Holotnak v. The Queen, 87 DTC 5443, [1987] 2 CTC 217 (FCTD), aff'd 89 DTC 5527 (FCA)

Cullen, J.:—This is an appeal by way of a statement of claim from a decision of the Tax Court of Canada dated January 5, 1986, which allowed in part the plaintiff's appeal from notices of reassessment issued by the Minister of National Revenue (M.N.R.) in respect of the plaintiff's 1980 and 1981 tax years.

The Tax Court allowed 50 per cent of the air fare the plaintiff claimed as an expense in his 1980 tax year and the car rentals claimed as an expense in the 1981 tax year. (This part of the decision is not being appealed.) However, the Tax Court disallowed:

(1) the mortgage interest expense in the amounts of $1,649.23 and $2,164.61 claimed by the plaintiff in his 1980 and 1981 tax years; and

(2) the amount of $3,427 in respect of supplies claimed as an expense by the plaintiff in his 1981 tax year.

The items disallowed are the subject of this appeal.

Facts

The plaintiff was employed as a personnel director at the Alberta Children's Hospital and carried on business in the name of "The Storybook Store". The plaintiff also has rental property located at 622 Edmonton Trail NE in Calgary subsequently referred to as the "rental property". On January 9, 1980, the plaintiff paid off the amount outstanding on the second mortgage on his rental property, from his own savings.

On March 24, 1980 the plaintiff obtained a loan in the amount of $12,740 from the Tuxedo Savings Credit Union. In order to do this the plaintiff mortgaged his rental property by placing another second mortgage on this rental property in the amount of $12,740. According to the plaintiff, the proceeds of the second mortgage were allocated in the following manner: $7,657.92 for the rental property and $5,082.08 for the principal residence.

The defendant contends that the proceeds of the second mortgage on the rental property were used by the plaintiff to buy his principal residence.

In calculating his income for the 1980 and 1981 taxation years, the plaintiff claimed $1,649.23 and $2,164.61 respectively as interest costs.

On September 26 and 27, 1981, the plaintiff's enterprise, "The Storybook Store" was the sponsor of a Children’s Folk Festival in Calgary. The plaintiff indicated. that the income from the sale of tickets to the Children’s Folk Festival was included in the sales income for "The Storybook Store".

In calculating his income for 1981 the plaintiff claimed $15,859 on account of "materials and supplies’ of which $12,431.82 was documented. The remaining $3,427.46 claimed as supplies was not documented (no records or receipts, i.e., the amount was unvouchered in that the "receipt" was handwritten by the plaintiff). The plaintiff maintains that this amount was the cost of the production of the Children’s Folk Festival.

The M.N.R. reassessed the plaintiff in respect of his 1980 and 1981 taxation years and disallowed the interest cost claimed by the plaintiff in 1980 and 1981 tax years, as well as the $3,427.46 claimed as a deduction on account of “supplies, materials" in his 1981 tax year. The notices were dated July 22, 1983 and November 4, 1983.

The plaintiff filed a notice of objection. He appealed the reassessments to the Tax Court of Canada. With respect to the matters before me, the plaintiff argued that the interest was a deductible expense, although the plaintiff noted only that percentage (60 per cent) attributed to rental property should have been deducted. The plaintiff also maintained that the unvouchered amount of $3,427.46 was part of the cost of the production of the Children's Folk Festival and was a deductible expense.

Decision of the Tax Court

As indicated earlier, the Tax Court allowed 50 per cent of the air fare claimed as an expense in his 1980 tax year and car rentals claimed as an expense in the plaintiff's 1981 tax year but disallowed the interest expense claimed by the plaintiff in his 1980 and 1981 tax years, as well as the undocumented amount of $3,427.46 in respect of supplies claimed as an expense in his 1981 tax year.

Plaintiff's Position

The plaintiff is arguing that only a portion of the second mortgage on his rental property ($5,082.08 or approximately 40 per cent) was used to purchase his principal residence and therefore the remaining portion (60 per cent) related to his rental property and was used to produce business income. Accordingly, the equivalent percentage (60 per cent of $1,649.23 =

$991.35 and 60 per cent of $2,164.61 $1,301.15) on the interest was in respect of business rental income and therefore considered an allowable deduction. The plaintiff relies on subparagraph 20(1)(c)(i) of the Income Tax Act.

The plaintiff indicates that the expenses in the amount of $3,427.46 represent the cost of producing "a Children's Folk Festival” and is the missing "unvouchered" documentation. However, the plaintiff still claims that this amount was a business expense in that it was used to produce income for "The Storybook Store". On cross-examination he conceded that his records were in disarray and when asked, "are they (i.e. unvouchered expenses) in fact related to record sales?” he replied, "they could be related to anything”. Incidentally, the plaintiff calculated his own returns and does admit to making many errors. The plaintiff relies on sections 20 and 67 of the Act.

Defendant's Position

The defendant maintains that the M.N.R. properly reassessed the plaintiff in respect of the amounts claimed as interest costs ($1,649.23 and $2,164.61) for the 1980 and 1981 tax years. The defendant argues that these amounts (or any portion thereof) were not paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property, nor were they paid (including any portion thereof) in respect of a legal obligation to pay interest on an amount payable for property acquired for the purpose of gaining or producing income from a business (per paragraph 20(1)(c) of the Act). Instead, they are personal or living expenses per paragraph 18(1)(h) of the Act in that the proceeds of the second mortgage were used by the plaintiff to purchase his principal residence. Further, of the amount of $15,859.28 claimed by the plaintiff in his 1981 tax year on account of “supplies, materials", only $12,431.82 was shown to have been made or incurred by the plaintiff for the purpose of gaining or producing income from the plaintiff's business or property and therefore the M.N.R. properly disallowed $3,427.46 as a deduction, per paragraph 18(1 )(a) of the Income Tax Act.

Issues

(1) Whether the plaintiff is entitled to deduct for tax purposes mortgage interest costs in the 1980 and 1981 tax years.

(2) Whether the plaintiff is entitled to deduct for tax purposes an un- vouchered expense in the amount of $3,427.46 on account of supplies.

Relevant Legislation

Sections 20, 67, paragraphs 18(1)(a) and 18(1)(h) of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended.

Discussion

Issue #1 — Interest Deduction: Deductions Permitted in Computing Income from Business or Property

The provisions of paragraphs 18(1)(a) and 18(1)(h), subsection 20(a), and paragraph 20(1)(c) of the Income Tax Act are set out below:

General Limitations

18. (1) in computing the income of a taxpayer from a business or property no deduction shall be made in respect of

General Limitation

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

Personal or Living Expenses

(h) personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals or lodging) incurred by the taxpayer while away from home in the course of carrying on his business;

Deductions Permitted in Computing Income from Business or Property

20. (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: Interest

(c) 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), or

(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;

Purpose

Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. Not all borrowing expenses are deductible . . . Interest on borrowings used for non-income purposes, such as personal consumption or the making of capital gains is similarly non-deductible.

The Queen v. Bronfman Trust, [1987] 1 C.T.C. 117 at 124; 87 D.T.C. 5059 at 5064.

Subparagraph 20(1)(c)(i) of the Act allows a taxpayer to deduct amounts paid in the year or payable, pursuant to a legal obligation, as interest on borrowed money which is used for the purpose of earning income from a business or property of the taxpayer.

Requirements:

Therefore, in order for the amount in question to be deductible under subparagraph 20(1)(c)(i) it must be:

(1) paid or payable pursuant to a legal obligation to pay interest on the borrowed money;

(2) paid in the year or payable in respect of the year (not at issue in this case) ;

(3) used for the purpose of earning income from business or property.

Legal Obligation:

The provision of subparagraph 20(1)(c)(i) requires that there be some type of evidence of a legal obligation to pay interest on the money borrowed, basically an obligation on the part of the borrower and a legally enforceable right to the interest on the part of the creditor (Canada Tax Service, 644, 20-1054).

Money borrowed must be used for the purpose of earning income from a business or property:

For a discussion of the "purpose" test we look to Dickson, C.J.'s comments in the Bronfman case (supra), who notes at page 125 (D.T.C. 5064),

The statutory deduction [referring to subparagraph 20(1)(c)(i) of the Act] thus requires a characterization of the use of the borrowed money as between eligible use of non-exempt income from business or property and a variety of possible ineligible uses.

Dickson, C.J. continues,

The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction.

Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income.

The case law indicates that it is the "current use” instead of the original use of the borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments. The Supreme Court of Canada, in the Bronfman case (supra), affirmed the notion of “current use” and at page 125 (D.T.C. 5064) referred to the Federal Court's decision in Lakeview Gardens Corporation v. M.N.R., [1973] C.T.C. 586; 73 D.T.C. 5437, per Walsh, J., for a correct application of this principle.

Dickson, C.J. continued with a discussion of direct and indirect uses of borrowed money and at page 126 (D.T.C. 5065) states that, “In my view, neither the Income Tax Act nor the weight of judicial authority permits the courts to ignore the direct use to which a taxpayer puts borrowed money." The plaintiff has not convinced me otherwise and basically the plaintiff took out a second mortgage on his rental property to arrange for a loan to purchase his home.

In the reverse situation it has been held that a taxpayer cannot deduct interest paid on the mortgage of his principal residence even if the taxpayer claims the borrowing avoided the need to sell income-producing investments. (see Bronfman (supra), at page 127 (D.T.C. 5066) and Toolsie v. The Queen, [1986] 1 C.T.C. 216; 86 D.T.C. 6117). Dickson, C.J. also notes at page 128 (D.T.C. 5067) of Bronfman the trend in tax cases toward attempting to ascertain the "true commercial and practical nature of the taxpayer's transactions. However, it does not mean that the interest deduction is to lose all its strictures".

The plaintiff admits in Item A-7 of his statement of claim that the total interest costs were claimed in error. The plaintiff contends that the interest cost should be apportioned, as were the proceeds from the second mortgage, between the rental property and the principal residence. In a sense he is arguing a dual purpose in respect of the money borrowed. In Hills v. M.N.R., [1970] Tax A.B.C. 639, a dwelling, of which 75 per cent of the space was occupied by the owner and 25 per cent was rented out, was held, to the extent of 75 per cent, not to have been acquired for the purpose of gaining or producing income from property within the meaning of paragraph 20(1)(c) of the Act, with the result that the disallowance of 75 per cent of the interest paid to finance its purchase was affirmed (quoted from Canada Tax Service 641, 20-1062).

Perhaps in the circumstances, an apportionment would be appropriate if the plaintiff could fulfill the requirements of subparagraph 20(1)(c)(i) of the Act in respect of the rental property portion. He has been unable to do so.

Issue II - Deduction of Expenses re. "supplies, materials" which are unvouch ered

Section 18 of the Act provides a list of prohibited expenses. To pass the "test of deductibility” per paragraph 18(1)(a), an expense or an outlay must be made or incurred by the taxpayer for the purpose of gaining, producing, or maintaining income from the business or property.

Section 230 of the Act requires taxpayers to keep adequate books and records. "Adequate" is not defined but it would seem that these records should support whatever the taxpayer is claiming for tax purposes.

The onus of proof that the expenses were incurred for the purpose of earning income is on the taxpayer. (Wellington Hotel Holdings Limited v. M.N.R., [1973] C.T.C. 473; 73 D.T.C. 5391). Specifically, with regard to assessments, the onus is on the taxpayer to prove that the Minister’s assumptions and assessments are wrong (Strayer, J. in Schwarz v. The Queen, [1987] 2 C.T.C. 12; 87 D.T.C. 5274) quoting from Johnston v. M.N.R., [1948] S.C.R. 486). The Schwarz case (supra), also involved a situation where the plaintiff's purchases were not supported by vouchers. As Strayer, J. points out, the onus is on the taxpayer to prove wrong the M.N.R.'s reassessment as the taxpayer is in a better position to prove what actually happened.

For the reasons stated above the appeal is dismissed with costs to the defendant.

Appeal dismissed.