Kalousdian v. The Queen, 94 DTC 1722, [1994] 2 CTC 2127 (TCC)

Mogan, J.T.C.C.:—In 1986, the appellant received a $100,000 loan from a corporation of which he was a significant shareholder and employee. The proceeds of the loan were used to assist the appellant to acquire a dwelling for his habitation. The Minister of National Revenue included the whole amount of the loan in the appellant's income under subsection 15(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). The issue in this appeal is whether bona fide arrangements were made at the time of the loan for its repayment within a reasonable time.

At all relevant times, the appellant owned one-half of the issued shares of Industrial Motor Service Ltd. (referred to herein as "IMS"). The other half of the issued shares was owned by Roberto Sanz. The appellant and Mr. Sanz are not related persons within the meaning of section 251 of the Income Tax Act. The appellant lived in Egypt and came to Canada as an adult. Roberto Sanz lived in Spain and came to Canada as an adult. For each man, English is a second language. The appellant and Mr. Sanz met around 1964 when they worked for the same employer. In 1976, they purchased the business now carried on by IMS. In 1978, they purchased the land and building at 793 Warden Avenue, Scarborough, where the IMS business was and is carried on. They purchased the property in their personal names and rented it to IMS. The purchase of the property was financed with a first and second mortgage.

On October 28, 1985, the appellant and his wife entered into an agreement to purchase for $301,500 the house located at 6 Leacock Crescent in the City of North York, a suburb of Toronto. The transaction closed on January 10, 1986. To assist the appellant and his wife in completing the purchase, IMS issued a cheque for $100,000 to the appellant on January 10, 1986. This is the same $100,000 which was added to the appellant's 1986 income and is the subject of this appeal. Exhibit A-8 is a promissory note dated January 10, 1986, signed by the appellant which states:

Due Jan. 10/91

Jan. 10, 1986

Five years after date I promise to pay to the order of Industrial Motor Service Ltd. $100,000 at Toronto together with interest @ 11.5 per cent per annum.

Repay principal $20,000 per year.

Value received.

G. Kalousdian (signed)

IMS carries on the business of rewinding and repairing electric motors. The company has only five employees: the appellant and Mr. Sanz, two men who work in the shop, and a woman bookkeeper. The appellant looks after orders, speaking with customers and invoicing while Mr. Sanz manages the actual operation in the shop. The IMS financial statements for the fiscal period ending January 31, 1986 (Exhibit A-11) disclose total sales of $432,257; cost of goods sold $230,383; operating expenses $165,445 (including rent to the appellant and Sanz of $21,600 or $1,800 per month); miscellaneous revenue $9,987; and pre-tax income of $46,416. The appellant’s 1986 income tax return (Exhibit A-9) shows employment income of $44,082 from IMS; taxable dividends of $21,345 from IMS; and net rental income of $5,383 from IMS.

The appellant and Sanz knew in late 1985 that IMS had about $110,000 in redundant cash invested in term deposits and they decided that each would withdraw $50,000. Upon further reflection, Sanz realized that he did not need the money and that the appellant did need it to complete the purchase of his house. It was therefore decided that IMS would lend $100,000 to the appellant at 11.5 per cent interest per annum and that Sanz would not withdraw any cash. Although the promissory note stated that the principal would be repaid at the rate of $20,000 per year, the appellant and Sanz agreed that the principal amount of the note would not be repaid until they personally had paid off the two mortgages on their building in which the IMS business was operated. The appellant could not afford to make repayments of principal on his house loan until after the two mortgages were paid off. The second mortgage was paid off in 1989 and the first mortgage was paid off in 1992.

In 1986, IMS was paying rent at the rate of $1,800 per month. The appellant and Sanz required approximately $1,100 per month to maintain the first and second mortgages on their building at 793 Warden Avenue and to pay the municipal taxes. Therefore, the pre-tax cash from the rent was only $700 per month to be divided between the appellant and Sanz. The appellant stated that he could have and would have started repaying his house loan earlier if IMS had paid more rent for the use of the building.

There was no resolution of the directors of IMS authorizing the loan to the appellant. The amended repayment agreement was not reduced to writing because no one advised them to put it in writing, and they trusted each other. In 1977, about a year after they had purchased the business, Sanz burned his hand and could not work for a long time. The appellant had insisted, however, that Sanz draw equal salary with the appellant during his (Sanz's) convalescent period because they were equal partners. Mr. Sanz testified in this appeal and stated that the appellant had been so fair to him in 1977 when he was injured and could not work that he was content that IMS lend $100,000 to the appellant in 1986 to help the appellant to buy his house even though no similar loan was made to himself (Sanz). After the remaining mortage on the building was paid off in 1992, the apppellant repaid about $8,500 to IMS with respect to his house loan. Mr. Sanz stated in evidence that, in his view, the appellant is keeping up his half of the loan agreement.

The relevant words in subsection 15(2) of the Income Tax Act are as follows:

15(2) Where a person. . .is a shareholder of a particular corporation. . .and the person. . .has in a taxation year received a loan from. . .the particular corporation. . .the amount of the loan. . .shall be included in computing the income for the year of the person.. .unless

(a) the loan was made. . .

(ii) in respect of an individual who is an employee of the lender. . .to enable or assist the individual to acquire a dwelling. . .where the dwelling is for the individual’s habitation,

and bona fide arrangements are made, at the time the loan was made. . .for repayment thereof within a reasonable time;

The conditions in the opening words of subsection 15(2) are satisfied because the appellant received a loan from IMS in 1986 when the appellant was a shareholder of IMS. And the conditions in subparagraph 15(2)(a)(ii) are satisfied because the appellant was an employee of IMS and the loan was made to assist the appellant to acquire a dwelling for his own habitation. The respondent argues that the appellant has failed to satisfy the last condition in subsection 15(2) because bona fide arrangements were not made at the time of the loan for its repayment within a reasonable time. Specifically, the terms of the promissory note (Ex. A-8) were amended by an oral agreement between the appellant and Sanz; the terms of the oral agreement were never recorded in a document signed by the corporation (IMS); the amended arrangement required some formality; the corporation held no security for the loan; and the six year delay (1986-92) for repayment of any principal was not a reasonable time within the meaning of subsection 15(2).

There is no document in evidence which discloses the oral agreement between the appellant and Sanz that repayment of the principal amount of $100,000 could be deferred until after the two mortgages on their building had been paid off in 1992. And it is desirable to formalize certain arrangements between a shareholder and his corporation. In The Queen v. Neudorf, [1975] C.T.C. 192, 75 D.T.C. 5213, Heald, J. stated at page 196 (D.T.C. 5215):

It is my further view that since one of the parties to the arrangement was a corporation, there is more formality required (such as corproate resolutions, for example) than in the case of individuals and particularly where the details of a relationship are important as against third persons such as the Revenue.

In my view, the need for formality is greater when an individual owns all of the issued shares or is the controlling shareholder of the corporation. There may not be as much need for formality if the shares of a corporation are held in equal portions by two or more persons who deal at arm's length. In those circumstances, if only one shareholder has received a loan from the corporation on terms which are not reduced to writing, and if all of the shareholders are in agreement with respect to the oral terms of the loan, the conflicting commercial interests of the arm’s length non-borrowing shareholders will ordinarily cause them to ensure that the loan is repaid within a reasonable time. In Massey-Ferguson Ltd. v. The Queen, [1977] C.T.C. 6, 77 D.T.C. 5013, Urie, J. speaking for the Federal Court of Appeal stated at page 13 (D.T.C. 5017):

The whole development of commercial law over the centuries is replete with examples of the courts recognized that businessmen do not always depend on expert documentation to prove the true characterization of their transactions. Rather, they tend to achieve their desired ends, particularly when the relationships between them are close, in informal and expeditious ways which perhaps are abhorrent to lawyers. In doing so they ran [run] the risks inherent in such a practice of determining their respective rights Frequently no difficulties ensue, but if they do, in the absence of contracts or other documents, courts must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind.

When there is a shareholder loan which meets the conditions of subsection 15(2), the question of whether the terms of repayment are “within a reasonable time" is primarily a subjective question which will depend in large part upon the particular circumstances. One significant factor would be whether the funds for the loan were redundant to the corporation's business or whether the corporation itself was required to borrow those funds and thereby encroach upon the line of credit which supported its business. In this appeal, it appears that the borrowed funds were redundant to the IMS business. The balance sheet of IMS at January 31, 1986 (21 days after the loan to the appellant) showed that the corporation had no bank debt or other capital borrowings as at the balance sheet date. Another factor would be whether the corporation had only one shareholder or a controlling group of shareholders within one family. If there were only one controlling shareholder or a controlling family, it would be relevant to ask why the funds were not withdrawn by way of salary or dividends. In this appeal, there were two equal arm's length shareholders and Mr. Sanz had no need to withdraw any funds.

Both the appellant and Mr. Sanz testified at the hearing. I find that they were believable witnesses, and I conclude that the terms of repayment were those described by these two men. The funds ($100,000) were redundant to the needs of IMS, and Sanz did not need a loan. Although IMS held no security for the loan, there was implicit trust between the appellant and Sanz. Also, the appellant and Sanz were equal owners of the building in which IMS operated its business and, if the two shareholders had disagreed, Sanz had the opportunity to tie up the appellant’s interest in that building. In all of these circumstances, I find that it was not unreasonable for the appellant to defer payment on the principal of his house loan until 1992 when the two mortgages on the Warden Avenue building would be paid off. I will state that finding in more positive words. At the time of the loan, there were bona fide arrangements made for its repayment within a reasonable time.

When filing his income tax return for the 1986 taxation year, the appellant included in the computation of his income a deemed interest benefit in the amount of $9,750 with respect to his house loan pursuant to section 80.4 of the Income Tax Act. When issuing the reassessment which is under appeal herein, the Minister of National Revenue included in the computation of the appellant's income for 1986 the full amount of the house loan and deducted the deemed interest benefit previously reported by the appellant. I would allow the appeal, with costs, and refer the assessment for 1986 back to the Minister of National Revenue for reconsideration and reassessment to reverse those two determinations. The amount of the house loan should be deleted from the appellant's income and the deemed interest benefit of $9,750 should be included.

Appeal allowed.