Lessard v. MNR, 93 DTC 680, [1993] 1 CTC 2176 (TCC)

Tremblay, T.C.C.J.:—This appeal was heard on April 8, 1992, in Sherbrooke, Quebec.

1. Point at issue

The point at issue is whether the appellant, the sole shareholder of the capital stock of Gestion Roger Lessard Inc., was correct in deducting interest of $8,249, $8,109 and $5,812 respectively in calculating his income for the years 1984, 1985 and 1986. Most of this interest was paid on a personal loan of $83,000 at the Caisse populaire de Louiseville. The money borrowed was used to purchase class E preferred shares in Gestion Roger Lessard Inc., which had purchased 2,000 common shares of “Le Groupe Choisy Inc.”, that is 10.25 per cent of the voting shares of the latter company. According to the appellant, the expenditure was incurred for the purpose of earning income.

The respondent was of the opposite view.

The application of the principles stated by the Supreme Court in Bronfman Trust, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059, is at the heart of the problem.

2. Burden of proof

2.01 The burden is on the appellant to show that the respondent's reassessments are incorrect. This burden of proof derives from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1182.

2.02 In the same judgment, the Court found that the facts assumed by the respondent in support of assessments or reassessments are also deemed to be true until there is evidence to the contrary. In the instant case, the facts assumed by the respondent are described in subparagraphs (a) to (i) of paragraph 6 of the respondent's reply to the notice of appeal. The appellant admitted, denied or made comments. This paragraph 6 reads as follows:

6. In reassessing on December 2, 1988, the respondent took for granted, in particular, the following facts:

(a) the facts stated in paragraph 1 of the present reply to the notice of appeal; [admitted]

1. The respondent notes that the appellant admits the facts stated in the letter from the Department of National Revenue dated August 15, 1988, which are as follows:

1.1 On December 28, 1983, the corporation Gestion Roger Lessard Inc.

was incorporated under Part 1A of the Quebec Companies Act. The capital stock issued and paid up as of January 23, 1984 was:

10 class A shares	$1,359
1 class B share	$ 100
10 class C shares	$ 100
83 class E shares	$83,000

Mr. Roger Lessard, the appellant, owns 100 per cent of the shares of all the classes of the capital stock of Gestion Roger Lessard Inc. [admitted]

1.2 The 83 class E shares were paid for with the proceeds of an $83,000 loan bearing interest at 10.75 per cent taken out by the appellant at the Caisse populaire de Louiseville. [admitted]

1.3 With the aid of this amount, Gestion Roger Lessard Inc. purchased 2,000 common shares of the company" Le Groupe Choisy Inc.” from the estate of Yvon G. Trudeau and from Mr. Pierre Trudeau. Gestion Roger Lessard Inc. owns 10.25 per cent of the voting shares of the company" Le Groupe Choisy Inc.” [admitted]

1.4 Gestion Roger Lessard Inc. gradually bought back the class E shares from the appellant as it received dividends from the company "Le Groupe Choisy Inc.” With the proceeds from the redemption of his shares, the appellant repaid his loan at the Caisse populaire de Louiseville. [admitted with comments; see paragraph 3.05.1]

1.5 No dividend was ever paid on the class E shares of Gestion Roger Lessard Inc. [admitted with comments; see paragraph 3.05.2]

1.6 The class E shares of Gestion Roger Lessard Inc. are non-voting and non-participating, of no par value, redeemable at their capital paid on issue, non-cumulative dividend of up to 10 per cent per year, ranked in second place in the calculation of dividends. [admitted with comments; see paragraph 3.05.3]

(b) the appellant borrowed $83,000 in 1984 from the Caisse populaire de Louiseville; [admitted]

(c) the interest paid by the appellant on this loan was

— $8,249 for 1984;

— $8,109 for 1985;

— $5,812 for 1986; [admitted]

(d) in 1984, the appellant also paid notary's fees of $1,300 in respect of the agreement concerning the loan of $83,000; [admitted]

(e) the appellant did not use the $83,000 borrowed for the purpose of earning income from a business or property, but to acquire the class E preferred treasury shares of the corporation Gestion Roger Lessard Inc. [denied, see paragraph 3.05.4]

(f) the class E preferred shares of the corporation Gestion Roger Lessard Inc. offer no guarantee that a dividend will be declared and paid, and the maximum rate (10 per cent) of the non-cumulative dividend that could be declared is furthermore less than the rate of interest (10.75 per cent) payable on the $83,000 borrowed; [denied]

(g) no dividend was in fact declared or paid on these class E shares in 1984, 1985 or 1986; [admitted]

(h) the $83,000 borrowed by the appellant was used indirectly, through the corporation Gestion Roger Lessard Inc., to finance the purchase of 2,000 common shares of the company" Le Groupe Choisy Inc.”, that is 10.25 per cent of the voting shares of that company; [admitted]

(i) the corporation Gestion Roger Lessard Inc. redeemed the class E shares held by the appellant as it received dividends from the shares of the company "Le Groupe Choisy Inc.” [denied; see paragraph 3.05.5]

[Translation]

3. Facts

The appellant, the sole witness heard, related the following facts in his examination-in-chief and cross-examination.

3.01 He first explained what had encouraged him to go into business. He had been working for the company "Le Groupe Choisy Inc.", located in Louiseville, since 1975, when, in 1983, the estate of the principal shareholder decided to sell the shares. The appellant was then 35 years of age. With the experience he had acquired in the company, he saw a fantastic opportunity and an extraordinary chance to acquire a certain number of shares. He was advised to proceed through an investment company in order to accumulate funds, make other investments and, lastly, earn income from all these transactions. He expected that the income might be either short-term or long-term; everything would depend on the economic situation.

He therefore formed the company Gestion Roger Lessard Inc. (hereinafter called "Gestion").

3.02 He thus took out a personal loan of $83,000 at 10.75 per cent interest and invested it in Gestion. The latter purchased 2,000 shares of Le Groupe Choisy Inc., that is 10.25 per cent of its voting shares. In addition to Gestion, 10 other shareholders (companies and individuals) invested in Le Groupe Choisy Inc. The latter had 200 employees, including four chemists and five or six laboratory technicians.

3.03 Roger Lessard was the sole shareholder of 100 per cent of all the shares in all classes of Gestion. According to the appellant, the whole structure was linked to him so that he could withdraw ail the income at the proper time.

3.04 According to the appellant, even though the respondent considered only the class E shares of Gestion in preparing his notices of reassessment, everything was related and had to be considered as a comprehensive investment designed to generate income. "The only reason the $83,000 was put into class E shares,” he said, “was to simplify valuation if any shares were redeemed, which would have been very complicated if the amount had been invested in another class. (Valuation at market price, annual valuation, accounting cost, etc.)."

3.05 Referring to the facts assumed by the respondent and cited above (2.02), the appellant made the following comments concerning the subparagraphs indicated below.

3.05.1 Item 1.4 of subparagraph (a): This subparagraph does not necessarily apply because the loan was repaid at the rate of $250 a week plus an annual payment. Furthermore, the appellant contended that, to date in 1992, he allegedly had not received enough dividends or share redemptions to repay the loan principal and interest.

3.05.2 Item 1.5 of subparagraph (a): No dividend was ever paid by Gestion. “The reason is simple,” he said. "There was not enough revenue.”

3.05.3 Item 1.6 of subparagraph (a): It is not necessary,” he gued, ” to invest in common shares in order to receive interest deductions for the loan taken out in order to purchase shares.” Furthermore, he again recalled that he was the sole shareholder of the other classes, A, B and C, of Gestion. This was a comprehensive plan.

3.05.4 Subparagraph (e): "The entire spirit of the transaction, from the time the $83,000 was borrowed, lay in a desire to earn an income. That was the fundamental reason. Otherwise, it makes no sense."

3.05.5 Subparagraph (i): To this allegation, the appellant answered that, since the $83,000 had been invested, there had also been share redemptions totalling $54,000. Furthermore, he had had to reinvest $25,000 in 1987 and $22,000 in 1991. In 1992, the appellant still held $76,000 in class E shares, which was almost the same amount as the initial investment of $83,000. “In other words," he said, "almost everything was reinjected in Gestion. Since 1989, Gestion has not received any dividend from Groupe Choisy Inc. because of the economic situation."

3.06 During the cross-examination concerning the dividends, the respondent filed the certificate of incorporation of Gestion Roger Lessard Inc. (Exhibit 1-1). Concerning the dividends from the various classes of shares, it states:

1. Class and all maximum numbers of shares which the company is authorized to issue.

The company is authorized to issue an unlimited number of class A, B, C, D and E shares of no par value. These shares of the company will carry rights, privileges and preferences and will be subject to the following restrictions and limitations.

2. Dividends

(a) Holders of class A, B, C, D and E shares will be entitled to receive separately, out of the funds of the company that may then legally be used for these purposes, dividends in the following order:

(i) In first place, on all class A shares issued, to a maximum amount, however, of five dollars ($5) for each of the class A shares issued, non- cumulative;

(ii) In second place, a non-cumulative dividend on all class E shares issued, to a maximum amount of ten per cent (10%) per annum on the amount paid;

(iii) In third place, a non-cumulative dividend on all class B shares issued to a maximum amount of eight per cent (8%) per year on the amount paid;

(iv) Lastly, without preference, a residual dividend on all class C and D shares.

[Translation]

This certificate of incorporation provides further on that only the class B shares are voting shares. Lastly, under the heading “Redemption and Purchase", the certificate provides as follows concerning the redemption of class E shares:

The company shall pay, for each class E share to be redeemed, a price equal to the amount of capital paid in respect thereof plus all dividends declared on such shares and unpaid.

[Translation]

The wording concerning the redemption of the class B shares is similar.

3.07 The respondent filed the income tax returns of Gestion for the years 1984, 1985 and 1986 as Exhibit 1-2. The statement of income was as follows:

OPERATING EXPENSES 1986 1985 1984

Interest paid			665
Professional services	230	495	500
Taxes and permits	150	135	70
	$ 380 $ 630 $ 1,235
NET PROFIT	9,374	3,994	9,684
RETAINED EARNINGS
AT OPENING	13,678	9,684
RETAINED EARNINGS
AT CLOSING	$23,052	$13,678	$ 9,684

3.08 Gestion's balance sheet during the years in issue reads as follows concerning the declared capital stock:

4. Law — case law — analysis

4.01 Law

The main provision of the Income Tax Act involved in this case is paragraph 20(1)(c). It reads as follows:

20. Deductions permitted in computing income from business or property.

(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) Interest. — an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

(iii) an amount paid to the taxpayer under

(A) an Appropriation Act and on terms and conditions approved by the Treasury Board for the purpose of advancing or sustaining the technological capability of Canadian manufacturing or other industry, or

(B) the Northern Mineral Exploration Assistance Regulations made under an Appropriation Act that provides for payments in respect of the Northern Mineral Grants Program,

or a reasonable amount in respect thereof, whichever is the lesser, or

(iv) borrowed money used to acquire an interest in an annuity contract to which section 12.2 applies, or would apply if the contract had a third anniversary in the year, except that, where annuity payments have commenced under the contract in a preceding taxation year, the amount of interest paid or payable in the year shall not be deducted to the extent that it exceeds the amount included under section 12.2 or paragraph 56(1)(d.1) in computing the taxpayer’s income for the year with respect to his interest in the contract.

4.02 Case law

The following case law was referred to by the parties:

1. Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059;

2. Lipson v. D./M.N.R. Quebec, [1979] 1 S.C.R. 83; [1979] C.T.C. 247, 79 D.T.C. 1222;

3. Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717, [1957] C.T.C. 335,57 D.T.C. 1239;

4. Attaie v. The Queen, [1990] 2 C.T.C. 157, 90 D.T.C. 6413;

5. Boidman v. M.N.R. (1964),37 Tax A.B.C. 156, 65 D.T.C. 22;

6. Gregg v. M.N.R., [1967] Tax A.B.C. 203, 67 D.T.C. 145;

7. Fallis v. M.N.R. (1966), 40 Tax A.B.C. 370, 66 D.T.C. 233;

8. Livingston International Inc. v. The Queen, [1991] 1 C.T.C. 155, 91 D.T.C. 5066 (F.C.T.D.); aff'd [1992] 1 C.T.C. 217, 92 D.T.C. 6197 (F.C.A.).

4.03 Analysis

4.03.1 The appellant argued that Bronfman Trust [4.02(1)] cannot be applied to his case. He did not borrow the money in order to avoid selling corporate shares at a loss, as in the case cited above. He borrowed in order to invest, as he had been advised to do, in an investment company, namely Gestion Roger Lessard Inc. Reiterating what he had said in his testimony, inter alia, at paragraphs 3.02, 3.03, 3.05.3, 3.05.4, and Gestion's financial statements confirmed his allegations, he said that the situation must be considered as a whole in order to determine whether his intention in borrowing was obviously to make profits in the short or long term.

4.03.2 Counsel for the respondent, for her part, argued that the doctrine explained in Bronfman Trust on the direct use of money borrowed for the purpose of earning income applies to the present case. ”. . . it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner," the Supreme Court found, at page 46 (C.T.C 125, D.T.C. 5064), in referring to Auld v. M.N.R. (28 Tax A.B.C. 236, 62 D.T.C. 27).

"Consequently," the Supreme Court stated, "the focus of the inquiry must be centred on the use to which the taxpayer put the borrowed funds." In Bronfman Trust, the Supreme Court referred, at page 51, to Rand, J. in Canada Safeway Ltd. (4.02(3)), at page 726 (C.T.C. 127-28, D.T.C. 5066):

No doubt there is in fact a causal connection between the purchase of the stock and the benefits ultimately received; but the statutory language cannot be extended to such a remote consequence; it could be carried to any length in a chain of subsidiaries; and to say that such a thing was envisaged by the ordinary expression used in the statute is to speculate and not interpret.

Referring to the interest expense deduction for borrowed money used for the purpose of earning income from business, Rand J. concluded at page 727:

What is aimed at by the section is an employment of the borrowed funds immediately within the company’s business and not one that effects its purpose in such an indirect and remote manner.

Turning to borrowings used to generate income from property, he made the following observations at page 728:

There is nothing in this language to extend the application to an acquisition of "power" annexed to stock, and to the indirect and remote effects upon the company of action taken in the course of business of the subsidiary.

It should be said that, in Canada Safeway Ltd., the loan was used to purchase shares in Canadian companies. However, such dividends received from Canadian companies from 1947 to 1949, the years in issue, were not taxable under the Act. Likewise, the expenses (including interest) incurred in order to earn non-taxable income are not deductible. Canada Safeway Ltd. nevertheless claimed to be entitled to the interest deduction because the share purchase had resulted in a retailer coming under its control and, consequently, in an increase in revenue earned from its existing commercial operations.

The Supreme Court found, as cited above, that this was not a consequence of the immediate use of the borrowed funds.

4.03.3 In the instant case, what was the immediate use of the $83,000 loan? It was to purchase shares in the company Gestion Roger Lessard Inc. (2.02(1.1)), which in itself is a valid purpose. Must the fact that the appellant never received dividends from Gestion be taken into consideration? Gestion, which received dividends from Le Groupe Choisy Inc. until 1989 (3.05, 3.07), did not deem it appropriate to issue any to the appellant. In themselves, the financial difficulties of a company in which one purchases shares do not affect the purpose, that is to earn income, of the investment or of the loan used in order to do so.

It appears, however, that Gestion redeemed $54,000 worth of shares (3.05.5).

It is known that the value of the class E shares fell from $83,000 in 1983 to $60,000 in 1986 (2.02(1.1), 3.08). However, in 1992, the appellant still owned $76,000 worth of class E shares. The appellants investments of $25,000 in 1987 and $22,000 in 1991 were no doubt used in part for this purpose, that is to purchase class E shares.

Furthermore, Gestion's redemption of shares cannot be considered as a source of income because it constituted quite simply a return on investment, unless the dividends had been declared and unpaid, as provided in the certificate of incorporation (3.06 in fine). But there was no evidence to that effect.

4.03.4 The respondent made much of the fact that the appellant had borrowed $83,000 at 10.75 per cent, whereas the dividend on the class E shares could only be 10 per cent.

The respondent concluded that no profit was possible. However, to achieve the goal of earning income, there must be profit. The word income in the Income Tax Act (18(1)(a), etc.) means net income, that is to say profit.

The respondent relied on Fallis (4.02(7)). In that case, the appellant had borrowed more than $600,000 at an interest rate of 6 to 7 per cent in order to purchase securities from Trans-Canada Pipe Lines Ltd. bearing interest of 5 /2 per cent. Assistant Chairman Fordham of the Tax Appeal Board properly decided that there had been no possibility of income, that is to say of profit.

In the instant case, the interest on the loan was 10.75 per cent, and the dividend was "10 per cent per annum on the amount paid" (3.06.2(ii)). According to the respondent, that expression means: “amount given in payment of the shares". Normally, then, the expression “ capital paid” cited above (3.06 in fine) concerning the share redemptions must be used.

In a legal document of this kind, such as a certificate of incorporation, just as in a statute, a single expression must be used to express a single reality. The Court thus tends to assign the expression "amount paid” a different meaning, that is the amount paid in dividends.

It appears from the introduction 2(a) of Exhibit 1-1 under the heading "Dividends" (3.06) and subparagraph (i) concerning the class E shares that the amount paid refers to the dividends: ‘’. . . will be entitled to receive dividends. . .(ii). . .a dividend. . . of 10 per cent on the amount paid”. Furthermore, subparagraph (iv) concerning class C and D shares, concerns the “residual dividend”.

Since the dividends were paid out of retained earnings, 10 per cent of those dividends do not constitute the same basis as the capital paid by the shareholder for the shares, even if the capital paid is a factor which a company must take into account in order to distribute the dividends. A shareholder who has apparently paid for only 60 per cent of his shares can only receive 60 per cent of the dividends which he would have received if he had paid for all his shares.

Furthermore, even if the meaning attached to the expression "amount paid” were that given it by the respondent, one would have to take into consideration the rights of the taxpayer-individual who receives a dividend under the Income Tax Act then in effect. However, for the years in issue, the appellant was entitled to claim the dividend tax credit under sections 12(1)(j), 82(1) and 121. Thus, even if the appellant borrowed at 10.75 per cent and received only 10 per cent in dividends, it would still be more profitable for him. Furthermore, section 110.1 granted a dividend exemption of up to $1,000 during the years in issue.

Lastly, apart from the above arguments, consideration must be given to the fact that the appellant was not only the owner of the class E shares, but of all classes of Gestion’s shares. He was thus entitled to all the dividends in any case. One may therefore say that the loan was taken out for the purpose of earning income.

4.03.5 In my view, the appellant cannot be criticized for the financial difficulties, that is to say for the lack of income which Gestion received during the years in issue.

The worst that can happen to the appellant is that he may one day lose his investment as a result of those financial difficulties.

4.03.6 Furthermore, if one considers the introduction of subsection 20(1) cited above (4.01), which provides that, in computing income for a taxation year from a business or property, one may deduct amounts that are wholly applicable to "that source".

Can it be said that there is an existing source when a dividend was not paid?

The Court is of the view that there was a potential source of income and that it was always existing. It is not as though the appellant sold his Gestion shares and wanted to continue to deduct the interest on his loan. In that case, there would then no longer have been a source.

5. Conclusion

The appeal is allowed with costs.

Appeal allowed.