1 CTC 2244 (TCC)

Garon, T.C.CJ.:—In this case, the appellant appeals reassessments dated October 11, 1989, and October 7, 1988, for the 1985 and 1986 taxation years respectively. By his reassessments the respondent added to the appellants income for the 1985 taxation year the amount of $136,007 and for the 1986 taxation year the amount of $20,916. These reassessments were established pursuant to subsection 15(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") on the basis that the amounts involved in these reassessments represent the appellants unpaid shareholder's loans.

I must also indicate that at the outset of the hearing of these appeals, counsel for the appellant made a motion that the amount of income that has been taken into account by the respondent in the reassessment issued on October 11, 1989, with respect to the 1985 taxation year, should be reduced by $53,684. In support of this motion, counsel for the appellant took the position that in a reassessment made under subsection 165(3) of the Income Tax Act the Minister of National Revenue could not reassess an amount of tax greater than the amount of tax assessed in a prior assessment or reassessment in respect of which a valid notice of objection had been served on the respondent pursuant to subsection 165(1) of the Act. He also pointed out that in the present case the reassessment of October 11, 1989, could not have been made pursuant to the general assessing power conferred on the respondent by subsection 152(4) as the applicable three-year limitation period had elapsed. The normal reassessment period is applicable here since there has been no allegation by the respondent of misrepresentation or fraud or no filing of a waiver by the appellant with the respondent.

The appellant practised as a lawyer in the real estate and commercial law area for six or seven years in Moncton, New Brunswick. He stopped practising law in April 1983. While he practised his profession, the appellant used to get money to live on through drawings against future earnings.

The appellant asserted that he was persuaded by a friend to go from the private practise of law into the night club business. The concept of the night club business began being developed in 1982 and was followed by the period of construction of the required facilities. The appellant and another individual caused a company by the name of Stardust Enterprises Ltd. (the"corporation" or "Stardust") to be incorporated in September 1982. The fiscal year-end of the Corporation was August 31. Throughout the relevant period, Stardust owned and operated Ziggy's Night Club in Moncton, N.B. The club opened in early January 1983. The appellant had planned to be a passive investor but events did not develop as anticipated. The other shareholder ceased being involved in the business managed by Stardust in early 1983 as he left New Brunswick at about that time. The appellant was at all relevant times the president and the sole director and shareholder of Stardust. The appellant worked for the corporation on a full-time basis during the years in issue.

The appellant did not enter into a written employment contract with Stardust and he never received a salary from the corporation. The appellant asserted that he put over $200,000 into the corporation at the commencement of its operations over a period of a few months and that by December 1984, the corporation still owed him some money but he could not indicate the precise amount thereof. During the taxation years 1985 and 1986, he took money out of the corporation by way of cheques and the funds made available to him by the corporation constituted at the time his principal source of livelihood. His drawings, so to speak, from the corporation, which he considered as advances against earnings, were made on an irregular basis, the cash flow of the corporation at any given point in time being a factor. The appellant admitted that he became indebted to the corporation at one point in an amount of $136,007 but he stated that within six months or one year from the end of the corporation's relevant taxation year, the total amount of his indebtedness to the corporation was cleared out of the shareholder's loan account in the accounting books of the corporation by the latter corporation paying him bonuses and dividends. The appellant stated that, except for one occasion, he never borrowed money in a formal sense from Stardust. The one instance did not happen during the years in issue but later on in 1988, when he borrowed from the corporation a sum in the amount of $44,334.06 for the purpose of purchasing a residence for his habitation, as evidenced by the minutes of a director's meeting held on January 7, 1988.

The evidence is clear that on December 31, 1983, the corporation owed him $157,006. It has also been established that between September 1982 and December 31, 1984, there were no drawings taken by the appellant apart from an amount of $27,000. The latter amount was included in the appellant's income although the corporation owed him, at the end of August 1984, $50,794.

The detailed evidence respecting the inflows and outflows of funds between the appellant and the corporation was tendered on behalf of the appellant by Mr. William Walker, C.A. Mr. Walker has been practising his profession of chartered accountant since December 1973, in Moncton and in St. John, N.B. Mr. Walker has been the appellant's tax adviser from 1980 through 1987. He has, in particular, been advising the appellant in matters relating to Stardust and he prepared the financial statements for the corporation in respect of its 1986 and 1987 taxation years. The corporation's unaudited financial statements for 1983, 1984 and 1985, were prepared by Peat, Marwick, Mitchell & Co. These financial statements had been reviewed by Mr. Walker. Mr. Walker was involved right from the beginning in the audits and assessments made by the Department of National Revenue which led to the reassessments in issue in these appeals.

In the course of his review over a period running from 1983 to 1987 of the salient developments that may have a bearing on the reassessments in issue, Mr. Walker stated that the first reassessments relating to the shareholder's loan account were initially made in 1988, for the 1984, 1985 and 1986 taxation years. It was revealed that by the initial reassessment for the 1984 taxation year an amount of $59,767 was added to the appellant's income for this year. The figure of $59,767 was taken from an item in this amount described as “Due from shareholder" on the asset side of the balance sheet of Stardust as at August 31, 1985. As a result of discussions between Mr. Walker and an official of Revenue Canada, the respondent agreed to reassess the appellant by reducing the appellant's income in respect of shareholder's loans from $59,767 to $6,083, which was the amount that was due from the appellant to the Corporation as at December 31, 1984, according to Mr. Walker. It was agreed by both parties that the amount of $6,083 came from the shareholder's account cards in the Stardust's records.

I shall now advert to the 1985 taxation year. The evidence disclosed that by the first reassessment in respect of the appellant for the 1985 taxation year, an amount of $82,323 was added to his income on the basis that the shareholder's loan account on August 31, 1986, in the balance sheet of the corporation showed an amount of $142,090 from which the respondent deducted the amount of $59,767 that had been included in the appellant's income by the first reassessment for the 1984 taxation year. The amount of $82,323 represents the increase in the shareholder's loan account from September 1, 1985 to August 31, 1986. The first reassessment made on the appellant for the 1985 taxation year by which an amount of $82,323 had been added to his income, as noted earlier, was followed by a second reassessment whereby the respondent increased the appellant's income by $53,684 to bring the amount up to $136,007. This amount of $136,007 represents the difference between the total amount of $142,090 owing by the appellant on August 31, 1986, as shown in the Stardust's balance sheet as at August 31, 1986, minus the amount of $6,083 which had been added to the appellant's income by the second reassessment for the 1984 taxation year in respect of the appellant's indebtedness to the corporation.

Mr. Walker testified that as at December 31, 1985, the shareholder's loan account showed a balance due from the appellant of $151,966. This figure was shown on the corporation's ledger sheets. On the other hand, the corporation was indebted to the appellant in an amount of $38,000. According to Mr. Walker, this amount of $38,000 is part of a larger amount of $118,659 [1] appearing under the description “Accounts payable and accrued liabilities in the liabilities section of the corporation's balance sheet as at August 31, 1985. This amount of $38,000 represented a bonus payable to the appellant. It is why it was shown as a liability in the corporation's books. This bonus was in fact paid in January 1986. In addition, a dividend in the amount of $30,000 was declared, as appears from the minutes of a director's meeting of the corporation held in July 1985, payable on August 26, 1985, to the shareholders of record as at August 12, 1985. The latter dividend was in fact paid to the appellant in January 1986. Mr. Walker explained that the appellant's indebtedness in the amount of $59,767 to the corporation that was outstanding on August 31, 1985, was, to adopt his terminology, "paid or eliminated from the company's records” as result of the payment in January 1986, of both a bonus in the amount of $38,000 and a dividend in the amount of $30,000.

Mr. Walker also provided general explanations as to the general context in which the amounts “due from shareholder” came about in the records of Stardust in these terms:

The amount due from shareholder was accumulated during the year. He would have—there would have been cheques issued and they were charged or accounted for in the company's records on an account called “Due from share holder". It’s just an accumulation of cheques or disbursements which were made which did not relate to the operation of the company but were of a personal nature.

It would also appear from the evidence that many transactions referred to earlier were simply done by appropriate journal entries in the books of Stardust. As part of the evidence adduced on behalf of the appellant, it is worth paying particular attention to the Exhibits A-6 and A-7. From these exhibits which contain information extracted by Mr. Walker from the files and financial statements of Stardust for the years 1984 to 1987 and from the explanations given in relation thereto by Mr. Walker, the following points in this evidence are of special interest:

1. It is stated in Exhibit A-7 that the appellant paid tax in 1985 in respect of drawings in the amount of $50,000 and a dividend amounting to $30,000.

2. In 1986 tax was paid on $75,000 drawings and on a $30,000 dividend.

3. The Corporation was indebted to the appellant in an amount of $50,000 as at August 31, 1986. This accrued liability represented a bonus payable to the appellant which was in fact paid in January 1987.

4. A dividend in the amount of $100,000 was declared payable in January 1987.

5. It was stated by Mr. Walker that these amounts of $50,000 and $100,000 wiped out any balance owing by the appellant to the Corporation as at August 31, 1986.

6. These amounts of $50,000 and $100,000 were included in the appellant's income for the year in which they were received by the appellant.

7. The indebtedness owed by the appellant to Stardust as at August 31, 1987, had been repaid in full on December 22, 1987.

No witnesses were produced on behalf of the respondent. Much reliance was placed by the respondent on Exhibit R-1 which was filed with the Court in the course of the cross-examination of the appellant. Exhibit R-1 is made up of copies of journal entry sheets of the general ledger of Stardust. These sheets show a great number of transactions.

Submissions of the Parties

The appellant's position formulated in the course of oral argument is that the respondent failed to take into account bonuses and dividends that were owing by the corporation to the appellant in the 1985 and 1986 taxation years. As a result, the appellant was not indebted to the corporation at the end of both the 1985 and 1986 taxation years and therefore no amount should have been included in the appellant's income for both the 1985 and 1986 taxation years. Also, in the two notices of appeal, the appellant contended in substance that the respondent erred in classifying advances made to the appellant "as a series of loans and repayments". In addition to these general submissions, it will be recalled that counsel for the appellant propounded the argument set out at the beginning of these reasons to the effect that the respondent in responding to the notice of objection served by the appellant in relation to the first reassessment in respect of the 1985 taxation year should not have reassessed tax in an amount which was larger than the amount of tax levied by the first reassessment to which the appellant had objected.

The respondent's main submission is that the amounts of $136,007 and $20,916 were properly included in the appellant's income as "unpaid shareholder's loans due to the corporation" for the 1985 and 1986 taxation years. The respondent also put forward an alternative submission in paragraph 7 of each reply to the notice of appeal in respect of the reassessments for the two years in issue. I will limit myself to reproducing paragraph 7 of the reply to the notice of appeal dealing with the appeal from the reassessment dated October 11, 1989 for the 1985 taxation year as the wording of paragraph 7 of the reply to the notice of appeal in respect of the 1986 taxation year is virtually identical except, of course, as to the amount of income in issue. Paragraph 7 of the reply to the notice of appeal in respect of the 1985 taxation year reads as follows:

If this Honourable Court concludes that the amount of $136,007.00 was offset by an amount representing some management fees or bonus payable to the Appellant (which the Respondent denies), the Respondent respectfully submits that such amount represents therefore salary, wages or other remuneration from an office or employment received by the appellant during the 1985 taxation year with the consequence that such amount should nonetheless be included pursuant to sections 3 and 5 of the Income Tax Act.

In the course of the oral argument, it was urged on the Court by counsel for the respondent as an additional alternative argument that the appellant was involved at the relevant times in making repayments of his indebtedness at various times in a series of loans or other transactions and repayments and could not therefore invoke in his favour the exception found in paragraph 15(2)(b) of the Act.

Analysis

Subsection 15(2) of the Income Tax Act provides by way of exception that a shareholder who has become indebted to a corporation will not be required to include in his income the amount of his indebtedness if such indebtedness is repaid within one year from the end of the corporation's fiscal year in which the indebtedness arose. It follows that if the indebtedness was incurred early in a corporation's fiscal year the shareholder may take advantage of a period of almost two years before effecting repayment of the amount owing to the corporation without being required to include such amount in his income. It is provided however, that a shareholder cannot avail himself of this exception if the repayment of the indebtedness was made as part of a series of loans or other transactions and repayments.

Bearing in mind the applicable provisions of subsection 15(2) of the Income Tax Act, these appeals involve issues of facts as to whether the appellant's indebtedness to the corporation in the 1985 and 1986 taxation years had been repaid within one year from the end of the taxation year of the corporation in which the particular indebtedness was incurred. From the depositions given at the hearing of these appeals, the following evidence is of particular significance:

1. The appellant was not, at any time, indebted to the corporation prior to September 1, 1984. In fact, on August 31, 1984, the corporation owed the appellant $50,794. Until that point in time, the appellant's account with the corporation had always been in a credit position, the appellant having advanced to the corporation more than $200,000 over a period of time shortly after its incorporation. I leave out of consideration the amount of $27,000 which the appellant took in the form of drawings some time in 1984, since this operation does not distort the overall picture of the financial net result of the dealings between the appellant and the corporation.

2. The appellant's indebtedness to the corporation in the amount of $59,767 as at August 31, 1985, was fully satisfied following the payment of a bonus and of a dividend totalling $68,000 by early 1986.

3. The shareholder's loan account showed a balance due from the appellant to Stardust of $151,966 as at December 31, 1985.

4. The appellant's indebtedness to the corporation as at August 31, 1986, was repaid in full as a result of, inter alia, payments of bonuses and dividends in January 1987.

The evidence concerning these facts is extracted mainly from Mr. Walker's testimony. I have not been persuaded that the information contained in Exhibit R-1, to the extent that evidence was adduced in relation to it, is at variance with the fundamental elements of the evidence which I have just outlined. Exhibit R-1 does not appear to cover all transactions relating to the payment of bonuses and dividends. Also the shareholder's loan account portion of Exhibit R-1 did not run over the entire period that may be relevant in applying subsection 15(2) of the Act to the facts of the present case. Since the appellant's indebtedness to the corporation in the amount of $59,767 as at August 31, 1985, had been repaid by January 1986, the point must not be overlooked in analyzing the evidence that the appellant was not required to include in his income for the 1985 and 1986 taxation years any indebtedness incurred after August 31, 1985, and before September 1, 1986, if such indebtedness was discharged by September 1, 1987. In this connection, the evidence respecting any action taken by the appellant prior to September 1, 1987, to pay off his indebtedness is relevant. Here, as indicated in subparagraph of the preceding paragraph, full repayment was made by the appellant in January 1987 in respect of his indebtedness as at August 31, 1986. Likewise, any indebtedness incurred in 1986, but after August 31, should be included in the appellant's income for the 1986 taxation year only if it was not repaid by August 31, 1988. Here again the evidence is to the effect that the appellant was not indebted to the corporation by early 1987. I am not sure that these time frames available to the appellant under subsection 15(2) of the Income Tax Act for making repayments of his indebtedness were clearly appreciated at the time the reassessments in issue were made.

From the above evidence, I conclude that it has been established by the appellant on a balance of probabilities that the appellant's indebtedness to the corporation at the end of the 1985 and 1986 taxation years had been extinguished or paid off within one year from the end of the relevant corporation's taxation year in which the particular indebtedness arose.

It therefore follows that subsection 15(2) of the Act does not require that the appellant's indebtedness to the corporation incurred during the years 1985 and 1986 be included in the appellant's income for these two years unless, as contended by counsel for the respondent in his alternative submission made during oral argument, the repayment of the appellant's indebtedness was made as part of a series of loans or other transactions and repayments.

In considering this alternative position I proceed first by stating that this issue was not raised in the replies to the notice of appeal and there are no assumptions of fact supporting this allegation. Although reference was made by the appellant to this question in paragraph 8 of each notice of appeal, I seriously doubt that it would be fair to permit the respondent to raise this issue for the first time at the hearing of these appeals. In any event, the burden of proof with respect to the factual foundation for this allegation would rest with the respondent. See the decisions in the cases M.N.R. v. Pillsbury Holdings Ltd., [1964] C.T.C. 294, 64 D.T.C. 5184, David Tobias v. The Queen, [1978] C.T.C. 113, 78 D.T.C. 6028, and Kit-Win Holdings (1973) Ltd. v. The Queen, [1981] C.T.C. 43, 81 D.T.C. 5030.

Moreover, I do not believe in the validity of this alternative submission since the appellant's indebtedness in the present case was repaid at various times by bonuses and dividends which, because of their very nature, must be included in the appellant's income for the year in which they are received. In the case of bonuses, the inclusion requirement is found in paragraph 3(a) and possibly section 5 of the Act while dividends are included in income by virtue of paragraph 12(1)(j) and section 82 of the Act. In effect, I do not think that it can be seriously contended that the second requirement to the effect that the repayment was not made as part of a series of loans or other transactions and repayments is not met where the repayments in question are made by a number of payments of bonuses and dividends. Parliament could not have intended that the indebtedness of a shareholder be caught by the general language of subsection 15(2) of the Income Tax Act providing for its inclusion in the income of a taxpayer where such indebtedness is repaid by a series of payments of bonuses and dividends which in turn must be included in a taxpayer's income by virtue of the specific provisions of the Act referred to earlier. The provisions of subsection 4(4) of the Act make it clear that" unless a contrary intention is evident" no provision in Part I of the Act shall be construed so as to require the inclusion of an amount more than once in computing a taxpayer's income for a taxation year.

As to the other alternative argument advanced by the respondent in paragraph 7 of each of the two replies to the notice of appeal, I will simply reiterate that the evidence in the present case establishes that the appellants indebtedness to the corporation was at least in large part repaid by the payment not only of bonuses but of dividends and it has not been suggested that such bonuses and dividends had not already been included in the appellant's income.

I am therefore of the view that the two alternative arguments propounded by the respondent are devoid of merit.

In the circumstances, it is therefore unnecessary for me to consider the alternative submission made by counsel for the appellant (to which reference was made at the beginning of these reasons) with respect to the validity of the reassessment for the 1985 taxation year.

For these reasons, the appeals are allowed, with costs, and the reassessments are referred back to the respondent on the basis that the amounts of $136,007 and $20,916 should not be included in the appellant's income for the years in question.

Appeal allowed.