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Citation: 2003TCC82
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Date: 20030226
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Docket: 2001-199(IT)G
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BETWEEN:
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BANNER PHARMACAPS NRO LTD.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Mogan J.
[1] The Appellant was
incorporated under the laws of the Province of Alberta on or
about January 2, 1996. The Appellant's corporate T2 income
tax return for 1996 (Exhibit 22) shows its first taxation year as
running from February 14 to December 31. The reason for the
Appellant's choice of February 14 as the commencement of its
first fiscal period will be apparent from the facts set out
below. The principal issue in this appeal is whether the
Appellant was a "non-resident-owned investment
corporation" (within the meaning of section 133 of the
Income Tax Act) in its 1996 taxation year. A
non-resident-owned investment corporation is commonly referred to
as an "NRO" in all Canadian tax literature, and I will
use that abbreviation herein. The second issue is whether the
Appellant received in 1996 or was required to include in its 1996
income a particular dividend in the amount of $5,647,775. The
only taxation year under appeal is 1996.
The Facts
[2] Banner Pharmacaps
Inc. (hereafter "Banner USA") is incorporated under the
laws of Delaware, one of the states in the U.S.A. Banner USA
carries on the business of manufacturing soft gelatin capsules in
bulk for the pharmaceutical and nutritional industries. Banner
Gelatin Products (Canada) Ltd. (hereafter "Banner
Canada") is incorporated under the Canada Business
Corporations Act and carries on business at Olds, Alberta
about 100 kilometres north of Calgary. Banner Canada carries on
the same kind of business as Banner USA. Prior to 1996, all the
issued shares of Banner Canada were owned by Banner USA. At all
relevant times, all of the issued shares of Banner USA were owned
by Sobel Inc. (an American corporation) and all of the issued
shares of Sobel Inc. were owned by Sobel NV (a Netherlands
corporation).
[3] Banner Canada has
carried on business since around 1982. By the end of 1995, Banner
Canada had retained earnings of approximately $5.6 million. In
1995, a decision was made to insert an NRO between Banner Canada
and Banner USA. As stated above, the Appellant was incorporated
in January 1996. The Appellant was the intended NRO. The theory
of an NRO was explained as follows in a letter dated September 7,
1994 (Exhibit 20) from BDO Dunwoody, the outside auditors of
Banner Canada:
(i) Banner
Canada controlled by a non-resident was taxed in Canada at
corporate rates of 45-50%.
(ii) Interest
paid on borrowed money by Banner Canada to an NRO would be
deductible in computing income and would result in an outright
saving at general corporate rates (45-50%) in the hands of
Banner Canada.
(iii) Interest
received by an NRO on money loaned to Banner Canada would be
taxed in Canada at a rate of only 25%.
(iv) A dividend paid
by an NRO to its non-resident parent would trigger an
"allowable refund" to the NRO. In general terms, an
allowable refund is 25% of the amount of the dividend paid; and
such refund is remitted to the NRO by Revenue Canada. In other
words, if the amount of interest received by an NRO from Banner
Canada were flowed through to its non-resident parent by
way of a dividend, that dividend would trigger an allowable
refund to the NRO from Revenue Canada equal in amount to the tax
which the NRO was liable to pay on receipt of the interest from
Banner Canada.
(v) There would be
withholding tax in Canada of about 10% (subject to the terms of
the Canada-U.S. Income Tax Convention) on the dividend
paid by the NRO to its non-resident parent.
[4] The concept of an
NRO has been part of the income tax law in Canada for more than
50 years. Apparently, it was first introduced as a vehicle to
encourage non-residents to invest capital in Canada. Attitudes
change, however, and the federal budget of February 2000
announced the phasing out of all NROs.
[5] By an agreement
in writing made as of February 14, 1996 (Exhibit 1), Banner USA
agreed to sell to the Appellant all of the issued shares of
Banner Canada at a price of $8,700,000. The Appellant satisfied
the purchase price by delivering to Banner USA 2,979,737 fully
paid common voting shares of the Appellant. The balance sheet
included in the Appellant's 1996 income tax return (Exhibit
22) shows that its share capital at December 31, 1996 was
$2,979,737. Exhibits 2, 3, 4, 5, 6, 7 and 8 are corporate
documents confirming that on February 14, 1996, Banner Canada
became a wholly-owned subsidiary of the Appellant, and the
Appellant became a wholly-owned subsidiary of Banner USA.
[6] On February 15,
1996, the day following the Appellant's acquisition of Banner
Canada, there were two significant commercial transactions.
First, Banner Canada reduced the stated capital of its shares by
the amount $852,225. And second, Banner Canada declared a
dividend in the amount $5,647,775. The aggregate of those two
amounts is $6,500,000. Exhibit 10 is the resolution of the sole
shareholder of Banner Canada reducing the stated capital and
declaring the dividend. Set out below are the operative parts of
the shareholder resolution:
1. RESOLVED THAT
the Corporation reduce the stated capital of its shares by the
amount of $852,225 by distributing $852,225 to the holders of
record of its shares on the date hereof, payment of such
distribution to be made by the issuance of a demand promissory
note which shall bear interest until paid at the prime rate of
the Toronto-Dominion Bank plus 1% per annum;
2. RESOLVED THAT
there is hereby declared on the shares of the Corporation a
dividend to be payable to the holders of record of the shares of
the Corporation on the date hereof, such dividend to be in the
aggregate amount of $5,647,775 and to be payable by the
Corporation by the issuance of a demand promissory note which
shall bear interest until paid at the prime rate of The
Toronto-Dominion Bank plus 1% per annum;
3. RESOLVED THAT
the foregoing resolutions are passed on the basis that the
undersigned is reasonably satisfied that after giving effect to
each of the foregoing resolutions the Corporation will be able to
pay its liabilities as they come due and the net realizable value
of the assets of the Corporation will exceed the liabilities of
the Corporation and the stated capital of all of the shares of
the Corporation; and
4. RESOLVED THAT
in connection with the foregoing transactions, any officer of the
Corporation is authorized to take such action and to execute and
deliver for and on behalf of the Corporation (and under corporate
seal or otherwise) such agreements, documents and instruments as
such officer deems appropriate to give effect to the foregoing
resolutions.
[7] Exhibit 12 is a
copy of the demand promissory note dated February 15, 1996 in the
amount of $852,225 issued by Banner Canada with the following
operative words:
FOR VALUE RECEIVED, Banner Gelatin Products (Canada) Ltd. (the
"Corporation") hereby promises to pay on demand to
Banner Pharmacaps NRO Ltd. the principal amount of Eight Hundred
and Fifty-Two Thousand Two Hundred Twenty-Five Dollars ($852,225)
and to pay interest thereon at a rate equal to the prime rate
announced from time to time by the Toronto Dominion Bank plus one
percent (1%) per annum with interest to be payable annually on
the last business day of each year. Such indebtedness shall be
prepayable by the Corporation at any time without premium.
Exhibit 13 is a copy of the demand promissory
note dated February 15, 1996 in the amount of $5,647,775 issued
by Banner Canada with the following operative words:
FOR VALUE RECEIVED, Banner Gelatin Products (Canada) Ltd. (the
"Corporation") hereby promises to pay on demand to
Banner Pharmacaps NRO Ltd. the principal amount of Five Million
Six Hundred Forty-Seven Thousand Seven Hundred Seventy-Five
Dollars ($5,647,775) and to pay interest thereon at a rate equal
to the prime rate announced from time to time by the Toronto
Dominion Bank plus one percent (1%) per annum with interest to be
payable annually on the last business day of each year. Such
indebtedness shall be prepayable by the Corporation at any time
without premium.
[8] Exhibit 15 is a
copy of the letter dated March 22, 1996 from BDO Dunwoody to
Revenue Canada with respect to the Appellant electing to be an
NRO. The first paragraph of the letter states:
Re: Banner Pharmacaps NRO Ltd.
("Corporation")
Pursuant to the provisions of Section 500 of
the Income Tax Regulations ("the Regulations")
to the Canadian Income Tax Act ("the
Act"), this letter is to advise you that the
Corporation elects to be taxed under Section 133 as a
Non-Resident Owned Investment Corporation ("NRO").
Exhibit 16 is a copy of the letter dated July
16, 1996 from Revenue Canada to the Appellant confirming that the
election to be an NRO was valid. Because it is short, I will set
out all of Exhibit 16:
RE:
Election to be Taxed as a Non-Resident-Owned Investment
Corporation (Section 133 of the Income Tax Act)
Please be advised that based on a review of
the documentation submitted in support of the above election, the
election is considered to be valid.
If you have any questions about this letter,
please contact Joan Hampl at 691-8674.
"Signature"
Exhibits 17 and 18 are letters dated June 12
and July 9, 1996, respectively, between Revenue Canada and the
Appellant with respect to further information requested to
complete the Appellant's election to be an NRO.
[9] The
Appellant's financial statements for the year ended December
31, 1996 are Exhibit 27 and they disclose the following
information:
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(i)
Revenue - Dividends
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$5,647,775
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(ii)
Retained earnings
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5,647,775
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(iii) Assets-
Loan receivable
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6,500,000
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(iv) Assets -
Investment
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2,127,512
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The revenue and retained earnings are the
precise same amount as the dividend declared on February 15, 1996
by Banner Canada. The loan receivable is the aggregate of the two
demand promissory notes described in paragraph 7 above. And the
investment of $2,127,512 is the original share capital of Banner
Canada ($2,979,737) less the reduction in stated capital
($852,225) effected on February 15, 1996.
[10] Mr. Reynolds, the
first witness for the Appellant, explained Exhibits 28, 29 and
30. Exhibit 28 is the general ledger postings for Banner Canada
which showed the reduction of the stated capital ($852,225), the
payment of the dividend ($5,647,775), and the issuing of the
promissory notes in the aggregate amount of $6,500,000. Exhibit
29 comprises seven pages of the Appellant's accounting
records. The first page of Exhibit 29 shows that the Appellant
first accrued interest receivable with respect to the promissory
notes of $6,500,000 in October 1996 when interest of $269,126 was
recorded to the end of September. Thereafter, interest was
accrued each month as follows:
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October
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$31,431.51
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November
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29,071.92
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December
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28,671.23
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[11] At December 31, 1996,
the Appellant had accrued interest receivable of $358,301.38. The
fourth page of Exhibit 29 shows that the Appellant accrued
interest of $28,671.23 in each of January and February 1997 but
the aggregate of those two amounts ($57,342.46) was reversed in
March, probably around the time when BDO Dunwoody began to
question the NRO status of the Appellant. That same fourth page
of Exhibit 29 shows that in May 1997, the Appellant reversed the
entire amount of interest receivable ($358,301.38) which had been
accrued to December 31, 1996.
[12] Exhibit 30 comprises
six pages of accounting records for Banner Canada. In effect,
Exhibit 30 shows the other side of the transactions in Exhibit
29. Whereas in Exhibit 29 the Appellant was accruing interest
receivable on the promissory noted in late 1996 and then
reversing that interest receivable in May 1997, Banner
Canada in Exhibit 30 was accruing interest payable on the
promissory notes in late 1996 and then reversing that interest
payable in May 1997. In particular, the sixth page of
Exhibit 30 shows the journal entry where interest payable of
$358,301.38 is reversed in May 1997.
[13] The Appellant's
financial statements for the year ending December 31, 1996
(Exhibit 27) and the accounting records of the Appellant and
Banner Canada in Exhibits 28, 29 and 30 prove that Banner
Canada's reduction of stated capital ($852,225) and
declaration of dividend ($5,647,775) were real transactions.
Those transactions were accepted by the Appellant and Banner
Canada and recorded in their respective books and records.
[14] In early 1997, the
person at BDO Dunwoody (Mr. Butalia) who was advising Banner
Canada and the Appellant became concerned that the Appellant
would not qualify as an NRO. Specifically, Mr. Butalia was
involved in negotiations with Revenue Canada on behalf of another
client; and Revenue Canada was taking the position (i) that the
provision of even one loan by the NRO would be considered as the
business of making loans; and (ii) that the loan-making
corporation would be denied NRO status. Mr. Butalia communicated
his concerns to the Banner group of companies by memorandum dated
April 25, 1997 (Exhibit 21). In that memorandum, Mr. Butalia
recommended that the Appellant not be used as an NRO.
[15] Mr. Butalia's
recommendation was accepted and followed by the Banner group of
companies. When the Appellant filed its 1996 income tax return
(Exhibit 22) in May 1997, it filed as an ordinary corporation and
not as an NRO. It was in the same month (May 1997) that the
Appellant reversed its interest receivable with respect to 1996,
and Banner Canada reversed its interest payable with respect to
1996 as described in paragraphs 11 and 12 above. When filing as
an ordinary corporation (not as an NRO), the Appellant relied on
section 112 of the Act to deduct in computing taxable
income the amount of $5,647,775 which it had included in income
as a dividend received from Banner Canada. Accordingly, the
Appellant reported nil taxable income in its 1996 income tax
return.
[16] Although the Appellant
filed its 1996 income tax return as an ordinary corporation and
not as an NRO, the Minister of National Revenue issued a Notice
of Reassessment dated February 7, 2000 (Exhibit 23) adopting the
position that the Appellant was an NRO with respect to its 1996
taxation year. The Appellant objected to the Reassessment but the
Minister confirmed his position (Exhibit 25) that the Appellant
was an NRO for 1996. The consequences of the reassessment are
significant to the Appellant because, under
subsection 133(2) of the Act, an NRO may not deduct
in computing taxable income any amount received as a dividend
from a Canadian corporation. An NRO does not enjoy the benefit of
tax-free intercorporate dividends under section 112 of the
Act. The Notice of Reassessment showed Part I tax payable
in the amount of $1,411,943.75.
Analysis
[17] As stated above, the
principal issue in this case is whether the Appellant was an NRO
in its 1996 taxation year. An NRO is defined as follows in
subsection 133(8):
133(8) In this section,
"non-resident-owned investment corporation"
means a corporation incorporated in Canada that, throughout the
whole of the period commencing on the later of June 18, 1971 and
the day on which it was incorporated and ending on the last day
of the taxation year in respect of which the expression is being
applied, complied with the following conditions:
(a) all of its
issued shares and all of its bonds, debentures and other funded
indebtedness were
(i) beneficially
owned by non-resident persons (other than any foreign affiliate
of a taxpayer resident in Canada),
(ii) owned by trustees
for the benefit of non-resident persons or their unborn issue,
or
(iii)
owned by a non-resident-owned investment corporation, all of the
issued shares of which and all of the bonds, debentures and other
funded indebtedness of which were beneficially owned by
non-resident persons or owned by trustees for the benefit of
non-resident persons or their unborn issue or by two or more such
corporations;
(b) its income
for each taxation year ending in the period was derived from
(i) ownership of
or trading or dealing in bonds, shares, debentures, mortgages,
bills, notes or other similar property or any interest
therein,
(ii) lending money with
or without security,
(iii)
rents, hire of chattels, charterparty fees or remunerations,
annuities, royalties, interest or dividends,
(iv)
estates or trusts, or
(v)
disposition of capital property;
(c) not more
than 10% of its gross revenue for each taxation year ending in
the period was derived from rents, hire of chattels, charterparty
fees or charterparty remunerations;
(d) its
principal business in each taxation year ending in the period was
not
(i) the making of
loans, or
(ii) trading or dealing
in bonds, shares, debentures, mortgages, bills, notes or other
similar property or any interest therein;
(e) it has, not
later than 90 days after the commencement of its first taxation
year commencing after 1971 elected in prescribed manner to be
taxed under this section; and
(f) it has not,
before the end of the last taxation year in the period, revoked
in prescribed manner the election so made by it;
except that in no case shall a new
corporation (within the meaning assigned by section 87) formed as
a result of an amalgamation after June 18, 1971 of two or more
predecessor corporations be regarded as a non-resident-owned
investment corporation unless each of the predecessor
corporations was, immediately before the amalgamation, a
non-resident-owned investment corporation;
[18] There is unequivocal
evidence that five of the six conditions in the definition of NRO
were satisfied in 1996. I will summarize the evidence with
respect to those conditions in the same order as they appear in
the statute:
(a) All of the
Appellant's issued shares were beneficially owned by Banner
USA, a non-resident, from incorporation to the end of December
1996.
(b)(iii) All of the
Appellant's income for 1996 was derived from interest or
dividends.
(c) No
part of the Appellant's gross revenue for 1996 was derived
from restricted sources.
(d) In
dispute!
(e)
Exhibits 15 and 16 prove that the Appellant elected to be an NRO
on March 22, 1996; and the election was accepted as valid by
Revenue Canada. See paragraph 8 above.
(f)
There is no evidence that the Appellant ever revoked its election
to be an NRO. Mr. Butalia stated that it was not necessary to
revoke the election because, in his view, the Appellant was
disqualified from being an NRO for 1996 because its principal
business in that year was the making of loans - contravening
condition (d).
[19] Regulation 500
describes the manner in which a corporation may elect to be an
NRO and the manner in which a corporation may revoke a prior
election.
500 Any election by a corporation to
be taxed under section 133 of the Act shall be made
by forwarding by registered mail to the Director-Taxation at the
District Office of the Department of National Revenue, Taxation
that serves the area in which the head office of the corporation
is located the following documents:
(a) a letter
stating that the corporation elects to be taxed under the said
section 133;
(b) a
certified copy of the resolution of the directors of the
corporation authorizing the election to be made; and
(c) a
certified list showing
(i) the names
and addresses of the registered shareholders and the number of
shares of each class held by each,
(ii) the names and
addresses of the holders of the corporation's bonds,
debentures, or other funded indebtedness, if any, and
(iii) the names and
addresses of the beneficial owners of shares, bonds, debentures,
or other funded indebtedness in cases where the registered
shareholders or holders, as the case may be, are not the
beneficial owners.
501 Any election to be taxed
under section 133 of the Act shall be revoked by a
corporation by forwarding by registered mail to the Deputy
Minister of National Revenue for Taxation at Ottawa the following
documents in duplicate:
(a) a letter
stating that the corporation revokes its election; and
(b) a
certified copy of the resolution of the directors of the
corporation authorizing the election to be revoked.
The requirement to produce a certified copy
of the authorizing directors' resolution to elect or to
revoke indicates that those decisions are serious matters.
[20] The principal issue in
this case may be reduced to the basic question arising from the
fourth condition in the definition of an NRO: was the
Appellant's principal business in 1996 the making of loans?
Counsel for the Appellant argued strongly in the affirmative that
the making of loans was the Appellant's principal business in
1996. For the reasons which follow, I do not accept the
Appellant's argument. In a nutshell, my conclusions are that
(i) the Appellant did not make any loans in 1996; (ii) if the
Appellant made one or more loans in 1996, such loans were not
made as part of any business; and (iii) the Appellant did not
have any business in 1996 and, accordingly, the Appellant could
not have had a principal business in 1996. I will explain how I
reach these conclusions.
[21] Did the Appellant make
any loans in 1996? Appellant's counsel referred to the
definition of "loan" in Black's Law
Dictionary, sixth edition:
Loan. A lending. Delivery by one
party to and receipt by another party of sum of money upon
agreement, express or implied, to repay it with or without
interest. ... Anything furnished for temporary use to a
person at his request, on condition that it shall be returned, or
its equivalent in kind, with or without compensation for its use.
...
In Bradley v. The Queen, 96 DTC 2040,
I referred to the following definition of "loan" at
page 2043:
A "loan" is a contract by which one
delivers a sum of money to another and the latter agrees to
return at a future time a sum equivalent to that which he
borrows.
A "loan" within the law of usury is
the delivery of a sum of money to another under a contract to
return at some future time an equivalent amount with or without
an additional sum agreed upon for its use.
To constitute a "loan", there must
be an express or implied agreement whereby one person advances
money to another, who agrees to repay it on such terms as to time
and rate of interest, or without interest, as parties may agree.
Words and Phrases, Permanent Edition, Volume 25A, Page
79.
The above definitions refer to a
"delivery" or "advance" of money. The
Appellant never had any money in 1996 to deliver or advance. The
Appellant received two promissory notes from Banner Canada but
those notes were only evidence of Banner Canada's liabilities
to the Appellant with respect to a reduction of stated capital
($852,225) not yet distributed to the shareholder, and a dividend
($5,647,775) not yet paid to the shareholder.
[22] Both counsel referred
to the decision of the Supreme Court of Canada in T.E. McCool
Limited v. M.N.R., 49 DTC 700. In that case, Mr. McCool sold
certain assets to his company and, as consideration for the
assets, the company assumed Mr. McCool's business
liabilities; paid a small amount of cash; issued 600 fully paid
shares; and delivered a promissory note for $123,097. One of the
issues before the Court was whether the company could deduct
interest on the promissory note. The relevant section of the
Income War Tax Act stated:
5(1)
"Income" as hereinbefore defined shall for the purpose
of this Act be subject to the following exemptions and
deductions: --
...
(b) Such
reasonable rate of interest on borrowed capital used in the
business to earn the income as the Minister in his discretion may
allow ...
All five judges who heard the McCool
case agreed that interest on the promissory note was not
deductible. Estey J. stated at page 708:
Terms such as "borrowed capital",
"borrowed money" in tax legislation have been
interpreted to mean capital or money borrowed with a relationship
of lender and borrower between the parties. Inland Revenue
Commissioners v. Port of London Authority, [1923] A.C. 507;
Inland Revenue Commissioners v. Rowntree & Co. Ltd.,
[1948] 1 All E.R. 482; Dupuis Frères Ltd. v. Minister
of Customs and Excise, [1927] Ex. C.R. 207. It is necessary
in determining whether that relationship exists to ascertain the
true nature and character of the transaction. In this case the
promissory note arises out of an exchange in which, as already
detailed, the purchase price was paid by assuming outstanding
obligations, a small payment of cash, allotment of capital stock
and the execution and delivering of this promissory note. Under
such circumstances it cannot be held that the relationship
of lender and borrower in respect to this note exists between the
respondent company and the payee of the note.
Along the same line of thought, Kellock J.
stated at page 712:
In the second appeal the company claims that
the interest paid on the note given to McCool for the balance of
the purchase price of the assets acquired by the company should
be allowed as an operating expense on the ground that the note
represents borrowed capital used in the business to earn the
income within the meaning of section 5(1)(b) of the
statute. This claim was disallowed by the Minister and the
company's appeal was dismissed by the learned trial judge, on
the ground that in order to qualify under the statute the
taxpayer would have to be in the position of a borrower and some
other person would have to be a lender, while in fact there was
no such relationship as between the company and McCool. I agree
with the learned trial judge that the company cannot bring itself
within the language used in section 5(1)(b). To employ the
language of Viscount Finlay in Commissioners of Inland Revenue
v. Port of London Authority, [1923] A.C., 507 at 514, in
order to enable the statute to apply, "there must be a real
loan and a real borrowing". Here there is nothing more than
unpaid purchase money secured by a promissory note which, in my
opinion, is insufficient. ...
[23] Mr. Reynolds, the
Appellant's first witness, stated that Banner Canada
delivered promissory notes to the Appellant because it did not
have the funds to pay the dividend of $5,647,775 or to distribute
the reduction in stated capital of $852,225. After the promissory
notes were delivered, there was a real liability owing by Banner
Canada to the Appellant. The books and records of both companies
recorded that liability. The Appellant's balance sheet
(Exhibit 27) erroneously shows Banner Canada's liability as a
"loan receivable". There was no "loan
receivable". There was a creditor/debtor relationship
between the Appellant and Banner Canada but it was not the result
of any lending or borrowing. The creditor/debtor relationship was
the result of Banner Canada's inability to pay the dividend
or distribute the reduction in stated capital.
[24] When a purchaser does
not have enough funds to pay the purchase price for certain
property but delivers to the vendor a promissory note for all or
part of the purchase price, the purchaser has become a debtor of
the vendor but the purchaser has not borrowed any money from the
vendor; nor has the vendor loaned any money to the purchaser.
That is the principle of the McCool case. By parallel
reasoning, if a corporation like Banner Canada declares a
dividend and does not have enough funds to pay the dividend but
delivers to its sole shareholder a promissory note, the
corporation has become a debtor of its sole shareholder but the
corporation has not borrowed any money from its shareholder; nor
has the shareholder loaned any money to the corporation.
[25] A recent decision of
the Federal Court of Appeal applies the principle of
McCool in circumstances similar to the facts herein. In
Parthenon Investments Ltd. v. M.N.R., 97 DTC 5343, the
corporate taxpayer declared a dividend payable to its parent
corporation; and "paid" the dividend by delivering an
interest-bearing promissory note. The corporate taxpayer deducted
the interest on the note when computing income but the Minister
disallowed the deduction. The corporate taxpayer had to come
within the terms of paragraph 20(1)(c) of the Act
which permits the deduction of interest owed on "borrowed
money". The Federal Court of Appeal cited McCool and
held against the corporate taxpayer. MacGuigan J.A. stated at
page 5344:
We are all agreed that the learned Tax Court
Judge was right in holding that the appellant did not borrow
money on which it could deduct interest as required by subpar.
20(1)(c)(i) of the Act. In the words of Locke, J.
(sic) in Minister of National Revenue v. T.E. McCool
Limited (1949), 49 DTC 700, 712, in interpreting the same
provisions, "in order to qualify under the statute the
taxpayer would have to be in the position of a borrower and some
other person would have to be a lender." More recently,
Stone J.A. has made the same point for this Court in The Queen
v. MerBan Capital Corporation Limited (1989), 89 DTC
5404, 5413:
What is fatal to the Respondents' case in
my view is that paragraph 20(1)(c) requires that for
interest to be deductible it must be paid pursuant to money
borrowed by the taxpayer and not by someone else. The taxpayer
must have created a borrower-lender relationship which gives rise
to interest being paid.
[26] The Appellant relies
on the 1950 decision of the Tax Appeal Board in Modern Dairies
Ltd. v. M.N.R., 50 DTC 442. The corporate taxpayer declared a
dividend and Mr. S. (one of its shareholders) was thereby
entitled to receive $60,935. When the dividend was declared, Mr.
S. and the corporation agreed that he would loan $60,000 to the
corporation with interest at 4½% per annum. The
corporation deducted in 1947 the interest which it paid to Mr. S.
with respect to the $60,000 loan. In my view, Modern
Dairies is distinguished by the contemporaneous agreement to
lend almost the whole amount of the dividend back to the
corporation at a rate of 4½% per annum. The chairman of
the Tax Appeal Board referred to the then recent decision of the
Supreme Court in McCool but he allowed the appeal and did
not follow McCool. If the decision in Modern
Dairies is not distinguished by the contemporaneous loan
agreement, I question whether it is good law having regard to
McCool and Parthenon.
[27] The Appellant also
relies on the 1951 decision of the Tax Appeal Board in Boyles
Bros. Drilling Company Ltd. v. M.N.R., 51 DTC 70. After
declaring a dividend, the corporate taxpayer wrote to each
shareholder asking if the shareholder would lend his
proportionate share of the dividend to the corporation for five
years with interest at 5% per annum. The corporation deducted the
various amounts of interest but the Minister disallowed the
deductions. In its decision, the Board referred to McCool
but followed Modern Dairies and allowed the appeal. Again,
I view the positive loan agreements between the corporation and
its shareholders as distinguishing Boyles Bros. from the
Appellant's circumstances but, even if I should be wrong, I
question whether Boyles Bros. is good law. McCool
and Parthenon are strong authorities against the Appellant
on this primary issue.
[28] Having regard to all
of the documentary exhibits, there is no objective evidence of
any intention on the part of the Appellant or Banner Canada to
regard either the $852,225 or the $5,647,775 as loans. The
closing agenda (Exhibit 19) does not refer to any loan
transaction. The resolution of Banner Canada directors (Exhibit
10) does not refer to borrowing or lending. And the internal
accounting records of the Appellant and Banner Canada (Exhibits
28, 29 and 30) do not refer to loans. Those accounting records
do, however, refer to "note".
[29] Relying on what I
perceive to be the principle of law established in McCool
and Parthenon, I conclude that the Appellant did not make
any loans to any person in 1996. If I should be wrong, and if it
could be held in law that the Appellant did lend money to Banner
Canada in 1996, was the Appellant in the business of making loans
in 1996? When considering this question, it may be helpful to
review the decision of the Supreme Court of Canada in Canadian
Marconi Company v. The Queen, 86 DTC 6526. When
distinguishing between income from business and income from
property, Wilson J. stated at pages 6529-6530:
... It is trite law that the
characterization of income as income from a business or income
from property must be made from an examination of the
taxpayer's whole course of conduct viewed in the light of
surrounding circumstances: see Cragg v. Minister of National
Revenue, [1952] Ex. C.R. 40, [52 DTC 1004], per Thorson P. at
p. 46. In following this method courts have examined the number
of transactions, their volume, their frequency, the turnover of
the investments and the nature of the investments themselves.
...
[30] When trying to decide
if the Appellant was in any business in 1996, I would observe
that the Appellant did not initiate any transactions on its own.
The Appellant was the passive recipient of two promissory notes
which resulted from two transactions of Banner Canada. It is
difficult to examine the number, volume or frequency of
transactions when there are none at all to examine. Apart from
acquiring all of the issued shares of Banner Canada which was the
sole reason for its incorporation, the Appellant was totally
passive in 1996. I have no hesitation in concluding that the
Appellant did not engage in any business in 1996. Therefore, it
could not have as its principal business "the making of
loans" when it did not have any business at all. I reach
this conclusion fully cognizant of the broad meaning given to the
word "business" in section 248 of the Act.
[31] The Appellant cannot
succeed on the principal issue. It was an NRO at all relevant
times in 1996. It elected to be an NRO. It did not revoke its
election. And it did not engage in any transaction or
transactions which would have disqualified it from remaining an
NRO throughout 1996.
Did the Appellant receive in 1996 a
dividend of $5,647,775?
[32] On the second issue,
the Appellant argues that, if it was an NRO in 1996, then the
dividend of $5,647,775 was not received and, therefore, no part
of the dividend should be included in the Appellant's income
for 1996. I find no merit in this argument.
[33] Considering the
content of the Appellant's T2 corporate income tax return for
1996 (see Exhibit 22), the Appellant certainly regarded itself as
having received a dividend in the amount of $5,647,775. On the
list of Information Schedules, the Appellant answered
"Yes" to item no. 57: "Has the corporation
received any dividends or paid any taxable dividends for purposes
of the dividend refund?" And in the box segregated for
"Taxable income and base amount of Part I Tax",
the Appellant showed $5,647,775 as "Taxable dividends
deductible under section 112 or 113, or both (item 57)".
[34] Although neither
counsel argued the contrast between the "cash method"
and "accrued method" of accounting, and there was no
expert evidence on generally accepted accounting principles
("GAAP"), it seems to me that the Appellant cannot
succeed on the second issue unless it claims that it is entitled
to adopt the cash method of accounting. After declaring the
dividend, Banner Canada did not pay the dividend by cheque, money
order or other means of transferring cash. Quite the contrary.
The resolution declaring the dividend (Exhibit 10) provides
" ... such dividend ... to be payable by the
Corporation by the issuance of a demand promissory note ...
". A promissory note is, of course, not payment but only a
promise to pay and, therefore, evidence of a debt or
obligation.
[35] Notwithstanding the
absence of any payment, the Appellant recorded the dividend in
its books of account as if the dividend had been paid. In its
1996 financial statements (Exhibit 27), the Appellant shows
revenue ("Dividends") of $5,647,775 (the precise amount
of the dividend from Banner Canada) and retained earnings of the
same amount described as "Net income for the year,
representing retained earnings, end of year". The balance
sheet shows a receivable of $6,500,000 which is the aggregate of
the two promissory notes representing the dividend ($5,647,775)
plus the reduction in stated capital ($852,225). The receivable
of $6,500,000 is an important component of the Appellant's
balance sheet at December 31, 1996 permitting its assets to be in
balance with its liabilities and shareholder equity.
[36] The financial
statements (Exhibit 27) are a clear indication that the Appellant
in fact adopted the accrual method of accounting and not the cash
method. The Appellant may not have had any choice. I question
whether any corporation is permitted to adopt the cash method of
accounting if it is part of a corporate group having transactions
with one or more other corporations in the group which carry on
an active business. The circumstances in this appeal are on
point. Banner Canada carries on an active business. The
Appellant, its parent company, carries on no business. Exhibits
28, 29 and 30 are accounting records of the Appellant and Banner
Canada recording the payment of the dividend, the reduction in
Banner Canada's stated capital, the issuance of the
promissory notes, and the accrual (and later reversal) of
interest on the notes. Having regard to these intercorporate
transactions, in order to be consistent, the books and records of
the Appellant would have to be a mirror image of the books and
records of Banner Canada.
[37] In an old case, Ken
Steeves Sales Ltd v. M.N.R., 55 DTC 1044, the Exchequer Court
held that, when determining the profit or loss of a business, the
cash method of accounting is not permissible under the
Act. Cameron J. stated at page 1050:
For these reasons I must reach the conclusion
that the "Cash Receipts and Expenditure" method
purported to have been used by the appellant in this case is a
method which is not permissible under the Act. I say that
because of the fact that it excludes as an item of income all
receivables, which in my opinion form a necessary part of any
trader's profit and loss statement. Such a method is
incomplete and misleading and one which fails entirely to show
the true state of a taxpayer's position or to reflect his
true profit or loss. ...
I am not aware of any subsequent case which
has diminished the effect of Ken Steeves Sales.
[38] There is an underlying
assumption in the Income Tax Act that income from business
or property will be determined by the accrual method of
accounting. Many examples support that underlying assumption.
When computing income:
-
paragraph 12(1)(b) requires receivables to be
included;
-
paragraph 18(1)(a) permits the deduction of expenses
incurred; and
-
paragraph 20(1)(l) permits the deduction of a reserve for
doubtful debts.
In section 28, there is explicit permission
to use the "cash method" to compute income from farming
and fishing. Without such explicit permission, it appears to me
that farmers and fishermen would be required to use the accrual
method of accounting.
[39] In my opinion, the
Appellant has no choice. It must adopt the accrual method of
accounting. It cannot adopt the cash method. It must include in
its income for 1996 the amount of the dividend represented by the
promissory note for $5,647,775. The appeal is dismissed, with
costs.
Signed at Ottawa, Canada, this 26th day of
February, 2003.
J.T.C.C.
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